The S.E.C. Rule That Destroyed The Universe
How the coronavirus is creating a political opportunity to overturn one of the worst practices of the kleptocracy era
The Covid-19 crisis has revealed gruesome core dysfunction. Drug companies have to be bribed to make needed medicines, state governments improvise harebrained plans for emergency elections, and industrial capacity has been offshored to the point where making enough masks seems beyond the greatest country in the world.
But the biggest shock involves the economy. How were we this vulnerable to disruption? Why do industries like airlines that just minutes ago were bragging about limitless profitability – American CEO Doug Parker a few years back insisted, “My personal view is that you won’t see losses in the industry at all” – suddenly need billions? Where the hell did the money go?
This breaks a taboo of nearly forty years, during which politicians in both parties mostly kept silent about a form of legalized embezzlement and stock manipulation, greased by an obscure 1982 rule implemented by Ronald Reagan’s S.E.C., that devoured trillions of national wealth.
The mechanics of buybacks are simple. Companies buy their own stock and retire the shares, increasing the value of shares remaining in circulation. This translates into instant windfalls for shareholders and executives that approve the purchases. That this should be proscribed as market manipulation, and additionally offers a clear path to insider trading – former SEC chief Rob Jackson found corporate insiders were five times as likely to sell stock after a share repurchase was announced – is just one problem.
The worse problem comes when companies not only spend all of their available resources on stock distributions, but borrow to fund even more distributions. This leaves companies with razor-thin margins of error, quickly exposed in a crisis like the current one.
“When companies spend billions on buybacks, they’re not spending it on research and development, on plant expansion, on employee benefits,” says Dennis Kelleher of Better Markets. “Corporations are loaded up with debt they wouldn’t otherwise have. They’re intentionally deciding to live on the very edge of calamity to benefit the richest Americans.”
It’s hard to overstate how much money has vanished. S&P 500 companies overall spent the size of the recent bailout – $2 trillion – on buybacks just in the last three years!
Banks spent $155 billion on buybacks and dividends across a 12-month period in 2019-2020. As former FDIC chief Sheila Bair pointed out last month, “as a rule of thumb $1 of capital supports $16 of lending.” So, $155 billion in buybacks and dividends translates into roughly $2.4 trillion in lending that didn’t happen.
Most all of the sectors receiving aid through the new CARES Act programs moved huge amounts to shareholders in recent years. The big four airlines – Delta, United, American, and Southwest – spent $43.7 billion on buybacks just since 2012. If that sum sounds familiar, it’s because it equals almost exactly the size of the $50 billion bailout airlines are being given as part of the CARES Act relief package.
The two major federal financial rescues, in 2008-2009 and now, have become an important part of a cover story shifting attention from all this looting: the public has been trained to think companies have been crippled by investment losses, when the biggest drain has really come via a relentless program of intentional extractions.
Corporate officers treat their own companies like mob-owned restaurants or strip mines, to be systematically pillaged for value using buybacks as the main extraction tool. During this period corporations laid off masses of workers they could afford to keep, begged for bailouts and federal subsidies they didn’t need, and issued mountains of unnecessary debt, essentially to pay for accelerated shareholder distributions.
All this was done in service of a lunatic religion of “maximizing shareholder value.” “MSV” by now has been proven a moronic canard – even onetime shareholder icon Jack Welch said ten years ago it was “the dumbest idea in the world” – and it’s had the result of promoting a generation of corporate leaders who are skilled at firing people, hustling public subsidies, and borrowing money to fund stock awards for themselves, but apparently know jack about anything else.
During a Covid-19 crisis where we need corporations to innovate and deliver life-saving goods and services, this is suddenly a major problem. “We’re seeing, these people don’t have the slightest idea of how to run their own companies,” says University of Massachusetts economist William Lazonick, whose substantial research on the buyback issue has been a cornerstone of the movement toward reform.
Wall Street analysts spent the last weeks mulling over the grim news that society is wondering if it can afford to keep sending most of its wealth to a handful of tax-avoidant executives and corporate raiders (known euphemistically in the 21stcentury as “activist investors”). The Sanford Bernstein research firm sent a note to clients Monday warning buybacks would be “severely curtailed” in coming years, for the “intriguing” reason that they were becoming “socially unacceptable” in this crisis period.
