Misuse of corporate resources objections fall into two categories:
- issuer repurchases divert the issuer’s resources from expenditures that would benefit workers and their companies; and
- that buybacks create perverse incentives for senior executives to use stock buybacks to trigger additional compensation.
We discuss each of these issues below.
Diversion of Resources/Allocation of Capital.
Those who believe that Rule 10b-18 prevents issuers from raising wages or making other investments, in effect, are suggesting that the SEC should regulate capital structures of corporations. That would be a radical departure from both the law and the spirit of the federal securities laws. It also would be a policy mistake.
It is axiomatic that Congress employed a disclosure model of regulation when it enacted the Securities Act and the Exchange Act. Eschewing merit regulation, Congress embraced the philosophy of Louis Brandeis that “sunlight is said to be the best of disinfectants; electric light the most efficient policeman.” The Securities Act and the Exchange Act prohibit manipulative or fraudulent behavior for public and private offerings, but they do not prescribe how corporations must operate or require them to have a specific corporate structure. Shortly after Congress enacted the Securities Act, William O. Douglas and George Bates described this unique structure:
As a matter of fact there are but few of the transactions investigated by the Senate Committee on Banking and Currency which the Securities Act would have controlled. There is nothing in the Act which would control the speculative craze of the American public, or which would eliminate wholly unsound capital structures. There is nothing in the Act which would prevent a tyrannical management from playing wide and loose with scattered minorities, or which would prevent a new pyramiding of holding companies violative of the public interest and all canons of sound finance. All the Act pretends to do is to require the “truth about securities” at the time of issue, and to impose a penalty for failure to tell the truth. Once it is told, the matter is left to the investor.
Congress only granted the SEC authority to regulate capital structures under very limited circumstances:
- The Public Utility Holding Company Act of 1935 (PUHCA). That legislation empowered the SEC to restructure the entire public utility industry in the wake of the Insull scandal, the Enron of its day.
- The Trust Indenture Act of 1939 (TIA), among other things, prohibits sale of certain debt instruments “unless a formal agreement between the issuer of bonds and the bondholder, known as the trust indenture, conforms to the standards of this Act.”
- The Investment Company Act of 1940 (Company Act) imposes limitations on structures of investment companies. For example, the Section 18(f) of the Company Act makes it
unlawful for any registered open-end company to issue any class of senior security or to sell any senior security of which it is the issuer … Provided, That immediately after any such borrowing there is an asset coverage of at least 300 per centum for all borrowings of such registered company….
The SEC has issued various exemptive rules, such as Rule 18f-4, that permits funds to use derivative securities without running afoul of the prohibitions in Section 18.
Congress has not granted the SEC broad authority to establish capital structures and only has granted narrow authority in limited circumstances. Indeed, Congress narrowed that authority as it gained experience with the results of such efforts.
Finally, when the SEC attempted to assert its authority over publicly-traded companies’ capital structures, the Court of Appeals for the District of Columbia ruled in 1990 that the SEC lacked authority to do so. In 1988, the SEC had adopted Rule 19c-4:
barring national securities exchanges and national securities associations, together known as self-regulatory organizations (SROs), from listing stock of a corporation that takes any corporate action with the effect of nullifying, restricting or disparately reducing the per share voting rights of [existing common stockholders].” *** Because the rule directly controls the substantive allocation of powers among classes of shareholders, we find it in excess of the Commission’s authority under Sec. 19 of the… Exchange Act …”
The court rejected the SEC’s assertion that it had exceptionally broad discretion under Section 19 of the Exchange Act. The court stated that: “if Rule 19c-4 were validated on such broad grounds, the Commission would be able to establish a federal corporate law by using access to national capital markets as its enforcement mechanism.” Although the court left open the possibility that other statutory provisions would “provide authority for promulgating these or other rules,” the court declined to search for such grounds.
Moreover, Congress has declined to grant the SEC authority to regulate the capital structure of public companies despite ample opportunities. Congress made two extensive revisions to the federal securities laws in the wake of major scandals. In 2002, Congress enacted the Sarbanes-Oxley Act in response to the Enron and WorldCom scandals. That legislation “mandated a number of reforms to enhance corporate responsibility, enhance financial disclosures and combat corporate and accounting fraud, and created the ‘Public Company Accounting Oversight Board,’ … to oversee the activities of the auditing profession.” After the Great Recession of 2008, Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd Frank Act). “ That act “set out to reshape the U.S. financial regulatory system in a number of areas including but not limited to consumer protection, trading restrictions, credit ratings, regulation of financial products, corporate governance and disclosure, and transparency.” Despite the breadth and scope of both statutes, neither authorized or directed the SEC to regulate the capital structure of public companies. Accordingly, it is unlikely that any effort to do so directly would withstand judicial scrutiny.
