TCS Daily

Chairman Donaldson Oversteps His Bounds Again

By Stephen Bainbridge - March 4, 2005 12:00 AM

Periodically, Securities and Exchange Commission Chairman William Donaldson worries publicly about executive compensation. As he has done several times in the past, Donaldson recently told the Wall Street Journal (sub. req'd) that the SEC's rules governing executive compensation need to be revised so as to make corporate disclosures in this area more transparent. This time, however, Donaldson went on to suggest the need for substantive regulation.

Chairman Donaldson told the Journal that some officials are paid simply for hitting Wall Street earnings estimates rather than for actually improving their company's long-term performance. Donaldson apparently wants to change that culture by getting corporate pay closer attention to the metrics they use to set executive compensation.

Let's be clear about two things. First, the SEC has no power -- none, nada, zilch -- to regulate the substance of corporate governance, including but not limited to the merits of executive compensation. As the U.S. Supreme Court has made clear, these issues are left to state corporate law. The SEC thus has no business trying to regulate -- even if only through use of the Chairman's bully pulpit -- substantive issues, such as the metrics by which boards set compensation. Second, while the SEC has authority to regulate corporate disclosures relating to executive compensation, it should be loath to do so.

In CTS Corp. v. Dynamics Corp. of Am., 481 U.S. 69 (1987), for example, the court explained that "state regulation of corporate governance is regulation of entities whose very existence and attributes are a product of state law." Accordingly, the court reaffirmed that: "It . . . is an accepted part of the business landscape in this country for states to create corporations, to prescribe their powers, and to define the rights that are acquired by purchasing their shares."

In CTS, the Supreme Court further explained that the country as a whole benefits from state regulation in this area. Justice Lewis Powell observed for the majority that the capital markets are essential for providing capital not only for new enterprises but also for established companies that need to expand their businesses. In turn, Powell opined, these markets and the "beneficial free market system" they comprise depend on the fact that corporations are organized under, and governed by, the law of the state of their incorporation.

This is so in large part because ousting the states from their traditional role as the primary regulators of corporate governance would eliminate a valuable opportunity for experimentation with alternative solutions to the many difficult regulatory problems that arise in corporate law. As Justice Brandeis pointed out many years ago, "It is one of the happy incidents of the federal system that a single courageous State may, if its citizens choose, serve as a laboratory; and try novel social and economic experiments without risk to the rest of country." (New State Ice Co v. Liebmann, 285 U.S. 262, 311 (1932).) So long as state legislation is limited to regulation of firms incorporated within the state, as it generally is, there is no risk of conflicting rules applying to the same corporation. Experimentation thus does not result in confusion, but may well lead to more efficient corporate law rules.

Where then do we draw the line between the state and federal regulatory regimes? As a general rule of thumb, federal law appropriately is concerned mainly with disclosure obligations, as well as procedural and antifraud rules designed to make disclosure more effective. In contrast, regulating the substance of corporate governance standards is appropriately left to the states.

As that last observation suggests, the SEC admittedly has authority to regulate disclosure, including disclosure relating to executive compensation. As a prudential matter, however, this is an unwise use of the SEC's powers.

To be sure, the SEC long has argued that its rules should provide shareholders with a clear and concise presentation of compensation paid officers. Presumably, greater disclosure enables shareholders to 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.

The theory of rational shareholder apathy, however, predicts 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. (For reasons I've discussed elsewhere, the rising importance of institutional investors doesn't change this basic fact.)

If shareholders are rationally apathetic, more comprehensible information will not lead to better decisions. Indeed, greater volumes of information will only make the situation worse. If the SEC's executive compensation disclosure rules thus increase the cost to companies of complying with their disclosure obligations, but do not lead to more informed shareholder decisionmaking, what then is their purpose? One can but infer that Donaldson wants the SEC to get back into the therapeutic disclosure business. In other words, he wants the Commission to use disclosure requirements not to inform shareholders, but to affect substantive corporate behavior. In this case, to put the brakes on executive compensation.

Therapeutic disclosure requirements undoubtedly affect corporate behavior. Therapeutic disclosure, however, is troubling on at least two levels. First, seeking to effect substantive goals through disclosure requirements violates the Congressional intent behind the federal securities laws. When the New Deal era Congresses adopted the Securities Act and the Securities Exchange Act, there were three possible statutory approaches under consideration: (1) the fraud model, which would simply prohibit fraud in the sale of securities; (2) the disclosure model, which would allow issuers to sell very risky or even unsound securities, provided they gave buyers enough information to make an informed investment decision; and (3) the blue sky model, pursuant to which the SEC would engage in merit review of a security and its issuer. The federal securities laws adopted a mixture of the first two approaches, but explicitly rejected federal merit review. As such, the substantive behavior of corporate issuers is not within the SEC's purview.

Second, and even more disturbing, in this case the SEC's rules overstep the boundaries between the federal and state regulatory spheres. In the past, the Commission has contended that its rules bring shareholders into the compensation committee or board meeting room and thereby enable them to see specific decisions through the eyes of the directors. This goal, however, flies in the face of the separation of ownership and control created by state corporate law. Under state law, shareholders have no right to approve most board decisions, let alone to initiate corporate action. Of particular relevance in this context, shareholders have no right to participate in compensation decisions. In other words, they have no right to be brought within the meeting room.

In sum, Donaldson ought to go about his business. The SEC has plenty to do without getting into these areas in which it has no power or authority.


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