Our Recommendations

In this section, we present our recommendations for improving the corporate governance system. In some cases, we briefly repeat the proposals of others (see Chapter 12) to put our recommendations in perspective. The following recommendations are presented in the same order of the incentives and monitoring participants that we have discussed in this book.

Stock and Stock Option Incentives

The purpose of granting shares of stock or stock options to executives is to align their interests with those of the shareholders. If the executives can create value for a firm, the stock price will rise. The added stock wealth makes shareholders richer. The executives can then cash in their stock or options for a big profit and also become richer. We have argued that this equity-based compensation partially aligns management's interests with those of shareholders. However, it also creates a short- term focus in which executives manage earnings (fraudulently or otherwise ) to maximize the stock price in the short run, not the long run. In this way, executives can cash out their rewards quickly and at a high price. Unfortunately, this may be at the expense of the future financial health of the firm.

We have also identified the problem that stock options reward managers for increases in the stock price. However, the stock price is not the best measurement of managerial performance. Poor measurements lead to the wrong incentives and, ultimately, to the wrong behavior. We address these problems in the next two subsections.

Insider Equity Sales

To better align the interests of insiders to those of the average shareholder, we propose that insiders announce their intent to sell equity and must spread out their sales over a three-year period. Specifically, the insiders would file a schedule with the SEC showing a plan for equally distributing the total number of shares to be sold quarterly over a minimum of three years. For example, when a CEO decides to sell one million shares of stock, he or she would file a form with the SEC stating that 83,333 shares will be sold each quarter over the next three years .

Consider how this rule changes the incentives of insiders. When managers can cash out all at once, they end up having a short-term focus. They may try to maximize the stock price at one point in time, and they can do this by being aggressive in accounting methods by moving future sales to the present. For example, Enron would make a deal to sell energy over the next 20 years to a client. Then it would book all the profit over the 20 years into the current quarter or year. Enron called this marking-to-market. It sure makes the present year look good ”but at the cost of mortgaging the future. Then the executives cashed out hundreds of millions of dollars in profits while the stock price was artificially high. If those executives were forced to sell over a three-year period, their incentives would change. They would no longer be willing to sacrifice the future for the present because much of their own profit would have to be obtained in the future. Many of the recent corporate scandals originated with executives who were trying to maximize the stock price at a given point in time to exercise their stock options. They hired consultants and investment bankers to figure out ways to do this. The boards weren't watching and the auditors either missed it or were hampered by their own conflict of interest. If the executives had a different incentive, like maximizing the stock price for the long term, they would have acted differently. Our recommendation better aligns the managers' motives with the shareholders' goals. After all, shareholders want high stock prices too, but they want high prices without having to worry about managers' myopic motives.

We consider insiders to be the top executives and the board of directors of a firm. This definition should also apply to insiders' family members and people who have been (but no longer are) insiders of a firm at any time during the previous three years. That is, leaving the company does not absolve someone of the requirement to sell over a three-year period. After all, we don't want the CEO to quit when the company is facing tougher times just so he or she can cash out.

It is always suspicious when an insider of a firm sells equity right before a big stock price decline. Did the insider have information about the future that was not publicly disclosed? Did he or she trade on the information? If insiders had to announce their equity sales and spread them over three years, there would be no need to be concerned that insiders were making investment decisions from private information. That information would become public during the three years the insider was selling. President Bush and Vice President Cheney would not be under the vale of suspicion that they are now under because they would have sold their stock over time instead of all at once near a market peak. Martha Stewart would still be under suspicion because she could still have dumped her ImClone stock (she would not be considered an insider of that firm). However, under our proposed insider selling regulation, CEOs like ImClone's Sam Waksal might become less willing to divulge inside information.

Changing Option Structure

Stock options give the executives of a firm the incentive to manage the firm in such a way that the stock price increases. This is also what the stockholders want. Therefore, stock options are believed to align managers' goals with shareholders' goals. This alignment helps to overcome some of the problems with the separation of ownership and control (Chapter 2). Using stock options to align managers' interests with shareholders' interests has become very popular over the last 30 years. However, there are problems with the way that these options are being used. One problem was addressed in the previous section. That is, options lead to a market timing incentive. There are other problems that can be fixed by altering the structure of options issued.

