The SEC's compensation proposal

So the SEC unveiled its compensation disclosure proposal. The proposal would gather together and quantify all forms of compensation, presenting it in neat tabular form, and in plain English.

I have previously opined on news this proposal was impending. I have pointed out the hidden costs, including fodder for litigators; and that this was really about populist concerns about executive “greed” – in other words, something for the resentful to chew over.

What is there to be said for the proposal? Well Chairman Cox introduced the proposals by saying “Our purpose here today is to help investors keep an eye on how much of their money is being paid to the top executives who work for them.” Indeed, he has august academic support for this in today’s W$J: Harvard professor Bebchuk, the guru of academic critics of executive pay, says “investors shouldn't have to devote significant time and effort to put together a company jigsaw puzzle.”

Ok, who are these “investors”? What do you do when those proxy statements come rolling in? Would you hesitate on the way to the garbage because you knew there were these neat little pay tables in them? Actually, you might, out of curiosity, but then I suspect you'd continue on your journey.

Anyway, I invest in mutual funds. Should I care that my fund managers – for the non-index funds I unfortunately still own – can now read neat little tables in “plain English”? Actually, yes – I should immediately chuck the ones that care about this trivial measure of corporate performance, and the ones that needed “plain English” to figure it all out.

Many of the new disclosures are worse than trivial – they’re misleading. As Bebchuk points out, “investors care not only about total pay but also the relationship between pay and performance. They should get information that enables them to assess the incentive effects of pay packages.” These disclosures don’t provide much new in that category. Instead they stress the least important number from an incentive perspective – the total numbers.

To be fair, the new disclosures will include more “Compensation Discussion and Analysis” to “address the objectives and implementation of executive compensation programs - focusing on the most important factors underlying each company's compensation policies and decisions.” So there is something relevant here.

But relevant to whom? The investors who are throwing this away? Are the shareholders who need this plain English in a position to evaluate “the company’s compensation policies and decisions”. Duh. Steve Bainbridge points out that this flies in the face of the rational apathy that characterizes shareholder behavior. What the proposals assume is irrational non-apathy.

So what does all this accomplish? Bebchuk does have one point: the “disclosures would eliminate distortions caused when pay-designers use some forms of compensation for camouflage value rather than economic efficiency.” Possibly – though the cynical among us would say that companies will just have to work harder at camouflage now.

No, this is not about “investors,” or at least the rational ones who care about shareholder value. At worst, this is about reducing pay to please those who obsess over executive “greed,” those, like unions, who want a political lever to extract more for themselves from the corporate pie, and litigators who want more rules they can litigate over.

But maybe I’m wrong. At best, as I’ve said, this is chicken soup, that saves us from even worse stuff the SEC could be doing. I hope I’m right, but even if I am it’s not exactly a ringing endorsement.

Update: Geoff Manne promises to confront head-on my "chicken soup" hypothesis of disclosure, which, as he notes, I've backed off from myself.  I'm looking forward to that.  In the meantime I'm continuing to think along the lines of this post and the comments to this post: what do the proponents of compensation disclosure really want and why do they want it?  Of course they want executive pay to be lower, and not just more transparent. But why?  Stay tuned.

Comments

[Allison Garrett]

Let's just hope that at some point during this process, the SEC and the IRS will attempt to get on the same page regarding who makes compensation decisions.

When the IRS drafted the regulations implementing IRC 162(m) several years ago, it inadvertantly set requirements for compensation committee membership that differed from the SEC's requirements for award of options by the compensation committee.

According to the IRS, you cannot make a decision about whether performance-based compensation goals were met if you had more than $60,000 in transactions with the issuer. Presumably, this number was pulled from Reg S-K.

The SEC's regs on award of options say you cannot participate in the award if your transactions are discloseable. There are some transactions that exceed the $60,000 threshhold, but still are not discloseable (e.g., competitively bid transactions).

The new SEC proposals make the SEC and IRS even further apart on these issues. The regs implementing section 162(m) apply to the CEO and the four other most-highly compensated officers. The new SEC regs relate to the CEO, CFO and three other executive officers.

