Comp Committees Take Note: Stock Buybacks as a Mechanism for Manipulation
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With thanks to Cydney Posner of Cooley
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You’ve surely seen all the press about companies spending much of their savings from the 2017 Tax Cuts and Jobs Act on stock buybacks. See, for example, this article. And this article reports on a JP Morgan prediction for this year of over $800 billion in stock buybacks. According to this article in CFO.com, S&P 500 firms repurchased $166.3 billion worth of shares just during the first quarter of 2018, up 18.7% from a year ago. A common rationale for conducting a stock buyback is that the shares are undervalued—thus signaling optimism about the company’s future. In addition, buybacks are often viewed as a useful way to provide shareholders with a cash distribution or to offset dilution. However, in some cases, the author of this study contends, the real motivation may be more opportunistic—managing EPS and increasing executive compensation, regardless of the operational success of the company, where EPS is a performance measure. Comp committees: take note. The study author examined 293 accelerated share repurchase (ASR) transactions initiated during the period from 2004 to 2011. An ASR, sometimes referred to as an “overnight share repurchase,” is a popular technique for conducting stock buybacks that can give EPS a quick booster shot. In these transactions, the company enters into a transaction with an investment bank for repurchase of a number of shares. In exchange for payment, the bank then delivers to the company a large block of its shares that were borrowed from institutional investors such as mutual funds. The repurchased shares are recorded as the company’s treasury stock, immediately reducing the company’s outstanding share count. The bank then conducts a series of regular open-market purchases over time (typically around five months) to replace the borrowed shares. But it doesn’t matter to the company how long the bank takes to complete the purchases because, from the company’s perspective, the deal is done and reflected on its books. Had the company conducted the buyback through a broker, the limitations of the Rule 10b-18 safe harbor would typically have imposed a much slower time frame. The study found that, on average, the companies that engaged in these transactions reported improved operating performance during the post-ASR period. But that wasn’t universally the case: in some cases, the author suggests, the companies may have used the ASRs for EPS management. According to the study, approximately 29% of the companies examined were “EPS-suspect,” that is, the companies met or beat analysts’ consensus EPS forecasts within a tight range (i.e., 0 to 5 cents), but would have missed the analysts’ EPS targets had they not conducted the buybacks. (By comparison, only 14% of the companies that conducted regular open-market buybacks during the same time period were EPS-suspect.) Supporting the view that EPS management was a prime motivation, the author argues, the data showed that the proportion of companies that provided their CEOs with EPS-contingent bonuses was greater among EPS-suspect companies than among non-EPS-suspect companies, as was the proportion of “habitual EPS beaters…. As predicted, these results imply that meeting EPS targets is a more important concern for EPS-suspect firms than non-EPS-suspect firms. In addition, the mean book-to-market ratio of EPS-suspect firms is lower than that of non-EPS suspect firms, suggesting that equity undervaluation is less of a concern for EPS-suspect firms.” Moreover, EPS-suspect companies did not report improved operating performance following the ASR announcement, compared with the control group, which did realize significant positive operating performance during the post-ASR period. With regard to the reactions of investors, the study showed that, after controlling for other relevant factors, for EPS-suspect companies, stock returns following the ASR announcement were, “on average, 2.1 percentage points lower than that for …control ASR firms…. These results suggest that investors are not fooled by firms’ attempts to use ASRs to meet or beat consensus forecasts.”
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SideBar The author of “Executive Compensation and Stock Buybacks: The Pros and the Cons,” in The Corporate Governance Advisor concurs that stock buybacks can be used for financial manipulation. The article indicates that long-term incentive awards are now more prevalent than ever, representing an increase from 22.8% in 2010 to 36.7% in 2016 for companies in the Russell 3000. In addition, in 2016, 64% of mid-market companies used LTI performance metrics based on income-related measures such as EPS, while among the top 200 companies in 2015, the use of income-related measures was at 51%. Further, in addition to EPS, buybacks can also positively affect other financial ratios used to calculate capital efficiency measures, such as Return on Equity (ROE), Return on Assets (ROA), or Return on Invested Capital (ROIC), and these ratios also serve as performance metrics for LTI purposes. In 2016, 27% of mid-market companies used these types of capital efficiency measures as performance metrics, while among the top 200 companies, in 2015, 47% employed these types of capital efficiency measures as LTI performance metrics. Another issue identified in the article is that, while a buyback generally occurs in the course of an award’s performance period, companies rarely make corresponding adjustments to the performance goals to offset the positive effect of the buyback. The author cautions that companies should take care in “selecting performance measures that can be manipulated by financial engineering such as Buybacks,… and be ready to explain the reasoning behind such choices in the annual proxy statement.” Note, however, that shareholder proposals submitted by the AFL-CIO (see this PubCo post) and James McRitchie (with John Chevedden as proxy) have sought to address the issue of potential financial engineering by preventing the use of EPS or related financial ratios in determining executive comp unless the board excludes the effect of a stock buyback on the outstanding share calculation during the relevant period. (See this no-action letter and this PubCo post.)
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The study author observes that “[i]nterestingly, in only three out of 293 cases, [did] compensation committees report taking into account the EPS impact of an ASR when deciding whether EPS targets [were] achieved. Thus, while using ASRs does not seem to help firms generate a positive investor reaction at earnings announcements, it likely helps some managers secure their bonuses and increase their compensation…and maintain their reputations in the executive labor market.” The study concluded that, while ASRs can be useful tools to signal confidence regarding future prospects, the “research suggests that ASRs are indeed open to abuse and used opportunistically by some managers to quickly boost EPS.” Accordingly, companies that want to “signal better future performance to the stock market should carefully consider the timing of an ASR transaction…. Further, corporate boards need to be cognizant of managers’ incentives related to ASR,” particularly in the context of policies related to repurchases and executive compensation.
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SideBar In remarks before the Center for American Progress, SEC Commissioner Robert Jackson discussed his recent research on corporate stock buybacks, in light of the substantial increase in buybacks following the 2017 Tax Cuts and Jobs Act. His focus: to call on the SEC to update its buyback rules “to limit executives from using stock buybacks to cash out from America’s companies.” If executives are so convinced that “buybacks are best for the company, its workers, and its community,” Jackson suggested, “they should put their money where their mouth is.” But Jackson’s particular bête noire in this regard was the “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, especially those shares designed to link executive pay with long-term performance. Jackson observes that grants of equity comp typically result in higher levels of pay, in exchange for which “investors—and the economy as a whole—tie executives’ fortunes to the growth of the company.” To Jackson, allowing executives to cash out—at prices often inflated by the company’s buyback announcement and open-market purchasing activity—undermines the purpose of equity comp: to give executives “incentives to create long-term, sustainable value.” If buybacks are really the right long-term strategy for the company, he contends, then executives “should want to hold the stock over the long run, not cash it out once a buyback is announced.” (See this PubCo post.)
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