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Jour nal of F inancial Economics 23 (1989) 7-35. N orth-Ho lland

DE CE NT RAL I Z E D INVE ST M E NT BANKINGTh e C ase of Discount Dividend-Reinves tment

and Stock.Purchase Plans

Myron S. SCH OLE SStanford University Stanford CA 94305 U SA

Mark A. W OLFSO NStanford U Mversity Stanford . CA 94305 US AHarvard Univers ity Boston M A 02163 USA

Received A pril 1989 , final version received July 1989

D isco un t dividend-re iavestm ent and stock-purchase plans allow shareholders to capture part ofthe u nd erw riting fee s incurred in new stock offerings and save sponso ring firms some o f the usualun der wr iting costs. W e tested the degree to w hich individual investor~ can p rofitably serve thisinvestm ent ba nkin g fun ction by implementing simple inves tme nt/tradin g strategies designed tocapture the discounts and distribute the shares in the market. The large profits earned by ourstrategies raise serious questions abou t why it takes firms so long to raise the target level of capitaland why many eligible shareholders do not participate in these discuunt plans.

1. |n t roduct ion

T he idea that in an efficient market investors cannot p rofit from publiclyavailable information is taught in nearly all introductory finance courses.Despite supporting evidence, however, several papers present empiricalanom alies. Fo r example, F rench (1980) and Gibbons and t tess ( 981) dem on-strate that returns are significantly lower on M ond ays than on other days~ By

imp lication, investors wh o plan to alter their stock positions should s ell onFrida y an d buy at the close of M onday's t rading. K eim (1983) f inds thatinvestments in small stocks yield abnormally positive returns during the firstweek in January. By implication, investors could profit if they buy shares ofsma ll stocks jus t before the first of th~ year.

These and other documented anomalies weaken the case for the efficientmarket . (See also the 'Symposium on Some Anomalous Empirical E~denceRe gar ding M arke t Efficiency', 1978.) On the other hand , non e of these papers

*W e h ave benefited from discussions w ith Jer,.zmy Bulo w, Paul He~ ly, Michael Jensen, Rob ertKaplan, Robert Mnookin, Krishna Palepu, Andre Perold, Richard Ruback, and Clifford Smith,the referee.

03 04 -40 5X /89 / 3.5 0 1989, Elsevier Science Publishers B .V. (No rth-Ho lland)

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8 M .S. Scholes and M.A. Wolfson Decentralized investment banking

tes t whether investors can actually profi t from the=e anomalies . We add to thelist of anomalies but with a twist. W~ ~:i~cument not only an apparent prof i topp ortu ni ty but a lso the resul ts f rom invest ing our own money.

Our inves tment s t ra tegy was s imple . We discovered tha t many companies

offered s tockholders the f ight to buy addit ional shares at a discount, typical lyof 5 .263% (or 5 /9 5) f rom ex tant m arke t prices . To qual i fy to buy th is d iscounts tock, one had only to hold a t leas t one share of com pany s tock in cer t if ica teform and s ign up to par t ic ipa te in the d iscount s tock-purchase program. Thenext s tep was to mai l in a check for s tock per iodica l ly. The company thenissued, free of commissions, discount shares that could be sold in the marketwithin a few weeks. W ith an investment of 200,000 we real ized a profit cf

421,000 (consis t ing of 163,800 of net discoun t incom e (the sum of al l grossdisco unts less transaction costs) , 182,600 of return on investme nt due to agenera l increase in s tock pr ices , and 74,600 of abnorm al re turn on inves tm entbeyond the net discount income). This profi t is net of brokerage fees , hedginglosses , and other transaction costs . Ninety percent of our act ivi ty occurredover less than two years .

Fo r exam ple, a J .P. Morg an shareholder could buy up to 5,000 of I .P.M orga n s tock each m onth a t a 5 .263% discount. I f the shareholder couldim m edia tely sel l this s tock at no cost , a sure profi t of 263.16 wou ld result oneach t ransac t ion . We would have preferred J P. Morgan 's sending us a checkfor 263.16 each m outh to our having to ma il in the check, bu y shares , andthen sel l them at a la ter date . In fact , i f we could have avoided the transactioncosts incurred in undertaking these tasks , we would have been sat isfied torece ive somew hat less . I f inves tment i s unde r taken once a m onth a t a d iscountof 5.263%, the compound annual return e~ceeds 85% of the monthly invest-m e n t a m o u n t .

A ltho ug h i t is a useful teaching device, the efficient m arkets hyp othe sis mayleave stu den ts with the false imp ression that inno vation s go unrewarded Infact , successful innovation holds the possibi l i ty of producing both generousfinancial reward for the i~,dividual and s ignificant improvement in socialwelfare . In contem pla t ing the t ransac t ion cos ts and the poss ib le imp act of thediscount , rock-purchase programs on s tock prices , we considered i t quiteposs ib le tha t the profi t oppor tuni t ies were more ap parent than rea l. Al thoughour back-of- the-envelope ca lcula t ions indica ted tha t par t ic ipa t ion in the pro-grams would be prof i table , we thought t ransac t ion cos ts , o ther unant ic ipa tedcos ts , and par t ic ipa t ion by o ther t raders might wel l make abnormal re turnsimpossible . By running our experiment with actual t rades , we were able toprovide d i rec t evidence of our abi l ity to innovate and earn ab norm al re turns inthe market .

Th at we d id profi t han dsom ely suggests that the ma rket is not as effic ient asthe textbook model sugges ts . Moreover, many of the p~grams exis ted forsevera l years before we began our exper iment , and program sponsors rout ine lyinformed shareholders of record of the opportuni t ies toi n v e s t t a discount.

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M .S. Scholes and M .A. Wo tfson Decentralized investment banking 9

Even tua l ly, m any compan ies e limina ted the d i scoun ts on the ir p rogram s a s wewe re jo in ed by o the r a rb i t rageurs w ho he lped the f i rm ra ise subs tant ia l capi ta l .W e v iew o u l p ro f it s a s compensa t ion fo r the p rov i s ion o f inves tmen t bank ingservices to corpora t ions offer ing d iscount s tock-purchase programs, which

delega te the underwri t ing process to shareholders . In re t rospec t , we were pa idtoo much . We and o the rs migh t have p rov ided the s ame se rv ices fo r a muchlower d i scoun t . We do no t know whe the r sponsor ing corpora t ions cou ld haveach ieved the s ame re su l t s a t lower cos t us ing an unde rwr i t e r o r whe the r weea rned abn orm a l p rof it s because o the r inves to rs d id no t jo in us soon enough .Had more inves to rs pa r t i c ipa ted , co rpora te sponsors p robab ly would havereduced the i r d iscounts sooner, reducing our prof i t , and, as a resul t , reducingthe cos ts to o ther shareholders of ra is ing capi ta l .

Ov er t ime , m any corpora t ions rea li zed they cou ld rai se subs tan t i a l amo untswi th th is decentra l ized inves tment banking concept . BankAmerica , for exam-ple , reduced i t s d iscount four t imes in less than two yzars and a l lowedshareholders to inves t much more than $5,000 per month . As a resul t , i t ra isedover $350 mil l ion over th is per iod a t d iscounts averaging wel l be low 4%.

Th e use o f d iscoun t s tock-purchase p lans , and the c lose ly re la ted prac t ice ofa l lowing shareholders to buy s tock a t a d iscount only wi th re inves ted d iv i -dends , ra ises severa l ques t ions . We inquire whether these programs are equi-table to nonpar t ic ipa t ing shareholders and whether they represent an e ff ic ientins t i tu t iona l device for ra is ing capi ta l . We only begin to shed f ight on theanswers to these ques t ions . In conduct ing our exper iment , we d iscovered anu m be r o f in te re s ting fea tu res o f these a r rangemen ts .

In sec t ion 2 , we descr ibe some fea tures of these d iscount p lans , and insec t ion 3 , we lay out de ta i l s of the inves tment s t ra tegies we used to de terminethe cos ts of secur ing the d iscounts . In sec t ion 4 , we t :ompare d iscounts tock-purchase p lans wi th convent iona l ur iderwri t ings as means of ra is ingcapi ta l . Concluding remarks appear in sec t ion 5 .

2 Ch arac te r i s t ic s o f d i scoun t p rogramsDiv idend- re inves tmen t and s tock-purchase p lans have been popu la r, e spe -

c ia l ly among publ ic u t i l i t ies , for two decades . We ident i f ied 82 companiesoffer ing d iscount s tock-purchase p lans a t se ine point be tween 1984 and 1988.Cash d iscount p lans a re concentra ted in banking and f inancia l se~wices ,al thou~:: public ut i l i t ies , real es tate f irms, and a few manufacturers are alsorepresen ted .

2 1 Ind us try concentrationFable 1 reveals that 74 of the 82 plans we identif ied were concentrated in

three |ndus t r ies : banking (45) , rea l es ta te , inc luding rea l es ta te inves tment

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10 M S Scholes and M A Wolfson~ Decentralized investment banking

Table 1

D is t r ib u t io n b y in d u s t ry o f cash in v es tm en t in co m m o n s to ck s p u rch ased a t a d i sco u a t t h ro u g hstock-purcha.se plans (1984-1988).

N u m b ei o f f irm s

Real Range o fes ta te investment To ta l

o r per f i rm investmentCateg ory '~ Bank R EIT Ut i l i ty Other To ta l ( 000) ( 00~)

I 21 4 9 4 38 0

II 8 5 1 0 14 02 1 2 0 5 > 0 - 61 3 0 1 5 > 6 - 502 0 1 2 5 > 50 -100a 2 0 I 7 > 100 -1503 0 0 0 3 > 150 -2001 0 1 0 2 > 200 -3003 0 0 0 3 > 300 -400

24 11 5 4 44

I + I I 45 15 14 8 82

III 14 5 2 4 25

00

24182371899573530

10303609

3585

To ta l i n v es tm em b y in d u s t ry :B a n kN o n b a n k :

Real es ta teUt i l i tyO t h e r

360335322

2592

1017

Total 3609

a Categ ory I : f i rms in which we d id n o t become shareho lders o f record and thus were inel ig ib leto par t ic ipate in d iscoun t p rograms.