Specifically, options are a poor, merit-based compensation scheme because managers only have partial influence over stock prices. Stock prices are affected by the performance of a company. However, many other factors influence prices that executives have no control over. When the economy thrives, stock prices rise ”even for those companies that are poorly run. This may richly reward executives through their options when they do not deserve rewards. For example, consider the fate of Nabors Industries. From 1995 to 1997, the oil and gas drilling company's stock increased by 386 percent. This seems impressive, doesn't it? However, the oil and gas drilling industry rose in value by 424 percent over the same period. Nabors Industries actually underperformed the industry. Yet, Nabors Industries executives cashed in equity compensation worth nearly $48 million. ^[1] Quite a payday for a firm that was a laggard in the industry!

Alternatively, the stock market may fall because of poor economic conditions or investor pessimism. A company with management that is able to outperform its competitors may still find that its stock is falling ”and thus not be rewarded for success. Companies have responded to this last situation by repricing the executives' options. If the options give a CEO the right to buy at $40 per share (the strike price) and the stock is currently trading at $20 per share, the options are underwater. To give the CEO more incentive, the board may reprice those options to a strike price of $20 per share.

Repricing options is not a very good solution to the problems with options as compensation. First, repricing only attempts to solve one of the two problems we just identified. Second, and more importantly, it creates bad incentives for executives. If repricing becomes common, the CEO knows that he or she can take some risk with the firm. If risky decisions pay off, the stock price will soar and the CEO cashes in for megabucks. If those decisions fail, the stock price plummets. The CEO negotiates for repricing and is ready to take another big risk with the firm. Repricing options takes away the risk for the CEO! ^[2] With no risk to his or her own future wealth, the CEO has an incentive to gamble with the firm (heads, the CEO and shareholders win; tails , the shareholders lose and we try again).

We think a better solution is to use indexed options. That is, executive options should be linked to an industry index. Traditional options fix the price at which executives can buy shares of stock. A bull market will increase the stock price to a level much higher than the fixed price (or strike price). A bear market will sink the stock price to a level far below the strike price. Therefore, the price of the stock might be more related to the type of stock market (bull versus bear) than to the results of a CEO's decisions. Indexed options take into account the type of stock market and reward executives for outperforming their industry ”even in a bear market.

The following describes how indexed options work. Consider, for example, that the stock of a company is currently trading at $50 per share. The CEO is given indexed options with a strike price at $50 that is linked to the industry. Over the next few years, the company's stock price increases to $75 per share. With traditional options given to CEOs, he or she could buy stock for $50 per share with the option and sell it for $75 per share, thus making a $25 profit on each option owned. However, the price at which the CEO can buy the stock is linked to the industry index in an indexed option. For example, let's assume that during the same period, the entire industry also increased such that the indexed option strike price moved to $65 per share. The CEO did indeed manage the firm well. The industry increased in value by 30 percent while the company increased 50 percent. The executive is rewarded through the options with a $10 per share profit (=$75 “$65). If he or she has options for 1 million shares, the profit would be $10 million. However, if the industry did better than this company, the strike price might rise to $80 per share. Since the company's stock only rose to $75 per share, the CEO did not manage the firm as well as the other firms in the industry were managed by their CEOs. He or she should not be rewarded for his or her sub-par performance. And, indeed, the CEO is not rewarded by the index-linked stock options ( “$5=$75 “$80).

Now consider the effect of a bear market. If the stock price were to drop to $30 per share, normal stock options have no exercisable value and are said to be underwater. However, the index-based option may still have value for a good manager. If a firm's industry index dropped to $25 per share, the manager has beaten the index and deserves some reward. The indexed option pays $5 per share (=$30 “$25).

The advantage of indexed-linked options is that they reward managers for outperforming their industry regardless of good or bad economic times. In this way, only good managerial performance is rewarded, and it is rewarded in both bull and bear markets. This type of option compensation creates a better alignment between managers and shareholders and avoids the problems of option repricing. Although indexed options are a more recent evolution of executive compensation, their option pricing and valuation dynamics have been worked out. For example, there is another advantage for companies that expense options. Option valuation models show that the initial value of the indexed options is lower than the value of the traditional options. ^[3] Therefore, indexed options cost a company less to issue!

