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American Accounting Association

Ben Haimowitz (212-233-6170)

Click Here to read the full text of the article as submitted for presentation
at the American Accounting Association 2011 Annual Meeting.

Corporate stock repurchases are commonly employed specifically to thwart short-sellers, new research reveals

"Maybe it's time for the SEC to crack down on the use of stock buybacks to manipulate markets"

During the past five years, few companies have been more assiduous in repurchasing shares than Netflix, which spent about $1 billion toward that end. Yet, through most of this period, short interest in the stock was quite high, with as much as 40% of the firm's outstanding shares on loan to short-sellers at one point.

Likewise, Sears Holdings has been a major repurchaser of its stock, reducing shares outstanding by more than a third, while short interest in the company's shares ranged as high as 57%.

How to explain this apparent anomaly — major companies' carrying out extensive buybacks, an activity traditionally associated with the belief that a stock is underpriced, in the midst of extensive short-selling, an activity based on the belief that a stock is overpriced?

The answer, according to a new study presented in August at the annual meeting of the American Accounting Association, is that, odd though the association of these activities may seem, repurchasing stock is a common way for companies to thwart short-sellers — that is, investors who trade in a stock in anticipation that its price will fall.

In the words of the study, which the authors believe to be the first to investigate the relationship, "our most important finding is that changes in corporate share repurchases are strongly and positively associated with contemporaneous changes in short interest."

Moreover, the anomaly is not owed either to any superior knowledge on the part of corporate managers or any conviction among them of short-sellers' villainy. Comments Edward P. Swanson of the Mays Business School at Texas A&M University, who carried out the study with doctoral student Harrison Liu, "Managers may act in opposition to short-sellers with the company's money, but, when their own money is at stake, their trades typically are a reflection of short interest; in other words, at the same time that they're buying shares with the company's money, they'll be selling shares on their own account."

In sum: "The dirty little secret that our study uncovers is that corporate managers commonly use company money to fight short-sellers but are perfectly content to trade in concert with them when the money comes out of their own pockets."

From an analysis of tens of thousands of corporate stock repurchases over the seven years 2003 through 2009, Swanson and Liu found that the buybacks were as strongly, or even more strongly, associated with short-selling activity than an array of factors commonly associated with repurchases, such as companies' current stock performance, excessive cash in hand, and level of indebtedness. They estimate that, all else being equal, "quarterly share repurchases [by individual companies] increase by $1,140,000 for each one percent interest in short interest."

The authors see this widespread use of repurchases in opposition to short-selling as suggestive of market manipulation on a large-scale. In their words, "using corporate share repurchases to counteract short sales could constitute price manipulation under the 1933 and 1934 Securities Acts."

Adds Swanson: "SEC rules require repurchasing to take place under conditions that allow the market 'to establish a security's price based on independent market forces without undue influence by the issuer.' Actively trading against short-sellers would seem an obvious attempt to exert undue influence on market price."

And buybacks in response to short interest turn out to be rather effective in buoying prices, at least in the relative short term, the study reveals. Focusing on quarters in which company repurchases and short interest both increase, Swanson and Liu find that, on average, the value of a firm's stock increases by 2.86% one quarter ahead and that the increase is even greater in firms with the most growth in short interest. As the authors put it, "Our analyses indicate that managers do not lose money when they increase corporate share purchases to fight short-sellers."

Is the practice, then, justified as a means of protecting shareholders' investments?

"The fact that repurchases buoy the share price for a quarter does not mean that this is in the longer-term interest of investors, any more than various forms of earnings management are," Prof. Swanson says. "Like earnings management, using buybacks to fight shorts may temporarily benefit current shareholders (although certainly not new purchasers), but, over the long term, like earnings management, it is likely to prove counterproductive."

The professor continues: "Both represent means of manipulating stock prices, but, while earnings management has been studied exhaustively, corporate buybacks' relationship to short interest has hardly been studied at all, at least until now, so its manipulative nature is only now becoming clear. Indeed, the relationship between buybacks and short interest revealed in this study came as something of a surprise to us. We would have been less surprised if we found the relationship to be negative, since it appears to defy logic for companies to be buying shares widely viewed as overpriced; yet, the relationship is not only positive but strongly positive, which suggests to us that the practice is commonplace.

"Further, the association exists above and beyond other factors that can affect repurchases, such as negative stock returns or an abundance of cash or lack of debt, suggesting an activity undertaken specifically in opposition to short-sellers. In the sense that short-sellers make a legitimate — and even important — contribution to the market, this would seem to represent undue market manipulation on a large scale."

In sum: "The SEC is diligent in enforcing rules against the use of earnings management to manipulate markets. Maybe it's time for the SEC to crack down as well on the use of stock buybacks to manipulate markets."

The study, entitled "Do Corporate Managers Trade Against Short-Sellers?" was among hundreds of scholarly presentations at the annual meeting of the American Accounting Association, a worldwide organization devoted to excellence in accounting education, research, and practice. More than 3,000 scholars and practitioners attended the meeting in Denver, Aug. 6-10.



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