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Heads Up! CEOs Using Stock Buybacks Are Now Threatened

Posted By John Schroy On 3rd November 2006 @ 14:36 In Equities, Corporate Managers, Equity Risk | No Comments

According to an article in CFO Magazine of November 2006 (”[1] Can You Have Your Stock and Sell It, Too?“), plaintiff’s attorney William Lerach of Lerach Coughlin* recently said:

“In our view, there is an inherent conflict of interest when insiders are using the stockholders’ money to buy back shares on the theory that they are undervalued, and at the same time are unloading their own shares. We believe it to be an inherently bad practice. Certainly, when we evaluate whether to bring suit against insiders for securities fraud, it’s something we look for, and when we see it, we view it to be very incriminatory. … even if there is a 10b5-1 program, I continue to believe there’s an inherent inconsistency in using the stockholders’ money to buy back stock while you’re unloading your stock.”

Editor Randy Myers of CFO Magazine reported that:

“attorney Lerach is putting the finishing touches on a lawsuit he plans to file against ‘one of the most high-profile companies in the United States,’ along with its CEO, over issues relating to its buyback programs.”

A Warning From a Powerful Class-Action Litigator

Now Lerach Couglin is not just any law firm: it is a 130-lawyer class-action powerhouse, with offices is six major US cities, and claims of $25 billion in damages won from major US corporations. It is preeminent in the field of class action litigation, specializing in cases involving investors and shareholders rights, violations of federal securities law, and financial fraud.

Lerach Couglin has successfully gone up against some of Wall Street’s biggest banks and law firms, several international financial giants, and a bevy of executives and directors of companies with securities traded in the US market.

Three years ago, Lerach Couglin negotiated a settlement of shareholder litigation with Sprint Corp. (now Sprint Nextel Corp.) involving the sale of Sprint shares while the company was engaged in a buyback program.

When a senior partner of Lerach Coughlin ties the concept of securities fraud with stock buybacks in the context of class action litigation, it behooves any investor in equities to wake up and pay attention; it’s high noon on Wall Street and time to rethink one’s investment strategy.

A Harbinger of Bad Times for Equities?

Over the last year or so, there has been a gradual change in opinion regarding the ethics of stock buybacks. Doubts regarding the practice have now been heard from [2] Warren Buffett, the [3] Harvard Business Review, the [4] Wall Street Journal, [5] Moody’s, [6] BusinessWeek, and many others.

According to the CFO Magazine article, Audit Integrity, an accounting and governance analysis firm, sent a note to clients, warning of 16 companies with capitalization of over $100 million at high risk for fraudulent behavior involving stock buybacks and insider selling.

Googling for articles about both “stock buybacks” and “fraud”, you now get over 14,000 hits, whereas a few years back, the two concepts were rarely linked.

Now, let us put lawyer Lerach’s comments in context:

  • According to Federal Reserve flow of funds accounts, net stock buybacks are running at a record rate of about one trillion dollars every two years. Individual direct investors in stocks have been net sellers of equities for well over a decade. In recent quarters, institutional investors have been lightening up on stock purchases. (See: [7] Stock buybacks continue at record levels Q2 2006).

  • Even a single, highly-publicized, successful class-action litigation suit against corporate executives for activities related to stock buybacks would send a bitter chill through Wall Street. A significant reduction in the volume of stock buybacks would almost certainly cause stock prices to fall, perhaps crash.

  • Class action litigation on stock buybacks could be far more rewarding to tort lawyers than asbestos, tobacco, or firearms all together. Whereas these other areas involve claims against relatively few companies, buybacks now take in hundreds and hundreds of corporations, in amounts exceeding two trillion dollars.

This is the Great White Whale of class action litigation, and once the chum is in the water, the sharks will have a feeding frenzy.

The question for long-term investors is whether it is wise to hang onto equities, continuing to believe in the [8] Common Stock Legend, at a time when stocks are significantly overpriced in historical terms and when powerful tort lawyers are circling to tear down the principal pillar supporting the equity market?

Examining the ‘It’s Not Against The Law” Argument

Proponents of stock buybacks are quick to point out that it is not against the law for a company to buyback its own stock, and, in this, they are correct. However, it is also not against the law to mail a letter, but if the letter contains a fraudulent proposition, it becomes a federal crime.

So far, criticism of stock buybacks is rather timid. Some limit their concerns to ethics and appropriate behavior. The Securities and Exchange is nibbling around the edges of the issue, investigating post-dating of options. Even lawyer Lerach, quoted above, so far, seems only to be focused on corporate buybacks that are simultaneous with executive sales of equities.

