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Trillion-dollar bailouts for a bank sector whose executives pocket millions have enraged the masses. The pay packages, larded with stock options and perks equivalent to the GDPs of small nations, have to be reined in, they cry. Failing that, off with their heads!

There is no doubt executive pay is out of control. When AFL-CIO Executive PayWatch looked at 200 large American companies in 1980, it found that CEOs were making 42 times as much as workers-a figure that seemed outrageous even then. By 2008, the ratio was seven times more outrageous, at 319 to 1.

While the calls to contain this greed are amply justified, there's a more fundamental reason why one element of executive pay-stock options-needs to be taken down a notch or nine. Stock-option plans are bad for the whole economy because they encourage stock buybacks, which in turn deprive companies of the funds they need to innovate and to protect themselves during economic downturns.

Buybacks have been a prominent feature of North American markets since the 1980s. Today, many big companies buy back their own shares as a matter of course. Why? Because investors, wedded to the cult of "shareholder value," adore them. The purchases prop up share prices and having fewer shares outstanding translates into higher earnings per share. Officially, companies often purchase their shares to offset dilution from stock-option programs and to find a use for excess cash flow. Google, for instance, has faced pressure to buy back shares because it's sitting on a stack of cash teetering at $24 billion-and growing (all currency in U.S. dollars).

But it appears the real reason buybacks have been all the rage for decades is executive greed. Because they goose share value, buybacks translate into richer stock-option rewards. In this sense, buybacks are blatant stock manipulation and should be restricted or stopped, says William Lazonick, a Canadian-born director of the Center for Industrial Competitiveness at the University of Massachusetts Lowell.

Paying largely in stock was supposed to focus the executive's mind by aligning his fortunes with those of the company. He would be inspired to emphasize innovation, and thus the company would gain market share and pricing power. As the business performed better, the shares would go up and he would get richer. Nice theory, but it didn't quite work that way, because innovation is hard work. There are easier ways to get the shares moving; draining the treasury to buy back shares is one of them.

Data compiled by Lazonick on the 438 companies in the S&P 500 index that remained publicly traded between 1997 and 2008 show explosive buyback growth. During that period, those companies spent a total of $2.4 trillion-about twice Canada's GDP-on buybacks. Repurchases averaged $292 million in 2003. By 2007, that figure had grown to an average of $1.2 billion.

But even this doesn't tell the whole story. In the early 1990s, the repurchases were valued at about 23% of the combined net income of the companies. By the late 1990s, the figure had climbed to about 44%, and to an astounding 91% by 2007. Big companies, in other words, were spending essentially all of their profits on buybacks. Some were even borrowing money to do so. Not surprisingly, escalating buybacks helped to boost the stock market-the 2003-'07 period marked one of the greatest bull runs in history. Executive pay, of course, also rose.

Every dollar spent on buybacks means one less dollar spent elsewhere-on R&D, on training, on equipment, on creating employment, on innovation. Ultimately, competitiveness and economic growth suffer.

Worse, buybacks may have made the financial crisis more damaging than it need have been. Some of the bailed-out banks were the very companies that spent fortunes on their own shares, including Citigroup ($42 billion from 2000 to 2007) and Lehman Bros. ($16.8 billion in the eight years before its collapse).

If the buybacks hadn't happened, would those companies have floundered? It's impossible to say, but there is no doubt the missing loot reduced their ability to withstand the crunch. To take another example, General Motors spent $20 billion on buybacks between 1986 and 2002, an era when it was losing market share to Japanese competitors. Imagine what could have happened if those billions had instead been spent on innovation.

Since buybacks and executive compensation are linked, the fix is fairly simple. If stock-option plans were severely restricted, executives would feel less need to keep the buyback spigot wide open. And if buybacks were likewise restricted-there have been times in Europe and in Japan when they were illegal-they would make stock-option plans less attractive. Ideally, both stock-option plans and buybacks would be tamed. As it is, the combination of the two, feeding on each other, is capitalism at its ugliest.

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