- $1 Trillion expected to go into buybacks this year
- Executives are permitted to secretly manipulate the market in their own favor at the time of the buyback
- Much of the Trump tax cuts intended to create jobs flowed instead into buybacks
Last month, Sears, the giant retailer that was a shoppers icon for 125 years, filed for bankruptcy showing an unmanageable $5 billion in debt. Since 2005, under the leadership of former Goldman Sachs trader and Wall Street superstar, Eddie Lampert, Sears had spent $6 billion in share buybacks. Why would a high paid brilliant executive do such a remarkably stupid thing?
First, let’s take a look at Lampert’s surprising salary structure. In 2014, CNN Money reported that he was one of a number of leading CEOs whose salary was one dollar per year. Now that does not mean that he took home only eight cents a month. His other compensation, all in stock, was $4.3 million.
There’s a very strong motivation for this seemingly selfless salary configuration and its popularity among executives; one due to a combination of exemptions in an SEC rule, a tax break and a misguided concept: shareholder value. The key to seeing why buybacks are bad for us lies in understanding the interaction between these three policies.
BTW: Lampert was not selected CEO after a talent search. Lampert had absolutely no experience in retail or business of any kind. He was a successful passive investor; his hedge fund, ESL Investments, got control of Sear’s shares and he muscled his way in.
Now, let’s have a look at what Edward S. Lampert, did. This former wonder kid of the Street instituted a policy based on the belief that share buybacks were the best use of the company’s money. Business Insider reported that Sears continued buybacks, even through the financial crisis of 2008, that totaled $5.8 billion between 2005 and 2010— while Sears’ earnings in the same period were $3.8 billion.
Lampert had Sears borrow to buy back. And why not? He had his own ever-increasing stock through his salary, and was also the majority shareholder through his hedge fund—and Sears could legally buy his shares back and in priority to mom and pop shareholders—explained below.
And the Sears experience is not unique. A Roosevelt Institute study found that whereas firms once borrowed to invest and improve their long-term performance, they now borrow to enrich their investors in the short-run. That same study also saw that: “Before the 1970s, American corporations paid out 50% of profits to shareholders, while retaining the rest for investment. Now, shareholder payouts are over 100% of reported profits, because firms borrow in order to lift payouts even higher.”
Lampert defended the buybacks as the most efficient use of capital, arguing that investment in store upkeep, modernization, and advertising wasn’t necessary. Two years before the bankruptcy an employee of a Sears store in Elyria, Ohio, had told Business Insider that his store was falling apart.
“The walls and floors in my store are all beat to hell … the roof leaks, the escalator and the elevator break down frequently, but ‘Fast Eddie’ doesn’t want to spend money on the stores.”
Making Stock Market Manipulation Legal
Surely, anyone, with the slightest knowledge of most CEO’s personal values and the stock market, would know the danger of market manipulation if corporations, which are controlled by executives, were allowed to buyback executives’ shares. Indeed, it was once absolutely prohibited because of the opportunity for fraud. Previously, executives could sell on the open market, but never to their own Corporation.
Then in 1982, in the Reagan years of government-is-the-problem, that prohibition was softened with an exemption. If the buyback met four conditions, Securities and Exchange Commission rule 10b-18 gave it a “safe harbor” absolution. The exemption covers the manner of repurchase, the time of the repurchase, the prices paid and the volume of shares repurchased.
In response to a request from Senator Tammy Baldwin (D-WI), SEC Commissioner Mary Jo White (2013–2017) admitted that policing compliance with the safe harbor exemption was impossibly complex — and the SEC was not doing the least thing about it.
So, unless you believe that these high paid executives are totally unselfish and would not take advantage of a dark closet situation, but would rather share the opportunity unselfishly with us, the investing public, we have a problem — a very big problem.
Now Add A Tax Incentive
During the 1990s when the voting public’s outrage at the escalating executive pay was forceful enough to force politicians to act, President Bill Clinton (1993–2001) successfully campaigned on a promise to put a lid on it. As promised, he immediately changed the tax code so that only $1 million of high-end executive pay could be deducted from income. That should do the trick, Clinton believed.
His advisors advised an exemption— of course, we see an ‘exemption’ again. Exemptions should be noted as a red flag. They sometimes completely undo what the politicians say the legislation is supposed to do. Here we will see another clear example of this truly effective technique.
BTW: These undercuttings of legislation do not come about by accident. The advisors and drafters of potential legislation come from the civil service which corporations and, especially bankers, learned to populate with their alumni quite some time ago. Many times the politicians themselves don’t realize the cunningly deceptive advice they are given. I certainly don’t believe Clinton intended the result—but his advisors did.
