In the latest installment of his series “Breaking Through the Jobless Recovery,” economist William Lazonick explores how the agency meant to protect stock market investors has instead promoted stock-price manipulation and stratospheric executive compensation.
In 1991, well-known compensation consultant Graef S. Crystal published In Search of Excess: The Overcompensation of American Executives in response to an explosion in executive pay that occurred in the US in the 1970s and 1980s. How, Crystal asked, did it make any economic sense for the CEOs in his sample of 200 large US corporations to be making 130 times the pay of the average American worker? And why were they making about seven times the compensation of their CEO counterparts at Japanese companies, many of which were out-competing their US rivals?
Yet the surge in top executive pay that Crystal observed 20 years ago pales in comparison to the volcanic eruption that has occurred since then. In the mid-2000s, top executive pay in the United States was about three times higher in real terms than the levels of the early 1990s. And the ratio of the average compensation of the CEOs of the largest corporations to that of the average worker climbed as high as 525:1 in 2000 before declining to what has become the “new normal” of about 350:1 in 2010. The gains from exercising stock options represent both the largest and most variable component of top executive pay, giving CEOs, CFOs, and other top dogs a huge interest in allocating corporate resources in ways that jack up their companies’ stock prices — most notably through stock buybacks that can run into billions of dollars per year.
Large corporations use buybacks to manipulate the stock market. And the fact that top corporate executives can sell the shares that they acquire from exercising stock options without any delay means that, avoiding any risk, they can capitalize on the short swings in their company’s stock price that their corporate allocation decisions help to create. Nice work if you can get it! And guess how they got it? A gift of the regulator of US stock markets, the Securities and Exchange Commission (SEC).
In 1982 and 1991 the SEC – the US government agency which is supposed to protect stock-market investors from stock-price manipulation and short-swing profits by insiders — promulgated rule changes that gave the wolves free access to the chicken coop.
Under the Securities Exchange Act of 1934, large-scale stock repurchases can be construed as an attempt to manipulate a company’s stock price. In November 1982, however, SEC Rule 10b-18 changed all that. The new rule provided companies with a “safe harbor” that assured them that manipulation charges would not be filed if each day’s open-market repurchases were not greater than 25% of the stock’s average daily trading volume for the previous four weeks and if the company refrained from doing buybacks at the beginning and end of the trading day. Under these rules, during the single trading day of, for example, July 13, 2011, a leading stock repurchaser such as Exxon Mobil could have done as much as $416 million in buybacks, Bank of America $402 million, Microsoft $390 million, Intel $285 million, Cisco $269 million, GE $230 million, and IBM $220 million. And, according to the rules, buybacks on these scales can be repeated day after trading day.
Stock-buyback programs — say, $10 billion over four years — require the approval of a company’s board of directors. But, with a program in place, the company is not required to disclose the dates on which buybacks are actually done (a 2004 amendment to Rule 10b-18 only requires that a company report in its 10-Q filing repurchases in the previous quarter, well after the fact). So top executives who make decisions to do buybacks are privy to inside information that, as holders of stock options, can be very valuable to them.
Why did the SEC pass Rule 10b-18 back in 1982? According to a Wall Street Journal report dated November 10, 1982 on the new regulation, Rule 10b-18 “made it easier for companies to buy back their shares on the open market without fear of stock-manipulation charges”. SEC Chairman John Shad, who had previously been a top executive at the Wall Street investment bank E. F. Hutton, was an advocate of the rule change. He argued that large-scale open market purchases would fuel an increase in stock prices that would be beneficial to shareholders. One of the SEC Commissioners, John Evans, argued that as a result of Rule 10b-18, some manipulation would go unprosecuted. But then he agreed to make the Commission’s vote for the rule change unanimous.
Coincidentally, it happens that November 1982 was the start of what would be the longest stock-market boom in US history, lasting until the Internet bubble burst in late 2000. In the process, both stock buybacks and stock options became the yin and yang of US corporate executives.
As a complement to Rule 10b-18, in 1991 the SEC made a rule change that enabled top executives to make quick gains by exercising their stock options and immediately selling the acquired shares, thus avoiding any risk that the price of the acquired stock would decline before being sold. Under Section 16(b) of the 1934 Securities Exchange Act corporate directors, officers or shareholders with more than 10% of the corporation’s shares are prohibited from making short-swing profits through the purchase and the subsequent sale of corporate securities within a six-month period. As a result, top executives who exercised stock options had to hold the acquired shares for at least six months before selling them.
Treating a stock option as a derivative, however, in 1991 the SEC deemed that the six-month holding period required under Section 16(b) was from the grant date, not the exercise date, of the option. Since all stock options take at least one year to vest from the grant date, the rule change meant that executives could now immediately sell the shares acquired by exercising options. The new rule eliminated the risk of loss between the exercise date and the sale date, and gave top executives flexibility in their timing of option exercises and immediate stock sales so that they could personally benefit from, among other things, stock-price boosts from buybacks.
In 1987, after leaving the SEC, John Shad donated $20 million to Harvard Business School (HBS) to fund the teaching of business ethics courses that could curb abuses on Wall Street. HBS subsequently had difficulty putting that money to its intended use. But it did manage to spend $20 million to build Shad Hall, an ultra posh fitness center designed especially for executives who attended the School’s advanced management courses.
One does need to stay in shape to do buybacks and exercise options.
William Lazonick is director of the UMass Center for Industrial Competitiveness and president of The Academic-Industry Research Network. His book, Sustainable Prosperity in the New Economy? Business Organization and High-Tech Employment in the United States (Upjohn Institute 2009) was awarded the 2010 Schumpeter Prize.