Directors and Boards, Third Quarter 2022, commentary of Alexandra Reed Lajoux: "Defying Critics and Curbs, Buybacks Persist: Should Executives Benefit From Them?" [Update of evolving professional views guiding board consideration of stock buybacks]

Source: Directors and Boards, Third Quarter 2022, commentary

ARTICLE

Defying Critics and Curbs, Buybacks Persist: Should Executives Benefit From Them?

By Alexandra Reed Lajoux

Buybacks can be a boon for shareholders, but a detriment to employees.

Despite the new 1% tax on share repurchases under the Inflation Reduction Act of 2022, U.S. public companies today are still using share buybacks to return cash to shareholders — including executives with equity-heavy pay — at unprecedented rates. This year has seen well over half a trillion dollars’ worth of stock repurchased by S&P 500 firms in the first eight months of 2022 alone — including a $500 million plan by Kohl’s, one of more than two dozen public companies so far to announce buybacks since President Joe Biden signed the new tax into law on August 16, 2022. While there are signs of buyback slowdowns ahead, this is the highest reported level since the SEC’s 1982 passage of Rule 10b-18 granting a safe harbor for buybacks, enabling them to rival (and in some years surpass) dividends as a way of returning cash to shareholders.

Wall Street loves buybacks, as is demonstrated in the Nasdaq Global Buyback Achievers Index and the Nasdaq US Buyback Achievers Select Index, as well as the S&P 500 Buyback Index. But do shareholders really benefit from them? What about other stakeholders, such as employees and customers? How do buybacks affect the long-term value of companies? What difference do buybacks really make, and to whom?

Such questions are important for directors to consider, both generally and with respect to their own companies.

Why Buybacks?

Buybacks, whether accomplished through a direct purchase of shares from the open market or (less often) by a premium tender offer, can happen for a variety of reasons. When companies repurchase some of their shares, they take cash out of the company (or, if leveraging, incur debt) and return cash to shareholders who choose to sell — sometimes giving a short-term boost to the stock price for those who do not sell, and often increasing earnings per share (because of the decrease in the ratio’s denominator, typically calculated as total shares outstanding).

Through direct market buybacks, a company with undervalued stock can “buy low” in a repurchase in order to later “sell high” in a new stock offering. Another reason for a buyout is to reduce dilution that occurs when companies issue new stock (including new stock that goes to pay their executives): the more stock, or “float,” there is out in the marketplace, the less each share is worth, so a buyback reverses that dilutive effect.

Yet another reason companies may buy back their shares is to minimize the risk of a hostile takeover, as companies with high cash balances and lackluster stock price can attract raiders. Finally, a cynical view is that boards approve buybacks in part to increase the value of shares held by executives, who typically are awarded the lion’s share of a firm’s equity compensation.

Legal Context for Buybacks

Whatever the reasons for buybacks, one thing is clear: In the United States, it is up to directors to approve them. (In some other countries, shareholder approval is necessary as well.) As stated in the Key Agreed Principles of the National Association of Corporate Directors (NACD), directed toward U.S. public companies, directors must approve all material capital expenditures and transactions “not in the ordinary course of business,” which would include share repurchases. The American Bar Association’s Model Business Corporation Act (MBCA) defines repurchases as a kind of “distribution” to be approved by directors and establishes liability (under Section 8.32(a) of the MBCA) for directors who approve distributions improperly. It is no wonder that the law firm Skadden Arps has stated, in a client letter on the topic, that “any share repurchase should be authorized and approved by a company’s board of directors.”

In many cases, this approval process begins at the committee level. All public companies listed on the major stock exchanges are required to have independent audit committees, and the charters of these committees may mention share repurchases as an area of oversight. Examples include Biogen and Citrix Systems. For boards that have finance committees (14%, according to the NACD), this oversight duty often appears in those committee charters, as seen at Philip Morris and Walmart.

Of course, director approval of buybacks does not occur in a vacuum; share buybacks are not the only extraordinary transaction legally requiring board approval. That is, under most state corporation laws and corporation governing documents, directors must also approve dividends, major acquisitions, mergers and the sale or liquidation of the company. And these transactional approvals occur in the broader context of corporate capital allocation.

