Because we produce 22 columns a year, we’re always looking for topics. Some come from readers, others from students, and some we pluck out of midair. For this column, we thank Allan Sloan, who published a piece called Buy High, Sell Low in the Feb. 4, 2008, issue of Fortune magazine.Sloan’s article skewers the managers of the “Wall Street Four” — the large investment banking/brokerage/etc. conglomerates, including Citigroup, Merrill Lynch, Morgan Stanley and UBS.
He struck home, near as we can tell.
Earlier in 2007, when the market as a whole was sky-high, these companies’ own shares soared. Being flush with cash, management plunged into huge stock buyback programs. Later in the year, with their cash hemorrhaging, they sold stock and convertible securities.
To what extent?
Sloan says that Merrill bought treasury stock at $84.48 but then sold it later at only $48 a share. Citi paid $53.24 for a ton of stock, but later sold disadvantageous convertibles when its common was selling around $30. His point scored — these financial genius managers executed really lousy transactions because they forgot that their business is risky. As capitalists, they need to hold onto, duh, their capital, but they spent it like sailors on liberty with no thought for tomorrow.
We have some additional condemning data. According to its 2007 10-K, Bear Stearns bought back 3.4 million shares in October and November for $373 million, or $108.32 per share; in late March, a tender offer of $10 per share was made, indicating a loss of $339 million on that deal alone, not to mention losing almost everything else.
These numbers are peanuts compared to Merrill Lynch, though. Over 2005-2007, it repurchased 178.7 million shares for $14.4 billion, or $80.42 per share. At the market close on March 26, the value was only $44.42 per share, which means $6.4 billion of capital was dissipated for no good reason.
We join Sloan in condemning these miscreants, but we’re not content to stop there. We believe significant blame for the problem falls on accountants.
SOME HISTORY
Near as we can tell, GAAP for treasury stock is clearly POOP, our acronym for “Pitifully Old and Obsolete Principles.” The most recent guidance is found in APB Opinion 6, issued more than 42 years ago in 1965. All it did was endorse the accounting described in ARB 43, issued 12 years earlier. It, in turn, had simply codified ARB 1, issued 14 years before. And ARB 1 merely restated an unnumbered rule issued another five years back by the American Institute of Accountants. All told, treasury stock accounting is 73 years old! (Thanks to Dr. Steve Zeff of Rice University for this archaeology.)
In the old days, even as “recently” as the APB era, no one contemplated that managers would ever spend billions buying back millions of shares. They worried about only occasional insider transactions that might occur, and the main technical questions were whether treasury stock is an asset and whether the cost or par-value method is preferable. Since then, no reconsideration has been given to the imprecise answers of “usually not” and “it depends,” respectively. Alas, treasury stock is not even mentioned in the Financial Accounting Standards Board’s November 2007 preliminary views document on financial instruments and equity, so we don’t think anything is going to change soon.
It’s obviously high time to reform prehistoric accounting principles that cover up the thousands of abuses that have occurred.
ABUSES, WHAT ABUSES?
We see several categories of abuses that are not being accounted for usefully.
* Buybacks. The controversy created by treasury stock purchases is that they are really discretionary dividends paid to only some shareholders. So who are they and why do they get company cash when others don’t? Another issue is why it makes sense to buy stock instead of paying a dividend to create price stability, or investing the cash elsewhere to earn higher profits than shareholders can make on their own with after-tax dollars.
Regrettably, GAAP financial statements don’t make it plain when management loses bigtime in buybacks while depleting the treasury of precious cash. If the financial statements don’t hold managers accountable for these downside consequences, there is no check to keep them from overusing buybacks to their own advantage, propping up the value of the stock and boosting the value of their executive options and other incentive pay. With better reporting, Merrill Lynch would have had to reveal its scandalous multi-billion dollar losses from buying stock and putting it back on the market for much less not even a year later.
* EPS management. Contrary to its popular reputation, earnings per share is nothing more than a crude measure of an entity’s performance for comparison to prior years. Holding them accountable for EPS should focus managers’ attention on boosting earnings in the numerator.
Unfortunately, many would rather inflate EPS by reducing the shares in the denominator. These denominator moves, while popular, are shams, because the resulting increase is only statistical and has nothing to do with performance. Further, they cannot sustainably boost the stock price. In fact, buybacks have become so routine that we suppose most managers don’t even notice the deception behind them.
* Covering call options. Back in the options heyday, we remember seeing many a management team justify buybacks to provide the shares needed to cover their option exercises. This is a smokescreen and here’s why. First, most managers argued long and loud that options are “non-cash” compensation while they were spending cash equal to the market value of the shares they then sold to themselves at the much lower strike price. If the difference between those two amounts isn’t a cash expense, what the heck is it? Second, some conducted buybacks specifically to cover up dilution caused by their stock deals. To us, this practice is like what a cat does in its litter box.
MORE THAN DEBITS AND CREDITS
As flexible and efficacious as the accounting equation and double-entry bookkeeping have been in so many situations for centuries, they simply don’t work for treasury stock. One basic tenet dating back to the 1930s is that treasury stock dealings cannot produce “earned surplus.” In other words, no gains or losses on these deals.
That makes technical sense if you simplistically view buybacks as reducing equity and issuances as increasing it. The problem is this treatment fails to provide a framework for evaluating bum deals. We’re convinced more disclosure is needed to inform users and discourage managerial misbehavior.
We propose a “Schedule of Stock Dilution and Antidilution” that reveals relevant details of all transactions involving a company’s shares. Every transaction (or groups of similar transactions occurring at about the same time) would have its own line in the schedule. Columns would reveal how many shares were bought, sold, exchanged, converted or optioned, when each event occurred, the transaction price, the stock’s market value on that day (if different), and the total cash or other value paid out or received. In addition, the description of each event would reveal who the other parties were and why it was deemed to have been in all shareholders’ best interests.
The ultimate purpose is to make managers more accountable for activities that they’ve been able to engage in with scant transparency. It’s clear their lack of accountability has allowed them to behave irresponsibly and thus encouraged them to do so. If they have to describe what they’re doing and why, maybe they’ll stop their profligate ways.
If you don’t believe that assertion, just look at how many of them have abandoned stock options, despite swearing that they were absolutely essential for holding onto their “talent.” What a crock!
Speaking of which ...
Trickery treasury stock,
It’s nothing but a crock.
The boss spends dough,
Then sells shares low.
Trickery treasury stock.
Trickery treasury stock,
It’s nothing but a crock.
The CPA says “Yes,”
So users have to guess.
Trickery treasury stock.
Trickery treasury stock,
It’s nothing but a crock.
FASB should look,
So owners don’t get took.
Trickery treasury stock!
Paul B. W. Miller is a professor at the University of Colorado at Colorado Springs and Paul R. Bahnson is a professor at Boise State University. The authors’ views are not necessarily those of their institutions. Reach them at paulandpaul@qfr.biz.
