20 Jan 2003  Views on News

Fixing Corporate Governance: A Roundtable Discussion at Harvard Business School

Bad business practices on a huge scale have made corporate governance Topic A of late. In a roundtable discussion, Harvard Business School professors Krishna Palepu, Jay Lorsch, Rosabeth Moss Kanter, Nancy Koehn, Brian Hall, and Paul Healy explore guidelines for change.

 

With corporate America rocked by revelations of conflict of interest, malfeasance, negligence, and greed, a group of HBS professors recently gathered to review the current crisis. Is it a case of dé jà vu or an unprecedented, systemic failure? This roundtable discussion, moderated by Professor Krishna Palepu, sought answers and suggested some corrective measures. Highlights of the conversation follow.

Krishna Palepu: Let's start with some background on these matters as they relate to your areas of interest and expertise. Then we'll discuss some of the challenges they pose. Brian, what about the issue of top-management compensation?

Brian Hall: As you all know, stock options were intended to give executives incentives to get share prices to rise, which in theory would create value for shareholders and society alike. That worked in many cases.

But some executives who were loaded up with stock options succumbed to the temptation to "game" a financial-markets inefficiency, inefficiencies caused by inadequate disclosure rules. Those executives essentially misled investors, falsified information, and pretended to create value when value hadn't really been created. If inadequate disclosure rules were cracks in the financial infrastructure, options were the rocket fuel that blew the cracks wide open, with some disastrous results.

I think all the attention being paid to the current problems—particularly by business itself—will help keep our system of capitalism democratic and in sync with the larger interests of the nation
— Nancy Koehn

Nancy Koehn: As a historian, I would note that this is not the first time that Americans have gone through intense questioning about the system and the conduct of its actors. For example, in the latter part of the 19th century, the railroad, the telegraph, and a host of other innovations related to them—along with the rise of powerful business figures, such as John D. Rockefeller—gave many observers pause. The reaction was increased oversight and anti--big-business sentiment.

I think such moments are part of something very important in the U.S. system. There is extraordinary freedom for business and other actors to race ahead, while at the same time, a range of stakeholders can question, claim their share, or put up guardrails around that headlong rush toward change. I think all the attention being paid to the current problems—particularly by business itself — will help keep our system of capitalism democratic and in sync with the larger interests of the nation.

Paul Healy: We may have been through these experiences before, but it's shocking where we have ended up, given all the advances in technology and improvements in governance. In spite of all the checks and balances, failures occurred with boards of directors, auditors, regulators, financial analysts, and professional investors and money managers.

We thought we had a pretty good system, one the rest of the world looked to as a capital market that effectively allocated resources in the economy. I still think that our approach is a good one, but maybe not as good as we thought. Hopefully, we'll better understand the conflicts of interest, improve the system, and have more awareness of the risks of investing.

Rosabeth Moss Kanter: If a few rotten apples can spoil the barrel, I think we have to look at the nature of the barrel, not just the apples. Organizational design, structure, and culture do play a role and almost always have in corporate scandals. Companies that get into trouble often do so because of minimal internal connections between many parts of the organization. With deficient information and knowledge, you can't put all the pieces together or understand when something might be going wrong.

Jay Lorsch: There was a cycle of greed throughout the system, and boards, for their part, allowed it to go unchecked. Some audit committees and compensation committees didn't do their jobs responsibly.

But boards can only do so much — their members, after all, are part-timers. And while they're expected to be independent, they have to rely heavily on managers and auditors for information. One problem in all this was that the boards weren't getting appropriate information and that was compounded by directors' complacency because everything seemed to be going well.

Palepu: Mention of compensation committees brings to mind the issue of dramatic escalations in executive pay. What's behind these big increases?

Hall: One element was the rising stock market. Another was the use of stock options—because options are so complex, they can obscure the amount of pay actually being given to executives.

In most cases where we see big excesses, it has to do with compensation committees not holding the line, as Jay noted. They granted packages that ensured their executives would receive above-average pay even though all executives can't be above average. The market for executives is not one in which there are strong competitive pressures to keep compensation down; so, in the end, it's the boards that must resist the pressure to overpay executives.

