In the aftermath of the Great Depression observers noted how certain of the wealthy could cash in on a crisis and dubbed them ‘market crash millionaires’. There were only a few then. However, at that time there was a counter balance: the bailout in the 1930s went to the distressed homeowners and continued the progress toward economic equality for workers that had begun slowly in the 1900s.
But by 2020, the super-rich had perfected methods of ensuring that they got the full benefit from every economic crisis. It’s a tale of how both Democrat and Republican administrations supported, and still support, this trend. To understand how the present stimulus package is going to permanently put the economy at risk for the salaried classes, but protect the moneyed classes, I’ll review a pernicious relationship that is never discussed in the media: the role of executive compensation related to buybacks.
We need to go back to 1993 when Bill Clinton ran on the promise to stop the outrageous executive compensation that had been wildly escalating since the 1970s.
Clinton’s solution: any pay over $1 million could not be deducted from the corporation’s tax. Sounds good, but next comes a method often used to actually do the opposite of what the politicians say is being done: an exemption. The corporations could deduct pay over $1million if based on performance. The board of directors could set targets. If the executives met these targets, the corporation could pay them, not in cash, but in stocks or stock options in the corporation.
Great! said those who promoted this exemption. This puts the executives’ interest in line with the best interest of the corporation: if the company does better, they do better. But it doesn’t. It puts the executive’s interest at odds with the corporations in what economists call a perverse incentive. Executives can manipulate the company’s affairs to artificially inflate the share value at the time of their sale. The company pays more than the true value on the buyback. The executives get a benefit based on a temporary illusion.
As the graph by the Economic Policy Institute below shows, until the 1970s CEO-Worker pay ratio was 20:1. Then CEO pay started a gradual rise. In the Reagan years (1981–89) the curve angled up slightly, but not until the Clinton years (1993–2001) did it achieve full lift off.
The Executive Buy Back is Done in Secret
As a result of the Clinton reform, the executives had mountains of stock. They needed a way to convert it to cash. Enter the buyback. Buy backs were once absolutely prohibited because of the opportunity for stock price manipulation. It’s not just that corporations buying their own shares is the ultimate insider trading, the executives can arrange the company’s affairs to make it look more profitable in the quarter of the buyback. For example, they can defer expenses to another quarter, making the financial statement at the time of the buyback look better than it is.
There otta be a law against it. Indeed, there is a law against it; but, and I hope you’ve already anticipated it: there is an exemption. Under Regan, and at the beginning of the government-is-the-problem deregulation extravaganza, the SEC passed a regulation to allow corporations to buy back their own shares including executive shares. It’s a convoluted set of restrictions in SEC Rule 10b-18, called a safe harbor, saying the corporation can buy its own shares if the purchase meets complicated restrictions. Complexity is another tool to obfuscate what is really happening or make it impossible for regulators to get a conviction.
Mary Jo White, when head of the SEC, said it was not policing these buybacks because it was impossible. So, the executives, who are in control of the corporation, get to arrange the buybacks of their own shares with no one watching.
More Perversity in the Incentive
This incentive distorts the value of the stock market. According to the capitalist model, sophisticated investors like Warren Buffett should review the financial statements for value and determine the price of the stock by what they are willing to pay for it. But buybacks create an artificial demand that inflates the value of the stock.
Additionally, the company cancels the stock it has bought back making the remaining stock more valuable. Most of the money from the Trump tax cuts went into buybacks. Thus benefiting Trump as it made the stock market look better than it actually is. A crisis will reveal this artificial inflation. As Warren Buffett once put it: it’s only when the tide goes out that we will see who has been swimming naked.
Unfortunately, he and other sophisticated investors will know the cause of the nakedness of the financial statements, but the vast majority of voters will not understand that it was completely avoidable and preventable for the future
Buy Backs: A Tide That Raises Only Yachts
On March 16, 2020, Brandon Kochkodin of Bloomberg News reported that “the major air carriers had spent 96 percent of their cash over the past decade on stock buybacks. American, for instance, went deep into debt while spending $15 billion on buybacks. All told, six of the country’s largest airlines approved roughly $47 billion in buybacks over the past decade.”
