Capital Gains Lock-in and Share Repurchases Capital Gains Lock-in and Share Repurchases ABSTRACT Anecdotal

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  • Capital Gains Lock-in and Share Repurchases

    Jonathan B. Cohn McCombs School of Business University of Texas at Austin

    Stephanie A. Sikes The Wharton School

    University of Pennsylvania

    June 23, 2011

    The authors appreciate helpful comments from Andres Almazan, Aydoğan Altı, Daniel Beneish, Sugato Bhattacharyya, Matthew Billett, Andriy Bodnaruk, Brian Bushee, John Core, Dan Dhaliwal, Amy Dittmar, John Graham, Jennifer Juergens, Li Jin, Denys Maslov, Ed Maydew, William Moser, Jeff Pontiff, Jana Raedy, Josh Rauh, Michael Roberts, Cathy Schrand, Doug Shackelford, Clemens Sialm, Laura Starks, Sheridan Titman, Scott Weisbenner, and workshop participants at Boston College, Duke University, Indiana University, University of Maryland, University of North Carolina-Chapel Hill, University of Pennsylvania, Penn State University, Rice University, University of Texas at Austin, and University of Texas at San Antonio; participants at the 2009 Texas Finance Festival, the Texas Tax Readings Group, the University of Arizona tax doctoral seminar, the 2009 American Accounting Association Annual Meeting, the 2009 Southeast Summer Accounting Research Colloquium, the 2009 European Finance Association Meeting, the 2009 Lone Star Finance Symposium, the 2009 Duke/UNC Fall Camp, and the 2011 American Finance Association Meeting. We also thank Denys Maslov for excellent research assistance and Brian Bushee for sharing his institutional investor classifications.

  • Capital Gains Lock-in and Share Repurchases

    ABSTRACT Anecdotal and empirical evidence suggest that price is an important determinant of firms’ share repurchase decisions. We investigate a factor that could affect a firm’s stock price around a repurchase and thus the number of shares a firm repurchases. We predict that tax-sensitive investors’ reluctance to sell stocks for which they have unrealized capital gains reduces the supply of a firm's shares available in the market, and thus raises the price at which the firm can repurchase its shares. Using unique data on the tax-sensitivity of a sample of institutional investors, we find evidence consistent with our prediction. Moreover, as expected, the negative relation between capital gains lock-in and the number of shares repurchased is only present when the supply of a firm’s shares is inelastic.

  • Many factors drive corporate share repurchase decisions. Chief among them is price. A

    recent survey of corporate financial executives finds that a firm’s current stock price is the single

    most important factor in its share repurchase decisions (Brav et al. 2005).1 The price at which a

    company can repurchase its shares is determined by shareholders’ willingness to sell them. If

    shareholders are willing to supply an unlimited quantity of a firm’s shares at a single price that

    reflects the firm’s fundamental value – that is, if the supply of a firm's shares is perfectly-elastic

    – then supply considerations should not impact repurchases. However, there is substantial

    evidence that supply and demand in the market for corporate shares is not perfectly-elastic.2

    This raises an important question: Given the price sensitivity of firms when repurchasing their

    shares, do limits to the supply of a company’s shares cause it to repurchase fewer shares than it

    otherwise would?

    We address this question by examining the effect of a well-documented tax-based constraint

    on the supply of shares. An investor’s gain on a stock is subject to taxation only when the

    investor realizes the gain by selling the stock. This gives taxable investors an incentive to delay

    selling stocks for which they have unrealized gains.3 Consistent with this argument, prior

    studies find that taxable investors refrain from selling shares when they would face large capital

    gains tax bills upon doing so, an effect typically referred to as capital gains “lock-in.”4 This

    withholding of shares with unrealized gains reduces the supply of shares available in the market.

