treasury shares guide
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Treasury SharesA GUIDE TO THE COMMERCIAL AND TECHNICAL ISSUES
THE ASSOCIATION OF
INVESTMENT TRUST COMPANIES
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Contents
Foreword 5
Executive summary Key potential benefits of treasury shares 8
Key features of treasury shares 9
Issues for board consideration 10
Introduction 12
SECTION ONE
Treasury shares - commercial issues 14
Background 14 Considerations for strategy 14
SECTION TWO
Selling treasury shares at a discount- the principle 25
Introduction 25
Share buy-backs and treasury salesas an overall strategy 26
Conclusion 32
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Selling treasury shares at a discount- the practice 33 Obtaining shareholder approval 33
Communication 36
Who manages the use of treasury shares? 37
Split capital trusts 37
Management/performance fees 37
SECTION THREE
Treasury shares - technical issues 39 Company law 39
The Listing Rules 42
Taxation 42
The Takeover Code and the SubstantialAcquisition Rules 44
Accounting 44
NAV calculations 47
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Something less than a year ago, an individual (clearly falling into the
category of high net worth), approached the AITC to explain why
he, as a potentially significant investor in the sector, had effectively
dismissed it for the foreseeable future.
The background was that he, having done his research, was in a
position to make various substantial investments in a number of
funds run by a particular fund manager that he liked the look of.
He had no strong view on the unit trust versus investment trust
question but, on balance, he was leaning towards investment trusts
on account of the attractive discounts a number of the identified
possible candidates were trading at, one in particular.
[By way of background, this particular trust had bought back shares
in the past in an attempt to narrow its discount, though this process
had been curtailed in more recent times as stock market falls had
begun to have a significant impact on its TER. Indeed, as further
falls happened, its reduced size was even threatening its viability.Arbitrageurs were beginning to circle.]
Being a long-term, committed investor, one unlikely to be a forced
seller, any widening of the discount was not a major concern.
He sat at his screen, the price of the particular trust was right and he
was in a position to deal. The trouble was that, on trying to make his
first investment, he was informed by his broker that he was not able
to satisfy his order at the price quoted on his screen. Not satisfied
with this response, the individual had approached the fund managerto see if there was anything it could do.
The fund manager explained that the trust concerned was a relatively
small trust and that liquidity was an issue given the order size being
placed. During the conversation, the investor mentioned the unit
trusts that he might also be interested in. The fund manager made
it clear that there was no problem satisfying an order of the same
size within the range of unit trusts, that it would be able to arrange
it so that any front end load that smaller retail investors would pay
would be waived and that the deal could be done and dusted within
a matter of days.
Foreword
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The upshot was that, having been frustrated along the way in trying
to deal in investment trusts at what he considered was a fair price,
the investor simply placed the deal with a unit trust instead.
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A model for the future?
One of the most concerning things about the above scenario is that
there are so many losers and so few winners:
the broker loses out because he has not been able to place a deal
on the terms that the client wants to do business. There is the
direct financial impact from losing the commission on the actual
trade itself, but also the risk to an ongoing relationship.
the particular trust concerned loses out on the immediatedemand for its shares, but also on the prospect of having a
long-term committed shareholder on its share register.
the industry as a whole loses out, as the experience of this
individual left him with a view that the investment trust industry
as a whole was simply not for him.
Even the manager could have lost out completely if the individual
had not been interested in any of the unit trusts it managed.
But why should this position change in the future? Indeed, it is a
common complaint from IFAs that they are approached by the AITC
arguing the merits of investment trusts, then approached by
management groups arguing the merits of individual trusts, but
when they come to place deals with anything other than the largest
trusts, problems of this nature crop up. Much the same applies to
private client stockbrokers, some of whom have set minimum levels
of marketability which individual trusts must meet if they are to be
included on their buy lists.
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This problem is likely to get worse as IFA firms, as has been the
case with private client stockbrokers, continue to consolidate.
As the days of the one man band IFA disappear, deal sizes are likely
to increase, making the need to be able to satisfy sizeable demand
quickly, easily and fairly even more important.
It is always possible to point the finger in the above scenario.
The cynics would argue that, from a fund managers perspective,
a deal to buy shares in investment trusts adds nothing to funds under
management. How likely is it that the fund manager bent over
backwards to facilitate this deal, especially when there is an easy
deal to be had with its unit trusts which will add to funds under
management? But the information provided by the manager was
objective and accurate. There simply was no way of satisfying the
investors demand with the tools at its disposal. And you can hardly
blame the manager for satisfying an order from its range of unit
trusts, as the customer had already expressed an interest in these
funds, and no manager in its right mind is going to turn downbusiness when the alternative is that it will do no business at all.
Others would question the role of the client or the broker. If he had
gone to the right person, if he (or the broker) had known how to
play the market better, if he had been properly advised etc, he could
have got round these problems, or kept them within manageable
proportions, and got the shares he wanted.
Maybe this is true. But he didnt and he wasnt.So he couldnt and he didnt.
This paper hopes to show how, amongst other things, treasury
shares could help change this position.
Ian Sayers
Technical Director, AITC
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Key potential benefits of treasury shares
1) Increased control over the investment trusts share capital
structure, arising from the ability to buy back shares temporarily
into treasury for possible sale at a later date (as opposed to
having to cancel them).
2) A reduction in discounts and/or discount volatility as a result of agreater ability to balance supply and demand for a trusts shares.
3) Increased demand from retail investors by enhancing the
attractiveness of Savings and Investment Schemes, ISAs etc.
In particular, the option of satisfying demand from such schemes
more frequently and in smaller lots than is economically possible
by way of purchases in the secondary market.
4) The ability for investment trusts to sell treasury shares without the
imposition of stamp duty.
5) The ability to raise funds for new investment opportunities other
than through gearing or the sale of other investments.
6) Improving liquidity by satisfying demand for shares through the
sale of treasury shares as opposed to purchases in the
secondary market.
7) Managing and optimising gearing levels more efficiently through
changes in the companys capital structure as opposed to otheroptions (e.g. the repayment of debt).
8) Greater NAV enhancement for long-term investors than may be
possible through share buy-backs for cancellation alone.
Executive summary
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Key features of treasury shares
1) Treasury shares will permit an investment trust, having carried
out a share buy-back, to hold up to 10% of its share capital in
treasury. A buy-back into treasury is conducted in the same way
as a buy-back for cancellation.
2) An investment trust can hold treasury shares indefinitely and thenchoose, at a later date, either to cancel them, or sell them for
cash at a price generally no less than 10% below the mid-market
price at the time the sale takes place.
3) Until they are sold, treasury shares carry no voting rights or rights
to dividends. In most respects, they essentially cease to exist.
4) Treasury shares come with pre-emption rights and therefore
trusts wishing to sell treasury shares back onto the marketgenerally (as opposed to all shareholders proportionately on
equal terms) will require shareholders to waive these
pre-emption rights.
5) For most legal, regulatory and accounting purposes, shares
bought back into treasury are treated as if they have been
cancelled, and any sales of treasury shares are treated like a
new issue. Therefore, no tax is payable on any profits arising on
the sale of treasury shares (nor any relief available for losses) and
no stamp duty is payable by investors acquiring treasury shares.