Category I I : f i rms in which we d id become shareho lders o f record , a l though , as the tab lereveals , we chose to invest th rough the d iscoun t p rograms o f on ly 30 o f these 44 f i rms.

Category Il l : al l but the first two rows of Category II f irms.

trusts (15), an d public utilities (14). Of ou r 3.6 million in inve stm ents, 2.6mill ion was invested in banks, and the res t was spli t re lat ively equally amongreal estate firms, public utilities, and other firms. Banks' prominence in theseprograms may reflect experimentat ion with an al ternative inst i tut ional ar-rangement for rais ing capital in the face of regulatory pressure. We exploreother motivations in sect ion 4.

2 2 Inv estm ent cei lings and discounts

All f irms ' discount programs fimit the al lowable investment. The l imitsprevent certain shareholders , such as inst i tut ional and corporate investors ,

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M .S. Scholes and M . ~. W olfson Decentrafized investment banking 13

Table 3

Fr equency d i s t r i bu t i on o f m ax i m um annua l c a sh i nves t m en t am oun t pe r m i t t ed pe r a ccoun t f o rthe 57 5% discount program s for which da ta a re ava i lab le (1984-1988) .

Rang e o f annu a l i nves t m en t , IMon t h l y Qua r t e r l y Annua l

p r og r am s p r og r am s p r og ram 3 To ta lI < 10,000 9 1 10

10,000 < I < 20,000 4 10 1420,000 < I < 25,000 1 20 I 2225,00 0 _< I < 50,000 1 150,000 < I < 100,000 6 2 8

I > 100,000 1 1 2

12 43 2 57~ . . _ : ~ _ ._

2 3 Ca lculating the actu al discount receivedTh e p r ice pa id for shares pmch ased a t a d i scount i s based on an average of

market pr ices observed over anywhere f rom one to twenty t rading days, (Seetable 4 . ) The mo st com mo n averaging per iods a re one day and f ive days .

In pr ivate conversat ions, corporate t reasurers and investor re lat ions admin-is t ra tors for some plan sponsors said they based the sales pr ice on an averageof p r ices ov er a num ber of days to minimize the effect of shor t sales op, sharepr ice . M an y inves tors in d i scount programs ap parent ly lock in sure re turns bysel l ing shares shor t o n the investm ent date . Fi rs t Chicago, for exam ple, a ltered

i ts pr ic ing formula, for precisely this reason, f rom one based on the pr icesolely on the investment date to one based on a f ive-day average of high andlow prices. 2

Besides varying in length of the averaging per iod, plans vary along threeother dimensions that are re levant to calculat ing discounts . Fi rs t , there is thequest ion of which pr ices are used: las t t raded, dai ly high and low, or c losingbid a nd ask. M ore than 40 of the f irms use las t t raded pr ice. A s imilarnumber use an average of dai ly highs and lows. One in s ix f i rms use theaverage of closing bid and ask pr ices .

Secon d, the averaging per iod var ies . In 60 of the plans it ends on the dayof investment and in the rest on the day before. Third, the date by whichinvestment funds must reach the plan adrn~nis t rator var ies . Many f i rms permitfunds to be tendered wel l beyond the point a t which the averaging per iod fordetermining price ,~egins.

3 Historical development of the investment program

W he the r a 5 discount is a generous induce m ent to shareholder: ; to play theunderwri t ing role depends on the costs of par t ic ipat ing in the plan. These

2It is possible, however, to sel l short on each of the f ive days preceding the purchase date.

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14 M.S. Scholes and M.A. Wolfson Decentral ized investment baizking

Table 4

Form ulae to determine purchase p r ice o f shares and t iming of paym eat requ irements .

N u m b e r o fdays p r icesfactored in

Nu m ber of f irms using: Averaging period Adv ance

Last Average Average ends on day: paym enttraded high and closing bid Of Preceding requiremen tprice low price ask prices investment investme nt ( in days)

1 0 1

15 120 1

2

1 x

1

1

21

235

xx 1x 2x 5

x1

x 4 b

x 5 3 5

1 x

1 2

D 2

X 1

2 5

2X 5

2 - -2c 5

X 2dXX 10

X > 10eX 4 fX 1x ~

a On e of these f irms expressed wiJlingness to relax the ten-day a dvance -paym ent requirem ent.b The adva nce-p aym ent requirement varies mo nth ~o mo nth, averaging four days.' :One firm initially used closing bid prices. It later changed to the average of bid and ask prices,

effect ively reducing the discount by one-half of the bid-ask spread.d This f irm required advance paym ent at least ten business days preceding the investn~e~t date.

However, funds were refundable up to 48 hours prior to the investment, so the effect iveadv anc e-pa ym ent requirement is two days. This is importa nt in determ ining the effect ive discount ,since the investm ent can be avoided if prices decl ine durin~ ,he averaging period.

CAdvaace-payment requirement varies with the d:vidend-record and dividend-payment dates.fThe advance-payment requirement varies month to month, averaging four days, Despite the

f i f teen-day averag ing , the advance-payment requ i rement was waived by phone one month whenthe price had r isen substantial ly, making the discount approximately 10~.

gThe advance-paym ent requ i rement var ies month to month , ave ra~ng four days . The averag ingperio d is the averag e closing price for the entire montl~ preced ing the investme nt.

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M .S. Scho les an d M.A. Wo lfson D ecentralized investment banking i5

include the costs of becoming informed about the plan's details, the cost ofbearing or avoiding undesired market risks, the cest of monitoring the invest-ment, the transaction costs incurred in the secondary market, and the cost ofcomplying with margin requirements and tax laws. Because we faced so many

uncertainties in implementing our investment strategies, we felt that simulat-ing or otherwise estimating our costs using exogenously determined parame-ters would be too unreliable. As a consequence, we document here some ofthese costs from actual experience.

In August 1984, we obtained a prospectus for J.P. Morgan 's discountprogram offering the opportun ity to invest up to 5,000 per month per accountat a discount of 570 (actually 5/95 or 5.26370) from market prices. Tblsappeared to be so generaus thal: we wondered why money didn' t simply pourin, reaching the capital target almost immediately.

We decided to find out first hand what some of the costs to reap the'underwrit ing' discounts must beo 3 Since we knew there were other discountprograms as well, we decided to participate modestly in a number of them todocument their differences.

Our initial sources of data for discount programs were Standard and Foor'sCumulative Dioidendswhich included a table entitled 'NYSE and ASECompanies Offering Dividend Reinvestment Plans' (pp. 162-163 in the 1984volume), and a M oney Magazinearticle entitled 'No Brokerage Fees, andDiscounts Too ' (Jordan E. Good'nan, October 1983, pp. 171-172). We tele-phoned or wrote to the admini:.trators of some of the identified plar~:s forgeneral information and prospectuses.

In September 1984, we purchased a single share in each of ten companiesthrough a Merrill Lynch Sh~rebuilder acec, unt (maximum commission rate of1070 of the purchase price). The investment totaled less than 400, and ourcommission was 33.06. Single shares in an additional fifteen companies werepurchased in .early October at a cost of roughly 300. Since virtually allprograms require that participants be shareholders of record, we instructedMerrill Lynch to transfer shares out in one of our names.

It took three to six weeks for our stock certificates and the sign-up forms forthe discount programs to arrive. Eventually, we learned that investment couldbegin as soon as the plan administrators recognized us as shareholders ofrecord in their computers. This cut the delay from the purchase of initialqualifying shares to investment in discou~,t shares to about two weeks.

On November 1, we made our first discount investments: 3,000 in HospitalCorpora tion of America (we could have invested 12,500) and 4,000 in

3This is a corollary of the Fama proposi t ion. This proposi t ion results from the apocJ 'yphal taleof the t ime Eugene Fama, Professor o f F inance a t the Univers i ty o f Chicago and one of the

fathers of 'eff icient market theory ' , was out strol l ing with a colleague. On being told that he hadjust walked past a twenty-dollar bi l l that was lying on the sidewalk, Fama immediately replied:'N on sen se If there were a twenty-do llar bi l l ly ing there, i t would already have been picked up."

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16 M.S. Scholes and M .A. Wolfson D ecentralized investment banking

Ban kers T rus t ( the ce il ing was 5 ,000). L ater tha t mon th , we mad e our f ir s tin v es tmen t in s ,wen o th e r co mp an ies an d o u r seco n d in v es tmen t in HCA an dBan kers Trus t . Our to ta l inves tment in No vem ber was 47 ,500 .

Unless the investor requests a cert i f icate for shares purchased, the sponsors

re ta in the shares ' fo r safekeep ing and conven~eace '. Some prog ram adm in is t ra-tors wil l sel l shares on request and mail a check for the proceeds, less acom miss ion . W e occas ional ly used th is serv ice , bu t w e found that w e cou ldsecu re b e t t e r co mmiss io n s th ro u g h o u r o wn b ro k er, an d we b e l i ev ed o u rbroker cou ld secure bet ter execu t ion o f t rades as wel l , par t icu lar ly wi th l imi to rders . In any even t, we typ ica l ly reques ted tha t a cer t i fica te fo r ' a l l who leshares purchased wi th the enclosed inves tment ' be mai led ou t .

In ear ly December, we received o~r f i r s t cer t i f ica tes fo r shares purchasedth ro u g h th e d i sco u n t p ro g rams . In th e mean t ime , we h ad n eg o t i a t ed v e ryfavorab le commiss ion ra tes wi th a San Fr,aacisco b roker. We prompt ly so ldour shares as cer t i f ica tes were received and deposi ted the net p roceeds in ourb a n k acco u n t . T h e cy c le h ad b een co mp le ted , an d th e h id d en cas t s weex p ec ted to en co u n te r n ev er emerg ed . We were n o w read y to p ro ceed to th enext stage of ~he investment strategy.