The Board’s Capital Allocation Responsibility

While capital allocation may sound theoretical, it is as real a responsibility as it gets. “Capital allocation is the most fundamental responsibility of a senior management team of a public corporation,” opines Michael Mauboussin on his webpage for ValueEdge Advisors. This responsibility falls on the company’s directors, as companies are managed under the direction of boards. In the wake of Business Roundtable’s 2019 declaration on stakeholder value, Al Rappaport, pioneer of the shareholder value theory, published a Bloomberg op-ed challenging CEOs and boards to walk the talk of stakeholder value by making tough capital allocation decisions.

Capital allocation is indeed at the heart of the fiduciary duty of directors, who oversee how the company spends its cash — not only via the extraordinary transactions that they must approve, but also expenditures that arise as a part of ordinary business (such as meeting payroll, paying vendor bills, reducing debt and so forth). Although these ordinary business matters do not typically require board approval, directors should be aware of all these uses of cash whenever they approve a stock buyback, since an imprudent buyback approval could cause financial distress. In fact, Section 160 under Title 8 of Delaware corporation law says that a corporation may not “purchase or redeem its own shares of capital stock for cash or other property when the capital of the corporation is impaired or when such purchase or redemption would cause any impairment of the capital of the corporation.”

To avoid capital impairment, and more generally to make wise determinations, directors need to understand buybacks in a financial context — both generally and with respect to their companies.

Financial Context for Buybacks

As of July 26, 2022, reports The Wall Street Journal, companies have spent $514 billion this year buying their own stock. SeekingAlpha.com shows strong buyback activity for August 2022, listing over 80 transactions for the month, including several worth billions.

But overall, the buyback rage seems to be calming. Quarterly analysis trends are telling. In the first quarter of 2022, reports S&P Dow Jones, companies listed in the S&P 500 bought back $281 billion worth of their own stock, up 4% over the previous quarter’s record of $270.1 billion. And looking back the previous 12 months (from Q2 2021 through Q1 2022), the $985 billion in buyback dollars set an all-time record, nearly doubling the previous 12-month period ending Q1 2021 — which was a mere $499 billion.

In the second quarter of 2022, the trend slowed, with an 8% drop in buybacks over Q2 2021. In July 2022, while some banks such as M&T Bank, announced major buybacks, others held back. Jamie Dimon, CEO of JP Morgan, announced a freeze on buybacks in anticipation of a recession, and other banks have made similar announcements.

A study of 75% of the S&P 500 showed that although buybacks still dominate corporate allocation at $175.5 billion, compared with $165.5 billion in capital expenditures and $140.6 billion in dividends, the rate of quarter-to-quarter growth for capital expenditures, at 21%, is higher than the other two categories, both at 14%. Add to that the 1% tax to be levied on some buybacks under the aforementioned Inflation Reduction Act of 2022, and a slowdown seems likely.

But whatever the megatrends may be, buybacks will never disappear as an alternative, so directors need to consider their effects —detrimental, positive or neutral.

Detrimental Impact of Buybacks

When buybacks are funded by debt, they can have a detrimental effect on key financial ratios, such as debt-to-equity, considered an indicator of financial risk. (It is nicknamed the “risk ratio.”) A 2019 Bloomberg study on debt-financed buybacks accused the practice of “benefiting shareholders at the expense of creditors” and declared that companies were rightly abandoning it. In a September 1, 2022, article in Strategic Finance, Andrew Bargerstock and Naveed Abbasi warned that, although buybacks can increase earnings per share, they can also reduce shareholders’ equity — sometimes into negative territory.

The larger concern in recent years has been the association of buybacks with executive pay increases and employee layoffs. Critics say that all stakeholders (including shareholders) would do better if companies put their cash to work rather than distributing it. They accuse executives of doing these deals to get a short-term boost in the value of their stockholdings to the detriment of companies and their employees.

