Corporate Governance: Don't Rush ReformsFrank Aquila
The last decade has been an economic perfect storm. Things got off to an unpleasant start with the bursting of the dot-com bubble. The Enron/WorldCom/Tyco scandals followed close behind. The past few years have featured the subprime mortgage crisis and the credit crunch precipitated by the Lehman Brothers bankruptcy. For equity investors pummeled by losses, this has been a decade to forget. When bad things happen, human nature yearns to identify and punish whoever is responsible. Seeking protection, we also want to fix things so that such problems never occur again. However, this can be a bit like generals fighting the last war: Legislating a "one-size fits all" solution in response to a particular economic situation is rarely effective at preventing future, largely unpredictable problems. If it were otherwise, the Sarbanes-Oxley legislation enacted in 2002 would have eliminated all problems in corporate governance, financial controls, and disclosure. That hasn't happened. Sarbanes-Oxley has not, as many predicted when it was enacted, eliminated all corporate ills. While the legislation certainly did not create the subprime mortgage crisis, it unfortunately did not prevent it. In fact the subprime meltdown and its aftereffects may well be the best testimony that even the most comprehensive revision to American corporate governance in more than a generation could not repeal the economic cycle or pop the next "bubble" before it burst. The reality is that no set of corporate-governance mechanisms could have forestalled a crisis of the magnitude or complexity of the one we have experienced. U.S. directors act for shareholdersWhat is corporate governance and why should we care about it? In modern capitalism there often is a distinct separation of ownership (the shareholders) from control (the board of directors and senior management) of the business enterprise. Corporate governance defines the relationship between the shareholders and the managers. The willingness of investors to purchase a corporation's shares is based not only on the performance of the business, but also on the trust in that corporation created by effective corporate governance. In the U.S., the cornerstone of corporate governance has long been reliance on the board of directors to act on the shareholders' behalves to supervise and direct the management of the corporation. Corporate governance is not designed just to avoid the next financial disaster. Effective corporate governance is also good for business. Academic studies have consistently shown that companies with independent boards of directors produce greater returns on shareholder equity, achieve higher profit margins and return more capital to their investors than competitors without independent boards. The shareholders of Enron learned the hard way that weak corporate governance can facilitate an environment in which fraud and mismanagement can occur. James Wolfensohn concluded when he was president of the World Bank that "the governance of companies is more important for world economic growth than the government of countries." Simply put, well-governed companies deliver better results. a corporate-governance free-for-all?We have seen a steady stream of corporate-governance reform proposals in the last several years. Some are worthy, some are bad, and a few are distinctly misguided. While many of these proposals focus on increased shareholder influence over corporate policy, many focus on political "hot button" issues such as social responsibility, global warming, government influence, and political contributions. As we consider various proposals and their proponents, a few observations become increasingly clear. First, corporate governance is now merely a catchphrase used to promote and justify a relatively broad range of restrictions and requirements on the U.S. private sector. Second, the constituencies that are staking a claim to the "corporate-governance" turf are extraordinarily diverse, with varied agendas. Whether we agree or disagree with their proposals or subscribe to their agendas is largely irrelevant. So another round of corporate-governance reform is likely inevitable. It has long been the premise of American capitalism that profit and return on investment to shareholders are the primary indicators of the success of a business enterprise. Guided by this thesis, corporate-governance mechanisms have been, and should be, designed to increase the likelihood that the corporation will create value for its owners. Strong corporate governance is essential to achieving shareholder value and sustainable economic growth. To be effective, a balance must be found that gives weight to the legitimate interests of all stakeholders. Few businesses can achieve long-term profitability and growth if they are at war with their employees, consistently violate the law, or are in conflict with the communities in which they operate. This does not mean that the employees, the government, or local communities necessarily have a formal role to play inside the boardroom. Rather, the board of directors needs to take into account the interests of these constituencies and achieve a balance which will likely create long-term growth for the corporation. shareholder value and economic growthCertain basic elements of corporate governance appear to work across industries, geographies, and circumstances. The independence of a majority of the board and accurate, transparent public disclosure are key in almost all circumstances. If a majority of the directors of the board of a public company is independent and faces no impediments to making fully informed and disinterested decisions regarding the company, the best possible results are likely to be achieved. An independent board of directors—coupled with accurate, clear, public disclosure—has consistently provided shareholders with the most effective protections. To implement changes that go beyond the basic principles that have worked so well would risk losing focus on the role of corporate governance and indeed, the role of the corporation in our society. The farther corporate governance strays from these core principles, the less likely it is that directors and the corporations they oversee will be able to achieve their fundamental mandate of increasing value for shareholders and providing economic growth for society as a whole. Corporate-governance reform is coming, but any "reform" that fails to recognize the ideals that have made American capitalism the global symbol for prosperity and wealth creation will most certainly fail. As any doctor will caution, the first rule is do no harm. We can only hope that legislators, regulators, and shareholders remember that rule.