The right incentives are key

In the wake of the Enron and World.com scandals, the public demanded corporate governance reform. Congress responded and quickly implemented the Sarbanes-Oxley Act (SOX). In A Framework for Assessing Corporate Governance Reform , Hermalin and Weisbach assess new provisions that have politically become popular. They find that some measures are effective and some, although they are appealing at face value, are not—there may be a reason why the market did not naturally adopt them. Specifically, mandating an increase in the minimum level of reporting may not be beneficial, but imposing threats like jail-time are. For the most part corporate governance appears to be the market solution, so the idea that major reform is needed is incorrect.

Corporate governance is a response to a constrained optimization problem. The CEO wants to make as much money and have as many perks as possible while making him or herself look good in order to keep the job. The job of the board is to monitor the CEO to ensure that he or she is maximizing profits for the owners (the shareholders). The function of the board is to assess the CEO’s ability with the information it has available. If he does not perform to a satisfactory level, he is replaced. The role of the CEO is to increase profits. If the board believes someone else can generate more profits (after the transition costs for switching CEOs are factored in), then a new CEO will be installed. The CEO benefits from controlling the company and this provides incentive for him to distort information available to the board to make him look favorable.

The key feature in this relationship is that there is an asymmetry of information, particularly on the part of the CEO, and this asymmetry can be exploited if bad incentives are not corrected. Contract theory provides three necessary conditions where governance can improve welfare:

1. there is asymmetric information during the writing of contracts
2. governance failures impose externalities on third parties and
3. the actual government uses punishments that are not available to the third parties (i.e jail).

Hermalin and Weisbach create models to show what happens if these conditions are not met. The major findings of manipulations to the model are:

1. What happens when the government increases the minimum quality of reporting from a CEO?

This can have a negative or positive impact, but in an efficient market this is generally bad. There is an optimal level of reporting which is different for any corporation, and mandating that a corporation go beyond this level with a law will hurt that company. The Sarbanes-Oxley Act, like many other corporate governance provisions, increases the minimum quality of reporting (also called corporate transparency). It makes the CEO report about off-balance sheet financing and special purpose entities and makes him liable for major cheating in the accounting. Enron did not report this information, and they used it to distort the representation of their finances. Previous research shows that when firms voluntarily provide better information about their company, the cost of capital decreases. Because capital decreases, value of the firm increases. A major conclusion of this paper however is that increasing reporting change other incentives which more than negate what would normally be a benefit in ceteris paribus.

The authors find that in equilibrium this escalation of reporting leads to a higher turnover of CEOs and higher salaries for CEOs. The increase in salary can overshadow the benefits derived from better reporting about the CEO, and this in turn, would cause a firm’s profits to drop. As the quality of the reporting increases due to greater transparency, the board will place more weight on this information. Because the board places more weight on the signal, the CEO will have a greater incentive to distort the information. As distortion increases, value will decrease.

To keep the CEO from distorting information, the board must pay the CEO more money so that he the risk of losing his job has more bite in preventing malfeasance. Therefore, the board must pay more ex ante to keeping the CEO. Also, the board must pay him more because he is more likely to be fired. The reason why he is more likely to be fired is because with better reporting, the chance of being caught cheating is greater. Therefore, the marginal benefit received from increasing reporting (with everything else remaining equal raises firm value), must be weighed against the distortions (the CEO distorting information, greater turnover, higher salaries.)

2. What happens if the government increases the costs to the CEO if he tries to conceal information?

The model finds that increasing the costs borne by the CEO from punishment by government can increase value. The reason is that the government can use the powerful threats not available to the private sector. The main threat is incarceration. By increasing the costs associated with malfeasant behavior, the government lessens the incentive for a CEO to cheat. A related example is parking tickets. If the cost of a parking ticket was very small, people will be more likely to park illegally because they do not fear the consequences. However, if the government were to threaten illegal parkers with jail time, the illegal parking would drop. Greater threats prevent cheating. The greatest threat a corporation can give a CEO is firing him. The government can go beyond this jail time. The model also finds the government uses a threat already available to the corporation, welfare will not be improved and will possibly fall. Government bureaucracy can be slow, and this only adds inefficiency.

One major theme throughout the paper is how mandates from the government differ from voluntary measures. For example, in labor-market equilibriums, there is a difference between when firms voluntarily raise wages as opposed to when the government raises the minimum wage. The latter creates unemployment and the former does not. The implication is that government regulation for corporate governance must ensure that their distortions are minimized. For corporate governance, higher disclosure leads to a behavioral change by those involved, and therefore, the overall welfare change must factor in these changes of behavior. Another important point is that in order for a reform to be beneficial, it must be implemented at the time of the contracting. Although this idea is intuitive and implicit in the work of the major corporate governance theorist, William Coase, the authors argue that a lot of research ignores this critical point.

Theoretical work in the corporate governance dates as least as far back as Adam Smith who noted that once a company sells stock, the managers will be not work as hard of be as cautious because they are not risking other people’s money. The focus of corporate governance is how incentives are distorted. Economists have taken renewed interest because of the recent corporate scandals, and the authors believe much is still to be learned.