Corporate Governance: Don't Rush Reforms

Bloomberg BusinessWeek columnist Frank Aquila tells why new efforts to change corporate-governance practices may be doomed to fail

By Frank Aquila

The last decade has been an economic perfect storm. Things got off to an unpleasant start with the bursting of the dot-com bubble. The Enron/WorldCom/Tyco scandals followed close behind. The past few years have featured the subprime mortgage crisis and the credit crunch precipitated by the Lehman Brothers bankruptcy. For equity investors pummeled by losses, this has been a decade to forget.

When bad things happen, human nature yearns to identify and punish whoever is responsible. Seeking protection, we also want to fix things so that such problems never occur again. However, this can be a bit like generals fighting the last war: Legislating a "one-size fits all" solution in response to a particular economic situation is rarely effective at preventing future, largely unpredictable problems. If it were otherwise, the Sarbanes-Oxley legislation enacted in 2002 would have eliminated all problems in corporate governance, financial controls, and disclosure.

That hasn't happened. Sarbanes-Oxley has not, as many predicted when it was enacted, eliminated all corporate ills. While the legislation certainly did not create the subprime mortgage crisis, it unfortunately did not prevent it. In fact the subprime meltdown and its aftereffects may well be the best testimony that even the most comprehensive revision to American corporate governance in more than a generation could not repeal the economic cycle or pop the next "bubble" before it burst.

The reality is that no set of corporate-governance mechanisms could have forestalled a crisis of the magnitude or complexity of the one we have experienced.

U.S. directors act for shareholders

What is corporate governance and why should we care about it? In modern capitalism there often is a distinct separation of ownership (the shareholders) from control (the board of directors and senior management) of the business enterprise. Corporate governance defines the relationship between the shareholders and the managers. The willingness of investors to purchase a corporation's shares is based not only on the performance of the business, but also on the trust in that corporation created by effective corporate governance.

In the U.S., the cornerstone of corporate governance has long been reliance on the board of directors to act on the shareholders' behalves to supervise and direct the management of the corporation.

Corporate governance is not designed just to avoid the next financial disaster. Effective corporate governance is also good for business. Academic studies have consistently shown that companies with independent boards of directors produce greater returns on shareholder equity, achieve higher profit margins and return more capital to their investors than competitors without independent boards. The shareholders of Enron learned the hard way that weak corporate governance can facilitate an environment in which fraud and mismanagement can occur.

Business Exchange

Track and share business topics across the Web.