Almost 20 organizations, including the AFL-CIO and nonprofit consumer advocacy group Public Citizen, have filed a rulemaking petition with SEC “to revise Rule 10b-18 to curb manipulative practices by firms and encourage corporations to fairly compensate American workers.” In essence, the petition seeks to repeal Rule 10b-18 and requests that the SEC “undertake a rulemaking to develop a more comprehensive framework for regulating stock repurchase programs that would deter manipulation and protect American workers.” In light of the almost—dare I say it—“bipartisan” interest in reviewing the practice of stock buybacks, will the SEC decide that it’s worth taking a look?
As you know, Rule 10b-18 provides a “safe harbor” from liability for “manipulation” under the Exchange Act where a company conducts a stock repurchase program in conformity with the Rule’s volume, manner, price and timing conditions. As described in the petition, the SEC intended the Rule to be “a scheme of regulation that limits the ability of an issuer *** to control the price of the issuer’s securities.” The petition characterizes the impact of adoption of the Rule in 1982 as giving rise to “a sea change in corporate finance, after which stock repurchases became more common. Prior to its adoption, repurchase programs were relatively rare due to the threat of a manipulation charge; after the Rule took effect, the aggregate value of stock repurchases rose significantly.”
And, after the enactment of the recent Tax Cuts and Jobs Act, the use of buybacks “skyrocketed”: according to the petition, in 2018, “the first full year after the tax cut, repurchases surged 64 percent over the previous year and topped $1 trillion overall. Yet real wages for typical workers remained flat.” Although the tax bill “provided significant tax benefits to large corporations, such as a lower corporate tax rate and an incentive to repatriate offshore cash,” instead of raising wages, as was widely touted by those promoting the bill, companies “raced to repurchase their own stock[, leading] to a 64 percent increase in stock repurchases while real wages for workers remained flat. Indeed, analysts estimate that in 2018 corporations used nearly 60 percent of their corporate tax cut to repurchase stock. In other words, at a time when wages for average workers have failed to keep up with inflation, corporations have used the corporate tax break to collectively pay $1 trillion to executives, boards of directors, and large share sellers. Instead firms could dedicate this capital to worker wages, training, hiring, and other investments necessary for innovation and growth.”
As discussed in this article in The Atlantic, while many companies are now publicly expressing support for many social causes, “[w]hen it comes to how businesses treat their employees,… that same enthusiasm for equality and progress is often nowhere to be found. Wage stagnation persists even as American corporations’ profits grow, and the gig economy has made it difficult for many workers to take comfort in the basics of traditional employment, such as economic stability and access to health care. Meaningfully raising wages and improving benefits for employees at the expense of profits can feel like the third rail of American enterprise.”
But hear this from what might seem to be an unlikely source, the Chairman of the U.S. Chamber of Commerce: “‘Milton Friedman says businesses should only make money, and I just disagree with that….You’ve got to serve customers. You’ve got to make money, because that’s one of the things you get paid to do. But you’ve also got to create jobs and improve our communities….The shareholder thing, I think that’s completely crap, to be honest. The noisiest ones are the ones who are in and out; they’re trading all the time, and you just have to ignore them….You don’t get paid to run a business to take orders, you get paid to run a company.’”
Of course, he is referring here to the “shareholder preeminence theory” developed by the Chicago school of economics, beginning in the 1970s, with economist Milton Friedman famously arguing that the only “social responsibility of business is to increase its profits.” (See this PubCo post.) The problem, the article suggests, is that companies usually don’t keep stats about “how many jobs they create in a particular year, or how many of those jobs are high-value roles that pay a solid wage for reasonable work hours. ‘Businesses need to be held accountable for creating more high-value jobs,’ [the Chairman said], explaining that executives shouldn’t point to the currently low unemployment rate to mask their own company’s low wages and poor working conditions. ‘Thirty-seven percent of Americans don’t have $400 for an emergency, so you can’t take comfort in the fact that they’re all working.’” The Chairman recommended that some basic standard measures of job creation be adopted at a federal level.
What’s more, the petition argues, the conditions of the Rule have failed to achieve their essential purpose of limiting the ability of a company to manipulate its stock price and volume: the Rule has “failed to prevent executives from using repurchases to boost a company’s stock price or meet other performance goals at the expense of investing in its workers. And the inadequate disclosure requirement in Rule 10b-18 frustrates oversight by investors and the Commission.” Because stock repurchase programs tend to pump up stock prices, the petition contends, executives have a “strong financial incentive …to use these effects of repurchases to increase their own compensation.” The impact is compounded by the recent trend to award executive compensation that is “performance-based, tied to stock price or earnings per share…. Repurchase programs offer a direct lever to achieve those [performance] goals. Indeed, empirical analysis of firm behavior has revealed that the likelihood of repurchases is higher at firms that would have just missed analyst earnings expectations without the effect of the repurchase. This strongly suggests that firm executives rely on repurchases to meet earnings targets and thus increase their own performance-based compensation.” But nowhere does Rule 10b-18 address this issue, the petition claims.
