Benjamin Hermalin, Willis H. Booth Professor of Banking and Finance, spoke with Bonnie Azab Powell of UC Berkeley’s Public Affairs Office about executive compensation and the relationship of board structure to financial performance. The following is an excerpt of their interview.
Can you trace this current rash of corporate wrongdoing to any particular catalyst?
There have been considerable changes in corporate governance in the last 20 years. Even before the Internet boom of the 1990s, academics encouraged tying executive compensation more closely to performance, in the form of direct stock grants or stock options.
Whenever you change incentives, if the new incentives increase the temptation to behave badly, initially you’ll find a rise in bad behavior. Does that mean there is a general rise in crookedness? Well, no. We’ve always had bad apples. Not that long ago there was the S&L debacle. Pick any period of time and you’ll find other spikes of bad behavior.
Most of these executives are claiming that rather than being crooked, they just “didn’t know.” Could that be true?
It’s a tradeoff. You can admit guilt and go to jail, or you can say you didn’t know what was going on and basically claim incompetence.
There have been instances in business when terrible things have happened to firms and the people at the top really didn’t know, like the Barings Bank disaster, where an underling did something wrong, disguised it, and brought the whole bank down. That doesn’t mean the bank wasn’t culpable – it should have had better oversight and controls – but the management didn’t do anything criminal.
However, when we’re talking about the heads of Enron or WorldCom, I think they’re not being honest.
Has the Securities and Exchange Commission in fact done an adequate job policing these companies?
Economists like me tend to have a lot of faith in the markets. We know, however, markets can break down when you have informational asymmetries, meaning people trading don’t have the same information. And that’s a huge problem in the stock market. Without regulation, you can easily find yourself trading against people who are much better informed than you – like insiders at the firm – and then you’re certain to lose. If you want to have a well-functioning capital market, you have to make sure that someone is out there as a referee. It’s a game that can’t self-regulate.
Should executives be forbidden from selling their shares until they retire?
That really interferes with freedom of contract. It would also have unintended consequences in the sense that it would likely make managers risk averse, which may not be what shareholders want. Also, if they are denied that form of compensation, they’ll demand other kinds: we’d see them getting more cash, more bonuses tied to performance, and these would incur their own problems.
Is there any way to salvage stock options as acceptable management incentives?
Boards of directors have to ask themselves: Are we being responsible in granting these options? In many cases they might say we’ve misused them. Perhaps one way of restoring confidence is to make them seem less like a giveaway.
We also need much more prompt disclosure of all transactions involving options and executive sale and acquisition of stock. Take the “form four,” which executives are supposed to fill out and submit when they trade stock in the company. You can do it electronically, which is very quick, or you can fill it out on paper and it takes weeks to process. We have the heads of the world’s greatest tech companies filling it out on paper, not because they can’t be bothered to fill it out electronically, but because they want to have that delay. That has to go.
What effect would the stock exchanges’ requiring that company boards be headed by an independent chairperson, not its CEO, have on fraud?
Generally most studies that look at how the board is structured have had a difficult time finding any relationship between the board and the firm’s performance. Usually the board’s structure matters in extraordinary circumstances, like when you need to fire a CEO or deal with an acquisition, but not in the day to day.
However, there’s a real trend toward having more outside representation. That doesn’t always mean the board is more independent. For instance, say Company A puts the CEO of company B on its board, and Company B puts Company A’s executive on its board. They’re not going to be terribly independent.
One of the reasons we should be suspicious of all these exogenous fixes to the board is that if they’re so grand, why haven’t people done them already? Some of my work tries to come up with reasons why individual boards would evolve in ways that are less than optimal. But remember, we’ve been complaining about boards for 200 years. Go back to Adam Smith and The Wealth of Nations and there’s a line about how boards of directors can’t be trusted.
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