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Pay for Destruction: The Executive Compensation Arrangements That Encourage Value-Decreasing Stock Buybacks

Nitzan Shilon

Previous studies by myself and other scholars have shown that stock buybacks can increase executive compensation by altering ratings on performance yardsticks that determine bonuses and stock awards. In this article, I argue that executives’ incentives to conduct buybacks for this purpose are undesirable, as they encourage stock buybacks that destroy firm value and separate pay from performance. Because commonly used performance yardsticks, which are designed to measure the impact of ordinary business decisions on firm value, fail to properly reflect the intertemporal, financial, and stock trading impact of stock buybacks on firm value, they invite various forms of abuse. Specifically, I show that stock buybacks that shortchange long-term value can improve earnings per share (EPS), that buybacks that excessively increase a firm’s financial risk can elevate EPS and total shareholder return (TSR), and that buybacks that manipulate the stock price can lift TSR. My empirical inquiry indicates that these incentives matter because such performance criteria determine almost one third of S&P 500 CEO total pay. My analysis related to stock buybacks is especially troubling, because it shows that the executive compensation reforms undertaken to alleviate the systemic problems highlighted by the financial crisis of 2008–2009 have exacerbated those problems instead. I explain the corporate governance failures that enable corporate executives to act on their undesirable buyback incentives, and I propose regulatory reforms that would make the impact of stock buybacks on executive compensation transparent and empower shareholders to opine on this information in their advisory “Say on Pay” voting. My proposed reforms can be expected to push boards and shareholders to remedy the flaws inherent in the design of performance metrics affected by stock buybacks.

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