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Stock Buybacks and Buyback Commissions: continued

The Boeing Buyback

From Asset-lite to True Inefficiency

Of course, when the market for the company stock is large – as it usually is for listed companies – it takes a lot of money to force prices upwards.

For an executive to earn one hundred thousand dollars on options or other performance-based remuneration, a company may need to spend millions to move the price.

In the case of Boeing, the company disbursed over nine billion dollars in buybacks from 1998 to 2001.

However the remuneration of company executives was only a small percentage of this amount. Buybacks are an extremely inefficient way to remunerate executives and are debilitating to the financial interests of long-term stockholders.

It would be simpler, more principled, and greatly in the interest of long-term stockholders to pay executives directly the amount that they would have earned through options linked to stock prices.

Boeing’s permanent investors could have received at least eight billion dollars more in dividends over the years 1998 to 2001, if such a policy had been followed.

Over eight billion dollars in dividends are not paid.

However it would have been unacceptable to baldly pay ninety million dollars to Boeing’s top five executives for three years work, without the charade of pretending that improvements in the ROE and stock prices proved that they were worth this amount.

The reasons behind the devastating buyback culture are multifarious and involve many interests beyond those of shareholders and executives.

The brew includes a heavy dose of hypocrisy, fallacious reasoning, political expediency, third-party greed, and failure of fiduciary responsibility.

The players include the U.S. Congress, the tax authorities, the SEC, the labor unions, accounting professionals, fund managers, investment bankers, and stockbrokers.

Like the tangled mess of the U.S. health system that embroils insurance companies, tort lawyers, doctors, and hospitals, the imbalance caused by stock buyback/option programs is a societal problem that may be particularly difficult to unravel and resolve, especially if investors are not even aware of their disadvantage.

In order to understand why buybacks may have become a permanent feature of the American capital market and, consequently, of longer-term importance in capital flow analysis, we may use the Boeing case to quantify the interests of other powerful players – those who cash in from buybacks other than company executives.

Why Buybacks May Be Here To Stay

If long-term shareholders did not receive any advantage from the two-year rise and fall of Boeing stock, we might ask, who did benefit?

It is obvious that executives with stock options were rewarded, but the amount they received – although in the tens of millions – was small compared to the nine billion dollar cost of the buyback program.

If buybacks were merely a tricky ploy of ethically-insecure executives to increase their pay, it is likely that, with the collapse of the Great Stock Bubble, there would have been recriminations and reform.

Instead, despite Enron, WorldCom, and other scandals that brought the supposedly tough measures of the Sarbanes-Oxley Act of 2002, there was no outcry that buybacks were a misuse of corporate money.

Executive remuneration did draw some fire, and fumbling attempts were made to partially expense the ‘cost’ of executive stock options, raising outcries from aggrieved executives and Wall Street.

However the mammoth trillion dollar buyback movement that had driven stock prices upwards for twenty years went unnoticed.

In any corrupt society, from ancient Rome with its gladiatorial games, to the slave plantations of the American South, to the self-indulgent excesses of the Soeharto family in Indonesia, the perception of immorality from within is infinitely less acute than it is to the eyes of outside observers.

Few consider stock buybacks to be unethical.

Every society uses its greatest skills and nimblest brains in rationalizing and legalizing the status quo.

For any system to survive, whether a dictatorship or democracy, many people must be involved, and this often requires condoning what foreigners, victims, or outsiders might deem improper.

It is often only after a society collapses and history is rewritten, that perceptions can be changed.

Buyback Commissions Are Substantial

In the case of buybacks in the U.S. capital market, it is not difficult to trace who, other than company executives, benefited from the programs.

When Boeing spent nine billion dollars repurchasing its stock on the exchange, we can estimate that the brokerage industry earned about ninety million dollars – about one percent – on the buy-side trades, plus another ninety million dollars from the investors that sold their stock to the company.

The sellers, then having cash to reinvest, would provide brokers with at least another ninety million dollars in commissions.

Note: A typical commission on a stock trade might be one percent. However in negotiating a repurchase program a company may be able to arrange lower fees.

On the other hand, brokers have other ways to profit from handling trades, such as holding credit balances prior to the trade.

Without access to the accounts of both the company and the brokers, we can only guess at a stockbroker’s profit on a buyback program.

Nine billion dollars injected directly into the hands of active traders, as happens with the Boeing buybacks, will roll around the market for a considerable time, before settling into long-term portfolios or being withdrawn for consumption or shifted to another asset-class.

