March 13, 2019 / 3:41 PM / 2 months ago

Breakingviews - Hadas: Share buybacks aren't worth defending

LONDON (Reuters Breakingviews) - When Goldman Sachs goes on the defensive, someone must be attacking with force. The Wall Street firm just published research that tries to clear up some negative “misperceptions” about corporate share repurchases. For many critics of contemporary capitalism, stock buybacks have become emblematic of a corrupt system. As far as this particular practice goes, the critics have a good case.

A street sign, Wall Street, is seen outside New York Stock Exchange (NYSE) in New York City, New York, U.S., January 3, 2019. REUTERS/Shannon Stapleton

Until 1982, the rules set by the U.S. Securities and Exchange Commission made it difficult for companies to purchase their own shares in the market. Most experts considered buybacks to be inherently unfair to outside investors, since only company insiders knew they were happening, at what price and in what number. Also, the corporate managers in charge might be tempted to abuse the privilege.

Besides, dividends already did what buybacks do, only better - and less sneakily. Both techniques deliver cash to shareholders. The key difference is that dividends are equitable and open, while buybacks are opaque. Both are totally flexible to change along with available cash. If companies like to keep normal dividends steady, they can always declare special distributions.

However, the SEC succumbed to the “trust the market” deregulatory spirit rampant in the 1980s. The regulator made buybacks legally safe from claims of market manipulation, as long as the companies concerned announced roughly how many shares might be bought over roughly how long. Other national regulators gradually followed the American lead.

The SEC decision should have inspired tax authorities to do some economic thinking and treat buybacks in exactly the same way as dividends. Instead, they allowed the fiction that buybacks are returns of capital. That choice made buybacks more tax-efficient than dividends. As a by-product, it also somewhat reduced the government’s potential tax revenue.

Accountants also chose to ignore economic reality. They did not extend to buybacks the adjustments made when companies split their stock or pay dividends in the form of shares. Without compensating for the phony reduction in share count that goes with buying back shares, the practice artificially increases earnings per share. Corporate bosses love that, since some are partly judged by EPS and others by stock prices, which can follow EPS higher.

Managers have taken to buybacks with enthusiasm. Goldman’s note last week counted up distributions to shareholders for the companies in the S&P 500 Index since 1880. The report’s six authors found that since the current period of economic recovery began in the third quarter of 2009, market purchases of shares had made up just over 60 percent of the $8 trillion of total distributions.

Critics often claim that higher payouts have come at the expense of corporate investments - a concern that intensified in 2018 as the Republicans’ tax cuts kicked in, giving companies more post-tax profit to play with. The Goldman figures basically support the complaint. Between 1971 and 1982, shareholders received closer to half of reported profit. That rose to 70 percent between 1983 and 2001 and to 90 percent since 2002.

Goldman’s researchers draw the opposite conclusion, by comparing the current payout with the 78 percent average ratio between 1880 and 1980. From that perspective, they see the last 40 years as a gradual return to normal. That’s unrealistic. Reported earnings were often understated relative to today’s until regulators required the consolidation of a company’s subsidiaries in 1959. Also, back then higher payouts were often accompanied by more frequent calls on shareholders for new capital.

The Goldman report does one valuable service. It treats buybacks correctly, as quasi-dividends. That is ammunition for proponents of substantial buyback reform. After all, two economically identical arrangements should involve the same taxes and accounting.

The note does not address the old concerns about inadequate or unequal information about buybacks, but they are as pertinent as ever. Undisclosed corporate share-buying is likely to distort market prices.

Corporate insiders can also game the system. Robert Jackson, a commissioner of the SEC, presented evidence in a speech last year that suggested senior executives are taking advantage of buyback-related information. They tend to wait to sell their shares until just after the announcement of a buyback has pushed up the share price.

A newer and less noticed problem is that buybacks distort index investing. An accurate measure of market capitalisation in necessary to ensure fund holdings track their benchmark indexes accurately. That’s not available when buybacks reduce a company’s share count at an undisclosed rate.

All these problems may sound minor, but stock markets are supposed to be a level playing field. Distortions, especially those which help insiders, feed suspicions that the rich and powerful have an unfair edge. The preference for buybacks over dividends goes along with venture-capital investors capturing most of the growth of new companies and leveraged-buyout firms extracting much of the cash flow of previously stable companies.

Those other problems are hard to solve, but discouraging buybacks is easy. Economically accurate accounting standards, tax rules that equalize them with dividends, and instantaneous disclosure of purchases are just a few regulations away - and for all Goldman’s protests, they wouldn’t be that controversial. Or regulators around the world could simply admit that they made a mistake in the 1980s and turn back the clock.

Breakingviews

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