Share repurchases, equity issuances, and the optimal design of executive pay

Texas Law Review

Volumn 89, Issue 5, 2011, Pages 1113-1147

  Fried, Jesse M ^a  

^a HARVARD LAW SCHOOL   (United States)

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EID: 79958026722     PISSN: 00404411     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Article

References (133)

1. John E. Core et al., Executive Equity Compensation and Incentives: A Survey, FRBNY ECON. POL'Y REV., Apr. 2003, at 29.
2. See EQUILAR, 2010 CEO PAY STRATEGIES: COMPENSATION AT S&P 500 COMPANIES 11 (2010).
3. See Brian R. Cheffins & Randall S. Thomas, The Globalization (Americanization?) of Executive Pay, 1 BERKELEY BUS. L.J. 233, 246-47 (2004) (describing the increasing use of equitybased pay in Europe and Asia).
4. Michael C. Jensen & Kevin J. Murphy, CEO Incentives-It's Not How Much You Pay, But How, HARV. BUS. REV., May-June 1990, at 138, 139.
5. See, e.g., Jeffrey N. Gordon, "Say on Pay": Cautionary Notes on the U.K. Experience and the Case for Shareholder Opt-In, 46 HARV. J. ON LEGIS. 323, 352 (2009) (reporting that the widespread adoption of stock options in the 1990s resulted, in part, from institutional investor pressure on firms)
6. Jensen & Murphy, supra note 4, at 141 (urging boards to use more stock options to better tie equity pay to performance).
7. See LUCIAN BEBCHUK & JESSE FRIED, PAY WITHOUT PERFORMANCE: THE UNFULFILLED PROMISE OF EXECUTIVE COMPENSATION 176-77 (2004) (describing executives' ability to unwind stock options and restricted shares as soon as they vest).
8. See, e.g., id. at 184 (analyzing problems resulting from the broad freedom of executives to unload equity incentives in the short term).
9. See, e.g., id. at 175 (suggesting that executives be required to hold stock for the long term)
10. Lucian A. Bebchuk & Jesse M. Fried, Paying for Long-Term Performance, 158 U. PA. L. REV. 1915, 1928-36 (2010) (putting forward more detailed recommendations for long-term holding requirements and explaining that executives should be allowed to unwind only a small fraction of their equity each year)
11. Sanjai Bhagat & Roberta Romano, Reforming Executive Compensation: Focusing and Committing to the Long-Term, 26 YALE J. ON REG. 359, 361 (2009) (suggesting that executives be paid only with restricted stock and stock options that cannot be unwound until after retirement).
12. See Jesse M. Fried, Informed Trading and False Signaling with Open Market Repurchases, 93 CALIF. L. REV. 1323, 1331 (2005).
13. Aggregate shareholder value is the net cash flow from the firm to all of the firm's shareholders over time, where net cash flow equals the cash received by shareholders from the firm via dividends and share repurchases less any cash paid by shareholders to the firm for their shares. I use the term aggregate shareholder value rather than shareholder value because shareholder value may be taken to mean the value flowing to the firm's current shareholders.
14. For purposes of this Article, I assume that the firm's current and future shareholders are the only residual claimants to the firm's cash flow and thus that aggregate shareholder value is equivalent to social value. I will thus use the terms "aggregate shareholder value" and "social value" interchangeably. This assumption, made purely for expositional convenience, does not affect the Article's analysis of the distortions caused by tying executives' payoffs to the stock's future value, or the desirability of the constant-share proposal this Article puts forward.
15. Tying pay to the stock's future value also fails to tie executives' payoffs to the value flowing to two other groups of shareholders: (1) shareholders who sell their shares in the market before the executive's cash-out date and (2) the investors who buy these selling shareholders' stock. However, the cash that changes hands when investors buy and sell a firm's shares to each other in the secondary market does not affect aggregate shareholder value-the total amount of value flowing from the firm to shareholders over time. Rather, trading in the secondary market merely redistributes value among different shareholders. Thus, these shareholders' returns can be ignored when analyzing the extent to which equity compensation ties executives' payoffs to aggregate shareholder value.
16. In this Article, I abstract from the question of how much-and what elements of-aggregate shareholder value should be paid to executives. That is, I do not consider here how much equity executives should receive, whether equity pay should take the form of stock or options, or the extent to which the payoffs from these instruments should be designed to filter out changes in the stock price that are due to market-wide or industry-wide fluctuations.
