Few corporate policies have generated as much controversy in recent years as stock buybacks.  If excessive compensation for senior managers is the most criticized use of corporate funds, stock buybacks may well take second place.

But like most controversial capital allocation decision, the details of stock buybacks are complex and nuanced.

Buyback opponents argue that the practice overwhelmingly benefits top executives.  Conventional wisdom is that buybacks give executives the opportunity to manipulate the stock price and, as some have argued, “create a sugar high for the corporation.”

Proponents of stock buybacks point out that share repurchases give companies the flexibility to return excess cash to shareholders. Moreover, companies may believe its shares are undervalued and are confident in its growth, which would make repurchasing shares a smart move.

Companies have no obligation to complete announced share buybacks, nor do they have to say when they have halted buybacks. They just stop buying shares.

In a share repurchase, a company buys back some of its outstanding shares, typically at a price greater than the going rate for the stock.  The shares are then retired or held as treasury stock.

Although there are several ways for a company to buy back shares, doing so through an open market repurchase program is the most prevalent. There are three other stock repurchase methods. One is a fixed price tender offer where the company offers to repurchase a specified number of shares at a single specified price.

Another method is a Dutch auction, in which the price is set at the end of a tender process rather than at the beginning. The company offers a range of prices set above the current market rate at which it is willing to buy back shares.  Shareholders submit their proposals by stating the lowest price they would accept and the shares they are willing to sell. The Dutch auction tender offer is executed at the lowest price that allows the company to repurchase the shares.

Finally, a company may contact one or more large owners directly and offer to buy back its shares from them. The share purchase price, in this instance, includes a premium.

In the past, companies rarely repurchased shares in the open market because of potential liabilities related to price manipulation.  However, a 1982 SEC rule provides a “safe harbor” for U.S. listed companies to repurchase their shares without being subject to liability for manipulation under the Securities and Exchange Act of 1934. The rule proved to be the catalyst for increasing share repurchase activity in the United States.

Companies buy back stock for many different reasons.  In addition to senior management believing the company’s stock is undervalued, they may have more money than available investment opportunities.  There may also be instances in which managerial compensation incentives such as earning per share may influence the decision to repurchase shares.  Of course, this aspect of share repurchases is rarely mentioned by corporate executives and lends some credence to concerns expressed by opponents of share buybacks.

Lastly, share repurchases may be used to counter a hostile takeover or greenmail threats, where a corporate raider acquires a large stake in the company in the open market and then threatens a takeover. Companies may use share buy backs as a defensive action to reduce the possibility that a potential acquirer would get a controlling interest in the company.

Share buybacks, like any other capital allocation decisions, can be problematic when used to prop up the stock without regard for the value of the company, are poorly timed or serve to increase compensation for company insiders.  All this is in contrast to dividends that are carefully considered, and predictable.  A whole lot of things have to go just right for share buybacks to be done properly.