Essay

A Simple Fable

An honest tale speeds best being plainly told.
Shakespeare, Richard III (1592-93)

 

Black's Law Dictionary defines fraud as,

'an intentional perversion of truth for the purpose of inducing another in reliance upon it to part with some valuable thing belonging to him or to surrender a legal right.'

It goes on to say that, fraud 'comprises all acts, omissions, and concealments involving a breach of a legal or equitable duty and resulting in damage to another.'

Fraud and Buyback Schemes

The fraud inherent in buyback schemes consists of management, supported by fund managers using voting rights of beneficial owners, diverting profits to their advantage and ignoring their duty to shareholders, while using false and misleading arguments.

No one knows how much of the more than one trillion dollars used to finance stock repurchases during the Great Bubble ended in executives' pockets and how much went to fund managers, investment bankers, accountants, and other intermediaries.

Long-term investors who retired during the 1980s and 1990s benefited.

A fraud is still a fraud, although victims may not know they have been taken.

However, most stockholders did not sell into the rising market and were cheated.

A fraud is still a fraud, although victims may not know they have been taken and may delay in filing suit.

If the bear market that started in the summer of 2000 continues long enough, there will be millions of unhappy investors and fertile ground for tort lawyers.

Suits against the tobacco industry became effective when millions gave up smoking, making it easier to impanel sympathetic juries.

When Baby Boomers start to cash in their mutual funds after 2012, tort lawyers may find profitable opportunities for action against the directors, fund managers, and investment bankers that profited from corporate buybacks — if they are still alive.

A Complicit SEC

Corporations cannot force stock prices up alone.

During the boom, help came from mutual funds, state and local government controlled portfolios, life insurance companies, and foreign investors.

The SEC also played a part by granting corporations safe-harbor from stock manipulation and by not requiring adequate disclosure of costs associated with buybacks and executive stock options.

The SEC condoned manipulation and steered business to brokers.

The SEC actually supported buybacks, as long as investment bankers managed the programs, thereby assuring that Wall Street would profit from the scheme, providing brokers with inside information for trading desks and favored clients.

Pension plan trustees may have exercised their votes to approve buyback programs, thereby keeping management happy and securing lucrative corporate trust business.

Federal tax laws also favored buybacks by allowing companies to charge off executive remuneration under option schemes, without reporting such expenses to shareholders.

There was less federal tax due on buybacks linked to stock options than on the fairer and more transparent alternative of dividends and cash salaries for executives.

Cover Stories Galore

Throughout the eighties and nineties, most investors were hardly aware that buybacks were occurring, much less the size, scope, and impact of buybacks on market prices.

Those who understood did not complain because stock prices were rising.

During the long bull market, buyback promoters used an arsenal of technical sophisms.

During the long bull market, buyback promoters used an arsenal of technical sophisms, the Efficient Market Hypothesis, and a 'cover story' that went like this:

The United States is the greatest, best-run country in the world. American business is extremely efficient and productivity is increasing. Americans won the Cold War.

The people are clever and innovative, creating a vast number of hi-tech inventions that are leading the world into the Information Age.

Advances have been so great that corporate profits are increasing at a faster rate than any time in history.

Hundreds of thousands of highly skilled, well-informed professionals and specialists have taken advantage of full and honest corporate disclosure, under the sharp eye of the U.S. Securities and Exchange Commission – the best market regulator in the world – and have concluded that current levels of stock prices are appropriate and perhaps even a little cheap.

Professors at the greatest universities, including Nobel laureates, have studied this highly efficient market and have concluded that not only does history show that common stocks will continue to be the best investment, but that economic theory proves that even if one buys a random portfolio of a stock market index, one will be assured of a comfortable retirement.

This story is a mish-mash of truth, half-truth and misleading propositions, mixed with cheap appeals to national pride.

Fraud And Victim Cupidity

Great frauds depend on the cupidity of the victims.

As long as increasing paper profits appease long-term investors, executives can link buybacks to the stock options that put shareholder money in their own pockets.

The mass of investors, saving for retirement, are locked in by long-term tax-deferred plans.

When investors try to cash in, millions may be left holding the bag.

Like any Ponzi scheme, as long as few investors sell stock, prices rise.

When more investors try to cash in, perhaps ten or twenty years from now, the money may not be there, and millions will be left holding the bag.

In the summer of 2000, the bubble burst, starting what may be a long bear market – or perhaps just a warning shot.

Fraud victims usually will not admit they are being cheated, until it is too late.

As long as buybacks produce paper profits, few will concede that anything is wrong.

Dreams Of Riches

Millions want desperately to believe that they are better off.

During the 1990s, many looked forward to early retirement, luxury travel and a better life style.

Paper wealth encouraged spending, which boosted company profits and employment.

Paper wealth encouraged spending, which boosted company profits and employment.

This led to higher taxes, which most were willing to pay as long as the market showed that they are richer.