17. Cf. William T. Allen et al., COMMENTARIES AND CASES ON THE LAW OF BUSINESS ORGANIZATION 7 (3d ed. 2009) (urging the use of Kaldor-Hicks efficiency as the criterion for evaluating corporate law and corporate governance arrangements).
18. See Michael C. Jensen, Agency Costs of Overvalued Equity, 34 FIN. MGMT. 5, 16 (2005) (arguing that managers and the board should treat all shareholders-including future shareholders-equally to maximize the firm's long-run economic value).
19. For example, much of an executive's equity is likely to consist of vested stock options and unvested shares and stock options. Measuring the executive's proportional equity ownership would require assigning share-equivalents to these instruments.
20. See Gustavo Grullon & Roni Michaely, Dividends, Share Repurchases, and the Substitution Hypothesis, 57 J. FIN. 1649, 1655 tbl.1 (2002) (reporting annual aggregate earnings of U.S. firms from 1972 through 2000).
21. See generally Douglas J. Skinner, The Evolving Relation Between Earnings, Dividends, and Stock Repurchases, 87 J. FIN. ECON. 582 (2008) (comparing the percentages of firms that pay dividends, firms that repurchase shares, and firms that do both).
22. See id. at 584.
23. See Gustavo Grullon & David L. Ikenberry, What Do We Know About Stock Repurchases?, J. APPLIED CORP. FIN., Spring 2000, at 31, 33-34 (reporting that in the 1990s additional cash flows were channeled into share repurchases instead of dividends); Skinner, supra note 20, at 583 (explaining that in 2005 only 7% of firms paid dividends and did not distribute any cash through repurchases).
24. Press Release, Standard & Poor's, S&P 500 Buybacks Set Record of $589 Billion in 2007 (Apr. 7, 2008), available at http://www2.standardandpoors.com/spf/pdf/index/040708_SP500_BUYBACK_PR.pdf
25. see also Paul A. Griffin & Ning Zhu, Accounting Rules? Stock Buybacks and Stock Options: Additional Evidence, 6 J. CONTEMP. ACCT. & ECON. 1, 1 (2010) (reporting $1 trillion of repurchases market wide in 2007).
26. Jesse M. Fried, Informed Trading and False Signaling with Open Market Repurchases, 93 CALIF. L. REV. 1323, 1335 (2005).
27. Jesse M. Fried, Insider Signaling and Insider Trading with Repurchase Tender Offers, 67 U. CHI. L. REV. 421, 421 (2000).
28. See Monica L. Banyi et al., Errors in Estimating Share Repurchases, 14 J. CORP. FIN. 460, 460 (2008) (reporting that since 1996 open market repurchase programs have accounted for 88% of all announced repurchase programs, and the announced value of these open market repurchases has been over 93% of the total reported value of repurchase programs)
29. Grullon & Ikenberry, supra note 22, at 33-34 & fig.1 (reporting that between 1980 and 1999, open-market programs comprised about 92% of the total repurchase announcements and 91% of the total value of all repurchase announcements).
30. However, for purposes of this Article, the mechanism by which firms repurchase stock is irrelevant.
31. See, e.g., George W. Fenn & Nellie Liang, Corporate Payout Policy and Managerial Stock Incentives, 60 J. FIN. ECON. 45, 48 (2001) (finding a statistically significant positive relationship between repurchases and management stock options, and concluding that management stock options help explain the rise in repurchases at the expense of dividends). Repurchases may also offer shareholders a number of possible advantages over dividends. In many cases, they are a more taxefficient mechanism than dividends for distributing cash. Repurchases (unlike dividends) also may enable firms to acquire shares for increasingly popular stock-option plans or provide liquidity to a firm's selling shareholders.
32. See Fried, supra note 24, at 1336-40 (describing the possible advantages of repurchases over dividends and explaining why many of the advantages are likely to be quite modest).
33. See, e.g., Christine Jolls, Stock Repurchases and Incentive Compensation 1-2 (Nat'l Bureau of Econ. Research, Working Paper No. 6467, 1998), available at http://www.nber.org/papers/w6467.pdf (describing the structure of stock options and exploring how this structure affects management incentives).
