Does Corporate Governance Quality Lend Credibility to Open‐Market Share Repurchase Announcements?

• Author: Ruei‐Shian Wu
• Date: 01 September 2012
• Published date: 01 September 2012
• DOI: http://doi.org/10.1111/corg.12003

Does Corporate Governance Quality Lend

Credibility to Open-Market Share Repurchase

Announcements?

Ruei-Shian Wu*

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: Low-quality f‌irms may use share repurchase announcements to send a false or conf‌licting

message regarding f‌irm value to the capital market. This study examines whether f‌irm-level corporate governance mecha-

nisms can alleviate this mimicking behavior by affecting managers’ buyback behavior following open-market share repur-

chase announcements. I further investigate the extent to which differences in corporate governance affect the changes in

insider shareholdings and the degree of information content provided in repurchase announcements.

Research Findings/Insights: Using unique archival data from Taiwan, I f‌ind that the capital market reaction to share

repurchases announced for the purpose of signaling undervaluation is more favorable for f‌irms with quality corporate

governance. The increasing post-repurchase insider shareholdings conf‌irm the credibility of repurchase announcements for

f‌irms with better corporate governance. The buyback outcome subsequent to repurchase announcements is affected by

internal corporate governance mechanisms. Furthermore, external monitoring factors, such as having Big Four accounting

f‌irms as auditors, listing requirements, and regulatory preset buyback price ranges, also determine the execution rate of

repurchase programs.

Theoretical/Academic Implications: The signaling hypothesis, the leading hypothesis on open-market share repurchases,

suggests that low-quality f‌irms may engage in mimicking behavior to send a false signal regarding f‌irm value when the

signal cost is low. This study provides insight regarding the impacts of f‌irm-level corporate governance structures on the

signaling effects of repurchase announcements, the subsequent insider shareholdings, and the completion of repurchase

programs. In addition, this study is the f‌irst to analyze the inf‌luence of corporate governance mechanisms on the degree of

information content in open-market share repurchase announcements.

Practitioner/Policy Implications: This study suggests thathigher quality corporate governance mechanisms lend credibility

to a f‌irm’s open-market share repurchase announcement, which is also noteworthy in assessing the wealth effect of the

repurchase announcements on shareholder value. Moreover, the f‌indings suggest that buyback regulations (e.g., preset

buyback price ceiling and f‌loor) in Taiwan inf‌luence managers’ buyback decisions.

Keywords: Corporate Governance, Agency Theory, Open-Market Share Repurchase, Taiwan

INTRODUCTION

Research shows that open-market share repurchases are

widely used for a variety of purposes, including distri-

bution of excess cash, employee compensation, conversion

of debt to equity, achievement of earnings per share targets,

or signaling undervaluation (Bens, Nagar, Skinner, & Wong,

2003; Brav, Graham, Harvey, & Michaely, 2005; Hribar,

Jenkins, & Johnson, 2006; Jansson & Larsson-Olaison, 2010;

Jensen, 1986). Regulatory bodies often do not require a f‌irm

to disclose (or cannot conf‌irm the truth of) the motivation

behind a share repurchase. The f‌inancial f‌lexibility granted

by regulators surrounding share repurchases drives f‌irms to

increasingly use repurchases, relativeto dividends (Skinner,

2008).

Specif‌ically, share repurchase announcements maybe par-

ticularly appealing as a false signal because current regula-

tions do not require f‌irms to commit to reacquiring a specif‌ic

volume of shares from the market. When a f‌irm uses a share

repurchase announcement to signal undervaluation, the

*Address for correspondence: Ruei-Shian Wu, Yuan Ze University, College of Man-

agement, 135 Yuan-Tung Rd, Chung-Li 32003, Taiwan. Tel: 886-3-463-8800 ext.2195;

Fax: 886 -3-463-3845; E-mail: rswu@saturn.yzu.edu.tw

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Corporate Governance: An International Review, 2012, 20(5): 490–508

© 2012 Blackwell Publishing Ltd

doi:10.1111/corg.12003

intent is to exchange the market value of the f‌irm for its

expected true value (Ikenberry & Vermaelen, 1996; Zhang,

2005), though whether the f‌irm’s market value deviates

from the f‌irm’s true valueover time is unknown. Apart from

the abovementioned f‌lexibility, information asymmetry

between investors and f‌irms allows low-quality f‌irms to

engage in mimicking behaviors that send false or conf‌licting

messages regarding their value to the capital market. The

pooling equilibrium of open-market share repurchase

announcements provides evidence that this mimicking

behavior occurs in the marketplace.

In fact, Stephens and Weisbach (1998) f‌ind that a consid-

erable number of f‌irms buy back very few or no shares over

the subsequent three-year period following a repurchase

announcement. In addition, Chan, Ikenberry, Lee, and Wang

(2010) suggest that repurchase-announcement f‌irms suffer

no reputational penalty when they fail to buy back shares

following a repurchase announcement. However, a share

repurchase announcement is only a temporary cost-free

device that can be used to send a false signal to the market.

