To a casual observer, the United States corporate governance
system may seem as if it is beyond repair. Recent 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 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 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 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.
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
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
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 Overregulation
"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 overregulation. 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. 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.