The Dangers of Too Much Governance
Most people accept that innovating involves risk. If a gene therapy patient dies, regulators stiffen controls, but they don’t make gene therapy impossible. Similarly, the United States must apply balance in addressing business scandals. Corporate governance problems call for safeguards, but not to the point of hobbling risk taking and economic growth. As dangerous as an Enron Corp. is, even more dangerous would be a system designed to make all future Enrons impossible.
Consider the U.S. economy over the past 20 years. The bursting of the stock market’s bubble followed years of corporate restructuring and innovation. Boards seeking maximum value from the changes often offered executives generous incentives, including stock options.
Some executives manipulated boards for personal gain. The result: universal indignation and both regulatory change (new governance guidelines from the New York Stock Exchange and NASDAQ) and legislative change (the Sarbanes-Oxley Act of 2002).
Is corporate governance so in need of help? The belief that unbridled executive compensation has hurt the stock market irreparably and that investor confidence must be restored is not supported by the facts. The U.S. stock market outperforms those of other countries over long horizons, and even after the scandals it performed no worse than other stock markets.Moreover, two decades of restructuring (and executive incentives) have led to valuable productivity gains.
Why has the U.S. stock market performed so well over the long term? Although nongovernance factors have almost certainly played a role, it is likely that improved governance and incentives have contributed as well. Because CEOs have more equity ownership than they did 20 years ago, they care more about stock prices. Institutional investors have become increasingly important and are more likely to push for higher stock returns. And boards have become more independent.
In other words, the U.S. corporate governance and compensation systems are far from hopeless. The scandals have merely exposed weaknesses. For example, CEO stock ownership sometimes does create an incentive to inflate accounting numbers; most boards do not sufficiently restrict executives’ ability to exercise options, sell shares or hedge their positions through derivatives; and most options do not appear as expenses on company income statements, with the result that boards may undervalue the cost of issuing options.
Certainly, the biggest option grants have been unnecessary to motivate CEOs. In 2001, the top 10 executives in the Standard & Poor’s 500 were granted packages with an estimated value (at the time they were given) of more than $170 million each. Moreover, among those receiving the biggest grants in the past three years were many who already owned large quantities of stock and hardly seemed to need such incentives.
Excesses do not, however, necessarily indicate a poorly designed system. The recent scandals arose in an exceptional environment that is unlikely to occur again soon, and the existing system of corporate governance, including, in the broadest sense, the outraged public, tackled the problems appropriately. The NYSE and NASDAQ guidelines and normal market responses have the potential to make a good corporate governance system better. At the same time, boards are providing better oversight and more well-thought-out executive compensation contracts.
A system designed to eliminate all excessive behavior would pose far greater risks than the behavior itself. The Draconian regulations required would foster inordinate caution and suppress experimentation at a time when we need more organizational experimentation than ever to take advantage of new information and communication technologies. Enron was an experiment that failed. We 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.