On the plus side, the SEC has finally decided to address the $60,000 threshhold for disclosure that was in the rules in the 1970s, raising it to $120,000.

[William Henderson]

Larry, what is the endpoint in your analysis? You imply that small-time investors (which includes most law professors) rationally chose indexed mutual funds. Activist money-management at the retail level is a losing proposition. Most people have accepted this basic premise of portfolio theory.

So, obviously, disclosure is not the answer. Even if the compensation provokes (or ought to provoke) outrage, in most publicly held corporations with widely dispersed ownership, rational apathy is too engrained to overcome the collective action problem. There'll be no proxy fights. Yet, we don't sell our holdings either because we are all in indexed funds.

Thus, as the labor and political markets continue to operate to shift the burden of old-age to individuals, we have a systemic agency problem that transfers corporate assets from the corporation to managers. As noted NY Times article (1/14/06), "the total compensation of the five best-paid officers of all publicly held companies amounted to 10 percent of corporate earnings."

I wonder what is was 20 years ago. Further, what amount is "efficient"? With directors drawn from the CEO class, and consultants relied upon to generate benchmarks, this is not a market operating under the traditional laws of supply and demand.

To make matters worse, wealthy investors are diversifying into alternative investments such as private equity, hedge funds, and venture funds, that generate returns higher than indexed funds. So the wealth transfer of high executive pay is a problem that falls disportionately on middle-class investors.

This is a problem that will come home to roost when baby-boomers start getting angry over their flat retirement portfolios.

To curb the worse executive abuses, we could repeal the Williams Act to make hostile takeovers easier. Regular investors in indexed funds will then recoup some of what they are losing.

And Larry, some of your colleagues consider you conservative for lines like this: "At worst, [the new SEC disclosure policy] is about reducing pay to please those who obsess over executive 'greed,' those, like unions, who want a political lever to extract more for themselves from the corporate pie ... "

There is no doubt who has been on the short-end of the growing disparity between CEO and worker pay. Why would it be a bad thing to adjust how this pie gets sliced? When workers get angry about their bosses extravagent perks while they struggle to save for retirement and their kids' college tuition, are they really "obsess[ing]" over a trivial matter? Or there something distasteful about this type of collective action, especially as compared to the status quo? Perhaps these unions have a point that things are getting out of hand.

[Larry E. Ribstein]

The idea that "fixing" executive pay will bail out workers' retirement is really pretty absurd.

No, I don't have anything against collective action as such. It's worth pointing out that fighting over the corporate pie has costs,. Indeed, Mancur Olson saw this sort of fighting as a key to the decline of civilizations. But that wasn't the point of my post.

My point, very simply, was that this disclosure policy has nothing (positive) to do with investors.

BTW, this is not a "conservative" position, it is an honest position that reflects market realities - which is more than I can say for the SEC.

[William Henderson]

1) I did not imply that fixing corporate pay will "bail out" workers retirement. But if the top five CEO's get 2 percent of earning rather than 10, there is a significant amount of money on the table. Again, a historical comparision of CEO pay vis-a-vis earning is relevant here. Your reference to Mancur Olson implies that Rome will not burn as long as don't ask any contentious questions about the division of corporate spoils. On the other hand, there is some historical precedent that huge concentrations of wealth in the hands of a few carries its own political risks.

2) We agree: disclosure won't help investors very much. But what will help?

[Larry E. Ribstein]

You said: "as the labor and political markets continue to operate to shift the burden of old-age to individuals, we have a systemic agency problem that transfers corporate assets from the corporation to managers." That sounds like a connection to me, but I'm happy to hear you correct that impression.

Even if all you're saying is that less managerial pay means more for the workers (even if this doesn't "bail them out"), I'd like to know the basis for that. Might it not mean more for the shareholders? Should it not mean that?

Of course the workers are also shareholders, and for many people retirement depends on the stock market. Therefore we should be trying to maximize the value of firms, not redistributing managerial wealth to shareholders.

Anyway, I'm glad that somebody's had the honesty to squarely admit that this is about wealth redistribution and not investor protection. Now if we can just stop talking about "investor protection" in the same breath as executive compensation disclosure maybe we can have a meaningful debate.