D ur in g De cem ber, we inves ted an add i t ional 55 ,900 in var ious p rograms.In add i t ion , we purchased mul t ip le shares in the p rograms that appeared toopera te smooth ly. F inal ly, we began to search fo r add i t ional d iscoun t p ro -grams. We consu l ted the Apr i l 1984Directory of Companies Offering DividendReinoestment Planswhich l i s ted names and addresses o f companies tha tadm in is ter the i r own p lans and p lans fo r o thers . 4

In January 1985 , we began making inves tments in d iscoun t p rograms inbatches . With two adu l ts and two ch i ld ren in each househo ld , our batch s izewas typ ica l ly e igh t : e igh t checks and e igh t inves tment s tubs ind ica t ing ourin ten t to inves t and our des i re to have cer t i f ica tes fo r shares mai led ou t . Thechecks were mai led in e igh t company-supp l ied postage-paid f i r s t -c lass en-velopes o r sen t by overn igh t mai l in a s ing le envelope a t our expense .

We used overn igh t mai l to ensure tha t the p lan admin is t ra to r received thefund s on the requ isi te da te , 5 as well as to take ad van tage o f the averag ing ru lesmany p lans use to determine the purchase p r ice fo r new shares .

4 By us ing an o p t i ca l scanne r and a so r t /m erge func t ion o f a word -p rocess ing package we wereab le to send ou t wi th in hours seve ra l hundred l e t t e r s r eques t ing p rospec tuses . Th i s p roceduretu rned up a nu m ber o f d i scoun t p rogram s no t iden ti f ied in o the r da ta sou rces . Some t ime la t e r wecame ac ross an annua l pub l i ca t ion pu t ou t by Everg reen En te rp r i se s l i s t ing compan ies wi thd iv idend- re inves tmen t p rograms . I t spec i f i ca l ly no te s those wi th cash d i scoun t p rograms . Al -thoug h w e l ea rned o f some new p rograms f rom th i s sou rce we found i t con ta ined somew ha t da tedi n f o r ma t i o n .

5The da te on wh ich funds had to be rece ived by p rogram adm in i s t r a to r s o f t en p receded the da te

on w hich fund s were invested by severa l days . We are qui te sure tha t in severa l cases fun dsreceived af te r the required date were nevertheless accepted for investm ent . In one ins tancehow ever fund s were re turned for being ~oo la te .

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M .S. Scholes and M .A. Wo lfson Decentralized investment banking 17

We were surpr i sed tha t many programs do not requi re inves tment funds tobe tendered before the averaging per iod s tar ts . As a resul t , we were granted avaluable opt ion. I f share pr ices decl ined dur ing the averaging per iod, par t oral l of the discount could disappear, and we could choose not to invest that

per io d. 6 This opt ion is par t icular ly valuab le in p lans that impo se investmentce i lings over per iods tha t cover more than one inves tment da te . Fo r example ,i t i s common to a l low inves tment once a month wi th a maximum per accountfor any calendar quar ter. In these programs we avoided investment in the f i rs tm on th of each ca lendar quar te r unless the pr ice on the day before the requiredpa ym en t d a te had increased dur ing the averaging period by a program-spec if icthre sho ld p ercentage. This s t ra tegy enab led us to increase ou r average discountab ov e the 5.263 we v, ould have expected i f we had ignored pr ice behav iordu r ing the averaging per iod in m aking our investments . In one case, we wereable to achieve a discou nt of 10 throug h s trategic t iming of investment . Inseveral oth er cases , we earned 8 . 7

Batch process ing was jus t one of severa l re finements we ma de in o urinv estm en t s t ra tegy in Januar y 1985. Th e others incI .Med (1) the purchase ofinsurance against pr ice decl ines on our net investment posi t ion; (2) thepurchase of more than eight ini t ia l (qual i fying) shares in companies offer ingnew pro gra m s w hich enabled us to exper iment wi th se tt ing up mo re than e ightinves tm ent accounts a l though we had only e ight soc ia l secur ity numb ers in ourtwo immediate famil ies ; and (3) the secur ing of l ines of credi t a t local banks.

3 1 I n s u r a n c e

Fr om t ime to t ime, we u sed three .arategies to , protect ourselves againsts tock-pr ice decl ines . Fi rs t , we purchased in- the-money put opt ions on thestocks in which we took long posi t ions (e .g. , J .P. Morgan, Firs t Chicago,Hospi ta l Corporat ion of America) . These specif ic hedges were effect ive butexpen sive. Th e b id- as k spreads on f irm-specif ic opt ions are relat ively high, asare the comm issions. On e could easily spend 1 of the expo sure in purchasinginsurance in this fashion. Moreover, i t i s t ime-consuming to implement thesehedges .

Our second hedge was to sell short . This method, too, is effective butexpensive, but here the expense is of a di fferent sor t . We did not receive theproceeds f rom our shor t sales , and we were required to pledge cash or

To i l lus tra te , suppo se the purchase pr ice for shares is 95% of the average c los ing pr ice over thefive da ys en din g just prior to the inves tme nt date. If these prices are 25.00, 24.50, 25.00, 23.75,and 23 .00 , the average is 24 .25 , and the purchase pr ice becomes 95% of th is average, o r

23 .0375. The 'd iscounted ' purchase pr ice of the shares actual ly exceeds the las t t raded pr ice of23 .00 , and the effective d iscount becom es a negat ive 0.16%.

7Although we calcu lated opt imal investment s t ra teg ies for these averaging programs, we d idn ' ta lways im p lem en t the,n . The ca refu l mon i to ring o f d~ ly p r ice movemcn ts is t ime-consuming .

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18 M.S. Scholes and MoA. W oifson Decentralized investment banking

securi t ies as collateral. Althoug h we put up 200,000 of pers ona l capital , itwasn ' t long before we faced a capi ta l cons t ra in t even af te r margining ouraccounts . A number of program sponsors have to ld us tha t shor t se l l ing iscommon, par t icular ly among inves tors who contro l a la rge number of inves t -

ment accounts . Apparent ly, such inves tors do not face the same capi ta lcons t ra in ts we did .Our ini t ia l motivation in using specific hedges, despite their cost , was to

de termine whether s izabler i s k l e s s profi ts could be , :ecured. Once we estab-l ished that r iskless profi ts of roughly 4% of investment could be secured on atypica l 5% discount program, we dec ided not to use these hedges fur ther,because the effect ive ' insurance premium' ( including transaction costs) ex-ceeded the benefi t of price protect ion.

Speci f ic hedges had another drawback. Shares he ld for more than s ix

m on ths were e l ig ible for long- te rm capi ta l ga in t rea tment a t federa l tax ra tescapped at 20% in 1984-1986 versus 50% otherwise) But a specific hedgeprevents the holding period flora running. Several of our f irms turned out tobe m erge r targ ets giving rise to large capital gains . W here specific hedg es werenot em ployed , we chose to hold for s ix months secur it ies tha t ha d apprec ia tedsignificantly in the three to f ive weeks between our investment and our receiptof a cert if icate for shares purchased. As a result , long-term capital gainscom prise 65% of ou r to tal ca pital gains. 9

O ur th i rd h edge was a macro hedge , in which we simply purchased ac t ive lyt raded put opt ions on a marke t index. This enabled us to s leep reasonablycomfortably a t n ight even when, a t i t s peak, our to ta l inves tment in s tocksex cee de d 500,000. Still, industry-specific an d firm-specific risk we re no t wellhedged throughout most of the period, and we did suffer one disaster, a

16,000 loss on a 34,o00 investmen t in Banks of Mid-A m erica in 1986. In al l ,the three hedg ing s trategies gave rise to gross losses of 27,000 from short salesand put opt ions .

3 2 R e s t r i c t i o n s o n i n v e s t m e n t a c c o u nt s

W e realized early that econom ies of scale were s ignificant in ou r operat ions.The mo st im portan t cos ts were f ixed: the t ime we spent learning of programs '

SActual ly, the gain could be taxed a t 0 i f the shares were used to m ake qual i f ied char i tablecon t r ibu t ions , an opp or tu , l i ty we chose to exp lo i t fo r some o f ou r apprec ia ted sha res . Som e o fthese shares wci 'e used to endow char i table t rus ts (e .g . , the Mark and Shei la Wolfson Phi lan-throp ic Fu nd) . This enabled a tax deduct ion to be taken in 1986, a t a federa l tax ra te of 50 , forchar i table g i f ts to worthwhile causes to be made in years af ter 1986, when tax ra tes were scheduledto Ize well below 50 .

9The d i scoun t f rom m arke t p r i ce a t wh ich shz res a re so ld to pa r t i c ipan t s i s t axed a s d iv idend

incotuc , not capi ta l ga ins . In fac t , th is d iv idend income is even e l ig ib le for the d iv idends-receivedded uc t ion (wh ich has r anged f rom 70 to 85 ove r the 1984-1988 pe r iod ) fo r co rpora te inves to rs .Th i s makes mos t o f the d i scoun t income tax -exempt a t the co rpora te l eve l .

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M.S. Scholes and M .A. Wolfson Decentralized investment banking 19

e.~stence, about when and where to invest , and about when to sel l securi t ies .Bec ause o ur inves tmen ts across accounts were ' carbon copies' , there were grea teco nom ies in record keeping as well.

There were a lso la rge economies of sca le in brokerage commiss ions . Our

bro ke r agree d to se ll the shares in our e ight accounts in a s ingle t rade througha s ingle brokerage account , cut t ing e ight separa te checks for the proceeds3The brokerage fee was the same whether shares were sold for two or e ightsep ara te shareholders . This enabled us to t rad e a t comm iss ions averaging lessthan one-quar te r of 17o of the marke t va lue of the shares so ld , wi th manytrade s a t less than one-e ighth of 1%. l l

Given these sca le economies , we tes ted whether we could se t up moreaccoun ts in some p rograms than the e igh t we a l ready had . We found p lansvar ied t rem endo us ly in the i r wi ll ingness to to le ra te proli fe ra tion of aczounts .

