Jesse Fried on Inequality, Stock Buybacks, and Misplaced Fears about Short-Termism in Corporate Governance
March 2019. GrowthPolicy’s Devjani Roy interviewed Jesse Fried, Dane Professor of Law at Harvard Law School, on inequality, stock buybacks, and misplaced fears about short-termism in corporate governance. | Click here for more interviews like this one.
* “Short-Termism and Capital Flows” (with Charles C. Y. Wang), The Review of Corporate Finance Studies, March 2019.
* “Will China Cheat American Investors?” (with Matthew Schoenfeld), The Wall Street Journal, December 13, 2018.
* “Trump and Warren are Both Wrong,” Harvard Law School Forum on Corporate Governance and Financial Regulation, September 6, 2018.
* “Trump and Warren Offer the Wrong Diagnosis of Short-Termism,” Financial Times, August 27, 2018.
* “The Real Problem with Stock Buybacks” (with Charles C. Y. Wang), The Wall Street Journal, July 6, 2018.
* “Are Buybacks Really Shortchanging Investment?” (with Charles C. Y. Wang), Harvard Business Review, March-April 2018.
Growthpolicy.org. What should we do about economic inequality?
Jesse Fried: At the risk of speaking heresy, perhaps the answer is “nothing.” Clearly, America has many serious domestic problems, problems that harm our collective well-being: decrepit infrastructure, low-quality schools, pockets of joblessness and social decay, and an inefficient healthcare system. By all means, let’s try to fix them. Does the mere fact that some Americans are much wealthier than others, by itself, also cause harm? I’m not convinced. Less well-off Americans seem to admire, not resent, the financially successful. This might help explain why so many low-income voters supported Donald Trump in 2016. If economic inequality isn’t harmful, we should focus our energies on solving other problems, ones that actually harm us.
If, however, the answer is “something,” let’s reduce economic inequality sensibly. Many proposed measures would be counterproductive. For example, a higher national minimum wage is likely to reduce employment opportunities for low-skilled workers, and thus may well exacerbate inequality, as businesses shift to overseas labor and automation. It would be far better to increase the estate tax and top marginal rates on income, and using the extra revenue to reduce payroll and other taxes imposed on lower-income Americans. This would lower after-tax income for the top of the income distribution, increase after-tax income for the bottom, and thus chip away at inequality from both ends of the spectrum.
Growthpolicy.org. In a recent op-ed in the Wall Street Journal, you note, “Americans now collectively own most of the public equity of China’s biggest tech companies […]. It’s also extremely risky, at least for American investors.” Could you expand on the nature of the risk?
Jesse Fried: Sure, but first a little bit of history. When China’s biggest tech companies—including Alibaba, Baidu, and Weibo—were younger and sought to raise equity from public markets, Chinese regulators did not permit them to IPO in China; they were considered too risky for Chinese retail investors. As a result, the firms sold shares in the United States. So these firms, which are now the crown jewels of Chinese tech, have no Chinese public investors and trade only in America. To understand how strange this arrangement is, imagine if all of the public investors in Amazon, Facebook, and Google were Chinese citizens and these firms’ shares traded only in China.
For American investors, this odd arrangement creates two kinds of risk. First, there’s the possibility of a confiscatory “take private” transaction led by the Chinese controlling shareholder. In such a transaction, the controller forces U.S. investors to accept a low price for their shares and then typically relists the shares in China at a much higher valuation.
Here’s an example: the July 2016 take-private of Qihoo 360, an internet security firm. The founders squeezed out U.S. shareholders at $77 a share, reflecting a value of $9.3 billion. In February 2018, they relisted Qihoo on the Shanghai Stock Exchange at a valuation north of $60 billion. That’s a 550% return. Qihoo’s chairman personally made $12 billion upon relisting, more than what he claimed the entire company was worth 18 months earlier.