Consequently, the U.S. brokerage industry may have earned three hundred to five hundred million dollars in commissions, directly and indirectly, just from the Boeing buyback program of 1998-2001.

In the larger sense, buybacks had become the lifeblood of Wall Street.

Considering that the net amount of stock repurchases recorded in the Federal Reserve flow of fund accounts for the period 1980-1999 exceeded one trillion dollars, and that gross buybacks were undoubtedly much greater, since the flow of fund amounts show new issues less buybacks, the brokerage commissions generated by buybacks during these two decades probably amounted to thirty to fifty billion dollars!

Over thirty billion dollars in commissions to WallStreet.

As Everett Dirkson, the Illinois Senator, once said, “A billion dollars here; a billion dollars there. It adds up. Before you know it, you're talking about some real money.”

If Boeing had paid the nine billion dollars proportionately to its shareholders as dividends, it is likely that a far smaller percentage of this money would have settled in the hands of day traders.

There certainly would have been no brokerage commission paid on the initial distribution. Stockbrokers would have benefited far less.

Voices of the Establishment

In the late 1990s, Wall Street was riding high and stockbrokers were a power in Washington. Robert Rubin, the U.S. Secretary of Treasury, was the former Chairman of Goldman Sachs.

People with links to investment banking, former executives, and academic consultants were sprinkled throughout the Federal Reserve and the U.S. Treasury.

Even after the market collapsed, when investment reform and the abolition of double taxation of dividends was debated in Congress, Jon Corzine, another ex-Goldman Sachs CEO, representing New Jersey investors in the U.S. Senate, opposed eliminating the double tax on dividends and any measures that might provide real benefits to long-term shareholders.

During this period of ‘reform’, Wall Street, company executives, and politicians on the left, vigorously sponsored John H. Biggs to head a new board to clean up accounting practices.

He was, as the ultra-liberal commentator, Bill Moyers, somewhat inaccurately put it, “the man just about everybody wanted to be the new public watchdog, the man to keep an eye on the books.” ("Now, with Bill Moyers”, In-depth Transcript, November 1, 2020, PBS HomeSearch Programs.)

John Biggs, as TIAA-CREF chief, was prominent in trying to improve corporate governance.

Mr. Biggs was top dog at TIAA-CREF, the giant pension fund, and the director who chaired the Boeing executive remuneration committee during the nine-billion-dollar buyback binge. The TIAA-CREF trustees were dominated by academics in high office at leading universities, sympathetic to the Nobel gods and the Efficient Market ideology that addled Wall Street during the Great Bubble.

Mr. Biggs presented his credentials as a paladin of ‘corporate governance’ in testimony to the U.S. Senate Committee on Banking, Housing, and Urban Affairs on February 27, 2020:

My name is John Biggs and I am Chairman, President and CEO of TIAA-CREF, the system providing pensions and other financial products to the education and research community.

We manage about $280 billion in assets through TIAA, a New York licensed insurance company, and CREF, the country’s first variable annuity plan. Our company also offers to the general public life insurance products, trust services, mutual funds, and college tuition savings plans.

As the CEO of TIAA-CREF, I am proud to report that our stock analysts covering the energy business could never understand how Enron could make enough money to cover its obligations – so our active portfolio held less than the benchmark level, resulting in relatively favorable results for our participants.

We did unfortunately hold positions in our Index Funds since Enron once held a prominent position in the S&P 500.

My other experience relevant to your deliberations is as an independent public sector participant in financial regulation. I served for two years as a Governor of the NASD and some five years as a Trustee of the Financial Accounting Foundation, which funds the Financial Accounting Standards Board, or FASB, and appoints its members.

I now serve as a Trustee of the Foundation supporting in a similar way the new International Accounting Standards Board (IASB). I was also a member of the Blue Ribbon Committee on Improving the Effectiveness of Audit Committees. And currently I continue as one of the five trustees, all of us independent, of the Public Oversight Board. As you know, this Board will go out of business on March 31 of this year.

I am not an accountant but did start my career as an actuary and earned a Ph.D. in economics along the way.

I serve as a Director of the Boeing Company, which is the only major U. S. company to adopt FAS 123 expense, in order to report to its shareholders the true cost of its stock compensation plan.

Boeing’s executive compensation plan is based heavily on tough performance tests which are prohibitively expensive under the 1972 accounting model used by all other companies. For the record, Boeing adopted its plan and FAS 123 in 1996, before I became a director.

