In the wake of the Enron collapse and other highly publicized business scandals, corporate governance has become a hot topic. A number of Tuck professors and the Center for Corporate Governance are looking at what works, what doesn't, what's broken, and how to fix it.
Corporate governance didn't begin with Enron, though sometimes it seems that way. The 2001 implosion of one of America's largest companies in a convoluted heap of scandal and accounting fraud rattled investors' and the public's confidence in its corporations and put the need for changes in how companies govern themselves into sharp relief.
"The most important effect of scandals such as Enron, WorldCom, Parmalat [Italy], and Ahold [the Netherlands] is that they create the political impetus for change," says B. Espen Eckbo, Tuck Centennial Professor of Finance and founding director of Tuck's Center for Corporate Governance, started in 1998. "We had been talking about the need for changes for years, but it's hard to get the world to turn. Angry people are in a better position to push the system."
The Heart of the Problem
In countries like the U.S., with well-developed financial systems, governance of public companies is driven by the balance of power among shareholders, boards, and top executives. That balance, says Eckbo, is out of kilter. As an agent for the owners of the firm, the board is supposed to protect the shareholders, but it has no strong incentive to do so. As companies grow, the shareholder base becomes dispersed; each shareholder has only a tiny stake in a given company and little incentive to actively monitor it. Shareholders don't show up at meetings because it's simply too expensive. If they bother to vote by mail, they tend to passively vote with management. They become "rationally impassive," Eckbo says, and the board, lacking input from shareholders, looks to management for guidance. "If the board doesn't see the shareholders, they'll turn to management, and management has a lot of incentive to influence the board," though not necessarily in ways that are in shareholders' interests. Eckbo has written that the "absentee shareholder" breeds "corporate arrogance," and this combination of "shareholder absenteeism and strong corporate insiders...creates a problem that lies at the heart of today's governance crisis." The board's role in protecting shareholder interests is further compromised by the practice common in developed nations of having CEOs and other corporate insiders sit on corporate boards and, in the U.S. at least, typically chair those boards. Since hiring and firing corporate managers is one of the board's chief responsibilities, this practice creates an inherent conflict of interest. That conflict, says Eckbo, has led to many governance abuses, including "draconian" measures to block takeover bids, even though a hostile takeover may be in shareholders' best interest.
CEO Compensation
Excessive power in the hands of senior executives was one manifestation of the corporate world's seeming obsession with the superstar CEO, agrees Robert Howell, Distinguished Visiting Professor of Business Administration. Another is excessive compensation. Howell handles financial training for the National Association of Corporate Directors, a nonprofit organization that looks at the role of boards in corporate governance. "Corporate compensation, as currently practiced," he says, "is fraught with problems. The methodology for paying CEOs in the U.S. has been to look around and see what other companies are paying their CEOs. We have a peer comparison basis. Some of these hired executives think they're entitled to make very large salaries and accumulate retirement benefits that let them live luxuriously in their retirement. Personally, I think it's excessive for a hired executive to retire a near-billionaire. A CEO ought to get paid for results." And, Howell adds, these exorbitant compensation packages are increasingly being awarded to highly visible, quick-fix CEOs with no real attachment to the companies they are hired to lead. He would like to see more leaders like Warren Buffett of Berkshire Hathaway and Microsoft's Bill Gates—long-term builders who, not incidentally, have been rewarded handsomely for their efforts and results. Howell says that another part of the compensation problem was the practice of giving executives stock options as a substantial part of their compensation package. If the stock price goes up, the executive gets rewarded, and this may create incentives for driving up the stock price, such as stretching the company's financial results. Also troubling was the tendency of most companies to avoid booking options included in compensation packages as expenses on their income statements, thereby overstating reported earnings and making the companies look stronger. "They are effectively misrepresenting their results to their shareholders and the general public," he says.
When Laws Matter
Following the predictable physics of the business world, action—in these cases, scandal on a large and public scale—begot reaction, in the form of law. The 2002 Sarbanes-Oxley Act was a quick response to Enron, WorldCom, Tyco, and other corporate disasters.
Sarbanes-Oxley called for a number of changes, including more stringent financial-reporting guidelines, greater auditor independence, public reporting of executive compensation, and increased civil and criminal penalties for failure to comply with the law. One of its most visible provisions holds CEOs and CFOs personally accountable for the accuracy of their company's books, requiring them to certify that reported financial records are truthful and don't omit any material facts. The law has been controversial—some see it as a much-needed legislative response to corporate misconduct, while others think its reporting requirements are unfairly onerous and expensive, especially for smaller companies.
Professor of Finance Rafael La Porta, an international expert on corporate governance, isn't convinced that Sarbanes-Oxley—or any increased public enforcement—is the answer, as least as far as the development of financial markets is concerned. Although he acknowledges that it is difficult to measure the strength of public intervention, he has not found it to correlate with large financial markets. "We don't see criminal sanctions as leading to good outcomes," he says. "They don't correspond to bad outcomes either, but they don't seem to be a good use of resources."
