David Green

Are companies that buy back their own shares manipulating the market?

Are companies that buy back their own shares manipulating the market?
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Last week’s white paper on industrial strategy put forward a few useful ideas but ignores the main structural problem we face: the ‘financialisation’ of the economy. At a time when we urgently need to invest to raise productivity, PLCs have been putting over half their profits into buying back their own shares. This practice used to be against the law. Under common law it was treated as a kind of market manipulation. Company law, including the 2006 Companies Act, still has some hallmarks of this assumption but a radical change was made in the Companies Act of 1981. Before that, British companies were not permitted to purchase their own shares. Reliable estimates of the scale of buybacks has been published for companies making up the Standard and Poor’s 500. Professor William Lazonick of the University of Massachusetts Lowell has reported that between 2004 and 2013, 454 publicly-listed companies in the S&P 500 index in March 2014 spent 51 per cent of their net income on buybacks.

There is now widespread concern about buybacks among business leaders and in the business press. For example, Forbes magazine published an article this year headed ‘The ugly truth behind stock buybacks’. In 2015, the Atlantic published an article entitled ‘Share buybacks are killing the American economy’; and the Harvard Business Review published a long critique of buybacks by Professor Lazonick in 2014. Business leaders have criticised buybacks in their company annual reports, including Laurence Fink, CEO of BlackRock and Martin Sorrell, CEO of WPP.

In his 2017 report Sorrell quotes a report by McKinsey, published in February 2017, that compares 615 companies. Its Corporate Horizon Index distinguishes companies that think long-term and those that think short-term. The former, for instance, would be more likely to seek real earnings and not to manipulate earnings per share through share buybacks. (When companies purchase their own shares they often cancel them, which increases earnings per share without adding to real earnings.)

The McKinsey study found that between 2001 and 2014 US companies that took the long view grew their earnings 36 per cent more; and their profit by 81 per cent more. Moreover, companies with a long-term focus invested almost 50 per cent more in research and development; their market capitalisation grew £5.3bn ($7bn) more than that of other businesses in the study; and they added nearly 12,000 more jobs on average. The report by McKinsey concluded that if ‘all US publicly listed firms created as many jobs as the long-term firms, the US economy would have added more than five million additional jobs over this period’.

A group of large corporations has joined together to support an initiative called Focusing Capital on the Long Term (FCLT) and in September 2016 it launched FCLT Global. The group includes McKinsey, BlackRock, Dow Chemical and Tata. A similar initiative has been launched by America’s Aspen Institute: the American Prosperity Project, which defines itself as a non-partisan project for long-term investment. Participants include Unilever, Royal Dutch Shell, Levi Strauss and WPP.

The leaders of those businesses are alert to the dangers of short-termism, but legal reform is also needed and a strong case can be made for cancelling the reforms of the 1980s. We can now see that the relaxation of constraints was a mistake. There were good reasons for the law to treat share buybacks as a form of market manipulation.

In America, the system was heavily regulated by the 1934 Securities Exchange Act until the Securities Exchange Commission revised its rule 10b-18 in 1982 to make buybacks easier. Buybacks were possible before that date, but the reform led to a huge increase.

The assumption of the law was that the share price should reflect the demand for shares by investors who were independent of the company. If a company bought back its own shares it was assumed to be potentially giving a false impression of independent demand, and was therefore a kind of market manipulation. The 1934 Act, section 9(a)(2) says that a company should not carry out purchases to create ‘actual or apparent active trading’ in a security or raise or depress the price ‘for the purpose of inducing the purchase or sale of such security by others’. The explanatory document explaining the reform of rule 10b-18 declares that its intention had been to prevent the timing of purchases from undermining the independent price mechanism, and to ensure that the volume of shares purchased should not be so high as to influence the price. Moreover, it stipulated that a single broker should handle the purchase to avoid giving a false impression of widespread demand. Despite these acknowledged fears, rule 10b-18 was reformed by providing what it calls a ‘safe harbour’ from accusations of market manipulation under the 1934 Act.

In the UK the simplest approach would be to scrap the relevant section in the 1981 Companies Act and any similar subsequent enactments and to restore the assumptions of the common law: namely that a company buying back its own shares was potentially a form of market manipulation and that reducing capital (when repurchased shares are cancelled) threatens creditors.

Another approach would be to create genuine shareholder democracy. Hayek argued that shareholders should be allowed to decide each year how their share of the profits should be used. Individuals might choose to leave their profit share with the company to reinvest, but if the company planned to use its profits to buy its own shares, investors might well decide that they can think of a better use for the money.

The combined effect of these measures would be to release huge corporate reserves for investment, not by telling companies what to do, but by creating legal conditions in which the best way to make profits is by investing in productive capabilities, rather than by financial engineering. That, after all, is how capitalism is supposed to work.

David Green is CEO of Civitas