6) The Listing Rules will require full disclosure of transactions in
treasury shares.
7) The use of treasury shares should have no impact on the ability
of an investment trust to obtain approval under s842 and can be
ignored for these purposes.
8) It is intended that investment trusts will be asked to producetreasury NAVs in circumstances when they intend selling treasury
shares at a discount.
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Issues for board consideration
1) The AITC believes that treasury shares should generally not be
considered a new strategy, in isolation to share buy-backs, but as
part and parcel of a broader strategy relating to the control over
the supply of shares to the market.
2) Treasury shares, in conjunction with buy-backs, could be animportant part of strategies aimed at:
Enhancing NAV by selling treasury shares at a premium (page 15)
Reducing discount volatility (page 16)
Enhancing the attractiveness of Savings and Investment Schemes,
ISAs etc. (page 17)
Balancing supply and demand (page 20)
Dealing with other problems associated with the closed-endedstructure (page 20)
Counteracting the problems associated with shrinkage (page 21)
Improving liquidity (page 21)
Managing gearing (page 23)
3) Boards may also wish to consider the possibility of enhancing NAV
by selling treasury shares at a discount, but at a lower discount
than that at which they were bought back (page 25 onwards).Unlike share buy-backs for cancellation (which give rise to a
one-off NAV enhancement), the repeated use of buy-backs and
treasury share sales offers potentially unlimited NAV
enhancement opportunities.
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4) Boards considering selling shares at a discount may wish to
consider whether they should impose further parameters on
treasury shares such as:
Ensuring that buy-backs and sales of treasury shares are NAV
enhancing on the roundtrip (page 34)
Prescribing a life for treasury shares (page 35)
Prescribing a maximum amount of treasury shares that may besold in any one year (page 36)
5) The AITC does not consider that restricting the sale of treasury
shares to times when this would give rise to an absolute profit will
often be appropriate (page 35).
6) Boards should communicate their strategy for their use of
treasury shares clearly to ensure that shareholders agree to waive
their pre-emptions rights (page 36).
7) Boards should establish who will manage what aspects of any
buy-back and treasury share strategy (e.g. the Board, the broker,
the manager) and then ensure that each party is fully aware of
what is expected of them (page 37).
8) The use of treasury shares is likely to be harder for split capital
investment trusts than conventional trusts due to the impact the
sale of one particular class of treasury share could have on the
entitlements of other share classes (page 37).
9) Boards should consider what impact, if any, the use of treasury
shares should have on any management/performance fee
arrangements (page 37).
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On 1 December 2003, company law will, for the first time, permit
companies to buy back their shares and hold them in treasury for
possible future sale. Prior to these changes coming into force,
companies buying back shares have to cancel them immediately.
The process by which these legal changes have been brought about,
in particular in relation to investment trusts, has been a lengthy and
at times a difficult one, most notably when, in December 1999, the
Government announced its decision to press forward with treasury
shares, but decided that investment companies (which most
investment trusts are) should be excluded from the legislation.
As the AITC believes that the use of treasury shares could be a major
benefit for investment trusts and their shareholders, it launched an
intensive campaign to get investment companies included.
This included rallying support from stakeholder groups and engaging
with potential opponents to the measure, as well as making
representations to both the DTI and the Treasury. The campaign took
over two years to be resolved but was ultimately successful.Having now secured the option for investment trusts to use treasury
shares, the industry now has some time to consider how, in practical
terms, they may best be used in shareholders interest. As treasury
shares are a new development, this paper takes the form of a Guide
to Issues, rather than Best Practice Guidance, and seeks to raise
issues that Boards will want to consider before they choose to use
treasury shares.
This guide should be read in conjunction with the earlier Report onShare Buy-backs by ITCs(which forms Appendix 6 of the AITCs
Handbook for Directors of Investment Trusts), as well as the report
Secondary Liquidity in the Investment Trust Sector, published
separately by the AITC in May 2002. These are referred to
subsequently as the Share Buy-backs Report and the Liquidity
Report. Frequent cross-references to these other reports have
therefore been made.
Introduction
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This guide is broken down into three main sections:
Section 1 discusses the commercial benefits, risks and
considerations that may be associated with the use of
treasury shares;
Section 2 discusses the principle and the practical
implications of selling treasury shares at a discount to the
current NAV; and
Section 3 summarises the technical issues relating to
treasury shares (in terms of company law, the Listing Rules,
taxation, the Takeover Code and Substantial Acquisition
Rules, and NAV calculations).
Cross-references have been made between the three sections where
it is considered helpful to the reader.
Conclusion
If the industry grasps the opportunity that treasury shares represent,
the AITC believes that treasury shares could offer significant benefits
to investment trusts and their shareholders, perhaps even more than
was the case when share buy-backs were introduced.
As a trade association, we can suggest many ways in which
treasury shares could be used for the benefit of our Members
shareholders we can also highlight possible issues of concern.
However, ultimately it is up to Boards, considering the specific
circumstances of their own trusts, to make the case for treasury
shares so that shareholders permit them to use them to their fullest
potential and then for Boards, in conjunction with their managers,
brokers and other parties, to deliver on these undertakings.
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Background
What are treasury shares?
Currently, when an investment trust buys back its shares, it must
cancel them (i.e. they cease to exist). The companys share capital,
and funds under management, are therefore permanently reduced.
The treasury shares legislation, when it comes into force on1 December 2003, will permit an investment trust, having carried out
a share buy-back, to hold up to 10% of its share capital (or 10% of a
particular class of shares) in treasury.1
When shares are held in treasury, they effectively go into a state of
limbo. Although they still exist (the registered shareholder being the
company itself) and are shown as issued share capital on the
companys balance sheet2, they do not carry any voting rights,
dividends on them are suspended and they have no entitlements on a
winding-up. Once bought back into treasury, the company can hold
them indefinitely and then choose, at a later date, either to cancel
them, or sell them at a price generally no less than 10% below the
mid-market price at the time the sale takes place3.
It is perhaps worth stressing that treasury shares can only come into
existence after a share buy-back has taken place. It therefore follows
that trusts which have a policy of not buying back shares, and which
maintain this policy in the future, will not be able to make use of
treasury shares.
Considerations for strategy
The issues that treasury shares raise depend upon the purposes for
which they are used. Some reasons for using treasury shares (which
in part build on the suggestions made in respect of share buy-backs
in the Share Buy-backs Report), depending on the individual
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1 See also page 39 for a discussion of the company law position2 See also page 44 for a discussion of the accounting position3 See also page 42 for a discussion of the Listing Rules requirements
SECTION ONE
Treasury shares commercial issues
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circumstances of the trust, are:
a) Enhancing NAV by selling treasury shares at a premium
b) Reducing discount volatility
c) Enhancing the attractiveness of Savings and Investment
Schemes, ISAs etc.
d) Balancing supply and demand
e) Dealing with other problems associated with the closed-
ended structuref) Counteracting problems associated with shrinkage
g) Improving liquidity
h) Managing gearing
The frequent references to the Share Buy-backs Report are not
simply a means to avoid repetition, but reflect the fact that the AITC
believes that the use of treasury shares should not, in most cases,
be seen by trusts as a new strategy, considered in isolation to a
trusts strategy in respect of buy-backs. This is logical, as treasury
shares can only come into existence after a buy-back. Rather, the
use of treasury shares should be viewed as part and parcel of a
broader strategy relating to the benefits of investment trusts having
far greater control over the supply of their shares to the market.
