The financial classes love them, the left wants to ban them — but what exactly is the real story behind share buybacks?
Contents
[1] Company gains; worker losses
[2] In too deep?
[3] Elections, legislation and government - no easy solutions
[4] A workers’ dividend
The concepts of finance don’t often enter general public debate, especially in the United States. Yet, numerous American politicians have recently gone on the record to state their support for banning share buybacks. Bernie Sanders and fellow senator Chuck Schumer have proposed banning buybacks unless highly prescriptive requirements are met. Alexandria Ocasio-Cortez, the new darling of the American left, has spoken against them. Other bills and plans have been introduced or mooted, including some from senior Republicans like Marco Rubio (though on less severe terms than his progressive colleagues).
As with many financial contrivances, the concept of a buyback is light in its simplicity, and yet its implications slide far into shadowy uncertainty. As the name suggests, a company instituting a share buyback uses its spare funds to buy its shares back from shareholders, with those shares then cancelled, resulting in fewer shares in the company overall.
This has become a common strategy, particularly for publicly-traded companies, which undertake buybacks either ‘on-market’, wherein a broker on behalf of the company buys its shares back from the open market (in Australia, on the ASX). Or, the buyback occurs ‘off-market’, where shareholders are invited to sell their shares back to the company, usually at a discount, with the difference between the price paid and the market price made up for with a dividend component that carries tax advantages for the shareholders (franking credits, no capital gain tax).
Provided the company is sufficiently profitable and the share buyback can be financed by excess cash (or sufficiently cheap debt finance), what’s left is a company that makes more money per share, dividing the same pie into larger slices. Each share is worth more to its respective shareholder.
What, then, is all the fuss?
Buybacks were banned in the US until 1982 — not explicitly, but as a result of the more general ban on market manipulation. That they were considered a form of stock price manipulation is telling. (The practice was made legal by the introduction of a ‘safe harbour’ carve out from the prohibition on market manipulation for buybacks.)
Every dollar that a company spends on a buyback is a dollar that is not being used for some other purpose like, for example, research and development, training, further education; the building blocks of innovation, competition and the extension of workers’ skills and knowledge. To say nothing of salaries and wages. All of these are necessarily neglected when monies of the company are spent on buybacks.
Most shares are not directly held by the general public. They are either held by institutional players like banks and insurance companies or by the behemoth superannuation funds that do the investing on behalf of those saving for retirement. All these financial intermediaries are looking to increase the value of their portfolios, and are not spending the proceeds of buybacks as much as they are buying shares from other financial intermediaries, keeping the money locked in this self-serving loop rather than being returned to value-adding works.
Where money is spent on buybacks and not circulated back into the economy at large, the system misses out on innumerable additional points of taxation — the underpaid worker that misses out on a pay increase, in turn doesn’t take that family holiday; the holiday resort owner then takes home less money that season and pays less tax as a result.
Unlike dividends, which can only be paid out of cash profits that the company actually holds, buybacks can be paid for with cash on hand or funded by the company taking on debt.
The choice of debt to finance buybacks can be tempting for companies as interest on debt is tax deductible. However, the company will have to make extra money in the future in order to pay off its new loans. This can be a highly risky strategy, if not ruinous.
Other financial complications arise, too. Buybacks are generally undertaken in times of strength (or perceived strength). The company either needs to have a significant amount of spare cash lying around or the confidence that its future revenues will be sufficient to repay the required loan plus interest. However, by spending monies on buybacks, the company will have less cash on hand if it experiences a downturn.
[1] Company gains; worker losses
Drawing by David Kaldor
Most profound is the impact of share buybacks on workers.
You’ve seen the graph before. The one showing the sharp increase in both productivity and gross domestic product tracked against the profoundly flat course of income in real terms. It’s staggering, and the topic of a library of commentary. The causes are multitude; legion — but all arise from the fundamental truth that greater and greater value is being created by workers without greater reward.
Workers create the value of any business venture, whether they do so with their hands, their knowledge, or by some combination. The value that is created is evaporated to higher and higher climes, soaking into the pockets of those less and less connected to the original work.
Shareholders of large public companies are rarely involved in creating the goods or services that the entities they own exploit for profit. Yet their ownership gives them significant power — the power to influence, if not determine, the way in which those at the bottom of the organisational chart are remunerated; which to a serious extent determines the scope within which they can live their lives.
Executives and shareholders make natural allies, and their interests generally sound in concert. The greater the profits made by the company, the greater the money to be spread between them. Shareholders vote to establish executive boards that will do the most to maximise the value of the company based on its share price; in turn, those executives are well remunerated for their efforts. This furthers the inequality in wealth between those at the top and those at the bottom.
