The Reason CEOs Make 350 Times More Money Than Their Workers -- And Why That's Terrible for the Economy
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Why did the SEC pass Rule 10b-18 back in 1982? According to a Wall Street Journal report dated November 10, 1982 on the new regulation, Rule 10b-18 “made it easier for companies to buy back their shares on the open market without fear of stock-manipulation charges”. SEC Chairman John Shad, who had previously been a top executive at the Wall Street investment bank E. F. Hutton, was an advocate of the rule change. He argued that large-scale open market purchases would fuel an increase in stock prices that would be beneficial to shareholders. One of the SEC Commissioners, John Evans, argued that as a result of Rule 10b-18, some manipulation would go unprosecuted. But then he agreed to make the Commission’s vote for the rule change unanimous.
Coincidentally, it happens that November 1982 was the start of what would be the longest stock-market boom in US history, lasting until the Internet bubble burst in late 2000. In the process, both stock buybacks and stock options became the yin and yang of US corporate executives.
As a complement to Rule 10b-18, in 1991 the SEC made a rule change that enabled top executives to make quick gains by exercising their stock options and immediately selling the acquired shares, thus avoiding any risk that the price of the acquired stock would decline before being sold. Under Section 16(b) of the 1934 Securities Exchange Act corporate directors, officers or shareholders with more than 10% of the corporation’s shares are prohibited from making short-swing profits through the purchase and the subsequent sale of corporate securities within a six-month period. As a result, top executives who exercised stock options had to hold the acquired shares for at least six months before selling them.
Treating a stock option as a derivative, however, in 1991 the SEC deemed that the six-month holding period required under Section 16(b) was from the grant date, not the exercise date, of the option. Since all stock options take at least one year to vest from the grant date, the rule change meant that executives could now immediately sell the shares acquired by exercising options. The new rule eliminated the risk of loss between the exercise date and the sale date, and gave top executives flexibility in their timing of option exercises and immediate stock sales so that they could personally benefit from, among other things, stock-price boosts from buybacks.
In 1987, after leaving the SEC, John Shad donated $20 million to Harvard Business School (HBS) to fund the teaching of business ethics courses that could curb abuses on Wall Street. HBS subsequently had difficulty putting that money to its intended use. But it did manage to spend $20 million to build Shad Hall, an ultra posh fitness center designed especially for executives who attended the School’s advanced management courses.
One does need to stay in shape to do buybacks and exercise options.
William Lazonick is director of the UMass Center for Industrial Competitiveness and president of The Academic-Industry Research Network. His book, Sustainable Prosperity in the New Economy? Business Organization and High-Tech Employment in the United States (Upjohn Institute 2009) was awarded the 2010 Schumpeter Prize.