Now that litigators of class-action lawsuits have expressed concern as to the fairness of stock buybacks that dominate the equity markets, it is time to look beyond the rationalizations of Wall Street and try to judge the legal perils inherent in the buyback movement.

After all, if executives and directors come to find themselves in legal jeopardy, the buyback movement is finished and one of the pillars supporting equity prices will vanish. This is why capital flow analysis is relevant to the safety of your nestegg. We are not talking about sending greedy executives to jail, but about crashing the stock market!

A Growing Wave of Criticism

Over the last two years, criticism of buybacks has grown. As class action lawyers begin to look at the practice closely, they are likely to find previously overlooked legal vulnerabilities. And with buybacks running a trillion dollars every two years, it is well worth their time and effort.

As Sherlock Holmes might say, “The game is afoot!” A dramatic battle between lawyers and executives is beginning to unfold, with the potential of collapsing the stock market.

Legal ramifications of a corporate buyback are varied: there are questions of disclosure, market manipulation, insider trading, use of binding contracts, buybacks during distributions, tender offer rules, reporting of beneficial ownership, and compliance with short-swing profit restrictions … and more.

However, I would suggest that the reader consider just one common claim or suggested ’shareholder benefit’, put forth by corporations to justify buyback programs. This is the claim, hint, or intimation that buybacks are just a form of dividends — an equivalent way to distribute profits to shareholders, but more to the advantage of shareholders and to the company in terms of flexibility, efficiency, and taxes.

Are Stock Buybacks Really Equivalent to Dividends?

Now it is not necessary to go through SEC Rules 10b-18, 10b-5, 10b-5-1, 13e-3, 13d-g, and other regulations to show the fraud inherent in many stock buyback programs.

A basic principle of US security law is that material misstatements and omissions of fact in connection with the purchase and sale of any security are violations to be sanctioned.

So the question simply is this:

Is it true or not that stock buybacks and cash dividends are equivalent in any sense?

Are stock buybacks really as fair and beneficial to shareholders as dividends?

If not and if corporate executives have suggested otherwise, strict compliance with other SEC rules may be irrelevant. The corporate executives will have engaged in a material misstatement of fact in connection with the buyback program and will be liable.

How Buybacks Work

The basic pattern of a stock buyback program is simple (although the details are involved).

The corporate board, without prior shareholder approval, gives authority to corporate executives to repurchase up to a certain quantity of shares (or to spend a certain amount in buying back shares), most often without any commitment as to price, timing, or fulfillment of the program.

In an open market buyback, as long as executives follow the rules of the SEC and the limits set by the board, they may buy as many shares at whatever price and time they deem convenient.

In open market buybacks, shareholders are advised of the board’s decision but are in the dark as to the timing or execution of the program. Disclosure is partial and after the fact.

A shareholder has no way of knowing, when selling into an open market buyback, whether corporate executives intend to increase or drop the price of future purchases, or whether buybacks have started or have terminated, or whether a particular sale went to the company or to someone else.

The SEC rules DO NOT require that all shares be repurchased at the same price or equitably from all shareholders in proportion to their current holdings. As long as the rules are followed, executives can buy all shares from shareholder A and no shares from shareholder B. They can pay shareholder C ten dollars per share and shareholder D twenty dollars per share, as long as this is done in accordance with the guidelines.

Why Open Market Buybacks Are Materially Different From Dividends

Sometimes stock buybacks are limited by an overall monetary amount and sometimes the limit is only as to the number of shares. The mechanics of the buyback may differ, from a tender offer, a dutch tender offer, a private negotiation, or an open market buyback.

However, the majority of buybacks on the US market today are of the open market variety and it is this type that is likely to attract the interest of lawyers bringing class action suits for unfair dealing with shareholders.

Even if all shareholders were to decide to sell a pro-rata amount of shares into an open market buyback program, because of price variation, it is CERTAIN that these shareholders will NOT get their equitable portion of the funds distributed in this so-called “dividend equivalent”, as they would in the case of conventional dividends:

When buybacks are on the open market, each shareholder gets a different price per share, whereas in a conventional dividend, each shareholder gets the same cash payment per share.

In the case of dividends, there are no commissions to pay, whereas in a buyback program, shareholders must pay commission, some proportionately more than others.

Twenty years ago, when the buyback movement was starting, these programs were small relative to the capitalization of the company — perhaps only one or two percent. With small buybacks, the degree of ‘unfairness’ represented by the uneven distribution of price might be only pennies to the small shareholder — hardly enough to go to court about.

Today, however, buybacks run into billions of dollars and sometimes involve 25% or more of outstanding shares.

When considering a class action in the interest of shareholders of the many companies involved in buybacks, the cash flows total more than one trillion dollars and the ‘dividend differential’ runs into billions.

The Non-transparency of Buyback Programs

Shareholders receive conventional dividends automatically, even if they are dead, insane, or incompetent. To receive a dividend, the shareholder does not need to do a thing; being an owner is enough. The custodian bank collects the dividend and credits the shareholder’s account at no cost.

In the case of the “buyback dividend”, the shareholder must first be aware of the program and must be able to make the decision to sell in order to receive this so-called “distribution”.