Auditing Firm Incentives

The auditing process is an important part of the monitoring system in corporate governance. We describe the history and situation of auditing firms in Chapter 5. Two problems are identified. The first problem is the conflict of interest that occurs when auditing firms also provide lucrative consulting services to a company. The second problem is that auditing firms want to provide auditing services to a company for many years. That is, they want to keep the public company as a long-term client. This makes the auditors less willing to challenge the company's accounting methods.

The government's response to these problems is to mandate that a consulting firm cannot provide auditing services to any company it consults with, which effectively solves the first problem, and to increase the regulation in the auditing industry. The Public Company Accounting Reform and Investor Protection Act creates another regulatory organization called the Public Company Accounting Company Oversight Board to oversee the auditing industry. The oversight board operates under the discretion of the SEC. However, we foresee that the board will find that it has the same problem as the SEC and any other regulator ”it has few regulators watching many auditors, who, taken together, are conducting tens of thousands of audits . The first of the government's solutions actually changed auditor incentives. However, the creation of the new regulators does little to change incentives. Accounting fraud has always been illegal. There have been private organizations (like the new board) formulating policy and setting standards for many decades.

Instead of the government's two solutions, we propose one solution that changes incentives for auditors and solves both problems (and others!). We recommend that companies must change auditors every two years. When we refer to auditors, we are referring to both the auditing firm and the individual people who conduct the audits. After Arthur Andersen collapsed , other accounting firms hired many of the Arthur Andersen auditors. The same individual auditors ended up auditing the same firms ”only under a different auditing firm's logo. We want to avoid this way of sidestepping our recommendation. Consider the incentives that our recommendation could create. If you are an auditor, you do not want to be blamed for any errors or questionable practices in the company's past. Therefore, you will work hard to ferret out any problems of the past while you can still blame the previous auditor. Indeed, you had better do a good job because a different auditor will be examining your work in one or two years. That is, you would have an incentive to challenge the company's accounting practices when necessary because you know you cannot have a long-term relationship with the company and the next auditor will be closely reviewing your work. The real beauty of this recommendation is that it provides incentives for the thousands of auditors to monitor each other! That is, outsider audit regulators wouldn't even be necessary under our proposal because auditors are far more equipped to monitor each other than a handful of regulators. Thus, the system itself would become more self-sufficient.

By rotating the auditor every two years, it doesn't really matter if this year's auditing firm is also providing consulting services. All parties know that a different auditing firm will be hired soon and it will be closely examining the decisions made this year. Therefore, this solution also has a positive impact on the conflict of interest that occurs when both auditing and consulting are provided by the same firm to a company.

Our solution will also open up the industry to competition again. Over the past couple of decades, accounting firms have merged and consolidated. This has created a situation in which very few firms conduct the auditing services for the vast majority of corporations. Not too long ago, we referred to these major accounting firms as the Big 8. Recently, with the collapse of Arthur Andersen, there are only four big firms left (the Final 4). While there are many medium- sized and small accounting firms, it is hard for them to expand because of the long-term relationships these four firms have with their clients . Our recommendation breaks these long-term relationships and gives the medium-sized accounting firms the chance to compete for the business of the larger clients. Over time, this will give more accounting firms the opportunity to grow and will eventually increase the number of major accounting firms. We want to see this increased competition in the industry.

Critics of our recommendation will claim that the long-term relationship between a company and an auditing firm makes the auditing process more efficient. That is, the auditing team already knows the accounting systems and business operations of the firm, existing auditors do not have to relearn these systems every year, and the increased work will cause the auditing service to be more costly to the company. However, we argue that being too familiar with the systems and procedure makes the auditors more complacent. For example, auditors missed WorldCom's capitalization of billions of dollars of ordinary expenses (see Chapter 5). It appears that this occurred for several years ”perhaps because auditors were too complacent.

