We know that people respond to incentives, and that behavior will adjust in response to relative changes in price. But I think itâ€™s commonly assumed that the only relevant price change attributable to disclosure regulations is the nominal change in direct costs of compliance. Sure, we all understand that if shareholder or regulatory pressure is brought to bear on corporate actors as a consequence of disclosure, that pressure can change behavior. But for some reason we’re unduly optimistic about this change; we just assume it will be for the better (you know, because “sunlight is a good disinfectant.” Brandeis said so).
But I want to point to another, I think overlooked, aspect of this dynamic: Behavioral changes taken by corporate actors to minimize disclosure-induced, unfavorable (by which I mean privately-costly) consequences. These adjustments can be costly. They may whittle away whatever benefits we think might arise from the disclosure obligation in the first place, and, ironically, they may actually staunch the flow of information.
What Iâ€™m interested in is how disclosure regulations might alter substantive behavior, particularly in unintended fashion. It was probably once the case that disclosure obligations were intended merely to inform and not to regulate. But I doubt that is any longer the case, although rhetoric (which is to say, compliance with statutory authority) is sticky. The idea that targeted disclosure regulation has substantive effect is not newâ€”my dad mentioned it back in 1974 (and probably before); Steve Bainbridge more recently in The Creeping Federalization of Corporate Law. Iâ€™m sure there are many other examples. But we should also consider how disclosure has unintended, substantive effect as a function of actors’ efforts to avoid disclosure.
Proponents of disclosure regulation recognize that such regulations may â€œworkâ€? if the private benefit of conduct (say, taking an exorbitant pay package) decreases by dint of disclosureâ€”either directly because of pressure to reduce compensation, or indirectly if the executive feels shame (or some other psychic cost) once his compensation is made more public. What proponents seem to forget is that rational actors will spend up to the expected amount of that decrease in order to avoid it.
So hereâ€™s the basic abstract idea, call it the hydraulic theory of disclosure regulation: If required disclosure of activity A increases the cost of activity A relative to that of activity B, actors will shift some of their conduct into activity B. Pretty straightforward, right? Itâ€™s a basic substitution effect. Behavior A plus disclosure is more costly to some actors than behavior B without disclosure, so there is a shift toward behavior B. Will behavior B always be preferable to evil behavior A? I donâ€™t think we can know that ex ante, and sometimes the answer must be “no.”
And regardless of the relative merits of behaviors A and B in the abstract, if actors shift from regulated behavior A to unregulated behavior B, we have not increased information flow. In fact, quite to the contrary, we have induced a reduction in available information. Hardly a winning result for regulation aimed at disclosure of information. Iâ€™m pretty sure this sort of behavioral response to disclosure regulations is rarely considered, perhaps because disclosure is presumed not to be costly. But thatâ€™s patently falseâ€”not because of nominal compliance costs, but simply because othersâ€™ knowledge of oneâ€™s behavior can make that behavior less attractive.
So there are two costly aspects to this. First, as disclosure rules impose costs on the underlying behavior subject to disclosure, where behavior can be altered at lower cost than the cost of disclosure, disclosure rules will induce behavioral changes rather than increased information flow. This can be costly, to say nothing of contrary to regulatory intent (but maybe we have to count that in the benefit column . . . ). Second, as disclosure rules impose costs on the underlying behavior subject to disclosure, where behavior can be altered in a manner that lessens the cost of disclosure, disclosure rules will induce behavioral changes. These changes may not be desirable.
Hereâ€™s an example: SOX Â§406 requires companies to disclose waivers of their codes of ethics in an effort to bring the magical disinfectant of sunlight (and deterrence) to bear on particularly worrisome conduct. But there is an implicit assumption animating the presumption of deterrence that conduct will be relatively staticâ€”that codes of ethics wonâ€™t change in response. In fact, the more likely outcome is that codes of ethics will be (and have been) re-written in order to minimize the need for waivers, in the event actually stemming rather than improving the flow of information. In other words, disclosed waivers are (privately) costly, and it may be less (privately) costly to amend codes of ethics than to seek and publicize waivers. Underlying behavior may not change one whit (or it may get worse), but either way less of it will be disclosed. (On this aspect of SOX, see my colleague John Krogerâ€™s article, Enron, Fraud and Securities Reform: An Enron Prosecutorâ€™s Perspective.)
Or what about this? An executive is receiving a nice, pay-for-non-performance compensation package. His plan is complex enough that under current disclosure rules no one can really tell what itâ€™s worth, nor precisely how much pay comes from which source. Enter the new disclosure proposal. Letâ€™s assume it does what it’s intended to do (a dubious proposition, I know). Assume some analysts are now paying attention, the directors are getting squeamish, and a couple of big shareholders are squawking. Maintaining the “exorbitant” package might become much harder (and Iâ€™d wager, rhetoric to the contrary, for many this and not mere disclosure is the intent of the regulation). There are two options: Reduce/re-organize pay (which is to say, in the Bebchuk & Fried managerial power model, give back some of the ill-gotten rents to the shareholders) or find an alternative mode of compensation which is either a) not subject to disclosure or b) less susceptible of negative interpretation, even if disclosed. What might this look like? In the obvious (but maybe unrealistic) case, shirking comes to mind. Canâ€™t maintain the outright $10 million package for the work you did before? How about the $10 million performance-based (riskier) package for less work? Or how about $8 million, but we go ahead and build that new building youâ€™ve been pushing for, the one designed by Frank Gehry? Or we could upgrade the fleet of jets like you’ve been asking. Any of these forms of compensation would be undisclosed. I imagine the options are limitless, and I have to believe that they will be opted for. Oh, and if the options arenâ€™t immediately apparent to the executive and/or the board, then be sure to add in the additional cost of determining what they are.
Dealing realistically with the possibility that mandatory disclosure has costs is not the norm. One recent exception is Mike Guttentagâ€™s work. (Find his articles on disclosure here). Although I donâ€™t think Mike considers the sorts of costs I suggest here, he at least takes seriously the possibility that disclosure is not costless. We would surely do well to have more work of this sort.
By the way, Larry comes close to making this point today when he notes that perks and other illegitimate compensation wonâ€™t likely make it within the ambit of the new executive compensation disclosure rules. He need only have added, â€œand thus the new rules will exacerbate the problem.â€? Chicken soup, indeed.