For more on how bankers did it, see: How Washington Became Ruled by Wall Street
This tax exemption permitted compensation for performance to be deducted. Thus if a company paid a bonus, that reward would meet the test. And here’s the rub: the bonus could be in stock or stock options. (So, when you read that a CEO’s pay is $20 million, it will likely be $1 million in salary and 19 in ‘performance pay’: stock or stock options as Lampert’s, noted above, was.)
Great! The promoters of the exemption cried. They would have skin in the game. This would motivate executives to do better for the corporation, right? Of course, wrong.
A Geek Interlude: A stock option gives the executive the right to buy stock in the company at a fixed price. Let’s say the CEO gets up bonus stock option of stock worth $1 million in 2015 called the strike price. They have the right in, say, 2018 to buy that stock, selling now at the 2018 price of $1.5 million, for the lower 2015 price of $1 million.
So, by now any student of human nature has seen the problem. The executives are motivated to increase the short-term price of corporate shares on the day they exercise the option— and at the same time, or as soon as possible— have their corporation buy the shares from them for an immediate cash bonanza.
And, don’t forget, that as the ultimate insiders, the executives not only know if that day’s price is inflated—they have the means to make it so.
The many ways of unaccountable accounting would, and has, filled books. One of the simplest ways here would be to defer expenses for one quarterly earnings report giving a short-term boost to profitability that in turn raises the share price temporarily. On this golden day, the executives exercise their options and sell back to the corporation.
If anyone is interested in seeing a study of how CEOs have captured the large accounting and auditing firms, I highly recommend: Bean Counters: The Triumph of the Accountants and How They Broke Capitalism
CEOs also have the ability to determine which shares are bought back. The broker, who acts on behalf of the corporation to do the buybacks, may also hold the executives’ shares in a dark pool. The details of the transactions would never see the light of day.
Another Geek Interlude: A dark pool consists of the many and various shares held by an investment bank on behalf of all its clients. So if a client wants to buy shares in Apple, the broker does not go directly to the stock market, they first check if any of the bank’s other clients want to sell Apple shares. Given the size of the major investment banks, that is a highly probable coincidence of events. The transaction is done within that one investment bank and nobody but the broker knows any of the details. Often the clients don’t know how it was done.
Seemingly Unsolvable Soaring CEO Pay
Yearly, we read the infuriating statistics of just how much the eye-popping CEO pay packages have surged this year over the last. The Economic Policy Institute (EPI) reported that in 2017, the average CEO pay of the 350 largest firms was $18.9 million — rising 17% over the previous year — while the average worker salary remained almost flat, rising a mere .3%.
There are many excellent articles on skyrocketing CEO pay. For my take on it from a rarely discussed way laws give the CEOs untouchable power in setting their own compensation, see: More For The Few, Less For The Many: How Little Known Laws Allow CEO Pay To Skyrocket
And most relevant to our discussion, the EPI investigators found:
CEO compensation grew strongly because of the large stock awards given to CEOs and their ability to sell previously granted stock options in a rising stock market.
I like to quote SEC Commissioner, Robert Jackson Jr., a law professor on leave to the SEC, whenever I can. He is a long time Republican and a Trump appointment — no bleeding heart lefty. Even this conservative academic writes in blunt warning of the abuses of ‘legal’ conforming purchases in a speech whose title captures his message: Stock Buy Backs and Corporate Cash Outs
You see, the Trump tax bill has unleashed an unprecedented wave of buybacks, and I worry that lax SEC rules and corporate oversight are giving executives yet another chance to cash out at investor expense.
In addition to the opportunity to illegally manipulate quarterly income reports as I suggested above, Jackson’s investigators found opportunistic executives can unload legally within the safe harbor at an inflated price. The market responds to the announcement of a buyback coming in 30 days with an immediate rise in stock price automatically.
In fact, twice as many companies have insiders selling in the eight days after a buyback announcement as sell on an ordinary day. So right after the company tells the market that the stock is cheap, executives overwhelmingly decide to sell.
Thus, executives personally capture the benefit of the short-term stock-price pop created by the buyback announcement.
Then, as Emily Stewart writing in Vox points out, this should be expected if we pay the slightest attention to attention to history:
“But again, none of this is really a surprise. In 2004, President George W. Bush gave corporations a one-time tax holiday for them to bring back earnings to the US at a reduced tax rate; three years later, companies used that money as follows: 47 percent went to mergers and acquisitions, 37 percent to buybacks, and 13 percent went to debt payments. Companies increased capital expenditures by 10 percent and research and development by 7 percent.”
In 1933, J. Pierpoint Morgan argued that CEO pay should not exceed 20 times the average worker’s pay. If it did, the CEOs would become more interested in increasing their own wealth than in the best interests of the company.
