Harvard Professors Expose 'The Real Problem With Stock Buybacks'

First published in The Wall Street Journal,

Many critics say buybacks crimp investment. But the real problem is that - unlike dividends - buybacks can be used to systematically transfer wealth from shareholders to executives..

There is a problem with share buybacks - but it isn’t the one many critics and legislators are obsessed with.

Some critics claim that repurchases starve firms of capital they could invest for the long term, harming workers to enrich shareholders. Democratic Sens. Chuck Schumer of New York and Tammy Baldwin of Wisconsin agree and have introduced legislation to “rein in” corporate stock buybacks. The bill would give the Securities and Exchange Commission authority to reject buybacks that, in its judgment, hurt workers. It also would require boards to “certify” that a repurchase is in the “best long-term financial interest of the company.” Sen. Baldwin has introduced another bill, co-sponsored by Sen. Elizabeth Warren (D., Mass.), that goes even further: It bans all open-market repurchases.

This criticism of buybacks is flawed; there is simply no evidence that the overall volume of dividends and repurchases is excessive. The real problem with buybacks is that they tend to enrich executives at the expense of shareholders. Fortunately, there is a simple remedy.

Flawed argument

Buyback critics say S&P 500 firms don’t have enough investment capital because dividends and repurchases routinely exceed 90% of their net income. Between 2007 and 2016, for example, these companies distributed $7 trillion to shareholders, mostly via repurchases. That was 96% of total net income. But our research shows that public firms recover from shareholders - directly or indirectly - about 80% of the capital distributed via repurchases. Shareholders return this capital by buying newly issued shares, mostly from employees paid with stock, but also directly from firms. Taking into account all types of equity issuances, net shareholder payouts in S&P 500 firms during the decade 2007-2016 were only about $3.7 trillion, or 50% of total net income.

At this level, net shareholder payouts don’t appear to impair investment capacity. Indeed, our research shows that total R&D expenditures by public firms are at the highest level ever. A broader measure of investment intensity at public firms, the ratio of capital expenditures and R&D to revenue, has been rising over the past 10 years and is near peak levels not seen since the late 1990s.

One might argue that firms would invest even more if they had more cash at their disposal. But there is no shortage of cash. During 2007-16, cash balances at S&P 500 firms also rose by 50%, reaching around $4 trillion, providing ample dry powder for additional expenditures. This astonishing level of idle cash suggests that net shareholder payouts may actually be too low.

The real problem is that buybacks, unlike dividends, can be used to systematically transfer value from shareholders to executives. Researchers have shown that executives opportunistically use repurchases to shrink the share count and thereby trigger earnings-per-share-based bonuses. Executives also use buybacks to create temporary additional demand for shares, nudging up the short-term stock price as executives unload equity. Finally, managers who know the stock is cheap use open-market repurchases to secretly buy back shares, boosting the value of their long-term equity. Although continuing public shareholders also profit from this indirect insider trading, selling public shareholders lose by a greater amount, reducing investor returns in aggregate.

[ZH: As a reminder, senior executives and directors of Facebook, Amazon, Netflix, and Google parent Alphabet have dumped $4.58 billion of stock this year, according to data compiled by Bloomberg. They’re on track to exceed $5 billion for the first six months of 2018, the highest since Facebook went public in 2012.]

Executives can use repurchases to enrich themselves because disclosure requirements are woefully inadequate. When executives trade personally, they must publicly disclose the details of each trade within two business days. The spotlight created by such real-time, fine-grained disclosure helps curb trading abuses by executives. By contrast, the SEC only requires a firm to report, in each quarterly filing, the number of shares repurchased in each month of the quarter and the average price paid per share. Investors see this filing a month or so into the next quarter, one to four months after the buybacks occur. And they never see individual repurchases, just aggregate transaction data. Researchers can detect the existence of buyback abuses across a large sample of public firms, but investors cannot easily identify the particular executive teams using repurchases to line their own pockets.