In addition, the petition contends, the lack of effective disclosures obscures whether repurchase programs conform with the conditions of the Rule 10b-18 safe harbor. Firms disclose quarterly information about repurchase programs, but only after the fact and tabulated by month.
The petition also points to the study by SEC Commissioner Robert Jackson showing that executives often time the sale of their shares to benefit from the price increase created by stock repurchases and their announcement. The research revealed that, “[d]uring each of the eight days following an announcement, executives are twice as likely to sell shares as any other day and sell on average five times the volume of stock. As executives are not required to disclose their trading intentions to shareholders in advance of a repurchase program, shareholders are less able to scrutinize repurchase programs for conflicts of interest.”
Jackson’s study found “clear evidence that a substantial number of corporate executives today use buybacks as a chance to cash out the shares of the company they received as executive pay, especially those shares designed to link executive pay with long-term performance. To Jackson, allowing executives to cash out—at prices often inflated by the company’s buyback announcement and open-market purchasing activity—undermines the purpose of equity comp: to give executives “incentives to create long-term, sustainable value.” If buybacks are really the right long-term strategy for the company, he contends, then executives “should want to hold the stock over the long run, not cash it out once a buyback is announced.” (See this PubCo post.)
Jackson and his staff undertook to study executive stock sales in the context of 385 buybacks over the preceding 15 months. To no one’s surprise, they found that the announcement of a buyback led to abnormal returns of more than 2.5% in the subsequent 30 days. But the consistent behavior of executives did come as a bit of a shock:
“What did surprise us, however, was how commonplace it is for executives to use buybacks as a chance to cash out. In half of the buybacks we studied, at least one executive sold shares in the month following the buyback announcement. 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.
“And, in the process, executives take a lot of cash off the table. On average, in the days before a buyback announcement, executives trade in relatively small amounts—less than $100,000 worth. But during the eight days following a buyback announcement, executives on average sell more than $500,000 worth of stock each day—a fivefold increase. Thus, executives personally capture the benefit of the short-term stock-price pop created by the buyback announcement[. T]he evidence shows that buybacks give executives an opportunity to take significant cash off the table, breaking the pay-performance link. SEC rules do nothing to discourage executives from using buybacks in this way. It’s time for that to change.”
The petition follows calls by a number of politicians for legislation revisiting the buyback rules. At the beginning of February, in an NYT Op-Ed, Senators Chuck Schumer and Bernie Sanders wrote that the “pervasive corporate ethos” of shareholder preeminence—again, the idea that the duty of management and the board should be to maximize shareholder value (see this PubCo post)—has obsessed corporate boardrooms “to the detriment of workers and the long-term strength of their companies, helping to create the worst level of income inequality in decades. One way in which this pervasive corporate ethos manifests itself is the explosion of stock buybacks. So focused on shareholder value, companies, rather than investing in ways to make their businesses more resilient or their workers more productive, have been dedicating ever larger shares of their profits to dividends and corporate share repurchases.”
The problem, as they describe it, is both that buybacks benefit only a small percentage of the population and that, “when corporations direct resources to buy back shares on this scale, they restrain their capacity to reinvest profits more meaningfully in the company in terms of R&D, equipment, higher wages, paid medical leave, retirement benefits and worker retraining. It’s no coincidence that at the same time that corporate stock buybacks and dividends have reached record highs, the median wages of average workers have remained relatively stagnant.” Americans, they suggest,” should be outraged….”
Central to the Schumer-Sanders Op-Ed was the undertaking “to introduce bold legislation to address this crisis. Our bill will prohibit a corporation from buying back its own stock unless it invests in workers and communities first, including things like paying all workers at least $15 an hour, providing seven days of paid sick leave, and offering decent pensions and more reliable health benefits. In other words, our legislation would set minimum requirements for corporate investment in workers and the long-term strength of the company as a precondition for a corporation entering into a share buyback plan. The goal is to curtail the over-reliance on buybacks while also incentivizing the productive investment of corporate capital.”
I must have slept through it? I see a bill from Schumer on the “equitable management of summer flounder,” but nothing on buybacks. So where’s the beef?
Shortly thereafter, Republican Senator Marco Rubio released a proposal to “curb incentives for companies to use excess capital to buy back shares,” which would have taxed buybacks like dividends and allowed companies to immediately write off capex and R&D expenses.