As a result of this repeated behavior by low-quality f‌irms,

both the academic community (e.g., Massa, Rehman, & Ver-

maelen, 2007; Stephens & Weisbach, 1998) and the public

media (e.g., Hulbert, 2007; Hylton, 1995; Power, 1995) have

criticized the credibility of the signal quality of repurchases.

The distribution of share repurchase f‌ilings shows that

repurchase announcements increase during times of f‌inan-

cial crisis and economic recession, making it more diff‌icult

for investors to distinguish between high-quality f‌irms that

are signaling undervaluation and low-quality f‌irms that are

merely mimicking undervaluation to support stock prices.

Because strong governance should reduce agency problems

and control the nefarious effects of asymmetric information,

it is expected that f‌irms with strong corporate governance

will buy back more shares from the market following a

repurchase announcement and the f‌irm’s stock price will

ref‌lect an uptick in value, and vice versa.1Taken together,

the purpose of this paper is to investigate the eff‌icacy of

corporate governance mechanisms on open-market share

repurchases on three fronts. First, I examine whether corpo-

rate governance mechanisms affect managers’ buyback

behavior subsequent to open-market share repurchase

announcements. Second, I examine whether corporate gov-

ernance mechanisms affect insider shareholding surround-

ing share repurchase announcements. Last, I examine

whether a wealth effect exists for corporate governance on

repurchase announcements.

I have several motivations for using Taiwanesef‌irm data to

conduct this research. First, corporate governance issues are

an important factor in emerging markets. Stronger mecha-

nisms of corporate governanceyield higher quality informa-

tion. Therefore, share repurchases announced by f‌irms with

better corporate governance mechanisms should possess a

higher level of information content. Moreover, Taiwan is

characterized by high ownership concentration, individual

investors, and weak minority shareholder protection.

According to a report by the Securities and Futures Bureau,

domestic individual investors made up an average of

roughly 75 percent of the trading value in the centralized

market between 2000 and 2008. Such investors experience

higher information asymmetry than institutional investors

do, and require high-quality and reliable information.

Finally, the effect of corporate governance on the market

reaction to the announcement of open-market share repur-

chase in Taiwanese f‌irms should be more pronounced, thus

providing a stronger test of my hypotheses.

Second, most countries, including the United States, do

not require f‌irms to state their intended purposes for

announcing a share repurchase. Because repurchases can

be used for a multiplicity of purposes, management’s true

motivation can be diff‌icult to identify, and thus participants

in the capital markets can f‌ind repurchase information

perplexing to interpret. Likewise, research results cannot

fully exclude the effects of factors outside those associated

with the researchers’ interests. In addition, if repurchase

announcements were misused, the damage could have

compounding harmful effects on an innocent third party,

creating concerns for policy makers. However, Taiwanese

regulations require f‌irms that announce share repurchase

programs to f‌ile a declared purpose. Owing to the suitable

setting provided by Taiwanese f‌irm data, this study provides

direct evidence of market reactions to share repurchase

announcements solely for signaling undervaluation.

Third,research on the context of open-market share repur-

chases has been impeded by the def‌iciency of share repur-

chase data in many countries. In Taiwan, f‌irms are required

to implement their repurchase programs within two months

of announcing the repurchase program, whether or not they

intend to reacquire any or all of their announced volume. In

addition, the f‌irms are required to report the completion of

buybacks within f‌ive days after the termination of the execu-

tion period to the Market Observation Post System, which is

observable by investors.

To address my hypotheses, I f‌irst review the corporate

governance literature and extract 12 governance variables. I

then apply principal component analysis (PCA) to deter-

mine their factors and develop a f‌irm-level corporate gov-

ernance index for Taiwan. I use the variables and factors

to examine the effect of the level of governance on the

execution rate of share repurchases, insider sharehold-

ing changes, and stock returns surrounding repurchase

announcements. These examinations facilitate the under-

standing of the impact of each governance dimension on

managers’ buyback outcomes. Furthermore, I investigate

on which governance dimension the stock market places a

relatively high weight when the market evaluates repur-

chase events. I use the governance index for Taiwan as a

comprehensive proxy of the corporate governance mecha-

nisms to examine the association between governance and

the execution rate of repurchases, changes in insider share-

holdings, as well as stock returns, to obtain an all-inclusive

portrait of the eff‌icacy of corporate governance mecha-

nisms. I f‌ind that managerial decisions related to actual

share buyback are determined by the level of internal cor-

porate governance. Managers also take into account having

Big Four accounting f‌irms as auditors and listing require-

ments, as well as the preset buyback price range when

executing repurchase programs. Moreover, managers of

well-governed f‌irms increase their post-repurchase share-

holdings to time the market, while managers of f‌irms that

are not well governed decrease their post-repurchases

shareholdings to reap the prof‌its. Last but not least, better

CORPORATE GOVERNANCE AND REPURCHASE ANNOUNCEMENTS 491

Volume 20 Number 5 September 2012© 2012 Blackwell Publishing Ltd