Buybacks began to gain notoriety for their harmful effects when they increased sharply following the Tax Cuts and Jobs Act of 2017, which gave companies large amounts of unplanned extra cash. Absent any strategies to invest this windfall, many boards voted to approve buybacks. In 2018, buybacks increased by 64%, in some cases triggering layoffs. That was the finding of a 2019 study by AFL-CIO and other labor groups petitioning the SEC to ban buybacks. That labor group study identified four major companies that combined buybacks and massive layoffs in 2018: AT&T, Sears, Walmart and Wells Fargo. The pairing of buybacks and layoffs also occurred in subsequent years. An April 2022 Brookings study of how 22 major employers weathered the 2020 peak of the COVID pandemic found that 16 of them had buybacks, and, of those, three (Best Buy, Gap and Macy’s) also engineered major layoffs. These findings do not prove that buybacks cause layoffs, but they do establish a covalence.

Buybacks have also been associated with the lowering of employee pay. A June 2022 study by the Institute for Policy Studies identified 106 companies at which worker pay did not keep pace with inflation. The study found that of those, 67 (including most notably Best Buy, Lowe’s and Target) had not only lowered employee pay but also spent billions buying back their own stock, which the study calls “a maneuver that inflates executive stock-based pay.”

These negative social results have attracted the attention of Washington — and not just in the new tax bill mentioned earlier. Others in Congress have been concerned. “Instead of spending billions driving up their own stock prices to line executives’ pockets, Wall Street should be reinvesting in workers,” tweeted Sen. Sherrod Brown (D-Ohio) when he reintroduced a “Stock Buyback Accountability Act” (also proposed in the previous Congress), which would impose a 2% excise tax on the value of repurchased stock. In the previous Congress, Brown was joined by five other Senators who had buyback-busting bills. Sen. Cory Booker (D-N.J.) and Sen. Bob Casey (D-Pa.) proposed a law in which buybacks would trigger worker dividends (as did Sen. Brown); Sen. Bernie Sanders (I-Vt.) and Rep. Ro Khanna (D-Calif.) wanted to ban them when CEO pay is more than 150 times median worker pay; and Sen. Tammy Baldwin (D-Wis.) proposed banning them outright. Depending on the outcome of the 2022 midterm elections, such anti-buyback measures could resurface.

Meanwhile, SEC rulemaking could slow the pace of buybacks. In December 2021, the SEC proposed a share repurchase disclosure modernization rule, which, among other requirements, would mandate daily reporting of buyback data, currently required on a quarterly basis under Item 703 of Regulation S-K. The announcement acknowledged some benefits of buybacks but also cited some commenters who alleged “opportunistic and harmful use of issuer share repurchases by issuer insiders.” As of mid-September 2022, the proposal is still pending.

Benefits of Buybacks

Buyback defenders allege that, under the right conditions, stock buybacks can contribute to long-term company value for the benefit of all stakeholders. After learning of the latest proposed tax on buybacks, academics Jeffrey Hoopes and Allison Koester wrote a July 2022 op-ed (in The Hill) arguing that “Buybacks help the company eliminate its least productive capital and make the company more efficient (smaller and with more productive assets, on average).” A 2021 paper in Journal of Corporate Finance by Viet Dang et al. finds that, in states with laws that prevent the firing of unproductive workers, higher firing costs enhance “employee entrenchment” so companies “have an incentive to increase share buybacks to mitigate a wealth transfer from shareholders to employees.” This is so because buybacks by definition increase the relative percentage of company funds paid out to shareholders vs. other constituencies for the period studied. A 2019 study by Alberto Manconi et al. of more than 9,000 buybacks around the world concluded that they increased long-term share value as long as shares were undervalued at the time of the buyback.

The proposed SEC rule on buyback disclosure elicited a number of defenses. Veteran compensation consultant Ira Kay refuted the notion that buybacks prevent capital expenditures, finding that companies with large buybacks make greater capital expenditures than companies with small buybacks. Also writing in response to the proposed SEC rule on buyback disclosure, Darla Stuckey, head of Society for Corporate Governance, called it unduly burdensome. She noted that share buybacks “increase investor returns, improve market liquidity, return funds to shareholders that they can deploy to invest in smaller companies and allow issuers to obtain shares that can be used for employee incentive compensation without diluting the interests of existing shareholders.”

Shareholders are not the only potential beneficiaries of buybacks. Business Roundtable and Council of Institutional Investors have reasoned that “money returned to shareholders through buybacks and dividends does not disappear from the economy. Individual investors can use it to purchase something they’ve been saving for. The money can be lent to other companies that are hiring and growing. It can be invested in new businesses as seed money for start-ups or financing for emerging technologies.”

