The Economist has called them “an addiction to corporate cocaine.” Reuters has called them “self-cannibalization.” The Financial Times has called them “an overwhelming conflict of interest.” In an article that won the HBR McKinsey Award for the best article of the year, Harvard Business Review has called them “stock price manipulation.” These influential journals make a powerful case that wholesale stock buybacks are a bad idea—bad economically, bad financially, bad socially, bad legally and bad morally.
Yet despite these powerful denunciations, stock buybacks not only continue. Today, “it’s raining stock buybacks on Wall Street,” as Matt Egan points out on CNN. The immediate stimulus? President Trump’s massive corporate tax cuts.
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According to research firm Birinyi Associates, share buybacks are at a record-high for this point of the year and more than double the $76 billion that Corporate America disclosed at the same point of 2017.
Goldman Sachs has estimated S&P 500 firms will return $1.2 trillion to shareholders via buybacks and dividends in 2018, increasing share buybacks by 23 percent to $650 billion this year.
While the White House has celebrated the tax cut bonuses unveiled by Walmart, Bank of America and Disney, shareholders, not workers, are the big winners from the Tax Cuts and Jobs Act of 2017. On one tally, the tax cut scoreboard stands as follows: Workers $6 billion; Share buybacks $171 billion.
The Origin Of Share Buybacks
Why have so many of the biggest and most respected companies gotten involved in stock price manipulation on such a massive scale? Why is it still tolerated by regulators?
It’s simple, as finance professor Bill Lazonick explains. Once firms began in the 1980s to focus on maximizing shareholder value as reflected in the current share price, which even Jack Welch has called “the dumbest idea in the world,” the actual capacity of these firms to generate real value for shareholders began to decline, as cost-cutting, dispirited staff and limited capacity to innovate took their toll. Thus, the C-suite faced a dilemma. They had promised increasing shareholder value, and yet their actions were systematically destroying the capacity to create that value. What to do?
They hit upon a magic shortcut: why bother to create new value for shareholders? Why not simply extract value that the organization had already accumulated and transfer it directly to shareholders (including themselves) by way of buying back their own shares? By reducing the number of shares, firms could, as a result of simple mathematics, boost their earnings per share. The result was usually a bump in the stock price—and short-term shareholder value.
Of course, by diverting important resources to boost the stock price, the tactic ran the risk of further hindering the firm’s capacity to innovate and generate fresh value for customers in future. But why worry about that? With luck, by the time it became apparent that the firm had undermined its long-term capacity to add real value to customers, the executives responsible for the decisions would be safely retired, with bonuses already paid. The loss of capacity to create value would be someone else’s problem.
Rule 10b-18 Of The Securities Exchange Act
There was just one snag. Jacking up the share price with large-scale share buybacks would constitute stock price manipulation and hence would be illegal. But not to worry! In 1982, the Reagan administration was happy to remove the impediment and the SEC instituted Rule 10b-18 of the Securities Exchange Act.
Naturally, the SEC didn’t announce that it was legalizing stock-price manipulation. That would have created a political outcry. Instead, they passed a very complicated rule that made it seem that stock price manipulation was still illegal, but provided protection to firms so that it would be hard to detect and almost invulnerable to legal challenge.
The complex rule that the S.E.C. came up with is the following. Bear with me if you find the rule hard to understand. That of course is the whole point of the language: to make it hard to understand.
- Under the rule, a corporation’s board of directors can authorize senior executives to repurchase up to a certain dollar amount of stock. After that, management can buy more company’s shares provided that, among other things, the amount did not exceed a “safe harbor” of 25% of the previous four weeks’ average daily trading volume.
As a result, companies can repurchase their shares on the open market with virtually no regulatory limits. Even better: since the share purchases are happening in the background, the public can’t see what is going on.
