The Board Game

Enron and other corporate scandals have crippled market confidence in US corporate governance. Enron's deceptive accounting practices were so convoluted, involved such obvious conflicts of interest with Enron officers, and occurred on such a scale, that one can only marvel at the failure of the Enron board and audit committee to detect and prevent such abuse. Its members failed to perform their primary task, which is to protect the corporation's stockholders from abuses by managers.

With the dawn of the modern large-scale corporation in the second industrial revolution of the late nineteenth century, there came a new potential for managerial abuse, as corporate stockholding in such large entities became fragmented and detached from management. Stockholders' interests were not automatically aligned with those of managers.

In their 1932 classic on corporate governance, Adolf Berle and Gardiner Means identified these potential conflicts of interest. In modern parlance, managers can extract "control rents"--value that does not represent an appropriate market reward for their actions, but rather the ill-gotten gains from being able to operate in conflict with stockholders' objectives. Managers may redirect funds for themselves and their friends; they may shirk their duties; or they may prolong their employment against the interests of shareholders.

The board, as the representative of the stockholders and the source of managerial authority, is supposed to prevent such abuse. But board actions depend on individual board members' skills, diligence and willingness to oppose management. Without all three ingredients, boards will fall short of their leadership mandate.

Why did the Enron board fail, and what does that failure tell us about possible reforms that could improve corporate governance? One idea that has been popular among some is the need for board "independence". Independent board members--that is, board members who are not involved in company management--should be able to exert more effective oversight since they are disinterested parties.

Able, perhaps, but not necessarily willing. Independent board members are busy people; they are chosen because of their name recognition, not because they have either the time or the inclination to discipline management, or the technical knowledge to perform adequate audits. And their very independence may be compromised if their seat on the board depends on continuing management support, as it often does.

Enron's board was almost entirely "independent", and composed largely of highly skilled and experienced corporate managers. It included chair Robert Jaedicke, a professor of accounting and dean of Stanford Business School, and Wendy Gramm, former Chair of the Commodity Futures Trading Commission. Yet they and their colleagues seem to have been asleep at the switch.

Evidence is mixed on the question of whether the independence of directors improves corporate governance. Recent studies suggest that board independence may matter, but that effective independence (measured by the board's ability to restrain executive compensation) is influenced by a variety of other board attributes, including the size of the board (smaller is better), the number of boards on which board members serve (fewer is better), the age of board members (younger is better), and whether the independent member was chosen by the chief executive (which reduces effectiveness).

How can we establish a process for selecting and rewarding board members that will place stockholders' interests above those of managers? Here, economics teaches us that incentives are as important as skills. The key to effective board leadership is establishing a process that selects board members who have both the ability and the incentive to be dogged pursuers of the stockholders' interest. There are three approaches to ensuring such a process of board selection.

1. Concentration of Ownership

First, if board members and managers both own sufficiently large amounts of stock, the conflict of interest between managers and stockholders may be largely overcome by the direct incentives of board members to protect their own wealth. The positions of board members with sufficiently large stockholdings are secure, and they have strong incentives to discipline managers to pursue value maximisation.

A 2002 study found that countries with the weakest legal protections for outsider stockholders also saw the greatest concentration of stock in the hands of insiders. In both the US and UK, where legal protections are relatively strong, the median insider ownership share of the largest 150 corporations are 1 per cent. In France and Germany, where legal protections of stockholders are weak, the proportions are 55 per cent and 61 per cent.

During the first industrial revolution of the early nineteenth century, when the scale of manufacturing production was relatively small, ownership and management were typically closely aligned. Naomi Lamoreaux's study of the period shows that industrial insiders also leveraged their equity financing by using banks that they controlled to sponsor industrial growth. Banks operated like industrial credit co-operatives for their board members. Because the same group of people owned and controlled the industrial borrowers and the banks, interests were closely aligned, and companies and banks, along with their outside investors, prospered together. Managerial opportunism was constrained by the direct oversight of investors with a material vested interest in the value of the company.

But concentration of ownership in the hands of insiders can be very costly, especially in a modern industrial economy. When owner-managers and directors hold most or all of their wealth in the stock of one company, they suffer from extreme lack of diversification. Consequently, they will pay less for corporate stock and require much higher managerial compensation if they must hold such an undiversified portfolio, which will limit corporate growth opportunities.

