During a speech before members of the Center for American Progress on Monday, SEC Commissioner Robert Jackson addressed his concerns about corporate stock buybacks. He also detailed research produced by his staff at the Securities and Exchange Commission “that raises significant new questions about this activity.”
One issue, he said, is the Trump tax bill that became law last December, promising to bring overseas corporate cash home.
“Now, we all know what happened the last time a Republican-controlled government pushed through a corporate tax holiday in 2004. As that bill’s sponsors hoped, American companies repatriated billions of dollars of overseas cash,” Jackson said. “But corporations didn’t invest most of that money in innovation. They didn’t invest it in retraining their workforce or raising wages. Instead, executives largely used the influx of fresh funds for massive stock buybacks.”
Jackson said he worried that, 14 years later, history would repeat itself and the latest tax bill would cause managers to focus on financial engineering rather than long-term value creation. “Sure enough, in the first quarter of 2018 alone, American corporations bought back a record $178 billion in stock,” he said.
“Even more disturbing, there is 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,” Jackson added. “We give stock to corporate managers to convince them to create the kind of long-term value that benefits American companies and the workers and communities they serve. Instead, what we are seeing is that executives are using buybacks as a chance to cash out their compensation at investor expense.”
Jackson called upon his colleagues at the SEC to update rules to limit executives from using stock buybacks to cash out from companies.
He also called for an open comment period to reexamine the Commission’s rules in this area “to make sure they protect employees, investors, and communities given today’s unprecedented volume of buybacks.”
Jackson further delved into why stock buybacks can be problematic.
“Basic corporate-finance theory tells us that, when a company announces a stock buyback, it is announcing to the world that it thinks the stock is cheap,” he said. “That announcement, and the firm’s open-market purchasing activity, often causes the company’s stock price to jump, so the SEC has adopted special rules to govern buybacks.”
Those rules, first adopted in 1982, provide companies with a safe harbor from securities fraud liability if the pricing and timing of buyback-related repurchases meet certain conditions.
After experience proved that buybacks could be used to take advantage of less-informed investors, the SEC updated its rules in 2003, “though researchers noted that several gaps remained,” Jackson said.
“In the meantime, the use of stock-based pay at American public companies has exploded,” he added. “Although these pay programs present many challenges, the one that I’ve spent much of my career thinking about is how to make sure that corporate management has skin in the game—that is, how to keep top executives from cashing out stock they receive as compensation.”
The theory behind paying executives in stock is to give them incentives to create long-term, sustainable value,” Jackson said. “Because executives who receive shares rather than cash demand higher levels of pay, the use of stock-based compensation has led to eye-opening pay packages for top executives. In the trade, investors—and the economy as a whole—tie executives’ fortunes to the growth of the company.”
That only works, however, when executives are required to hold the stock over the long term, Jackson explained. “It’s no surprise that in the years leading up to the financial crisis, top executives at Bear Stearns and Lehman Brothers personally cashed out $2.4 billion in stock before the firms collapsed.”
While the SEC continues to foot-drag on enacting executive compensation rules mandated by the Dodd-Frank Act, “the Trump tax bill has unleashed an unprecedented wave of buybacks,” Jackson said. He worries that “lax SEC rules and corporate oversight are giving executives yet another chance to cash out at investor expense.”
After the Trump tax bill took effect, Jackson asked his staff to take a look at how buybacks affect how much skin executives keep in the game.
His team studied 385 buybacks over the last fifteen months and matched those buybacks to information on executive stock sales available in SEC filings.
They found that a buyback announcement leads to a big jump in stock price. In the 30 days after the announcements were studied, firms enjoyed abnormal returns of more than 2.5 percent.
“That’s unsurprising,” Jackson said, “when a public company in the U.S. announces that it thinks the stock is cheap, investors bid up its price. 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 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,” Jackson says. “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,” he said. “This trading is not necessarily illegal. But it is troubling, because it is yet another piece of evidence that executives are spending more time on short-term stock trading than long-term value creation. It’s one thing for a corporate board and top executives to decide that a buyback is the right thing to do with the company’s capital. It’s another for them to use that decision as an opportunity to pocket some cash at the expense of the shareholders.”
Moving forward, Jackson described ways the SEC could get involved. The SEC’s rules governing buybacks in 2003 give companies a safe harbor from liability when pursuing buybacks. There are no limits, however, on boards and executives using the buyback—and the safe harbor—as an opportunity to cash out.
“I cannot see why a safe harbor to the securities laws should subsidize this behavior,” Jackson said. “Our rules should be updated, at a minimum, to deny the safe harbor to companies that choose to allow executives to cash out during a buyback.” He called for an open comment period to reexamine the Commission’s rules in this area.
“At the very least, our rules should stop giving executives incentives to use buybacks to cash out,” he said.
Jackson added that “corporate boards and their counsel should pay closer attention to the implications of a buyback for the link between pay and performance. In particular, the company’s compensation committee should be required to carefully review the degree to which the buyback will be used as a chance for executives to turn long-term performance incentives into cash.”
“If executives will use the buyback to cash out, the committee should be required to approve that decision and disclose to investors the reasons why it is in the company’s long-term interests,” he added. “It is hard to see why a company’s buyback announcement shouldn’t be accompanied by this kind of disclosure.”