A company’s share price is based on how valuable each share is to its holder, which, in turn, largely reflects the amount of money the company makes divided by each share held by shareholders (the so-called ‘earnings per share’, or EPS). This is, of course, money made after deducting the expenses of running the business — including the expense of rewarding workers for creating the value of the thing or things that the company sells. The amount left over represents the surplus value of the labour of the company’s workers.
The diabolic pact between shareholders and executives is clear. They can readily turn their focus on furthering each other’s interests, but only ever at some expense to workers.
It is because of the redistribution of wealth away from the workers that create it that many have called for buybacks to be banned. Sanders and Schumer, writing in The New York Times at the release of their bill restricting buybacks, said, in a useful part-summary of the case against, that:
...buybacks don’t benefit the vast majority of Americans. That’s because large stockholders tend to be wealthier. Nearly 85 percent of all stocks owned by Americans belong to the wealthiest 10 percent of households. Of course, many corporate executives are compensated through stock-based pay. So when a company buys back its stock, boosting its value, the benefits go overwhelmingly to shareholders and executives, not workers.”
Information on the percentage of shares held by Australia’s wealthiest 10% is not to hand. But we do know that the country’s wealthiest 1% now own at least the same amount of wealth as the bottom 70% combined. That is a staggering amount, and it is only growing, in keeping with a trend dating back decades.
Economist Thomas Piketty succinctly diagnosed ever-increasing wealth inequality in developed nations as a necessary consequence of an economic situation in which the rate of return on capital is higher than the overall growth in the economy. Return on capital (including, for example, the return shareholders see when their shares increase in value as a result of share buybacks) flows disproportionately to the wealthy who can afford to hold significant capital holdings (including shares). While return on capital is income, growth is a by-product of it: the more that is earned and spent, the more overall demand increases, and the more the economy grows. The rate of return on capital is, then, a measure of performance for those who hold capital (generally the wealthy and ultra-wealthy) and growth a measure of performance for the system overall — where the wealthy are doing better than the collective, inequality rises.
The market loves buybacks, and rewards them handsomely. Even an announcement that a company is going to buyback its shares can do wonders to its share price — even if it eventually does not follow through with its commitment.
In short, buybacks benefit the wealthy at the expense of the poor. Wealth inequality is exacerbated.
Buybacks help boost the return on capital enjoyed by those that own it — and the greater the holding, the greater the return. Though it is clear that buybacks are a means of companies returning their proceeds to the wealthy and not to workers, it is dangerously simplistic to think that an outright (or even partial) ban would amend the situation.
[2] In too deep?
The defences to share buybacks have been issued with a strength similar to their antagonists. Goldman Sachs cast a sternly-worded report of the practice in light of the increased scrutiny, and found (perhaps unsurprisingly) that financial disaster would be wrought by any move to ban buybacks.
“[Buybacks] have consistently been the largest source of U.S. [share] demand … Without company buybacks, demand for shares would fall dramatically,” the firm’s analysts wrote.
In other words, without companies buying back their own shares, there would be less total purchasing of shares, but on a scale that would severely depress share prices and the value of the market overall. That buybacks represent such a significant portion of total share trading speaks to the extreme extent to which they occur t. But Goldman was right on this point — removing or limiting the largest purchasing category of share buyers would radically lessen demand and therefore value in the stock market. As a subsidiary effect, volatility would soar with lessened liquidity, with prices swinging around far more wildly than is desirable.
Australian superannuation funds are poised to soon own 50% of the entire Australian stock market. Funds typically hold around 25% of their assets in domestic equities and another 25% in foreign shares, mostly from the US. This intermingling ties the fortunes of major economies together, and helps account for a depression in one country having a knock-on effect on others. Many low-income Australian’s life savings are limited to their superannuation funds, which would be devastated.
Buybacks are, then, a kind of economic Frankenstein to which we are tied; an opiate for the finance classes. Such a great proportion of share, and therefore market, value is generated by share buybacks that we stand to lose — all of us — significantly if this crutch,which we have allowed ourselves to become reliant on, were to suddenly be removed.
[3] Elections, legislation and government - no easy solutions
The recent Australian election was clouded somewhat by the debate on franking credits, restrictions which were generally described by mainstream media as harmful to pensioners, retirees and battlers more generally. Ignored in that debate was the spectre of buybacks.
When a company makes a profit, it will (or, at least, should) pay tax on those profits (the corporate tax rate is 30% and 27.5% for companies with less then $50m turnover) When the company pays out those profits to shareholders as dividends, a franking credit attaches to those payments to acknowledge the tax paid by the company. A shareholder paid a dividend will be obliged to pay tax at their marginal rate on the payment, but, to the extent of the franking credit, will be entitled to deduct 30% (or some portion thereof) from that tax rate as recognition of the company’s tax payment.
