Regulating Corporate Governance:

The Magic of the Marketplace

 

Murray Weidenbaum

Murray Weidenbaum holds the Mallinckrodt Distinguished University Professorship at Washington University where he is also honorary chairman of the Weidenbaum Center on the Economy, Government, and Public Policy. This speech was a presentation to the Conference on Corporate Governance, Washington University.

Financial markets, regulation, and business management interact in a variety of ways. Let us begin by trying to disentangle these three interrelated variables. To start, I suggest that the impacts of financial markets on business decision making are fundamental and well known. By purchasing a corporation’s stocks and bonds, participants in financial markets provide the long-term capital that finances the activities of the enterprise.

Examples of the disciplinary features of financial markets are commonplace. Poor financial performance makes it more difficult and costly for the enterprise to sell its bonds. For the more capital-intensive companies that issue debt regularly, notably utilities, this is a continuing source of concern to senior executives and it influences a host of everyday decisions.

Likewise, for any publicly held company, it is the rare member of the management that cannot tell you the current price of the company’s stock—and that does not mean something as ancient as yesterday’s closing price. To the holders of significant blocks of stocks and/or options, such information is compelling. So is it to executives whose current compensation depends in part on the performance of the company’s stock.

From a broader viewpoint, changes in the price of a company’s stock can have many repercussions on business decision making. A rising stock price lubricates acquisitions and makes new stock offerings more attractive. It also helps to keep shareholders happy. Conversely, a poorly performing stock restricts corporate discretion. It also arouses shareholders and it may make the company more vulnerable to a hostile takeover.

Finally, any doubters of the influence of financial markets on business decision making should recall the recurrent criticism of the short-term orientation of American business. Critics claim that too much—rather than too little—management attention is focused on actions that could raise the stock price in the next quarter or two. We can even recall instances where extraordinary compensation was promised to top management if the company’s common stock would reach a designated price for just a 10-day period. That may be the epitome of focusing management attention on financial markets. The adoption of such compensation practices surely raises serious issues of corporate governance.

Let us now turn to the role of government regulation. We are in the midst of an unusually rapid expansion of federal involvement in corporate governance. As a long-term corporate director, I feel impelled to report a personal attitude that departs considerably from the views that we economists hold on the subject of regulation.

Just for the record, I have devoted a substantial portion of my academic research to evaluating the impacts of regulation on American business, especially manufacturing. Early on, I advocated the introduction of benefit/cost analysis to screen proposed regulations. This approach enables the analyst to take an ostensibly neutral position, giving equal weight to the benefits and the costs. I did learn that, if you are in the middle of the road, you will be hit by traffic going in both directions.

As a board member, however, I instinctively view regulatory requirements in a negative light, as an annoying and unhelpful intrusion. As a practical matter, I lean heavily on the general counsel and the chief financial officer to keep the bureaucrats at bay—so that we directors can continue to exercise our independent and informed judgment on the important issues facing the board and the company.

To clear the air, the desired result is not passivity on the part of the board. Having led the ouster of the CEOs of two large companies, I may have a different view of the boardroom than others. Surely, there are serious matters that directors face in dealing with the chairman and the management—especially when the two roles are combined. My point is that I do not find government officials helpful in that process.

In any event, regulation is a rising influence on corporate governance. Surely, if the requirements imposed by the Sarbanes-Oxley bill result in substantially greater confidence in the financial reporting of American business, the results may well justify the added costs being imposed. I remain a skeptic, however, because I believe that the Enron experience had a greater—and more positive—impact. Indeed, Enron continues to be a presence in many boardrooms today. No director wants to suffer the fate of the Enron directors who were tossed off other boards just because they wore the Enron badge of shame.

Advocates of more governmental intrusion in corporate governance tend to ignore the demonstrated ability of private enterprise to reform itself. As I recall, the initial requirement for a board to have an audit committee of outside directors came, not from the governmental securities regulators, but from the New York Stock Exchange. Also, following substantial criticism, most boards of larger corporations voluntarily shifted their composition to a heavy majority of outside (albeit not necessarily independent) directors.

I remain a skeptic of the effectiveness of government regulation for reasons that go beyond the area of corporate governance. Unlike the familiar tools of government expenditure and revenue, regulation is politically popular because it does not involve significant amounts of federal resources. The substantial compliance costs generated by regulation are buried in business financial and operating reports. I refer to the hidden tax of regulation, which is thus also off-budget. As politicians occasionally admit, “The best tax is a hidden tax.”

Regulation frequently generates adverse side effects and Sarbanes-Oxley (SOX) is no exception. Several foreign companies have taken action to avoid the hidden tax imposed by the new statute. They have done so by withdrawing their shares from trading in the United States and also have withdrawn their registration with the Security and Exchange Commission (SEC). Perhaps a far greater side effect of the recent expansion in government regulation of corporate governance is the tendency of some companies to go private. Also, some investment advisers urge their wealthy clients to avoid serving on corporate boards. Their concern relates to the rising liability facing directors.

This situation is compounded by a loophole in the normal regulatory review process. Like other independent regulatory commissions, the SEC is exempt from the requirement for federal agencies to do a benefit/cost analysis prior to promulgating a new regulation. Hence, there may be more than a remote possibility that the costs imposed by the regulations issued pursuant to SOX exceed the benefits generated.

Some indirect evidence is provided by the studies of the relationship between board composition and company performance. These studies in general do not support the implicit assumption underlying SOX. There is no impressive body of evidence demonstrating that outside directors enhance company performance. Perhaps that should not be surprising. After all, Enron’s board likely met the Sarbanes-Oxley requirements with flying colors.

I must report that ostensibly independent outside directors at times can rubber stamp management proposals while some inside directors can exert their independence. In earlier years, when inside dominated boards were commonplace, the compensation of CEOs was less dramatically large and closer to that of other members of management.

To complete this analysis, I submit that one of the lessons learned from earlier regulatory statutes is that, sooner or later, companies learn how to adjust to and comply with regulatory requirements. They build such compliance into their operating procedures. Like any other cost it faces, management tries to minimize it and sometimes learns how to get around the law and regulations. This leads us back to the powerful and continuing role of financial markets in disciplining corporate decision making.

Does the overall process of relying primarily on the pressures of the market work effectively? The answer is clear. Compare the performance of American business with that of other advanced industrial economies. Over the years, we outperform Western Europe and Japan—in production, profitability, and job creation. It is a tribute to what Ronald Reagan called “The Magic of the Marketplace.”     *

“When those who are governed do too little, those who govern can—and often will—do to much.” –Ronald Reagan