Taxes paid public servants who rewarded the Party of Big Government with votes.

This, perhaps, was the Virtuous Circle to which Chairman Greenspan referred.

A Tale Plainly Told

At the millennium, there was a general failure to admit that buybacks cheated investors.

The hypnotic delusion of market value had dulled the minds of the crowd.

There are so many technical arguments supporting buybacks and the details of specific cases can be so complex and befogged, that it is easy to be confused.

A simple Einstein 'thought experiment' reveals the nature of the deal.

However, when analyzing seemingly complex financial transactions, I have found that by stripping away extraneous details and making up a simple story – a so-called Einstein elementary 'thought experiment' – the nature of a transaction becomes apparent.

Although unethical practices may persist for a long time, eventually the poisons of bad customs so distort society that change becomes inevitable.

Modern economics has discarded the ethical foundations of Adam Smith.

However, if the capital market is viewed as a product of society, rather than of abstract mathematics, it becomes clear that eventually ethics matter and the defrauded will react.

This simple fable describes the buyback fraud in plain language:

Mr. Simple & Mr. Sharp

A Fable

Once upon a time, there was an investor, Mr. Simple, who owned all the common stock of Simple Company and who planned to retire in thirty years.

Mr. Simple owned all the stock in Simple Company.

Simple Company's only asset was a one million dollar, thirty-year tax-exempt, investment grade bond, with a seven percent coupon.

Because of this bond, Simple Company had tax-free profits of seventy thousand dollars each year.

Simple Company paid no dividends and retained profits in a non-interest-paying bank account.

Mr. Simple, the sole investor, planned to liquidate Simple Company after thirty years to get cash for retirement.

He expected that his net worth after thirty years would be three million one hundred thousand dollars.

Simple Company had only one director, Mr. Sharp, who served with no pay.

One day, Mr. Sharp came to Mr. Simple and said,

'I am a clever man.

I know how to make the value of Simple Company increase on the stock exchange.

This will make you very rich.

Everyone will speak well of Simple Company and your friends will see what a smart investor you are.'

Director Sharp was going to make Mr. Simple very rich.

'All I ask is for you to let me share a little of your new riches.

Just give me a few stock options each year, as my only remuneration and I will be happy.

Also, I will only get paid in proportion to the new wealth I bring you.

What could be fairer than that?'

'Besides, I promise you that each year our auditors will give you a report showing that the income of Simple Company continues to be seventy thousand dollars.

Even better, so as not to dilute your ownership in Simple Company, each year the company will buy back all the stock that has been issued as options.'

Mr. Simple thought this was a good idea and that he had nothing to lose.

After all, Simple Company would continue to earn seventy thousand dollars each year and Mr. Sharp deserved a bonus if he could make Simple Company more valuable.

And so, the plan was put into action.

Each year, Mr. Sharp was issued some options on Simple Company stock. Each year, the auditor's report showed that Simple Company earned seventy thousand dollars.

Each year the market value of simple company increased – sometimes ten percent, sometimes thirty percent – so the investor could easily see that he was becoming richer.

After twenty-nine years, the market value of Simple Company reached three hundred ten million dollars – and Mr. Simple was one hundred times more affluent that he had expected to be at this time of life.

He was one of the richest men in Simple Town.

Because of his vast wealth, he felt he could prudently spend all of his other income.

Mr. Simple borrowed on his paper profits to build a mansion.

Simple Town bankers were impressed by his personal balance sheet and lent him twenty million dollar on his note to build a luxurious mansion.

Then Mr. Sharp retired.

Each year he had earned seventy thousand dollars on his stock options, which he had deposited at No-Interest Bank.

He now had over two million dollars saved.

Mr. Simple was happy that Mr. Sharp had been able to accumulate a nest egg – after all, he deserved it and it was less than one percent of the great wealth that Mr. Sharp had earned for him.

Mr. Simple gave Mr. Sharp a gold watch, a handshake, and waved good-bye as he left by plane for retirement in Tahiti.

Mr. Sharp waved goodbye as he sailed for Tahiti.

After Mr. Sharp was gone, some strange things began to happen.

First, there was no more trading of Simple Company on the exchange.

The stock was not delisted – there were just no buyers or sellers now that Mr. Sharp had left town.

After six months, the Simple Town banker who had lent him twenty million dollars came to Mr. Simple and said that he would need to get the stock of Simple Company appraised, to renew the loan.

An appraiser studied the balance sheet of Simple Company, and said:

'Simple Company is worth one million dollars. The only asset is a one million dollar bond that comes due next year.'

'But I don't understand,' said Mr. Simple,

'Every year for almost three decades the company has shown a profit of seventy thousand dollars.

I have audited statements to prove it. There have been no expenses. We should have over two million dollars in the bank.'

The appraiser responded:

'It is true that every year Simple Company showed a profit of seventy thousand dollars, and this was reported under General Accepted Accounting Practices.'

