by Cydney Posner
Lots of companies have been buying back their stock in recent years, either on their own initiative because, for example, management thinks the shares are undervalued, or sometimes at the insistence of hedge fund activists bent on increasing the market price of the shares. Now, as discussed in this NYT DealBook article, an issue that not so long ago was an obvious non-starter has suddenly gained some legitimacy: is the government going to make open-market stock buybacks illegal or perhaps impose more onerous regulation on them?
As the DealBook article notes, buybacks were once looked upon favorably: “over the past decade [stock buybacks] have become one of the business world’s favorite corporate finance tools.” But, “it wasn’t until 1982 that the [SEC] gave companies so-called safe harbor against charges of manipulation if they bought their stock in the open market under certain circumstances….Indeed, it was that rule change that led to the surge in buybacks, which were considered shareholder friendly. And it’s considered tax efficient: Unlike a dividend, there is no tax to be immediately paid.”
More recently, however, the concept of stock buybacks has attracted its fair share of media criticism, along with serious scrutiny from academics. For example, a 2014 article in The Economist observed that the critics of stock buybacks either view buybacks as “a form of financial sorcery, on a par with all those abstruse credit derivatives that helped cause the financial crisis” or accept them as legitimate but worry that they are overused, “a kind of corporate cocaine” that will, in the end, ” damage firms and the economy.” Likewise, William Lazonick, a professor of economics at the University of Massachusetts Lowell, argues in “Stock buybacks: From retain-and-reinvest to downsize-and-distribute,” published by the Center for Effective Public Management at Brookings, April 2015, that massive stock buybacks have damaged companies and the economy:
“Stock buybacks are an important part of the explanation for both the concentration of income among the richest households and the disappearance of middle-class employment opportunities in the United States over the past three decades. Over that period the resource-allocation regime at many, if not most, major U.S. business corporations has transitioned from ‘retain-and-reinvest’ to ‘downsize-and-distribute.’ Under retain-and-reinvest, the corporation retains earnings and reinvests them in the productive capabilities embodied in its labor force. Under downsize and-distribute, the corporation lays off experienced, and often more expensive, workers, and distributes corporate cash to shareholders. My research suggests that, with its downsize-and-distribute resource-allocation regime, the ‘buyback corporation’ is in large part responsible for a national economy characterized by income inequity, employment instability, and diminished innovative capability – or the opposite of what I have called ‘sustainable prosperity.’”
And now some have been questioning whether that safe harbor, Rule 10b-18, is indeed sheltering manipulative conduct. Some companies, the DealBook article charges, were “driven to pursue buybacks by executives seeking to lift their pay. Buybacks enable companies to issue more stock to executives without diluting other shareholders because they can buy shares to offset the dilution that occurs when executives exercise their stock options. It also led to another point of contention in executive compensation plans because buybacks have the effect of increasing earnings per share, a metric that some compensation committees use to determine the pay of their executives. It also has the impact of increasing the stock price in the short term irrespective of operational success, potentially letting executives cash out of some of their shares at artificially high prices. Buybacks are enticing for corporate executives, but they can create other problems, including the risk that they repurchase their companies’ shares at the exact wrong time, when their stock prices are too high. Worse, some companies take on debt to buy their own shares.”
As the article points out, this election year, some politicians have begun to jump on the bandwagon. Senator Tammy Baldwin sent a letter to the Chair of the SEC requesting that the agency revisit the rules on stock buybacks. (See this post.) Senator Elizabeth Warren joined in the battle, urging the SEC to recognize the potential for manipulation in buyback transactions. More recently, after observing that other advanced countries require companies to disclose stock buybacks within one day, former Secretary Hillary Clinton advocated that the U.S. follow suit. “We have to take a hard look at stock buybacks,” she argued, “Investors and regulators alike need more information about these transactions. Capital markets work best when information is promptly and widely available to all.”
The DealBook article asserts that accelerated disclosure requirements “would most likely make it much tougher — or at least more expensive — for American companies to buy back shares. Indeed, international companies have done a lot less of it.” In addition to revising existing or adding new securities rules related to the buyback transactions themselves, the article suggests, the government could impose tax changes that make stock buybacks more expensive to corporations than paying dividends or making investments in productive assets. Whether these types of regulations ever come to pass remains to be seen.