A solution

A simple, common-sense regulatory change would curb such abuses. In particular, the SEC should require a firm to disclose each trade in its own shares within two business days, as it does for executives personally trading company stock. This two-day rule would shine a spotlight on repurchases, discouraging executives from using them opportunistically. For example, if such real-time disclosure leads investors to believe that executives are using a buyback to buy underpriced stock, the stock price would start rising, reducing executives’ indirect profits from any subsequent repurchases, and thereby increasing public investors’ returns.

Perhaps all we need is a modest regulatory tweak: subjecting firms to the same trade-disclosure requirement as their own executives.

A two-day rule won’t unduly burden firms’ use of repurchases for proper purposes, just as the rule doesn’t unduly burden individual insiders. Indeed, some of the largest stock markets outside the U.S. already require even more timely disclosure by firms trading in their own shares. In the U.K. and Hong Kong, firms must report a repurchase to the stock exchange before trading begins the next day. Japan requires same-day disclosure, and Swiss investors see these trades in real-time.

Even if the two-day disclosure rule doesn’t eliminate completely executives’ abuse of buybacks, it will generate fine-grained data about repurchases that can be used to decide whether more aggressive regulation is desirable.

The regulatory reforms currently under consideration, such as empowering the SEC to block buybacks, might curb these abuses even more. But they also could generate huge economic costs by impairing the circulation of capital in the economy. It would be foolish to go straight to such drastic measures rather than start with a modest regulatory tweak: subjecting firms to the same trade-disclosure requirement as their own executives.

*  *  *

Prof. Fried is a professor at Harvard Law School, and Prof. Wang is an associate professor at Harvard Business School.

Comments

Endgame Napoleon Stuck on Zero Sun, 07/08/2018 - 18:15 Permalink

That would be too constructive. To get to the next step up on the decadence ladder, we need corporations to ditch the pretense of making things, wantonly trading just for the sake of further enriching the 1% of business leaders and the top 20% of salaried, non-job-creating, dual-high-earner babyvacationers in the top 20%. Why not? They long ago shed any pretense of caring about the economic strength of their own country, shifting 5 million breadwinner jobs and potential SS contributions to the racially homogenous, cheap-labor paradises of Asia & Mexico without batting an eyelash. 

In reply to by Stuck on Zero

puckles dead hobo Sun, 07/08/2018 - 19:42 Permalink

The real point here is that this is malinvestment, pure and simple.  If any of these corporations had truly responsible (and responsive) boards, never mind activist shareholders, this would not and could not happen. US (and to a large extent, worldwide) boards have become rubber stamps for whatever senior management wants to do, which is always and forever now to enrich themselves at the cost of the shareholders.  This is not capitalism.  It is sheer thievery.

In reply to by dead hobo

847328_3527 dead hobo Sun, 07/08/2018 - 15:50 Permalink

Harvard must be pissing in their pants now that we have a more conservative Supreme court given the cases that will surely head their way:

Harvard sued for alleged discrimination against Asian American applicants

https://www.theguardian.com/education/2018/jun/15/harvard-sued-discrimi…

And there's a bunch of suits against these univerisities that discriminate on the basis of race....against Asian and white students in favor of the Entitled Race.

In reply to by dead hobo

Krink26 Sun, 07/08/2018 - 15:43 Permalink

Ahhhh, it took someone from Harvard to figure this out. Uh huh, right. Nobody except an "expert" from a tier 1 uni could see this. 

And people ask how can we be losing so much faith in our institutions...

konadog Sun, 07/08/2018 - 16:08 Permalink

Buybacks are a clever way to avoid dividend taxes, but when companies start borrowing money, cutting R&D, laying off employees, and so on to fund buybacks, that's called FRAUD. If the SEC did anything but twiddle their thumbs and whistle past the graveyard, these crooks masquerading as "executives" would be in prison.

dead hobo konadog Sun, 07/08/2018 - 16:14 Permalink

Sorry, but it's not fraud or even illegal. Especially if the board approves it. Bad management is not illegal. Becoming a top executive is the brass ring. Nobody else matters as long as the rest of the people at the top get theirs.

Stealing inventory is illegal. Borrowing money to fund a stock buyback for the purpose of enriching the people at the top is perfectly OK.

In reply to by konadog

Balance-Sheet Sun, 07/08/2018 - 16:15 Permalink

These people quoted in the article above are National Socialists of the same type as the National Socialist German Workers or the Fascist Party of Italy. Both of them are currently out of business so the modern example would be Chinese Communist Party.

