Let’s Rethink Stock Buybacks—and Drop Biden’s Proposed Excise Tax

Share buybacks should be transparent and funded by readily available cash

The Wall Street entrance to the New York Stock Exchange in New York City, on Nov. 15, 2022. Brendan McDermid/Reuters

Commentary

Bloomberg, citing private newsletter publisher Birinyi Associates, reports that “announced buybacks more than tripled (in January) to $132 billion from a year ago, reaching the highest total ever to start a year.”

For those of us who follow these things, it’s not surprising: the record level of stock buybacks comes amid an earnings season that has been largely anemic.

It’s nothing new.

In December 2015, customers at Chipotle Mexican Grill, the Mission-style burrito and bowl restaurant chain, suffered one of the highest profile Norovirus outbreaks in history. A restaurant near the campus of Boston College sickened some 120 students, including many of the university’s NCAA Division I basketball team. The outbreak exacerbated Chipotle’s reputational damage after reports of earlier e-coli outbreaks in multiple states.

Chipotle’s food safety troubles made national news and had a precipitous negative effect on Chipotle’s same-store sales and, consequently, the value of the stock. On Dec. 4, 2015, because conditions had cratered so badly, Chipotle filed an “Other Event” Form 8-K , pursuant to securities laws, to withdraw its forward guidance for 2016. But on the same 8-K, Chipotle also announced a $300 million stock buyback!

It seemed to me, at the time, a cynical effort to obfuscate the falling stock price by intervening in the markets instead of addressing the underlying food safety issues.

Fast forward to 2023: Chipotle has cleaned up its act with rigorous food safety protocols, replaced its CEO, and restored its stock to good health. But the Chipotle experience shows how CEOs and corporate boards can sometimes use stock buybacks for what I would describe as cynical purposes: to obfuscate trouble in a business that could harm share prices.

And that should never happen.

How Buybacks Work

Stock buybacks were considered to be stock manipulation and subject to penalties, until 1982. It was then that the Securities and Exchange Commission (SEC) promulgated a “safe harbor“ from penalties that permitted a company, or ”issuer,” to buyback its own shares if certain conditions were met. Issuers that conduct buybacks without the safe harbor are liable to the allegation that the stock buyback was stock manipulation, so most abide by the safe harbor.

Corporate boards and executives, for a number of reasons, like stock buybacks rather than disbursing an equivalent amount as a dividend. First, buying back shares tends to increase the value of the stock that remains outstanding and to increase earnings per share (EPS). That’s important because the cash bonus compensation of many in the executive suite is tied to stock price performance and EPS.

Second, as with the Chipotle example, engaging in a buyback can prop up the price of an otherwise sagging stock. We’re seeing that now, as companies try to retain or increase share values as earnings have been disappointing.

Finally, share buybacks tend to consolidate ownership percentages among the remaining shareholders and, thus, control. Management likes to have shareholders that support it, as evidenced by their continuing stock ownership, to have greater control.

Also, shareholders only pay tax on the portion of the share buyback proceeds that exceeds the shareholder cost. With a dividend, the entire amount paid out is subject to tax.

Why Some Oppose Buybacks

In 2022, the Inflation Reduction Act imposed a 1 percent excise tax on stock buybacks, and last week, during the State of the Union, President Joe Biden proposed raising the tax to 4 percent.

The president’s proposal is a long-simmering, albeit misinformed, progressive political attack on buybacks.

Biden and other progressive Democrats, like senators Bernie Sanders (I-Vt.) and Chuck Schumer (D-N.Y.), suggest that buybacks somehow harm the economy, because they believe “when corporations direct resources to buy back shares ... they restrain their capacity to reinvest profits more meaningfully in the company in terms of R&D, equipment, higher wages, paid medical leave, retirement benefits and worker retraining.”

If companies could deploy the capital used for the buybacks to good use to enhance their stock value, responsible managers would. But they don’t for lack of opportunities.

The progessives ignore that funds spent on stock buybacks go to shareholders who usually redeploy their capital to other new and more profitable companies, sometimes even as venture capital, that enriches the whole economy by creating new companies. Sometimes the funds received are reinvested in activist mutual or private equity funds that make companies more efficient by eliminating waste and increasing efficiencies. It is those proceeds that invest in research and development (R&D) and equipment and new companies that make society more productive, create new jobs, and raise Americans’ standard of living.

As to more generous wage and benefit packages to workers, no company will pay workers wages and benefits above the market rate for workers’ services; that’s an element of market dynamics and negotiations. New jobs created by new investments, where shareholder capital is reinvested, bid up the price of labor, which is a good thing. But neither the president nor Sanders nor Schumer nor anyone else should look to private companies to subsidize politicians’ social agenda. If the politicians want “higher wages, paid medical leave, retirement benefits, and worker retraining,” let them pass a law to do so in Congress and have a president sign it. Don’t try to do an end-run around the “democracy” they purport to “defend” by putting those costs on businesses.

My View

I generally have little objections to stock buybacks, except insofar as they can be used to manipulate stock prices in such a manner as to deceive retail investors. I have said so for years, as in this article I wrote for The Hill in 2017. Current rules say that stock buybacks require reporting only in the quarterly reports, Form 8-K, that companies file with the SEC, which can be generally several weeks after the close of the quarter when the buyback occurred. That’s different from the rules in other leading economies with stock exchanges. In the London Stock Exchange, for example, “any purchases of a listed company’s own equity shares must be publicly disclosed as soon as possible, and in any event no later than 7.30 a.m. on the business day following the calendar day on which the purchase occurred.” The European Union imposes a similar rule, as does Hong Kong. The SEC has proposed a similar rule, but it is yet to be formally adopted. It’s been outstanding for a over a year.

I also object to excess leverage in stock buybacks. Borrowing funds to buy back the issuer’s stock reeks of financial engineering more so than sound business management. Companies should have sufficient current assets (e.g., cash or assets readily convertible to cash, like inventory or receivables) to make the buyback. Borrowings used to effect a stock buyback that exceed the value of current assets should be discouraged, perhaps by denying a tax deduction for the excess interest expense. (Borrowings against current assets effectively convert them to cash and should be allowed.)

Summary

Share buybacks should be transparent, so the SEC should adopt the proposed reporting rule as soon as practicable.

But there are other things that the SEC should consider doing as well. For example, companies that conduct buybacks should be encouraged to do them as a tender offer in conjunction with, or instead of, the buy back. That might tend to bid up the price of the stock, with perhaps the issuer being at risk of being outbid by investors hoping to increase their interests—or gain outright control—of the company. By comparison, buybacks are effectively done at the market rate whenever the buyback occurs. Doing the buyback as a self-tender offer also puts the incumbent management at risk, just as happens occassionally with “bidding wars” for companies that are targets for acquisition.

Imposing an excise tax at 1 percent or 4 percent is simply a revenue grab. It serves no purpose other than for leftist politicians to virtue signal their base that they “stand up to ‘Big Business.’” If the politicians were consistent, they would demand an excise tax on all distributions to shareholders or impose income tax on the entire proceeds from the stock buyback. It makes no sense.

Stock buybacks serve a good and important purpose. But they must be disclosed almost contemporaneously, allow for competing bids, not be overly leveraged, and be made for particular business purposes (i.e., having excess cash) not soley to boost sagging share prices.