Enhancing NAV by selling treasury shares at a premium4
This is perhaps the most straightforward of the possible strategies,
as few commentators would have any concerns about a trust issuing
shares at a premium to NAV. The usefulness, however, is likely to be
limited by the number of trusts able to sell treasury shares regularly
at a premium. In addition, though there are a number of trusts which
do currently issue shares at a premium, the enhancement of NAV is
often an incidental (and relatively minor) benefit of the share issue
rather than the intention of the share issue (see next section).
Historically discounts have tended to be far more significant in
absolute terms than premiums and therefore the potential for any
NAV enhancement is likely to be more limited. A trust buying back
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4 See also share Buy-backs Report (SSB) page 6, para (c)
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10% of its shares at a 10% discount (which is a relatively modest
discount by historical standards) will enhance NAV by approximately
1%. Issuing 5% of its shares at a 5% premium (quite a high premium
by historical standards) enhances NAV by less than 0.25%.
However, as discussed later, the AITC believes that oppportunities for
NAV enhancement exist even if treasury shares are sold at a discount,
providing they are sold at a discount lower than that at which they
were bought back.
Reducing discount volatility5
Some Boards actively adopt share buy-back and issuance strategies
with a view to keeping the discount within a target range, say from a
3% discount to a 3% premium (though it is rare for a trust to publicly
state this as a policy). In these cases, although shares are only issued
when the trusts shares are standing at a premium, and therefore
will marginally enhance NAV, this is not the main purpose for issuingthe shares.
Such a strategy can be particularly appropriate for tracker trusts
(though these are relatively rare in the investment trust
industry) where it is important for the returns received by
shareholders not to under or outperform the chosen index by too
great an extent. Where share price performance is concerned, the
greater the swings in the discount, the greater the tracking error.
Where NAV performance is concerned, a tracker should (in theory)always underperform its index due to the costs it incurs.
The marginal uplifts in NAV that arise through buying back shares at
a discount and issuing them at a premium could reduce this
underperformance. Such a strategy could also be important for
fund of funds type arrangements, where the prospect of discounts
on top of discounts would exacerbate the problems associated with
discount volatility.
Traditionally, share issuance powers have been limited to 5%
in accordance with guidelines agreed by institutional shareholders.
165 See also SSB page 6, para (b)
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However, there is no legal requirement for the trust to limit the
amount of shares being issued in any one year to 5%. Whether
institutional shareholders will be prepared to permit investment
trusts to use treasury shares to provide even greater flexibility in this
area will, of course, depend on the terms under which the Board
proposes to sell them and how well they can convey the benefits
under the terms proposed.
Enhancing the attractiveness of Savings and Investment Schemes,
ISAs etc.
The creation of wrapper products (such as Savings and Investment
Schemes, ISAs, Investment Trust Personal Pensions etc, referred to
collectively as Savings Schemes) can be an important source of
demand for the shares of investment trusts. By their nature, they are
also extremely important for any investment trust wishing to shift its
shareholder base over the medium to long term from the institutional
to retail. Over the years, management groups have made greatefforts to make such Savings Schemes attractive and easily
accessible, through low minimum contributions levels, low charges
and great flexibility.
However, in spite of the progress made, investors still
sometimes have concerns over the operation of such schemes.
These concerns tend to fall into one of three categories:
they are suspicious of Savings Schemes that deal on fixeddays, even if fairly regularly, on the grounds that the market
will see them coming. Some investors have tracked their
Savings Schemes over many months, years even, and believe
that they can prove this to be the case (though often an
explanation of discrepancies can be explained away by the
fact that the investor is using close of day prices, or mid
market prices, in their analyses).
they believe that management groups who deal in bulk, and
infrequently, do so because it is more convenient for them,
but that this will result in them achieving a worse price than
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if they dealt in smaller and more frequent lots (ignoring the
fact that any additional admin costs that would arise by
dealing in smaller lots would probably result in higher costs
for the Savings Scheme, unless the trust is prepared to
pick this up).
they are upset if the price moves against them in the period between
contributing the money to the Savings Scheme and the day it is
actually invested (forgetting the times when it works in their favour).
They want dealing to be done immediately.
Clearly, some of these concerns may be unfounded (though this does
not mean that they should be ignored altogether) and in some cases
the reality may be precisely the opposite of what the investor
instinctively believes to be the case. As the Liquidity Report
comments, bulked orders may well result in a better stock market
price for the investor6.
There is obviously a balance which needs to be drawn between the
service level that the management group provides (where the
customer wants the highest possible level of service) and the cost of
providing that service (which the customer wants to be as low as pos-
sible). The advantage of treasury shares is that, providing manage-
ment group systems are up to speed, shares could potentially be sold
much more frequently, and in smaller batches, into Savings Schemes
at a price which would more readily be perceived as fair by investors.
1% products
The current Government, rightly or wrongly, has indicated that it
considers costs of 1% per annum to be a benchmark for what
represents fair value for consumers (though it is currently
reconsidering its position on this). CAT Standard equity ISAs and
Stakeholder Pensions come with a cap on charges set at 1% per
annum. The future range of Sandler Stakeholder products, and
Child Trust Fund, are likely to come with similar charge caps.
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6 Liquidity report (LR) pages 27-28(III. Problems encountered by savings plans)
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Currently the presence of investment trusts within such 1% products
is extremely limited.
In reality, there are many other reasons, aside from the charge cap,
which have made it difficult for investment trusts historically to enter
this market. The AITC is currently lobbying to overcome these but,
even for products outside the 1% world, the 1% level may become a
benchmark which Savings Schemes will wish to meet even if they are
not being offered in designated CAT or Stakeholder Products.
One particular problem with such products is that, in determining
whether the 1% cap has been exceeded, stamp duty (currently 0.5%)
must be taken into account. This makes it extremely difficult for
trusts with a TER at or above 0.5% to fall within the 1% cap. The sale
of treasury shares, however, does not attract stamp duty and
therefore this increases the possibility of investment trust shares
being used in such products. Care will have to be taken, however, to
ensure that all buyers of shares are treated fairly. If, for example, aninvestment trust has a supply of 100,000 treasury shares available,
but orders for 110,000 in the Savings Scheme, the question arises as
to whether the stamp free treasury shares should be allocated on a
first come, first served basis (if there are lump sum orders as well
as regular contributions) or whether the benefits of stamp free
purchases should be spread evenly across all purchases in a given
period. Care will also need to be taken to explain the position to
buyers who may feel disconcerted if one month they buy shares with
no stamp duty payable but next month they have to pay it.
It could also be potentially damaging to the reputation of the industry if,
for example, it was subsequently discovered that treasury shares were
habitually used to satisfy demand from major IFAs/private client
stockbrokers but regular monthly Savings Schemes were satisfied
through purchases through the secondary market, or indeed vice versa.
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Balancing supply and demand
Most of the issues relating to this strategy are covered in the Share
Buy-backs Report7. Clearly, a trust which considers that its
shareholder register has an overhang of institutional shareholders
who are largely sellers of their shares, and future demand is likely to
come from retail investors, is likely to concentrate buy-backs on
removing institutional shareholders from the register (whilst still
treating all shareholders fairly) and selling treasury shares
through retail distribution routes (e.g. Savings Schemes, IFAs, private
client stockbrokers).
