CEOs and Market Woes: Is Poor Corporate Governance to Blame?Published: December 10, 2008 in Knowledge@Wharton
From Wall Street to Detroit, chief executives are losing their bonuses, agreeing to work for a dollar a year and in many cases losing their jobs. Congress is invading the executive suite, demanding veto power over management decisions as a price for tax-funded rescues.
And, of course, stock prices have plummeted.
It all looks like a sweeping vote of no confidence, as if the world thinks America's executives and boards of directors are beset with an epidemic of incompetence, self-dealing or both. Many shareholder advocates see the financial collapse and economic woes as stunning proof of their long-held claim that too often the wrong people are in charge -- and that attacking this problem demands an overhaul in corporate governance regulations.
They propose a range of measures to encourage chief executives to focus on the long term rather than the next quarter, to give shareholders a "say on pay" and to make it easier for them to field their own candidates for directorships.
"The recent volatility we have seen shows that the need for better corporate governance has never been clearer or more pressing," writes Nell Minow, editor and co-founder of The Corporate Library, a research firm that presses for better governance practices. She adds that "this latest mess is so pervasive and so -- apparently -- legal that it has called into question the most fundamental notions of trust in Wall Street and in the American economy."
Not everyone sees governance as the culprit, and some warn that a kneejerk attack on established corporate practices could backfire. But many experts expect that regulators, Congress and the incoming Obama administration will take a hard look at whether rule changes could improve the management of public companies.
"The failure of so many firms can partly be attributed to structural factors beyond anyone's control, but not entirely," says Wharton management professor Michael Useem. "One has to infer that we also have a combination of leadership and governance problems that can explain why so many companies went south so quickly." With hindsight, he notes, it is clear that many corporate directors and executives failed to appreciate the "risks lurking in what they were doing, and the risks lurking in the economy at large."
The main exhibits for reform advocates: First, the near collapse of the three U.S. automakers, while foreign competitors thrived in the same market conditions; and, second, the extraordinary level of borrowing and risk-taking that sank major investment banks.
The Madness of Crowds
For many experts, the common thread was a focus on short-term results that endangered firms' long-term health. The car makers promoted profitable SUVs and trucks, failing to develop enough fuel-efficient vehicles or upgrade plants so they could swiftly produce different vehicles as consumer demand changed. Investment banks and mortgage lenders soaked up profits on high-risk loans and securities tied to mortgages, ignoring the damage that must eventually come when the home-price bubble burst.
General Motors executives and directors, for example, can be faulted for misunderstanding the implications of a gasoline-starved and environmentally threatened world, Useem says, while Wall Street is "dominated and driven by investors and equity analysts" with a short-term outlook. Wharton management professor Thomas P. Gerrity describes the run up to the collapse as "a classic delusion, a madness of crowds. We've lived through it over and over again."
Washington is already addressing governance issues, and most experts think more will come. Banks that take federal rescue money have to agree to executive-pay restrictions, such as a loss of tax deduction on pay exceeding $500,000 a year and a ban on big paydays for departing executives, called "golden parachutes."
For the moment, pay restrictions may be necessary to get support for rescue measures from an angry public and Congress who resent big pay for those who presided over disaster, says Wayne R. Guay, a Wharton accounting professor. But he questions whether making such restrictions permanent would be wise, arguing that big firms "are not going to survive long-term by paying their executives $500,000. They're just not going to attract the talent."
Even severance payments can make sense, he says, citing cases of CEOs faced with losing their jobs by selling their firms, which is often the best move for shareholders. "A severance package is going to provide that CEO with some incentive to say, 'I am willing to sell out the firm and get fired, because there is a golden parachute that I will get,'" he suggests.
To critics, however, this reasoning underscores the corporate culture's hazardous fixation on self-interest. A top executive who is already wealthy by any ordinary standard should not need to be paid extra to do right by his shareholders, according to this view.
Minow says Corporate Library studies show that executives receive outsized pay because they exert excessive influence over their boards of directors -- influence that also can help a poor-performing executive hold on to his job. She says her organization's proprietary studies, which are sold to subscribers, show a correlation between excessive pay and poor shareholder returns.
While Minow argues that the widespread failures among financial firms show how pervasive bad management has become, others say the breadth of the problems shows the crisis was unpredictable, noting that not many regulators or academics saw it coming either. "This was not something that was missed by a bunch of dummies. They just didn't get it," says Gerrity. "The few voices that were expressing skepticism were drowned out by the fact that the market was booming." Executives felt compelled to jump into the subprime mortgage and other risky markets to compete. "Everyone was playing the roulette wheel."
Guay, too, feels it is too easy to blame corporate governance for the whole mess. "It is just hard to tell a story about why these firms would choose executives who weren't trying to maximize shareholder value," he says. Hence, executives striving to match competitors' use of lucrative mortgage securities were doing what their shareholders wanted -- and shareholders were not complaining at the time. "Most of these executives held a vast majority of their own wealth in their companies' stock or stock options, so they had the greatest possible incentives to maximize profits," he says, noting that many Wall Street executives not only lost their jobs after the business soured but much of their fortunes as well. "It's hard to say that all the banks hired bad executives."