It is not clear why an investment manager would admit to being “proud” to invest in the stock of companies which he could not understand, even in amounts “less than the benchmark level.”

However, clearly, Mr. Biggs considered Boeing to be a paragon of good corporate governance. He was no enemy of buybacks, and someone to be warmly supported by Wall Street.

However, due to opposition from Harvey Pitts, Chairmen of the SEC and a lawyer that had represented accounting firms, the drive to elevate Mr. Biggs failed, although the political battle cost Chairman Pitts his job.

Without taxation of dividends, the intellectual argument supporting buybacks would be weakened.

In fact, if investors were to backslide into ways of their grandfathers, buying stocks based on dividend yields, the culture of modern Wall Street would be turned upside down.

Therefore, it was to be expected that President Bush’s plan to eliminate double taxation of dividends would be forcefully attacked, ridiculed, and dammed-with-faint-praise from Republicans, Democrats, fund managers, stockbrokers, and the Wall Street Journal.

The word ‘buyback’ was rarely mentioned in the dividend tax debate.

Wall Street has been deeply committed to stock buybacks for a generation.

The idea that investors deserved cash rather than paper-profits was a heresy to be exorcised.

Only because of President Bush’s strong stand, were dividend taxes reduced at all, and then, only by half, with equal benefits going to speculators’ income: capital gains.

The Boeing buyback was never approved by its shareholders, because corporate law allows such decisions to be made by the board of directors, acting alone.

The law does not require any substantial accounting or reporting as to the results and beneficiaries of a stock repurchase program.

Indeed, rules on customer confidentiality prohibit such disclosure – other than in the case of insiders – and the public does not know exactly who sold their shares back to the company and at what price, nor what conflict of interests might have been involved.

At the close of Boeing’s nine-billion-dollar buyback program, there was no comprehensive report as to how much stock was repurchased from executives and directors, investment funds, former shareholders of McDonnell Douglas, or which stockbrokers handled the buybacks, or the prices each group received when cashing out.

Not only is such a report not required, but methods of stock trading make it extremely difficult, if not impossible, to adequately trace net changes in ownership that result from a buyback scheme.

The SEC has lax rules for disclosure of stock buybacks and grants safe harbor for market manipulation..

We do know, however, that the reputation of directors and executives of Boeing, and consequently, their ability to justify their handsome remuneration, depended on the published opinions of Wall Street analysts.

These analysts, by and large, were employed by stockbrokers. Analysts’ pay was dependent on how much they contributed to their firms’ profits and on their ability to forecast short-term price movements of specific stocks.

Analysts would, therefore, view with favor the decisions of Boeing directors to buyback twenty-five percent of company stock, because this would not only make it easier to predict a rise in the stock, but would also contribute to the general wealth of stockbrokers.

If directors were to approve a massive cash dividend instead of a buyback program of the same size, this would be seen by Wall Street analysts as unfashionable and against what they professed to be the interests of shareholders, especially when the price fell ex-dividend along with ROE.

Analysts could easily support their dislike of dividends, not only by flashing their credentials as Certified Financial Analysts, but also by presenting learned opinions from prestigious academics and honored economists.

The scandals involving analysts following the collapse of the Great Bubble exposed the venality of this conflicted profession and the frailty of any connection between their opinions and the interests of investors.

Besides, the mutual pecuniary interests of Wall Street stockbrokers and the management of public companies are far stronger than the connection between either of these parties and small investors.

Therefore, it is possible that the heresies of the asset-lite philosophy and stock buybacks may be embedded in the sociology of the American capital market for a long time.

Conflicted Intermediaries

Boeing’s adherence to the asset-lite philosophy, with its attendant stock-options and buybacks, would never have been feasible without the support of the majority of shareholders that elected the directors.

This majority was controlled by institutional investors who bore fiduciary responsibility to act in the interests of uncounted numbers of ultimate owners – small shareholders of mutual funds and beneficiaries of pension plans.

Although Boeing had over one-thousand-six-hundred institutional shareholders, the top fifteen held over thirty-five percent of Boeing stock.

For practical purposes, the directors of Boeing could be chosen, elected, and controlled by a few dozen of its over one-thousand fund managers.

The top five institutional shareholders, controlling over twenty-three percent of Boeing stock, were:

Regulation of investment advisors in the United States is primarily administrative and procedural, rather than substantive.

Advisors must register with the SEC, maintain certain records, pass a test on securities law, avoid insider trading, and take steps to safeguard assets.

