The collapses of Enron and other major U.S. companies in recent years are highlighting the need to amend corporate governance rules that overemphasize management protection so that an effective market for corporate control can be restored, said William Niskanen, head of the Cato Institute, a U.S. think tank.
Speaking at a seminar in Tokyo organized by the Keizai Koho Center at Keidanren Hall on Nov. 11, Niskanen, acting chairman of the Council of Economic Advisers to former President Ronald Reagan in 1985, said the Enron scandal gave corporate America a number of new lessons to learn.
One is that the public shouldn’t put too much emphasis on the accounting when assessing a company’s condition. Another is that corporate auditing can’t be trusted much either. But the most important lesson, Niskanen said “is that the rules of corporate governance do not now adequately protect the general shareholder against the discretionary behavior of corporate managers.”
This situation is prompting a re-evaluation of the roles played by corporate boards, institutional investors and banks, he said.
While the monitoring model of the corporate board in the United States has evolved dramatically over the past 30 years, Enron and similar scandals have shown that independent directors have little power to deter accounting scandals, excessive compensation or bankruptcy.
Enron’s board of directors for example — judged one of the five best boards in the U.S. by Chief Executive Magazine in 2000 — was a model case, even under the tighter standards adopted in 2002. “When Enron declared bankruptcy, it was in full compliance,” except for some loans to its officers, he said.
Niskanen suggested that institutional investors, such as pension funds and mutual funds, have a greater role to play in corporate governance. Since institutional investors manage over 50 percent of the corporate shares in the U.S. today, they have great potential to influence corporations. But shareholder activism in these funds is insignificant.
Because institutional investors “are inclined to behave much like individual investors — to be so diversified that they do not care much what happens to any single corporation and to sell rather than fight in response to information about mismanagement of a firm,” he said.
Commercial banks have even less potential to serve as watchdogs, he said, because most major companies are much less dependent on banks than in the past.
The current state of corporate governance in the U.S. evolved from legal changes made in the 1960s. These regulations created an army of incumbent corporate managers with overprotected interests, he said.
Particularly significant was Congress’ passage of the Williams Act in 1968. This act imposes various requirements on a person or group who acquires over 5 percent of the outstanding shares of a company, the aim being to protect managers from takeover bids.
“This act . . . substantially increased the cost of successful tender offers and completely eliminated the potential for surprise . . . and reduced hostile takeover activity in the 1970s,” Niskanen said.
Although a combination of conditions led to a resurgence of hostile acquisitions in the 1980s, the number sharply dropped again in the 1990s following a 1987 Supreme Court decision that allowed states to implement control share acquisition statutes, and subsequent moves by 42 states to insert takeover defenses in their own laws, he said.
“Enron was a predictable consequence of rules that inhibit the efficient functioning of the market for corporate control,” he said, quoting a U.S. scholar. Borrowing the words of a former SEC commissioner, he also said corporate America “is now governed by directors who are largely impervious to capital market electoral challenges.”
So what should be done?
The obvious choice is to restore an effective market for corporate control. While Congress could help by repealing the 1968 Williams Act, individual state and board-approved antitakeover measures would still be in place, he warned. Which is why he recommends that the case for restoring the corporate control market be taken to the general public, the media and politicians.
“There is reason for some optimism,” he said. “More than half the U.S. households now own some equity, and the accounting scandals, the explosion of executive compensation, the gross mismanagement of too many U.S. corporations, and the large decline in U.S. stock markets after March 2000 should make them receptive to the argument and evidence that the current rules of corporate governance do not serve us very well.”