A couple of p lans openly encouraged mul t ip le accounts , wi th adminis t ra torste l l ing us by pho ne tha t som e inves tors had ma ny m ore accounts in thei r p lantha n we did . Fo r example , severa l la rge bank s have had mo re than oneinve s tor w i th be tween 50 and 100 re la ted accounts These inves tors rout ine lyinves ted the max imum a ll~wed pe r accoun t and qu ic~ y tu rned ove r the sha resto a rb i t ra ge the d iscoun t income. Other p lan s we~e less sanguine abo ut th ispra ctic e. Consider he following:

'O pt io na l cash pay me nts rece ived in excess of $12,500 per c a lendar quar te rpu~orted to be inves ted in mul t ip le accounts for the benef i t of the same

Part ic ipant wi l l be re turned, wi thout in te res t , i f the company reasonablydetermines tha t the same Par t ic ipant i s , through the opening of mul t ip leacco unts , inves ting an aggregate of m ore than $12,500 in a ny ca lenda rquar te r ' .

(Hospi ta l Corpora t ion of Am erica , Supplement toProspec tus da ted 8 / 26 /8 2 , Supp lement da ted 1 /1 7 / 84 , p . 1 )

Similar sent im ents a re re flected in the prospec tuses of Cal i fornia Real E s ta teIn v e s t m e n t Tru st ( 9 / 3 / 8 5 , p . 1 6 ) , N e w J e:~ ey N a t io n a l B a n k (7 / 1 6 / 8 4 ,pp. 5-6) , and Storage Equi t ies (8 /30/85, p . 10) .

Most p lans d id not inc lude language such as tha t repor ted above , however,an d the use of m ul t ip le accounts was publ ic ly acknowledged by som e adminis -trators . For example, according to the adminis trator of t reasury services atTE C O Energy, a n um ber of investors es tabl ished mul t ip le accounts to c i rcum-vent the l imi ts on cash payments (source :Wall Street Journal 4 / 2 6 / 8 6 ,p. 33). The director of shareholder relat ions for Indian Head Banks, in a le t ter

1 To m i n i m i z e c o n f u s i o n a m o n g t h e ta x i n g a u t h o r i t ie s we c o n s t r u c t e d a s p re a d s h e e t t r a c i n geach sa le to the speci f ic sha reho lde r s . T h i s becam e ou r so -ca ll ed 1099-B reconc i l i a t ion schedu le ac o p y o f wh i c h wa s f i l e d w i t h e a c h o f o u r t a x r e t u r n s .

l l Th i s i s t h eround-trip c o mmi s s i o n c o s t s i n c e s h a r e s a c q u i r e d d i r e c t l y t h r o u g h t h e d i s c o u n tp r o g r a m a r e c o m m i s s i o n - f r e e .

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20 M .S. Scholes and M .A. Wolfson Decentralized investment banking

to share ho lde rs announ cing the terminat ion o f cash d iscoun ts, s ta ted tha tarb i t rage and mul t ip le accoun ts were the p r imary reasons fo r cancel l ing thep r o g r a m .

To es tab l i sh wbether mul t ip le accoun ts cou ld be used , we crea ted revocab le

trusts . ~2 W e invested a to tal of 96,000 of t rust funds throu gh the discou ntp ro g rams o f sev en co mp an ies .W e soug ht legal counsel on the use o f these t rus ts to aug me nt ou r par t ic ipa-

t ion in some d iscoun t p rograms, and were assured o f the i r legal i ty. None o fthe companies in ~h ich t rus t inves tments were made res t r ic ted mul t ip leaccounts in the i r p rospectuses . Moreover, none o f these companies everque s t ioned ou r e l ig ib i li ty even though we m ai led checks and inves tme nt s tubsin the same Federa l Express envelope used fo r the o ther e igh t accoun ts . Oncewe es tab l i shed that add i t ional accoun ts were poss ib le , we s topped us ing them.

3 3 Secu ring lines of credit

Once we began inves t ing in batches , we soon faced a cap i ta l const ra in t . Inrespon se, we arrange d for l ines of credit to tal ing 300,000: a 200,000 l ine atp r im e p lus 1 .5% and a 100 ,000 line a t p r ime p lus 2 .0%. Ou r borro win g neverexceeded 50% of our to ta l inves tment because o f marg in ru les .

Th e cre d i t l ines were termina ted a t the end o f 1986. Du r ing the tw o years inwhich the y were ac tive , we accum ulated 14 ,000 in in terest expense . At an

average in teres t ra te o f 1 2% , th is t rans la tes to an average loan balanc e o fabo u t 58 ,000 . The ac tual am oun t f luc tuated considerab ly. Indeed , a t somepoin ts w e held substan t ia l cash posi tions , genera t ing 7 ,000 o f in teres t incom eover these two years. Since id le cash yielded in terest at roughly 2%belowpr ime, w e were carefu l to pay down our loans before accumu lat ing cash . At anaverage in terest rate of 8%, our average cash bal .ance was on the order of

44,000, or 14,000 less than the average size of our lo an ) 3

3 4 Ch ang es in the level o f investmen t activiiy over timeTable 5 repor ts tha t we inves ted th rough the d iscoun t p rograms o f 30

companies over the 1984-1988 per iod . For a l l bu t two f i rms, we inves tedposi t ive amounts in th ree o r fewer o f the f ive years , p r imar i ly because

~2A revocable trust is a trust controlled by the grantor or another designated trustee. Assets canbe added to or removed from the trust at any time. We were able tc~ obta in additi on, l t~.xidentification numbers by using these trusts, and tbds was a requirement to set up additi onalaccounts in some programs. For each trust, we designated a 5,% income beneficiary and named thetrust after that person. We retahaed the residual interest in the trust income and assets.

~3The 14,000 excess of average loan position over average cash balance is equal to the 14,000of gross interest expense on our loans only by coincidence.

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M .S. Scholes an d M.A. Wolfson Decentral ized investment bank~r~g 21

Table 5

Cash inves tment amounts in common s tocks purchased a t a d iscount thrc~gh s tock-purchaseplans by firm and year (in thousands of $).

1984 1985 1986 1')87 ~9~8 To tal

1 . B ~ k A m e r i c a2 . Bank o f Ne w Eng land 3153. Ban ks of Mid-A merica 34

4. Bank ers Tru s t 13 1855. Ch esebr ough Ponds 54 326 . C e l u m b i a G a s 5

7. Chem ica l Ban k 58. CS X 5 120 129. Fi rs t of Am erica Bank 5 125 160

10. Fi rs t Am erican of Tennessee 36 48

11. Fi rs t Ch icago 14512. Fi rs t Un ion I0 105 60

13. Ho spi ta l Cor pora t ion of Am erica 25.5 12.514. Ha r t fo rd Na t iona l /S haw mu t Na t ' l 5 50 16015. Hu bba rd Rea l Es ta te 3

16. He xce l 1 28 3217. India n He ad Banks 2 36 481 8 J P M o r g a n " ",, 370

19. Ko ger Co. 4020. Ko ger Proper t ies 4021. M ul t iba nk Financia l 5

22. M eridian Ban corp 16 9623. Ne w Jersey Na t ional 90 4024. Prop er ty Tru s t Co. of Am erica 20

25. San ta An i ta Real ty 4 64 6426. Signet B an k/ B an k of Virginia 322";. Stora ge Equ ities 5 80 40

28. South Jersey Indus t r ies 16029. TE CO Energy 630. Un i ted W ate r Resources 60 24

962otal 118 .5 2082.5

40 60

32

24

96

200 200315

10 44

19886

5

5137290

84

145175

38315

3

61118406

4040

5

112130

20

13256

125

80 2406

84

350 3609

Num ber o f i r m s i n whichinves tments were made:

In o~dy one ca len dar year 11In two diffe rent years 11In three d i ffe rent years 6In four d i ffe rent years 1In five different year s 1

Number of i rms in whichinvestments w ere made:

During 1984During 1985During 1986During 1987During 1988

142217

34

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22 M.S. Scholes and M .A. Woifson D ecentralized investment banking

discou nts w ere el iminated. 14 W e invested in only on e calen dar year in elevenfirms, two calendar years in eleven firms, three calendar years in six firms, fourcale nda r y ears in one f i rm, and al l five calend ar years in one f irm. W e investedin 14 firms in 1984, 22 firms in 19 85, 17 firms in 1986, three firms in 1987, and

four f i rms in 1988. Although w e invested over 2 mil lion in 1985, we investedjus t un de r 1 million in 1986 an d 100,000 in 1987.O ut to tal in i tial inve stm ent over the f ive-year period for an y given fi rm

ran ge d fro m a low of 3,000 to a high of 400,000. Fo r any given year, init ialinve stm ent in individual f irms ranged from a low of 1 ,000 to a high of

370,000. T he 370,000 wa s invested in J.P. M org an in 1985. Mo rga n'sdisco unt w as termina ted in Oc tober 1985. Th e 370~000 investm ent was theresul t of invest ing 5 ,000 per mon th in eight accounts for eight m onth s plus

5,000 in ten accou nts for one month. A total of 315,000 was invested inBank of Ne w England , a lso in 1985 . Like J .P. M organ the ban k terminated i tsd iscount la te in 1985 . The news of such terminat ions b roug ht us about asmuch cheer as the receipt of an iRS audi t not ice. In table 6 we l is t the stocksin which we acquired ini t ial shares but made no further investments. In mostcases, these companies terminated their d iscounts before we could buy shares.

W hi le we knew of a num ber o f o ther p rograms, a ll were less a t t rac t ive to usthan those we ini tiaUy patronized. 15 Som e prog ram s in which we d id notpart icipate imposed investment cei l ings that we bel ieved were too small tojust i fy the cost of t ime and expl ici t t ransact ion costs . In others, the discountwas less than 5%.

In principle, a 3% discount program was qui te profi table, but not generoosenough to compensate for our t ime given the modest scale at which weinvested. O ur out-of-pocket expenses consisted prima ri ly of bro kerag e ,~ees andexecut ion costs . Execut ion costs ar ise because we expect to buy shares atprices that represent an average of the bid and ask prices, while we are l ikelyto sell shares in the market at prices closer to prevailing bid prices.