Dealing with other problems associated with the
closed-ended structure
Again, many of the issues raised concerning the movement from a
rigidly closed-ended structure to a more open-ended one are
discussed in the Share Buy-backs Report8.
Although much is made of the merits of the closed-ended structure
versus the open-ended structure (mostly on the grounds of fund
managers having to sell investments at less than ideal times to meet
redemptions) this is a double-edged sword. Managers of unit trusts
with a steady inflow of funds may be able to acquire an investment
more cheaply by using these additional funds than a closed-ended
fund which may have to sell other investments, thereby incurring
costs, to fund the purchase.
In the venture capital sector, the use of the limited partnership
structure has often been considered preferable not simply due to the
problems associated with the discount, but also due to the ability to
raise funds from, and return funds to, investors more efficiently than
in a closed-ended fund. Treasury shares may help by providing the
managers of closed-ended venture capital funds with a mechanism
which enables them to return funds to shareholders when an
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7 SBB page 7, para (d)8 SBB page 7-8, para (e)
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investment is realised (e.g. through a tender offer) but then to hold
some of the shares in treasury should a new investment opportunity
arise. The benefits to Venture Capital Trusts specifically may be
limited by the fact that one of the major tax benefits that comes with
an issue of new shares (i.e. income tax relief at 20%) is not available
on the sale of treasury shares9.
Counteracting the problems associated with shrinkage
As the Share Buy-backs Report makes clear, some of the advantages
associated with buying back shares at a discount can be reduced, or
even eliminated, by disadvantages in other areas (e.g. higher TERs,
an increase in the effective level of gearing, a reduced commitment
by brokers and other suppliers10 or even the prospect of the
shrinkage creating forced sellers when major shareholders have set
rules regarding the maximum percentage of a company they can
hold, or minimum size requirements for investee companies11).
Clearly, the ability to sell treasury shares could have a beneficialimpact on all these areas.
Improving liquidity
As the case study discussed earlier demonstrates, there is anecdotal
evidence that even private shareholders have been put off the
investment trust sector due to their inability to deal in quantity
within the touch.
Obviously, individual circumstances vary and some larger
management groups comment that liquidity is rarely a major issue
and business that cannot be satisfied via the market can generally be
placed where there is a will. However, the greater the obstacles that
need to be overcome, the greater the chance that business which
should be accommodated by investment trusts simply goes
elsewhere. Telling customers that there are problems which can be
overcome is generally second best to removing the problems in the
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9 See section 3, page 4310 SBB pages 8-9 para (f)11 SBB page 7 para (d)
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first place. There are also concerns that, because a purchase of
shares in the secondary market does not add to funds under
management, there is less incentive for managers to facilitate
such deals.
Some commentators have questioned whether there is a liquidity
problem in the investment trust sector at all. This is an interesting
angle, given how many people on the buy side say there is.
Sometimes it is tempting simply to quote the old adage If people
think there is a problem, there is a problem.
Perhaps the view that there is no liquidity problem stems from the
fact that any issues raised are no different from any other listed
company. Try and place a 1m buy order for a 50m listed
manufacturing company and no doubt much the same problems can
arise. But investment trusts are not conventional operating
businesses, they are not perceived as such and people do not buy
them for the same reasons as other listed companies. Just becauseother listed companies have liquidity problems is no reason for the
investment trust industry not to improve its own position if it can.
Real-time information on bid and offer prices is a relatively recent
development and people naturally believe, if they cannot deal within
these prices, that they have, in some way, lost out. As they say, how
many other markets exist where people may be told that the more
they want to buy of the product, the more they will have to pay per
unit? If, in the case study, the trust had placed previously boughtback shares into treasury, the order could potentially have been
satisfied through the broker or the fund manager within the touch,
with the added advantage that the sale would have increased the size
of the company, thereby alleviating some of the problems that had
arisen due to its shrinking asset base.
How many other successful businesses selling into a retail market,
and seeing sales suffer, adopt the line that the problem lies with the
consumer, or some other party, not with them? Even if this is a
reaction, those that persist with this attitude, and more importantly
let it influence their business strategy, generally do not survive.
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Investment trusts are different. They can be riskier and more
complicated. Few consumers, even wealthy ones, have the skill,
knowledge or desire to get their heads around all the complications.
Rather than tell customers that they can get round these barriers if
they put the extra effort in, a better approach must surely be to
remove as many of these barriers as possible.
One phrase that has been used in the context of treasury shares is
that an investment trust could become its own market maker of last
resort. Such comments have probably served to increase concerns
on the part of the market making community, notwithstanding the
fact that there may be increased opportunities within their broking
arms to match supply and demand for shares. The withdrawal of
three major market makers from the investment trust sector shows
that market making is a commercial business and that market
makers do not consider that they owe the investment trust industry
a living.
If market makers consider that their business in investment trusts is
under threat, then it is possible that they will react by widening
spreads, reducing their capital commitment or withdrawing from
the market altogether. If this happens, many of the benefits of
treasury shares in improving liquidity will turn out to have been
counterproductive. The term of last resort is, of course, relevant.
Suggestions that investment trusts will be able, through the active
use of treasury shares, simply to bypass the market makers
altogether is obviously not true and treasury shares may be used tosatisfy demand when liquidity otherwise is not available. The 10%
limit on shares that can be held in treasury should also act as a
natural limiter on the amount of business that could be done
in this way.
Managing gearing
Typically, trusts gear up and down in response to investment
opportunities, or the lack of them. Gearing is usually changed by
increasing or reducing debt and more rarely by issuing new equity or
making buy-backs. Changing the equity base of the trust is seen as a
major step rather than an operational expedient. Treasury shares23
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could allow the equity base of the trust to be changed as easily,
perhaps more so, as its debt level, which will give greater operational
flexibility in the way managers fund their investments and deal with
cash from disposals.
In particular, the use of treasury shares could make it easier for
trusts to optimise their gearing levels. The recent examples of
problems in the Splits sector demonstrates the difficulties that trusts
can experience if they begin to run close to, or breach, their banking
covenants. However, if such concerns cause Boards and managers
to adopt a lower level of gearing than they believe is warranted on
pure investment grounds, then one of the major advantages of
investment trusts may be underutilised. The ability to sell treasury
shares may help a trust to optimise its gearing level or,
alternatively, provide a more flexible way of reducing gearing at
the appropriate time.
Conclusion
As the above indicates, there are many ways in which the active use
of treasury shares could help improve the attractiveness of the sector.
However, the ability for treasury shares to do so will be extremely
limited if the sale of treasury shares is limited only to those times
when the share price is trading above net asset value per share.
As the question of selling treasury shares at a price below net asset
value per share is perhaps the most controversial issue of all, it is
considered worthy of a separate discussion.
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In the past, Boards have almost universally only issued new shares
when trading at a premium. Some clearly feel that they are obligated
to do so and would be failing in their duties to shareholders if they
were to issue shares at a discount. As the Liquidity Report identified,
views on this issue vary enormously12.
