I'm going to be on a panel on "Rethinking Shareholder Value and the Purpose of the Firm" here at UCLA on Thursday:
Join UCLA School of Law, The Aspen Institute and top thinkers in business and law to explore what priorities are legally demanded of corporations, rethink what is meant by "creating shareholder value," and ask "What really is the purpose of the firm?"
Panelists include Professor Stephen Bainbridge, UCLA School of Law; Professor Henry Hansmann, Yale Law; and Roger Martin, Dean, Rotman School of Business, University of Toronto. The panel will be moderated by Professor Lynn Stout, UCLA School of Law.
The organizer sent around several questions to stimulate our thinking, including the following:
In light of all that has happened in financial markets and the economy over the past several years, has your thinking changed about the purpose of corporations and their role in society?
I gather that the question was designed to get at my views on corporate social responsibility. Since my views on that subject remain unchanged and simple--to quote Milton Friedman,The Social Responsibility of Business is to Increase its Profits, I'm going to follow the hallowed academic conference practice of ignoring the question and talking about what I want to talk about instead. So here's where I'm going to go:
People get religion about ethics and corporate governance in down markets. When things are going well, they tend to forget about it. Given the savage economic downturns that bookended the last decade, it is hardly surprising that legislators, regulators, business people, and investors have gotten the corporate governance religion. But have they found true religion or are they worshiping false idols?
The economic crises of the last decade prompted two sweeping federal statutes affecting corporate governance. In response to the scandals that followed in the wake of the dotcom bubble, Congress passed the Public Company Accounting Reform and Investor Protection Act of 2002 (Sarbanes-Oxley or SOX), which President Bush praised at its signing for having made “the most far-reaching reforms of American business practices since the time of Franklin Delano Roosevelt.” At the end of the decade, when the economy suffered through an even worse downturn following the bursting of the housing bubble and the subprime mortgage crisis, populist outrage motivated Congress to pass the Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank).
Sarbanes-Oxley and Dodd-Frank are the latest iterations of the recurring pattern of federal intervention in corporate governance. In the United States, regulation of corporate governance traditionally was the states’ job rather than that of the federal government. Since the New Deal, however, the federal government repeatedly has responded to major economic crises by significantly expanding its role in corporate governance regulation.
In an influential law review article, which slammed the Sarbanes-Oxley Act as “quack corporate governance,” Yale law professor Roberta Romano singled out five of Sarbanes-Oxley’s corporate governance provisions for detailed criticism. First, she criticized Sarbanes-Oxley § 301’s mandate that all public corporations must have an audit committee comprised exclusively of independent directors. Romano contended that the empirical evidence on the efficacy of director independence in general and audit committee composition in specific was, at best, mixed. Second, she pointed out that § 201 prohibited accounting firms from providing a wide range of non-audit services to public corporations they audit, even though the weight of the evidence was that provision of such services did not degrade audit quality. Third, she argued that § 402(a)’s prohibition of most loans by corporations to their executives was unjustified because such “loans in many cases appear to serve their purpose of increasing managerial stock ownership, thereby aligning managers’ and shareholders’ interests. . . .” Fourth, she argued that §§ 302’s and 906’s CEO and CFO certification rules imposed significant costs even though the evidence as to whether such certifications provide useful information to investors was ambiguous. Finally, she correctly predicted that § 404’s requirement that management and the firm’s outside auditor certify the effectiveness of the company’s internal controls over financial reporting would prove hugely burdensome.
In my forthcoming book, Corporate Governance After the Financial Crisis (Oxford University Press 2011), I show that subsequent developments have fully confirmed Romano’s pessimistic assessment of SOX has been fully borne out. The benefits of SOX have been difficult to identify—let alone quantify—while the costs have been dramatic and far higher than anyone anticipated. (You can pre-order the book from Oxford or Amazon.)
