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.

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