As if boards didn’t already have plenty to worry about, they face increasing pressures to rethink the very common practices of stock buybacks and dividend disbursements.
Several factors are converging to make these shareholder offerings as controversial as they are commonplace. There is the ongoing balancing act that companies face regarding long-term growth prospects versus short-term goals and earnings. Layered in is ongoing scrutiny of executive compensation.
Also, the world of activist investors can no longer be defined so simply as the corporate raiders they once were, and it includes a panoply of interests, strategic demands, and time horizons. In fact, a growing number of shareholder proposals in recent years have been decidedly anti-buyback, at least when they are viewed as a calculated boost to share price with the intention of helping executives reach company performance targets. In December, for example, the AFL-CIO’s Equity Index Fund said it would use shareholder proposals to target “companies where CEOs stand to collect a bundle as a result of large stock buyback programs.”
Also in play is an April 2015 letter where Sen. Tammy Baldwin (D-Wisc.) called upon the Securities and Exchange Commission and Chairman Mary Jo White to defend oversight and enforcement efforts amid an “explosion of stock buybacks.” In 1982, the number of buybacks was near zero; by 2015, the buybacks and dividends of U.S. corporations reached an historic $1 trillion.
In her letter, Baldwin cited research showing that from 2003 to 2014, S&P 500 companies used 54 percent of their earnings, $2.4 trillion, to buy back their own stock. Dividends accounted for another 37 percent; only 9 percent was reinvested back into companies, down from an average of 70 percent in the early 1980s. Cash handed back to shareholders in 2014 was 95 percent of profits.
“Against the backdrop of activism, boards need to be focused on what the best use of corporate cash is.”
Paul DeNicola, Managing Director, PwC's Governance Insights Center
“In the past, this money went to productive investments in the form of higher wages, research and development, training, or new equipment,” Baldwin wrote. “Today, cash is being extracted from companies and placed on the sidelines. Buybacks are now undermining the stock market’s role in capital formation.” From 2005 to 2014, the value of shares withdrawn from the market surpassed the value of stock issued by an annual average of $399 billion.
The increase of stock repurchases “worryingly corresponds with the increase in executives receiving stock-based compensation,” Baldwin added. In 2013, the 500 highest paid U.S. executives named in proxy statements received 84 percent of their compensation from stock-based instruments, and recent research finds that buybacks are more likely when a CEOs bonus is directly tied to the company’s earnings-per-share. “Buybacks aiming for earnings per share targets were associated with corresponding reductions in employment and investment at the company,” she wrote.
Baldwin asked White to provide a response on the adequacy of SEC rulemaking in this area and background on any enforcement actions. The response she received shouldn’t have come as a surprise given the agency’s history on such matters.
In the 1980s, executives avoided buybacks, fearing the liability created if those arrangements were suspected of market manipulation. Then, in 1982, the SEC, with pro-business Regan Administration appointees, adopted Rule 10b-18. It provided a safe harbor from market manipulation charges so long as companies stuck to a few simple rules: no buybacks at the beginning or end of a trading day; avoiding a single broker for the trades; purchasing shares at market price; and capping buybacks at 25 percent of the average daily trading volume of the previous four weeks.
SEC RULE ON BUYBACKS
The Securities and Exchange Commission's Rule 10b-18 provided a safe harbor that ushered in the era of corporate stock buybacks. The following is from the Commission's summary of ammendments ratified in 2003.
Rule 10b-18 as a "Safe Harbor"
In 1982, the Commission adopted Rule 10b-18, which provides that an issuer will not be deemed to have violated Sections 9(a)(2) and 10(b) of the Exchange Act, and Rule 10b-5 under the Exchange Act, solely by reason of the manner, timing, price, or volume of its repurchases, if the issuer repurchases its common stock in the market in accordance with the safe harbor conditions. Rule 10b-18's safe harbor conditions are designed to minimize the market impact of the issuer's repurchases, thereby allowing the market to establish a security's price based on independent market forces without undue influence by the issuer.
Although the safe harbor conditions are intended to offer issuers guidance when repurchasing their securities in the open market, Rule 10b-18 is not the exclusive means of making non-manipulative issuer repurchases. As the Rule states, there is no presumption that bids or purchases outside of the safe harbor violate Sections 9(a)(2) or 10(b) of the Exchange Act, or Rule 10b-5 under the Exchange Act. Given the widely varying characteristics in the market for the stock of different issuers, it is possible for issuer repurchases to be made outside of the safe harbor conditions and not be manipulative.
