Is It Time to Wind Up the Securities Act of 1933? Strict Liability Makes No Sense in Today's Capital Markets
Spindler, James, Regulation
Mandatory disclosure rules are often perceived as a no-lose quick fix. After all, what is the harm in simply requiring, say, a seller to give a prospective buyer information that the seller already has in her possession? It appears to promote fairness with little, if any, overall social cost.
Based largely on this premise, disclosure rules are a popular choice among academics and legislators. But information is costly to obtain and certainty may be impossible to achieve. The disclosure rules create hidden costs: when information is incomplete or uncertain, the party burdened with making accurate disclosure is made to bear the risk that those disclosures will prove incorrect.
Take a recent example of the costs of disclosure in the corporate compensation realm. The Securities and Exchange Commission recently scrapped part of a new proposal that would have required disclosure of compensation contracts for very highly paid non-executives of public firms. The proposal had come to be known as the "Katie Couric Clause" because it would have required compensation disclosure regarding such entertainment luminaries such as Couric, Jay Leno, and Brad Grey.
Why did the SEC scrap the proposal? The short answer is that Hollywood voiced fierce resistance, claiming it would compromise the privacy of both the studios and the stars themselves. But the more complete answer lies in the nature of what would have been disclosed. Suppose Tom Hanks is being paid with a cut of box office receipts, DVD sales, European licensing, and product merchandising. Full disclosure of Hanks' compensation would require disclosure of those projected amounts. That is, the Hollywood studios would be charged with telling investors what Hanks is going to make in the future based on projections for how their core business projects are going to perform. Guess too low and Hanks' compensation would be wrongly--and perhaps fraudulently--underreported. Guess too high and the firm may wrongly--and fraudulently--overstate the amount of money that it is going to make on its upcoming big-tent film project.
One can imagine that, at the margin, the Couric clause could have affected the way in which compensation contracts are structured--that is, the way that firms choose to pay their employees. One might imagine that this would also affect whether certain employees choose to work for public firms in the first place.
Even though Couric and Leno are now safe, the SEC is charging ahead with the rest of the compensation disclosure proposal, and variable or performance-based compensation is therefore becoming a risky proposition. Full and complete disclosure creates potential liability where compensation is based on fuzzy measures of success or failure. Just ask Dick Grasso who, after a by-all-accounts successful tenure at the New York Stock Exchange, now faces prosecution for his going-away compensation package. Or ask any of the reported 100-plus firms under investigation (as of the time of this writing) for stock options backdating. In hindsight, it can be difficult to distinguish compensation for a job well done from stealing from the till.
The current stock options backdating scandal, which ostensibly involves 29.2 percent of all publicly traded companies, is the same problem writ larger. Were the directors and executives who authorized the backdated awards trying to mislead shareholders as to the intrinsic value of such compensation in order to make it look like option grants were the product of hard bargaining rather than a wink and a handshake? Were the executives who received such backdated awards failing to fully inform the compensation committees about what the awards themselves were? From the outside and in retrospect, it is simply hard to say. But if you require full disclosure regarding these sorts of intrinsically unclear things, and if you make failure to fully and truly disclose punishable by personal civil liability or, under Sarbanes-Oxley, 25 years of jail time, you can expect executives and boards to get a bit jittery. …