Furthermore, as mentioned earlier when explaining motivations for buybacks, buybacks can be used as protection against hostile takeovers. This is ironic, since shareholders — parties presumed to benefit from buybacks — tend to welcome hostile takeovers, while employees — the supposed victims of buybacks — are often harmed by them. In this sense, the role of buybacks as anti-takeover devices can advance rather than harm the interests of employees.

Buybacks as Financially Neutral

So far, we have reviewed the negative and positive effects of buybacks, but time-honored financial theory offers a third perspective, namely that buybacks are neither bad nor good for company value (and therefore stakeholders): They are neutral. In a 1958 article in The American Economist, Franco Modigliani and Merton Miller famously concluded that a company’s capital structure does not affect its value. They said, “as long as management is presumed to be acting in the best interests of the stockholders, retained earnings can be regarded as equivalent to a fully subscribed, preemptive issue of common stock.”

The argument of buyback neutrality is supported by both logic and evidence. As a matter of reason, buybacks per se should not automatically boost per-share price. While it is true that the company’s value is spread out over fewer shares (with each remaining shareholder holding a larger percentage of the company), it is also true that the company’s value is proportionately reduced by the fact that cash has left the company (or, if the buyback is financed by debt, leverage has increased). Furthermore, any positive anti-dilution effects may be temporary. Any reduction of the number of shareholders outstanding can be offset if the company then issues new shares, for example, in a new pay plan for executives.

That is why, although the buyback-focused indexes do well enough, they perform no better than the many other indexes attempting to achieve the elusive alpha (higher than average returns). For example, the June 2022 Index Dashboard: S&P 500 Factor Indices show the buyback index ranking 11th for year-to-date return and 14th for June total return, out of 17 S&P indices.

Sample Questions For Directors to Ask

Whether buybacks have a negative, positive or neutral impact on shareholders and other stakeholders, the fact remains that directors need to make a reasonable and informed decision when approving them. Here are some sample questions for directors to ask.

What will this buyback cost? What are its basic characteristics (total number of shares, average price per share)?
Is the price per share of this buyback set at market price or is it a premium? If we are paying a premium, how was this calculated?
Is there a need to return cash to our shareholders at this time? Why?
If one of the reasons for the buyback is to increase the value of compensation paid to executives, is this the only way to achieve this goal — and is the goal appropriate at this time?
What capital expenditures does this company need to make, and by when, and how would this buyback affect those needs? (For example, do we need to invest more in technology or in securing patents for our intellectual property?)
How much time do we have to make the decision to approve or reject this proposed buyback?
Will this proposed buyback be made in part to support a stock plan? If the repurchase is to be made to support a plan, is this the final bloc, or will there be more repurchase? What is the expiration date of the plan, if any? Who is covered by the plan?
If the buyback leads to share price appreciation, who will benefit?
Does the company plan any layoffs in the near future? If so, why? Would the funds used for this buyback be better spent to retain employees?
When we announce this buyback, what rationale will we give?

Buybacks as a Governance Litmus Test

Buybacks, in the end, are an ultimate litmus test for a company’s decision-making, as well as its values.

The buyback decision, like any board decision, can be scrutinized under various standards arising from the duties of care and loyalty. If buybacks are challenged, courts will want evidence of informed, nonconflicted decision-making.

When it comes to company values, buybacks can be associated with socially negative conditions, such as excessive senior executive pay, low employee pay or major layoffs. In companies where human capital is a stated value, it is particularly important to avoid giving the impression — or creating the reality — that the company puts people last.

Buybacks per se are neither good nor bad in and of themselves. Each buyback decision is company-specific. It is up to directors to ask questions that look beneath and beyond buyback proposals to see how they will affect their companies. In this sense, buyback proposals can serve as the ultimate governance litmus test.

Alexandra “Alex” Reed Lajoux retired from the National Association of Corporate Directors as chief knowledge officer emeritus in 2016 after 30 years there. From 1978 to 1981, she served as editor of Directors & Boards, which was founded by her father, Stanley Foster Reed, in 1976.