by Cydney Posner
A recurring demand by hedge fund activists is that the target company return capital to its shareholders by buying back its own stock. Data compiled by S&P and Bloomberg shows that companies in the S&P 500 spent 95% of their earnings on repurchases and dividends in 2014, including spending $553 billion on stock buybacks. But, in some cases, conducting a stock buyback can be an ultimatum with which company executives are actually happy to comply. Why? One of the more appealing consequences of the buyback trend for company executives is that, in some cases where compensation performance metrics are stock-price- or EPS-related, buybacks can juice executive compensation, irrespective of the operational success of the company. Now, some governance activists are beginning to challenge whether that favorable consequence should be curtailed.
While some applaud these stock repurchases, the concept of stock buybacks has recently attracted its fair share of media criticism, along with serious scrutiny from academics, claiming that buybacks and related short-term stock price hikes come at the expense of long-term value creation. For example, some academics have contended that, instead of using corporate profits for investment in innovation and “productive capabilities,” companies are spending those profits (and more) on enormous stock buybacks. (See this PubCo post and this PubCo post.) A September 2014 article in The Economist,“The repurchase revolution,” 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.’” (See this PubCo post.)
Now, the AFL-CIO and others are beginning to take steps to eliminate what they view as one of the motivations for buybacks — or at least one of the side effects. For 2016, the AFL-CIO (and entities apparently acting on its behalf) has submitted a new shareholder proposal asking companies to adjust executive pay metrics to exclude the impact of stock buybacks. According to this AFL-CIO publication, the proposals were submitted this year at IBM, Illinois Tool Works, 3M and Xerox.
Generally, the shareholder proposal urges the target companies’ compensation committees to “adopt a policy that financial performance metrics shall be adjusted, to the extent practicable, to exclude the impact of share repurchases when determining the amount or vesting of any senior executive incentive compensation grant or award. The policy should be implemented in a way that does not violate existing contractual obligations or the terms of any plan.”
The proponent contends that buybacks directly affect many of the financial ratios used as performance metrics, but, while they may boost stock prices in the short term, the proponent is “concerned that they can deprive companies of capital necessary for creating long term growth.” The proponent believes that, because senior executives are responsible for improving operational performance, “senior executives should not receive larger pay packages simply for reducing the number of shares outstanding. Executive pay should be aligned with operational results, not financial engineering.”
The proponent also asserts that, for “the 12 months ended June 30, 2015, S&P 500 companies spent more money on stock buybacks and dividends than they earned in profits.” In addition, the proponent looks to the chair and CEO of BlackRock, who urged that “[l]arge stock buybacks send ‘a discouraging message about a company’s ability to use its resources wisely and develop a coherent plan to create value over the long term.’” In each case, the proponent compares the amount spent on stock buybacks with the amounts spent on R&D and capital expenditures. For example, for Illinois Toolworks, according to the proponent, the company “spent $2.9 billion on share buybacks in 2014, but only $227 million on research and development, and $361 million on capital expenditures.” The proponent also identifies the CEO’s comp and the amount received in awards that are dependent on financial metrics that are susceptible to being goosed by stock buybacks.
Among the arguments made in the companies’ various statements in opposition are that the companies are committed to organic growth through capital expenditures and research and development and that they have capital allocation strategies designed to create growth opportunities through investment and to return excess capital to shareholders, that their boards assess their capital requirements to ensure that there is sufficient capital for investment for future growth, that performance metrics are designed by compensation committees (which, they contend, are in the best position to make these determinations) to align pay and performance, that among the metrics is typically an organic growth metric and that limiting the companies’ ability to use appropriate performance metrics is not in the best interests of the companies or their shareholders.
Interestingly, while the AFL-CIO proposal appears in the definitive proxy statements filed for this proxy season by Illinois Tool Works, 3M and Xerox, it does not appear in the proxy statement filed for IBM. Perhaps IBM negotiated a settlement with the AFL-CIO to withdraw the proposal? Only the parties know for sure. However, in its 2016 proxy statement, IBM’s description of its Performance Share Units has been enhanced this year to address the impact of “unplanned” stock buybacks: it provides that “the two metrics [used for the Performance Share Units] are operating EPS and free cash flow. The targets for the Performance Share Unit program are set at the beginning of each three-year performance period, taking into account IBM’s financial model shared with investors and the annual budget as approved by the Board, including the impact our share buyback program has on operating EPS. In addition, for Performance Share Unit awards made in 2016 and beyond, the Committee has determined that actual operating EPS results will be adjusted to remove the impact of any change from the budgeted share count, including share repurchase transactions. This method formalizes the Committee’s longstanding intention of not having unplanned share repurchase practices affect executive compensation.”
Possibly signaling that this effort may expand, an Amalgamated Bank fund has submitted a very similar proposal to Wal-Mart Stores, which Wal-Mart attempted to exclude without success. Wal-Mart has not yet filed its definitive proxy statement. The question remains: will we see more of these proposals next year?