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,
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
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
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.
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.
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
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
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
"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
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