That reference to debt raises another threat to the entire economic system. Prior to the buyback exemption, corporations used to pay half of their profits in dividends and retain the other half for future expenses including a risk management practice for a rainy day fund to provide against the absolutely unexpected. It would tide them over for several months of a crisis. Sometime after the Reagan era, corporations began stripping out all of their profits in high executive pay, dividends and buybacks. They then had to borrow to meet valid on going business expenses.
Years prior to the pandemic of 2020, analysts began warning that the size of corporate debt was so mountainous, that even a normal slow downturn in the economy could cause a raft of bankruptcies. In November, 2018, Jeff Cox, writing for CNBC, called the colossal corporate debt a” ticking time bomb” in the US economy.
The Fountainhead of Income Inequality
In 2013, economist Thomas Piketty startled the liberal establishment with his book Capitalism in the 21st Century, calling attention to the rising economic inequality supported with substantial academic research. He showed that now inherited wealth, through investment, earned more than working for wages. Wealth would continually accumulate in an increasing number of fewer wealthy families. That wealth has given those families increasing political power. We see enacting before our eyes what Louis Brandeis warned in the early 19th century: We can have democracy in this country, or we can have great wealth concentrated in the hands of a few, but we can’t have both.
Piketty also asserted that the mushrooming gap between soaring executive pay and stagnating worker pay drives the inequitable distribution of the income of a nation.
In his later work published this year, Capital and Ideology, he connects rising inequality as a prime cause of populous movements like the one that elected Trump. Changing ideology, he claims, is responsible for the policies that have facilitated this inequality.
Perhaps, but a greater factor is simply that the voting classes are kept ignorant of how it’s done. Every crisis could be a tipping point for positive change as in the 1930s. The corporations seeking relief today were not in a strong position to bargain. If a critical mass of voters had understood the damaging role that the buyback safe harbor exemption played, they could have demanded complete retraction of that exemption for all time and not just one year after the date of the bailout. Yet, where can an educated voter learn what I have written here?
So, only 12 years after politicians vowed there would never be another bailout, the corporations could come, show flimsy financial statements, claim, hey we’re not like the banks: we didn’t do it, the virus did it; and demand trillions of dollars in aid. But they did do it. And their techniques are successful as long as they all do it. They can unitedly threaten the entire economic system collapse unless the government, in an another act of extreme socialism for the rich, bails them out.
As a result of the bail out, they definitely will live to do it again. The politicians had the opportunity to revoke the safe harbor exemption and absolutely prohibit buybacks as in the pre-Reagan era. There should have been an outcry from the salaried classes — but there wasn’t a murmur. The workers who suffer under this device have no idea how it’s hurting them and paving the way for further black mail. The 2020 handout only said it could not be immediately used for buybacks and until one year after the loan is repaid. After that corporations will be free once more to put the economy in jeopardy for the benefit of the executive class. And they will!
The Democrats had control of the presidency, the House, and the Senate during Obama’s first term. It was clear by then that the Clinton reform on executive pay had backfired and that executives were insider trading without restraint. Why didn’t the Democrats remove that exemption allowing this practice? An investigation into that question may explain why no Democrat reform has been, or ever will be, effective to end economic inequality.
Critics may well claim that this article discusses just one aspect of how laws are used for the upward transfer of wealth through the corporate form. True, there are other factors at play. For example: why, if shareholders are owners, can’t shareholders reign in executive pay? Who is behind the dividend stripping? Are there more groups that benefit from stock manipulation than the executives? And most importantly, how can some of it get to the workers? For we can be sure that even if part of the executive pay is kept in the corporation, it will not go to workers without more. Certainly valid issues, but for another day.
Jan D. Weir is a lawyer who has advised international corporations, banks and accounting firms. He has taught business law at the University of Toronto, and is the co-author of The Critical Concepts of Canadian Business Law (6e) Pearson. Follow him for updates on laws that affect inequality @JanWeirLaw and Medium.com,