The appraiser had some bad news for Mr. Simple.

'However, each year this seventy thousand dollars has been used to repurchase Simple Company stock on the exchange.

Accountants and the SEC do not consider this to be a cost, but only a charge to capital accounts.'

'But the company cannot be worth only one million dollars,' exclaimed the investor.

'Just six months ago, the company had a market capitalization of three hundred ten million dollars.

A famous professor told me that market value is the same as intrinsic value.'

The appraiser answered, sadly:

'Perhaps the professor will pay you three hundred ten million dollars for Simple Company, but I must report to the bank that the company is only worth one million dollars.'

A few days later, the Simple Town banker called Mr. Simple and asked for repayment on the twenty million dollar loan.

Since Mr. Simple could not pay, the banker took all the investor's property, including the stock of Simple Company.

Mr. Simple was fortunate to find a distant relative that allowed him to sleep on a cot in the garage, while he worked as a bag boy at the supermarket to pay for food.

Meanwhile, Mr. Sharp lived happily on his beach in Tahiti, snuggling up with island women and drinking vodka tonics.

Mr. Sharp on the beach, drinking vodka tonics.

In this parable, the fraud is plain.

Mr. Sharp persuaded the investor to exchange real assets for an illusion.

Mr. Sharp's 'intentional perversion of truth' was his suggestion that market capitalization was worth more than cash in the bank.

A director has a legal and equitable duty to act in the best interests of the shareholder.

An accounting loophole allowed the company to continue to show profits, even though the money was used to pay a director.

Mr. Sharp had a legal and equitable duty to act in the best interests of the shareholder, not in his own interests.

He failed in this duty.

All that is needed to prove fraud is to show that the director had the intent to divert the investor's assets to his own benefit and that he knew the audited reports were misleading.

Real Life Is More Complicated

The buybacks that dominated American finance over the last generation were more complex and better concealed than in our fable.

Nevertheless, the principle is the same and the fraud is greater for being better hidden.

The worth of companies with many affiliates, thousands of employees and hundreds of products, is not clear in financial accounts that misstate profits and camouflage assets and liabilities.

Fraud becomes darker when conflicted fiduciaries control companies through mutual funds.

The fraud becomes darker when fiduciaries with conflicted interests control companies through mutual funds.

Fund managers have reason to inflate portfolio values on which their fees are based.

This may seem to be to the investors' advantage.

However, eighty percent of equity mutual funds are long-term savings, intended for retirement or a child's education. Much of this money is in 401(k), Keogh, or IRA plans, with early withdrawal subject to fines or taxes.

Unrealized capital gains represent higher fees to locked-in investors of mutual funds and pension plans.

A prudent fund manager with a sense of fiduciary responsibility would prefer the stock of companies that reinvest profits to maximize the capacity to pay dividends when the investor retires.

Stock Buybacks: A Ponzi Scheme?

It is not ethical to pay management excessive salaries and dissipate corporate reserves merely to temporarily jack up stock prices.

Investors are dazzled by the illusion that market value is wealth, while the wise guys walk away with the cash.

When everyone is happy, who will believe they are being defrauded?

As long as everyone is happy, who will believe they are being defrauded?

In the 1960s, when I was working in the Brazilian capital market, I witnessed a much-publicized Ponzi scheme called 'Carnet Fartura' that went on for a while, even though the fraud was obvious to most investors.

Eventually, of course, the scheme blew up, inflicting losses on its victims. Later, I spoke with a man who had lost a large amount in this fraud.

'How could this happen?' I asked,

'You knew the scheme was a sham.'

'Yes I did,' the investor replied,

'but it was so profitable while it lasted, and I thought that it would keep going for just a while longer.'

So it was with the Great Buyback Scam of the twentieth century.

When the Bubble burst in 2000, many who knew the market was over-valued were tempted to hang on too long.

Tort Lawyers, Boomers, and Foreign Issuers

Even one successful suit based on alleged harm from buyback programs could throw cold water on the practice.

Any decrease in buybacks would remove support from the market, allowing stock prices to retreat to levels justified by cash dividends.

The buyback era would be over and the market would move into a new phase, influenced by causes not yet apparent.

Foreign issuers, with different motives than domestic companies, will take advantage of low capital costs.

However, the end of buybacks does not depend on tort lawyers:

The practice is self-defeating.

As dividend yields approach zero and as baby boomers near retirement, investors will switch their tax-deferred savings from equities to fixed income securities, reducing the upward pressure on stock prices.

Meanwhile, foreign issuers, with different motives than domestic companies, will take advantage of low capital costs.

The lower the cost of capital, the more foreign issues will come to the market, eventually swamping domestic buybacks.

It will take more and more money each year for companies to keep prices going up and keep the buyback scam going.

When profits can no longer increase fast enough, the buyback money needed to support the market will not be there.

The manipulation will have run its course.

July 25, 2020

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