The Dangers of Too Much Governance

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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.


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