34. Id. One could preserve the value of an executive's stock option following a dividend by reducing the exercise price by the amount of the dividend. However, for various reasons such dividend adjustments are uncommon.
35. See Kathleen M. Kahle, When a Buyback Isn't a Buyback: Open Market Repurchases and Employee Options, 63 J. FIN. ECON. 235, 242 n.2 (2002) ("[O]nly 1% of CEOs with options have dividend protection." (citation omitted)). Thus, dividends typically reduce the value of an executive's stock options.
36. Jolls, supra note 29, at 2.
37. Jolls, supra note 31, at 1.
38. Fenn & Liang, supra note 30, at 65.
39. Executives paid with restricted stock will also have an incentive to repurchase shares rather than issue dividends if the executives are not entitled to receive the value of any dividends paid while the restricted stock is vesting. However, most executives compensated with restricted stock appear to be entitled to receive dividends while the stock is still vesting.
40. See Phyllis Plitch, Executives Find Restricted Stock Pays Dividends from the Get-Go, WALL ST. J., Feb. 28, 2005, at C3 (reporting an estimate that 90% of U.S. publicly traded companies award dividends on unvested restricted stock).
41. Fenn & Liang, supra note 30, at 47-48.
42. Fried, supra note 10, at 1344-46.
43. When a firm buys stock at a price below its actual value, the precise distributional effects depend on whether the redeeming shareholders would have otherwise sold their shares to new investors for the same price. If so, the redeeming shareholder cannot be said to "lose" any value as a result of the bargain-price repurchase. Instead, the repurchase deprives would-be new investors of a gain. For simplicity, however, I will assume that it is the redeeming shareholders that lose money as the result of the bargain-price repurchase.
44. I assume that ABC does not issue any dividends (or sell any equity) before Liquidation Date.
45. In the No-Transaction Scenario, all $20 flows to shareholders at Liquidation Date. In the Repurchase Scenario, $8 flows to shareholders during the repurchase and $12 flows to shareholders at Liquidation Date (for a total of $20). Throughout the examples in this Article, I ignore the time value of money (or alternatively, assume it is zero). This assumption, made purely for convenience, does not affect the analysis.
46. Alon Brav et al., Payout Policy in the 21st Century, 77 J. FIN. ECON. 483, 514 (2005).
47. Id. Earlier studies yielded similar responses. When asked in a 1988 survey to name the most important circumstance precipitating a repurchase was, 66% of the surveyed executives responded "low stock price," six times as many as those offering the next most popular answer, "need for treasury stock."
48. George P. Tsetsekos et al., A Survey of Stock Repurchase Motivations and Practices of Major U.S. Corporations, 7 J. APPLIED BUS. RES. 15, 17-18 tbl.2 (1991).
49. See Elias Raad & H.K. Wu, Insider Trading Effects on Stock Returns Around Open-Market Stock Repurchase Announcements: An Empirical Study, 18 J. FIN. RES. 45, 57 (1995).
50. See Murali Jagannathan & Clifford Stephens, Motives for Multiple Open-Market Repurchase Programs, 32 FIN. MGMT. 71, 71-72 (2003).
51. See Guojin Gong, Henock Louis & Amy X. Sun, Earnings Management and Firm Performance Following Open-Market Repurchases, 63 J. FIN. 947, 983 (2008) (reporting that firms adjust accruals to decrease their reported earnings before stock repurchases).
52. Fried, supra note 10, at 1343.
53. Indeed, it is not completely clear under current law whether it is ever illegal for a corporation to buy its own stock in the public markets on inside information.
54. See Mark J. Loewenstein & William K.S. Wang, The Corporation as Insider Trader, 30 DEL. J. CORP. L. 45, 70-72 (2005) (noting that the SEC takes the position that an issuer trading on material inside information would violate Rule 10b-5 but that this position has not been endorsed by any court).
55. Konan Chan et al., Economic Sources of Gain in Stock Repurchases, 39 J. FIN. & QUANT. ANALYSIS 461, 463 (2004)
56. see also Urs Peyer & Theo Vermaelen, The Nature and Persistence of Buyback Anomalies, 22 REV. FIN. STUD. 1693, 1701 (2009) (finding, in a large sample of firms announcing OMRs, a 24.25% cumulative market-adjusted return over 48 months following OMR announcements).