Similarly, in this 2018 letter to SEC Chair Jay Clayton, 21 senators requested, in light of the accelerating pace of stock buybacks, that he look into how companies and executives are using the buyback process and solicit public comment regarding the buyback rules. The letter indicates that both Commissioner Peirce and the Chair himself had previously indicated support for a review of Rule 10b-18. During her confirmation process, Peirce indicated that, in her view, “a review of Rule 10b-18 would be ‘timely’ given the increase in buyback activity, adding ‘I look forward to working with my fellow Commissioners and the SEC staff to look at the evidence about how and why buybacks are occurring and assess whether, in light of this evidence, changes to the regulatory framework are needed.’ Similarly, at a Senate Banking Committee hearing last year [Clayton] noted, ‘one thing that does trouble me is if these stock buybacks are motivated not by the long-term interest of the company but some short-term interest.’”
To make that case (and just in time for the upcoming Corp Fin roundtable on short-termism—see this Pubco post), the petition presents the buyback issue as squarely within the ambit of short-termism: large repurchase programs further the trend of favoring short-term returns over strategic re-investment for the long term, “as firms suppress wages even for educated and experienced workers to shift capital to short-term shareholders. Long-term shareholders, alternatively, may lose out as firms fail to make strategic long-term re-investments to improve their market position in the future.”
Of course, there is another side. For example, this article in Fortune contends that stock buybacks are actually efficient in funneling money where it’s best used: “Repurchases,” the author argues, “channel corporate earnings from old-economy stalwarts lacking profitable places to reinvest the cash to the industries of the future.”
According to the author, all the proponents of curbing buybacks share a common misconception:
“The assertion that the cash from buybacks is somehow wasted, rather than invested, when it’s really funneled to capex that yields a lot more profit than if CEOs who generated the earnings kept the money. The Schumer-Sanders manifesto combines factual errors on the size and shareholder-enriching power of buybacks, and a misconception that forcing companies to retain far more earnings, or spend what they now pay for buybacks on extra pay and benefits, would create durable increases in employment and incomes. The first inaccuracy is the claim that buybacks automatically result in ‘boosting the value of the stock.’ In reality, repurchases simply trade cash, an asset owned by shareholders, for a reduction in the share count that increases the value of their ownership in the enterprise by exactly the amount….. Second fact-check: The editorial strongly, and wrongly, implies that America’s big companies are reinvesting, at best, a tiny fraction of their profits….. The real number is…$350 billion, amounting last year to 32% of S&P earnings…”
Moreover, “companies that retain big portions of their earnings grow a lot more slowly than those that return most of the profits to shareholders––meaning they squander a lot of those retained earnings.”
And in this NYT Op-Ed, the president and chief executive of Business Roundtable and the executive director of the Council of Institutional Investors make a similar point: that
“returning some profits to shareholders is not necessarily a bad thing, either for the company or for society at large….Money returned to shareholders through buybacks and dividends does not disappear from the economy. Individual investors can use it to purchase something they’ve been saving for. The money can be lent to other companies that are hiring and growing. It can be invested in new businesses as seed money for start-ups or financing for emerging technologies. Moreover, it is a myth that buybacks and dividends displace investments that companies would otherwise make to grow or develop innovations. While there was a substantial increase in buybacks and dividends last year, business investment also increased substantially and grew at the fastest rate since 2011. American companies invested nearly $3 trillion in the economy during 2018, including $460 billion in research and development. And the firms doing the largest buybacks are also the ones doing the most capital investment. Among large public companies, those that repurchased stock in the first three quarters of 2018 tended to engage in more capital expenditures and research and development investment than those electing not to do buybacks, according to our analysis of Securities and Exchange Commission filings of companies in the S & P 500.”
Of course, some companies do abuse the practice. But to avoid abuses, “public companies should have strong corporate governance practices guiding how the decisions about stock buybacks and dividends are made, to ensure they are made with the long-term interests in mind. By contrast, imposing federal limitations on how companies decide to use their capital would stifle innovation and opportunity in America.”
More specifically, the petition requests:
- Repeal of 10b-18 with the aim of “keeping firms subject to the deterrent effect of market manipulation charges for abusing repurchase programs.”
- Development of “a more comprehensive framework for regulating stock repurchase programs that would deter manipulation and protect American workers.” Here the petition looks to SEC proposals from the 1970s that “would have placed conditions ‘designed to ensure that an issuer neither leads nor dominates the trading market in its securities’ on repurchase programs,” including:
- “Limiting repurchases to 15 percent of the average daily trading volume for that security.“Creating a narrower safe harbor and allowing repurchases that fall outside this safe harbor to be reviewed and approved on an individualized, case-by-case basis.
- “Providing that repurchases inconsistent with the safe harbor are expressly ‘unlawful as fraudulent, deceptive, or manipulative.’
- “Requiring various disclosures, including whether any officer or director is purchasing or disposing of the issuer’s securities, the source of funds to be used to effect the repurchases, the impact of the repurchases on the value of the remaining outstanding securities,and specific disclosures for large repurchases.”
In addition, the petition recommends that the SEC look to the rules of other countries that “require immediate disclosure, have bright-line trading limits, require shareholder rather than board approval, and prohibit executive trading during repurchase program periods.”