We do indeed expect that the cost of auditing services will initially increase if our recommendation is implemented. However, two factors will operate to eventually bring the cost of auditing services back down. First, the market will adjust to the new problems of providing an audit. That is, companies will change to accounting methods that are more likely to be easily understood and approved by auditors. Also, new standardized software and procedures will be developed to improve the ability of new auditors to get up to speed. However, the most important factor will be an increase in competition. As the number of major accounting firms increases, so will competition for auditing. The increased supply should lower auditing fees.

Boards of Directors

Compared to the boards of corporations 100 years ago, modern board structure and function has improved considerably. So, while there has been general improvement, the recent collapse of several companies and other corporate scandals have shown that there is obviously room for improvement. Many of the proposals by the NYSE and some of the new laws in the Public Company Accounting Reform and Investor Protection Act address problems with boards of directors. In general, we feel these proposals are good. If anything, they do not go far enough. The following are some additional ways that boards can be improved.

1. The NYSE proposals recommend that all of the boards of key subcommittees, such as the audit committee, compensation committee, and director nominating committee, should be comprised entirely of independent directors. The criterion for being an independent director was also improved. We wholeheartedly approve of these recommendations.

2. Increase the level of financial and accounting expertise of board members should be increased. The NYSE proposals and the act mandate that members of an audit committee should have significant knowledge of accounting and financial practices. However, more experience in these areas would be useful for a large portion of the board. For example, when board members have banking expertise, they can provide valuable opinions regarding the debt market. ^[4]

3. The NYSE also recommends that independent board members should meet frequently without management present. We recommend going a step further. Independent directors should become more involved with the firm so that they get a better understanding of the firm. Directors need to take the initiative to occasionally talk with employees . For example, Home Depot's board policy requires directors to regularly visit its stores to better appreciate the business.

4. Pay a significant portion of directors ' pay in stock so that they have a personal interest in the firm's success. We recognize that this recommendation could give board members the same short-term focus and market timing incentive as executives. Therefore, in order to make it effective, board members would have to be restricted in selling the stock in a manner recommended in the "Insider Equity Sales" section of this chapter. The restriction gives board members a materially long-term focus and incentive to actively monitor the firm.

5. Separate the CEO and board chairman positions . The chair has a strong influence on a board's agenda and the information that is distributed to the board members. Also, the effectiveness of the board is obviously undermined when the person who is the chairman is also the same person who the board is supposed to evaluate. In fact, it should not be surprising that there is some evidence that shows that a manager who is both the CEO and chairman rarely gets fired even when the firm's performance is poor. ^[5]

6. Make boards smaller. This suggestion may seem counterintuitive (more heads are better than one?), but smaller boards are actually more active and effective (too many cooks spoil the broth!). Imagine that you are one board member out of 20. You are more likely to think that other directors are doing the monitoring and you do not have to work so hard. However, if you are one of ten directors, it is more obvious that each director must be an effective monitor for the board to function properly. In fact, there is evidence that suggests that firms with fewer directors have higher market values, which indicates their effectiveness. ^[6]

Investment Banks and Analyst Incentives

Many of the problems with the behavior of investment banks and analysts have to do with their association with one another. As we discussed in Chapters 7 and 8, sell-side analysts have become salesmen for the investment banking business. Once this happens, analysts' recommendations and analyses become biased ”they go from research to advertising. The American public already knows not to trust what is said on a TV commercial. Yet the advertisement disguised as unbiased research is trickier.

Some good recommendations have been made to separate analyst research and investment banking activities. Indeed, analyst conflicts of interest came under scrutiny before the investigations of the other corporate governance system participants. On May 10, 2002, the SEC approved rule changes proposed by the National Association of Securities Dealers (NASD) relating to research analyst conflicts of interest. The NASD Rule 2711 recommendations establish standards governing analyst relationships with investment banking activities. Of particular interest are the following rules:

• Analysts cannot be supervised or controlled by investment banking departments.

• Analysts' compensation cannot be tied to specific investment banking transactions.

• Analysts are not to provide favorable research to acquire banking business.

• Analysts must report conflicts of interest in research reports and public appearances .

