Frequent Stock Repurchases, False Signaling, and Corporate Governance: Evidence from Korea

• Author: Bong‐Soo Lee,Minji Song,Seung Hun Han
• Published date: 01 November 2014
• DOI: http://doi.org/10.1111/corg.12069
• Date: 01 November 2014

Frequent Stock Repurchases, False Signaling,

and Corporate Governance: Evidence

from Korea

Seung Hun Han, Bong-Soo Lee*, and Minji Song

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: We examine the relation between stock repurchases and their potential false signaling of

undervaluation using unique Korean data.

Research Findings/Insights: We f‌ind that the f‌irms that repurchase stocks frequently are less undervalued and have lower

post-announcement operating performance than f‌irms that repurchase stocks infrequently. We further f‌ind that agency cost

and industry-adjusted Tobin’s Q of frequent repurchase f‌irms negatively affect abnormal returns from the repurchase

announcement. Corporate governance, especially ownership structure and board independence, affects the probability of

frequent signaling.

Theoretical/Academic Implications: Our results suggest that the main motivation for frequent stock repurchases is likely

to be false signaling, and that corporate governance can mitigate false signaling caused by agency cost.

Practitioner/Policy Implications: Frequent stock repurchases are not necessarily motivated by f‌irm undervaluation. Rather,

the degree of agency problems and managers’ abuse of information asymmetry tend to increase the frequency of stock

repurchases. Therefore, frequent stock repurchases are associated with false signaling by managers; this false signaling can

be lowered through better corporate governance. This f‌inding supports the monitoring effect of corporate governance

systems.

Keywords: Corporate Governance, Stock Repurchase, Agency Cost, Ownership Structure

INTRODUCTION

“How often are stock repurchases done to create more value

for stockholders?” This question, posed in the article “The

Pros and Cons of Stock Buybacks”1in The Wall Street Journal

discusses whether f‌irms execute stock repurchases with the

“wrong motivations,” such as to boost stock price or to offset

the dilution of options. The article argues that stock repur-

chases are benef‌icial in the short term following stock repur-

chase announcements, but that heavy buybacks afterwards

usually destroy f‌irm value.

According to the signaling hypothesis, the motivation for

a stock repurchase is to signal undervaluation of a f‌irm to

markets and investors. Dittmar (2000) argues that informa-

tion asymmetry between managers and shareholders can

induce f‌irm undervaluation in the market, and that a stock

repurchase is the process of releasing to the market the

information available only to managers. However, there is

room for managers to misuse information asymmetry.2

Therefore, Wu (2012) argues that poor-quality f‌irms may

pretend to have good quality by sending false signals when

the information cost is low, and Kracher and Johnson (1997)

argue that abusing information asymmetry with unethical

false signals can mislead the market. In a similar vein,

Jagannathan and Stephens (2003) argue that the assumption

that f‌irms send credible signals of undervaluation on a

regular basis in stock repurchase programs is not reason-

able, so they argue that the motivation of f‌irms that fre-

quently repurchase stocks is different from that of f‌irms

that repurchase stocks infrequently. These authors f‌ind that

infrequent repurchases induce stronger stock price reaction

to the repurchase announcement compared to frequent

repurchases. Similarly, Yook (2010) shows that the degree of

undervaluation positively affects abnormal returns from the

stock repurchase announcement and f‌inds that f‌irms with

frequent stock repurchase programs do not show signif‌icant

*Address for correspondence: Bong Soo Lee, Department of Finance, College of

Business, Florida State University, Tallahassee, FL 32306, USA. Tel: 85-644-4713;

E-mail: blee2@cob.fsu.edu

482

Corporate Governance: An International Review, 2014, 22(6): 482–500

© 2014 John Wiley & Sons Ltd

doi:10.1111/corg.12069

long-term abnormal returns. These f‌indings imply that the

intention behind a f‌irm’s frequent stock repurchases is

potentially a false signaling of undervaluation. However,

Jagannathan and Stephens (2003) and Yook (2010) do not

explain any direct motivation for frequent stock repur-

chases. Thus, we hypothesize that frequent stock repur-

chases are potentially an intentional false signaling of

undervaluation,and these signals are due to the agency costs

arising from asymmetric information between shareholders

and managers. We test this hypothesis using a unique stock

repurchase sample from Korea.

There are several benef‌its to using the frequency of stock

repurchases, especially in the Korean market, to test our f‌irst

hypothesis. Previous studies have uncovered the symptoms

of false signaling by using the completion ratio (Baker, Veit,

& Powell, 2011) and earnings quality (Chan, Ikenberry, Lee,

& Wang, 2010). However, in our sample, Korean f‌irms are

required by regulation to complete stock repurchases.

