How to Fix One Root Cause of Our Economic Crises

The slow demise of the U.S. car industry over decades and the spectacular collapse of the U.S. financial system have a lot in common. Both implosions are the result of poor management: shortsighted incompetence in the car industry and reckless risk-taking in the financial sector. Where was the oversight? And what could be a better indictment of the incentives in our system than the fact that even the executives who made the most egregious calamitous decisions are all walking away as rich men, while many of their shareholders have been wiped out?

(The Corporate Library reports that Richard Fuld, the person primarily responsible for the destruction of Lehman Brothers (and clearly among the most incompetent CEOs of all time), was the 13th highest CEO in 2007, with $71.92 million in compensation in 2007, including more than $40 million in value from realized stock options. The third highest-paid executive on the list was Angelo Mozilo, former CEO of Countrywide Financial Corp., which collapsed on its subprime loans. His total actual compensation for 2007 was $124.69 million. Bank of America had to pay him another hundred million dollars to make him disappear. It took government intervention to stop the CEOs of Fannie and Freddie from receiving $25 million in parachutes. The list of scandalous pay and no board supervision goes on and on.)

The fact is that our US corporate governance system is dysfunctional. The most important feature of a governance system is its ability to limit the power of those CEOs—the black sheep if you will—who are inclined to break it. Therefore, the only effective mechanisms are those that are external to the firm — those that cannot be dismantled by bad CEOs: management’s fiduciary duty, the requirement to hold an annual meeting, the possibility of an external takeover (at least before Delaware gave management the poison pill and staggered boards to prevent them), the negative publicity surrounding excessive salaries. In contrast, internal governance mechanisms, such as the power of the Chairman’s board to fire the CEO, are seldom effective. Any bad CEO worth his salt will have worked hard to make this extremely difficult.

It is imperative to our global competitiveness that we improve our corporate governance system. If we do not, we may fix all our present economic calamities only to have new ones erupt elsewhere before long.

Some of my fellow economists argue on principle against almost all government intervention. But this is wrong. Would they really advocate allowing corporate boards to vote to eliminate all fiduciary duty to shareholders? I hope not.

Of course, government regulation is a tricky business, but a debate for or against it misses the point. Firms and markets cannot function efficiently with too little regulation (witness Somalia) or too much (witness the Soviet Union). All markets require some rules and policing. What we need now is a debate over the right kinds of regulations that should be put in place. We need regulations that are effective and cheap — a difficult combination to come by.

An example of what our political process usually comes up with is Sarbanes-Oxley—a knee-jerk reaction to the latest corporate scandal. SOX created large compliance costs and few governance benefits. Its cost-benefit ratio was too high. Even with the best intent of our lawmakers, Congress is simply not capable of dealing with the dynamics of our markets and firms. If Congress were to legislate detailed corporate governance regulations, whether intentional or not, it is likely that our next corporate governance bill will be just another employment bill for lobbyists, lawyers, and accountants, with black sheep managers running circles around the law’s intent.

So what should we do? There is, in fact, one example of government regulation that works, and it operates in our own country. The Financial Accounting Standards Board (FASB) is the official government-endorsed institution in charge of Generally Accepted Accounting Principles. FASB is not perfect, nor is it entirely immune from political influence, but it is a success story. Its standards are followed even by many firms that are not required to do so.

I propose that we charter an equivalent official standards board that sets best practices for corporate governance—one definitive board, not twenty different commissions, think tanks, or firms that try to sell their corporate governance consulting services to the corporations that they rate. Like FASB, our governance board can rely on the expertise of many of its constituents, such as experts from the corporate sector itself, from academia, from the consulting industry, and so on. Most importantly, it would be more insulated from the “scandal-du-jour” and the day-to-day political wrangling that characterizes Washington. It could focus better on its mission of setting good governance standards.

Boards that follow the official standards should be afforded an additional layer of safe-harbor protection against shareholder lawsuits. With the addition of some social pressure “to get on board,” I believe that this essentially voluntary system could nudge most U.S. firms to adopt standards that would give shareholders meaningful control to rein in poor CEOs, without imposing excessive costs on good CEOs. For example, the standards board might adopt a rule against staggered boards. Some firms may find that the benefits of a staggered board outweigh its costs. If they keep it, the standards to which such a board’s behavior should be held in a shareholder lawsuit should then be higher. Even in our current system (that is, even without an extra safe-harbor for complying firms that I would advocate), the very fact that a board has not followed official best practice would expose its members to more legal risk.

We can argue about what this standards board should recommend; I have my own list of favorites. However, we should not let a debate over specific ideas cloud the more important issue: the creation of an institution that has the ability to think about good and cost-effective corporate governance in an ongoing, expert fashion. It will not be perfect. There is no telling whether it will err on the side of too little or too much governance regulation. But it is much more preferable to having corporate governance be made in Washington.