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William Lazonick: SEC allows corporate executives to make fortunes exercising stock options after large buybacks boost prices

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PAUL JAY: Welcome to The Real News Network. I’m Paul Jay. We’re in Bretton Woods, New Hampshire. We’re at the INET conference talking about causes and solutions to the economic crisis. And one of the factors many people pointed to as a contributing factor to the crisis is various forms of executive compensation that lead executives to be more concerned about their own quick bucks than what’s good for the economy, or certainly for their–even–and sometimes for their own company. Now joining us to talk about one form this takes is William Lazonick. He’s a professor of economics at the University of Massachusetts. Thanks for joining us.

WILLIAM LAZONICK: Nice to be here.

JAY: So you’ve been doing some work on this whole question of the way companies buy–do stock buybacks, and the effect that has, and why it takes place. So explain to us what this is about.

LAZONICK: Okay. So the thing people see most readily is this constant increase in executive pay that gets into the papers, and they’ll talk about sometimes an explosion of executive pay. That goes back already to the early ’90s, where people were saying, you know, why is pay now 100 times what a worker gets, the average worker gets. It was 40 times in 1980. It turns out that 40 times was pretty high, too, by international comparison, particularly when you look at the Japanese, who we were competing against then. Okay. But the pay just kept going up. And now it’s–in 2000, it was up as high as 500 times, and now it’s maybe anywhere between 300 and 400 times. Okay. And when you start looking at the components of executive pay, you see that anywhere from 50 to 80 percent of the pay, let’s say, of the top 500 comes from natural gains they make when they exercise stock options. So stock options are these, the right to buy stock at a certain price that are given to them by the board. And they then–at some point they usually have a window of nine or ten years can say, okay, the stock price has gone up, I want to exercise the price. They exercise the stock. They exercise the stock. They sell it. They make some money.

JAY: And so in theory, at least on the face of it, it sounds like compensation is somehow linked to performance.

LAZONICK: Yeah. So if you take the stock price as being a measure of performance, which has become the norm since the 1980s and is very much related to this increase in executive pay, you can say, okay, that’s what the good performance of a company, and so that is why they’re getting paid. Okay. The problem is, when you start looking at what actually drives stock prices, I divide it into three different types of things. [incompr.] company can actually produce higher-quality, lower-cost products [incompr.] it has a competitive advantage in the market. It gains market share. And this is what I call, generally, innovation. And then the stock price goes up. Usually that’s after the fact. People then say, hey, I should have invested in Cisco five years ago, Microsoft, or Google, or whatever. Okay. So that is something that actually is better performance. That’s not been, I would argue, over the last 15 years or so, even the last 20 years, the main driver of stock markets. The other two things are speculation, which most people recognize. There’s also these speculative bubbles. And a third thing is manipulation. And speculation was something that really was occurring, became stronger and stronger through the ’80s and ’90s, until the internet boom crashed. You have, if you look at the stock price yields–so the average yields of stock prices in the ’80s and ’90s–in the ’80s are about 12 percent per year; in the ’90s, they’re about 15 percent a year. So you can’t lose. You know. I mean, you might–there might be ups and downs, but particularly since you have this long window, you just figure out when to do it.

JAY: Meaning you can’t lose if you have stock options.

LAZONICK: If you have stock options. And I should say, it’s not just top executives, because really one of the things they did in companies like Cisco or Intel or Microsoft–.

JAY: Google.

LAZONICK: Google. You know, everybody has stock options, although what the people at the top get is sometimes 1,000 more what everybody else gets. But, nevertheless, this–.

JAY: Okay. Well, so far [incompr.] it’s linked somehow to something real [crosstalk]

LAZONICK: Okay. Yeah. Yeah. So you have the innovation. Then, actually, the speculation often results from innovation. So you say, ah, I should have bought Microsoft five years ago, and then you start speculating [incompr.] people. Then at some point, where it’s just people who know that, hoping there’s some greater fool out there that is going to buy the stock, and there’s some–you know, the stock market investors, as we know, anybody’s looked at what’s happened recently.

JAY: [crosstalk] let’s get to manipulation. This is the category [crosstalk]

LAZONICK: Yeah. So, basically what we get is in 2000 this boom, this peak, and then it comes down. Okay. Now, rather than say, well, those are just crazy evaluations, okay, now we’re back to normal, basically the corporate world said, how can we get stock prices up again? Now, something they had started doing already in the ’80s but not that systematically was buying back their stock. Okay. Now, this was something that they really didn’t do very much before the mid 1980s. For one thing, SEC regulations could say this was manipulation if you do a large-scale buyback.

JAY: Well, you–it kind of is.


JAY: I mean, obviously, you buy a bunch of your stock, the price is going to go up, and you triggered it.


JAY: And you had foreknowledge of it.