Therefore, the completion ratio is not a proper measure for

detecting false signaling in Korea. Earnings management

may not be a good measure in that it is not necessarily

directly related to the stock repurchase event itself, so the

motivation for earnings management may be interpreted in

many ways (Healy & Wahlen, 1998). Therefore, earnings

management is not unique evidence of false signaling, but a

general indicator of an agency problem. Thus, frequency of

stock repurchases can be a better measure that demonstrates

a more direct relation with stock repurchases in Korea. In

addition, based on Korean regulations, f‌irms must f‌ile their

intention to repurchase stocks for the following categories:

stabilization of stock prices, stabilization of management

rights, preparation or payout of stock options for managers

and employees, f‌inalization or protection from mergers and

acquisitions, activation of stock transactions by increasing

trading volumes, and disposing earnings. Among these cat-

egories, we use only repurchases for the purpose of stabiliz-

ing stock prices, which implies signaling. Thus, for our

sample, there is little room to argue whether the purpose of

a stock repurchase is something other than signaling. For

these reasons, the Korean sample is homogeneous and thus

appropriate to test our hypothesis.

Further, we hypothesize that corporate governance (i.e.,

ownership structure) can mitigate agency problems associ-

ated with potential false signaling in frequent stock repur-

chase programs. Jagannathan and Stephens (2003) f‌ind that

f‌irms with infrequent stock repurchases have lower institu-

tional ownership and higher insider ownership than those

with frequent repurchases. Moreover, Ginglinger and L’her

(2006) suggest that ownership structure as a corporate gov-

ernance indicator is an important factor for the decision to

pursue a stock repurchase and the market valuation of the

stock repurchase. This view is consistent with the literature,

which shows that ownership structure has a signif‌icant

impact on the degree of agency problems (Denis, Denis, &

Sarin, 1997; Ang, Cole, & Lin, 2000; Singh and Davidson III,

2003). False signaling is also a kind of agency problem, but

Ang et al. (2000) suggest that an agency problem can be

reduced when the manager’s ownership is increased. Thus,

we assume that the ownership level of insiders affects

the probability of false signaling, and we examine whether

strong corporate governance can decrease false signaling.

In this context, Korea is suitable for testing our hypothesis

because of its corporate governance reform following the

Asian f‌inancial crisis of 1997. Chaebols feature a high level

of control rights for the major shareholders and high family

ownership; however, because of these features, chaebols

experienced larger drops in f‌irm value during the crisis

(Baek, Kang, and Park, 2004). Thus, when the Korean gov-

ernment implemented corporate governance reform after

the f‌inancial crisis of 1997, chaebol groups were the main

target of the policy. The main content of the reform was to

reinforce minority shareholder rights (Mathews, 1998; Nam

& Nam, 2004). We test whether chaebol groups have signif‌i-

cantly different frequency of stock repurchases compared

to non-chaebol groups. Specif‌ically, we examine whether

chaebol groups with high-level monitoring systems, such as

boards of directors, have relatively better corporate gover-

nance than do non-chaebol f‌irms.

For our robustness check, we examine the relation

between the degree of the agency problem and the fre-

quency of stock repurchases using the asset utilization ratio

(Ang et al., 2000) and the general administrative expenses

ratio (Singh and Davidson III, 2003), because false signaling

is one symptom of the agency problem caused by informa-

tion asymmetry. We count stock repurchase announcements

and divide the sample f‌irms into two groups: frequent and

infrequent stock repurchase groups. If the number of total

stock repurchases by a f‌irm is four or above, four being the

median number for all sample f‌irms, then that f‌irm is

included in the frequent stock repurchase group; otherwise,

it is included in the infrequent stock repurchase group.

In addition, we examine whether both stock repurchase

frequency and ownership may respond to the same

latent common factor. This raises concerns about inferring

causality on the role of corporate governance (especially

ownership), when really what is happening is a spurious

correlation. To address this issue more substantively, we

examine what happens when there are observable gover-

nance changes (e.g., CEO departure, acquisition/sales, or

regulatory change) and see whether repurchase behaviors

and insider ownership are signif‌icantly different after the

governance change. Specif‌ically, we focus not on regulatory

changes but on CEO turnover and mergers and acquisitions

(M&A), because our sample period is in the post-governance

reform period, in which we do not f‌ind any observable regu-

lation changes related to corporate governance.

Our empirical results are as follows. First, we f‌ind that the

industry-adjusted Tobin’sQ of the frequent stock repurchase

f‌irms is higher than that of the infrequent stock repurchase

f‌irms, and frequent stock repurchase f‌irms havelower cumu-

lative abnormal returns (CARs) and lower post-operating

performance. These f‌indings imply that the frequent stock

repurchase f‌irms’ motivation to repurchase stock is not nec-

essarily a positive signalbased on undervaluation of the f‌irm

but potentially a false signal. Second, Tobin’s Q and the

agency costs are inversely related to abnormal returns. This

relation highlights the market values of the stock repurchase

programs associated with undervaluation and low agency

problems. Third, f‌irms with a higher S&GA ratio, which is

sales and general administrative expenses divided by sales,

lower asset utilization ratio, and higher Q are more likely

to repurchase stocks frequently, but insider ownership and

FREQUENT STOCK REPURCHASES 483

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