Healy: To put it in context, we live in a society in which the stars—entertainers, professional athletes, the top performers in any industry—make all the money. That includes the executive market as well.

The irony about pay-for-performance is that pay packages had no built-in control for the general rise in all stock prices. Executives benefited from the run-up in the stock market, rather than for taking their companies to the next level.

Kanter: There's a danger, however, in focusing only on boards and compensation and not on organizational performance writ large. If we don't concentrate on the entire organizational system—in short, the shape of the barrel—we may not find remedies. We may have a flurry of new regulations here and there, but we won't have genuine solutions for these problems that are not only causing scandals but are also hurting the performance of the economy.

There was a cycle of greed throughout the system, and boards, for their part, allowed it to go unchecked.
— Jay Lorsch

Koehn: Board performance and the culture of organizations as factors affecting a firm's integrity have been issues in American business since the rise of the corporation more than two centuries ago. So why this cycle of greed, why this eruption now? I think it goes deeper than just the rising stock market in the 1990s and the possibilities that presented to all kinds of people. Perhaps we're in the midst of a larger technological and information-driven transformation, a rare inflection point in industrial capitalism, in which there's been widespread exuberance and some bad bets made to this point, but in which a range of more positive outcomes are on the way.

Lorsch: To me, the trouble began in Silicon Valley and spread from there. Everybody was going to get rich! And that created a tone for much of corporate America throughout the 1990s. When that bubble burst, we suddenly discovered a lot had been hidden by the fact that everybody was doing well—nobody was being critical of what was transpiring. The question is, How did we get started, and what were the norms that led to this disregard for traditional verities?

Kanter: The two big messages of the 1990s were "The old rules don't hold" and "There are no new rules, and if there are, you should break them." I think that leads to a particular kind of culture where people start feeling foolish if they're not participating in these perceived changes.

Getting down to business

Palepu: How can we begin to fix some of these problems?

Hall: On the issue of executive compensation, "clawback"—forcing executives to pay back ill-gotten gains from option exercises that preceded accounting restatements—and longer vesting would be great. Another significant step would be to expense stock options, which would make their costs more evident and more transparent. Expensing would likely result in fewer excesses and would encourage moves toward moderation in equity-based pay packages, such as the use of indexing.

Palepu: With costs more apparent, might board compensation committees also gain a better understanding of what they're actually giving up?

Hall: Absolutely. Because stock options aren't expensed, compensation committees have focused on them without thinking hard about alternatives. Expensing, I think, would actually liberate companies by enabling them to choose among a variety of compensation methods they've heretofore been ignoring because they involved expensing.

The board must be wired into all systems so that it can get the information, too.
— Rosabeth Moss Kanter

Lorsch: People talk about curbing the power of CEOs, but I frame the issue in terms of enhancing the power of boards. Over the last decade, I think there's been a lot of progress made in boardrooms. Problems remain, of course, but cronyism has diminished, the principle of independence is becoming well established, and board members are trying to do the right thing. How do we make boards even stronger? Some good ideas I've heard recently call for getting the independent directors to meet alone without management and having somebody other than the CEO lead the board, at least in its independent deliberations. Boards need to think more carefully about how they manage and organize themselves.

Palepu: Paul, you spoke about the breakdown of checks and balances in the system generally. Can you elaborate?

Healy: One thing that strikes me is the enormous pressure for short-term performance in the capital market. Analysts and money managers are mostly worried about quarterly performance. That filters all the way back to management, which feels pressure to deliver good numbers for the next quarter's performance. And if that pressure gets too intense, some managers are going to do things that we'd rather they didn't.

Ironically, all this is driven by things that we prize and value: competition, with its pressure to perform well, and freedom, as in the ability to move our money around. Unpalatable as it may be, perhaps we need to impose some costs or incentives that would help get us away from this short-term fixation.