57. Chan et al., supra note 51, at 476.
58. After making a repurchase announcement, which is not binding, executives can choose how much (if any) equity to actually repurchase.
59. See Fried, supra note 10, at 1335 (explaining that firms announcing authorization of open-market repurchases are not required to indicate the number of shares they intend to repurchase or to commit to repurchasing any shares).
60. See Konan Chan et al., Do Managers Time the Market? Evidence from Open-Market Share Repurchases, 31 J. BANKING FIN. 2673, 2676, 2686-88 (2007).
61. For other studies indicating that executives in the United States and elsewhere tend to repurchase stock when it is underpriced
62. See Paul Brockman & Dennis Y. Chung, Managerial Timing and Corporate Liquidity: Evidence from Actual Share Repurchases, 61 J. FIN. ECON. 417, 418 (2001)
63. and Clifford P. Stephens & Michael S. Weisbach, Actual Share Reacquisitions in Open-Market Repurchase Programs, 53 J. FIN. 313, 313 (1998).
64. See David Ikenberry et al., Market Underreaction to Open Market Share Repurchases, 39 J. FIN. ECON. 181, 183 (1995) (discussing delayed market reactions to announcements of important corporate events such as repurchases, mergers, proxy contests, and spinoffs).
65. See, e.g., Harrison Hong & Jeremy C. Stein, A Unified Theory of Underreaction, Momentum Trading, and Overreaction in Asset Markets, 54 J. FIN. 2143, 2143 (1999)
66. Ikenberry, supra note 53, at 183.
67. See Fried, supra note 10, at 1351-56 (developing the argument that executives can use repurchase announcements for false signaling and providing anecdotal accounts of such false signaling)
68. Jesse M. Fried, Open Market Repurchases: Signaling or Managerial Opportunism?, 2 THEORETICAL INQUIRIES IN L. 865, 879-81 (2001) (explaining that executives can use repurchase announcements to boost the stock price before selling their shares). Alternatively, firms may announce a repurchase because they need to repurchase shares for employee stock-option programs.
69. See Konan Chan et al., Share Repurchases as a Potential Tool to Mislead Investors, 16 J. CORP. FIN. 137, 139 (2010) (finding evidence consistent with the notion of executives of poorly performing firms making share repurchase announcements without an intention to repurchase shares).
70. Because of the problem of false signaling, I have suggested that firms be required to disclose not only their intention to repurchase shares but also the exact details of any buy orders given to brokers shortly before the orders are placed.
71. Fried, supra note 10, at 1330.
72. Such a predisclosure rule would increase the accuracy of price adjustments to repurchase announcements and reduce the amount of underpricing when the stock's price is below its actual value.
73. See Ikenberry et al., supra note 55, at 190 (reporting that the average market reaction to OMR announcements for all of the OMRs announced between January 1980 and December 1990 by firms listed on the ASE, NYSE, and NASDAQ was 3.54%).
74. See Peyer & Vermaelen, supra note 51, at 1697 (finding that, in a sample of OMR announcements from 1991-2001, there were average abnormal stock price reactions of 2.39% in the three days around the announcement).
75. See supra note 44 and accompanying text.
76. See Alok Bhargava, Executive Compensation, Share Repurchases, and Investment Expenditures: Econometric Evidence from U.S. Firms (2010) (unpublished manuscript) (on file with author).
77. See Daniel A. Bens et al., Real Investment Implications of Employee Stock Option Exercises, 40 J. ACCT. RES. 359, 359 (2002) (finding evidence that firms that repurchase shares to satisfy option exercises exhibit subsequent poor performance because the repurchases divert cash from productive investments).
78. Stewart C. Myers & Nicholas S. Majluf, Corporate Financing and Investment Decisions when Firms Have Information that Investors Do Not Have, 13 J. FIN. ECON. 187, 187 (1984).
79. See generally id. at 187-220.
80. See Lucian Arye Bebchuk & Jesse M. Fried, The Uneasy Case for the Priority of Secured Claims in Bankruptcy, 105 YALE L.J. 857, 879 (1996) (noting that the difficulty of specifying all possible contingencies is likely to cause covenants to be overinclusive in some respects)
81. Marcel Kahan & David Yermack, Investment Opportunities and the Design of Debt Securities, 14 J.L. ECON. & ORG. 136, 138-40 (1998) (explaining that the potential overinclusiveness of particular covenants may cause the parties to avoid such covenants when their ability to renegotiate these covenants is diminished).