[Larry E. Ribstein]

You said: "as the labor and political markets continue to operate to shift the burden of old-age to individuals, we have a systemic agency problem that transfers corporate assets from the corporation to managers." That sounds like a connection to me, but I'm happy to hear you correct that impression.

Even if all you're saying is that less managerial pay means more for the workers (even if this doesn't "bail them out"), I'd like to know the basis for that. Might it not mean more for the shareholders? Should it not mean that?

Of course the workers are also shareholders, and for many people retirement depends on the stock market. Therefore we should be trying to maximize the value of firms, not redistributing managerial wealth to stakeholders.

Anyway, I'm glad that somebody's had the honesty to squarely admit that this is about wealth redistribution and not investor protection. Now if we can just stop talking about "investor protection" in the same breath as executive compensation disclosure maybe we can have a meaningful debate.

[William Henderson]

Yes, I am talking about maximizing the value of the firm for shareholders, which redounds to the benefit of retiring middle-class workers. If paying the CEO an extra dollar add $.10 to firm value, great. It is the reverse scenario that should give us pause.

[Larry E. Ribstein]

In your initial comment you said "there is no doubt who has been on the short-end of the growing disparity between CEO and worker pay. Why would it be a bad thing to adjust how this pie gets sliced?"

I'm glad to hear you're no longer talking about slicing the pie.

[Bob]

> To make matters worse, wealthy investors are diversifying

That's only because securities law makes attracting middle-class investors a bad idea. The high cost of doing a general offering makes the startup costs of small offerings prohibitive and adds significant administrative expense on top of that. I'd love for middle-class investors to get the same opportunities wealthy investors do, but no rational small fund manager will accept the headaches. Unfortunately some pundits in the media seem to think this is more of "the rich get richer" rather than an artifact of regulation.

[Al]

"Ok, who are these “investors”? What do you do when those proxy statements come rolling in? Would you hesitate on the way to the garbage because you knew there were these neat little pay tables in them? Actually, you might, out of curiosity, but then I suspect you'd continue on your journey."

Hey, let's get rid of the '34 Act in its entirety! I mean, if investors are reading Annual Reports and proxy statements and the rest, why require that companies continue to put them out?

Apparently Ribstein thinks that disclosure is passe. It's the basis of all of the securities laws, but who cares! Nobody reads that stuff anyway!

[Larry E. Ribstein]

In fact, there is a real question whether disclosures should be designed for "ordinary investors." That doesn't necessarily mean that companies should not have to disclose information that can be used by the professionals in the market. The SEC lacks authority to drastically limit disclosure, but for the reasons I've given it should not expand disclosure requirements in this situation.

[Michael Guttentag]

Larry. I like the clarification you offer in your comment on January 18th at 5:20 pm. It rebuts a criticism I offer of your earlier argument in a comment I posted on the Conglomerate. I pointed out in that comment that the compensation information the SEC is requiring be disclosed may be relevant to some sophisticated investors, and therefore affect share prices. It seems now that you agree with this, but would point out that the SEC crafted these disclosures to benefit ordinary investors. In my view, this is just another example of the SEC being sloppy in the way it justifies disclosure requirements, and thereby introducing waste into the system by requiring companies to repackage relevant disclosures in a nominally more investor-friendly format. This on its own does not invalidate the potential value of the required disclosures.

[William Goodwin]

Larry, you (and Professor Bainbridge) are setting up a straw man here. The case for disclosure of executive compensation has nothing to do with small investors or with wealth distribution. It has to do with sophisticated fundamental investors who want a better sense of how a corporation is actually being run -- that is, whether the CEO's decisions are being rubber-stamped by a passive board or whether there is some meaningful oversight of his/her choices. I know a number of successful mutual-fund managers who look closely at pay-to-performance ratios specifically and executive compensation generally when making investment decisions. The SEC's proposal will give these people more information, make it harder for companies to deceive them, and for that reason will make the market (on the margin) more efficient.

Warren Buffett, after all, has said that executive compensation is the "acid test" for corporate governance. And with all due respect, I think most of us would trust Warren Buffett's evaluation of what is or isn't relevant to shareholder value over your own.