The Glass is Not Broken

Evaluating the State of U.S. Corporate Governance

Research by Steven N. Kaplan

To a casual observer, the United States corporate governance system may seem as if it is beyond repair. New research poses the question: If U.S. corporate governance is so bad, why has performance been so good?

For the past two years, enormous media attention has been trained on the alleged corporate board and governance failures at Enron, WorldCom, Tyco, Adelphia, Global Crossing, and others. Top executive compensation is routinely criticized as inefficient, excessive, or both.

According to Steven N. Kaplan, a professor of at the University of Chicago Graduate School of Business, and Bengt Holmstrom of Massachusetts Institute of Technology, these criticisms and turmoil lose sight of one overarching fact-the U.S. stock market and the U.S. economy have performed remarkably well relative to the rest of the world.

"To read the financial press, you would think that the U.S. corporate governance glass is completely broken," says Kaplan. "We argue that the glass is not broken, but, rather, is more than half full."

In their new study, "The State of U.S. Corporate Governance: What's Right and What's Wrong?," Kaplan and Holmstrom analyze the failures and concerns that have served as catalysts for recent legislative and regulatory change. Given the positive performance and those changes, the greater risk in the current environment is overreaction by the political and regulatory systems.

The authors argue that the data on U.S. stock market performance and overall country productivity is not consistent with a deeply flawed U.S. corporate governance system. Rather, the data is consistent with a system that is well above average. The system demonstrated its strength by responding to extreme events in a swift and effective manner, through public outrage, legislative change such as the Sarbanes-Oxley Act of 2002, and regulatory change such as the new governance guidelines from the NYSE and NASDAQ.

If the U.S. corporate governance system were as flawed as critics claimed, one would expect the U.S. stock market to perform particularly poorly. Instead, the U.S. stock market has performed well relative to other stock markets, both recently and over the longer term. In fact, the U.S. market has generated higher returns than the European and Pacific markets over every time period considered-since 2001, since 1997, since 1992, since 1987, and since 1982.

In regard to overall country productivity, the results for the United States are again strong. From the beginning of 1992 to the end of 2000 (the last year with comparable data), growth in GDP per capita has been greater in the United States than in France, Germany, Japan, and Great Britain. Given the strong U.S. productivity numbers through the recent downturn, it is likely that this gap has widened since 2000.

Because many factors affect stock returns and productivity, the authors note that it would be inappropriate, although not inconsistent, to claim that superior U.S. corporate governance explains these differences. It is appropriate, however, to claim that the supposed weaknesses and flaws of U.S. corporate governance are not apparent in the stock return and productivity data. Thus, the flaws, to the extent they exist, have not been sufficiently great to lower U.S. performance relative to that in the rest of the world.

The Strengths

Why have U.S. markets performed relatively well? The authors suggest that part of the explanation lies in the fact that equity ownership, including stock options by CEOs, has increased by a factor of roughly ten times over the last twenty years.

CEOs care far more about their stock prices than they did twenty years ago, which in general is a positive change. Now when CEOs make decisions, they keep in mind how such decisions will affect the stock price.

Buyout investors and venture capitalists routinely reduce their own ownership stakes by giving CEOs substantial stock and option packages. If this method were inefficient, these investors would be unlikely to do so.

Another part of the explanation is that large institutions increasingly dominate the stock market. Institutions are able to put more pressure on corporate management to increase stock prices than individual investors.

Finally, board governance also has improved. Boards are now smaller, more independent, and more likely to hire CEOs from outside the company.

The Weaknesses

While U.S. corporate governance mechanisms have performed well over the last twenty years, the events at Enron, Tyco, WorldCom, and others have exposed important weaknesses.

First, as executive stock and option ownership have increased, so have the incentives to inflate accounting numbers in order to inflate stock market values and sell shares at those inflated values.

Second, most boards do not put strong restrictions on the ability of top executives to tap into their equity-based compensation through exercising options, selling shares, and using derivatives to hedge their positions.

Third, most options have been issued with an exercise price equal to the then-current stock price. While such option grants can have a large expected economic cost, companies do not need to record such option grants as expenses on their income statements under existing accounting rules. Because the options do not appear as an income statement expense, it is likely that some (or many) boards of directors undervalue the true economic cost of issuing those options.

Kaplan and Holmstrom acknowledge that the magnitude of some of the option grants has been far greater than necessary to retain and motivate CEOs. In 2001, the top ten executives in the S&P 500 were granted option packages with an estimated value of over $170 million each.

Even if some of these packages represent multiyear awards, the amounts are staggering. The authors find it particularly disconcerting that among those receiving the largest grants over the past three years, many were large owners, such as Larry Ellison of Oracle, Tom Siebel of Siebel Systems, and Steve Jobs of Apple-individuals unlikely to need extra strong incentives.

Despite enormous pressure on management to keep stock prices high, the number of companies that broke the law in an egregious way was small.

However, major changes have been put forth to prevent further corporate fraud. The Sarbanes-Oxley Act, passed in the summer of 2002, mandated a number of changes in corporate governance for publicly-listed companies. There are now more detailed requirements for auditors and rules that affect compensation, among other changes.
The level of government involvement in correcting corporate wrongdoing is a subject of much debate.

"The jury is still out on the pluses and minuses of the Sarbanes-Oxley Act in the long term," says Kaplan. "There is no doubt, however, that complying with the Act in the near term will impose large one-time costs to public companies."

The NYSE and NASDAQ also have mandated corporate governance changes for firms listed on their respective exchanges. The authors suggest that boards will likely provide better oversight and will structure executive compensation contracts more effectively in the future. These changes reflect normal market responses that, overall, are likely to make a good U.S. corporate governance system a better one.

Dangers of Over-Regulation

"The current 'problems' arose in an exceptional environment and are not likely to happen again soon," write Kaplan and Holmstrom. "That doesn't mean the perpetrators shouldn't be punished or that the system can't be improved."

The fact that the public and the political system were outraged and became involved does not mean the system was poorly designed from the start. The public and the politicians are part of the broader system of corporate governance meant to take care of extreme events.

"The media reaction and scrutiny is actually a very good part of our system," says Kaplan. "When people misbehave, the spotlight shines brightly on them."

However, with public and political oversight comes the danger of over-regulation. The Sarbanes-Oxley Act in particular has the short-term effect of increasing fixed costs for all companies, whether or not they have committed accounting fraud. While Sarbanes-Oxley creates incentives against fraud, it also has the potential to increase litigation and reduce investment in productive activity. For companies already following the rules, the result may be substantial amounts of time and money being spent on paperwork.

The authors argue that excessive regulation fosters conservatism and suppresses experimentation. Managers will be less likely to innovate if they worry that they will be sued or imprisoned if the innovation simply fails and the company subsequently reports the poor performance.

According to the authors, "We need more organizational experimentation than ever right now. New business models and new organizational structures are essential for taking full advantage of new information and communication technologies. Enron's business model was an experiment that failed. We should learn from the failure, not by withdrawing into a shell, but rather by improving control structures and corporate governance in a way that allows continued experimentation and occasional failures."

While the Enron scandal represented a severe breakdown in corporate governance, it is even more alarming to create a system that makes all future organizational experiments and failures impossible. The public and the government play important supervisory roles in the overall U.S. corporate governance system and must be given room to do their jobs.

Steven N. Kaplan is Neubauer Family Professor of Entrepreneurship and Finance at the University of Chicago Graduate School of Business.

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