Rx for the Ills of Corporate Governance
edited by Pam Losefsky
In the wake of the last two years of scandal, corporate governance has become the topic of the day. Nearly every major business publication has put together a cover story or series on needed reforms. Where “changing the rules” dominated headlines three years ago, Sarbanes-Oxley now defines the mood.
Many pundits beating the drum for reform today, of course, were sounding the bell for “buy, buy, buy” just a short while ago. For a more long-term look at corporate governance, therefore, we assembled a group of McCombs scholars who were focused on the topic long before Martha Stewart was accused of anything besides dominating our domestic consciousness.
Our crew included an international audit specialist and the American Institute of CPAs Professor of the Year for 2002 (William Kinney), two New York Times op-ed writers (Michael Granof and Robert Prentice), the expert on corporate boards who over the last decade showed the greatest increase in academic citations in the entire field of economics and business (James Westphal), and three nationally recognized experts in governance as it relates to finance (Andres Almazan and Laura Starks) and technology (Andrew Whinston). What follows is an edited transcript of their discussion.
Andres Almazan—Honesty is Good, Transparency May Not Be: We used to believed that managers always tried to maximize shareholder value through their activities, but by the 1970s there started to be evidence that this is not always the case. We started seeing that managers actually sometimes don’t do what they’re supposed to do to increase shareholder value.
And in fact, my research has found that if you leave managers too free to choose different capital structures, they tend to do what is best for themselves.
But I have also looked at the extent to which it is a good thing to force companies to be transparent. It’s very good to force companies to be honest, but that’s not the same thing as forcing them to be transparent. For one thing, forcing management to disclose information too early can have a negative effect on potential investors. In governance matters, therefore, one has to be very careful when making recommendations
Bill Kinney—Sarbanes-Oxley Act Should Help: The Sarbanes-Oxley Act does several things that should substantially strengthen the corporate governance process and the quality of reporting in America. One change is that the audit committee comprised of independent outside directors will have extended duties when dealing with the outside auditor. The audit committee will have a legal responsibility to the stockholders to enforce better accounting through better communication with the auditor.
Sarbanes-Oxley also requires management to publicly assert that they have a reliable system of internal control (or the procedures to provide reasonable assurance that they’ll have reliable reporting, and that they’ll comply with the laws and regulations of the land). And then the auditors are required to audit that assertion and say that they agree or disagree. This helps because it ensures that the records are in good shape every day of the year, and management is better informed about problems in the business so they can make better decisions, and the investors can get better information.
Look for those provisions to help the governance process and improve investor confidence.
James Westphal—Debate Should be About Board Effectiveness, Not Independence: I’m interested in defining an appropriate role for boards of directors—to what extent should they exercise independent control on the issues of strategic decision-making or executive compensation, for instance, versus to what extent should they play the traditional role of a counsel to top management?
Boards basically have three possible roles. Least common are those that act as independent controllers. Some serve as ad hoc assistants, providing advice and direction as called upon, and there are more of these. Then there are what I call the “do nothing” boards—and the largest number of boards fall into this category. The board members are symbolic figureheads.
The debate about board involvement has so far centered on the ideology of board independence rather than on improving effectiveness. How effective can a board be if the members have no connection to management, especially in strategic decision-making? I concede that in some functions, like on the audit committee, you need independence, but at the board-level independence has side effects. A board’s primary function is supposed to be overseeing the strategic direction of the firm, and you need to have close connections to management to provide valuable contributions to strategy.
Laura Starks—Institutional Investors Play a Monitoring Role: Institutional investors own over 50% of widely-held firms in the U.S. on average, so they have the capability of being substantial actors in corporate governance. We researched executive compensation and how it varies over different ownership structures, and found that when there is a higher concentration of institutional investors, there are more pay-for-performance salary structures. We also found that the managers, once you control for size and industry, don’t get paid as highly. This implies that institutional investors are performing a monitoring role.
Bill Kinney: We’re working on a study in which we are exploring how to get audit directors to better monitor the squishiness in the accounting process. This is an experimental study involving directors, auditors, and management accountants designed to apply some psychology-based rules that may help directors be more skeptical about management’s numbers.