82. In principle, these covenants preventing a value-increasing investment could be renegotiated, with the resulting surplus shared between the lender and the borrower. But such renegotiation is often difficult or costly, particularly when the borrower must simultaneously renegotiate with multiple creditors to obtain the modifications needed to facilitate the new investment.
83. I assume that ABC does not issue any dividends (or sell any equity) before Liquidation Date.
84. In the No-Transaction Scenario, all $20 flows to shareholders at Liquidation Date. In the Repurchase Scenario, $8 flows to shareholders during the repurchase and $11 flows to shareholders at Liquidation Date (for a total of $19).
85. See BEBCHUK & FRIED, supra note 7, at 174-79.
86. See Raad & Wu, supra note 45, at 57 (reporting higher levels of insider stock purchases in the month immediately preceding a share repurchase announcement).
87. Of course, executives whose total pay is tied to firm size may have somewhat less incentive to engage in a costly repurchase, or indeed any kind of repurchase.
88. See Eugene F. Fama & Kenneth R. French, Financing Decisions: Who Issues Stock?, 76 J. FIN. ECON. 549, 550 (2005) (reporting that 86% of publicly traded firms in their sample issued stock after their IPOs between 1993 and 2002).
89. Among the largest 200 firms in 2007, the range of shares allocated to equity compensation plans ranged from 0.92% of outstanding shares to 62.6% of outstanding shares, with the median around 10.5%. PEARL MEYER & PARTNERS, 2008 EQUITY STAKE STUDY: STUDY OF THE TOP 200 CORPORATIONS 2 (2009).
90. See Fama & French, supra note 74, at 573-74 (describing various purposes for stock issuances). These cash-raising issuances may take the form of seasoned equity offerings, private placements, convertible debt, warrants, or rights issues.
91. Id. at 550.
92. See id. at 554 (explaining the tax advantage of using acquirer-firm stock to purchase shares of targets).
93. The issuance of equity for compensation indirectly moves cash into the firm. The firm gives equity to executives and other employees, who eventually sell the equity for cash on the open market to investors. This practice has the same economic effect as a transaction in which the investors buy stock from the firm for cash and the firm then uses the cash to compensate executives and other employees. The issuance of stock to raise cash to pay down debt can also indirectly shift cash into the firm by reducing future interest payments.
94. I assume that ABC does not issue any dividends (or repurchase any equity) before Liquidation Date.
95. In the No-Transaction Scenario, all $20 flows to shareholders at Liquidation Date. In the Equity Issuance Scenario, $13 flows from shareholders during the equity issuance, and $33 flows back to shareholders at Liquidation Date (for a net amount of $20).
96. See, e.g., Tim Loughran & Jay R. Ritter, The New Issues Puzzle, 50 J. FIN. 23, 25, 47 (1995) (examining 3702 seasoned equity offerings between 1970 and 1980 and finding evidence consistent with firms announcing stock issues when the stock is grossly overvalued, the market failing to revalue the stock appropriately, and the stock remaining overvalued when the issue occurs).
97. See Loughran & Ritter, supra note 74, at 23-25 (examining SEO underperformance between 1970 and 1990)
98. see also Jeffrey Pontiff & Artemiza Woodgate, Share Issuance and Cross-sectional Returns, 63 J. FIN. 921, 943-44 (2008) (finding evidence of post-SEO stock underperformance in a more recent sample of U.S. SEOs). For evidence that SEOs are used in other countries to sell stock at an inflated price
99. see Brian J. Henderson et al., World Markets for Raising New Capital, 82 J. FIN. ECON. 63, 66 (2006) (concluding that "firms are more likely to issue equity when the stock market appears to be overvalued").
100. The failure of investors to immediately impart all of the information signaled by these transactions into the stock price is another example of the investor underreaction discussed earlier.