But laws, says La Porta, who has conducted extensive research on the relationship between law and finance, do matter and work best when they designate the rules by which the private sector plays the game. The healthiest environments for markets to thrive are those where laws require open, accurate, and complete disclosure of company information and make it possible for interested parties to take action against those who fail to provide it. "The sun is the best disinfectant," says La Porta (paraphrasing U.S. Supreme Court Justice Louis Brandeis). "You provide for ample disclosure and you allow investors to hold insiders liable if disclosure turns out to be false."
La Porta's work focuses on understanding cross-country differences in the development of financial markets. In one study of securities laws in 49 countries, he and his collaborators compared the influence of public enforcement and private-sector enforcement through prospectus disclosure and litigation on stock-market development. They found that unregulated markets are small but found no evidence that public enforcement boosts market development. By contrast, they found ample evidence that laws mandating disclosure and facilitating private enforcement are good for stock markets. Another study looked at the regulation of self-dealing in 72 countries and found that stock markets are larger in countries where shareholders get both the information they need about a company and the power—through voting and litigation—to act on it. "There is a particular kind of regulation that works," La Porta says, "and that is regulation that supports private enforcement through disclosure and litigation."
When Size Matters
One of the most influential developments in corporate governance, says Eckbo, has been the increase in institutional activism by large investment funds such as pension funds, which control hundreds of billions of dollars of investments. By wielding power that comes with their size, they are giving shareholders a stronger voice and influencing everything from board composition to corporate compensation. "Pension funds are long-term investors, and they have increasingly started to voice opinions about issues that are important to minority shareholders," says Eckbo, who is an advisor to the $200+ billion Norwegian Pension Fund, one of world's largest equity funds. "Size matters in these debates. When a large pension fund talks, people listen. As a result, the small absentee shareholder has effectively regained her voice."
Large pension funds tend to hold shares of thousands of stocks around the world, and it's their sheer size that captures the attention of corporate boards and executives. And when several pension funds talk together in a unified voice, people listen even more attentively. Eckbo notes that pension funds and other large institutional funds—such as mutual funds and hedge funds—are forming coalitions on issues, and these coalitions have been at the forefront of a number of welcome developments in corporate governance, including promoting transparency and mounting a movement to end the practice of having CEOs serve as board chairs. Eckbo believes that one of the most important fronts in the corporate governance wars involves board-member voting reform, and here the battle is still being waged. Institutional funds have argued for reforms that would give shareholders greater access to the election process and, in certain cases, would let them mount a competing slate of directors. Eckbo notes that resistance to such reforms in the U.S. from executives and from organizations such as the Business Roundtable, whose members include the CEOs of many of the nation's leading companies, has been strong and, so far, successful. (See page 33 on the visit to Tuck by John Castellani, president of the Business Roundtable.) But despite these setbacks, institutional funds promise to remain a powerful force working to improve corporate governance. "The large institutional investor represents a fundamental change in the governance landscape," Eckbo has written. "The balance of power between corporate insiders and shareholders is likely to tip in favor of outside investors. The result is increased competition among corporate insiders and, ultimately, increased corporate competitiveness."
A Question of Ethics
The gorilla in the room where corporate-governance debates take place—or at least one of the gorillas in the room—is greed, and greed is unquestionably part of the problem that improved corporate governance measures aim to solve. Furthermore, greed isn't going away any time soon. And as important as legal reform, open disclosure, shareholder empowerment, and other measures may be, to counteract this fundamental force of human nature, corporate ethics must also be part of the solution.
Eckbo says that ethics is a central concern in his work advising the Norwegian Pension Fund. Of the leading members of his advisory group, Eckbo is the only governance and finance expert; the group's chairman is Henrik Syse, a renowned author and ethical philosopher who has also written about the ethics of war.
The fund itself offers one look at that place where corporate governance and ethical behavior intersect. It has one owner—the government of Norway, noted for a relatively high degree of interest in social welfare—which has laid down two guidelines for investment: one, maximize long-range financial returns, and two, follow certain ethical principles, such as, says Eckbo, "don't invest in companies that produce cluster bombs. Most of the time there is no conflict between the two goals. But when there is, the debate is over how much long-range financial return you give up to promote the ethical principles. The question becomes, given that you own stock, what are you going to do to influence ethical issues? And no one has a good answer, because you can't quantify these things. You probably can't have the cake—the financial returns—and eat it—promote ethics—too. However, the very fact that large owners are raising ethical issues will influence corporate behavior in the long run."
This kind of top-down model of ethical behavior is relevant for individual corporations as well, because, says Howell, if the problem starts at the top, so does the solution. Howell views the stock market run-up of the 1980s and 1990s as the time when greed went on steroids and people began getting rich behind the false valuations of their companies. When things were good—or at least looked good—people tended to believe all the good things senior executives were telling them and not notice the financial houses of cards some companies had become. "If the minister is fiery and spellbinding," says Howell, "maybe you get caught up in the hype."
The best way to set a tone for how a corporation should act, he says, is by having senior management and boards model behavior that is above reproach. But that's much easier said than done. To enforce that kind of ethical behavior, it's just as important to create systems of checks and balances that discourage wrongdoing and can stop it when it occurs. That's what open disclosure is about. That's what financial reporting requirements are about. That's what whistle-blower protection is about. "Businesses are made of people," Howell says, "and there are bad apples in every group. If somebody is doing something that's not right, usually somebody else knows about it. It helps if you have an environment that says 'speak up.'"
