Pay for Destruction: The Executive Compensation Arrangements That Encourage Value-Decreasing Stock Buybacks

We are living through a stock buyback revolution. Over the last decade, the amount that U.S. public firms have spent on buying back stock from their shareholders rose threefold to a record level of roughly $1 trillion in each of 2018 and 2019. By the end of 2019, the scale of buyback activity had increased to the point that total shareholder payouts (stock buybacks and dividends together) took up the full amount of corporate earnings. After a pandemic-related pause in 2020, the buyback wave is roaring to life again.

The economic and financial importance of stock buybacks has sparked a vibrant debate among prominent economists, lawyers, business leaders, and politicians over their desirability. Senior academics, including Michael Jensen and Jesse Fried, and leading business figures such as Warren Buffet and Lloyd Blankfein, have justified buybacks as a means to reduce managerial agency costs, signal undervaluation of a company stock, and improve capital allocation. Other academics, including William Lazonick, and leading Democratic senators, among them Hillary Clinton, Elizabeth Warren, Bernie Sanders, and Chuck Schumer, have argued that the cash outlay required by stock buybacks shortchanges investment in long-term productive capabilities and harms employee welfare, and that allowing firms to increase demand and reduce supply for their own stock through repurchases creates the potential for stock price manipulation.

Understanding the relationship between executive compensation and stock buybacks is essential for understanding management incentives around buybacks. Previous studies by me and other scholars have shown that stock buybacks can increase executive compensation by altering ratings on performance yardsticks that determine bonuses and stock awards. In a new paper, I argue that executives’ incentives to conduct buybacks for this purpose are undesirable, as they encourage stock buybacks that destroy firm value and separate pay from performance. Because commonly used performance yardsticks, designed to measure the impact of ordinary business decisions on firm value, fail to properly reflect the intertemporal, financial, and stock trading impact of stock buybacks on firm value, they invite various forms of abuse.

First, conducting stock buybacks that squander the cash earmarked for long-term investment improves short-term earnings per share (EPS), which commonly determines executives’ annual bonuses and the amount of their stock-based awards. Although such buybacks could harm long-term EPS, the time required for many long-term investments to generate revenues together with corporate executives’ shortening tenure (down to 7.8 years for S&P 500 CEOs) suggests that they need not internalize the adverse long-term impact.  They are thus positioned to ask themselves: Why invest in working hard for the long term when you can conduct a short-term-driven buyback and be compensated for boosting EPS now?

Second, executives can benefit from debt-financed stock buybacks that excessively increase the firm’s financial risk. In efficient markets, elevated financial risk should be compensated by increased expected return, which, in turn, should improve executives’ ratings on capital efficiency measures that decide their performance compensation, such as EPS and return on invested capital (ROIC). Regrettably, however, such improved ratings need not reflect improved performance or value creation. Instead, they may just reflect elevated risk, in which case they reward the executive for imposing a higher risk, even when it is excessive.

Third, executives have an incentive to use stock buybacks to manipulate the stock price because increasing the price improves total shareholder return (TSR), which commonly determines the amount of stock-based compensation they receive. The incentive to manipulate is high even when it succeeds only temporarily, because firms commonly calculate TSR based on the last 20 days of the measurement period. Unfortunately, loopholes in the conditions set by SEC Rule 10b-18 and lax disclosure rules allow firms to secretly and materially intervene in the trading of their own stock and lift its price artificially. The success of such manipulation is evidenced by executives’ high-volume stock sales following buyback announcements.

I further show that the perverse incentives to conduct value-destroying buybacks make a significant difference to the amount of CEO compensation. My empirical analysis of current executive compensation arrangements of all S&P 500 CEOs indicates that stock buybacks that destroy firm value can improve ratings on performance criteria that decide one-half of executives’ incentive compensation, which amounts to almost one-third of their total pay.

The perverse incentives that corporate executives have around stock buybacks have repercussions that extend far beyond value destruction in individual firms. In particular, the incentive to sacrifice good long-term investments cripples the competitive advantage of the U.S. economy, a phenomenon that Forbes has labeled “a cancer on capitalism.” The motivation to elevate financial risk by conducting superfluous debt-financed buybacks is contributing to the formation of a giant junk bond bubble that could pop and lead to another stock market crash and recession. The incentive to manipulate firms’ stock price helps to undermine the credibility and fairness of the financial system as a venue for capital formation that advances sustainable growth and social welfare.

Unfortunately, systemic corporate governance failures allow corporate executives to act on their undesirable buyback incentives. Buybacks in the U.S., unlike in many other countries, do not require shareholder approval, thereby weakening shareholder checks on buyback decisions. Also, CEOs enjoy considerable discretion over the timing and amount of buyback executions within the boundaries of board-approved plans. Corporate directors have little incentive to curb executives’ buyback decisions because they can sell their own stock compensation at the inflated prices that buyback announcements commonly create. In addition, severe deficiencies in disclosure rules prevent effective monitoring by shareholders. The result, I report, is that buyback activity is highly correlated with CEO pay incentives around buybacks.

Altogether, the perverse pay incentives around stock buybacks, coupled with these corporate governance failures, are consistent with the view that managerial power and influence have shaped executive compensation in publicly-traded U.S. companies. Ironically, the attempt to alleviate the systemic problems highlighted by the financial crisis of 2008–2009 and to reduce agency costs through performance metrics has transformed stock buybacks into a means of separating pay from performance, increasing agency costs, and destroying firm value.

To remedy the flaws identified in my research, I propose reforming Regulation S-K to require firms to conspicuously disclose how they address the impact of stock buybacks on the performance targets they set for executive compensation. My suggested disclosure reform would also empower shareholders to opine on this information in their advisory “say on pay” voting. With this additional information and increased shareholder power, I expect boards and shareholders assisted by proxy advisers, executive compensation advisers, and practitioners to identify and remedy the flaws inherent in the design of performance metrics affected by stock buybacks.

This post comes to us from Nitzan Shilon, a full professor at Peking University School of Transnational Law and a former commissioner of the Israel Securities Authority. It is based on his recent study, “Pay for Destruction: The Executive Compensation Arrangements That Encourage Value-Decreasing Stock Buybacks,” available here.

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