LAZONICK: Yeah. And so what happened in November 1982, it’s one of these under-the-radar SEC changes in the rules. Who knows who’s pushing for them? They say companies can do large-scale buybacks and not get charged with manipulation. It’s a safe harbor. It’s still in place. That then became useful for companies if they wanted to get the stock price boosted. So when the crash of 1987–it is actually well known that IBM came in and started doing some big buybacks and started to getting the market moving up. Other companies came in. And so this actually was a way of you have a crash, get the market up. Okay. If that just happened, you know, in those extreme circumstances, you might say that’s not a bad idea. After 9/11, when the stock market was closed for four days, about 120 companies came in to buy back their stocks, and they said [incompr.] patriotic reasons, ’cause you wanted to make sure that the market–. And again you say, okay, in extreme circumstances, maybe you don’t–you know, you want to just stay–you know, it’s a stabilization. But what had happened is it became systematic. Okay. So–and it actually stopped buybacks as a form–.

JAY: And just to remind everybody, again, the people making the decisions are sitting on stock options–

LAZONICK: They benefited.

JAY: –that if they can get the price up, they exercise the option.

LAZONICK: It’s even worse than that, because we know when a company is going to–announces a program to buy stock. So let’s say that Microsoft has a $40 billion program over the next four years, which is more or less what it has. The board will have to approve it. It’ll be announced. That’s what we know about. We don’t actually know when they’re buying back the stock. And it’s thought that companies use this, for example, to offset bad news, to hit quarterly earnings targets, to get earnings per share up there. Now, this started being used much more systematically in the ’90s by companies that weren’t getting that speculative hit from the market and wanted to keep up. So companies like Cisco that the market was speculating on, they didn’t need to buy back their stock–although the next decade, huge repurchaser of stock. But then they didn’t need to. But it started then, and by 1997, buybacks as a form of distribution to shareholders had surpassed dividends. And dividends are very different from buybacks [incompr.] say you hold the stock, you get an income buyback [incompr.] have to sell the stock [crosstalk]

JAY: If you want to take advantage of the up, you have to sell it.

LAZONICK: Yeah. And this means that–dividends are based on stability, buybacks on volatility, on–.

JAY: And the other shareholders don’t mind, because they’ve driven the share up. They can cash out and find some–I shouldn’t use the word sucker, but somebody who will buy in [crosstalk]

LAZONICK: Yeah. No. So let’s say a big institution–.

JAY: And so they don’t care how much compensation this CEO or whoever’s making, ’cause they just–’cause it just made them a rack of [crosstalk]

LAZONICK: Yeah, if they can get the stock price up.

JAY: So who loses? It’s a win-win.

LAZONICK: Okay. So–okay. So here who loses? Okay. Well, let me just say that in the 2000s, this doesn’t just become something–or the aughts, as we call them–didn’t just become a thing that some companies did once in a while. It became, basically, something that companies did all the time. And in 2003, for the S&P 500, the 500 companies they index, it was about $300 million per company in 2003, which is already a high number. It was $1.2 billion in 2007. So that was about $600 billion, just before the economy tanked, that was spent just boosting the stock price back up. They actually got the S&P 500 index in 2007 slightly higher than it had been in 2000. But whereas in 2000 it had come up through speculation, now it was coming up through what I call manipulation. Okay. Now, why does it matter? Meanwhile, you have a kind of history that goes back to the early 1980s when we got hit by Japanese competition of good jobs being lost in the US economy. So you have a whole separate discussion about the loss of middle class jobs. Okay? And that now, we see that as not just blue collar workers, ’cause a lot of–most of them have disappeared. It’s also a lot of white collar workers, university-educated people, people in their 40s and 50s with lots of experience who [incompr.] economy should be able to make use of who are not getting employment, or getting laid off and can’t find jobs to use their education and experience. Okay. Those companies are–at the same time they’re doing the buybacks, they’re getting rid of people.

JAY: So they’re downsizing. They’re not investing in innovation, but they’re using their money to buy–it’s ’cause of–up the stock price, ’cause these guys can make money [incompr.]

LAZONICK: Yeah. The other thing that’s going on here is that there’s globalization, so in fact often they’re making a lot of money overseas, in China, particularly, but they’re not reinvesting it back in the United States. Now, there’s no reason why they shouldn’t necessarily reinvest it back in the United States, but that’s not what they want to do with it. They want to buy back their stock. I should say that in 2008, 2009, buybacks went way down, particularly in 2009, because companies didn’t have the profits, but now they’re on the way up. And so I predict there’s another escalation in this.

