The United States Court of Appeals for the Fifth Circuit rejected the Securities and Exchange Commission (SEC)’s rule for share repurchase disclosure modernization (“Share Repurchase Disclosure Modernization Rule”) on October 31, 2023, stating that the “[r]esponse to uncertainty about matters of low probability or low magnitude should be markedly different from those of high probability and magnitude.”
The SEC proposed a draft of the share purchase disclosure modernization rule, in December 2021 (“Proposed Rules”), to promote transparency, which in turn enhances efficiency, competition, and capital formation. A key factor that leads to information asymmetry among issuers, insiders, and investors, is the timing of the disclosure. In a share repurchase transaction, since the issuers of the securities are repurchasing their own securities, insiders and affiliated purchasers possess significantly more information about the issuers and their prospects. In contrast, investors only become aware of this information a month or so after the end of the quarter when the issuers’ 10-Q filing is released. To assist unsophisticated investors who lacked access to or the understanding of complex trading information, the SEC proposed that the details of the repurchase activities be disclosed daily. It believed that a daily disclosure of an issuer’s repurchase activities would provide investors with more granular information such as the reasons behind the repurchase. This would enable them to better evaluate the market for the issuer’s securities and the actions of the issuer’s insiders. It also sought alignment with global regulations like those of the U.K. and Hong Kong where issuers must report repurchases to the stock exchange before trading begins the next day.
One key concern regarding opportunistic repurchase activities is management’s interest. Repurchasing shares reduces the denominator for earnings per share, allowing an apparent increase in the issuer’s earnings per share. The management can use it to meet or beat its earnings forecast for the quarter or the year. Furthermore, if the management’s compensation is tied to earnings, the management can use repurchases as a tool to maximize its compensation. Through the disclosures, both the SEC and investors may be able to identify trading patterns and any bad-faith practices.
However, the Share Repurchase Disclosure Modernization Rule, which was finally adopted in May 2023, differed from the Proposed Rules. The SEC backed away from its initial position where it proposed that the trades be disclosed daily. In the Final Rules, the SEC mandated that issuers of securities disclose their aggregate repurchase activities on a daily basis, at the end of each quarter instead of the same day as the trade (“Aggregate Disclosure Regime”).
The Chamber of Commerce protested the Aggregate Disclosure Regime. It believed that the Share Repurchase Disclosure Modernization Rule allows the SEC to micromanage and discourage repurchase activities. It argued that while there may be an increase in transparency pursuant to the disclosures, the rule does not explain how increased transparency will promote efficiency, competition, and capital formation. Further, the Chamber of Commerce by way of its comments on the Proposed Rules commented that the SEC should undertake different quantitative studies to justify the need for these heightened disclosures. It suggested various studies that the SEC could undertake to gauge if there is a need for these heightened disclosure requirements like (i) the percentage of issuers’ annual and long-term incentive plans that is tied to earnings per share and how it correlates with buybacks, (ii) the number of issuers using share repurchases to trigger executive bonuses that would not have been earned, (iii) investors’ reaction to more frequent repurchase disclosure in other jurisdictions, or (iv) the movement of stock prices on days that repurchases are disclosed in jurisdictions with daily reporting. The Chamber of Commerce pleaded before the Fifth Circuit that the SEC had acted arbitrarily and capriciously in formulating the proposed rule since it had not responded to the Chamber of Commerce’s comments on the proposed rule’s economic impact and could not “substantiate the rule’s benefits.”
In its order, the Fifth Circuit exercised its powers under the Administrative Procedure Act (“APA”) and ruled in favor of the Chamber of Commerce. The court held that the agency had not “examine[d] the relevant data and articulate[d] a satisfactory explanation for its action including a rational connection between the facts found and the choice made.” Motor Vehicle Mfrs. Ass’n of U.S., Inc. v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29 (1983). The Fifth Circuit held that “[i]f opportunistic or improperly motivated buybacks are not genuine problems, then there is no rational basis for investors to experience uncertainty [in the event the disclosure is made at a later date].” After all, motivated buybacks may be a matter of “low magnitude and low probability.” Accordingly, it held that the SEC had failed to “substantiate the rule’s benefits.” The Court ordered the agency to correct the “defects,” including the lack of justification for the heightened disclosure, within 30 days.
The purpose of the Proposed Rule, like that of the disclosure standards of some other jurisdictions, is to assist unsophisticated investors who lack access to or the understanding of complex trading information. Therefore, additional quantitative analysis of the proposed rule’s economic impact—demanded by the Chamber of Commerce—is hardly necessary to form a “rational connection” between the disclosure requirements and its concerns. However, the U.S. has been opposed to a continuous disclosure regime, and the Chamber of Commerce’s pushback on additional disclosures is no surprise.
While it remains to be seen whether the SEC will rectify the “defects” by modifying the heightened disclosure or justifying its position, most issuers will likely need to continue preparing their 10-Q filings in accordance with the Share Repurchase Disclosure Modernization Rule, which still applies to Q3 starting on October 1, 2023.