Professor Bainbridge...on law, politics, religion, culture & food

The fallout from Grasso? How about more worthless disclosure?

How will public corporations respond to the Grasso imbroglio? The New York Times speculates:

Directors of big companies, already under pressure to demonstrate independence from management, are now worried that they will be blamed for failing to explain not only how much but how they pay chief executives. ...

When companies send proxy statements to shareholders early next year, [Tom Wamberg, chief executive of Clark Consulting] said, they will be noticeably thicker, because directors feel compelled to spell out the terms of the deals they have struck with company officers.

"Our advice to our clients is overcommunicate, overexplain," Mr. Wamberg said. "For each required disclosure, what could have been four paragraphs is going to be eight paragraphs."

Wamberg's prediction strikes me as just about right. Risk averse lawyers will not want to be blamed by their clients if the firm gets bad PR for inadequate disclosure, let alone getting sued (successfully or not). Risk averse directors would rather provide excess disclosure than risk the sort of harm to their reputation that the NYSE's directors are currently experiencing. But is extra disclosure a good thing?

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 a discussion of why rational apathy is a good thing, see HERE.)

The SEC has consistently ignored these textbook principles, insisting that shareholders want more and better disclosure of executive compensation. Ultimately, however, more comprehensible information doesn't help and greater volumes of information only makes 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. What then will shareholders do with the enhanced disclosure they will be getting post-Grasso? 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 undoubtedly remains applicable even to most institutional investors. Participating in corporate governance is not a cost-less endeavor. Just as with any other shareholder, institutional investors must expend resources to make informed decisions. Most institutional investors therefore will probably seek to free-ride on the efforts of the few who are willing to expend such resources. As is typical of free-riding situations, this means that virtually no one will make informed decisions.

In sum, shareholders will want boards to make cost-effective disclosures. They will not want the board to spend a dollar on disclosure unless the shareholders get back at least $1.01 worth of additional value in the form of more informed decisions, greater accountability, and additional transparency. My guess is that Wamberg is right, and that many corporations will be spending a lot more on disclosure than the value the shareholders will get back.