JAY: So there are a lot of people talking about how you have to have lower and lower corporate taxes if the savings on the tax is just being used for stock buybacks, there’s [crosstalk]

LAZONICK: That’s one way of looking at it. Other people say we need more. I’m not against government stimulus or government spending at all. But if people say what we need is government stimulus to get this economy going, the theory behind that is there’s lack of business confidence. No, there isn’t any lack of business confidence. Any kind of break the business gets, they’re going to use that money to buy back stock. And let’s take a sector that–like the health insurers. Okay. So we [incompr.] a debate going on in this country, ’cause it’s not just about jobs. Cost of health insurance. So I would say most people would probably say we’ve got these health insurers, but we’re getting low-quality, high-cost services from them. Okay. That’s the opposite of innovation. The major health insurers–United Health Group, Aetna, WellPoint–they spend over 100 percent of their profits buying back their stock. So any time they exclude someone because of a precondition, makes them more money, that’s what they’re doing with the money. It goes from sector to sector. In oil refining we have ExxonMobil, $164 billion bought back in stock in the last decade. We need investment in alternative energy.

JAY: So what would you do about it?

LAZONICK: Okay. So, first of all, I would ban stock buybacks and say a large company to buy back its stock is a manipulation of the market. That’s already something that’s recognized in SEC regulation [incompr.] potentially being a manipulation, except they gave them the safe harbor. Okay? It’s also stock buybacks–.

JAY: They being the Bush-Cheney administration.

LAZONICK: No. This goes back to 1982. So [crosstalk] under Reagan.

JAY: Eighty-two. I’m sorry. I thought it was 2002.

LAZONICK: No, no. Eighty-two. No, this–.

JAY: Oh, it’s the Reagan administration.

LAZONICK: Yeah. This was right at the start of a long stock market boom. And, in fact, John Shad, who was the commissioner of the SEC at the time, said in a report that was done on this, let’s do this so it moves the stock market. Okay. [incompr.] some countries, stock buybacks are illegal. In Europe, most countries made them legal in the late ’90s to try to get into the acquisition game, ’cause they wanted to get their stocks up, let their companies acquire–.

JAY: Okay. So you would–

LAZONICK: But I would ban them.

JAY: –regulate them, ban them [crosstalk]

LAZONICK: Yeah, I would ban them, but–’cause I don’t–they’re a manipulation of the market by these large companies. The second thing is stock options. Okay. If you want to pay people in stock, there’s lots of different ways to pay them. So let’s say you use stock options, where you don’t actually have to buy the stock, there’s no risk until you buy it. I’d say that you can’t make money off them as a top executive, or probably just anybody, unless you do better than your competitors, better than the market as a whole. So you try to have rules about–.

JAY: So it’s not just based on share value. It’s based on overall performance.

LAZONICK: Yeah. It’s–so there’s some index. Now, Britain has this. So Britain has–within the ’90s, they put together a code of good corporate governance which has these sets of rules. They’re not obligatory, but many companies use them to ensure that if their executives get paid from gains from exercising stock options, they’ve done better than their competitors or they’ve done better than the Footsie 100.

JAY: So it’s not just a manipulation.

LAZONICK: So–and it’s speculation. So you try to eliminate the speculation from it so that it really reflects better performance, and you don’t allow the manipulation. You know. So there’s two sides of it. Speculation you can never get rid of. I mean, you can’t have a stock market without speculation, but you can get rid of it in the way you reward the executives so that they don’t benefit from something where the market’s just rising because of speculation. Everybody’s going to benefit. You just eliminate that.

JAY: Very good. Thank you.


JAY: Thank you for joining us on The Real News Network.

End of Transcript

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William Lazonick is a professor at the University of Massachusetts Lowell where he directs the Center for Industrial Competitiveness, and co-founder and president of The Academic-Industry Research Network (theAIRnet). He is also affiliated with the University of Bordeaux and the University of Ljubljana, and collaborates extensively on research in Europe. Previously, Lazonick was Assistant and Associate Professor of Economics at Harvard University, Professor of Economics at Barnard College of Columbia University, and Visiting Scholar and then Distinguished Research Professor at INSEAD. Lazonick holds a B.Com degree from the University of Toronto (1968), a M.Sc. degree in economics from the London School of Economics (1969), and a Ph.D. degree in economics from Harvard University (1975). In 1991 Uppsala University awarded him an honorary doctorate for his work on the theory and history of economic development. He is the author or editor of twelve books, including Competitive Advantage of the Shop Floor (Harvard University Press, 1990) and Business Organization and the Myth of the Market Economy (Cambridge University Press, 1991), and more than 100 academic articles. His latest book, Sustainable Prosperity in the New Economy? Business Organization and High-Tech Employment in the United States (Upjohn Institute for Employment Research 2009) has been awarded the 2010 Schumpeter Prize by the International Schumpeter Society. Currently Lazonick is directing an international project on financial institutions for innovation and development, funded by the Ford Foundation, and a project on the stock market and innovative enterprise funded by the Institute of New Economic Thinking.