    1 See, for example, Dann (1981), Vermaelen (1981), Bartov (1991), Comment and Jarrell (1991), Ikenberry, Lakonishok and Vermaelen (1995), Stephens and Weisbach (1998), and Dittmar (2000). 2 For evidence that supply of/demand for firms’ shares is inelastic, see Scholes (1972), Shleifer (1986), Holthausen, Leftwich and Mayers (1987), Loderer, Cooney and Drunen (1991), Kandel, Sarig and Wohl (1999), Kaul, Mehrotra and Morck (2000), Kalay, Sade and Wohl (2004), Schultz (2008), and Ahern (2010). 3 Delaying the realization of gains is potentially beneficial because unrealized gains are set to zero upon the death of the investor, because the investor can offset gains with any future capital losses, and because short-term gains are typically taxed at a higher rate than long-term gains. 4 See, for example, Feldstein, Slemrod and Yitzhaki (1980), Landsman and Shackelford (1995), Reese (1998), Klein (2001), Ayers, Lefanowicz and Robinson (2003), Blouin, Hail and Yetman (2009), Ivkovic, Poterba and Weisbenner (2005), Jin (2006), Ayers, Li and Robinson (2008), and Dai et al. (2008).


  • If limits to supply are an important driver of repurchase decisions, then a capital gains lock-in-

    driven supply reduction should have a negative effect on repurchases.

    We test this prediction by examining the relation between a firm's repurchases and the

    unrealized capital gains of its shareholders, and find broadly supportive evidence. We

    conservatively estimate that firms would have repurchased 2.5 percent, or $38 billion, more of

    their shares between 1987 and 2008 absent the lock-in effect. The negative effect of capital

    gains lock-in on repurchases is stronger when the long-term capital gains tax rate is higher (i.e.,

    when selling stocks with unrealized gains exposes investors to greater capital gains tax). This

    not only supports our conclusions, but also suggests that the anticipated increase in the long-term

    capital gains tax rate from 15 percent to 20 percent in 2012 could have a negative effect on the

    tendency of firms to repurchase shares.

    We implement our tests using data on the holdings of a set of institutional investors whose

    sensitivity to taxation we can reliably identify. Specifically, we use unique data on the client

    composition of investment advisers to classify these advisers as tax-sensitive or tax-insensitive,

    depending on the tax-sensitivity of their clients. We classify advisers as tax-sensitive if over 50

    percent of their clients are high net-worth individuals and as tax-insensitive if over 50 percent of

    their clients are individuals with tax-deferred accounts or tax-exempt entities (i.e., pensions, state

    and local governments, and/or charitable organizations).5 Using Section 13(f) quarterly holdings

    data, we estimate each investment adviser’s quarter-end unrealized capital gain in each stock that

    it holds.6

    5 We collect data on clienteles from Form ADV, which all investment advisers registered with the Securities and Exchange Commission (SEC) must file. We describe the data in more detail in Section II. 6 Since investors can offset realized gains in a stock with realized losses on other stocks, we focus on "uncovered" capital gains - unrealized gains that cannot be offset by realizing losses on other stocks in the portfolio.


  • If firms respond to a lock-in-driven supply constraint by repurchasing fewer shares, then tax-

    sensitive investors’ unrealized gains should have a negative effect on share repurchases.

    However, repurchases could be related to investors' unrealized gains for reasons other than the

    effect of capital gains lock-in on the supply of shares. For instance, investors with large

    unrealized gains may have an impetus to sell shares in order to rebalance their portfolios. In

    addition, investors could exhibit the “disposition effect,” defined as the tendency to realize gains

    at a quicker rate than losses (Shefrin and Statman 1985).7 Either of these effects could increase

    the supply of a firm's shares if the shares have appreciated and therefore have a positive effect on

    repurchases. In other words, these effects bias against us finding our predicted negative relation

    between capital gains lock-in and shares repurchases.

    To isolate the capital gains lock-in effect, we exploit the difference in the tax-sensitivity of

    the two groups of investors in our sample. Only tax-sensitive investors should exhibit the lock-in

    effect in their decisions of whether to sell a stock. Consistent with this argument, Jin (2006)

    shows that tax-sensitive institutions are less likely than tax-insensitive institutions to realize

    capital gains using a sample similar to ours. Thus, any effect of unrealized capital gains on

    repurchases due to capital gains lock-in should exist only for unrealized gains of tax-sensitive

    investors, and not for unrealized gains of tax-insensitive investors. Consider a dollar of

    unrealized capital gains in the holdings of an investor in a firm that is considering a stock

    repurchase. If these unrealized gains are in the holdings