Senator Bernie Sanders of Vermont and Senator Charles Schumer of New York recently proposed legislation that would restrict stock buybacks by companies. We discussed their proposal in a recent research note, laying out their goals as well as explaining why their arguments are faulty in their own right.
But that is not the end of the issue. The push to block or restrict share buybacks is fundamentally flawed on economic grounds, as well inevitably ineffectual.
The virtue of buybacks
It is important to understand that businesses reinvest capital when there is potential to see a return on that investment. If a company cannot find a good place to invest its profits, the best decision is usually to return it to shareholders, as former Goldman Sachs (GS, Financial) CEO Lloyd Blankfein pointed out in a recent tweet:
“A company used to be encouraged to return money to shareholders when it couldn't reinvest in itself for a good return. The money doesn't vanish, it gets reinvested in higher growth businesses that boost the economy and jobs. Is that bad?”
Decisions to use extra cash to buy back stock or to issue dividends are based on companies’ acknowledgment they do not need the cash to fund their operations or growth aims. That does not mean companies never commit to unsustainable payouts. But those that do so inevitably face financial pressure, which tends to hurt the corporate executives and shareholders who are the supposed beneficiaries of such overly generous payouts. It is a self-correcting mechanism.
Hence, one of the key points of the Sanders-Schumer proposal, that buybacks were stifling useful reinvestment, falls flat on its face.
Would it even work?
It does not take long to recognize the proposed restrictions, even if written into law and rigorously enforced, would be totally ineffectual. That is because corporations have another way of achieving essentially the same outcome: dividends.
While gallons of ink have been spilled over the past couple decades debating the relative merits of buybacks and dividends, the focus is generally on how it impacts investors - and even then it tends to be an argument only over benefits at the margins. From the corporation’s standpoint, however, spending cash on reducing the share count or distributing cash directly to shareholders is, functionally speaking, the same thing.
Thus, if Sanders and Schumer get their way, nothing will stop the companies currently engaged in share buyback programs to switch to dividend payouts. The flow of capital is unchanged; cash goes from company to shareholders, just in a more uniform distribution pattern.
Reach exceeds grasp
Sanders and Schumer are not quite so ignorant of the workings of financial markets as to be unaware of the existence of dividends. In their op-ed, they note dividends could be used to circumvent their policy. In response, they suggest the policy could one day be expanded to encompass dividends as well.
One might well ask why they would not simply include dividends in their current policy proposal now. The answer is simple: While federal laws govern buybacks, dividends are under the auspices of state law and are thus beyond the power of the senators to influence at present.
The looming threat
Of course, the federal government has taken various powers previously reserved to the states many times in the past, so it is not beyond the pale to consider the possibility that Sanders and Schumer might one day make good on their threat to bring dividends under the sway of their notional legislation.
Thankfully, the prospect of such a tectonic shift in the regulatory framework of U.S. capital markets is a distant longshot. Still, the possibility - however improbable - is frightening. It could have far-reaching - and potentially devastating - impacts on capital markets and the broader economy.
Looking ahead
Investors should watch policymakers very closely in the months ahead. Their actions could prove the primary drivers of capital markets in these volatile times.
Disclosure: No positions.
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