Corporate Governance

In their classic 1932 book, Adolf Berle and Gardiner Means warned that the separation of ownership and control in the modern corporation “destroys the very foundation on which the economic order of the past three centuries has rested . . . it is rapidly increasing, and appears to be an inevitable development” of the modern corporate system (p. 8). Many contemporary scholars, such as Jensen (1989, 1993) and Roe (1990, 1994), have voiced similar concerns but argue that the problem is not inherent in capitalism; instead, they maintain that tax incentives, antitrust policies, regulations, and political pressures to adopt antitakeover statues that protect incumbent managers have led to what Mark Roe (1994) calls “strong managers and weak owners.”1

Recent research has shown, however, that the separation of ownership and control has not increased since the 1930s. In fact, managerial ownership of publicly traded firms has increased, not decreased (see Holderness et al. 1999). The average percentage of common stock held by a firm’s officers and directors as a group rose from 13 percent in 1935 to 21 percent in 1995. Median holdings doubled from 7 percent to 14 percent. While the very largest firms had similar ownership percentages in both time periods, the average weighted by firm size was higher in 1995 than in 1935. In terms of real—that is, inflation-adjusted—1995 dollars, insiders’ holdings were, on average, four times as high in 1995 as in 1935, rising from eighteen million dollars to seventy-three million. For all firm sizes, there was an increase in ownership by firms’ officers and directors. Thus, managers generally have larger ownership stakes in the firms they manage today than in the past.

Managerial ownership, however, is but one of many devices that can help to align the incentives of managers and owners. Firms typically adopt a number of internal control and incentive mechanisms that can mitigate the agency problem. Bonuses and stock options, in addition to ownership stakes, tie the managers’ compensation to the performance of the firm. An informed, independent-minded board of directors also can directly monitor and discipline managers, since the board has the power to hire and fire top management. Firms that may be particularly difficult for outsiders in the market to monitor—for example, firms whose cash flows and earnings are highly variable—tend to use more of these internal incentive-alignment devices than firms that can more easily be monitored by outsiders, such as firms in very stable industries with little innovation (see, e.g., Demsetz and Lehn 1985; Holderness et al. 1999).

In addition, external market forces can help to rein in agency costs. In a competitive market, for example, firms that are better run—that is, firms that more effectively pursue the shareholders’ goal of profit maximization—tend to drive out firms that are less well managed. While competition in the market for the firm’s output is important, it may not be sufficient to ensure incentive alignment and protection of shareholders. Another market force is the socalled market for corporate control. That is, outsiders can buy or take control of poorly managed firms and replace the managers and the system of corporate governance. Although the threat of takeovers imposes a valuable check on managers, it does not ensure that agency costs will be kept to a minimum, particularly when laws and regulations, such as the Williams Act and state antitake-over statutes, can reduce the effectiveness of the takeover market.

The legal environment thus affects the disciplinary impact of both market forces and internal incentive-alignment devices. Obviously, poor alignment between the incentives of managers and investors increases the risks faced by shareholders. To the extent that they are aware of these risks, investors and potential investors would require a higher rate of return to compensate for the heightened possibility of misfeasance and malfeasance, thereby increasing the cost of capital for such a firm. Research over the past decade has focused on how stronger legal protections for minority investors and other similar reforms, for example, can significantly reduce corporations’ costs of obtaining outside financing, thereby improving corporate performance and capacity for growth (see La Porta et al. 1999, 2000, and 2002).

The financial reporting scandals that came to light during 2001 and 2002 have led to a reevaluation of the effectiveness of the corporate governance system in the United States and to significant responses by both the private markets and lawmakers and regulators.

Consider first the private market responses. After a firm’s accounting problems are revealed, the market reacts by sharply reducing the firm’s stock price. Interestingly, private market participants, not government regulatory agencies, discovered the problems in “scandal” firms such as Enron in 2001 and 2002. In addition, directors of firms associated with accounting problems or firms identified by watchdogs as being on boards of firms with poor governance practices are punished in the managerial labor market: they get fewer directorships (Wu 2004).

The private self-regulatory organizations such as the New York Stock Exchange (NYSE) and the National Association of Securities Dealers (NASD) have a strong incentive to maintain the confidence of investors in publicly traded firms. These organizations have changed their corporate governance requirements for firms listed on their exchanges. The new requirements mandate that a majority of directors be “independent” and that key committees of the board be formed of independent directors, not the executives of the firm. Also, the NYSE and NASD now require the independent directors to meet at least once per year without the executives on the board (i.e., without the “insiders”). Such changes are intended to increase confidence that the boards of the firms listed on these exchanges are actively monitoring and disciplining firm managers.