It would not be wise for Congress to grant such authority to the SEC if Congress’s goal is to raise workers’ wages or otherwise seek to address income disparity in the United States. To achieve the goals that the critics of Rule 10b-18 set forth, the federal government would need to dictate, for each public issuer:
- capital structure, including debt/equity and shares outstanding;
- size of the workforce and its compensation;
- investments in research and development, and
- executive compensation.
It is difficult to imagine that Congress or the SEC could develop a regulatory system for managing capital structures that would ensure that American businesses could adapt to an ever-changing marketplace. By eliminating Rule 10b-18, but more ominously, seeking to regulate public companies’ capital structures and expenditures, the federal government would impose a straightjacket on every public issuer of securities.
The market is a harsh judge of what management does or does not do. An issuer needs cash to repurchase its shares. If the issuer has cash in the bank, it may use those funds to repurchase shares. If it does not, it will need to borrow the money by selling debt securities or by borrowing from a bank. There are opportunity costs for whatever course of action an issuer takes or does not take.
Decisions about how to use an issuer’s resources are the responsibility of management, as overseen by its board of directors. The issuer’s stock price will fall if the issuer:
- hoards cash for no reason;
- uses too much cash for risky endeavors;
- fails to plan for the future and invest in new technology;
- uses too much money to pay for the buyback (whether from reserves or from loans) and then lacks resources for other initiatives; or
- hires too many or too few employees at salaries that diverge from market rates.
These are among the fundamental decisions that corporate management must make; failure to choose well will jeopardize not only the jobs of the senior executives, but the future of the company as a whole. Markets, not government, are the best measure of whether management’s decisions were wise.
Manipulating Measures of Success to Trigger Compensation.
Some critics suggest that issuer buybacks increase stock prices and allow executives to sell their shares at higher prices. The author looked at disclosures for Home Depot and Starbucks, examples noted above. Home Depot, which had a significant stock buyback program, uses a multitude of measures for awarding compensation. These include quantitative standards such as sales, operating profit, and inventory turns. To discourage executives from focusing on quarter-to-quarter profits, Home Depot uses a combination of performance shares, performance-based restrictive stock, and stock options. Some incentives have caps to avoid windfalls from unexpectedly high revenues. Starbucks has similar provisions. In summary, the compensation plans weigh a variety of factors and compensate executives based on a range of performance measures. Executive compensation depends on many factors, not just one measure, such as earnings per share.
It is important to remember that the conditions of Rule 10b-18 seek to minimize the market impact of the repurchases. Further, investors who sell during the buyback period have no idea whether the issuer or another investor is buying their shares. Most long sellers will not object if the price of the stock increases at the time of their sale.
It is easy to criticize executives who sell large blocks of stock and to suggest that they have either manipulated the price of the stock to rise at the time that they sell or that they are trading on inside information. Although it is impossible to prove a negative, the circumstances of executives’ stock sales may be complex:
- Senior executives may have accumulated extremely large positions in the issuer’s securities. It is only sensible money management for them to sell some of their shares in that issuer and to diversify their investments.
- Officers, directors, and 10% shareholders who buy and sell (or sell and buy) that issuer’s securities must avoid running afoul of Section 16(b) of the Exchange Act. Although not a violation of the securities laws, persons in those categories who trade too soon are subject to a lawsuit for disgorgement of any profits.
- Senior managers will not buy or sell shares during certain “blackout periods.”
- To avoid trading on inside information or appearing to do so, senior managers will not buy or sell shares in the issuer in the weeks before the issuer announces quarterly earnings or other material corporate events. It would be more problematic for a senior manager to sell their shares just prior to the issuer’s announcement of material news, than after. For this reason, most compliance departments only will allow their employees to trade shares in the companies for which they work during specific windows after major releases.
- Section 306(a) of the Sarbanes Oxley Act of 2002 and Regulation BTR prohibit directors and executive officers from selling the issuer’s shares during a pension black out period.
Finally, as noted, many corporate executives sell in accordance with Rule 10b5-1 plans. Such plans permit investors to defend against a claim of insider trading by establishing a plan to sell the issuer’s shares on an automatic basis.
Some critics claim that linking executive compensation to earnings per share (EPS) and share prices allow management to “move the goal posts” to suit their needs. For example, an issuer that buys back its shares could raise the earnings per share to a level that triggers additional executive compensation. Because a buyback often raises the issuer’s stock price, management could drive the issuer’s stock price up sufficiently to trigger additional compensation. A 2015 Reuters study observed the following:
255 of [S&P 500] companies reward executives in part by using EPS, while another 28 use other per-share metrics that can be influenced by share buybacks.