Weak Regulation of Fiduciary Responsibility

However, the law barely addresses conflicts of interest between investors and advisors, nor is the extent of an advisor’s fiduciary responsibility clearly stipulated.

Financial disclosure, the jewel of the regulatory system, does not include a requirement that information be parsed and delivered in terms that are actually useful and meaningful for the purposes and intellectual capacity of the investor.

Managers of defined-benefit pension plans have a precise understanding of investors’ goals. However, most managers of other collective investment funds do not know whether a specific shareholder, or even whether shareholders, as a class, are investing for six months or sixty years – although commonsense and simple observation of fund redemption figures would tell them that the majority of their shareholders are in for the long-term.

A short-term rise in portfolio value may represent a significant benefit for short-term investors who plan to cash out, while providing absolutely no advantage to the majority who are in the fund for the long haul.

Fund managers have selfish reasons to favor equity repurchases.

What fund managers do know, however, is that quarterly portfolio under-performance will result in less money in their own pockets.

In the competitive scramble for short-term returns, the fund manager that cannot present high total return with minimal volatility, judged against competitors, will not earn five stars from Morningstar.

A poor score leads to investor withdrawals, falling fund sales, declining management fees, and possible dismissal.

In the case of Boeing, it could be argued that the board’s decision to authorize nine billion dollars in buybacks was to the advantage of fund managers who controlled Boeing voting stock.

However, in the instance of a specific Boeing portfolio position in a single portfolio, the benefit to the fund manager was minimal and investors would be hard-pressed to claim damages.

Furthermore, because institutional investors have insisted that their voting for directors be confidential, there is no way of proving that a specific fund manager acted in bad faith.

Marginal Benefits For Fund Managers

Over the five years 1998-2002, the Boeing buyback program was spread over thirty-three months, temporarily doubling stock prices.

However, during this five-year span, the average increase in portfolio value in the thirty-three-month buyback period was only six percent greater than portfolio values during the months before and after the buybacks.

Since fund managers earn about one-percent each year on the value of their portfolios, and since the average position of Boeing stock in a particular portfolio would probably be less than two percent, the incremental gain to a specific manager arising from the Boeing buybacks was truly small.

Considering that the percentage of Boeing stock held by institutional investors, before and after the buyback program, stayed about the same, it appears that the typical fund manager did not sell Boeing stock at the top, and that, consequently, there were few realized capital gains to be distributed to fund holders under U.S. tax law.

Therefore, most long-run holders of fund shares did not benefit at all from the Boeing buybacks.

If Boeing board had voted to use the nine billion dollars as dividends, instead of using the money to finance stock repurchases, fund managers would have be obliged by tax law to distribute this money to fund holders, thereby permanently reducing the value of portfolios under administration and the amount of their fees.

Tax rules for mutual funds encourage buybacks rather than dividends.

Although this amount is indeterminate, it would be sufficient to cause fund managers to favor buybacks over dividends, if the question was ever raised.

Therefore, it would seem that fund managers have monetary incentives to encourage stock buybacks, although this may be against the interests of their investors.

There is an inherent conflict of interests resulting from tax laws and the customary way investment advisors are remunerated.

If fund managers as a class were to generally encourage stock repurchase programs for all companies in their portfolios and do so consistently for years, this would increase their management fees, although the policy would not be beneficial to their clients.

Throughout the 1980s and 1990s, investment advisors favored such policies, thereby contributing to the Great Bubble.

But there are still other questions regarding the behavior of fund managers. State Street Advisors, the largest institutional investor in Boeing, earned substantial fees as administrator of the company’s voluntary savings plans for employees.

Financial Conglomerates Create Conflicts of Interest

The SEC does not require investment advisors to disclose potential conflicts of interests regarding stocks their funds have in portfolio and on which they exercise voting rights.

The laws only are concerned with a single fund owning enough shares to control a company outright – not the cumulative voting power of management groups or collusion between company executives and fiduciaries holding proxies over millions of shares.

With the rise of financial conglomerates, a fund manager may belong to a group linked by lucrative service contracts to a company held in portfolio.

When the manager controls enough shares to influence the selection of directors, a conflict of interests exists.

The Enron bankruptcy shed light on conflicts of interest between auditing and consulting divisions of major accounting firms. These conflicts were detrimental to the rights of investors.

Although there have been no moves to examine possible conflicts between interests of fund managers and investors, commonsense suggests that when institutional investors control major companies, an opportunity exists for behavior contrary to their fiduciary duties.

Essay: continued >

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