Also, the supply of billionaires is somewhat limited. If many corporations have natural economies of scale that warrant global reach, it will be hard to staff all of them with billionaires. And, those lucky billionaires may lack the skills that are needed to best guide the corporations. The best managers typically don't begin life as billionaires.

Finally, there are enormous social benefits from broad public participation in stock ownership. Those benefits transcend the obvious social gains from portfolio diversification, and include the political economy benefits that come from a broad alignment of interests between large corporations and the public, which encourages growth-oriented tax and regulatory policies. The booming "investor class" in the US in recent decades, for example, has restrained populist impulses in public policy toward corporations, and spurred constructive reforms of accounting, disclosure and governance regulation.

2. Intermediaries

A second approach to aligning the incentives of board members and stockholders is to rely on third-party intermediaries to aggregate the voting power of stockholders and thus provide a formidable counterweight to incumbent managers. Historically, during the second industrial revolution, Germany and the US both used this approach to corporate governance, although its use in the US was much more limited in its scope.

In Germany, nationwide universal banks that combined lending, deposit-taking, underwriting and trust account management in a novel way were able to support growing industrial companies. They did so first with credit, financed by deposits, but, later in the company's life cycle, by underwriting stock offerings that were placed in the internal networks of accounts managed by those universal banks. Through their management of trust accounts, universal banks retained authority over stockholders' proxies and thus controlled boards of directors of their industrial clients.

Scholars have argued that the relationships between German universal banks and client companies, and the discipline over management provided by bankers, permitted industries to access external finance easily and thus grow rapidly, especially in new product areas that required large minimum efficient scale of operation (such as electricity generation). Although postwar Germany has been known for its reliance on debt as the main source of external finance, that was not true of pre-first world war Germany; in fact, equity finance was much larger a proportion of industrial funding there than in the US prior to the first world war.

In the US, banking regulations limited the geographic scope of banks, and therefore also the scale of banks. Those regulations constrained the role of banks in financing industrial growth by large-scale corporations during the second industrial revolution. As the scale and geographic scope of industry increased, industry outgrew banks, and bankers turned mainly to commercial finance. Commercial banks were also constrained from participating in underwriting, not by law prior to 1933, but rather by their small size and regional isolation, which made it hard for them to operate German-style networks for the sale of shares or the aggregation of voting rights.

Thus, US-style "finance capitalism"--typified by J.P. Morgan's famous network of partners who held seats on various boards of directors--was a very limited phenomenon reserved for the largest, established companies, which usually became "Morgan companies" as the result of consolidations of mature companies, rather than through public underwriting of equity to finance new investments. Morgan's role was typically as a reorganiser or a bond, not a stock, underwriter, and its authority came from the network of influential stockholders that relied on its advice and corporate governance skills. Research by Bradford DeLong and others argues that corporate chief executives who "wore the Morgan collar" wore it proudly and to great effect. They were better able to finance their growth and to weather financial storms than their competitors.

Despite its benefits, and even though its role in the economy was quite limited, J.P. Morgan's brand of finance capitalism was too much for populist US sentiment against the concentration of power. Successive acts of legislation constrained investment bankers' abilities to establish control through networks of skilled partners acting as disciplinarian board directors, and forced the separation of commercial and investment banking.

The role of intermediaries in controlling corporate boards took a third form in postwar Japan, as part of the keiretsu system, in which a company surrounds itself with a permanent structure of subsidiaries, banks and suppliers. Main banks of keiretsus controlled blocks of a client company's shares, both directly and through other companies in which they owned interests, and acted as an effective check on managers. By 1990, many US academics were writing paeans to the virtue of Japanese corporate governance, praising the high level of managerial turnover and the fact that bank-sponsored corporate governance helped companies economise on the costs of external finance.

Yet the postwar history of Germany and the past decade in Japan suggest that concentrating stockholder influence by means of universal banks and main bank-controlled keiretsus may also hinder corporate governance. That is especially true when banking systems become non-competitive. The managers of a highly concentrated and non-competitive banking system may collude to feather their own nests at the expense of both the stockholders and the managers of client companies.

The role of the Japanese bank system in resisting corporate reform over the past decade is one case. Another is the change in the role of German banks in the postwar era. The largest German banks used their network of trust accounts to engineer mutual control over their own stocks. They control, as a group, more than 50 per cent of any one large bank's stock. That lack of competition may help explain why postwar German banks have played such a small role in equity underwriting, or in spurring innovation and new industrial growth, in the postwar era, compared to the role they played prior to the first world war.

