Chapter 6: Governance

6.1 Corporate Governance

Stewart C. Myers

I'm proud to represent finance at the Sloan School's 50th anniversary celebration and in this volume. Finance is a much more important and sophisticated field than it was 50 years ago. I'm proud because many of the most far-reaching changes in finance during that halfcentury can be traced back to Sloan faculty and graduates. If you studied finance at Sloan, you had a head start on most of the rest of the world.

This paper^[1] focuses on corporate finance, specifically governance and financial management in Europe and China. The hot word today is governance, of course, and I know what you're thinking: Why talk about governance in Europe and China, given the mess we seem to face at home?

Two answers to that question. First, we have exceptionally bright and hard-working M.B.A. students at Sloan, but they couldn't tackle the whole world at once. The most notorious examples of unsound finance and governance in the United States had not come to light when the students' projects started up a year ago. Second, when something seems broken at home, it doesn't hurt to seek advice from thoughtful senior executives from other countries. It helps to see ourselves as others see us.

So we invited two distinguished international business leaders, Dr. Rolf Breuer and Dr. Victor Fung, to comment on governance and financial management in the United States and their own countries.

I will introduce this topic with a few extra words on governance and finance in the United States and then note three general lessons to keep in mind in reading the material that follows.

Why are we now so concerned about the recent state of American corporate finance and governance? The concerns can be traced to revelations of two general types. Either type of revelation would be a disappointment. Taken together, they are much worse.

The first is waste. Hundreds of billions of dollars were lost, especially in the telecom and dot-com meltdowns. I'm not just referring to falling stock prices—of course investors lost when the bubble burst. That was especially painful where retirement savings were at risk. But the $60 billion of market value that disappeared when Enron fell wasn't really lost. It wasn't there in the first place.

For the economy overall, the more important loss is the hundreds of billions of dollars of capital invested in real assets, both tangible and intangible, that are now nearly worthless. The loss also includes the human capital that could have been productive elsewhere, and is now looking for new employment.

The second revelation has to do with ethics. We have seen so many examples of egregious behavior by CEOs, CFOs, accountants, security analysts, investment bankers, and others. We've seen examples of dirty tricks, concealment, manipulation, lying, and top management compensation that amounts to looting.

Although there is no shortage of bad guys, please note that the stock market bubble created the space for the bad guys to operate. Investors must share the blame. They were driven by infectious greed to exploit the irrational exuberance of investors. (Double apologies to Alan Greenspan.)

The bad guys do serve a useful role, however, because they personalize the specific problems that need action now. The bad guys' behavior exemplifies what needs to be fixed. Thanks to them, we will get more transparent accounting, more independent and diligent boards of directors, more credible security analysts. We'll get more effective diversification of pension investments, and top management compensation schemes that are fairer and better aligned with stockholders' interests. We may even get expensing of stock-option grants, which should have been a no-brainer all along.

We'll achieve these things partly through tighter laws and regulations, but largely because investors will demand them. The present value of a reputation for competence and fair dealing has just scored a very healthy capital gain.

Tighter laws and regulations, designed to prevent the bad guys or gals from "doing it next time," are important now for investor confidence. So far these legal and regulatory changes—for example, the Sarbanes-Oxley bill and the New York Stock Exchange's new rules—are on balance positive. (I would say that about 50 percent of the specific changes are positive, 30 to 40 percent nearly harmless, and only a small minority dangerous.)

But it's about time to take a longer view, lest the dangerous changes multiply. We don't need new laws and regulations that penalize risk taking or impede the free movement of capital. Forgive me for stating the obvious, but the first task of the financial sector is to move capital to all the companies that can invest at superior risk-adjusted returns.

Some of that capital flows from fresh saving, some flows out of mature companies that exhaust their positive-NPV investments. (At least it should flow out of those companies. A financial system that restricts outflows of capital to investors—for example, by prohibiting share repurchases or blocking takeovers in declining industries—is just plain wasteful.)

How does this relate to governance? Again, I state the obvious. Capital flows only if it is protected. It flows through public equity markets only if public investors are protected.

The size of the stock market, relative to GNP, say, is a good rough measure of how effective investor protection is. The United States and other Anglo-Saxon countries score high on this market capitalization-to-GNP ratio, compared to most other developed economies. That may reassure American investors. I admit, however, that a positive year's return from the stock market would be even more reassuring.

You see my first general lesson: the main goal of improving corporate governance is not to catch or deter the bad guys, satisfying as that may be. It is to protect investors so that capital can flow in or out of the right companies at the right times.

I hasten to add that complete protection of investors is neither feasible nor desirable. It is not feasible because outside investors cannot know what employees and managers are doing or why they are doing it. One can write a law, regulation, or contract that specifies what a manager can't do, but no team of lawyers can write down what the manager should do. It is not just a problem of divining an uncertain future. We do not know what the future could be, much less what it will be.

Managers must be given discretion to act. Having discretion, they will consider their self-interest as well as investors' interests. The most that investors can do is to monitor and control through intermediaries, such as a board of directors. They can check that managers' and investors' incentives are reasonably congruent, and hope that laws, regulations, and the threat of takeover will keep management on the right track, more or less.

Complete protection for investors is not desirable, even if it were feasible. It would require too much of a power-shift to investors. I like to think of a public corporation as a kind of partnership between its insiders—its employees and managers—and the outside investors who finance the firm. A corporation requires coinvestment of human capital and financial capital. If you give the financial capital too much power, the human capital never shows up.

The second general lesson is this: An optimal system of corporate governance would ensure that human and financial capital are deployed with maximum joint efficiency.

The third general lesson is again obvious when you think of it. There is no single optimal system of corporate governance. Governance has to adapt to the nature of the business and to the legal and institutional environment. For example, the financing and governance arrangements that have evolved in U.S. private equity markets would not work in public markets, nor would the public markets' rules work for private equity.

Since we see different governance systems operating inside the United States, it should be no surprise to find that financing and governance have evolved differently elsewhere. When the student teams started their projects a year ago, there was no presumption that Anglo-Saxon finance should be exported to Europe or China. The only presumption was that corporate finance in Europe and China will change. The challenge was to understand how and why. The student reports and the comments of Drs. Breuer and Fung show how these governance systems are likely to change, and identify the most important issues of financial management in Europe, China, and the United States.

^[1]These remarks by Stewart C. Myers were presented at Sloan's 50th Anniversary Convocation. They have been edited to provide cross-references to other parts of this book.