TCS Daily

Is More Always Better?

By Stephen Bainbridge - September 22, 2004 12:00 AM

John Kerry recently told the AFL-CIO that, if elected, he intends to do something about executive compensation:

"I am very concerned about runaway executive compensation. Today, the average CEO makes more than 500 times what the average worker makes, and I think that's wrong. While I don't believe our government should place dollar limits on compensation, I do think there are steps we can take to make the system fair. We must curb abuses where they occur, especially such practices as funneling money to offshore accounts or tax shelters that allow executives to avoid paying their fair share of taxes."

I commend Kerry for recognizing that the government should not get in the business of setting executive compensation. As I've observed before on this blog, how much you get paid depends in large part on the thickness of the market for your services. In a thick market, wages tend to be low because there are many potential employees -- all more or less fungible -- competing for jobs. In a thin market, however, wages tend to be high because many employers are competing to hire a small number of eligible workers. The market for burger flippers is very thick. The market for CEOs of Fortune 500 companies is thin. Very thin. I'd guess the number of people who have what it takes to run a Fortune 500 company isn't much larger than the number of people who can run a NBA fast break. Its just supply and demand, folks.

Unfortunately, Kerry was not content to leave the problem to the markets. Instead, he proposes to get at executive compensation by imposing new disclosure obligations on firms:

"I believe that the SEC should consider requiring companies to provide greater transparency in the reporting of their executive retirement stock purchase and investment plans in order to determine whether executives receive significantly better compensation and retirement benefit packages than other workers in the same company."

Just how much more disclosure Kerry wants is unclear. As it is, executive compensation disclosures already constitute the bulk of most annual shareholder meeting proxy statements.

Indeed, the chief problem with Kerry's proposal is that the existing disclosure rules already provide shareholders with too much information. The assumption behind both the existing rules and Kerry's proposal is that enhanced disclosure will enable shareholders to participate more actively in compensation decisionmaking. Shareholders will complain to the board about excessively high compensation, challenge excessive compensation in derivative litigation, reject excessive compensation plans put to a shareholder vote, and vote out of office directors who approve excessive compensation.

This assumption is dead wrong. Basic financial economics tells us that most shareholders prefer to be passive investors. A rational shareholder will expend the effort to make an informed decision only if the expected benefits of doing so outweigh its costs. Given the length and complexity of SEC disclosure documents, the opportunity cost entailed in becoming informed before voting is quite high and very apparent. Moreover, most shareholders' holdings are too small to have any significant effect on the vote's outcome. Accordingly, shareholders assign a relatively low value to the expected benefits of careful consideration.

As a result, making disclosures more transparent won't help, while requiring greater volumes of information will make the situation worse. For most shareholders, the investment of time and effort necessary to make informed voting decisions remains a game that is not worth playing. Accordingly, they will do what they always do with corporate disclosure: ignore it and simply vote for management's director slate and management compensation proposals.

Some believe that this shareholder passivity model no longer holds true in light of the growing importance of institutional investors. To be sure, institutional investors are an increasingly important force in the stock markets and, moreover, some institutions are playing a more active role in corporate governance. At the same time, however, the passivity model remains applicable even to most institutional investors. Participating in corporate governance is not a cost-less endeavor. Just as with other shareholders, institutional investors must expend resources to make informed decisions. Other than a handful of public pension funds, most institutions have therefore opted for passivity.

In sum, adopting Kerry's proposal will increase the cost to companies of complying with their disclosure obligations, but will not lead to more informed shareholder decisionmaking. As such, it's lousy securities regulation policy.


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