It is also necessary to pay a commission to a stockbroker in order to receive this “dividend”.

Although corporations announce the board’s decision approving a buyback program, unlike a rights issue, tender offer, or other corporate actions, the company usually does not need to inform individual shareholders of this nor need they provide investors with information that might help in deciding whether to sell.

This is a peculiar blindspot in SEC “investor protection”. A voluminous prospectus must be mailed to each investor in the event of a public offering of only 1% of the capital of a major company, but a buyback program involving billions of dollars and 25% of the firm’s capital may pass without special disclosure.

Many buyback programs are conducted without the ultimate beneficial owners being aware of what is happening.

The Case of Shareholders Who Can’t Sell

But the “buyback-as-dividend-equivalent” argument really falls apart when one realizes that many shareholders simply may not be able or willing to sell shares to take advantage of this “distribution” of corporate cash.

• Shares pledged as collateral, or held in trust or escrow, or tied up in court due to divorce or probate, or held in joint names, may often be unavailable for sale.

• When shares have been purchased at a higher price than the current market, the shareholder must sell at a loss to take advantage of this so-called “dividend”.

• When shares have been purchased many years ago, the capital gains tax on a sale might exceed any supposed benefit of a buyback “dividend”.

In fact, about the only shareholders that will almost surely benefit from the “buyback dividend” are corporate executives exercising stock options at a convenient moment to sell for a guaranteed profit.

The Cherry on the Litigator’s Cake

Now let us imagine a class-action litigator bringing a case before a typical American jury, perhaps in rural Mississippi or in a high unemployment area of the rust belt.

Corporate executive claiming that “buyback dividends” really benefit shareholders who don’t sell because of increased earnings per share or book value are unlikely to find sympathetic ears.

After all, these juries will not be made up of financial MBAs and will have the common sense to know the difference between cold cash and ratios they barely understand and can’t be used to pay a widow’s medical bills.

But the cherry on the litigator’s cake is the question of motivation. It is not difficult for anyone to see that executives whose remuneration is tied to stock prices, often through stock options, have a direct and powerful interest in approving buyback operations, even to the disadvantage of ordinary shareholders.

To the executive’s argument that buying back a company’s own shares shows confidence in the future, the litigator need merely ask, “Why sir, were you then selling your own shares?”

And finally we have the image of the greedy, piggish corporate executive in the common understanding, supported in this view even by leading business magazines. Salaries and remunerations of tens and hundreds of millions of dollars simply do not endear these overpaid employees to the common working person. To the ordinary American, they reek of fraud and corruption.

It is not at all difficult to believe that corporate executives deliberately mislead shareholders when they claim buybacks to be just a more efficient form of dividends, and that they do so knowingly, in their own selfish interest, in violation of their fiduciary duty, and with the intent to defraud common shareholders.

And so, dear readers, stay tuned …

Net share repurchases by nonfinancial nonfarm corporations ran at an annual rate of $554.8 billion, about the same level as in Q1 2006 and more than ten times the level of 2001 and five times the level of 2000, the peak of the Great Bubble.

See flow of funds table F213.

Amounts paid to exiting shareholders (including holders of executive options and short sellers) exceeded amounts paid equitably to all shareholders as regular dividends by 44%.

Cash dividends plus net stock buybacks were 117% of net profits after taxes. It would seem that the imperative of keeping stock prices high to give value to stock options now clearly trumps most considerations of investing for the long term in US corporations.

This extreme level of buybacks was financed by issuing bonds, taking on new debt, and by drawing down cash reserves.

While corporate executives were keeping buybacks at record levels, other sectors were significantly easing up on equity purchases:

Sector	Q1 2006	Q2 2006	% Change
Rest of the World	223.6	16.8	-92%
Commercial Banks	1.9	-2.9	*
Life Insurance Companies	61.6	46.0	-25%
Fed Gov’t Ret. Funds	8.9	-3.1	*
Mutual Funds	204.5	94.0	-46%
Brokers and Dealers	31.4	-34.3	*

Note (*): Net buyers reversed into net sellers of equities. Figures in $ billions, annual rates

It would seem that stock prices in Q2 2006 were sustained mainly by extreme levels of stock repurchases by corporate executives.

Market capitalization of REITs reached $330 billion by December 2005, according to data published by the industry association, NAREIT.

Although REITs have been around since the 1970s, this market sector only began to become important in the 1990s, as the graph, at the end of this article, shows.

Market capitalization of the REIT sector is still small compared to the equity market ($11.2 trillion) and mutual funds ($6.4 trillion), and is of a similar order of magnitude as closed-end funds ($278.2 billion) and exchange-traded-funds ($321.6 billion).

Although the REIT sector got off to a rocky start and earned a bad name in the 1970s, when large commercial banks recklessly set up REITs to hold construction loans, causing substantial losses to investors, the business now has been reorganized and is focused on owning and operating large scale commercial properties for the long-term, rather than short-term speculative real estate financing.

Investing the Old-Fashioned Way

For investors who are fed up with the stock buyback-option games and other unethical shenanigans of the main equity market, REITs are a breath of fresh air:

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