We are adopting the two preliminary notes to Rule 10b-18 as proposed. The first note explains that, as a safe harbor, compliance with Rule 10b-18 is voluntary. However, to come within the safe harbor, an issuer's repurchases must satisfy (on a daily basis) each of the Rule's four conditions. Failure to meet any one of the four conditions removes all of the issuer's repurchases from the safe harbor for that day. Because we are adopting this sentence as part of the preliminary notes to the Rule, we have decided that it is unnecessary to also include this sentence in paragraph (d), as we had originally proposed. The note also states that the safe harbor is not available for repurchases that, although made in technical compliance with the Rule, are part of a plan or scheme to evade the federal securities laws.
The second note states that, regardless of whether the repurchases are effected in accordance with Rule 10b-18, reporting issuers must comply with the new disclosure provisions, i.e., Item 703 of Regulations S-K and S-B and Item 15(e) of Form 20-F (regarding foreign private issuers), and closed-end management investment companies that are registered under the Investment Company Act ("closed-end funds") must comply with Item 8 of Form N-CSR.
In her response letter, White told Baldwin that the current rules lack an enforcement mechanism: “Because Rule 10b-18 is a voluntary safe harbor, issuers cannot violate this rule.”
“Performing data analyses for issuer stock repurchases presents significant challenges because detailed trading data regarding repurchases is not currently available,” she added, choosing not to suggest that any changes to the status quo are, or would be, under consideration.
With the increased use and value of buybacks and dividends showing no sign of slowing—and with a distinct lack of regulatory involvement—boards find themselves with the unenviable task of finding a Solomonic middle ground between opposing viewpoints.
“The pressure that activists have put on companies, whether or not they are in the stock, has created more of a sense of urgency in boardrooms to make decisions,” says John Beckman, a partner at law firm Hogan Lovells. “If you polled directors, I think they would say they look out for the best interests of shareholders and think long term.” Directors, for the most part, are critical of “activists and investors who are just looking for short-term stock pops and want to get in and out.” On the other hand, “maybe looking at the long term can mean you take too long to do things.”
Among the sea changes of the last five years is a willingness of long-only institutional investors to engage in a dialog with activists, attempting to reach common ground. “That never happened before,” he says. “You also see companies not treating activists as a hostile acquirer. Five or seven years ago, the playbook was to treat them as hostile and not to talk to them. Now, that’s probably the wrong approach.”
Complicating matters is a push in certain circles to hold directors to term limits, an effort to phase in both fresh blood and specific expertise in areas such as cyber-security. The risk, perhaps, is that long-serving directors may be more inclined to think long term, while those with a mandated term limit may look for to a five-year plan that syncs to their own tenure.
“I consider tenure and term limits, and even age limits, as blunt instruments for addressing what really is the key issue, which is having the right mix on your board,” Beckman says. Amid the call for specialized expertise, boards cannot overlook their core responsibility of capital allocation, a responsibility that includes a well-reasoned view of buybacks and repurchases.
Issues surrounding buybacks and dividends intersect with what a recent PwC study—“Is Cash Burning a Hole in Your Pocket? Thinking through Share Repurchases and Dividends”—detailed as critical areas for investors discussing the board’s oversight role: the performance of the CEO, the company’s strategy, and the capital allocation plan.
Among the report’s suggestions:
Directors and investors must be comfortable that they fully understand the ramifications of a share buyback program and thought through short- and long-term effects.
Directors must clearly understand the downstream effects a buyback might have on the metrics that influence CEO compensation.
Continuous and transparent discussions with shareholders will allow the board and management to get useful feedback that help focus on strategy. The capital allocation plan should be part of these discussions.
“Against the backdrop of activism, boards need to be focused on what the best use of corporate cash is,” says Paul DeNicola, managing director at PwC's Governance Insights Center.
Details are important. What are the tax ramifications for the company (if it repatriates overseas cash) or investors (facing a capital gains tax on dividend payments)? How will the repurchase program be executed? Are their pending shareholder proposals tied to executive bonuses? “Ultimately boards, particularly compensation committees, need to carefully weigh the effect of share repurchases on the potential for executives to reach bonus targets directly tied to earnings per share,” DeNicola says. “It can certainly affect say-on-pay voting this year and in subsequent years.”
Does a focus on share repurchases signal a lack of creativity on the part of management, perhaps that they have run out of ideas for generating growth? “Ultimately, the question for directors is whether they have the right management team in place and the right leadership,” DeNicola says. All involved should be focused on the same thing: building real and sustainable shareholder value.