How the Share Buyback Became Popular: A Reform That Backfired

“A criminal is a person with predatory instincts without sufficient capital to form a corporation”. -Howard Scott

This is the third and the series on how the corporation is used for the massive upward transfers of wealth. The series begins here.

Buybacks are now a major means of the upward transfer of wealth because of Clinton’s attempt to limit CEO pay that backfired. This is the story of how that came about.

In the 1990s a significant number of voters were outraged over the increasing gap between executive pay and worker pay. Traditionally, it had been 20 to 1, but it was then reaching 100 to 1 (now 300:1). Bill Clinton as part of his ‘Putting People First’ campaign promised to rein it in.

Clinton’s solution: only allow a corporation to deduct $1 million in executive pay from its income tax.

But then Treasury Secretary, Robert Rubin (an ex CEO of Goldman Sachs) said there should be an exemption — read loophole — for performance pay.

So, let’s see what happened. The graph below shows that CEO pay was slowly increasing from the 1970s (at roughly 20:1) until the Clinton reform in 1993; then in the following year it skyrocketed.

Now, this compensation was mostly in shares, mountains of them. How were the executives going to turn them into cash?

Insider Trading Permitted

We all know the danger of insider trading

Thus, corporations were once completely prohibited from buying executive shares. Executives could sell on the open market only to non executive shareholders.

However, in 1982, during the Reagan administration, the SEC passed a ‘safe harbour’ regulation allowing a corporation to buy executive shares if they met four conditions.

And there is strong evidence that the stock prices are being manipulated so the corporations buy executives’shares above the true market price.

In an article for the 2014 Harvard Business Review entitled Profits Without Prosperity, economist William Lazonick explained that, contrary to the interests of the corporation, stock buybacks were done when the stock price was high. The reason in Lazonick’s words: “Because stock-based instruments make up the majority of executives’ pay, and buybacks drive up short-term stock prices.” He confirms his investigations found these firms are engaged in “what is effectively stock-price manipulation”.

Lest you think that this is an opinion only held on the left, Trump appointee, SEC Commissioner Robert J. Jackson, also studied corporate purchases of executives’ shares and concluded that there was price manipulation for the benefit of the executives: “Thus, executives personally capture the benefit of the short-term stock-price pop created by the buyback announcement . . .”

Ineffective Reforms

An additional carrot for the executives and other shareholders:

The current proposals to rein in buybacks focusses on a transaction tax on buybacks, so that the tax on buybacks would come closer to the tax on dividends. But as Hughes points out there has been a 1% tax transaction tax since January 2023 under the Inflation Reduction Act, and it’s not slowing the buybacks down at all. “Despite the excise tax taking effect on January 1st, it does not appear that buybacks are slowing. In fact, the early evidence looks like 2023 could be another marquee year for buybacks”.

Hughes believes the excise tax on buybacks would need to be approximately 10 to 12 percent so that buybacks were taxed the same as dividends (tax parity).

At Time of writing, Biden is proposing to raise the 1% to 4%.

This will raise tax revenue of an estimated $237 billion, very welcome, but do nothing to stop the buybacks. This reform is focusing on a secondary aspect. Executives are not going to stop having the corporation buy their shares even if the tax were the same as if the money was paid out by dividends. There are other benefits to the buyback:

Note, that in 2017 Congress removed that exception for performance pay so that all pay above $1 million would not be tax deductible. According to a study by Lisa De Simone, Charles McClure, and Bridget Stomberg in Contemporary Accounting Research,that removal did nothing to stop the skyrocketing executive pay. Another naïve assumption: that the executives care about how much tax a company will pay on their dazzling compensation-and that major shareholders care.

Money managers for equity/hedge funds and pension funds don’t care about outrageous executive pay as long as those executives strip out all possible profit in buybacks and dividends to pad the money managers own lucrative commissions.

• The first reform should be to eliminate insider trading and prohibit the corporation from purchasing executive shares.
• Executives could sell their shares on the market as everyone else does but not to their corporation.

There is no need to eliminate buybacks, only the safe harbour (10b-18) that allows executives to have the corporation buy their shares. The other equally important concern is that more of this retained profit be shared with the workers whose labor has produced it — just as it was in the past. That will take support for stronger unions.

Sufficient Profits for Fairer Worker Pay

Sarah Anderson, Sam Pizzigati and Brian Wakamo, writing for The Institute for Policy Studies, noted that with the Lowe’s buyback of $13 billion in 2022, the company could have given each of its 325,000 employees $40,000. Instead, worker median pay fell 7.6 percent to $22,697.

And note that paying the buyback amount to the workers would not:

In the year of that buyback, according to analyst Mark Roussin, Lowes increased its dividend.

But, at present, there is no consciousness in the voting public that a greater share of corporate profits could easily be given to workers without raising prices or affecting lucrative dividends-and so make America fair again. It’s time to make that known.

Acknowledgement: Money image by Alexander Scott, Unsplash

Originally published at https://jandweir.substack.com.