101. See, e.g., Loughran & Ritter, supra note 74, at 47-48 (discussing the market's "misvaluation" of SEOs).
102. See, e.g., Ming Dong et al., Does Investor Misvaluation Drive the Takeover Market?, 61 J. FIN. 725, 757 (2006) (finding that overpriced firms are more likely to try to acquire other firms that are less overpriced)
103. Matthew Rhodes-Kropf et al., Valuation Waves and Merger Activity: The Empirical Evidence, 77 J. FIN. ECON. 561, 600-01 (2005) (concluding that the "vast majority" of mergers involve "highly overvalued bidders")
104. Itzhak Ben-David et al., Are Stock Acquirers Overvalued? Evidence from Short Selling Activity 23-24 (Fisher Coll. of Bus. Working Paper Series, Working Paper No. 2010-03-011, 2010), available at http://www.ssrn.com/abstract=1572686 (determining that short-selling activity is consistent with acquirers using overvalued stock to buy other companies)
105. cf. Matthew Rhodes-Kropf & S. Viswanathan, Market Valuation and Merger Waves, 59 J. FIN. 2685, 2710 (2004) (presenting a model in which acquirers are more likely to use stock when they are overvalued)
106. Andrei Shleifer & Robert W. Vishny, Stock Market Driven Acquisitions, 70 J. FIN. ECON. 295, 300 (2003) (proposing that overvalued firms engage in stockfinanced acquisitions so that the overvalued firms' shareholders can benefit from obtaining hard assets at a discount).
107. See Pavel G. Savor & Qi Lu, Do Stock Mergers Create Value for Acquirers?, 64 J. FIN. 1061, 1063 (2009) (finding that the shares of a sample of stock-financed bidders that completed their acquisitions outperformed a control sample of stock-financed bidders that failed to complete their acquisitions by 25-30% over a three-year horizon, and demonstrating that the outperformance was due to the successful bidders ability to acquire cheap assets)
108. cf. Tim Loughran & Anand M. Vijh, Do Long-Term Shareholders Benefit from Corporate Acquisitions?, 52 J. FIN. 1765, 1775 (1997) (finding that managers of acquiring firms use stock to pay for the acquisitions when their firms' stock is likely to be overvalued and cash when their firms' stock is likely to be undervalued).
109. To the extent the stock is overpriced and insiders can cash out some of their equity immediately, they will have an incentive to unwind this equity even as they seek to boost the value of their remaining shares by having the firm issue overpriced stock.
110. See Daniel Bradley et al., Do Insiders Practice What They Preach? Informed Option Exercises Around Acquisitions 4-5 (Feb. 2009) (unpublished manuscript), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1364787 (finding that, around the announcement of stock-financed acquisitions, insiders of the acquiring firm exercise stock options and sell the underlying shares).
111. See Siew Hong Teoh et al., Earnings Management and the Underperformance of Seasoned Equity Offerings, 50 J. FIN. ECON. 63, 64-65 (1998) (reporting that seasoned equity issuers raise reported earnings by altering discretionary accruals and that this manipulation lowers post-offering returns)
112. cf. Daniel A. Cohen & Paul Zarowin, Accrual-Based and Real Earnings Management Activities Around Seasoned Equity Offerings 4, 10 (June 2008) (unpublished manuscript), available at http://ssrn.com/abstract=108193 (finding use of both accrual-based and real earnings management in a sample of 1,511 SEOs between 1987 and 2006).
113. See, e.g., Merle Erickson & Shiing-wu Wang, Earnings Management by Acquiring Firms in Stock for Stock Mergers, 27 J. ACCT. & ECON. 149, 151 (1999) (finding, in a sample of stockfinanced mergers between 1985 and 1990, that acquirers managed earnings upward before announcing the merger)
114. Henock Louis, Earnings Management and the Market Performance of Acquiring Firms, 74 J. FIN. ECON. 121, 134, 136 tbl.4 (2004) (finding that acquiring firms overstate earnings prior to stock-for-stock acquisitions).
115. See Sara B. Moeller et al., Wealth Destruction on a Massive Scale? A Study of Acquiring-Firm Returns in the Recent Merger Wave, 60 J. FIN. 757, 759 (2005) (finding that decreases in acquirer shareholder value were not due to wealth transfers from acquiring shareholders to target shareholders because the combined value of the acquirer and the target decreased significantly).
116. Id. To the extent that some of the decrease in the acquirer stock price following acquisition announcements is due to the offer signaling that the acquirer is overpriced, not all of this loss in shareholder value necessarily represents a destruction of social value.