By the middle of the decade, experience with the high compliance costs imposed by the Sarbanes-Oxley Act, especially § 404, generated significant push back from the business community. The SEC and the Public Company Accounting Oversight Board (PCAOB) offered several iterations of regulatory relief. There was even talk of a legislative fix for § 404. The financial crisis of 2007–2008, however, brought talk of deregulation to an abrupt end. Instead, Congress began looking at a so-called “New New Deal,” which would undertake massive new regulation of the financial markets.
In short order, a nearly universal consensus formed among legislators, regulators, and opinion makers that corporate governance was again at fault. The Organization for Economic Cooperation and Development (OECD) commissioned a fact-finding study premised on concern “that the financial crisis can be to an important extent attributed to failures and weaknesses in corporate governance arrangements.” The Shareholder Bill of Rights Act of 2009 introduced in the U.S. Senate contained an express Congressional finding that a “central cause” of the economic crisis was a “widespread failure of corporate governance.” In Europe, the High-Level Group on Financial Supervision in the EU concluded that financial institution corporate governance was “one of the most important failures” in the crisis. In the U.K., a government-commissioned review by Sir David Walker concluded that the “need is now to bring corporate governance issues to center stage.”
In fact, however, systemic flaws in the corporate governance of Main Street corporations were not a causal factor in the housing bubble, the bursting of that bubble, or the subsequent credit crunch. In the wake of the earlier dotcom bubble, Bengt Holmstrom and Steven Kaplan published a comprehensive review of U.S. corporate governance concluding that the U.S. corporate governance regime was “well above average” in the global picture. Indeed, the trend throughout the last decade with respect to major corporate governance practices was toward enhanced management efficiency and accountability. Pay for performance compensation schemes, takeovers, restructurings, increased reliance on independent directors, and improved board of director processes all tended to more effectively align management and shareholder interests.
These improvements had demonstrable results. Holmstrom and Kaplan showed that, even when the fallout from the bubble was taken into account, returns on the U.S. stock market equaled or exceeded those of its global competitors during five time periods going back as far as 1982. Likewise, U.S. productivity exceeded that of its major Western competitors.
According to a more recent survey by U.K. legal expert Brian Cheffins, “[a] striking aspect of the stock market meltdown of 2008 is that it occurred despite the strengthening of U.S. corporate governance over the past few decades and a reorientation toward the promotion of shareholder value.” A 2010 report commissioned by the NYSE reached the same conclusion, finding that “the current corporate governance system generally works well.”
We can draw a couple of important conclusions from this evidence. First, what constitutes good corporate governance depends on which constituency’s interests one is seeking to advance. Governance regimes that advantage shareholders may not be good for taxpayers. As we will see, however, virtually all of the reforms mandated after the crisis were designed to empower shareholders. The risk thus is that the reforms may make the next crisis more likely and potentially more severe.
Second, one size does not fit all in corporate governance. The problems of Wall Street and Main Street are quite different and may require quite different solutions. As we will see, however, the response to the crisis consisted almost without exception of one-size-fits-all mandates, from which derogation by private ordering is not allowed.
Why did corporate governance veer in untoward directions after the crisis? The crisis shifted the corporate governance game onto a new playing field and created an environment in which a new set of players took prominence. Specifically, it reengaged the federal government as a regulator, bringing with it powerful interest groups like unions, pension funds, activist investors, trial lawyers, and their academic allies.
Are Dodd-Frank’s governance provisions quackery, as were Sarbanes-Oxley’s? In my forthcoming book, I offer an affirmative answer to that question. Without exception, the “reforms” lack strong empirical or theoretical justification. To the contrary, there are theoretical and empirical reasons to believe that each will be at best bootless and most will be affirmatively bad public policy. Finally, each of Dodd-Frank’s governance provisions erodes the system of competitive federalism that is the unique genius of American corporate law by displacing state regulation with federal law. Dodd-Frank is thus shaping up to be round two of federal quack corporate governance regulation.