The Wall Street Journal


The Follies of Regulation
September 27, 2005; Page A18

Christopher Cox, the newly minted chairman of the Securities and Exchange Commission, has offered the first hints of his direction on substantive policy issues. Addressing the question of exorbitant executive compensation — which has become the focal point of the American public’s concern about corporate governance — Mr. Cox last week raised the venerable battle standard of the SEC: full disclosure. That is too bad; the regulatory philosophy of full disclosure has been tried for over 70 years and been found sadly wanting as a way to protect shareholders from corporate and financial abuses.

Of course, Mr. Cox has a large and probably ideologically hostile bureaucracy to contend with, was accused of being too “pro-business” by Democrats before he took office, and faces a public that has rarely been as angry about corporate derelictions as it is right now. But such is the stuff that leadership is made of, and one can hope that Chairman Cox’s initial sally into the regulatory wars is merely a feint to test the enemy’s position.

The problem begins with thinking (as reflected in his statement) that shareholders will use the information they receive as a result of full disclosure laws to make their hired agents toe the (bottom) line. But while information that would not otherwise be available is valuable to those who trade in it or make their livings dealing with it, that is not the position of most shareholders. That includes most institutional investors, to whom some savants look for shareholder protection.

Shareholders who do not also control a corporation and designate the management cannot supervise and monitor managers and their salaries. Despite the apparatus of the derivative suit, courts are rightly reluctant to overturn compensation decisions by independent boards. Even those who do have control but not all the shares, may, for familiar free-rider reasons, spend less on monitoring than they would if they owned all the shares. And, not just incidentally, institutional investors are barred from owning control of portfolio companies by the Investment Company Act of 1940.

The result in many large, publicly held companies is precisely the situation that Berle and Means, in their 1932 classic, “The Modern Corporation and Private Property,” envisioned and condemned as the “separation of ownership and control.” Today the more commonly used term is “agency costs.” Call it what you will, the implications are clear. With no effective means for shareholders to monitor the self-interested or even merely stupid behavior of a corporation’s managers, a lot of peculiar things begin to happen.For example, even independent boards will tend to pay managers higher salaries or other compensation than would be true in non-publicly held companies, since the competitive and oversight pressures for restraint are relaxed. Managers may hoard cash to guarantee their own emoluments or to expand an “empire,” even though a payout would be more in the shareholders’ interest. They may use corporate funds to overpay other employees and avoid the headaches of labor strife. Or they may use corporate funds for nonprofitable ventures or “social” purposes, justified as part of the corporation’s “social responsibility,” but not in the shareholders’ interest. We can, and do, see all of these things happening today and in greater amounts than ever.

Most shareholders do not care whether their investment is tanking because the executives are overpaid or because the same people live like monks and give all the company’s wealth to good causes. Disclosure of the facts, of the sort the SEC has so long and disingenuously promoted — and which Chairman Cox sounds like he is still pushing — will not make a significant difference in what actually occurs. This is especially so on a matter like executive compensation, where real competitive market forces do, in fact, substantiate obscene-sounding compensation figures and the business judgment rule will generally prevent courts from second-guessing the market.

By and large, the media, the government, and many academics have been looking for the explanation for “obscene” executive compensation in the wrong places. Greed, immorality, lack of full disclosure and cronyism have precious little to do with corporate economics. For at least 45 years, legal and finance scholars have had available the explanation of what is going on and, at least in theory, the proper fix for apparent problems. Alas, that fix is now so politically out of the mainstream that other, far less desirable solutions are regularly proposed.

A brief review of the economics may be useful for regulators and businesspeople alike. We start the scenario with managers of a publicly traded company who are providing less than the maximum feasible rate of return on the corporation’s assets. Consequently, share prices, sensitively following the facts, decline relative to those of similar companies that are well managed. When the decline is sufficient that the difference between the purchase price of control shares and a higher share price expected from new management would cover the costs of a displacement action, the incumbents will be ousted and replaced by more competent managers.