Where a taxpayer already enjoys a low tax rate (including many pensioners and superannuation funds), the deduction, reflecting the tax paid by the company, can result in a negative number, which is then paid to the taxpayer by the tax department as a rebate.
Labor’s proposed changes to the franking credit system would have eliminated the rebate. This was expected to greatly increase the number of buybacks undertaken, especially by those who had built up a significant amount in franking credits, including Caltex and Harvey Norman. Buybacks represented an alternative means for companies to return money to shareholders, and they were prepared to use it.
What is often overlooked is that the rebate scheme effectively dilutes the amount of actual tax paid on a company’s earnings. Every dollar of rebate that is paid out is a dollar of corporate tax not collected. Australia is somewhat unique in its highly-favourable franking credit system, which reflects a truism that our taxation system weighs more heavily on income taxes at the expense of levying taxes against capital than is the case in other wealthy nations.
The tax advantages, too, are not just limited to franking credits. Shareholders who benefit from buybacks through the inflated value of their shares only pay capital gains tax on their shares once they sell them, and so can postpone that taxation event until the optimal moment. As well, most shareholders (including many companies) would be entitled to the 50% capital gains discount on their marginal tax rate, which would be charged against the income earned from selling the shares. These savings are significant.
Just as companies would have readily switched from dividends to buybacks if the economic conditions so prevailed, so would they ditch buybacks for dividends if the ban was enacted. While this would ameliorate some of the issues inherent in buybacks that do not subsist in dividends, the Hydra of wealth leaking from worker to wealthy through the strictures of finance would be preserved. A broader solution is required.
[4] A workers’ dividend
Design by Cari Gray, Paperplane Collective
The Sanders / Schumer buyback bill would “set minimum requirements for corporate investment in workers and the long-term strength of the company as a precondition for a corporation entering into a share buyback plan”. But who will monitor and enforce compliance with these minimum requirements? At the risk of sounding rather like those who most advocate for buybacks, creating a new apparatchik of enforcement, a new burden of oversight, is not the answer.
Eliminating buybacks would have dangerous consequences for the economy, and, even so, there are other readily-available means and ways of passing on wealth to shareholders. An outright ban would not solve the problems that the practice presents.
But properly redistributing wealth to workers and employees would.
In the two decades from 1997 to 2017, Australia saw its real hourly wage — adjusted for inflation — increase by 12.5%, or on average of 0.6% per year. Growth in gross domestic product over the same period has been many multiples of this number. The total wealth created has overwhelmingly gone to the upper echelons of riches, and will continue to do so, for the same old reasons.
Woolworths recently closed a $1.7 billion buyback initiative. The lowest-remunerated Woolworths employees (of whom there are many) get paid $21 an hour; Brad Banducci, the company’s CEO, took a total compensation package of around $8 million in 2018. Woolworths has around 115,000 employees, making the $1.7 billion buyback worth just short of $15,000 per employee.
The Woolworths buyback sounds immense. It is. But it pales in comparison to the $14.5 billion buyback announced by BHP in 2018. BHP has around 62,000 employees and its CEO was paid around $6.5 million last year.
What if, when dividends and buybacks are paid out, some portion of the amount must be given to workers? After all, that payout to the shareholders is representative of the value created by workers that is not paid to them.
A workers’ dividend.
The finer details (taxed or untaxed; capped based on income; paid in cash or stock — even the percentage amount) need not be worked out in full for the concept to be right; the filigree is important, but less than the idea. This is where those asking for bans on buybacks should be focussing their attention. This is something that would have a material impact on the lives of employees and workers. And without creating much, if anything, of an administrative burden.
This will, of course, slightly dampen increases in share prices moving forward, though moderately. In turn, this price decrease will impact the superannuation portfolios held by common workers. There is an obvious riposte: the best thing to bolster savings is an increase to the principal amount going in, and eeking out some amount from the vast hordes of wealth being spent on buybacks — more benefiting the wealthy than anyone else — will help workers build pension savings in the first instance.
Share buybacks are nothing if not a guide to the extent of surplus value created by workers and employees.
Why ban them when we can redistribute them?
Scott Colvin
Scott Colvin is an internationally-acclaimed writer and lawyer based in Melbourne. His award-winning work has appeared in The Sydney Morning Herald, The Australian Financial Review, The Huffington Post, and a variety of other national and international publications. Scott writes on culture, politics and the economy and may be found on twitter: @SKJColvin
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By all means share wealth with workers. But I think the consequences of stopping buybacks are greatly exaggerated here.
The other way to look at it is that share prices have been greatly inflated by buybacks. Banning them would just return share prices to a more realistic level. There is no reason to expect volatility to change in the long term.
There may need to be transition arrangements so the short-term effects are not too disruptive, but that’s a different matter.