In addition, 303 also use total shareholder return, essentially a company’s share price appreciation plus dividends, and 169 companies use both EPS and total shareholder return to help determine pay.
EPS and share-price metrics underpin much of the compensation of some of the highest-paid CEOs, including those at Walt Disney Co., Viacom Inc., 21st Century Fox Inc., Target Corp. and Cisco Systems Inc.
Fewer than 20 of the S&P 500 companies disclose in their proxies whether they exclude the impact of buybacks on per-share metrics that determine executive pay.
Heitor Almeida, a professor of finance with the College of Business at the University of Illinois, says EPS “is not an appropriate target, it’s too easy to manipulate.”
Others disagree and dismiss the idea of management manipulating EPS for their personal benefit as a myth:
Myth #4: Management teams only repurchase stock in an attempt to inflate EPS and meet incentive compensation targets.
Reality: Executives whose compensation depends on EPS did not allocate a greater proportion of total cash spending to buybacks in 2018 than companies where management pay was not linked to EPS.
Indeed, among the S&P 500, the reverse is true.
Congress should not use Specialized Securities Disclosure Provisions to Achieve other Policy Goals.
When Congress tries to use the federal securities laws to address social problems in different policy arenas, the outcomes are not satisfactory – either in achieving congressional goals or from the standpoint of investor protection. In the Dodd Frank Act, Congress included three provisions that it intended to address policy concerns that it deemed important. The provisions directed the SEC to undertake rulemakings that had nothing to do with the SEC’s core mission. As a consequence, the SEC devoted an enormous amount of resources to discharge those responsibilities, distracting the SEC from its core mission. The three provisions of the Dodd Frank Act at issue are:
- Section 1502 – Conflict Minerals – Requiring issuers to disclose information about certain raw materials that they obtain from the Democratic Republic of the Congo;
- Section 1503 – Reporting Requirements Regarding Coal or Other Mine Safety – Requiring issuers to disclose information about mine safety violations;
- Section 1504 – Resource Extraction – Requires issuers involved with resource extraction to disclose information about payments to foreign governments.
Congress enacted these provisions with good intentions, but the disclosure requirements related to other public policy concerns. Congress did not give the SEC the discretion not to adopt these rules. The rulemaking for Section 1503 was apparently uneventful, but dealt with issues that are not within the SEC’s expertise. For example, it does not appear that Section 1503 permits the Commission to consider whether an issuer’s mine is material to the issuer’s financial position. Section 1503 and its rules require an issuer with a miniscule mining operation to make these disclosures whether or not the mining operation had any meaningful implication for investors. If Congress has continuing concerns about mine safety, it should examine the mine safety laws, not amend the securities laws.
The rulemakings for sections 1502 (conflict minerals) and 1504 (resource extraction) were administrative nightmares for the SEC. There were conflicting views as to whether Section 1502 helped or hurt the people of the Democratic Republic of Congo. These provisions drained the SEC’s resources and forced disclosures on issues that have nothing to do with investing.
Mary Jo White, SEC Chair at the time, observed about these Dodd Frank Act mandates:
[Some] mandates, which invoke the Commission’s mandatory disclosure powers, seem more directed at exerting societal pressure on companies to change behavior, rather than to disclose financial information that primarily informs investment decisions.
That is not to say that the goals of such mandates are not laudable. Indeed, most are. Seeking to improve safety in mines for workers or to end horrible human rights atrocities in the Democratic Republic of the Congo are compelling objectives, which, as a citizen, I wholeheartedly share.
But, as the Chair of the SEC, I must question, as a policy matter, using the federal securities laws and the SEC’s powers of mandatory disclosure to accomplish these goals.
Congress should not force the SEC to meddle in policy arenas for which it is not well-equipped and divert it from its core mission. SEC disclosure requirements should focus on the standard that the Supreme Court enunciated in Basic v. Levinson: “materiality depends on the significance the reasonable investor would place on the withheld or misrepresented information.” Congress’s attempts to use the securities laws for unrelated policy objectives have not been successful. Congress should not repeat that error.
When reviewing executive compensation and issuer repurchase disclosures, it is difficult to determine whether an issuer repurchase program altered earnings or price per share, thereby triggering any executive compensation. SEC rules require issuers to explain the compensation plans in detail and to describe their repurchase programs. But there is no requirement that issuers explain any nexus between repurchases and executive compensation. Further, the author could not determine whether an issuer was reporting its EPS before or after the repurchase programs and whether or how the repurchase affected the EPS calculation.
