(Bloomberg Opinion) -- The Democratic presidential hopefuls may disagree on many issues, but they seem united in their hatred of stock buybacks, which they see as a clever way for executives to manipulate share prices and enrich themselves. Even some prominent Republicans agree. Defenders typically argue that it is an effective way of returning capital to the economy, benefiting everyone in the long run.
Who’s right? History suggests that today’s leading role for stock buybacks is less the result of deliberate policymaking than a failure to enforce policies that Republicans and Democrats alike agreed would create a better market for all Americans.
Few corporations bought or sold their own shares prior to the market meltdown of 1929. But once the boom collapsed, a growing number of the era’s infamous investment trusts – as well as individual companies – tried to prop up their own share prices by snapping them up on the open market. The practice irked investors, brokers, and even the financial press.
The initial objections to stock buybacks sound remarkably like ones lobbed by present-day politicians. In 1932, The New York Times made its case against buybacks: They deprived companies of much-needed cash; diverted executives away from “business problems” and toward the “speculative gyrations of the stock market”; and enabled companies to buy up shares being dumped by directors, officers, and others connected to the firm.
In response, the Governing Committee of the New York Stock Exchange issued a directive that “urged corporations not to trade in their own shares,” as the Wall Street Journal put it. After a year of making little impact, the NYSE took a more aggressive tack, forcing companies to disclose any plans to repurchase their own shares.
In 1934, Congress made buybacks even less attractive after it passed the Securities and Exchange Act. The language of the law was so broad and vague that stock buybacks could be construed as a form of market manipulation, even if the practice went unnamed.
As a consequence, repurchases went into a steep decline. Then along came Georgia-Pacific. Between 1961 and 1966, the paper company bought up other firms using its own common stock. The key, though, was that the stock used in these transactions had to reach a certain price level if used in this way. Georgia-Pacific simultaneously began buying up its own shares in what looked like a pretty obvious attempt to maintain a floor beneath the share price.
The SEC took the company to court, and the case cast a pall over other companies’ plans to buy back their own shares. In 1968, Congress passed a bill saying that everyone “should have full information regarding the company's activities and intentions in repurchasing its own stock.”
This sounded like a pretty reasonable request. But the SEC struggled throughout the 1970s to reconcile two essentially incompatible directives. Were stock buybacks illegal? Or did firms simply have to disclose them?
The SEC never came up with a clear answer, so neither approach gained sway. Then came Ronald Reagan’s election and the great wave of deregulation that followed. In their revolutionary zeal, the SEC’s new masters rejected both the approaches debated in the 1970s. They did so with little debate or discussion, sweeping the whole matter on the rug by sanctioning buybacks with almost no strings attached.
On November 17, 1982, the agency issued Rule 10b-18, which created a “safe harbor” for corporations pursuing stock buybacks. This effectively shielded them from prosecution under the original 1934 legislation. But unlike similar regulatory safe harbors instituted at this time, the new rule had no mandatory disclosure requirements, relying instead on voluntary compliance.
That meant there was no way for the SEC to determine whether a company has put all its cards on the table when it starts buying up shares – and no way for ordinary investors to know that, either. The only people who might know are corporate insiders and executives, whose continued tenure is increasingly dependent on their ability to “maximize shareholder .”
This has given corporate leaders an understandable incentive to focus on maintaining share prices. At times, there is a more direct incentive, given that executive compensation since the 1980s has increasingly come in the form of stock options. The end result of these changes has been an astonishing increase in the scale of corporate share repurchases.
Yet these repurchases continue to proceed without any meaningful oversight. Researchers have shown that few companies consistently comply with the voluntary disclosure requirements; others have found that corporate insiders sell off shares in the wake of these price-inflating buybacks. Yet no company has been prosecuted for abusing buybacks since the passage of Rule 10b-18.
That a practice once synonymous with market manipulation in the Great Depression now enjoys such outsized influence on stock prices is a bit unsettling. In fact, a recent study of 43 different countries concluded that buybacks, not actual economic growth, has driven the outsized stock market returns of the past two decades.
That’s not sustainable. But how should buybacks be treated in the future?
History offers a solution. When buybacks remained legal but subject to SEC scrutiny, companies proved far more reluctant to pursue them, even though regulators actually prosecuted very few companies. The mere possibility of prosecution was enough to keep firms from abusing the practice. This is a point that often gets lost in arguments over regulation: Sometimes it’s not even necessary for regulators to do anything to have a regulatory impact.
The other option is to revisit the solution bandied about in the 1970s: mandatory disclosure. In that scenario, buybacks remain completely legal, but firms must disclose any material information that the public would not otherwise know about the company – including anyone in the C-suite who plans on seizing an opportunity to unload shares.
Both approaches acknowledge that buybacks still have a small part to play in equities markets – just not a starring role.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Stephen Mihm, an associate professor of history at the University of Georgia, is a contributor to Bloomberg Opinion.
©2019 Bloomberg L.P.
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