Recent evidence shows that the bid-ask spread, in relat ion to market pr ices,decreases wi th g reater t rad ing vo lume and wi th h igher market value ofoutstanding equity; for large, actively traded firms, the spread is less than 1%[see Sirri (1989) and Barclay and Smith (1988)]. Evidence also suggests thatnear ly 40% o f a ll trades on the New Y ork and Am erican S tock Exchanges ma yoccur wi th in the b id-ask spread . Al though we were no t ab le to document i t ,we bel ieve that many of our t rades (both market orders and l imit orders) were

14The two-year investment hiatus in South Jersey Industries in 1986 and 1987 resulted from theterminat ion of discounts at the end of 1985, followed by their renewal n 1988.

~SWe are aware of ten programs that were stili active at year-end 1988 and a few programs thatwere initiated in 1989.

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I14.S . Schole s and M.A. Wolf son Decen t ra l i zed inves tmen t bank ing 23

Table 6

Firms with discount programs in wh ich no investments were made.

Fi rm s in wh ich in i t ia l sha re s were pu rchased bu t no fu r th e r inves tmen ts were made : a

1. American Security

2. A rizona Bancwest3. Califc~mia RE IT4. Con necticut Water Service5. Firs t Wyom ing Bancorp6. Ho rizon Bancorp7. Linco ln Telecomm unications

8. N orth Fork Bancorp9. Niagara Mohawk

10. Ohio Edison11. ONEOK12. Sov ran Nation al13. Southeast Banking14. Texas Comm erce Bancshares

Fi rms in w h ich no sha re s w ere pu rchased : b

1. Ban corp Haw aii 20. Koger Partnership Lim 'ted2. Bank of New York 21. Ma nhattan Nation al3. Caro lina Pow er and Light 22. M FG Oil4. Ce lina Financial 23. Middle South Utilities

5. Chase M anhattan 24. Nabisco Brands6. Citizens Bancorp 25. Nevada Nation al Bancorp7. Energyn orth 26. Northeastern Bancorp8. Equ im ark 27. Northwest Energy9. E'tow n W ater 28. Piedmont Natural Ga s

10. First and Merchants 29. PNB Mortgage and Realty Trust11. Fl ori da Coast Banks 30. ProMed Capital12. Flo rida Na t'l Banks of Florida 31. Public Service New Mexico13. G ou ld Investors Trust 32. Rainier Bancorp14. G reen M ounta in Pow er 33. Southern Bancorp15. He alth Care RE IT 34. Suffolk Bancorp16. Hi ber nia 35. Sun we st Financial Sen, ce

17. India nap olis Water 36. Trac or18. lnterpace 37. US F& G19. Ke m per 38. Virginia Na tional Bankshares

a n m ost cases, the reason for not inv esting is that cash discounts w ere terminated before wereceived our shares.

bThe reasons for not investing include: (1) discount program terminated by the time we foundou t ab ou t it; (2) investment limits too smfll to compensate us for the value of our tim e; (3)estimated bid -as k spreads too large (rendenng execution costs too high) to justify investment;and (4) discounts of less than 5 .

e x e c u t e d w i t h i n t h e b i d - a s k s p re a d . M o r e o v e r , w e a re c o n f i d e n t t h a t th ew e i g h t e d a v e r a g e b i d - a s k s p r e a d f o r o u r f i rm s w a s u n d e r 1 7o . A s a r e su l t , 0 .5w o u l d s e e m t o b e a c o n s e r v a t L e u p p e r - b o u n d e s t i m a t e o f o u r e x e c u t i o n co s ts .O n t h e o t h e r h a n d , b y c h e c k i n g t ra d i n g v o l u m e s a n d t h e s iz e o f b i d - a s ks p r e a d s , w e e s t i m a t e d t h a t t h e e x e c u t i o n c o s t s t o t r a d e s h a r e s i ns o m ep r o g r a m s w e r e m o r e t h a n 2 70 , a n d w e a v o i d e d i n v e s t in g i n th e s e p la n s .

A n o t h e r r e a s o n f o r n o t i n v e s t i n g in c e r ta i n p r o g r ~ m s w a s t h a t t h e y r e q u i re dc o n s i d e r a b l e m o n i t o r i n g t o d e t e r m i n e w h e t h e r a r e a s o n a b l e d i s c o u n t w a s

a v a i l a b l e . C A L R E I T, f o r e x a m p l e , o f fe r s s h a r e s a t a 5 d i s c o u n t , b u t it s

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24 M .S. Scholes and M .A. Wolfson Decentralized nvestment banking

f o r m u l a f o r c a l c u l a t i n g t h e m a r k e t p r i c e r e q u i r e s n u m e r o u s t e d i o u s c a l c u l a -t io n s . T h e p r o s p e c t u s e v e n w a r n s t h a t tL ~ d ; s c o u n t c o u l d b e n e g a t i v e . 16

Tw o o t h e r f a c t o r s c o n t r i b u t e d t o o u r s a b b a t i c a l f r o m i n v e s t i n g i n 1 9 8 7 .F i rs t, a r e g u l a t o r y c h a n g e a p p l y i n g t o b r o k e r s p r e c l u d e d o u r t r a d e s f r o m b e i n g

m e rg e d i n t o a s i n g l e t r a n s a c t i o n a f t e r D e c e m b e r 3 1 , 1 9 8 6 . T h i s i n c r e a s e d o u rp r o p o r t i o n a l b r o k e r a g e f ee d r a m a t i c a l ly. F o r t h e t r a d e s u n d e r t a k e n i n 1 9 8 8 ,o u r b r o k e r a g e f ee still a v e r a g e d w e l l u n d e r o n e - h a l f o f 1 ~ , b u t i f w e h a du n d e r t a k e n t h e s a m e t ra d e s i n 19 8 5 a n d 1 9 8 6 u n d e r t h e p o s t - D e c e m b e r 3 1 ,1 9 8 6 r u l es , o u r c o m m i s s i o n s w o u l d h a v e b e e n t h r e e t o f o u r t im e s a s l a rg e a st h e 0.2 27 0 r a t e w e in c u r r e d i n th o s e y e a r s ( f o r a n a d d i t i o n a l c o s t o f 1 5 , 0 0 0 -

2 0 , 0 0 0 ) .T h e f i n a l f a c t o r r e l a t e s t o f a m i l y t a x p l a n n i n g . B e f o r e t h e e f f e c t i v e d a t e o f

t h e Ta x R e f o r m A c t o f 1 9 8 6 , t h e d i v i d e n d s a n d c a p i t a l g a i t. , , ~ a rn e d i n o u rc h i l d r e n ' s n a m e s w e r e t a x a b l e a t b a rg a i n r a te s . A s o f J a n u a r y 1 , 1 9 8 7 , th i s w a sno lon ge r t ru e to r two c t ,L ld ren . 17

3 .5 . S t o c k - p r i c e p e r f o r m a n c e f o r f i r m s i n w h i c h w e i n v e s t e d

O n e c o n c e r n w e h a d w a s t h a t p a r t o f o u r d i s c o u n t w o u l d b e lo s t to p o o rs t o c k p e r f o r m a n c e . W e c a n n o t a d d r e s s t h is q u e s t i o n d e f in i ti v e ly, b u t o u ra n e c d o t a l e v i d e n c e s u g g es ts t h a t, i f a n y t h in g , w e o u t p e r f o r m e d c o m p a r a b l ef i r m s n o t o f f e r i n g d i s c o u n t p r o g r a m s .

Ta b l e 7 s h o w s th a t w e g e n e r a t e d 1 9 0 ,0 0 0 o f g r o s s d i s c o u n t i n c o m e , 2 5 , 0 0 0o f d i v i d e n d i n c o m e , a n d 2 1 5 , 0 0 0 o f c a p i t a l g a i n s . F r o m t h is 4 3 0 , 0 0 0 o f g r o s si n c o m e w e s u b t r a c t n e t i n t e r e s t e x p e n s e o f 7 , 0 0 0 a n d 2 , 0 0 0 o f o t h e re x p e n s e s , l e a v in g 4 2 1 , 0 0 0 i n n e t p r o f it s .

H o w d o e s o u r n o n d i s c o u n t i n c o m e c o m p a r e w i t h w h a t w e w o u l d h a v ee a r n e d i f w e h a d i n v es te d a l t e rn a t iv e l y ? N i n e t y p e r c e n t o f o u r i n v e s t m e n t w a sc o n c e n t r a t e d a r o u n d 1 9 8 5 - 1 9 8 6 ( in c l u d in g y e a r - e n d 1 9 8 4 a n d t h e b e g i n n i n go f 1 9 8 7 ), a n d o v e r 7 07 o o f o u r f u n d s w e r e c o m m i t t e d t o b a n k s to c k s . D u r i n gt h is p e r i o d , a n i n v e s tm e n t i n t h e S t a n d a r d & P o o r ' s 5 0 0 i n d e x w o u l d h a v er e t u r n e d 5 6 7 0 , i n c l u d i n g d i v i d e n d s . T h e S a l o m o n B r o t h e r s i n d e x o f 3 5 b a n k

16'The Market Price is the highest of the following series of prices: (a) the average of the Highand Low Sale Prices of the C om mo n Shares, as quo ted under the A merican Stock ExchangeCom posite Transactions, .on the d ate the distribution is dec lared; (b) the average of the Da ilyClosin g Prices of the Cor~:|:aon Share s, as so q uoted , for a pe riod of ten (10 ) trading d ays prior tothe distribution paym ent late (the 'Investment Da te'); and (c) the average of the Hig h arm LowSale Prices of the C omm o::, Shares, as so q uoted, on the Investment Date . If no Co m m on Sharesare traded o n the relevan~ distribution declaration date o r Investment Date for p urp ose s ofcalculating the M arke t Price, the daily High and Low Sale Prices shall be determ ined on ~ e basisof the m ost recent prior date on which Comm on Shares were traded. ' (CA L REIT, Prospectus,9/ 3/ 8 5, p. 7) P age 15 of the CAL REIT prospectus w arns in italics that the discounll couldtheoretically turn out to be a negative one.

17Children und er fourteen now pay tax essentially at th eir paren ts' m arginal tax rates..

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M .S. Scholes and M.A. Woifson Decentralized investment banking 25

Tab le 7

Prof i tab i l i ty an d aggregate cash invested in com m on shares a t a d iscount th rough s tc~:k purcha seplans by year ( in thousands of $) .