The Floodgates Open
And so the floodgates opened. The resulting scale of share buybacks is mind-boggling. Over the years 2006-2015, Lazonick’s research shows that the 459 companies in the S&P 500 Index that were publicly listed over the ten-year period expended $3.9 trillion on share buybacks, representing 54% of net income, in addition to another 37% of net income on dividends. Much of the remaining 10% of profits are held abroad, sheltered from U.S. taxes. The total of share buybacks for all US, Canadian, and European firms, for the decade 2004-2013 was $6.9 trillion. The total share buybacks for all public companies in just the U.S. for that decade was around $5 trillion.
Theoretically, the SEC could launch investigations and intervene to prevent what is obviously share-price manipulation. But the SEC has been inactive. “The SEC,” says Lazonick, “has only rarely launched proceedings against a company for using them to manipulate its stock price.”
In fact, even in the Obama era, the SEC declared itself powerless to do anything about the problem. Thus, in July 2015, when Tammy Baldwin, the Democratic Senator from Wisconsin, asked the SEC head appointed by the Obama administration, Mary Jo White, to look into the issue of stock price manipulation resulting from share buybacks, White replied that the SEC could not consider the issue because of the protection offered by Rule 10b-18. The prospects of changing that ruling in the current investor-friendly administration seem even more remote.
A Massive Social And Political Problem
The result? Successful corporations no longer create broad economic prosperity in the United States. Prior to the 1980s, workers’ wages increased in tandem with their productivity. Yet since the 80s, they have become unlinked, which has led to decades of middle class wage stagnation despite rising profits and productivity. This has driven inequality to levels we have not seen since the period immediately preceding the Great Depression.
The systematic extraction of value from corporations on a macroeconomic scale isn’t an issue of a few misguided individual CEOs or occasional aberrations from the norm. It’s one of fundamental institutional failure.
CEOs are extracting value from their firms and helping other CEOs do the same thing. Boards are giving the C-Suite incentives to do it. Business schools are teaching them how to do it. Institutional shareholders have been complicit in what the CEOs are doing. Regulators search for individual wrongdoers, usually those below the C-suite, while remaining blind to systemic failure. Central bankers indirectly fund the operation and close their eyes to the economic consequences.
Senator Tammy Baldwin has been sounding the alarm on buybacks for years. She wrote to the SEC on several occasions urging them to monitor buybacks and improve their buyback disclosure regime. She also held SEC nominees this year in order to ensure they answered her questions on the dangers of stock buybacks. She has offered amendments to ask the SEC to review their rules and study buyback, but they have been blocked.
Draft Legislation
A first step is the repeal of Rule 10b-18, the 1982 SEC regulation which makes clear that open-market stock buybacks would not be considered stock manipulation. This has led to an explosion of buybacks. In 1981, the S&P 500 spent approximately 2% of its profits on buybacks. In 2017, the index spent 50% of its profits on buybacks (and 41% on dividends). Now that executives are largely paid in stock, they have a direct incentive to boost prices.
Now Senator Baldwin has proposed a new bill, “The Reward Work Act.” The bill is cosponsored by Senators Warren and Schatz. It would do three things:
- Repeal SEC rule 10b-18;
- Shift all buybacks to tender offers; and,
- Require that public companies let one-third of their board be picked by their workers.
It seems likely that executives will take a longer view only when the incentive to enrich themselves through buybacks is removed. As the stakeholders most affected by company decisions, it is only right to give workers a seat at the table. Further, because they have the most to lose, workers will be a much-needed counterweight to the short-term thinking that has become prevalent on corporate boards.
It’s time for society’s leaders to fix a flawed system. A systemic solution goes well beyond the obvious step of repealing the “safe harbor” provided by Rule 10b-18 of the Securities Exchange Act, which effectively enables big corporations to pursue illegal share buybacks on a massive scale.
Resolving the problem involves many institutions: corporations, corporate boards, investors particularly institutional investors, legislators, regulators, business schools, and central banks all need to think and act differently.
How CEOs Became Takers, Not Makers
The Economist: Blue Chips Addicted to Cocaine
Reuters: Big Firms Self-Cannibalized
HBR: Illegal Stock Price Manipulation
World’s Dumbest Idea: Shareholder Value
Steve Denning’s most recent book is The Age of Agile (AMACOM, 2018)