While public investors in a firm with a controlling shareholder always face the risk of an unfair take-private, investors in U.S.-listed Chinese companies are particularly vulnerable. Most incorporate in the Cayman Islands. This jurisdiction affords investors much less protection than Delaware, home to most U.S. companies. Neither U.S. nor Cayman court judgments can be enforced in China, where insiders and assets are based. Chinese controllers can thus squeeze out the minority on terms that would make American controllers blush. More than 60 U.S.-listed Chinese companies have been taken private since 2013.
Second, American investors face a separate risk of expropriation by Chinese regulators. Over the last year or so, these regulators have begun squeezing Chinese tech firms. Alibaba’s burgeoning e-payment business has been stifled by a series of curbs. NetEase, an e-gaming company, has been subject to a freeze on government approval of new games. The result: over $100 billion of market capitalization has been wiped out. Whatever their motives, I doubt Chinese regulators would be this aggressive if Chinese retail investors, rather than Americans, were the ones holding the bag.
In fact, Chinese regulators may well be deliberately driving down stock prices as part of an effort to bring these crown-jewel companies home. Last year, the Chinese government unveiled a pilot plan to encourage large overseas-listed Chinese companies to float shares in China while remaining listed overseas, in part to give Chinese investors access to these firms’ shares. Alibaba and several other large tech firms qualify, but none has yet chosen to participate. Beijing may be driving down stock prices to pressure Chinese controllers to float their shares in China, as well as to ensure that the Chinese retail investors who buy newly floated shares can get them at a lower price. I hope American investors in Chinese tech companies have priced in these risks.
Growthpolicy.org. Last year, you wrote an op-ed in the Financial Times about Senator Elizabeth Warren’s “Accountable Capitalism Act,” which would require all U.S.-domiciled businesses with revenues exceeding $1 billion to hand over at least 40 per cent of board seats to employees, and impose new stakeholder-oriented fiduciary duties on directors. What is your view of the Act?
Jesse Fried: Not a fan. Currently, the directors of U.S.-listed firms are accountable to public investors, at least when there is no controlling stockholder. When firms accumulate more cash than can profitably be invested, directors return the cash to shareholders, who can invest the funds elsewhere. The Accountable Capitalism Act would make corporate insiders accountable to nobody but themselves. When 40% of a firm’s board consists of managers or their direct or indirect reports, outside investors would need to win almost every other seat to wrest control from incumbents. While this would be difficult even under existing governance arrangements, the Act’s new stakeholder-oriented fiduciary duties could make it all but impossible—by justifying directors’ use of extreme anti-takeover defenses to protect their board seats.
If the Act becomes law, the outcome would be easy to predict. Freed from market discipline, companies would hoard cash or invest it unprofitably. Capital would be trapped in cash-rich firms and mis-spent, the flow of capital from larger public firms to smaller public and private firms would dry up, and wealth would be transferred from public investors to corporate insiders. Firms looking to raise cash would find it harder. After all, why would investors hand funds over to unaccountable directors? In short, this proposal would be devastating for the economy.
Growthpolicy.org. I’d like to talk about one of your recent research papers, “Short-Termism and Capital Flows,” that challenges the narrative that high levels of shareholder payouts are evidence of short-termist behavior by public companies. You show that S&P 500 shareholder-payout figures, albeit large, provide little basis for concluding that public companies suffer from short-termism. Could you tell our readers a bit more about your research?
Jesse Fried: We frequently hear that shareholder-driven “short-termism”—managers giving up profitable long-term investments to increase the short-term stock price—is a critical problem for U.S. public firms, their investors, and the nation’s economy. The claim is that pressure from investors for immediate returns substantially impairs firms’ ability to invest and innovate for the long term.
Recently, critics of short-termism have focused their attention on the increasing volume of repurchases, which comes on top of regular dividends. The claim is that the high volume of repurchases is leading firms to distribute too much of their net income to shareholders, potentially limiting their ability to invest and innovate. The high ratio of shareholder payouts to net income has been cited by BlackRock’s Larry Fink as evidence that market pressures deprive firms of the capital needed for long-term investment. Senator Elizabeth Warren cited such payout-ratio figures to justify her Accountable Capitalism Act. And at least a half dozen other Senate bills have been or will be introduced to curb or bar stock buybacks. My research with Charles Wang of HBS analyzes whether these shareholder-payout figures provide evidence that short-termism is a serious problem. The answer, in short, is no.