Goldman, Sachs chimed in with a similar observation. “Buyback activity will slow dramatically, both for political and practical reasons,” the bank told clients.
The political furor on the Hill in the last weeks has mostly been limited to grandstanding demands that recipients of aid in the $2 trillion CARES Act not be spent on stock distributions. “I’ll take it, but most of them don’t know what the hell they’re talking about,” is how one economist described these complains.
If politicians did understand the buyback issue more fully, they either wouldn’t have voted for this unanimously-approved bailout, or would have insisted on permanent bans, given the central role such extraction schemes played in necessitating the current crisis to begin with. The history is ridiculous enough.
The newspaper record of November 17, 1982 shows an ordinary day from the go-go Reagan years. Republicans boosted tax cuts and military budget hikes. An NFL player strike ended after 57 days. Soviet and Chinese foreign ministers met, and 80 complete skeletons were found in a dig at Mount Vesuvius in what one scientist called a “masterpiece of pathos.”
There was little news of a rule passed by the Securities and Exchange Commission and implemented with almost no documentary footprint. “It’s not written about in histories of the S.E.C.,” says Lazonick. “It’s barely mentioned even in retrospect.”
Yet rule 10b-18, which created a “safe harbor” for stock repurchases, had a radical impact. For decades before Reagan came into office and stuck E.F. Hutton executive John Shad in charge of the S.E.C. – the first time since inaugural chief Joseph Kennedy’s tenure in the thirties that a Wall Street creature had been made America’s top financial regulator – officials had tried numerous times to define insider purchases of stock as illegal market manipulation.
Again, when companies buy up their own stock, they’re artificially boosting the value of the remaining shares. The rule passed by Shad’s S.E.C. in 1982 not only didn’t define this as illegal, it laid out a series of easily-met conditions under which companies that engaged in such buybacks were free of liability. Specifically, if buybacks constituted less than 25% of average daily trading volume, they fell within the “safe harbor.”
The S.E.C. in adopting the rule emphasized the need for the government to get out of the way of such a good thing:
The Commission has recognized that issuer repurchase programs are seldom undertaken with improper intent… any rule in this area must not be overly intrusive.
The rule added that companies may be justified in “stepping out” of safe harbor guidelines, and said that there would be no presumption of misconduct if purchases were not made in compliance with 10b-18. Thirty-three years later, in 2015, S.E.C. Chief Mary Jo White would double down on this extraordinary take on “regulation,” saying that “because Rule 10b-18 is a voluntary safe harbor, issuers cannot violate the rule.”
10b-18 was a victory for a movement popularized in the late sixties by Milton Friedman and furthered in the mid-seventies by academics like Michael Jensen and Dean William Meckling. The aim was to change the core function of the American corporation. If corporate officers previously had to build value for a variety of stakeholders – customers, employees, the firm itself, society – the new idea was to narrow focus to a single variable, i.e. “maximizing shareholder value.”
Like objectivism and other greed-based religions that helped birth the modern version of corporate capitalism, “MSV” was anchored on hyper-rosy assumptions tying efficiency to self-interest. It was said CEOs paid in stock would become owners, which would lead to reductions in spending on private jets and other waste.
Shareholders previously were paid via dividends, or by waiting for share prices to appreciate and selling them. Now there was a shortcut: board members chosen by shareholders could raid their own companies’ assets to buy stock and to goose share prices.
Employees, customers, and society were suddenly in direct competition for resources with executives and shareholders. Should a company invest in a new factory, or should it just deliver instant millions to shareholders and executives paid in options?
By 1997, MSV became orthodoxy, as the Business Roundtable declared that the “paramount duty of management and of boards of directors is to the corporation’s stockholders.” This was understood to mean that the sole purpose of the corporation was to create value for shareholders.
In the 2008 financial crisis, many firms poured resources into buybacks even as they hurtled toward bankruptcy. Some kept shifting money to stock buys practically until the day of their deaths. Lehman Brothers, for instance, announced a 13% dividend increase and a $100 million share repurchase in January 2008, when the firm was already circling the drain. Many of the TARP bailout recipients kept up buybacks even during the bleakest days of the financial crisis.
“If you added up the capital distributions of the banks in just the few years before the crash,” says Kelleher, “it adds up to half the TARP. They wouldn’t have needed a bailout if they’d [curbed] distributions.”