117. See Michael C. Jensen, Agency Costs of Overvalued Equity, 34 FIN. MGMT. 5, 10 (2005) (arguing that managers of firms with overpriced stock make poor acquisitions in part to buy assets cheaply).
118. See Tim Arango, How the AOL-Time Warner Merger Went So Wrong, N.Y. TIMES, Jan. 11, 2010, http://www.nytimes.com/2010/01/11/business/media/11merger.html?_r=1 (reporting that the 2000 deal valued the combined firm at $350 billion and that ten years later the combined values of the companies, which have since been separated, was about one-seventh of their combined values on the day of the merger).
119. See Daniel Okrent, Happily Ever After?, TIME, Jan. 24, 2000, at 39, 39 (reporting that the transaction was an all-stock acquisition for about $162 billion of AOL stock).
120. See W. David Garnder, AOL Completes Spin-Off From Time Warner, INFORMATION WEEK (Dec. 10, 2009), http://www.informationweek.com/news/internet/ebusiness/showArticle.jhtml?articleID=222001597.
121. See, e.g., SEC, Registration Statement Under the Securities Act of 1933, at 10 (Form S-3), available at www.sec.gov/about/forms/forms-3.pdf (requiring a stock issuer to furnish the information required by Item 504 of Regulation S-K, namely the "principal purposes for the which the proceeds are to be used").
122. See, e.g., Merritt B. Fox, Civil Liability and Mandatory Disclosure, 109 COLUM. L. REV. 237, 262 & n.65 (2009) (observing that the distribution of proceeds from a new equity sale would signal that the issuer sold the shares simply because it believed the stock was overpriced).
123. See Woojin Kim & Michael S. Weisbach, Motivations for Public Equity Offers: An International Perspective, 87 J. FIN. ECON. 281, 283 (2008) (reporting that equity offerings are done both to raise investment capital and to exploit favorable market conditions)
124. Ming Dong et al., Stock Market Misvaluation and Corporate Investment 4 (Munich Personal RePEc Archive, Paper No. 3109, 2007), available at http://mpra.ub.uni-muenchen.de/3109 (finding that cash raised by overpriced firms issuing equity is used to increase investment).
125. I assume that ABC does not issue any dividends (or repurchase any equity) before Liquidation Date.
126. In the No-Transaction Scenario, all $20 flows to shareholders at Liquidation Date. In the Equity Issuance Scenario, $14 flows from shareholders during the equity issuance and $33 flows back to shareholders at Liquidation Date (for a net amount of $19).
127. Lucian Bebchuk & Yaniv Grinstein, Firm Expansion and CEO Pay 2-3 (Harvard John M. Olin Discussion Paper Series, Discussion Paper No. 533, 2007), available at http://papers.ssrn.com/abstract_id=838245.
128. See supra note 88.
129. Although I assume in the text that CEO sells and purchases shares whenever the firm transacts in its own stock, CEO's adjustments could be effected through the use of derivatives rather than the purchase or sale of actual shares. For example, if the firm issues 1,000,000 new shares, CEO could be required to swap, on the date her holding requirements terminate, (1) the value of 20,000 shares at the issuance price plus interest for (2) the value of 20,0000 shares on that date. Such a mechanism would avoid the need for the CEO to pay cash for additional shares.
130. Moreover, the adjustments required by the constant-share approach need not be made every time the firm transacts in its own stock. Rather, the firm could track its repurchases and equity offerings each year (and CEO's positions on the eve of each of these transactions) and, at year-end, require CEO to engage in a single transaction with the firm that leaves CEO in the same position as if contemporaneous adjustments had been made. The Appendix explains how an ex post adjustment could be effected.
131. Because the firm is repurchasing 20% of its stock, the proportional interest of each remaining shareholder, including CEO, will increase by 25%.
132. Because the firm is issuing an amount of equity equal to 25% of its pre-transaction outstanding shares, the proportional interest of each remaining shareholder, including CEO, will drop by 20%.
133. I am assuming that CEO is risk-neutral. If CEO were risk-averse, she may be deterred from engaging in a value-increasing equity-financed expansion if she is required to buy enough equity to maintain her proportional ownership of the firm. It might thus be desirable to reduce the purchase requirement for a risk-averse executive.