Taxab led iv idends & Shor t - te rm Long- te rm To ta l

Inves tmen t d i scoun t cap i ta cap i ta l cap i ta lY ear am oun t income a ga in s ' g a in sb gainsb

1984 $ 118.5 5 0 0 01985 2081.5 125 34 0 341986 962 64 25 97 1221987 96 4 2 4 61988 350 17 14 39 53

T o t~ $3609 $215 $75 $ 40 $215

Divide nds p lus cap i ta l gains $430In teres t incom e 7In teres t expens e (14)Othe r inves tmen t expenses (2 )N et prof i t $421

a Disc oun t incom e i s t axed as d iv idend income. The to tal g ro ss d i scoun t income i s app rox i -m ate ly $190,000, a nd to ta l d iv idend income is approxim ately $25 ,000.

bCapita l gains are net o f brokerage commiss ions of $10 ,000 , execut ion costs of perhaps twiceth is am oun t , a nd losses in 1985 of $27 ,000 f rom sh or t sa les and the purchase of pu t op t ions .

s tocks re turn ed 59%. W e were ac tua l ly somewhat m ore heavi ly inves ted dur ing1985 and the f irs t half of 1986 than during the second half of the 1986. TheS& P 500 s tock s retu rned 5970 in the s ix quarte rs end ing in mid-1986, and theSa lom on Bro the rs ba nk s tocks returne d 76%. S & P 500 st~cks then fell by 270in the sec ond ha l f of 198 6 and the bank s tock index fel l by 9%. W e werevir tua l ly out of the marke t in 1987 and began inves t ing aga in ear ly in 1988.Th is p rov ed qu ite lucky: ba nk s tocks lost 1770 in 1987 and gained 2370 in 1988.

To e s t ima te w he the r our inves tmen t in d i scoun t p rograms unde rpe r fo rmed ana ive inves tment s t ra tegy, we assumed tha t our inves tment a l te rna t ive wouldhave s imply been to inves t in the Sa lomon Brothers bank s tock index. Theseca lcula t ions a re shown in panel B of tzble 8 .

W e inves ted 200,000 a t the s ta r t of 1985. I f we had le f t th is ent i re amo untinves ted in the index throug hout 1985 and 1986, we would have rea l ized aret urn of 5970, or 118,000, in excess of our ini t ia l investment. At the en d ofJu n e 1986, ho~ ~wer, we with drew 150,000o This wou ld have saved us 13,.500,because the index declined by 970 over the second half of 1986. We alsoinves ted our gross d iscount income of approxim ate ly 171,500 dur ing 1985an d 1986. O n av erage, app roxim ately half, or 86,000, was invested through -out the ent i re per iod . An inves tment in the Sa lomon Brothers index wouldhav e re turn ed 50,700 on th is average inves tment over the period . Fina l ly, our

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26 M .S. Scholes an d M.A. Wolfson, Decentral ized investment ranking

Table 8

Actua l re turn versus bench ma rk re turn on inves tment .

Panel A

Ac t ua l r e t u r n

Subt rac t expec ted ne t d i scnunt income:Gr os s d i s coun t pe r do l l a r i nves tedLess broke rage fee (one way)Less execut ion cos t (one way)Net d i scount per dol la r inves tedNe t d i sco unt on 3 ,609,000 inves ted

5.26%0.22%0.50%4.54%

421,000

163,800

Actu a l re turn in excess of ne t d i scount incon:, ;

Exp ec ted re turn in escess of ne t d i scount income dueto the increase in bank s tock pr ices( t he ' ne t bench m a r k r e t u r n ' fr om pane l B)

Excess of ac tua l over benchmark re turn beyond thene t d i s coun t i ncom e

257,200

182,600

74,600

Note: On a n average inves tment of approximate ly 250,000 per year for two years and 90 ,000 fora t hird y~ at ', this excess retu rn is 12% per y ear.

Panel B

Pe r i od Benchm ar k Benchm ar kInves tm ent Inves tme nt of ra te of to ta lsou r ce Da t e am o un t i nves tm en t r e t u r n r e t u r n

Ir t ia l 1 / 1 / 8 5 -inves tment 1 / 1 / 85 200, 000 12 / 3 1 / 86 59t~ + 118, 000

Wi t h d r a w a l 7 / 1 / 8 6 - 1 50 ,0 00 7 / 1 / 8 6 -12 / 3 1 / 86 - 9% + 13, 500

Re i nves t m en t o fg r os s d i s coun ti ncom e a

I nves t m en tf inanced byl ine o f c redi t h

New i nves t m en t 1 / 1 / 8 8

Gr os s benchm ar k r e t u r nHedg i ng l o sse s

8 6 0 00 1 / 1 / 8 5 -1 2 / 3 1 / 8 6 59% + 50,700

1 4 , 0 0 0 1 / 1 / 8 5 -1 2 / 3 1 / 8 6 5 9 %

9 0 , 0 0 0 1 / 1 / 8 8 -12 / 31 / ' 88 23%

Brokerage fees and execut ion costs @ 025% and 0.50%, respect ivelyN e t b e n c h m a r k r e tu r n

+ 8,300

+ 20,700

211,200- 27,0001,600

182,600

a 3 ,259,000 inves ted a t a d i scount of approximate ly 5 /9 5 y ie lds 171,500 of gross d i scountincome. O n average , approxim ate ly ha l f or 86 ,000 i s inves ted throughout the ent i re per iod .

b 14 ,000 is t he ave rage exces s o f bo rr owi ngs ove r ca sh he ld ove r the pe ri od 1 / 1 / 8 5 - 1 2 / 3 1 / 8 6 .

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M .S. Scholes and M .A. Wolfson Decentralized investment banking 7

net bo rrow ing over the per iod ~veraged 14,000, and we would have earned8,300 on this investment.

We wi thdrew our ent i re inves tment a t the beginning of 1987. An averageinv estm en t of 90,000 in 1988 wo uld have return ed 20,700 if invested in the

bank s tock index .After subtra c t ing our hedging losses and t ransac t ion costs, we es t imate tha twe could hav e earned 182,600 by inves ting in the ban k s tock index ra therthan in the s tocks we ac tua l ly he ld . We ca l l th is the ne t benchmark re turn .Th is is a con serva tive bencth-nark, in th at 25% o f our actual inv estm ent was inindus t ry sec tors tha t underperformed bank ~tocks .

Tu rning to pane l A of table 8 we see tha t the ac tua l re turn was 257,200m ore tha n the 163,800 of ne t d iscount incom e wz earned. N et d iscountinc om e is es t im ate d to be 5.26% of the 3,609,000 invested less the costs to sel lshares ( inc luding both brokerage fees of 0.22% and execut ion cos ts of 0 .50%).

The 257,200 of nond iscount income is 74,600above the benchmarkre turn . W ith an average inves tment of approxim ate ly 250,000 per year fortwo yea rs and 90,000 for a third year, the excess return (abov e the bench-mark) i s 12% per year. So the concern tha t d iscount income would , in par t ,d isa ppe ar b ecau se of poor s tock performance for the sponsor ing fi rms was notborne out by our exper ience . The favorable s tock performance for f i rmsoffering d isco unt s tock-purchase p lans i s somew hat surpr is ing and is worthy offurth er invest iga t ion. A re there corm'non characteris t ics across these f irms, notrecogn ized by the m arke tex ante tha t caused them to perform so wel l?

4 D ecentra lized investm ent banking

Firms can ra ise equi ty capi ta l in myriad ways , inc luding convent iona lund erwri t ing s of co mm on o r preferred shares, equi ty r ights offerings , warrantofferings, convert ible bond and preferred s tock offerings, share issuances topurc hase asse ts or shares in mergers and acquisi t ions , and awards of shares (orcont ingent c la ims to shares ) to employees through re t i rement p lans andincent ive compensa t ion arrangements . In pr inc ip le , i s su ing shares d i rec t ly toshareholders a t a d iscount can make shareholders be t te r off than they wouldbe un der conv ent ion a l underwfi tings . I f the d iscount offered to shareholders iss imi la r to the fee an underw ri te r would charge , and i f the pos t - is suance va lueof the f irm is identical with the al ternative methods of rais ing capital , thediscount p lan can be v iewed as offer ing shareholders a d iv idend bonus . Butth is ana logy can be taken only so fa r, because mos t shareholders do notpar t ic ipa te in d iscount programs, the f ight to purchase shares a t a d iscount i stypical ly not related to the level of share ownership (unlike r ights offerings),and the p lans do not prevent new shareholders f rom purchas ing smal l owner-ship in te res ts in the secondary market and then supplying a d ispropor t iona teamount of the new capi ta l a i barga in pr ices .

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M.S. Scholes an d M.A. Wolfson D ecentralized investment banking 29

divide nds they pa id in 1985. By contras t, the seven f irms offer ing no d iscountsra i s ed an ave rage o f 12% (median ; the mea n i s 147o) o f the i r com mo n andpre fe r red d iv idends .

U ni ted W ate r Resources and H exce l o ffer le s s gene rous inves tmen t oppor tu -

ni t ies than the o ther s ix f i rms offer ing 570 discounts . Al though the table doesnot show i t , these f i rms ' common s tocks a re a lso less ac t ive ly t raded than thes tocks of the o ther f i rms , making execut ion cos ts h igher. Accordivgly, thecapi ta l ra ised for these f i rms , as a f rac t ion of common and preferred d iv i -den ds , i s jus t above 5070, or less than ha l f as m uch ra ised by the o ther f i rmsoffering 570 discounts .

Th e o the r f i rm tha t s t ands ou t is Har t fo rd Na t iona l . A l though th i s i s a la rgef i rm tha t offered generous inves tment l imi ts and whose shares t raded ac t ive ly,tbe p rog ram ra ised on ly 5170 o f comm on and p re fe r red d iv idends in 1985 . Theon ly c lue we have to exp la in th i s d i s c repancy i s tha t Har t fo rd Na t iona l wasno tab ly s lower in 1 985 than were o ther f i rms in sending us cert if ica tes forshares we bought through the d iscount program. I f our exper ience is typica l ,th is s lowness d iscouraged shareholder inves tment .