So here is, what seems to me, the rich red meat of the issue in simple terms:

  • Stock buybacks involve distributing money that belongs proportionately to all shareholders to only a few — those who actually sell shares.

  • For a variety of reason, not all shareholders are able to sell shares into a buyback, although the same shareholders would be able to receive their fair share of cash distributions in the form of dividends.

  • Corporate executives and directors have a fiduciary duty of dealing with all shareholders fairly and equitably. They breach this duty when they distribute corporate cash to only some shareholders through buybacks, in lieu of dividends.

  • When corporate executives and directors claim or suggest in public statements to their shareholders that corporate buybacks are equivalent to dividends, they are lying.

  • When corporate executives and directors have a direct financial interest in boosting stock prices by repurchasing stocks on the exchange, either because of stock options they hold or because of remuneration schemes tied to stock prices, they have a motive to lie and mislead shareholders.

In other words, most buyback programs are much worse than being simply unethical; they constitute criminal activity in violation of securities laws.

Why then has the SEC done nothing so far? Good question.

Part of the answer is that the SEC is closely engaged with Wall Street brokers and fund managers, who are profiting vastly from the buyback movement and who have the access necessary to persuade the regulator that buybacks are a good thing and even to grant a safe harbor from manipulation charges, whereas ordinary investors are either unaware of the fraud or have no influence with the SEC.

The other part of the answer is that the SEC follows, rather than leads. Its commissioners are chosen by political process and report to Congress. Until enough people begin to cry foul, they are unlikely to perceive that there is a problem.

Now some people are beginning to cry foul. If this keeps up and builds, eventually the SEC will begin to take action.

Catch-22 and The Perfect Storm for CEOs

Corporate executives with buyback programs are, collectively, now in a tight spot. It reminds me of the old Brazilian proverb, “Se correr o bicho pega, se parar o bicho come” (If you run, the beast will catch you, if you stop the beast will eat you.)

If you run, the beast will catch you; if you stop the beast will eat you.
If you run, the beast will catch you; if you stop the beast will eat you.

If all corporations were to stop buyback programs tomorrow, the stock market would crash. In today’s market, there is no other force capable of delivering equivalent buying power to keep prices up.

If prices crash, the SEC will wake from its slumbers and politicians of all stripes will be looking for someone to blame. Tort lawyers will have a much easier time convincing juries to impose heavy financial sanctions and federal prosecutors will have less difficulty sending CEOs to jail.

If corporations don’t stop repurchasing their own shares, sooner or later they will run out of the increasing amounts of cash needed to continue to manipulate prices upwards, and the market will crash anyway.

So what is the poor, criminal CEO to do, having to choose between the beast catching him if he runs, or eating him if he doesn’t?

Well, I really don’t care.

My sympathies are with investors who have been defrauded and who, I hope, get out of equities in time to watch from the sidelines the great spectacle of CEOs running and being eaten.


*) Lerach Coughlin Stoia Geller Rudman & Robbins LLP

 
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Article printed from Capital Flow Watch: http://capital-flow-analysis.com/capital-flow-watch

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URLs in this post:
[1] Can You Have Your Stock and Sell It, Too?: http://www.cfo.com/article.cfm/8099425/c_8102077
[2] Warren Buffett: http://capital-flow-analysis.com/capital-flow-watch/warren-buffett-attacks-buyback-option-schemes.ht
ml

[3] Harvard Business Review: http://capital-flow-analysis.com/capital-flow-watch/harvard-business-review-condemns-buybacks-almost
.html

[4] Wall Street Journal: http://capital-flow-analysis.com/capital-flow-watch/stock-buybacks-make-front-page-news-wsj.html
[5] Moody’s: http://capital-flow-analysis.com/capital-flow-watch/moodys-criticizes-the-use-of-bonds-to-finance-bu
ybacks.html

[6] BusinessWeek: http://www.businessweek.com/magazine/content/06_04/b3968099.htm
[7] Stock buybacks continue at record levels Q2 2006: http://capital-flow-analysis.com/capital-flow-watch/corporate-buybacks-continue-at-record-levels-q2-
2006.html

[8] Common Stock Legend: http://www.capital-flow-analysis.com/investment-tutorial/lesson_11.html
[9] Corporate Managers: http://capital-flow-analysis.com/capital-flow-watch/index.php?tag=corporate-managers
[10] Equities: http://capital-flow-analysis.com/capital-flow-watch/index.php?tag=equities
[11] Equity Risk: http://capital-flow-analysis.com/capital-flow-watch/index.php?tag=equity-risk
[12] stock buybacks: http://capital-flow-analysis.com/capital-flow-watch/index.php?tag=stock-buybacks
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