On January 6th, the Securities and Exchange Commission announced a new regulatory initiative to "consider whether to propose amendments to the disclosure requirements for executive and director compensation, related party transactions, director independence and other corporate governance matters, and securities ownership of officers and directors." The seemingly innocuous wording of the notice conceals a plan said to be of sweeping proportions.

Blogger Mark Carey reports that:

Under the control of Chairman Christopher Cox, who has made executive pay his priority agenda, the SEC may soon begin to require complete disclosure in proxy statements for total compensation of the top five highest paid executives. Locating total compensation has been an elusive effort for most shareholders. The information is typically buried in corporate filings. The SEC is believed to propose a new table in corporate proxy statements that will provide a breakdown of total compensation, including stock options and their value.

The proposed changes to be announced at the January 17, 2006 meeting ... may also require: 1) a lower reporting threshold of total aggregate perks to $10,000; 2) disclosure of specific change in control payments; 3) new compensation table that would also include retirement pay; and 4) a new compensation table for executives.

According to law professor and blogger Larry Ribstein, the cost to corporations to provide such disclosures will be substantial:

The WSJ says that the disclosures are more than any company is doing, even the "roughly 25% of the 500 biggest public companies in the U.S. [that] now disclose more about executive pay than current rules require." So there's a lot of new direct costs down the pike. The story quotes a securities lawyer as saying "It will take real preparation." ...

And then we have the same big-small problem as under Sarbox: the per capitalization costs of disclosure are more -- possibly way more -- for small than for big companies, particularly if the disclosures require more than the companies are already doing for tax purposes. Moreover, the smaller companies are generally riskier, and therefore must compensate their executives more aggressively.

There likely will be additional indirect costs. New disclosure requirements, for example, almost always create new opportunities for securities fraud litigation when errors occur in the mandated disclosures.

These costs might be worth bearing if the new disclosure rules were likely to benefit investors, of course. The odds are that the new rules will not do much for investors, however.

The logic of the SEC's proposal is that enhanced disclosure will enable 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.

If shareholders are rationally apathetic, more information will not lead to better decisions. Indeed, greater volumes of information will only make the situation worse.

Because the SEC's proposed new executive compensation disclosure rules thus will increase the cost to companies of complying with their disclosure obligations, but will not lead to more informed shareholder decision making, what then is their purpose?

One can infer that, in adopting these rules, the SEC got back into the therapeutic disclosure business. In other words, the Commission is using 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, and it 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. The last time the Commission tinkered with the executive compensation disclosure rules the SEC said that it wanted to 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.

It's disappointing that new SEC Chairman Cox has decided to make his first signature issue one whose costs exceed its benefits and which strikes a blow against the basic principles of competitive federalism that are the peculiar genius of American corporation law.