What is Dividend and What is Manufactured Dividend?
What is the Normal Stock dividend?
- Equity shareholders provide risk-capital to the company for managing & enhancing business.
- The company rewards its shareholders by distributing a portion of its net profits which is approved by majority shareholders & decided by the board of directors with regards to payout rates & frequencies during the year.
- Such reward to equity shareholders is known as a normal dividend.
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What is a Manufactured dividend?
- Stock exchanges help facilitate Securities Lending & Borrowing (SLB) Program for adequate market efficiency, liquidity, and assist financial institutions to hedge their exposures.
- Suppose, few institutions are long term investors with no intentions to sell shares for a certain duration. Financial institutions want to borrow such shares from their financial intermediaries like brokerage firms to short the stock (in anticipation of their convictions about stock being overvalued) and buy shares back after falling in prices of shares.
- SLB brings in such long term investors to lend their shares for one month to twelve months according to demand-supply and in return, earn extra income knows as rent for lending shares. Such lending of shares is a temporary transfer hence lenders reserve the right to receive any kind of dividend/benefit of corporate actions.
- The borrower temporarily collects such dividends because of transient ownership of shares. By nature, agreements take place between lenders & borrowers to submit lenders their due incomes in form of dividends as lenders face loss of income when their ownership has been retained by borrowers. Such a dividend is known as Manufactured Dividend.
Why do companies engage in Manufactured Dividend?
- As shown in the above diagram, lenders lend their instruments to borrowers in exchange of fees known as rents/yields. Borrowers also pay cash or nearly cash securities margin for providing cover to lender margins.
- The borrowers immediately sell stocks short & buy them back at depressed prices assuming their conviction becomes right in due course of time.
- For the duration, borrowers continue to retain transient ownership & hence receive dividends & other benefits.
- Borrowers return the shares along with other required payments to be made in lieu of other compensations to be passed on as per agreements.
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Impact of Manufactured Dividend:
- The Borrower shall be required to pass on any benefits received to the original owner of instruments.
- A manufactured dividend may give rise to complications with regards to taxation liabilities and refunds to both counterparties. In such cases, both parties need to address the issue with frameworks that provide tax-efficiency with efficacious situations for both parties.
About the Author:
Ashutosh Buch is CFP (FPSB India) & has passed Level-I of CFA Program. His primary interest lies in analyzing investments in primary & secondary markets. At present, he focuses on learning the nuances of financial markets & management consulting. He remains committed to his goal of helping businesses scale up & making them ESG-friendly.