This process occurs easily when enough shares are held by one or a few collaborating shareholders (and this includes hedge funds, which, for this reason alone, should not be further regulated) to allow them to vote the board and the overpaid executives out of office and preferably out of town. But when shares are widely owned and no one has a controlling block, incumbents cannot be so easily “fired.” Some other mechanism is required. Since the coordination costs of organizing diffused shareholders into a block are usually insurmountable, direct shareholder democracy in the form of a proxy fight has little chance of solving the problem. Only in the make-believe world of SEC regulation could anything like the proxy fight be seen as a significant solution to the agency-cost problem of exorbitant salaries.

But free markets do not tolerate economic inanities for long, even in the case of large, publicly held companies. Contrary to the popular liberal shibboleth, markets do not often fail on their own. It usually requires help from the government. In the late ’50s and ’60s, we witnessed the early development of the hostile tender offer — the most powerful market tool ever devised for dealing with non-profit-maximizing managers in publicly held companies. It did not appear before this time for the simple reason that there were very few companies that had the wide diffusion of stock ownership prerequisite to hostile tender offers. Tax laws and a growing understanding of the virtues of share diversification changed all that, and hostile takeovers were not slow then in making their appearance.

But their appearance was, for incumbent managers, a terrifying thing: surprise offers for almost all outstanding shares at a huge premium over current market price — and with little time for shareholders or the corporation to shop the offer, or for the incumbents to mount a counterattack or defense. The opportunity for affording such a premium, of course, was created by the low stock market value generated by the policies of the incumbent managers. There were no inefficiencies in the stock market that generated incorrectly low prices for these companies’ shares.

Even today, mention of the surprise hostile tender offer is enough to throw most executives into paroxysms of hysteria. And the politics of the situation were such that Congress, at enormous cost to shareholders, passed the Williams Act in 1968 to put a stop to surprise tender offers. Public disclosure of takeover intentions and plans for management, plus a lot more, were required to be made public when 5% of the target shares were acquired. This, of course, elevated the price of the other 95% of shares immediately and very significantly reduced the profitability of a takeover. State legislatures also got into the act with various anti-takeover rules, and state courts made it a lot easier for companies to adopt defenses or otherwise prevent a hostile takeover.

The number of hostile takeovers plummeted, and negotiated mergers and friendly takeovers increased to fill the gap. In these methods of changing control, however, incumbent managers became integral participants in the process of displacing themselves. Profits from control transactions, which previously were shared only between the shareholders and the raiders, now have to be shared as well by the incumbent managers, perhaps in the form of continuing employment without real responsibility.Further, as the cost of waging a successful displacement of incumbents escalated, managerial compensation was bound to go up. Any addition to the costs of displacement made just that amount of money available, which incumbents could claim for themselves. They did not have to perform better to get the higher figure; it was just there for the taking. Thus, the Williams Act and state takeover laws laid the groundwork for the controversy over executive compensation that we see today.

This is not just airy theory. Markets do work, and to the extent that these costs must enter the calculations of raiders and lower the number of hostile takeovers, the ensuing rents have to go somewhere. The most likely recipient of truly free and unconstrained money is the one who designates the recipient. And as some companies take advantage of this situation, competition forces everyone else to meet the new and higher market price for executives. That is the most obvious explanation of why we are seeing more and more obscene salaries.

Of course, the executives might choose to use some of the money for social purposes or good labor relations. This might make them feel better or keep pesky activists at bay. An increase in such behavior was predictable as management-displacement costs increased. Since the money is available, demands for such expenditures by anyone with an even slightly plausible-sounding claim on corporate funds became louder and shriller. The current frenzy for corporate social responsibility and stakeholder benefits has the same economic genesis as the obscene CEO salaries that Chairman Cox has vowed to curtail.

Until we return to something like the pre-Williams-Act market for corporate control, we shall continue to see egregious salaries, crazy option grants, and golden handshakes and parachutes. Disclosure as a solution to that problem is a bit like a New Orleans levee faced with Katrina. A return to the takeover law of the ’60s would substantially solve the compensation problem without ungainly regulation, and it would also deliver us from vacuous and harmful notions of corporate social responsibility. All that is required is a little guts from Mr. Cox, confidence in free markets from the managers of large corporations, and some humility about economic regulation from the U.S. Congress.

Mr. Manne, a resident of Naples, Fla., is Dean Emeritus of the George Mason University School of Law.

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