August 27, 2015    Volume 22, No. 10

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Stock Buybacks Are Tied To Growing Income Inequality And Low Rates Of Innovation

By Richard A. McCormack

There has been a slowly rising public and political debate over income inequality, the stagnation of wages for working Americans and the growing concentration of wealth among those with the highest incomes. But there has been little, if any, deliberation as to why such a small group of senior executives and financiers are making so much more money than workers.

There is an answer to the income inequality quagmire and it is simple: the "massive and pervasive" binge of corporate stock buybacks that has taken place over the past decade or more, according to William Lazonick, director of the Center for Industrial Competitiveness at the University of Massachusetts Lowell. He states that the practice should be banned outright and immediately, as a means to restore balance to the U.S. economy, encourage investment, reduce speculative stock-market bubbles and improve the prospects for America's middle class.

Companies are using trillions of dollars of net income to purchase their own shares as a means to purposefully manipulate their stock prices upward, with the intention of increasing wages for senior managers who receive most of the remuneration through stock options. This manipulation is neither regulated nor monitored by the Securities and Exchange Commission.

Raising stock prices by reducing the number of shares outstanding also helps companies fend off hedge fund managers who threaten takeovers and the subsequent and highly profitable but destructive divestiture of a company's assets. "Without having contributed anything to a company's development or success, hedge funds seek to extract money from companies that other people have generated," writes Lazonick, the American economist who has done extensive analysis of stock buybacks. "In effect, tens of millions of Americans go to work every day to create value in the companies that employ them, only to have this value extracted by stock-market speculators and manipulators who have typically played little if any role in the value creation process." In 2014, the top 25 hedge fund managers "personally reaped a combined $11.2 billion, or an average of almost $450 million each, which was down almost 50 percent from $21.5 billion, or $860 million each in 2013," Lazonick notes.

By siphoning off so much net income into buybacks, companies have little left to invest in new technology, production improvements and their workers.

Among the S&P 500 companies, buybacks exceeded the amount paid out in dividends starting in 1997. For 458 companies on the list, 52.5 percent of net income -- $3.7 trillion -- was expended on stock buybacks from 2005 to 2014, with another 35.7 percent of net income distributed as dividends.

What the majority of Americans don't realize is that this ongoing and massive level of buybacks is coming at their expense. Companies such as Aetna, United Health Group and Wellpoint "charge Americans high premiums and out-of-pocket expenses, while spending upwards of 70 percent of net income on buybacks," notes Lazonick. American drug companies like Pfizer, Merck and Amgen "have persistently distributed well over 100 percent of their profits to shareholders as buybacks and dividends." The result: U.S. drug prices are more than twice as high as anywhere else in the world and millions of low-income Americans are faced with making a choice of buying medicine or food.

Executives from firms like IBM, HP, Intel, Microsoft and Cisco are spending the company's hard-earned income on buybacks while laying off tens of thousands of highly skilled white-collar workers -- "and failing to invest sufficiently in future innovation," says Lazonick. Since September 2001, Cisco has been systematically pumping up its stock price by spending over 100 percent of its net income on buybacks. "That is their top priority," says Lazonick.

Exxon-Mobil, which is purchasing $22 billion of its shares per year, is joined in the buyback binge by Chevron and ConocoPhilips, while charging consumers more at the pump and "taking government subsidies for oil exploration and neglecting investments in alternative energy," adds Lazonick.

American taxpayers lost $11 billion in the federal government's bailout of General Motors, only to have that company buy back $5 billion of its stock this year with another $5 billion planned in 2016. This comes after a group of hedge funds "demanded $8 billion in buybacks and a seat on the GM board," notes Lazonick. Meanwhile, "autoworkers gave up multiples of that amount in lost jobs, wage concessions and retiree benefit reductions."

From 2004 through 2015, the 458 of the 500 S&P companies' "total net equity issues -- their new share issues less shares taken off the market through buybacks and merger-and-acquisition deals -- averaged minus $399 billion per year," writes Lazonick in an August 6, 2015, paper titled "Buybacks: From Basics to Politics," published by the Academic-Industry Research Network.

"I have been arguing for a ban against open market repurchases, which sounds radical until you understand the SEC rules and how much they legitimized stock price manipulation and the looting of companies," says Lazonick. "If you can ban the practice, a lot of companies would actually welcome it, by eliminating the pressure on them from the hedge funds that say they will come in and change the members of the board. If you can't do buybacks, then the leadership of the companies would have a chance to think about the future" and not about keeping the stock price up to fend off raiders.

It would not be hard to ban the practice. The Security and Exchange Commission can repeal the rule (10b-18) put in place in 1982 that allows them.

Institutional investors would also benefit by a ban, since companies would use their income to reinvest in their companies, introduce new products and improve prospects for growth. Hiring employees rather than putting more money in the pockets of a few wealthy individuals could help spur an economic revival, boosting corporate growth.

"Any institutional investor that is looking to generate income over the long term should be dead set against buybacks because you want a reasonable level of dividends and you want reinvestment so if and when you sell those shares, the stock price will be higher not because it has been manipulated but because the company has competitive products," says Lazonick. "The buyback binge over the past three decades reflects a failure of corporate executives to develop strategies for the long-run competitiveness of the firms that they manage."

America's most prominent economists like Paul Krugman of Princeton University and Joseph Stiglitz of Columbia Business School have written about income inequality, but have not considered stock repurchasing as the primary culprit. "They don't know what is going on in companies," Lazonick points out. "That was not part of their training as economists. Economists who understand business are usually advising business and are going with the flow. The people who would be critical within the businesses, those who see buybacks as something that are not good and try to convince the top executives that this is not a good thing to do, often get thrown out."

Other economists believe that it is something that the market will correct on its own. "But this is not about the market," Lazonick notes. "This is about what is going on in companies."

Lazonick has tried to convince economists at the Economic Policy Institute and those in the labor movement to work on banning buybacks, but to no avail. The first union to take up the issue has been the Service Employees International Union, driven by McDonald's decision to repurchase $3 billion of its shares without regard for giving its employees a raise. "SEIU is starting to look at how companies are not allocating resources to the problem of low-wage labor," says Lazonick. "The other people getting squeezed by this are the franchisees who are now realizing that there are problems with buybacks."

Lazonick's 2014 article in the Harvard Business Review ("Profits Without Prosperity: Stock Buybacks Manipulate the Market and Leave Most Americans Worse Off") started the political ball rolling. That article, which received the Harvard Business Review honor of being the outstanding article of the year, raised the issue among Democrats in the U.S. Senate. Sen. Tammy Baldwin (Wisc.) asked Securities and Exchange Commission Chairwoman Mary Jo White in an April 23 letter to reply to questions about the legality of buybacks. White's July 13, 2015, response stating that the SEC had not performed an analysis of the impact of buybacks "because detailed trading data regarding repurchases is not currently available." White further explained that rule 10b-18 allowing stock buybacks "is a voluntary safe harbor." That statement, says Lazonick, means the SEC views Rule 10b-18 "as a license to use open-market repurchases to manipulate stock prices."

Democratic Sens. Elizabeth Warren (Mass.) and Bernie Sanders (Vt.) as well as Hillary Clinton have made some noise recently about buybacks. Republicans have not addressed it. "There is a lot of common sense about what is going on, and a lot of ideology," says Lazonick. "But ideology trumps logic and common sense."

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