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Chief Economist Reviews The Nature of Shareholdings

In remarks to the National Investor Relations Institute, the SEC's chief economist, Chester Spatt, discussed the nature of shareholdings. He said that corporate decisions about the form and level of compensation have received the attention of investors and regulators because of the conflict that, despite various safeguards, is so direct. The options backdating scandal represents the most recent example of these concerns, he said.

Most people would agree that accounting policy should attempt to set a level playing field and to be neutral about the different types of compensation, Spatt said. With respect to option grants, he said that satisfying the underlying measurement objective of FAS 123R, which is to reflect the cost to the company, is crucial for proper estimates of this expense. The concept of options expensing was controversial, he said, and the recent backdating scandal sheds more light on the controversy.

Spatt pointed to the strong evidence that stock prices tended to decline prior to the issuance of grants and to rise right afterwards. Recipients tended to be extremely lucky in obtaining particularly low exercise prices for the issuance of the option grants, he said. The evidence suggests that the option grants reflect not only the timing of firm-specific price movements, but also of market-wide movements. The latter seems implausible to most financial economists, he advised, unless the grants reflected knowledge of post-grant price movements. He also pointed to the reduction in these patterns after the Sarbanes-Oxley Act required that grants be disclosed within two days, which limited the opportunity to backdate options.

From an economist's perspective, Spatt said the purpose of option compensation is to align the employee's incentives for stock performance with those of the shareholders. Backdating, however, leads to a very different form of compensation from what was disclosed. It also raises questions about the conflict associated with the self-interest of management. Spatt said that disclosure in this area is very important because of the potential conflicts.

The impact of increased disclosure requirements on compensation is not clear, Spatt added. Enhanced disclosure could reduce executive compensation. On the other hand, if the executive requires a compensating differential when his or her compensation is disclosed, it may increase the affected executive's compensation. The compensation disclosure by other firms may also alter the bargaining power between a firm and its executives, he said.

Spatt also addressed the contrast between direct ownership on the books of a firm and indirect ownership through omnibus or street name accounts. He pointed to a growing focus on the rights and responsibilities of ownership, including the different taxation on dividends and dividend substitutes, short sales, borrowing and securities lending.

When owners hold shares in street name, they are arguably delegating to the broker-dealer the responsibility to act for them. This delegation is not necessarily without cost, he said. The investor's access to the voting ballot can be impaired due to a failure to deliver the shares or because of the loan of the shares when they are in a margin account. Many shareholders have little interest in asserting their voting rights, Spatt said. However, voting issues are subject to an ongoing discussion, including the NYSE's proposal on broker votes and the SEC's electronic voting initiative.

Spatt noted that one cost of delegating ownership through a street name is the potential for receiving a dividend substitute rather than an actual dividend when the securities are lent. This represents a substantial cost due to the difference in tax treatment since 2003 between ordinary dividends that can qualify as long-term capital gains and dividend substitutes which are taxed as ordinary income. Retail investors are not always compensated for this cost, he said.

Conventional brokerage agreements require the customer to allow the broker-dealer to loan the shares in return for the ability to borrow capital and to borrow shares from others to create short positions. This is an indirect cost of borrowing, according to Spatt. However, he finds it puzzling that customers who sell stock short do not receive an interest credit for the short sale proceeds that the short sale frees up. Spatt wondered why short positions are so costly in the retail area and why competition does not force more reasonable pricing of long versus short positions. It illustrates one way in which intermediaries benefit from the clients' form of ownership, he said.