These are good ideas because they attempt to break the relationship between analysts and bankers and change the incentives of analysts. If the rules work well, analysts' reputations could increase over time. However, buy-side analysts seem to be skeptical whether the rules can be credibly implemented and/or enforced. ^[7] While analysts might not work for an investment banking department, their departments will still be in the same firm. At some point up the chain of management, someone will be in charge of both services. Thus, pressure to conform for the good of the company can still be felt.

In addition to implementing these rules, the SEC has one additional recommendation. A new proposal by the SEC called Proposed Regulation Analyst Conflicts would require that analysts include in their research reports a statement certifying that the views expressed accurately reflect their personal views about the company that they are analyzing. This is like the certifying of annual financial statements that the SEC requires of CEOs. Analysts have always signed their names to their research reports. This certifying process does nothing except make regulators feel better ” especially since most retail investors don't even read the reports. Of the information provided by analysts, most investors use the buy/sell ratings. Investors often access these ratings from financial Internet sites that compile multiple analysts' recommendations and report summary information. In other words, investors see the ratings, but they rarely see the analyses or reports.

We advocate the goal of increasing the research produced by independent analysts. The trick is to find a source of revenue for independent analysts. Institutional investors can afford to pay for independent research, and they often do. The recommendations of both buy-side analysts and independent analysts are confidential and not public. Therefore, retail investors only see sell-side analysts' recommendations. It would be ideal if independent analysts' recommendations were public. That way, retail investors would get unbiased analysis. Of course, independent analysts sell their research to institutional investors, and thus want it private. We want to create a group of analysts that is willing to make public recommendations but that does not work for the brokerage or banking firm underwriting a stock issue.

One possibility is to require each new stock issue (especially IPOs) that is underwritten to have security analysis reports from three analysts who do not work for the bank or brokerage firm doing the underwriting. These reports and recommendations would be publicly disclosed. We propose that an organization organize a pool (or list) of analysts who want to conduct this type of analysis for pay. When a firm issues a security, the investment bank would pay (with fees from the firm) the organization to obtain three independent reports from analysts who specialize in that industry. Independent credit agencies have been serving this function for bond issues for many years. These ratings are paid for by the issuing companies. The companies pay to get rated because they want to get a fair price for their issues. Why not improve and expand on this idea? Independent analysts like the ones we're suggesting will have no other incentive but to provide accurate assessments of each stock issue. Eventually, good firms will want good independent analysts to evaluate their stock issue as a way of proving the quality of the offering. Here, both potential investors and the firm are better off.

While the SEC could be the organization to create this pool of analysts, we feel that it would be better for the analysts' private association to do it. Analysts seek the Chartered Financial Analyst (CFA) designation from the self-governing body, the Association of Investment Management Research (AIMR). AIMR already has databases of analyst characteristics, and it is very concerned about professional ethics. It has been working with the SEC, Congress, and others to improve the integrity of analyst recommendations. Indeed, many of the new rules enacted by the SEC have been advocated by AIMR.

When investment banks try to take unworthy firms public, as they did in the late 1990s, they will find that it is hard to market an IPO when the analysts' reports are negative. In the past, they could underwrite any IPO and have their own analysts tout the firm. If investors were not paying as close attention as they should (as in the late 1990s), they would succumb to the marketing campaign of the banks, which included analysts' recommendations that were only disguised ads. The investment banks take on risk when they underwrite a security. If the true prospects of a firm will become public during the issue process, they will take more care in the quality of the issues that they underwrite.

Our recommendation has several good incentive outcomes . First, investment banks will be motivated to bring only quality stock issues to market. Second, investors will have access to unbiased analyst research and recommendations for free. Third, our recommendation lowers the chance that a stock market bubble will occur ”especially in the IPO market. And fourth, the stature gained by analysts in the industry's and the public's view of them will be earned through quality research and a history of accurate predictions .

Credit Rating Agencies

Credit rating agencies can be an integral part of the corporate monitoring system. However, there are some structural problems with the industry that could be improved. For example, government regulations are keeping the number of agencies to only three. In addition, they have been able to protect themselves from lawsuits by claiming their right to free speech. The lack of competition and the high degree of legal protection combine to create a situation in which credit rating agencies do not have a disciplinary mechanism. Without the possibility of being disciplined, these agencies can easily become complacent and have little incentive to be thorough in their analyses.