Palepu: Through tax deferments on pension money, society is giving tax breaks so that people can save and invest for the long term. And so one idea that has been proposed is that, because the government is giving a tax break, it should be able to put some restrictions on the short-term movement of that money.

Kanter: When that kind of intervention takes place, however, we hear cries that the tax system is being used for social engineering. But I certainly have the sense now that without some degree of public and social engineering, we're not necessarily going to solve these problems.

Palepu: Rosabeth, you mentioned the structure and design of the organization as possibly contributing to the current problems. What improvements can be made?

Kanter: We need more external information—both financial and nonfinancial—about the total, multidimensional performance of the organization. But external information should be reported less often, so that we ease the pressure to meet short-term targets.

Internally, we need more disclosure. The board must be wired into all systems so that it can get the information, too. More frequent internal reporting will not only encourage cross-fertilization and the exchange of ideas, but will also help catch problems, flaws, and weaknesses before they multiply.

Koehn: From the standpoint of organizations, it strikes me that what we have is an opportunity for companies that run a clean shop—culturally, organizationally, and financially—to educate their employees, their communities, the financial community, and the public, as to what they stand for and what they're really about. Make it not only a touchstone for how a particular company conducts its operations but, more broadly, the standard by which business is done—the "cool" way to run an organization.

A role for HBS

Palepu: Is there anything in the curriculum or classroom we can do that might enhance some of the changes we've talked about?

Lorsch: I think we can teach students more about what we mean by professional management and give them opportunities to test out their own values against what's expected of them as responsible professionals. We don't teach them about the dysfunctional aspects that we've been discussing here, and we should. As someone who's interested in corporate governance issues, I believe we can do more to reach out to the director community—through Executive Education programs—and help them think about some of these questions.

Kanter: Suppose we took some of these issues we've been discussing—CEO compensation, for example—and asked students to think of themselves as problem solvers. Suppose we asked them to think about how they might want to change the rules of the game to get to outcomes that are good. I'll bet they'd come up with lots of great ideas. They would go out into the field and grapple with these difficult questions, and it would give them a solid foundation for thinking about larger issues and the consequences of their actions.

Koehn: We should ask ourselves, How do we incite the best in our students? How do we help them learn that they're responsible for other people?

One expectation our students have when they come here is that HBS will transform who they are as a person and who they will be as a professional. So we should think long and hard about that developmental aspect, across disciplines and courses. As Jay noted, how do we teach and educate them to help them as professionals make sound decisions with great integrity? That's a complicated task, but it has been part of our mission—indeed, our imperative—for ninety-four years.

Hall: I teach a compensation course, and yet I always begin it with the idea that organizations exist to create value for society. I want to try to center things around the core reason we're here. Compensation—how we share in the value creation—is only one tool toward the larger purpose of motivating value creation.

Healy: One of the things that strikes me is we have a whole set of alumni who are really outstanding people with excellent values. We have so many graduates who are powerful role models—at every opportunity, we ought to get those people on campus to meet with our students. That kind of interaction would make a deep and valuable impression.

Hall: We need to show our students how incremental errors of judgment can lead down a slippery slope to a whole heap of trouble. In addition to having successful careers, our students want to be part of something great, to be inspired by what is great and noble in business. We can do more to tap into this desire.

Palepu: We could keep going for several more hours, but unfortunately, we're out of time. I'd just like to observe that, over the last twenty years, American financial markets have been the envy of the world for their ability to minimize transaction costs, maximize liquidity and access, and fund a lot of very innovative and complex businesses.

Unfortunately, the same forces that made markets so liquid may have made market institutions weaker. As a result, all the traditional checks in the corporate governance system—management-incentive systems, corporate boards, external auditors, analysts, and professional investing institutions—seem to need some reengineering to deal with these new market realities. I'm sure you and our other HBS colleagues will have plenty of ideas for dealing with this new set of challenges. Thank you all very much.

Reprinted with permission from "Bad Times for Business: Trouble in Corporate America," Harvard Business School Bulletin, Vol. 78, No. 6, December 2002.