Price Ceiling, Market Structure, and Payout Policies

Abstract

We show that frictions in share repurchases provide a unified explanation of two puzzles in the corporate finance and tax literature. The dividend puzzle asks why firms pay dividends even when tax rates on share repurchases are lower, and the share repurchase puzzle asks why share repurchases increase continuously relative to dividends over time even though share repurchases gradually lose their tax advantages. We explain these two puzzles using two share-repurchase frictions: price ceilings and market structure. To prevent issuers from inflating their share prices, SEC rule 10b-18 imposes price ceilings on share repurchases. As issuers cannot repurchase shares on open markets by offering higher prices than other traders, market structure emerges as a first-order effect because it determines execution priority among traders who quote the same price. Decades ago, dealers enjoyed the privilege of trading before issuers at the same price or even trading through issuers when issuers quoted a better price. The dealer priority at price ceilings provides one explanation of the dividend puzzle. We find that major market structure reforms provide one explanation of the share repurchase puzzle, because every reform increased share repurchases for treatment firms relative to matched control firms, first by repelling dealer priority, then by relaxing price ceilings through tick-size reductions, and finally by reducing monitoring costs at price ceilings. The 2016 Tick Size Pilot, a controlled experiment that partially reversed previous reforms, reduced share repurchases in randomly selected treatment firms by 21% relative to control firms.

Keywords: Price Ceiling, Market Structure, Share Repurchase, Dark Pool, Regulation

JEL Classification: G18, G35