The SEC needs to create a process by which additional credit rating agencies can gain the coveted Nationally Recognized Statistical Rating Organization designation. Currently, a firm must be considered large enough to be a credible, nationwide firm. However, a small credit agency cannot grow to be large enough without the designation. This catch-22 has ensured that only three firms remain in the industry. We recommend giving promising small credit rating agencies a limited designation. For example, the SEC could approve them for rating one type of security, like asset- backed securities. These debt instruments are mostly purchased by institutional investors who are more able to make their own judgments about risk than individual investors. Therefore, there is low risk to the general public in giving younger agencies this area to grow. If a new agency proves itself with a good track record in its ratings and sustains solid growth in the asset-backed securities area, the SEC can either expand the agency's designation to other securities or give it full recognition. Increasing the industry competition by adding trustworthy firms provides more incentives for the credit rating agencies to be diligent in their monitoring role.

Shareholders

We want investors, especially the large institutional investors, to have more ability and desire to influence the strategy of the companies they own. However, there is a fine line between investor activism designed to improve the performance of a firm and activism designed to further other objectives. For example, the origin of modern investor activism in the United States occurred in the 1970s. Early activists were interested in furthering their agenda for social justice . Therefore, their shareholder proposals involved resolutions on topics like South African apartheid, community development, and gender and racial equality. Many people with environmental agendas entered the shareholder activism arena after the 1989 Exxon Valdez oil spill disaster. There are many people who would like to use shareholder proposals to force companies to use union labor. Other people would like to use proposals to force companies to avoid union labor.

On the other hand, as indicated in Chapter 11, many institutional investors now coordinate their activism efforts through the Council for Institutional Investors to improve corporate governance. The ability to improve corporate governance through investor activism should be enhanced. These institutional investor activists first try to change things through dialogue with the managers and board of directors of a company. If that fails, they can make a shareholder proposal (also called a resolution) for the shareholders to vote on. However, there are often impediments to this process that make it difficult to achieve success. The following recommendations help to overcome some of the obstacles. ^[8]

1. A majority of shareholders approving a proposal should amend the company's bylaws . Some firms have supermajority rules that require a two- thirds approval for shareholder proposals. If more than half of the owners approve a proposal, it should be implemented. The higher approval hurdle is simply too high to get anything to pass because many shareholders do not even bother to vote.

2. The vote of each investor should be kept confidential . That is, company managers should not know how each investor voted. Institutional investors want to keep a dialogue going with managers. When managers see that an investor has voted against their wishes, they sometimes refuse to talk with him or her. This possibility pressures institutions to simply vote with management in order to keep the dialogue going.

3. Companies should avoid anti-takeover defense bylaws . Examples include poison pills and greenmail (payment by a takeover target to a potential acquirer, usually to buy back at a premium acquired shares that the potential acquirer already owns; in exchange, the acquirer agrees not to pursue the takeover bid). Anti-takeover defenses help prevent an investor or another company from taking over the company. These measures help members of management stay entrenched in their jobs. The corporate takeover market is an important disciplinary force for managers. If they run the firm poorly, it may get taken over by people who think that they can run the firm more profitably. The former managers get fired. Many firms enacted these bylaws in the 1980s when there was a trend of hostile takeovers. Takeovers are usually good for investors because the purchaser buys the firm for more than the current stock price (usually 20 to 30 percent or higher). This is a good return for investors who have seen their company perform poorly.

Having good corporate governance bylaws and policies helps allow institutional investors to influence a firm on those rare occasions when it might be appropriate. Are companies with good corporate governance actually good investments? The answer appears to be yes. In a recent academic study, financial economists ranked approximately 1,500 companies into ten groups based on their corporate governance policies. The group with the highest shareholder rights outperformed the group with the lowest shareholder rights by 8.5 percent per year during the 1990s. ^[9] Given that management compensation is predominately in stock or stock options, managers should want the company for which they work to have these good governance policies. However, since managers feel that their jobs may be at risk with these bylaws, they usually do not support them.