The history of Japanese and German financial systems suggests that financial system concentration during the later stage of industrialisation may offset the benefits of corporate discipline that result from the concentration of stockholder power in those intermediaries during earlier stages of development. The policy lesson seems to be that vigorous antitrust policy toward the financial sector should be pursued in order to ensure the continuing benefits of good corporate governance that concentration of control through intermediaries permits.

To what extent can intermediaries such as pension funds and mutual funds substitute for the Morgan collar, the universal bank or the Japanese main bank? So far, in the US, they have played a limited role. There is some evidence that institutional investor holdings of stock can improve corporate governance, but most commentators view these influences as weak and unreliable.

Franklin Edwards and Glenn Hubbard point out that legal impediments limit the amount of institutional ownership in any one company, and legal and regulatory risks to fund managers limit their incentives to own concentrated blocks of shares or to join boards of directors.

Further, fund managers' incentives to discipline companies may be weak and regulation of their fee structures discourages shareholder activism. In a perfect world, the efforts of fund managers to discipline portfolio companies' managers would be rewarded by their account holders. But regulation effectively prevents setting mutual fund and pension fund managers' fees to rise with profits. Thus, the fund managers' rewards are small and indirect, confined to increased asset inflows into funds in response to corporate profits.

Poland is an interesting case of a country that, during privatisation, consciously designed its network of institutional investors to improve corporate governance in newly privatised companies. Authorities there saw the desirability of concentrating some voting power for any portfolio company in the hands of a small number of intermediaries.

In 1993, Poland created 15 National Investment Funds (NIFs) to own 60 per cent of the shares in 512 medium- to large-scale enterprises and to help oversee the restructuring of those enterprises. Each NIF was given a lead role (and a 33 per cent stake) in approximately 30 companies. Shares in NIFs were allocated to the public and traded. Although the privatisation process was bumpy in Poland, as elsewhere, observers tend to regard its successes as partly reflecting the positive role of NIF managers in rationalising the restructuring process.

3. Hostile Takeovers

A third approach to disciplining directors and managers is the threat of a hostile takeover. In the presence of a credible threat, managers know that if managerial rent seeking gets sufficiently large, it will pay raiders to buy up shares to unseat them. That, in turn, encourages better corporate governance; and there is evidence that the hostile takeovers of the 1980s did, in fact, improve governance in target companies. The social gains from these takeovers were even larger, as many companies were encouraged to avoid takeovers by reducing managerial rent extraction.

But recently enacted legal obstacles to takeovers have protected managers and captive boards of directors from that external discipline. Takeovers were never easy, even during the 1980s. Acquirers had long been required by law to announce their intention of purchasing the company through tender offers, thereby reducing the gain to acquirers of improving corporate efficiency, and thus discouraging some efficient takeovers.

In the 1980s, in response to many successful takeovers, incumbent managers developed "poison pills" (corporate charter clauses that dilute the stock of hostile acquirers), which have succeeded in discouraging hostile takeovers. Courts in the US have upheld these techniques, while various states' "stakeholder statutes" have also served to discourage takeovers. In effect, the broadening of corporate goals makes it impossible to hold managers accountable to stockholders, or to any other constituency, for that matter.

The alternative means to wrest control from incumbent managers--a proxy fight--is no more attractive to would-be acquirers, owing to the many obstacles that boards can use to reduce the chance of success. The most popular of these is the staggering of board terms, which often limit the number of board members coming up for re-election at any one time to only a third or a fourth of the board. Would-be acquirers have to be willing to fight many proxy battles over many years before being able to take control of the target.


It is unrealistic to expect board members to serve the function of disciplining management and protecting shareholders' investments when we have designed a system that prevents boards from having the incentive to do so. The central problem limiting the effectiveness of boards, and of corporate governance more generally, is the lack of political will to place the interests of stockholders first when considering the rules under which corporate governance occurs.

Populist revulsion to concentrations of power, and special interest politics, have often resulted in the political decision to hobble the financial system as an instrument for disciplining corporate managers. The first step toward avoiding future Enrons is deciding that the overriding objective of the board is to maximise the value of the company. The second step is to enact laws that hold managers and board members accountable to that objective, and that encourage the concentration of stock in the hands of those who would ensure that the voices of stockholders are heard in the boardroom and, if necessary, in the courtroom.

Charles W. Calomiris is the Arthur F. Burns Scholar in Economics at AEI.

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