As with all controversial issues, it is easy for interested parties on
either side of the debate to be sucked into entrenched and extreme
positions. The advent of treasury shares should provide an
opportunity to discuss this issue in an open and constructive manner,
recognising that there are valid concerns on the part of those who are
likely to view such a development with suspicion.
To deal with one fairly straightforward point, legally Boards can sell
shares at a discount. Indeed, the Listing Rules specifically provide for
this eventuality where issuing new shares is concerned, simply
requiring shareholder approval before it can happen13. It would be
bizarre if the Listing Rules were to specifically authorise a course of
action which was automatically a breach of directors duties.
Secondly, when people say that it is not acceptable for trusts to sell
treasury shares at a discount, it is tempting to ask them what
discount they are referring to. There are so many different
calculations of NAV (diluted/undiluted, debt at par/market value,
including/excluding income etc) that it is quite possible that some
trusts may have already issued shares at a premium to one measure
of NAV, but at a discount to another.
Nor is it always the case that a purchase of shares at a discount is
NAV enhancing. The Share Buy-back Report refers to the fact that
some trusts buy back shares at discounts as low as 0.2% and issue
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12 LR pages 42-4313 Listing Rule 21.21
SECTION TWO
Selling treasury shares at adiscount the principle
Introduction
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at similar premia14. Without further information, it is impossible to
be categorical but, if this true, then such a buy-back would actually
appear to be NAV diluting rather than enhancing, as stamp duty of
0.5% would be payable on the buy-back.
As indicated previously, trusts adopting such an active strategy are
likely to be trying to hold the discount within a very narrow range
(perhaps a tracker trust or fund of funds wishing to avoid double
discounts). The almost infinitesimal dilution that arises by buying
back shares at a 0.2% discount is almost certainly worth sacrificing
for the benefit of the trust not moving to a wider and more intractable
discount. For a trust trading at around par, the detriment suffered by
shareholders if the shares were to move to a 5% discount hugely
outweighs any marginal dilutions in NAV (which will partly, if not
totally, be recovered if the trust issues shares later at a small
premium). There appears to be some evidence that it is easier to
prevent a trust moving to a wider discount than it is to move a
discount back once it has been established.
Share buy-backs and treasurysales as an overall strategy
Arguments against selling treasury shares at a discount tend
to focus on the sale of treasury shares in isolation. However,
as the example above of a trust buying back shares at a very small
discount (which is effectively dilutive), but recovering some of this
when issuing shares at a small premium indicates, another approach
is for buy-backs and treasury share sales to be considered as two
parts of one overall strategy. Although the AITC believes that NAV
enhancement is only one issue amongst a number that Boards will
want to consider, the benefit of NAV enhancement differs from
some of the other benefits that share buy-backs offer in that it is
demonstrable and certain. It is therefore worth considering any
impact that treasury shares may have on this benefit in some detail.
14 SBB page 7 para (e)
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So, for example, whilst the AITC would generally consider that it
would be difficult, other than in extreme circumstances, for a Board
to justify a buy-back of shares into treasury at a 10% discount and a
sale of these shares at a 15% discount, the position is less clear for a
buy-back at 15% and a sale at 10%. Some commentators would
argue that it would always be correct for the trust to cancel the
shares and take the maximum uplift. In reality, the position will not
always be as clear cut.
The earlier section on the possible problems associated with
shrinkage identifies concerns some Boards have felt that, whilst
attracted to the possibility of buying back shares in an attempt to
narrow discounts and enhancing NAV at the same time, they did not
consider that these benefits outweighed the potential dangers for
shareholders associated with permanently shrinking the asset base.
If a Board is unwilling to buy back shares at a 20% discount due to
such problems, then the full 20% NAV enhancement will be foregone.If, on the other hand, the prospect of being able to sell treasury
shares back out at a 10% discount in the reasonably near future is
sufficient to tip the balance in favour of a buy-back, then it must be
more appropriate to see the buy-back and sale combined as an NAV
enhancement for shareholders which would otherwise have been
foregone. The example below demonstrates that, all things being
equal, a trust that buys back shares into treasury at a 20% discount
and sells at a 10% discount is in a better position than if the buy-back
had never taken place. It also demonstrates that this is true even ifthe treasury shares are sold at a price which is lower than that at
which they were bought back.
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Example15
A trust with 100m of net assets and 50m 1 (nominal) shares in
issue, currently trading at a 20% discount, decides to buy back 10%
of its shares into treasury. It does not consider it would be in
shareholders long-term interests to buy back shares solely for
cancellation but commits to not selling treasury shares back at a
discount greater than that at which they were bought back. A year
later, its assets have fallen by 15% but its discount has narrowed to
10% and it decides to sell all its treasury shares at the prevailing
market price.
Immediately prior to the buy-back, the companys balance sheet,
basic NAV and share price are as follows:
000
Net assets 100,000
Share capital 50,000
Reserves 50,000
100,000
Basic NAV 200.00p
Share price 160.00p
15 This example should be read in conjunction with the comments andanalysis in section three in respect of the accounting presentation of
treasury shares and the calculations of basic and treasury NAVs forstatistical purposes. However, the key issue in terms of the example is thatthe basic NAV will be calculated by reference to the number of shares inissue but excluding any held in treasury.
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The share buy-back will cost the company (ignoring other
associated costs such as brokerage, stamp duty etc) 5m x 160p =
8m. Immediately after the buy-back the companys balance sheet
and basic NAV are as follows:
000
Net assets 92,000
Share capital 50,000
Reserves 42,000
92,000
Basic NAV 204.44p
Immediately before the sale of treasury shares, the companys
balance sheet, basic NAV and share price are as follows:
000
Net assets 78,200
Share capital 50,000
Reserves 28,200
78,200
Basic NAV 173.78p
Share price 156.40p
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The sale of treasury shares will therefore raise 5m x 156.40p =
7.82m. After the sale of treasury shares the companys
balance sheet and basic NAV looks as follows:
000
Net assets 86,020
Share capital 50,000
Reserves 36,020
86,020
Basic NAV 172.04p
Although the sale of treasury shares is, in one sense, dilutive,
if the original buy-back had never taken place, the trusts NAV would
have only moved in line with the growth or fall in net assets, namely
falling by 15% to 170p. In other words, the trusts basic NAV has
increased by 2.04p more through the use of treasury shares than if
the trust had done nothing. The fact that the sale of treasury shares
was conducted at a price lower than that at which the shares were
bought back (ie. a sale at 156.40p as opposed to the price paid on the
buy-back of 160.00p) does not change the analysis.
However, it is possible to go further than simply saying selling at adiscount may help to obtain an NAV enhancement that would
otherwise have to be foregone. It is possible that selling at a discount
might help to create NAV enhancements for long-term investors
which are greater than that which could be achieved through share
buy-backs for cancellation.
In the above example, some commentators might argue that the sale
from treasury should never have taken place, as it has reduced the
NAV from 173.78p to 172.04p. This, of course, ignores the fact that theNAV would, in the circumstances described, never have reached
173.78p if the shares had had to be bought back for cancellation, as
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the board had already decided that it would not be in shareholders'
interest to buy back shares if cancellation was the only option.