Michael Granof—Auditor Rotation Has Promise: Since the 1970s when computers were introduced and all of the sudden consulting became an extremely lucrative area for accountants, there has been tremendous pressure on firms to not only sell consulting services, but also to increase the profitability of auditing. There is at least some evidence that this impaired their independence.
Sarbanes-Oxley is, of course, dealing with some of the factors that may impair independence. Of particular interest to me is the requirement that audit partners rotate every five years. I think this is a step in the right direction, but even more intriguing is the provision that the GAO study the feasibility of mandatory audit firm rotation. Personally, I’ve always been in favor of that, but there are extensive costs associated, and the question is: are the costs worth the benefits?
Robert Prentice—Regulation: Do the Benefits Outweigh the Costs?: We all know that regulation carries costs. In the long run, we’ll know whether or not the benefits outweigh the costs. The first thing that needs to happen is to restore some trust in the system. Harvard did several cross-global studies of things like corporate governance structures and regulation of insider trading, and found that the stronger legal system you’ve got, the tighter controls, and the more disclosure you’ve got, the better it is for companies. You can raise more money faster and cheaper.
Trust is the key to all of this. And trust can’t come just from the government, but some measure can come from it.
Andrew Whinston—Reliable Communication May Improve Climate: My colleagues and I looked at how managers communicate information about the company. Our theoretical model is based on the idea that people provide information strategically. As a manager I might provide information to people because I want them to do something, so what I provide is not just a benign choice because I understand it and manipulate it from my point of view.
When investors start to understand this framework, they start to discount ALL information, and then even in cases where the company may have great promise, they may refrain from investing. The decline in the high tech industry, the fall of Nasdaq, may be a real economic event, but it is also a perception by investors that you can’t trust anybody, and so the overall decline may be unjustified.
This suggests that high tech companies could benefit from tightening their audit procedures, or governing their communications with shareholders, and also governing more diligently the selling of options or stock.
The intentions of managers to sell options and stock should be disclosed before they do it, so that the outside shareholders are aware of the intentions of the insiders. Our argument is that if we have this kind of regulation, the evaluations of high tech companies may actually improve because people will feel the communications are more reliable and that they can make judgments on and invest in companies that have good prospects.
Robert Prentice: Sarbanes-Oxley prescribes how you’ve got to structure your board of directors, and the various certifications that the CEO and the CFO have to make, and how your relationship with your auditor has to be set up. Porsche has actually decided not to list on our stock exchange because of these burdens. A lot of venture capitalists have said that they will continue to finance some companies privately rather than taking them public because of the added burden.
Mike Granof: You talk about costs. Of course S-O is going to increase costs. But the question is, what is the cost of doing nothing? We’ve lost trillions of dollars in market capitalization, and here’s the question—is it worth a few hundred million more to straighten it out? The key to S-O is how it’s going to be implemented. Will it change the traditional political relationships between CPA firms and corporations and Congress? If not, then I think S-O is not going to have a very great impact in the long run.
Laura Starks: Dictating that boards must be independent doesn’t solve the broad issue because all of the NYSE companies have had to have independent directors for years—Enron and WorldCom had to have 100% independent directors on their audit committees. And those directors may have been bamboozled by management.
James Westphal: There are actually two problems with the board when its independent—there’s the knowledge problem, and then there’s the problem of top managers’ reactions to an independent board. I’ve found evidence that top managers don’t view independent boards as a helpful source of input in decision making, but rather as a body that has to be managed. Managers spend more time trying to persuade the board of the merits of their policies and developing social relationships and less time seeking input into decisions.
I don’t think this is a regulation issue. My research suggests that building a good strong sense of teamwork between top managers and outside directors is the one thing that predicts good performance. The best performing boards were the ones that had social ties with CEOs and outside directors and that had mechanisms in place to align CEO incentives to shareholder interests—long term incentives.
The current conversation on governance is all about accounting, but that’s only one aspect of governance. Maybe we’ll get great accounting out of S-O, but beyond that, where is the strategic direction of the
firm headed?
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