Pro and cons

The Sydney Morning Herald has a pretty good habit of running commentators from different and conflicting view points, carrying the notion even onto the business sheets. Generally, Alan Kohler tends to be a bit of a market critic. Generally, Stephen Bartholomeusz tends to be a bit of a market apologist. They aren't poles apart, mind you, more like different shades of grey.

This is background to the introduction of this post. You may have read of Kohler's criticism of the share buy-back scheme here in the Stew. Bartholomeusz brags to differ in his commentary today:

DESPITE the ferocious, albeit narrowly based, campaign against them, it appears off-market buybacks are gaining in popularity and effectiveness.

The BHP Billiton buyback that closed yesterday was remarkably successful. Not only did the company get the buyback away at the maximum possible discount - acquiring the shares at $23.45, or the maximum 14 per cent discount to their volume- weighted average price in the five preceding days - but what was supposed to be a $1.5 billion buyback saw a staggering $6 billion of stock tendered. Had it been able to absorb the entire $6 billion of demand, BHP would have acquired about 7 per cent of the capital in the Australian arm of the DLC [dual listed company] structure [it's listed both in Australia and London].

In the latest tender, BHP could self-evidently have acquired a lot more of its shares than it did, and inevitably at a lower price than it did. The constraining factors were conservatism and the Australian Taxation Office. The group's directors wanted to ensure BHP retained enough franking credits to be certain of its ability to fully frank dividends and the Tax Office insists 14 per cent is the maximum discount allowable.

In the past three years there have been about 16 large-scale off-market buybacks. Between them they sought to raise just under $11 billion but attracted about $20 billion of demand. The companies scaled-up the value of their purchases to about $12.6 billion.The average discount to market price has been about 11 per cent.

Those numbers tend to underscore both the popularity of the programs and their primacy as a capital management tool for large companies. The size of the scale backs is increasing and the discount to market is consistently at, or close to, the top of the permitted range.

Much of the criticism of off-market buybacks relates to the view that they distribute an asset, the franking credits, that belongs to all shareholders to the select shareholders with low tax rates, notably superannuation funds and not-for-profit organisations.

There are a number of problems with that view, not the least of which is that none of the major buyback programs has jeopardised the ability of the company to continue to frank its dividends. The credits used are surplus to the companies' planned dividend requirements. Also, given that different investors have different tax rates and that the credits have a different value to them - they have minimal value to foreign shareholders - auctioning them off to the highest bidders is as good as any mechanism for ensuring their value for all shareholders is properly exploited.

The credits could be distributed differently, perhaps through a special dividend, but that isn't necessarily the most efficient way to use them to benefit all shareholders.

One-off measures also don't produce the long-term gains, in the form of the permanent reduction in capital through purchases at significantly below market price, that the off-market buybacks achieve.

The participation in buybacks is also steadily becoming more democratic.

While there may be critics of off-market buybacks, directors can't be criticised for acquiring their own company's shares at a significant discount to the market and supercharging their performance statistics.

In BHP's case, the directors could acquire an asset they should understand intimately - their own shares - at what has turned out to be a $500 million-plus discount to their market value by deploying credits that would otherwise be wasted in the hands of more than half their shareholdings base.

This is a fascinating entreaty for critics of buybacks to think again, given that it does not address one word of justification in contradiction to the basic criticism. The whole critique of the critics is that the scheme is just so nifty to the corporation's capital structure, to the performance packets being paid to its managers, and to the various shareholders of the corporation, each according to his individual tax need.

But the critic never once said those folks weren't benefited by the scheme. Indeed, it is the shameless rorting of the system to effect that end that is troubling. As Alan Kohler put it, the trouble with the scheme is not with the shareholders, rather, "Everyone's a winner - except me. I'm not a ... shareholder, merely a poor schmuck of a 48.5 per cent taxpayer distributing hard-earned cash to the undeserving."

And not once does Bartholomeusz even try to justify the enormous tax rort, which is the basis of Kohler no-brainer criticism:

Last year more than $500 million was lost to Commonwealth revenue through these plainly artificial schemes and this year we're up to $500 million and it's not even the end of February.

It's a bottom-of-the-harbour frenzy, a June-30-gumtree-scheme stampede.

Australian companies, especially miners, banks and wealth managers, are rolling in so much cash they can find nothing better to do with it than invest in themselves at a 14 per cent discount to the market, financed by taxpayers.

And it is this sale by shareholders to the companies at such a massive discount to the market price that should be the tip-off that not everything is on the up and up with the way this scheme is handled. Remember how the buyback works. The company pays a huge 14% discount to market to buy the shares from shareholders, who gladly allow themselves to be fleeced, and then who turn right around and rush the market barricades to buy back, at market prices, all the stock they just sold at a discount to the market price.

Doesn't that just scream madness? Doesn't that tell you that there is something going on here that just defies common sense and rational economic behaviour? If something sounds too good to be true, what do you think the chances of it being true are?

The criticism, which Bartholomeusz glosses over, is that this irrationally arranged scheme benefits a few shareholders and managers at a big expense to the Australian tax purse. It is a huge artifice of financial gerrymandering to enrich certain elements within the same class of shareholders. And if you want to see how quickly it would all dry up, just tax the thing like it should be taxed. As Alan Kohler said,

Why the Tax Commissioner agrees to this blatant scam can only be guessed at. He and his serried ranks of flint-eyed staff mercilessly pursue hapless small businesses with nothing but their nostrils out of the water, and then meekly allow large corporations to "deem" that the consideration for buying back shares is mostly a franked dividend.

Meanwhile the Australian Securities and Investments Commission just as meekly allows the same companies to unequally distribute the same dividends because they are deemed by ASIC not to be dividends.

The Corporations Act clearly demands that dividends are paid out of retained earnings and must be distributed equally to all shareholders. In a buyback they are obviously distributed only to those people who participate. The companies argue that all are equally invited to participate, which is true. But only those on a low tax rate can viably do so because of the 14 per cent discount to the market.

The modern Australian buyback is either a dividend, in which case it is in breach of the Corporations Law, or it is not a dividend, in which case it is a tax rort. Perhaps it is both, and breaches both the tax and corporate law.

Answer that criticism.