However, leaving this aside for the moment, committing to a share
buy-back strategy under which a trust must always maximise its NAV
enhancement (which, in practical terms, for most trusts, is likely to
be the same thing as arguing that all share buy-backs should be for
cancellation) means that any tranche of shares bought back gives
rise to a one-off NAV enhancement. However, with treasury shares,
the possibility exists that any NAV enhancement (albeit a lower one
than could be obtained through cancellation) could be repeated in the
future, perhaps many times over. In other words, a greater one off
NAV enhancement that would arise on a share buy-back for
cancellation could be exceeded by repeated smaller NAV
enhancements through the purchase and sale of treasury shares.
By way of example, and ignoring any movement in the underlying
assets, a buy back for cancellation of 10% of a trusts shares standing
at a 20% discount will enhance the basic NAV by 2.22%. If, on theother hand, the trust buys back the shares into treasury at a 20%
discount, then sells them at a 10% discount, then repeats the process
at the same 20%/10% discount levels, it will enhance NAV by 2.41%.
The counter-argument, of course, is that a trust buying back shares
for cancellation can repeat the process simply by buying back more
and more shares. However, there is a finite number of times this can
be done, and a small/medium sized trust buying back shares for
cancellation regularly in meaningful numbers may well find it hascreated more significant problems for itself than it has resolved.
Treasury shares, in theory at least, are unlimited in terms of how
often, and how much, they can enhance NAV for long-term
shareholders. However, this will only be the case in reality if they can
be sold at a discount.
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The Share Buy-backs Report also emphasises16 that, in any strategy
aimed at discount and/or discount volatility reduction, the trust is
likely to have to commit to buying back shares on a regular basis and
to be prepared to commit to this strategy for some time. Again, if the
only option is to cancel any shares bought back, it may be difficult for
many trusts to make such a commitment.
Conclusion
The above analysis demonstrates that the principle of selling shares
at a discount is not as black and white as it has sometimes been
presented. What is important is not whether, as a mathematical fact,
investment trusts are able to sell treasury shares at a price below the
current NAV, but how they will use these powers and whether they
can demonstrate that this is in shareholders interests.
32
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Selling treasury shares at a
discount the practiceShareholders concerned with the prospect of investment trusts
selling treasury shares at a discount can be reassured by the fact
that they have ultimate power to prevent it happening at all if they
so wish.
Obtaining shareholder approval
Treasury shares come with pre-emption rights (this, along with the10% limit, are the two key protections that company law provides).
This means that, unless shareholder approval is obtained, treasury
shares, when sold, would have to be offered to all shareholders on
equal terms. Clearly, given the suggestions made earlier as to how
treasury shares could be used, the failure of shareholders to waive
their pre-emption rights would be a fatal blow to any meaningful
use of treasury shares.
Shareholders, therefore, have the ultimate say and it would be
dangerous for Boards to assume, given the statements made by
institutional and other shareholders, that they will obtain this
approval if they are not prepared to make any commitment as to how
they will use treasury shares. Investment trusts with substantial
institutional shareholders would therefore be well advised to discuss
their strategy for the use of treasury shares with shareholders in
good time to ensure their approval is forthcoming.
Clearly, one major concern on the part of shareholders will be the
question of how, and to what extent, treasury shares might be soldat a discount. It may therefore be likely that, in order to obtain
shareholder approval to waive their pre-emption rights, Boards will
wish to self-impose further parameters in respect of the sale of
treasury shares over and above those imposed by law and regulation.
Possible parameters that a Board might wish to consider are:
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Ensuring that buy-backs and sales of treasury shares are
NAV enhancing on the roundtrip.
This could involve the Boards undertaking, for example:
to sell treasury shares at a discount lower than the average
discount at which they were bought back (e.g. by calculating
a weighted average discount at the time of each buy-back,
and then selling treasury shares at a lower discount than
this, or recording the individual discount on each buy-back
separately and ensuring that these individual lots of shares
are sold at a lower discount than they were bought
back at); or
to prohibit the buy-back of shares at less than a certain fixed
level of discount and the sale at greater than a fixed level of
discount, perhaps with a clear margin between the two
(e.g. by prohibiting buy-backs at less than a 10% discount andprohibiting sales at greater than a 5% discount).
Of the two types of approach, the former may be more attractive, as a
trust may not wish to publicly state the absolute level of discounts at
which it is likely to be buying and selling its own shares, for fear
of giving too clear a signal to the market. The latter approach might
work better as parameters which Boards instruct brokers and
managers to operate within, and which can be changed from time
to time as the Board sees fit.
Note: although we refer to this approach as being NAV enhancing on
the roundtrip, the AITC would not advise Boards to make an absolute
statement that the use of share buy-backs and sales out of treasury
will always be NAV enhancing. Although it is likely that this would be
true in the above scenarios, Boards should understand the difficulty
of proving this if challenged. Treasury shares have no time limits and
it is possible that some positions could be developing and unwinding
over many years.
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Prescribing a life for treasury shares
There is no legal requirement for a maximum life for treasury shares
(and no obvious reason why there should be). They can, however, be
cancelled at any time. The basis of calculating treasury NAVs17 will
take into account any dilutive impact that the sale of treasury shares
back onto the market may have. In other words, part of any NAV
enhancement will not crystallise for some NAV performance
reporting at the time of the buy-back into treasury. Boards may feel
that if, after 12 months since a buy-back, opportunities have not
arisen to sell treasury shares under the parameters established,
the shares should be cancelled to lock in this NAV enhancement.
Only selling treasury shares at an absolute profit
Although this has been suggested on a number of occasions, the
AITC can see no obvious reason why the price at which treasury
shares can be sold, on its own, should be a determining factor indeciding whether treasury shares should be sold. The example given
on page 28 shows that the sale of treasury shares at a loss can still
be in shareholders interest.
By way of an even more clear cut example, (accepting that this would
be a rare event), a trust has shares with an NAV of 1, trading at 90p,
and decides to buy back 10% of its shares. The NAV of this trust then
falls to 25p, rallies to 50p, and demand for the trusts shares
increases so much that the shares begin to trade at 52p in themarket. Clearly, any sale of treasury shares will be NAV enhancing,
even though each share sold will be making an absolute loss of
38p per share.
For shareholders who stay the full course, the question is not simply
whether the shares have gone up or down in price, but whether the
use of share buy-backs and treasury share sales has put them in a
better position than they would have been otherwise, which is the
case in the above example.
17 Section 3, page 4735
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Prescribing a maximum amount of treasury shares that may be sold
in any one year
Although there is a 10% limit on the amount of treasury shares that
may be held in treasury, there is no limit on the amount of treasury
shares that may be sold in any one year. For example, if the trust has
put in place the normal 15% buy-back authority, it is possible for a
trust to buy back 10% of its shares into treasury, then sell these, then
buy back a further 5% and sell these.
Communication
The Share Buy-backs Report emphasises the importance of
communication in any share buy-back strategy18. The same applies
in respect of treasury shares.
Where institutions are concerned, it is likely that the Pre-emption
Group will wish to consider how their guidelines should change as
a result of the introduction of treasury shares. Even after the
Pre-emption Group has given its views, Boards are likely to wish
to consult with major shareholders to discuss the specifics of their
own strategies.
