A company's cost of capital is determined by the implied cost of its issued equity, its cost of debt and the ratio of debt to equity within the company's capital base. Because the after tax cost of debt is generally cheaper than that of equity, companies have been seeking methods of reducing their cost of capital by raising greater levels of debt and buying back their shares. In May 1998, the Department of Trade & Industry issued a consultative document on share buy-backs, which discussed the possibility of a change in company law which would enable companies to retain any bought-in shares within their treasury as treasury stock, without their cancellation, with a view to the possible re-issue of such shares at a future date. The ability to re-issue treasury shares quickly and cost- effectively should give companies sufficient flexibility in the management of their capital base to allow them to run, on average, with a higher level of debt/equity gearing and a consequently lower cost of capital. For this reason the Association is supportive of the DTI's initiative on treasury stock. However, it believes that any such proposals should be subject to approval by shareholders as for any other purchases or reissues and should not violate the principle that existing shareholders have pre-emptive rights over the issue of shares by a company in order to avoid involuntary dilution of their investments.
After extensive consultations with the Association of British Insurers and the National Association of Pension Funds, the Association of Corporate Treasurers believes that it is possible for a treasury stock programme to co-exist with the maintenance of the principle of pre-emption rights for shareholders. The protection of pre-emptive rights and the use of treasury stock both have the same objective in the maintenance and possible improvement in the value of the company to its existing shareholders. The Association therefore proposes that the following guidelines be adopted by companies undertaking a treasury stock programme which are supported by the investment committees of the ABI and the NAPF in their adoption.
1. Companies may be able to buy in up to 10% of their issued equity through on- or off- market transactions provided that the price paid for such shares is not at a premium which is greater than 5% above the average mid-point closing price for the shares on the previous five business days. The 10% limit shall apply to both the cumulative quantity of treasury shares held in stock at any time and the cumulative number of shares able to be purchased into treasury stock in any financial year. Not more than 1% of the company's shares may be bought in to treasury stock in any one business day and a notification should be given to the London Stock Exchange on each occasion that the total of treasury shares in stock increases by 1%. Companies wishing to purchase shares into treasury at a rate greater than 1% of issued equity capital in any one day, or at a price premium greater than 5% above the average price for the previous five business days, must first offer to purchase such shares proportionately from shareholders.
2. Companies wishing to re-issue treasury shares may do so without notice provided the shares are sold either on- or off-market at a price which is not lower than a 5% discount to the average mid-point closing price of the last five business days and provided that no more than 1% of the issued equity base is sold on any one business day. Each 1% reduction in treasury shares in stock must be notified to the London Stock Exchange immediately following sale. Because any such re-issue of treasury stock will be an issue of shares for cash, the re-issue will count against the authority for dis-application of pre-emption rights conferred under Section 95 of the Companies Act at a General Meeting of shareholders.
The existing guidelines from the Pre-emption Group, which includes the investment committees of the ABI and NAPF, accept that companies may issue new shares for cash for a total of not more than 5% of the existing issued equity base in any one year and up to 7½% in any rolling three year period. Treasury shares issued for cash will be counted within these guideline limits. However, in order to facilitate the effective management of the treasury stock programme, a company may, at any time, through approval by its shareholders in a General Meeting, re-establish the company's ability to issue up to 5% of new shares for cash without offering such shares to shareholders. It is anticipated that the investment committees of ABI and NAPF would then disregard any shares previously issued non-pre-emptively from treasury stock in determining whether the 7½% rolling three year limit has been reached. The re-establishment of an annual 5% issue-for-cash headroom and the waiver of the cumulative re-issue of treasury shares for purposes of computing the 7½% three year limit will not normally be opposed by institutional shareholders who are members of the ABI and NAPF.
3. When presenting a resolution to shareholders for the dis-application of pre-emption rights on the purchase and re-issue of treasury stock a company's management will be expected to provide the following information:-
The Association intends to work closely with the DTI to enable an early change in company law to ensure that shares may be held by a company without cancellation. After further discussions with the ABI and NAPF investment committees it expects to be able to issue, with them, a jointly produced set of guidelines to companies that intend to introduce a treasury stock programme that incorporates the guidelines outlined above. The Association regards it as essential that the framework within which a treasury stock programme is conducted is well understood by shareholders, managers and institutional investors and it is therefore supportive of detailed guidelines being made available before companies seek approval of their shareholders for any treasury stock programme.
The Association believes that the accounting for treasury shares needs careful consideration. Shareholder value can be created or destroyed by a treasury stock programme and at present no such value creation or destruction would be reported in a company's annual report and accounts.