A Capitalist’s Solution to the Problem of Excessive Buybacks

VEA Vice Chair Nell Minow wrote about buybacks on the Harvard Law Forum on Corporate Governance and Financial Regulation:

 

We may not need a government solution to the issue of excessive corporate stock buybacks. We most certainly do not need the solution proposed by Senators Chuck Schumer and Bernie Sanders, requiring companies to adopt minimum wage requirements for hourly workers before buying back stock. What we need is a capitalist solution, removing misaligned incentives, moral hazards, and diversion of assets to make sure the market’s buyback decision is the right one.

The conventional thinking about stock buybacks is that when corporate managers and directors believe the stock is undervalued and do not have a better use for excess capital they should return it to shareholders. No one can argue with that; it is vastly preferable to the usual alternative, overpaying for acquisitions that are not core to the company’s business. That’s a whole different discussion of misaligned incentives.

But as we have often seen, most recently with mortgage-backed derivatives, good ideas can be abused and become destructive. In this case, the excess cash was not the result of operating efficiencies but a windfall from President Trump’s tax bill. The corporate tax cuts were sold as a way to increase compensation for workers and support strategic initiatives like research and development. Instead, 2018 saw record buybacks, over $1 trillion worth, much of it at the top of the market, so it was difficult to justify an argument that the stock was undervalued or that there was no better strategic use for the money.

study by Tim Swift in the Academy of Management Proceedings found that stock buybacks suppress innovation. A real-world example is Sears, where $6 billion buying back stock that was collapsing into bankruptcy could have been deployed to improve operations. And a 2017 studyreached a troubling conclusion that companies are not clear with their boards or their investors about the basis for the decision to buy back stock. “Few companies publicly disclose details about buyback decision-making and very few state the reasons for a specific buyback program.”

Why would directors and executives approve buybacks when the stock is not undervalued and there are worthwhile opportunities to invest the cash in support of long-term strategies? One reason is revealed in another study of buybacks, this one conducted by SEC Commissioner Robert Jackson, who found that “right after the company tells the market that the stock is cheap, executives overwhelmingly decide to sell.” And it is almost unheard of for companies to adjust their EPS targets for incentive compensation to reflect the reduction in shares from a buyback. There are two ways to reach earnings per share goals, by increasing earnings or reducing outstanding shares. But only one of those has real long-term benefits to shareholders. Executives do better from buybacks than retail investors, the exact opposite of what incentive compensation is supposed to accomplish. This is not just bad for the long-term viability of the corporations; the agency costs involved undermine the credibility of our system of capitalism.

Therefore, the solution is to re-align the incentives. And that is the job of the corporate boards, especially their compensation committees.

First, compensation committees should not allow a stock buyback unless the incentive compensation EPS goals are adjusted accordingly. Indeed, this is yet another reason that all stock and option awards should be indexed to the peer group or the market as a whole to prevent just this kind of manipulation.

Second, compensation committees should require all insiders—executive or director—to hold all of their shares, including exercised options, until three years after the most recent buyback.

And if they do not, then it is up to the investors, meaning the large institutional investors, to vote against compensation committee members who fail to insist on these provisions, and, if necessary, run their own candidates to replace them.

Shareholders may need to remind boards of directors that their decisions should be based on what will benefit shareholders over the long term. The key metric is not whether corporate insiders think their stock is a good investment; the key is whether the outside shareholders do.

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