Where private investors are concerned, it is still the case that much
confusion surrounds the use of buy-backs. Many ask why the
company cannot put the money to better use and it is clear from
such comments that they have not appreciated that, assuming that
the manager has put the best possible portfolio together, a share
buy-back can amount to buying this perfect portfolio at a price
below its current market price. This is one reason why it has been
argued that funds raised through gearing could perhaps be best used
to buy back shares where a trust stands at a reasonable discount19.
18 SBB page 10-12, para 219 SBB page 6, para (c)
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Treasury shares could add to their concerns, simply by virtue
of them being a further complication. If, however, they can be
convinced that treasury shares will only be used in a manner which,
combined with buy-backs, is NAV-enhancing overall, and if they are
assured that the price they will pay (if they acquire treasury shares)
will be no worse than the prevailing market price, and avoid stamp
duty as well, then these concerns may well recede.
Who manages the use of treasury shares?How many brokers to use?
Many of these questions are discussed in the Share Buy-backs
Report20 and apply equally to the use of treasury shares.
Split capital trusts
The use of treasury shares by split capital trusts is complicated by
the fact that any sale of treasury shares to one particular class of
share could have a material impact on the entitlements of other
share classes. However, as much the same issue arises with share
buy-backs, the use of treasury shares by split capital trusts is likely
to be far less common than by conventional trusts.
Management/performance fees
As indicated before, one of the major differences between a sale of
treasury shares to investors and a purchase by investors in the
secondary market is that the sale of treasury shares will increase
funds under management. Both Boards and managements will wish
to consider the implications of the sale of treasury shares on their
management/performance fee arrangements. For example,
if a performance fee is set by reference to NAV performance,
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consideration should be given as to whether this NAV performance
should be calculated in the future by reference to a basic NAV or a
treasury NAV.
The question of who manages the buy-back and treasury sale
strategy is relevant here. If the strategy is in the control of the
manager, shareholders might be concerned if a substantial number
of shares were bought back into treasury at the very end of the
performance fee period, enhancing NAV and thereby generating a
higher performance fee, and these shares were then sold back onto
the market immediately after the end of this period, thereby boosting
funds under management.
On the other hand, if control of the sale of treasury shares is in the
hands of the Board and its brokers, managers with a performance
fee based on NAV total return are likely to be concerned by the
possibility of their outperformance being diluted by the sale of
treasury shares at a discount.
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39
The following is intended as a brief summary of the technical
considerations that are likely to be of most interest to Boards of
investment trusts and is for general guidance only. It is not intended
to be an exhaustive analysis of the relevant legislation and
regulations and Boards should therefore take advice before acting
on anything contained in this guidance. It should also be noted that,
at the time of writing, many of the rules discussed were still in the
process of consultation and therefore may change as a result of
this process.
Rule of thumb
As a general rule, changes to company law and other regulations will
treat shares in treasury as if they had been bought back and
cancelled. So, for example, where current rules impose obligations
on parties (including the company itself) by reference to whether
certain percentage limits of the companys share capital have been
exceeded (e.g. notification of interests), these percentages will infuture be calculated by reference to the companys issued share
capital excluding any shares currently held in treasury.
Company law
The company law regulations come into force on 1 December 2003
and therefore, in theory, an investment trust could buy back shares
into treasury from this day onwards. Realistically, it is likely that the
AGM for December 2003 year end companies will be the earliest
point at which shareholder approval will be sought for the use of
treasury shares, with actual buy-backs into treasury taking place
some time after.
A company can only hold it own shares as treasury shares after it
has acquired them by way of a buy-back (including tender offer).
The legal requirements relating to the process of buying back shares
into treasury are largely identical to that of buying back for
cancellation (e.g. the requirements for distributable profits).
In other words, a company buys back its shares in the normal way
and then either cancels them or holds them in treasury. If the
SECTION THREE
Treasury shares technical issues
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company decides to hold shares in treasury, the companys own
name is entered into the share register. The shares cannot be held
by anyone else (e.g. a nominee or a subsidiary). Keeping track of
how many shares are held in treasury will therefore be a
straightforward matter, a position which will be bolstered by the
disclosure requirements of the Listing Rules21.
A company may only hold shares in treasury if they are listed
on the London Stock Exchange. This should present no problem for
investment trusts, unless exceptionally they have any class of shares
which are not listed. The suspension of a listing of shares does not
affect the ability for them to be held in treasury. However, if a
companys listing is cancelled, then any treasury shares must also
be cancelled immediately.
Maximum holdings
A company may not hold more than 10% of the nominal valueof its share capital in treasury at any time. If the company has more
than one class of share capital, the 10% limit is applied to each share
class separately.
Voting and other rights
All voting rights on treasury shares are suspended. A company
cannot therefore vote its treasury shares on any resolution that the
Board puts to shareholders. Any attempt to do so is treated as void.
In addition, no distributions (including dividends and any distributions
on a winding up) may be made in respect of treasury shares.
Sale of treasury shares
As a general rule, treasury shares may only be sold for cash (or cash
equivalents). So, for example, an investment trust will not be able to
issue treasury shares in return for an in specietransfer of shares into
its portfolio.
21 See page 42
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Proceeds of sale
If the proceeds of the sale of treasury shares are less than or equal
to the price paid for them (the price being the weighted average
price) then the full amount of proceeds is treated as a realised profit.
If the proceeds of the sale of treasury shares are greater than
the price paid for them, the excess is transferred to the share
premium account.
There is no guidance in the regulations as to whether the amount
recognised as a realised profit is revenue or capital in nature.
The identification of revenue and capital profits is of crucial
importance to investment trusts, given the legal provisions that exist
in respect of how such profits may be distributed. However, as the
profit arises in respect of the acquisition and disposal of something
which is, in legal terms, a capital asset (notwithstanding the fact that
the tax regulations and accounting rules will not recognise treasury
shares as assets), it is assumed that this profit should be treated as
capital in nature. This is likely to mirror the treatment on the
buy-back itself, for which capital profits are invariably used.
Pre-emption rights
Treasury shares come with pre-emption rights and therefore, unless
shareholder approval is obtained, treasury shares would have to be
offered to all shareholders on equal terms. Shareholders can choose
to waive their pre-emption rights and it is envisaged that investment
trusts wishing to make use of treasury shares will seek suchapproval, probably within the limitations to be agreed with the
Pre-emption Group.
Notification of interests
In relation to the requirement to notify interests of more than 3% or
more of a companys issued share capital, the relevant percentage is
calculated by reference to the companys issued share capital but
excluding any of these shares which are currently held in treasury.So, if a shareholder holds 1.4m shares in an investment trust with
50m shares in issue, of which 5m are held in treasury, the relevant
percentage is 3.11% (i.e. 1.4m divided by 45m).
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The Listing Rules
Price-sensitive times
As with share buy-backs, the Listing Rules will prevent treasury
shares from being sold at price-sensitive times.
Investment companies already benefit from a potential exemptionfrom the Listing Rules which permit them, in certain circumstances
and with prior approval of the UK Listing Authority, to buy back
shares in close periods. The exemption will be extended to the sale
of treasury shares.
Disclosure
A company will be required to disclose details of all transfers
of shares in and out of treasury, and any cancellation of shares heldin treasury, at the time of the particular transaction. It must also
disclose the number of shares held in treasury following any of these
transactions.
