Bills recently introduced in Congress would regulate corporate share repurchases, or ban them outright, except in tender offers. But readily available curbs on buyback abuse exist, some of which require little or no government involvement.
How has recent buyback activity affected capital markets and business investment? More than $2 trillion was spent by Fortune 500 companies purchasing their shares in the past three years, much of it funded by debt. The CARES Act, enacted to boost companies' liquidity in response to COVID-19, limits buybacks while loans made under the law are outstanding, but longer-term solutions make sense. Sens. Chuck Schumer, Bernie Sanders and others have asserted that buybacks come at the expense of worker pay and benefits. They propose to legislate buyback preconditions, which would have the government determine the adequacy of companies' investment in pensions, health benefits and "long-term strength."
A legislative approach to corporate uses of capital substitutes government oversight for responsible corporate governance, and is needlessly complicated. Concerned Congress members' perception of the abuse is valid, but their remedies are unnecessary and disregard the usefulness of prudent buybacks.
Every stock repurchase requires company management to make at least two basic investment decisions; both are speculative and outside the proper scope of their expertise. First, whether the acquisition price is fair value; and second, what is the likely cost to the enterprise of future sales of equity? Additional considerations include whether there are better uses of company resources to grow the existing business, or make acquisitions to build enterprise value.
Fundamentally, buybacks are at odds with a company's reason for being — the conduct of its business for the benefit of owners, workers, suppliers, customers and the communities where it operates. Buybacks effectively reduce a company's assets by the amount of the purchase price, with a consequent loss of resources available for the production of income. Buybacks result in some shareholders giving up an asset, without the company acquiring one. Its shares are of no value to it until resold or otherwise disposed of. So, management's decision about the stock's value is an exercise in market timing. This was criticized as "trafficking in its own shares," an unauthorized corporate purpose, by English and American legal scholars, and courts, until as recently as 1960.
How do excessive buybacks cause harm?
- Impair conduct of true "auction markets" for company shares. When a company engages in large purchases of its own stock it distorts price data, giving a false impression of liquidity and "true" enterprise value.
- Drive up or stabilize a stock's price, feeding a need to continue the practice or risk price declines reflecting reduced buying pressure.
- Deprive a company, its employees and others, of the present and future production value of investing in the business.
- Distort earnings-per-share calculations. Buybacks permit management to boost earnings per share, meet earnings estimates, and reap outsized compensation rewards.
- Diminish the value of outstanding corporate debt by altering the company's debt/equity ratio, consequently its debt repayment ability.
- Benefit short-term vs. long-term investors since buybacks come at the expense of investments in the business.
- Attribute to management an ability to judge proper use of capital not in its business, but in public securities markets, with attendant risks.
- Promote borrowing to purchase shares, further reducing the company's credit worthiness.
Federal legislation is unnecessary as an antidote to excessive buybacks. Instead, reliance can be placed on existing federal securities law, and SEC rule-making, to halt companies' overuse of buybacks.
The Securities Exchange Act of 1934's Rule 10b-18 was adopted in 1983 to prevent buybacks from unduly influencing "normal" market activity. But its "safe harbor" provision has allowed buyback programs in much larger volume than the regulators contemplated. Companies' purchases became a major determining factor in stocks' price appreciation despite compliance with, or in defiance of, that rule. It has proved ineffective and should be amended or repealed. In the alternative, the 1934 Act's anti-manipulation provisions and proxy rules can be used to limit abusive buybacks, and involve shareholders in "corporate democracy." That requires no act of Congress, only use of disclosure, the underlying purpose of federal securities laws, or minor SEC rule changes.
One or more of the following measures included in annual shareholder meeting resolutions, or required by amended proxy rules, could restrain (although not prohibit) excessive and imprudent buybacks by requiring company management to:
- Prominently disclose the cost vs. current market value of all buybacks made under an ongoing program as purchases are made, and publish a summary of them by week or month, for the prior three or five years.
- Describe, when a buyback program is authorized and regularly thereafter, why capital to be used for buybacks under the program has no better corporate purpose.
- Furnish an independent investment analysis of significant buybacks, compared with payment of cash dividends, to be refreshed regularly during any ongoing buyback program.
- Provide an annual or more frequent statement of the buyback program's impact on credit worthiness and ratings.
- Adopt compensation practices reducing or eliminating reliance on earnings per share when buyback programs are ongoing.
Federal securities law rule-making and shareholder initiatives using existing or revised proxy rules can be effective curbs on abusive stock buybacks without resorting to congressional action.
William Dolan is a former Securities and Exchange Commission staff attorney, practiced securities law in Minneapolis from 1965 to 2010, and was a founder and co-owner of Goan Dolan Oehler Inc., a registered broker-dealer sold to Piper Jaffray Inc. in 1989. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.