Over the n ine months of 1985 in which J .P. Morgan offered a d iscountpro gra m , i t ra ised 92 mi l l ion through i ts d iv idend-re inv es tmen t p lan (or 4470of common and preferred d iv idends pa id for the ent i re year) . In 1986, in theabse nce o f a d iscount cash purcha se opt ion , 55 mi l l ion was ra ised throug h there inve s tme n t p lan (on ly 23% of com mo n and p re fe rred d iv idends ).

The dec l ine in cap i t a l r a i s ed th rough Bank o f New England ' s d iv idendre inves tment p lan was even more dramat ic . In 1986, in the absence of adisco unt , o nly 8 .3 mi l l ion was ra ised (dow n from 41.7 mi l l ion in 1985) . Thisis on ly 157o of com m on and preferred d iv idends (dow n from 96% in 1985) .

Inves tors c lear ly respond to the opportuni ty to buy new shares for cash a t adiscount , but a subs tant ia l major i ty of shareholders do not exerc ise the i ropt ion to purchase such shares . I t i s puzz l ing tha , f i rms are wi l l ing to incursuch h igh cos ts to pay d iv idends and then issue an offse t t ing amount of newequi ty. N ot only i s there the fam il ia r tax cos t of paying d iv idends , bu t here wea l so have the admin i s t ra t ive cos t o f runn ing the d i scoun t p rogram, thet ransac t ion cos ts assoc ia ted wi th resa les of shares in the secoraary market ,and perhaps mos t important , the cos t to exis t ing shareholders of offer ing 5%discoun ts to new sha reho lde rs . A l though the answer may re la te to conce rnover adverse s tock-market responses to cut t ing d iv idends or f loa t ing an equi tyi s sue th rough an unde rwr i t e r, these phenomena a re no t we l l unde rs tood anddeserve c loser a t tent ion .

4.2. Are short term traders really welcome?

Apparent ly, f i rms have objec t ives o ther than ra is ing capi ta l in sponsor ingd i scoun t s tock-purchase p rograms . Some a re in te re sted in p rom ot ing long- te rm

J.FE. B

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30 M .S. Scholes and M .A. Wolfson Decentralized investment banking

inves tment by shareholders . Others appear in te res ted in encouraging widerownership of shares , perhaps to make a change in corpora te contro l moredifficult to effect . And with the possible exception of BankAmerica and acou ple of o the r large banks, a ll fi rms seem to be conce rned ab out the effect on

share prices of arbitrage by plan part ic ipants .Al though a few program sponsors seem content to have shareholderspurchase shares at a discount and then sel l them quickly, others clearly opposesuch act ivi ty. Excerpts from prospectuses for f irms in the la t ter categoryappea r be low:

' I f i t appears to Chesebrough tha t a par t ic ipant has used, is us ing or may beus ing the opt iona l cash payment fea ture to genera te shor t - te rm prof i t s or(act) otherw ise with an effect that , in the sole jud gm ent a nd discret ion ofChesebrough, i s not in the bes t in te res ts of Chesebrough or Chesebrough 's

other shareholders , then Chesebrough may dec l ine to i s sue a l l or anyport ion of the shares of Chesebrough Common Stock for which anyopt iona l cash pa yme nt by or on behal f of such par t ic ipant i s tendered. '

(Chesebrough P onds , Prospec tus ,5 / 2 2 / 8 5 , p . 8 )

The antiarbitrage language in these prospectuses is apparently not entirelywithout content . Our efforts to help Chesebrough Ponds raise capit ,d were,after a n um be r of rno~.~ths of faithful inve stme nt, reward ed with a sb :-mo nth

suspen sion o f four of our eight accounts . W e received no suspensions from a nyother com pan y, and our inves tments were never re fused. We never rece ived asingle le t ter of warning from program sponsors .

At the o ther ext reme from Chesebrough Ponds is BankAmerica . I t en teredthe discount program business relat ively recently, introducing i ts ShareholderInves tm ent Plan in June 1987. The p lan perm it ted shareholders of record toinvest up to 10,000 per mo nth in com m on shares at a 5% disco unt frommarket pr ices . The p lan was so popular tha t BankAmerica dec ided to reducethe disc ou nt ~o 4% a mere four m onths la ter.

In Jun e 178 8, the d iscount was reduced fur ther to 3% and the bankannounced tha t par t ic ipants could reques t permiss ion to inves t more than10,003 per mo nth. 19 W e inquired by pho ne whe ther an investm ent ef 100,000

in the for thcom ing month would be a l lowed. The answer was yes , bu t the p lanadminis trators would not reveal what the investment cei l ing might be.

The June 1988 amendment conta ined another change mai~ng i t c lear tha tthe ba nk was prima ri ly interested in using the discount prog ram to raise equitycapital a t low co st . i t a l lowed part ic ipants to en ter s tanding orde rs to have the

l ~It also an noo nce d that optional cash paym ents could be mad e electronical ly using the b~n k sHo me Ban k in gT or Business Conn ectionT systems.

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M.S. Scholes and M.A. Wolf on Decentralized investment banking 31

bank se l l the i r shares immedia te ly a f te r inves tment . The p lan adminis t ra torwo uld then s imply send a check for the proceeds less a brokerage commiss ion.

Ba nkA m erica ra ised over $150 mil l ion f rom i ts d iscount program in the f irstyear. In Se ptem ber 1988, jus t f if teen months a f te r the prog ram w as in t roduced,

the d isc oun t ra te was cut for the th i rd t ime, to 2 .5%. An d in F ebrua ry 1989,wh en m ore than $350 mil l ion had be en ra ised in jus t over a year and a ha l f a tan average d iscount ra te of wel l be low 4%, the d iscount was reduced onceagain, this t ime to 2%.

Th e B ank Am erica prog ram ra ises an in te rest ing tradeoff be tween equi ty andefficiency con sidera t ions. W hile a relat ively few well-endowe d shareholde rs arel ikely to dominate the plan, they are also l ikely to be the most effic ient'underwriters ' of the f irm's securi t ies , and at a 270 discount, the total under-writ in g fee pai d is 6070 less tha n that incurred in the 570 discoun t prog ram .

4.3. Co rporate inance implications of dividend reinvestment and discountstock purchase plans

The evidence in sect ion 3 suggests that ra is ing equity capital through adiscouat s tock-purchase p lan does not lower a f i rm's s tock pr ice . A negat ivevaluation effect cou d be capital ized into the price of the s tock, however, whenthe p lan is annou nce d. W e did n ot invest iga te th is poss ib i li ty, but some re la tedevidence in Dubofsky and Bierman (1988) is worth ci t ing. They find, for asample of 46 firms announcing the ini t ia t ion of discount divid~md-reinvest-me n t p lans (DR P) be tween 197 : and 1983 , and fo r which no o the rWall StreetJournal news i tems were repor ted in the three days surrounding the DRPannouncements , tha t common s tock re turns , in excess of the marke , : , werestat is t ical ly s ignificantlypositiveon the announcement by an amount ave rag-in3 1% to 1%.

These resul ts contras t wi th the documented announcement e ffec ts of under-writ ten s tock and s tock-rights issues . Asquith and Mull ins (1983) report a-3 .14% abnorma l two-day re tu rn fo r indus t r i a l s tocks and a -0 .75% abnor-mal two-day re turn for u t i l i t ies on the announcement of new equi ty i s sues .Eckbo and Masulis (1989), updating the results in Smith (1977) on ~mderwrit-ten s tock an d s tock rights issues through 1981, find. a s ignificant -3. 3%abnormal re turn on the announcement of an underwri t ten indus t r ia l offer ing ,approximate ly twice the abnormal re turn on a f ights offer ing . These negat ivere turns a re for the ent i re outs tanding equi ty of the f i rm and may represent avery large hack.ion (in so me cases m ore tha~ 100% ) of the new equP,1 beingissued.

We learned from our conversat ions with the sponsors of disco~mt s tock-purchase p lans tha t the negat ive response to an announced equi ty offer ing isan important cons idera t ion in dec is ions to ra ise equi ty through a s tock-purchase p lan . I t has been noted tha t the s tock-pr ice dec l ine may be a :

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32 M.S. Scholes and M .A. Wolfson Decentralized investment banking

t r ibutable to inves tor concern tha t equi ty i s be ing i ssued because managementhas pr iva te informat ion sugges t ing tha t the s tock i s overpr iced [ see , forexample , Myers and Maj luf (1984) ] . But i f management wants to ra i se equi tycapi ta l and does not have nega t ive ins ide informat ion , commit t ing the f i rm to

ra i se money to f inance a fu ture pro jec t over a per iod of months or years ,ra the r th an a l l a t once , m ay m i t iga te the adverse se lec t ion prob lem . R ais ingcap i t a l ove r t ime a l l ows some o f t he i n fo rma t ion managemen t has when t heplan to ra i se e qui ty i s ann oun ced to be re flec ted in publ ic ly d i sc losed ac count -ing measures of per formm~ce and o ther out le t s , thereby reducing informat ionasymmet r i e s .

Th i s m ay he lp t o exp la in why f i rms lim i t t he am oun t o f s tock i nves to r s m a?purchase a t a d i scount . Tl f i s prac t ice s lows down the ra te a t which funds a rera i sed , w hich m ay en able the f i rm to i s sue equi ty wi thout incur r ing the loss in

the marke t va lue tha t typica l ly accompanies convent iona l underwr i t t en equi tyi ssues . So d i scount s tock-purchase p lans can be v iewed as a form of ' sunshinet rading ' , where in f i rms announce to the marke t tha t they wish to ra i se a g ivenam ou nt L," capi ta l but g ive shareholders some cont ro l over the ra te a t w hich i ti s ra i sed . Al though th i s remains conjec tura l , i t would be in te res t ing to de te r-mine whether th i s i s an impor tant mot iva t ion for s tock purchase p lans .