Price
The basic rule is that treasury shares cannot be sold at a discount of
more than 10% to the mid-market price at the time of the sale.
This rule can be disapplied in certain situations (if, for example, anoffer is made to all shareholders on the same terms).
For investment trusts, the issue of the discount at which treasury
shares may be sold is far more likely to be considered by reference to
the NAV than share price.
Taxation
The basic framework of the tax legislation applicable to treasury
shares is that, if a company buys back shares, holds them in treasury
and then sells them at a later date, it will be treated for tax purposes
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as if it had bought back the shares, cancelled them and then made
an issue of new shares. As a result, no taxable profit (or relievable
loss) arises on the sale of treasury shares.
Section 842 considerations
In order to be approved as an investment trust, a company must
satisfy seven conditions on an annual basis. The holding of shares in
treasury, and sale of shares from treasury, would appear only to have
implications for one of the seven conditions, namely that no holding
in a company must represent, on acquisition, more than 15% of the
investment trusts investments. This raises two questions:
does a holding of treasury shares constitute a holding in a
company subject to the 15% limit; and
are treasury shares investments for the purposes of
measuring whether any holding in a company exceeds the15% limit (i.e. part of the denominator)?
The tax legislation provides that, where a company acquires treasury
shares, the shares are not to be treated as the acquisition of an asset
and that shares so acquired are to be treated for tax purposes as if
they had been cancelled. The Inland Revenue have indicated that, as
a result, treasury shares should not be considered a holding in a
company subject to the 15% limit and also should not be considered
as investments for the purposes of measuring whether this limit hasbeen exceeded.
This is administratively the most convenient position and means that,
by and large, the use of treasury shares should have no impact on a
companys status as an investment trust.
Venture Capital Trusts
The 20% income tax relief that is available to private investors on the
issue of new shares in a Venture Capital Trust is not available on the
acquisition of treasury shares.
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The Takeover Code and theSubstantial Acquisition Rules
In line with the rule of thumb set out on page 39, treasury shares
are generally excluded from the calculation of the relevant
percentages under these rules.
Accounting
The accounting treatment for treasury shares is almost certain to be
in line with International Accounting Standards, which treats the
price paid for treasury shares as a deduction from shareholders
funds and does not permit them to be shown as an asset of
the company.
Example 1
A company issues 100m 1 (nominal) shares at 1.50 per share.
After a number of years its balance sheet looks as follows:
000
Net assets 200,000
Share capital 100,000
Share premium 50,000
Reserves 50,000
200,000
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The companys shares have an NAV of 2 per share and its shares are
trading in the market at 1.80 (i.e. a 10% discount) and it decides to
buy back 10% of its shares and hold them in treasury. Ignoring other
costs, this will cost the trust 18m (10,000,000 shares at 1.80 per
share). After the buy-back into treasury, the companys balance
sheet will look as follows:
000
Net assets 182,000
Share capital 100,000
Share premium 50,000
Reserves * 32,000
182,000
* Note : it is not clear at the time of writing whether this net figure would
need to be shown separately as 50m reserves with a debit of 18m for
the purchase of treasury shares.
Where NAV calculations are concerned, it would clearly be
nonsensical for the trust to calculate its basic NAV on the basis of
100m shares in issue (which would give an NAV of 1.82). The NAV
should be calculated on the shares in issue, but not held in treasury(i.e. 90m), giving a basic NAV of 2.02 (see later for a discussion
of the basis of calculation of treasury NAVs).
Example 2
The same facts as above but the trusts assets grow by 50% over the
next few years and the trust begins to trade at a 5% premium.
The trust therefore decides to sell 5% of its issued shares (currently
held in treasury) at the prevailing market price.
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Before the sale the trusts balance sheet would look as follows:
000
Net assets 273,000
Share capital 100,000
Share premium 50,000
Reserves 123,000
273,000
The trusts basic NAV is 3.03 (273m divided by 90m shares in
issue but not held in treasury) and its shares are trading in the
market at 3.18.
The sale would raise 5,000,000 x 3.18 = 15.9m, of which 9m(5,000,000 x the weighted average price paid of 1.80) will be credited
to realised reserves and the balance of 6.9m will be credited to
share premium account.
After the sale, the companys balance sheet would look
as follows:
000
Net assets 288,900
Share capital 100,000
Share premium 56,900
Reserves 132,000
288,900
The trusts basic NAV is now 3.04 (288.9m divided by the 95m
shares in issue and not held in treasury).
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NAV calculations
By way of background, the AITC currently calculates six measures of
NAV for the purposes of its Monthly Information Release (which is
aimed primarily at professional users). Different NAVs are calculated
to include/exclude income and to reflect dilutions that may arise on
the conversion of warrants and convertibles. For the purposes of the
Monthly Information Service (which is aimed more at privateinvestors) the NAV shown will be the lowest of the six NAVs
calculated, as the AITC believes that, if only one NAV is to be
presented, it should be the most conservative. In this section, the
term basic NAV has been used to refer to the NAV which is
calculated on an entirely undiluted basis, and excluding income.
If treasury shares are never to be sold at a discount then, as
demonstrated in the examples above, the only difference between the
calculation of NAVs from that used at present is likely to be that thetotal number of shares used to calculate NAV per share should
exclude any shares held in treasury. If, however, treasury shares are
capable of being sold at a discount, the question arises as to how
NAVs should reflect this fact, if at all.
One option would be for all the NAVs currently calculated to take the
full uplift in NAV on the buy-back and only reflect any dilution on the
sale. The AITC, however, considers that it would be imprudent to
report NAVs on the basis of an uplift in NAV which could (at least in
part) evaporate the very next day. At the same time, it believes that
any dilution should represent a realistic possibility.
In order to meet the basic principle, it is proposed that Members
should be asked to calculate additional treasury NAVs on the
assumption that all treasury shares are sold at the current market
price except as follows:
if the current market price is above the basic NAV per share (i.e. at a
premium), then the treasury shares would be treated as if they weresold at a price equal to the current NAV (in practical terms, the
result of this is that treasury shares could simply be ignored).
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if the Board has set parameters which mean that treasury
shares could not be sold at the current market price, the
shares would be treated as being sold at the minimum price
at which they could be sold (subject to this price not being
above the current NAV).
Examples
A company buys back shares into treasury at a 20% discount to NAV.It has set a policy which means that it will not sell treasury shares at
a price below a 10% discount to the basic NAV at the time of sale.
Current Basic NAV Price at which
Share Price treasury shares
treated as sold for
treasury NAVs
1) 70p 100p 90p
2) 95p 100p 95p
3) 105p 100p 100p
In the above example 1), when the share price is 70p, it is not considered
appropriate for this to be taken as the price at which treasury shares are
treated as sold for NAV purposes, as this would be an unrealistic
estimate of the maximum dilution that could occur, as the trust would
not permit treasury shares to be sold at this price. In example 3), it is
not considered prudent to take an additional NAV enhancement above
that which would arise on cancellation (which is an option any time and
therefore a certainty) until it has actually crystallised.
It is proposed that the AITC Monthly Information Release would present
treasury NAVs in addition to those currently given and that the Monthly
Information Service would continue to show the lowest NAV of these.
The AITCs Statistical Committee is considering the above
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