Before and after 2008, American companies repeatedly begged to be subsidized by taxpayers even as they systematically liquidated revenues via buybacks.
For instance, as Lazonick pointed out in a 2012 paper, Intel in 2005 lobbied the U.S. government to invest in nanotechnology, warning “U.S. leadership in the nanoelectronics era is not guaranteed” and would be lost absent a “massive, coordinated research effort” that included state and federal investment. That year, Intel spent $10.5 billion on buybacks, and spent $48.3 billion on them in 2001-2010 overall, four times what the federal government ended up spending on the National Nanotechnology Initiative.
The classic extraction trifecta was to ask for public investment, take on huge debts, and enact mass layoffs as a firm spent billions on distributions.
Microsoft in 2009 laid off 5,000 workers (its first mass layoff) and did a $3.75 billion bond issue (its first long-term bond) despite earning $19 billion. That same year, the company spent $9.4 billion on buybacks and $4.5 billion on dividends. Lazonick argues such cash-rich companies borrowed money in order to avoid having to repatriate overseas profits, which would have forced them to pay taxes before blowing cash on buybacks.
Buyback waste is breathtaking. Exxon-Mobil, apparently disinterested in researching alternative energy sources, did $174 billion in buybacks between 2001-2010. The nation’s 18 largest pharmaceutical companies, who feed off NIH grants for free research and have relentlessly lobbied to be protected from generics, reimportation, the use of Medicare’s bargaining power to lower prices, spent $388 billion on buybacks in the last decade.
Apple, upon whose board sits relentless seeker-of-green-technology-seed-capital Al Gore, did $45 billion in buybacks in one year (2014) and $239 billion over a six year period between 2012 and 2018. Gore also owned over 79,000 shares of Apple as of last January, and sold nearly $40 million worth of Apple stock in February of 2017. So he’s probably not too upset that Apple is spending sums equivalent to major bailout programs on stock repurchases, rather than investing in new technologies.
In March of 2018, Wisconsin Senator Tammy Baldwin finally introduced legislation to halt the practice, called the Reward Work Act, which would:
Ban open-market stock buybacks that overwhelmingly benefit executives and activist hedge funds at the expense of workers and retirement savers. It would also empower workers by requiring public companies to allow workers to directly elect one-third of their company’s board of directors.
In summer of 2019, the Business Roundtable shook corporate America by abandoning “shareholder value” as the animating principle of American business. This led to a spate of breathless news reports: “Shareholder Value Is No Longer Everything” (New York Times), “Group of US corporate leaders ditches shareholder-ﬁrst mantra” (Financial Times) and, “Maximizing Shareholder Value is Finally Dying” (Forbes).
This was all going on against the backdrop of a Democratic presidential election campaign that in the campaigns of Bernie Sanders and Elizabeth Warren especially saw the rise of furious anti-corporate sentiment. The Roundtable response might have been P.R. designed to dull the pitchforks somewhat, but it’s notable that there was enough worry about the optics of shareholder piggery to even do that much.
As Forbes put it:
Maximizing shareholder value has come to be seen as leading to a toxic mix of soaring short-term corporate profits, astronomic executive pay, along with stagnant median incomes, growing inequality, periodic massive financial crashes, declining corporate life expectancy, slowing productivity, declining rates of return on assets and overall, a widening distrust in business…
Economist Lenore Palladino, who has worked on these issues for years, hopes Covid-19 and other looming crises will force politicians and the public to see fundamental changes to corporate structure as inevitable.
“I believe there will be a political mandate to ensure business resiliency in the 2020s, not only to survive coronavirus, but so that the American workforce can thrive in the era of climate change,” she says. Banning buybacks, she says, would (among other reforms) comprise “one step towards rebalancing power inside corporations.”
However, unless the public puts more pressure on politicians to keep the issue alive during the coronavirus crisis, the $2 trillion rescue and the near-daily barrage of radical new bailout facilities being introduced – the Fed as of this writing is introducing yet another amazing “bazooka” program to hoover up junk bonds – could just end up subsidizing the last decade of buybacks.
If political focus on repurchases becomes a purely temporary policy fixation, a la Joe Biden’s “CEOS should wait a year before gouging their own firms again” proposal, this bailout will be massively counterproductive, enshrining buybacks in non-emergency times as a legitimate practice. If we can’t fix a glitch as obvious as 10b-18, what can we change?