The government also responded to the corporate scandals with the Sarbanes-Oxley Act, the most sweeping changes in corporate governance legislation since the 1930s, and a sharp increase in funding for the Securities and Exchange Commission (SEC). Three basic economic principles that should guide any reforms to support effective corporate governance are: (1) accuracy and accessibility of information on a timely basis, (2) management accountability, and (3) auditor independence.

First, to act as effective monitors and provide discipline, private market participants must have accurate information about firms provided on a timely basis. Firms have an incentive to provide information to build confidence and reduce their cost of capital. Sarbanes-Oxley and the rules the SEC has adopted to implement the legislation have mandated, for example, more rapid disclosure of insider transactions. In addition, financial analysts and auditors must provide more information about potential conflicts of interest so that market participants have more information on which to judge the accuracy of the reports from both the firm and the analysts.

Second, managers must be held responsible for their actions, in particular if they commit fraud or cheat shareholders. Increasing funding for enforcement and increasing sanctions against wrongdoing should, in principle, reduce the incentive for a manager to undertake a bad act. Sarbanes-Oxley, for instance, significantly increased the maximum of both monetary sanctions and prison terms for fraud and various violations of securities laws. Along with a large rise in the SEC budget, enforcement has been enhanced by the creation of the Corporate Fraud Task Force to coordinate the expenditures and actions of the SEC, the Department of Justice, and other agencies. In addition, Sarbanes-Oxley clarifies and creates specific responsibilities for top officers, such as the requirement that the chief executive officer (CEO) and chief financial officer (CFO) personally certify the accuracy and completeness of the firm’s financial reports.

The fundamental economic idea behind the principle of management accountability thus is that a higher likelihood of being caught and held responsible accompanied by higher penalties will increase the cost (or reduce the benefit) of bad behavior, and hence will result in less of it. The key to making such reforms effective is that they not go so far as to make managers so risk averse—so concerned that their acts could be subject to legal sanction even if they are undertaken in good faith but turn out badly—that managers simply minimize the possibility of a lawsuit rather than maximize firm profits. Legal actions stemming from this changed regulatory environment have only begun to work their way through the courts, so the jury is still out on assessing whether the changes have struck the right balance.2

Third, to enhance confidence that the financial reports contain accurate information, it is valuable for the auditor to be perceived as not subject to conflicts of interest that might compromise the auditor’s independence and as exercising appropriate care and diligence in auditing the firm’s accounts. The Sarbanes-Oxley Act created a new agency, the Public Company Accounting Oversight Board, to monitor and regulate auditors of publicly traded firms. This board sets standards for auditor conduct and can sanction auditors who do not meet the standards.

One new responsibility for the external auditor under section 404 of the act, for example, is to attest to the effectiveness of the internal control procedures of each firm. In particular, the implementation of section 404 has generated much controversy, due to both the uncertainty of what standards should be applied by the auditor and to the costs of implementation. A survey by Financial Executives International of CFOs at firms with average annual revenues of $5 billion suggests that total direct costs of compliance with section 404 in its first year of implementation averaged $4.36 million per firm (see Kroszner 2005). Most CFOs in the survey predicted that compliance costs will decline in the future. It is too early to determine whether this greater scrutiny of internal procedures will reduce the likelihood of fraud or misconduct sufficiently to outweigh its costs.

Responses by both the private sector and by the lawmakers and regulators should be evaluated over time as data about the costs and benefits can be estimated, particularly since many of the changes enacted in 2002 have yet to be fully implemented. In conducting such cost-benefit analyses of the regulatory changes, it is imperative to specify clearly what the “baseline” comparison is (see Kroszner 2005). Two considerations are particularly important to keep in mind here. First, no regulation can prevent all fraud—ethics cannot simply be enacted at the stroke of a pen—and costs of attempting to ensure that no fraud ever occurs would be prohibitive. Second, even if there had been no formal legal and regulatory changes, firms, markets, and self-regulatory organizations would have responded—and did respond—to perceived problems. To raise capital, firms have to be credible in the market. Even without legislative change, the private sector would have generated pressures for additional expenditures by firms on auditing and monitoring systems to enhance their credibility with investors. The relevant benchmark for measuring the cost of the Sarbanes-Oxley Act thus would not be “business as usual” in pre-Enron 2001, but what the private sector would have generated in response to demands for greater monitoring and credibility.