They want Big Government to issue detailed instruction to private businesses which are NO part of the USG and operate globally and they wish to issue detailed instructions as to every aspect of their operations. These are publicly owned companies NOT government agencies. 

Anyone may purchase their stock and they may do so as well if the stock seems undervalued. If YOU DO buy any stocks in anything you are LOOKING FOR undervalued situations and that situation may be in the company where you work. If the stock seems overvalued anyone may SELL their shares.

They might seem nice if you met them but inside they are damnable tyrants - your votes may be able to cast them out.

navy62802 Sun, 07/08/2018 - 17:03 Permalink

Might as well just write a bill that prohibits stock buy-backs. This type of legislation is written by people who are covertly fascist but overtly capitalist. They want you to believe they support a free market but secretly they advocate for a market controlled by them.

GoldmanSax Sun, 07/08/2018 - 17:20 Permalink

The SEC is made up of the same pricks in the industry. Only non club members will be blocked. As usual, they will keep picking the winners and losers. Guess who is on the chosen winner list?

Haitian Snackout Sun, 07/08/2018 - 18:05 Permalink

Actually, they can get two paydays....By owning the senior bonds ( which you and I cannot buy ), they can get all the assets when the debt leverage sinks the company, the subordinate bond and stockholders being thrown under the bus. 

affirmed_78 Sun, 07/08/2018 - 18:18 Permalink

I believe exec stock options take into account dividends paid.  Otherwise, they would be incentivized not to pay dividends to keep the stock higher.  One solution to the buyback problem is that exec option strike prices should also adjust based on share count.

Let it Go Sun, 07/08/2018 - 18:33 Permalink

Not only do buybacks unfairly transfer wealth they also destroy true price discovery! As of 2015, just 30 firms accounted for half the profits of all publicly-listed U.S. companies, down from 109 in 1979. Only by accumulating debt have many laggards been able to afford the buybacks necessary to keep stock appreciation stable. The IMF warned last year that 22% of U.S. corporations are at risk of default if interest rates rise.

Share buybacks proliferate when the market is rising but evaporate when the market collapses. In many ways, the decision way back in 1982 to again allow stock buybacks may highlight the true meaning of the phrase. "Been there, done that, learned nothing." More on the importance of this in the article below.

 http://Stock Buybacks Driving Market-Where It Might Take Us.html

IntelligenceActs Sun, 07/08/2018 - 18:37 Permalink

"Legislation to “rein in” corporate stock buybacks"

It ain't a power .gov has so scrap it already!

It's being done to make these corporations To Big To Fail!

Let these idiot corporations do what they want and when they go bust, blow 'em into the wind...

timothy235 Sun, 07/08/2018 - 18:52 Permalink

Mandated transparency is the best government intervention because more information can only increase accountability and overall economic efficiency.

BunkerZee Sun, 07/08/2018 - 19:24 Permalink

" buybacks can be used to systematically transfer wealth from shareholders to executives "

 

No shit - you forgot they enrich themselves with their stock options - canhing them out for 10s of millions in profit - then leave the company saddled with enormous debt, while they golden parachute out to the next company to rape.

Roger Ramjet Sun, 07/08/2018 - 19:57 Permalink

Let's see:

1) Corporate boards award shares to their executives (as well as to the directors themselves) and at the same time authorized a share buyback program (oftentimes authorizing debt to finance the share buyback program);

2) the company then bids up the publicly traded shares via the corporate buyback scheme, and then;

3) Corporate insiders (and directors) unload the shares to less than astute public buyers (most likely pension funds and passive ETFs).

Seems perfectly above board and proper to anyone of unctuous ethics and lacking an ounce of moral character.

Meanwhile the SEC stands idly by and contemplates the propriety of such buyback arrangements.

Cassander Sun, 07/08/2018 - 23:20 Permalink

WTF do U.K., Hong Kong, Japan and Swiss regulators know about how executives scam investors with buybacks? Are they the Nation of Destiny? Are they the Greatest Country in the History of the World? F'em. We'll do it our way.