Accordingly, I suggest that the SEC amend Regulation S-K (17 C.F.R. § 229.402(d), instruction (7)) as follows:
7. Options, SARs and similar option-like instruments granted in connection with a repricing transaction or other material modification shall be reported in this Table.
However, the disclosure required by this Table does not apply to any repricing that occurs through a pre-existing formula or mechanism in the plan or award that results in the periodic adjustment of the option or SAR exercise or base price, an antidilution provision in a plan or award, or a recapitalization or similar transaction equally affecting all holders of the class of securities underlying the options or SARs. Explain any repricing that occurred to options, SARS, and similar-option-like instruments. Such explanation shall include answers to the following questions:
i. Did the issuer (or its affiliate) undertake an issuer repurchase of securities that resulted in a change in the calculation of the issuer’s earnings per share (or similar calculation)? and
ii. Did such change in calculation cause the issuer to pay a different amount of compensation to the persons specified in Item 402(a)(3) than it otherwise would have, had the issuer (or its affiliate) not repurchased the securities?
If so, specify the repurchase transaction(s) and the resulting changes to compensation, including the amounts, however paid or allocated.
If the answer to either of the prior questions is yes, identify the calculation and report the amount of earnings per share (or other calculation) before and after the issuer’s repurchase and explain the reason for the adjustment. [
Such questions would allow shareholders to judge for themselves if management altered the capital structure in a way that resulted in a benefit to those managers. The securities laws trust investors to use good judgment when they have access to material information. These circumstances are no different from other matters of corporate governance.
The federal securities laws and the SEC’s administration of those laws have fostered capital markets that are the envy of the world. According to SIFMA, for 2019:
- Equities: “U.S. equity markets represent 39.4% of the $95.0 trillion in global equity market cap, or $37.5 trillion; this is 3.9x the next largest market, the EU (excluding the U.K.).”
- Fixed Income: “U.S. fixed income markets comprise 38.9% of the $105.9 trillion securities outstanding across the globe, or $41.2 trillion; this is 1.9x the next largest market, the EU (excluding the U.K.).”
In my view, it would not be wise to repeal Rule 10b-18 with the purpose of reintroducing the uncertainty that caused issuers not to repurchase their shares. Rule 10b-18 creates legal certainty that permits issuers to repurchase their shares without fear of an SEC investigation or private lawsuit. Because the federal securities laws define fraud and manipulation broadly, it was previously risky for an issuer to repurchase its shares even for the most legitimate of reasons. Issuers wishing to avoid controversy would not undertake repurchases for fear that the SEC or a private litigant would charge the issuer with market manipulation. Suggesting that the SEC should withdraw the rule and reestablish that legal uncertainty is not a sensible way to make policy. Besides adding legal uncertainty, a repeal of Rule 10b-18 creates the likelihood that issuers will declare dividends to return cash to shareholders, which is a less efficient way to reward existing shareholders because of the higher tax burden. If Congress or the SEC want to prohibit or curtail issuer repurchases, they should do so deliberately and not by reintroducing a fog of legal ambiguity that discourages legitimate and questionable activity alike.
Further, Congress or the SEC should not repeal Rule 10b-18 if their real objective is some other policy goal. As demonstrated above, repeal of Rule 10b-18 will do nothing to address the concerns of some that executive compensation is excessive. Using the federal securities laws to try to achieve other public policy goals does not work well and distracts the SEC from its primary mission. As noted, the SEC has no special expertise in conflict minerals, mine safety, or resource extraction. Congress has numerous federal agencies at its disposal (and can create new ones) that do have relevant expertise in these or any other policy topics.
If the opponents of Rule 10b-18 believe that executive compensation is too high or that public companies are not investing for the future, Congress and the SEC should have that public policy debate directly, not through the backdoor of Rule 10b-18. Similarly, if Congress thinks that workers need a pay raise, it should debate raising the federal minimum wage and weigh the relevant economic arguments. Those who favor such changes to the operation of public companies must appreciate that the federal government would need to micromanage the operations of public companies to an unprecedented degree. If Congress were to embrace such a policy, many issuers would go private, or remain private longer. Preventing the public from investing in a broader range of issuers only will contribute to widening the wealth gap in America, not narrowing it.
Additional disclosure, not the elimination of Rule 10b-18 or other policy mandates, would give the public greater insight into stock repurchases and senior managers’ compensation at public companies. The recommendation above would help investors assess whether management is using repurchases to enrich itself. More sunlight, not more prescriptive measures, is the better approach.