Today we commonly read reports of a 300 to 1 ratio. A graph of its meteoric rise, below, helps us to see the effect of the two exemptions: CEO pays slow rise in the 1970s (from the historic 20:1) ratio got some lift after the early Regan years from SEC 10b-18 (the safe haven exemption) about 1983, but achieved full lift-off after the Clinton ‘tax cap’ in the early 1990s.
I can’t say it better than how commissioner Jackson rephrased J. P. Morgan’s concern:
Now, let’s be clear: this trading is not necessarily illegal. But it is troubling, because it is yet another piece of evidence that executives are spending more time on short-term stock trading than long-term value creation. It’s one thing for a corporate board and top executives to decide that a buyback is the right thing to do with the company’s capital. It’s another for them to use that decision as an opportunity to pocket some cash at the expense of the shareholders they have a duty to protect, the workers they employ, or the communities they serve.
BTW: Congress passed a rule to end these pernicious retention bonuses that appear to reward incompetence. Any business seeking Chapter 11 bankruptcy protection could not pay retention bonuses. Of course, there were exemptions. Law Professor Jerad A. Ellias, of the University of California (Hastings), studied the result. He found (to quote Hamlet), the rule was more honored in the breach (the exemptions) than in the observance. Likely, there were naïve politicians who had voted for the rule honestly believing it would be effective.
AND BTW: There is a Rantt video that cogently condenses the buyback issues with a clip of Trump telling workers that his tax cuts will result in more money for them.
Unfortunately, even if the buyback safe haven and the performance pay exemption were eliminated, there’s not a snowball’s chance the money would go to workers because of another and more perverse notion: shareholder value.
The Shareholder’s Trade-Off
Jack Welch, a legendary CEO of General Electric, who increased its share value 400% under his tenure, warned that shareholder value should not be a direct goal, but the result of solid long-range planning.
“I said it’s the dumbest idea possible. It isn’t a strategy; it’s an outcome. A strategy is something like, an innovative new product; globalization, taking your products around the world; be the low-cost producer…Shareholder value? What the hell is that Larry? It’s the result of you doing a great job, watching your share price go up, your shareholders win, and dividends increasing.”
However, shareholder value is applied in exactly the opposite way and as the main corporate goal. Shareholder value dictates that as shareholders are owners of the corporation, the corporation’s main purpose is to enrich shareholders by paying as much in dividends as possible, which also increases the stock price.
An idea like this has many sources, but most attribute an academic paper by finance professor Michael Jensen and Dean William Meckling of the Simon School of Business at the University of Rochester for its launch in the 1970s. That statement that shareholders are owners is a total misconception. In fact, and this is the brilliance of the concept of a corporation, shareholders are not owners. Go ahead, buy a share in Apple Computers and try to get past reception at Cupertino waving it at the security guards. Then you’ll see how much of an owner a shareholder is.
The unique and difficult idea underlying the success of the corporate form is the split in the power of ownership.
Shareholders have very limited ownership rights, for example, to receive an annual financial statement and to vote for members of the Board of Directors; beyond that, not too much. The real power, at least formally, lies in the Board of Directors.
For simplification, you could think of the shareholders as having about 10% of the control and the BOD having 90%. However, if you are a shareholder and you have tried to get one of your ideas even put on an agenda at the Annual General Meeting, you will think that I have exaggerated individual shareholder power. You will have learned that you have the same power as a citizen with voting power in a democracy to influence Congress.
On the plus side, you will never be liable for any of Apple’s debts if it was to become insolvent. That is the trade-off and brilliance of the idea: Investor chance to participate in the growth of the corporation without assuming the slightest liability for its debts.
A Legal Geek Point: With a true understanding of the very limited role and power of a shareholder in a corporation, you can understand the reason for the failure of the shareholder say-on-pay movements for decades to even get it as an item on the agenda for the AGM. It took a legislative directive in Dodd-Frank to require that corporations put executive pay on the AGM agenda—and in a bow to corporate power—on a non-binding basis.
If you are interested in seeing how CEOs effectively determine their own pay by manipulating the corporate structure, see More For The Few, Less For The Many: How Little Known Laws Allow CEO Pay To Skyrocket
How CEOs Became Shareholders Themselves
University Toronto professor Roger Martin, named the world’s #1 management thinker by Thinkers50 in 2017, raised the alarm about the long-term harmful nature of shareholder value in his very readable Fixing The Game: Bubbles, Crashes and What Capitalism Can Learn From the NFL in 2011. Since CEO pay today is largely in shares, they are among the shareholders who benefit if the company treasury is stripped to pay dividends. The CEOs personal interest is pitted against the long-term interests of the corporation.
