Is sunlight always the best disinfectant?
Ever since Brandeis turned the neat phrase “sunlight is the best disinfectant; electric light the best policeman” in praise of transparency, it has been virtually accepted wisdom in legal and policy making circles. But the efficiency and efficacy of “sunlight” is not always so obvious.
Consider two examples raised by new SEC Chair Christopher Cox. Cox said that two of the SEC’s priorities during his tenure will be requiring better disclosure of executive compensation and enforcing the new SEC registration rule for hedge funds, which is intended to help investors get more disclosure from funds. Both of these are, at best, a misallocation of the SEC’s scarce resources, and, at worst, flatly wrongheaded.
On executive compensation, the SEC’s concern mimics recent media and academic hand wringing about levels and types of CEO pay. The SEC apparently has bought the argument of academics Lucian Bebchuk (Harvard) and Jesse Fried (Boalt), that CEOs use their power over boards and shareholders to camouflage the true amounts of their compensation. (My forthcoming paper on executive compensation of firms in financial distress shows that the managerial power theory of Bebchuk & Fried is wrong or incomplete in that employment contracts written in low agency cost environments (distressed firms with few owners) are the same in amount and form as those written in higher agency cost environments (healthy, public firms). In other words, something more than managerial power must explain current compensation practices.) To prevent CEOs from hiding the true nature of their pay, Cox wants “shareholders [to] have one number, [with] . . . the different kinds of executive compensation add[ing] up to a number that's comparable, executive to executive and company to company.”
While this seems unobjectionable at first blush, there is absolutely no evidence that it will be effective, while it will impose real costs on shareholders. Putting aside issues of whether shareholders actually want such disclosure (if they do, why aren’t companies providing it already?) and whether the market is defective as Bebchuk & Fried suggest (and my paper refutes), the idea that disclosure is a panacea has already been discredited. During the last epoch of executive compensation hysteria in the early 1990s (before the stock market boom made the debate seem quaint), President Clinton signed legislation amending the tax code to require, among other things, increased disclosure of compensation. Proponents dragged out Brandeis’s old chestnut in defense of transparency, and the expected result was for shareholders to rise up and demand less compensation.
What actually happened was exactly the opposite. Shareholders remained passive investors, as the economic models predict, and managers’ compensation increased. One explanation for the increase was that CEOs, by nature a competitive lot, had more data to compare themselves to their competitors. If Susie running XYZ Corp. is making $5 million per year, then Harry running ABC Corp. figures he deserves at least that much. Disclosure in this case led boards to set compensation levels using an “above industry-average” methodology, which had the effect of ratcheting up all compensation levels – after all, no one wants to be below average, and firms looking to attract talent certainly won’t pay below average. Welcome to Lake Wobegon. Without the facts about what other CEOs make, boards would be forced to use other, internal calculations about CEO worth when negotiating about the market-clearing price for CEO talent. Instead of developing these techniques, executive compensation consultants and boards took the easy route provided by the disclosure. In this state of the world, providing a single number, assuming that this can be done in a meaningful way at a reasonable cost (something I doubt), may only make this tendency worse. The SEC, an “expert “ agency that is supposed to make empirical, fact-based decisions, should consider the potential unintended consequences of disclosure in a market like this before it acts.
The wisdom of more disclosure in the hedge fund industry is also questionable for several reasons. First, investors apparently aren’t bothered by the amount of disclosure currently provided by firms. Since 2000, investors have poured over $1 trillion into more than 10,000 new hedge funds, growing the industry to over $1.5 trillion. If investors were spooked by the amount of disclosure these new funds or the existing funds are providing, we wouldn’t see the money flowing in. (One potential counterargument here is that the SEC senses a bubble in the making, and is trying to burst it or prevent it from growing out of control. Evidence of this might be the fact that in the past year assets under management grew almost 40 percent while the industry beat the S&P index by less than 2 percent. If this is what the SEC is up to, and it isn’t at all clear, there are grounds for caution. The SEC’s onerous disclosure requirements didn’t prevent the Internet bubble from forming or bursting, and thousands of investors lost billions of dollars notwithstanding the fact that Pets.com and its ilk complied with every SEC disclosure regulation.)
Second, as recent survey data from Hedge Fund Manager magazine shows, about 80 percent of hedge funds provide investors with data about performance and other non-proprietary characteristics of the fund. But shouldn’t we be concerned about the 20 percent of firms that aren’t providing such data? Not really. We would be concerned if firms that are likely to commit fraud or meltdown are those not providing disclosure, but the survey evidence shows that new, small firms--the ones most likely to be frauds--are forced to provide disclosure to attract business, while the (marginally less risky) large, well-known firms with strong performance rely more on word-of-mouth reputation. This is a market working as it should, with firms basing disclosure decisions based on cost-benefit analysis, and with reputation playing a strong role.
Third, current regulations keep the pool of investors limited to sophisticated investors who, under the SEC's own precedents and governing philosophy, don’t need the protection of the securities laws. At current, only qualified investors with greater than $5 million in net worth (about 200,000 lucky Americans) and institutional investors (mutual funds and pension funds that the rest of us hold) can invest in hedge funds. It is difficult to argue that these investors need the help of the SEC to get more information about hedge funds, especially when the SEC admits that it doesn’t fully understand the industry, and is planning to use the new regulations to get up to speed with the investment community.
Finally, the recent enforcement actions against fraudulent funds like the Bayou Group, Rocker Partners, and Pontus show that the government is able to punish and deter wrongdoing through good old-fashioned fraud investigations based on tips from insiders, disgruntled investors, and enterprising analysts and journalists. According to industry experts, these successes have already increased demands within the industry for more disclosure and self-policing. While we should expect an increased awareness of the risk of fraud to lead to more regulation, these successes show that more enforcement of existing laws may be a more efficient result.
So while Brandeis was definitely on to something, it isn’t clear that the benefits of disclosure always outweigh the costs. As Richard Epstein says about publicly financed sports stadiums, the costs are real and the benefits often illusory. So too with disclosure.