Smi th (1986) has a rgued t ha t t he more s eve re t he i n fo rma t ion a symmet rybe tween ma nage r s and ou t s ide s ecu ri tyho lde r s the g r ea te r t he dem and fo r themoni tor ing and cer t i f i ca t ion serv ices of an inves tment banker. The d i scount of5.2670 offered to share holde rs in discou nt s tock-p urcha se plan s is s im ilar to thedi rec t cos t s incur red in us ing the serv ices of an underwr i te r. But the d i scounts tock-purchase p lan a l lows some of the d i scounts to be earned by cur rentshareholders , and these p lans appear to avoid a nega t ive impact on s tockpr ices . Eck bo and Masul i s (1989) es timate the to ta l ex l :enses of f i rm co mm it -ment offe r ings (where the inves tment banker bears the r i sk of s tock-pr iceuncer ta in ty whi le s tock i s be ing d i s t r ibuted in the marke tp lace) to be 4 .970over the per iod 1963-d981. These costs appear to average between 370 and 470in the Ec kbo and Masu i s samp le for the dol la r range of offe rings encom-passed by our s tock-purchase programs. These expenses inc lude d i rec t i s suecos t s o ther than inves tment banking fees tha t average under 170.

W hi l e Bhaga t , M ar t, and Tho mp son (1985) e s tima te t ha t the i n t roduc t i on o fRu le 415 (shelf reg is t rat ion) 2 in M arch 1982 redu ced fees s ignif icant ly(15-5070, depending upon how one in te rpre t s the i r da ta ) , th i s es t imate resu l t sf rom compar ing underwr i t ing cos t s of f i rms tha t used she l f reg i s t ra t ion f romthose tha t d id not , and these f i rms seem l ike ly to d i ffe r a long d imens ions notcaptured in the s tudy.

2 I n a she l f r e g i s t r a t ion f i rms c a n r e g i s te r s e c u r it i e s i n a dv a n c e o f a n i ssu e a n d up d a t e t he

r e g i s t r a t i on doc ume n t s on ly i f i n f o r ma t ion ha s c h a nge d s i nc e t he l a s t r e g i s t r a t i o n . T h i s a l l ow s af ir m to m a r ke t a ne w i ssue mor e qu i c k ly t ha n i f i t h a d t o s e c u r e n e w Se c u r i t i e s a nd E x c ha n geC o m m i s s i o n a p p r o v a l .

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M.S. Scholes and M .A. Wolfson Decentral ized investment banking 33

Table 10

Gr oss underw riting spreads for com mo n-stock issues (excluding initial pu blic offerings) by y earand size of issue for selected years over the period 1983-1989 (through m id-June of 1989)?

1983 1985 1987 1989

Avg. No. of A v g . No.-of Avg. No. of Avg. No. ofAll i ssues g ro ss i ssues g ro ss i ssues g r os s i ssues g ross i ssues

A//i ue b

0 -1 0 M M 7.6 1% 212 8.17% 116 7.80% 87 9.66% 1410 -2 0 M M 5.7 7% 186 5.86% 94 5.98% 53 6.25% 2320 -5 0 M M 4.5 3% 200 4.76% 91 5.01% 81 5.10% 1750 -10 0 M M 3.7 0% 91 3.74% 37 4.01% 46 4.36% 11

10 0- M M 3.3 0% 40 2.67% 42 2.93% 31 2.00% 2Banks b

0 -1 0 M M 6.94 % 5 6.77% 13 6.98% 11 7.47% 110-20 M M 5.32% 3 5 ,19% 11 5 .9 9 % 2 5 .50% 120-50 M M 3.59% a 4 .58~ 11 - - - - 6 .00% 150-100 MM 3.35% 2 3.14% 3 3 .61% 5 -- - -

100- MM 3 .01% 1 - - - - 2.96% 4 - - - -

aData source: Securities Da ta Co rporation's New Is sue s Service.bExclud es issues that d o not hav e gross spread information av ailable.

Ta b l e I 0 s h o ws t h e u n d e r wr i t i n g c o s t s b y s i z e o f o ff e r a n d y e a r o f o ff e r i n gfo r the pos t - she l f r eg i s t r a tion yea r s 1983 , 1985, 1987 , and 1989 th roug hm i d - J u n e o f 1 9 8 9 ), f o r a ll c o m m o n - s t o c k i s s u es a n d b a n k c o m m o n - s t o c ki s s u e s , o t h e r t h a n i n i t i a l p u b l i c o f f e r i n g s . T h e d a t a c o m e f r o m S e c u r i t i e s D a t aC o r p o r a t i o n ' s N e w I s s u e s S e rv ic e. In th e 2 0 - 5 0 m i ll io n r a n g e fo r s h a r ei s s u e s , t h e f e e s ( e x c l u d i n ~ d i r e c t i s s u e s c o s t s ) a r e 4 . 5 % t o 5 . 0 % o f i s s u e s i z e ,s o m e w h a t h i g h e r t h a n t h e s e r e p o r t e d b y E c k b o a n d M a s u l i s f o r t h e p r e - s h e l fr e g i s t r a t i o n p e r i o d . F e e s fo r s h a r e s is s u e d b y b a n k s a r e s o m e w h a t s m a l l e r,t y p i c a l l y 3 . 5 % t o 4% . S o w h i l e d i s c o u n t s t o c k - p u r c h a s e p r o g r a m s a r e n o td i r e c t l y c o m p a r a b l e t o u n d e r w i ' it t e n o ff e ri n g s a s a m e c h a n i s m f o r r a i s in g n e wc a p i t a l , t h e d i r e c t c o s t o f th e t w o m e c h a n i s m s a p p e a r t o b e s i m i la r , a n d

d i s c o u n t p r o g r a m s b o t h a p p e a r t o av o id m a r k e t i m p a c t c o s ts a n d a l lo w s o m eo f t h e u ~ i ~ d e r w r i t i n g f e e s t o b e e a r n e d b y e x i s t i n g s h a r e h o l d e r s .

5 Concluding remarks

De v e l o p i n g t h e r a w d a t a o n w h i c h th i s c a s e s tu d y i s b a s e d wa s f u n a t le a s tfo r a wh i le ) . 21 Th e e xper im en t a l lowed us n o t o n ly to t e s t w he th e r w e cou lde a r n a b n o r m a l p r o f it s b a s e d o n p u b l i c l y a v a / la b l e in f o r ma t i o n , i t a l so le d u s to

~B ut the next tim e we consider undertaking 'case research' we ho pe it will be a little lesslabor-intensive. Puttin g together a twenty-pag e single-spaced typed sch edule of cap ita] ga ins andlosses for our 1985 tax returns was not enjoyable.

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34 M.S. Scholes and M .A . Wo lfson D ecentralized investment banking

cons ider why f i rms would use d i scount s tock-purchase programs wi th res t r i c -t ions on inves to r par t ic ipa t ion . A t a d i scount ra te of 570, the progra m s inwhich we par t i c ipa ted offe red subs tant ia l prof i t oppor tuni ty, espec ia l ly toinves tors choo s ing to explo it the ava i lab le na tura l econom ies of bo th sca le ( for

a g iven p lan) and scope (across p lans) . S ince mos t shareholders do notpar t i c ipa te in these p lans (and theref6 te do not share in the d i scounts ) theques t ion a r i ses whethe r a 570 d i scount i s too generou s to m aximize the wel fa reof cur rent shareholders . The e l imina t ion of d i scounts on opt iona l cash pur-chases in so many p lans (par t i cu la r ly in 1986) i s cons i s ten t wi th th i s specula-t ion.

An o the r exp l ana t i on fo r te rmina t i on o f ca sh d i scou n t s i s s implyth t f i rmsra i sed the t a rge t l eve l of capita l. G iven the prof it s we (and presu ma bly o thers )made , f i rms might have been able to ra i se the same amount of capi ta l a t l essd i rec t co s t to shareholders by reduc ing the f i ze of the d i scount an d increas inginves tment l imi t s , as BankAmer iea and a few others have done . On the o therhand, i f there i s va lue in s lowing down the ra te a t which capi ta l i s ra i sed ,a l lowing la rge inves tors to acqui re shares too quickly could exac t an adverseselect ion-related cost by depressing share pr ices . But i f capi ta l i s required forimmedia te inves tment , ra i s ing capi ta l s lowly may not be v iable .

Some of the f i rms we spoke wi th found d i scount purchase programs a h ighlycost-effect ive means of ra is ing capi ta l . Others had less favorable exper iences.They were unhappy t ha t t hey cou ld no t con t ro l t he behav io r o f a rb i t r ageur swh o e s t ab l i shed ma ny accoun t s and i nves ted more cap i t a l t han t he sponsor ingf i rms would h~ve prefer red . A number of sponsors observed tha t the i r inves t -men t banke r s d i s couraged t hem f rom us ing t hese p rograms , a l t hough t heywere aware of the potent ia l conf l i c t s of in te res t tha t could mot iva te suchwarnings . Af te r a l l , the inves tment banks lose underwr i t ing fees i f theseprograms d i sp lace convent iona l underwr i t ings . As banks and o ther capi ta l -hungry companies gear up for the next round of capi ta l ra i s ing , i t wi l l bein te res t ing to see whether the d i scount s tock-purchase p lans p lay an impor tantro le , and i f so , how m uch, how of ten , and a t w :a t d i scount shareh olders a repermi t ted to inves t .

e f e r e n c e s

Asq uith, Pau l an d David Mullins, Jr., 1986, Equity issues and stock price dilution, Journa l ofFinancial Economics 15, 61-89.

Barclay, MAchael J. a nd Clifford W. Smith, Jr., 1988, Corpo rate pa you t pc[icy: Cash dividendsversus open market purchases, JoumM of Financial Economics, 61-82.

Bhagat, Sanjai, M. W ayne Marr, and G . Ro dney Thompson, 19 85, The Rule 415 experime nt:Equity markets, Journal of Finance 45, 1385-1401.

Dubofsky, David A. and Leonard 3ierman, 1988, The e ffects of dividend reinvestment planannou ncem ents on equity value, Akron Business and Economic Review, 58-68.

Eckbo, B. Espen and Ron ald W. M asulis, 1989, Rights vs. firm com mitm ent offerings of com m onstock: An em pm cal analysis, Onpubiished pape~ Uuive i~iy of Bridsh Columbia, V ancouver,BC).

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