In a Forbes article, Steve Denning quotes the essence of Martin’s argument against shareholder value:
“What would lead [a CEO],” asks Martin, “to do the hard, long-term work of substantially improving real-market performance when she can choose to work on simply raising expectations [share prices] instead ? Even if she has a performance bonus tied to real-market metrics, the size of that bonus now typically pales in comparison with the size of her stock-based incentives.”
Before the 1970s corporate managers believed that corporations had a responsibility not just to shareholders but to customers, workers, the economic welfare of their own country and future generations. In 1954 legendary management guru Peter Drucker said the only valid purpose of an enterprise is to create a customer. And until the 1970s, executives concentrated on long-term research and development and the CEO worker pay ratio was 20 to 1.
That began to change with the acceptance of an academic article published in 1976 by finance professors Michael Jensen and William Mechling of the Simon School of Business at the University of Rochester. They believed they had found the solution to the inherent conflict between executives wanting the most for themselves as fast as possible and the best interests of the corporation: make executives shareholders by increasing that part of their compensation package. Then, their financial interests would be aligned with the success of the corporation. And so it was done. Executive pay packages began to contain a larger and larger portion of stocks. This may explain the beginning rise in CEO compensation and the stagnation of worker salary as shown on the above graph.
Like so many other policies and the laws founded on them, the result was exactly the opposite than publicly stated. Now only one thing mattered: make immediate money for the ‘owners’ - who happened to include themselves. Executives became interested in immediate profits for immediate dividends. The average CEO term became six years. The CEOs realized that the fallout from their short-termism would fall on a successor.
Facilitating The Return Of The Rule Of The Super Rich
Who are the shareholders? About 80 percent of all stocks are owned by the richest 10 percent of Americans.
As a professor of political economy, Andrew Thayer said in the May 2018 Tax Justice Network podcast: “Being an investor sounds good, doesn’t it? Who wouldn’t want to be an investor, sounds like kind of a benefactor but actually in practice a lot of investment, possibly a majority of investment is purely extractive…And in our economy the asset rich have become richer at the expense of the asset poor, people who own very little”
Indeed, a good percentage of these stocks will be held by hedge fund and pension fund money managers who want to make the most, the fastest, to earn large commissions for themselves. They do not act as owners but corporate raiders— which journalists once accurately called them. Now journalists refer to them as ‘shareholder activists’ as if they were acting out of motives for the improvement of society like like an Occupy Wall Street group.
And by way of additional harm, these managers will approve any CEO pay package as long as the CEO is committed to their common interest of stripping out as much money from the corporation through dividends as possible. When you read that a shareholder vote approved an enormous CEO pay, ask further: who are these shareholders? Were they hedge funds. You won’t be able to find out. That is never reported.
William Lazonick, an economics professor at the University of Massachusetts Lowell, recently told CNN Money, that buybacks worsen wealth inequality. “Stock buybacks have been a prime mode of both concentrating income among the richest households and eroding middle-class employment opportunities.”
BTW: You might be interested in an article by Lazonick entitled Profits Without Prosperity that won the HBR McKinsey Award for the best article of the 2014, Harvard Business Review. Lazonick called buybacks “in effect, stock price manipulation.” Share buybacks represent a cancer on capitalism: if not remedied, the future of capitalism itself will be at stake. Or you can read Steve Denning’s summary for Forbes.
What’s Being Done
On June 29, 2018, Senator Tammy Baldwin got together with Chris Van Hollen (D-MD) and Minority Leader Chuck Schumer (D-NY) and mobilized twenty of their senatorial colleagues to write a letter as a group to the U.S. SEC Chairman Jay Clayton, calling on the S.E.C. to review the its current rules around stock buybacks.
“We are even more disturbed,” the senators wrote, “by the dramatic increase in stock sales by corporate insiders following the announcement of a buyback. This phenomenon means it is imperative that the S.E.C. revisit the evolution of Rule 10b-18 to ensure that corporate executives are not using the rule inappropriately to enable to enable advantageous sales of their own stock while ignoring the needs of their companies’ workers.”
U.S. Senator Bernie Sanders announced a bill this month, called the Stop Walmart Act, that would force big companies to better pay their lowest-earning workers before buybacks.
Will these initiatives end the abuse of shareholder buybacks? Senior corporate management will be joined by hedge fund and pension fund money managers to make certain that if any such law is passed, there will be sufficient exemptions to undercut the restrictions. It will take an informed voting public to understand what is at issue and how to end it: a complete prohibition on corporations buying back the stock held by executive insiders — no exemptions—as the law once was.