Some critics argue that stock and stock options give top executives an incentive to manipulate results or take excessive risks to boost stock prices over the short term, and they suggest that executive performance should be judged according to different gauges, such as revenue growth, earnings measures or other data calculated by corporate accountants. But Guay notes that many types of data produced in-house are more easily manipulated than share price, which is governed by the market's judgment.
Shareholder groups have been pushing "say on pay" initiatives that would require companies to put executive-pay issues to shareholder votes. While such votes probably would be non-binding, the idea is that the prospect of an embarrassing "no" vote would prod directors out of paying too much and compel them to justify pay packages publicly. But Guay and Gerrity question whether many shareholders are equipped to make such decisions. "These [decisions] are complex," Guay says. "They require a lot of detailed information.... If we move the decision-making that has traditionally been in the hands of the boards back to shareholders, we sort of move away from the reason we have boards of directors in the first place."
That begs another question raised by the crisis: If directors are there to make tough decisions and oversee executives, why did they allow so much risk taking?
Minow and other critics say directors are too cozy with the executives to oversee them adequately. In many cases, the CEO is the chairman of the board, giving him significant say over who is offered a board seat, which can be worth hundreds of thousands of dollars a year at a major corporation. Although directors must be elected by shareholders, critics note that traditionally a candidate needs only a plurality of votes to win an election. Reformers want to require that candidates receive at least 50% of votes cast to win. Indeed, this requirement has been adopted fairly widely in the past few years. "More and more firms are starting to move in that direction and I don't think it's a bad idea," Guay says.
Back in the USSR
The effect of such "majority voting" is dampened, however, by the fact that there typically is only one candidate on the ballot for each board opening -- a candidate nominated by the board itself. Critics liken this to elections in the Soviet Union, complaining it is just too hard for challengers to get board approval to be placed on ballots, and they seek regulatory reform to open up the process. Most proposals would require candidates to be listed if they produce petitions representing a significant portion of shareholders, such as 3% or 5%. Business groups oppose the idea, arguing it would allow unions, environmentalists or minority shareholders to foment destructive turmoil.
But Lucian A. Bebchuck, a law professor at Harvard who specializes in governance, says such reforms would strengthen U.S. corporations, arguing they would serve shareholders better if they adopted some of the United Kingdom's governance rules. In addition to opening the ballots to challengers and shareholder-sponsored issues, reform should include requiring all directors to face election every year, he says. In the "staggered" system common in the U.S., only a fraction of directors face election in any given year. Advocates say this promotes stability, while critics say it helps entrench weak directors and managers. Bebchuk's studies have concluded that staggered boards weaken corporate performance. He says the range of reforms he advocates could be swiftly enacted by amending the Delaware General Corporation Law, since most U.S. companies are incorporated in that state.
Obama has supported say on pay and other governance reforms, and most experts expect the Democratic-controlled Congress to push these issues next year.
Eric. W. Orts, professor of legal studies and business ethics at Wharton, warns against putting too much emphasis on governance reform, believing other regulatory changes are more promising, including improved public disclosures about new securities such as credit default swaps. Firms were not ignoring risks; they did not have the data needed to see how risk was spreading through the system. Consolidating regulatory functions now scattered among different agencies would help, he says. "This is the ideal moment."
Useem, too, cautions against a quick resort to a handful of politically popular remedies. "The great danger is [you] screw up free enterprise," he says, arguing that Obama should establish a blue chip task force to consider governance issues in depth. "The way in which regulation is going to be effective here is if it [comes from] a lot of smart people [looking at] what happened at Lehman, Merrill and General Motors and saying, 'we can't let it ever happen again.'"
Any analysis of successful companies shows there is no single governance style that guarantees success, Useem says. Nonetheless, he believes that moves to make directors more responsive to shareholders and to open board elections to challengers could be helpful. It also can be useful to better tie executive compensation to long-term results by parceling out compensation over a number of years, with provisions for withholding portions if performance fades.
Having been so badly stung, many firms are already moving to address risk taking, Gerrity notes. "We have a healthy new thrust in corporate governance called enterprise risk management" to establish standing operations to take a more sophisticated and comprehensive look at a firm's risks. Depending on the business, that can entail everything from the risk of hurricane damage or terrorist attacks to the risk inherent in portfolios of mortgage securities, or factors that could threaten access to cash and credit.
Because these evaluations are so complex, they could be hampered if too much authority shifts from management and employees to shareholders, Gerrity adds. "You're not going to improve [risk management] from a thousand miles away, with no real knowledge of the needs of the firm. The only solution to this is more intensity and more courageous questioning. People didn't look at the systemic risk, which is more obvious now than it ever has been in our history, because markets are more interconnected."
More important than regulatory change is the need for a cultural shift to better emphasize long-term issues, Useem says. Ultimately, he notes, Americans may adopt a disdain for short-term risk taking similar to the disgust they have developed for smokers who light up in crowded rooms. A new risk-consciousness held by the public should work its way into the boardroom and executive suite, he says. "Rebuilding the national culture becomes absolutely vital."