We show that S&P 500 shareholder payouts provide an incomplete and distorted picture of corporate capital flows and their impact on firms’ investment capacities. One cannot measure capital movements between firms and their shareholders without properly accounting for equity issuances by firms that move cash from shareholders to firms. When properly measured, net capital outflows from public firms to their shareholders are much smaller than they seem, and thus appear unlikely to substantially impair these firms’ long-term investment capacity. From 2007 to 2016, for example, S&P 500 firms distributed to shareholders more than $4.2 trillion through stock buybacks and about $2.8 trillion through dividends. These cash outflows, totaling $7 trillion, represented 96% of these firms’ net income during that decade. But during this same period, S&P 500 firms absorbed, directly or indirectly, $3.3 trillion of equity capital from shareholders through share issuances. Net shareholder payouts from S&P 500 firms were therefore only about $3.7 trillion, or 50% of these firms’ net income. So net shareholder payouts are about half of shareholder payouts.
We also look at investment by public firms and their cash holdings. We show that during 2007-2016, total investment (R&D and CAPEX) by S&P 500 firms rose to a record level. And relative to revenues, total investment rose to levels not seen since the late-1990s economic boom. Nor do these expenditures appear constrained by cash availability, as cash balances ballooned to $4 trillion by the end of 2016. Since 2016, these balances haves continued to grow, reaching $4.5 trillion by the end of Q3 2018 (the latest period for which we have data). This astonishing level of idle cash suggests that net shareholder payouts are not too high, but may actually be too low, given capital needs elsewhere in the economy. The data speak for themselves. There is simply little reason to believe that high levels of shareholder payouts are starving companies of the funds needed for long-term investment and innovation.
Growthpolicy.org. In an op-ed in the Wall Street Journal, you propose a two-day disclosure rule to curb share buyback abuses. If you believe the volume of repurchases is not problematic, what abuses are you worried about?
Jesse Fried: While I don’t think that the overall level of shareholder payouts is problematic—indeed, it might well be too low—corporate executives have an incentive to improperly use buybacks rather than dividends to distribute cash. Why? Because buybacks, unlike dividends, can enrich executives at public shareholders’ expense. Executives can opportunistically use repurchases to shrink the share count and thereby trigger earnings-per-share-based bonuses. Executives can also use buybacks to create temporary additional demand for shares, nudging up the short-term stock price as executives unload equity. Finally, managers who know the stock is cheap use open-market repurchases to secretly buy back shares, boosting the value of their long-term equity. This indirect insider trading shifts value from public investors to executives.
Lax disclosure requirements for repurchases facilitate such abuse. When executives trade personally, they must publicly disclose the details of each trade within two business days. The spotlight created by such real-time, fine-grained disclosure helps curb trading abuses by executives. By contrast, the SEC only requires a firm to report, in each quarterly filing, the number of shares repurchased in each month of the quarter and the average price paid per share. Investors see this filing a month or so into the next quarter, one-to-four months after the buybacks occur. And they never see individual repurchases, just aggregate transaction data. Researchers can detect the existence of buyback abuses across a large sample of public firms, but investors cannot easily identify the particular executive teams using repurchases to line their own pockets.
I have proposed a simple, common-sense regulatory change to curb such abuses (see “Insider Trading via the Corporation,” University of Pennsylvania Law Review, 2014). In particular, the SEC should require a firm to disclose each trade in its own shares within two business days, as it does for executives personally trading company stock. This two-day rule would shine a spotlight on repurchases, discouraging executives from using them opportunistically.
A two-day rule won’t unduly burden firms’ use of repurchases for proper purposes, just as the rule doesn’t unduly burden individual insiders. Indeed, some of the largest stock markets outside the U.S. already require even more timely disclosure by firms trading in their own shares. Even if the two-day disclosure rule doesn’t completely eliminate executives’ abuse of buybacks, it will generate fine-grained data about repurchases that can be used to decide whether more aggressive regulation is desirable.