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Cary Coglianese on Corporate Regulatory Policy

A slew of corporate scandals-from Enron to Arthur Anderson to World Com-have rocked the business world in recent years, undermining investor confidence and calling into question the integrity of the marketplace. While some reforms and new regulations have been adopted, there remain concerns about maintaining a healthy competitive market and transparent accountability standards. Cary Coglianese is associate professor of public policy and chair of the Regulatory Policy Program at the Center for Business and Government.

Q: What key regulatory changes have been adopted in wake of corporate scandals in recent years? And have they accomplished what they've attempted to do?

Coglianese: The Enron scandal and the World Com scandal broke in 2001 and 2002, and in a matter of a few weeks, the United States Congress adopted the Sarbanes-Oxley Act of 2002, which put in place a number of changes affecting the governance of corporations. That statute itself has led to a number of implementing regulations that the Securities and Exchange Commission (SEC) has adopted to put in place a lot of the provisions of the Act. In addition to that statute and its implementing regulations, there have been new standards that have been proposed by a new regulatory entity called The Public Company Accounting Oversight Board, which was created by the Sarbanes-Oxley Act.

And, in addition to these public regulations enacted by governmental bodies, the stock markets themselves have issued a series of new requirements for firms that are listed in their markets. These changes have affected a wide range of relationships and actors within companies from the top, the CEO, through to the board level, even sometimes proposed changes affecting the role that shareholders can play in the governance of corporations. So, these new requirements, this new regulatory landscape that has been put in place, in these past several years, has swept quite broadly and encompassed a lot of the interaction that takes place in the management, the operation, and the governance of our corporations.

Now, one of the key questions is what have these changes in public policy actually made a difference for in terms of the operation and the governance of public companies. And that's a key question that we can now begin to take stock of since several years have passed since many of these new requirements have been put in place. And, it's precisely to begin to take stock that the Kennedy School convened a round table dialogue in May of 2006 that brought together the key actors-CEO's, members of boards of directors, key gatekeepers, accountants and lawyers, and key government regulators as well-to have an off-the-record discussion about what this new regulatory landscape is actually meaning, what difference it makes for the operation of our economy. That's the subject of the report that we have released, that is called 'After the Scandals: Changing Relationships in Corporate Governance,' and it examines the subtle kinds of changes that may be taking place within relationships in the governance of our corporations.

Q: Are relationships-between CEO's, corporate boards, stockholders, regulators, outside auditors and lawyers-becoming more adversarial than in the past? What are the implications of that?

Coglianese: There have been concerns that relationships are changing in ways that provide excessive amounts of checks and balances in the governance of our companies. On the other hand, there are many who claim that there are still insufficient checks and balances. So, one of the questions that we focused on in our round table dialogue is really to just begin to understand what changes are really taking place at all. And, there've been a series of changes that have taken place. Many changes at the level of the board of directors-for example, Sarbanes-Oxley-put in place something that had been a growing trend, toward more independent directors, directors that are not also part of the management of a company. And as a result of both Sarbanes-Oxley's requirements and trends in best practices in corporate governance in recent years, boards are now participants in the round table talks; boards are composed of many more independent directors.

There are also far fewer situations where the CEO is also serving as the chairman of the board of directors. What has this meant? This has meant a couple of things. One, boards of directors are now asking questions that they may not have been asking as much in the past. There are also concerns about a shortage of good directors and whether we will get enough directors who will meet the requirements of independence.

There are other changes that we heard happening among gatekeepers and lawyers as well. One question arises whether these accountants and lawyers are becoming much more risk-adverse. Is the entire process of corporate governance itself becoming one in which the key overseers-whether boards of directors or gatekeepers-are becoming much more cautious at a time when risk taking may be important for us in terms of economic growth and productivity?

Q: How have regulators attempted to confront rapidly escalating executive compensation, which many perceive as a serious problem in corporate governance?

Coglianese: One of the areas that has seen the least amount of change has been the area of executive compensation. In fact, probably just since we held our roundtable dialogue in May 2006, concerns about executive compensation have grown even stronger in the media. There is a widespread perception that CEOs are earning compensation packages far in excess of the value they are bringing to companies, and even some changes in which companies aren't performing well and yet boards are rewarding their CEOs with higher and higher forms of compensation. This is not a new concern, but it's a concern that persists even in the wake of the series of changes that have taken place since Enron and World Com.

Part of the challenge of doing anything regulatory in this area is defining the problem. It's not always clear how to develop a good criterion for what makes an appropriate level of compensation. For many of us the degree to which compensation is excessive is something we can readily see when it is outrageous, but determining what is actually appropriate is something that a regulator would need to do, and it is not always clear how you compare the compensation for one CEO of one company versus the compensation for CEOs at other companies. That has been a challenge.

The SEC has proposed new regulations that would require better and fuller disclosure of the compensation that executives are receiving from publicly listed companies. For public company executives, the disclosure of their compensation may well have the effect of putting pressures on boards to bring compensation into better alignment with the actual performance of companies. On the other hand, one of the concerns that emerged from our roundtable discussion was the possibility that the disclosure of executive compensation information could have a perverse effect by revealing to CEOs what their counterparts are making. That could lead to what would be called a race to the top effect, where a CEO at one company points to how much a counterpart at another company is making and demands something equivalent or higher from his or her own board. That kind of perverse effect would be something that regulators need to be cautious about, and is another reason why regulating the area of executive compensation can be quite difficult.

Q: What lessons should business and government keep in mind when considering how best to confront these corporate governance challenges in the future?

Coglianese: There have been a number of regulatory changes that have taken place already-a number of high profile, criminal prosecutions that have sometimes sent perpetrators of corporate fraud to jail-and there have also been a number of trends that have arisen in the past decade about what are best practices in corporate governance. The key challenge going forward will be to do two things. First, untangle where any changes that are occurring in corporate behavior are coming from-whether from public policy, from law enforcement, or from changes in business norms. Right now we have a lot of change taking place, and it is important for business and government to take a very hard look at where these changes are coming from and to understand what they can do in the future to make additional changes.

The second challenge is to be mindful of a series of choices or tradeoffs that lie ahead-for both business and government-in addressing corporate governance. There are tradeoffs, for example, between whether we want to adopt measures that promote the short-term performance of companies versus the long-term performance of companies. There are tradeoffs and choices to be made about whether future changes in public policy ought to be made at the state level, where traditionally much corporate law has been made, or at the federal level, where laws like Sarbanes-Oxley have been taking place. There is also a key tradeoff ultimately about how much risk society wants to tolerate, the risk of corporate fraud, versus risk taking, which is the engine that drives a market economy.

We have seen these series of changes taking place in public policy, changes that have been taking place within relationships in corporate governance, that reflect by some accounts a better balance between risk-taking and risk-aversion. But there's always the persistent concern that that balance will get out of alignment, and that it will tip too far over toward risk-aversion to the detriment to the performance of capital markets. On the other hand, clearly in the wake of corporate frauds, the arguments that there has been too much tolerance of risk, of risk of corporate fraud, is clearly a persuasive one and one that has driven a lot of the changes that have taken place in public policy in these last four years.