January 2004
What's Right and What's Wrong with Corporate Finance Governance in the U.S. Today?

On January 21, 2004, the AEI-Brookings Joint Center and the University of Chicago Stigler Center hosted a panel discussion about corporate governance.  Following the recent scandals involving companies such as Enron and WorldCom, Congress and the Securities and Exchange Commission passed several reforms to restore shareholder confidence.

Is the corporate governance system flawed? If so, in what ways? Are reforms necessary for investor confidence? Do the costs of reforms outweigh the benefits? The Joint Center and the Stigler Center assembled a panel to address these questions. The panel consisted of Steven Kaplan, Professor of Entrepreneurship and Finance at the University of Chicago Graduate School of Business, and Paul Atkins, Commissioner of the Securities and Exchange Commission (SEC). Randall Kroszner, Professor of Economics at the University of Chicago Graduate School of Business, moderated the discussion.

Steven Kaplan
University of Chicago Graduate School of Business

Steven Kaplan made three arguments regarding corporate governance in the United States. First, contrary to public perception fueled by the media, the U.S. corporate governance system is not broken, as evidenced by the fact that U.S. stock markets and the overall economy have performed better than other countries' over the past twenty years. Moreover, during this period, executive compensation, shareholder activity, and monitoring by boards of directors improved in several ways: executive compensation became more equity-based, which encouraged management to align its interests with shareholders; institutional shareholders became more involved, which increased monitoring and pressure on management to perform; and boards of directors became smaller, more independent, and began to play a more active role in hiring and firing CEOs.
 
Second, despite these improvements in the system, the scandals that did happen occurred for a few reasons. Equity-based executive compensation increased the incentive to manipulate the accounting numbers, options were often undervalued and did not show up as expenses on the income statement, and shareholders were still restricted in actions on which they could vote.

Third, the legal and regulatory reactions to these scandals have been positive overall but have had some negative consequences. Regulations passed by the New York Stock Exchange (NYSE) required boards to meet without management present, a positive development. The Sarbanes-Oxley law helped restore confidence in the corporate governance system and reduced the ability of management to manipulate numbers, but the law's requirements are costly for firms to implement, especially for small firms and firms that were "doing things right." 

Paul Atkins
Commissioner, Securities and Exchange Commission
  
Paul Atkins discussed potential benefits and costs of the Sarbanes-Oxley law and how the SEC has reacted to Congressional legislation. He also commented on an SEC proposal regarding shareholder access to the proxy statement.

Atkins emphasized that the Sarbanes-Oxley law was fundamentally aimed at improving shareholder confidence and strengthening the role of directors as stewards of shareholders. Specifically, he expressed hope that Sarbanes-Oxley and the rules implementing it will help directors question and monitor management in a way that would have seemed "hard-hitting" two years ago.

He feared, however, that some rules intended to strengthen corporate governance may have perverse and unintended consequences. Rather than encourage competent candidates to serve on companies with the greatest need for independent directors, these rules may dissuade them due to fears of increased liability.  Moreover, the rules may discourage entrepreneurial and honest risk-taking. Despite these fears, he maintained that the new rules implementing Sarbanes-Oxley have not hindered the U.S. economic recovery and are balanced from a cost-benefit perspective.
 
Finally, he discussed the SEC proposed rule on shareholder access to proxy statements and the director nomination process. He argued that the owners of a corporation should decide how to govern themselves and choose representatives to oversee management.  However, he feared changes that could enable special-interest stakeholder groups to displace the majority interest on director nominations, harming the corporation. A rule targeted at corporate governance problems, therefore, may result in facilitating "pet" projects rather than improving corporate governance.

Question and Answer Session

The questions following the panel discussion reflected concerns about corporate fraud.  Two audience members questioned Mr. Kaplan's insight that the state of corporate governance has improved over the past two decades by drawing attention to media reports indicating the contrary. Mr. Kaplan responded by noting that the scandals have involved a tiny fraction of the nearly seventeen thousand publicly traded companies. He elaborated, saying, "...it is a very small fraction of the public companies out there. When you look at the overall numbers, it looks pretty good. There is no question that there were some bad guys out there. And one of the reasons that there were these bad guys was a combination of the equity compensation and an ability to manipulate the numbers and an ability to get liquid." Atkins agreed with Kaplan that we should devote more attention to empirical analysis rather than public hype. Finally, Kroszner warned of the consequences of an over-reliance on regulation: "We want to try and reduce the fraud, but we also do not want to kill the goose that laid the golden egg...A lot of the new regulations puts a lot of the heavy burden on the good guys."
    
Rohit Malik, a researcher at the AEI-Brookings Joint Center for Regulatory Studies, prepared this conference summary.