blower. I readily grant that pre-Sarbanes-Oxley audit committees were not
great discoverers of executive wrongdoing. But in truth, there is no way for
an audit committee, new or old, to uncover wrongdoing short of deploying
a vast army of investigators who would smother the firm with costly oversight
that would likely stifle corporate risk taking and ultimately threaten
the viability of the company.
Other Sarbanes-Oxley provisions extol the "independent" director.
Somehow, it is argued, competing voices will keep management honest. In
practice, directors who are independent of management tend to have very
little experience in the business they have been appointed to oversee. They
are not likely to know what type of chicanery is possible. I always thought
President Roosevelt had it right when asked how he could appoint Joseph P.
Kennedy, a Wall Street speculator (and father of JFK), as the first chairman
of the Securities and Exchange Commission. Wasn't it the classic case of the
fox guarding the henhouse? Roosevelt replied, "Set a thief to catch a thief."
A corporation can have only one strategy. Competing "independent"
voices with wholly different agendas undermine the effectiveness of the
CEO and the rest of the corporate board. I have served on boards with dissident
directors. Only business that was legally required at board meetings
431
THE AGE OF TURBULENCE
got done. Missing from those meetings was the useful exchange of ideas
that inform the corporate strategies of the CEO. With dissident directors—
such as those who represent potential investors seeking to take over a
company—human nature being what it is, most interchange between CEO-
supporting directors and incumbent corporate management occurs outside
the boardroom.
I do not wish to cast aspersions on the corporate takeover. On the contrary,
it is a key facilitator of creative destruction, and doubtless the most
effective remaining means by which shareholder voices can mold a corporation.
But while change in management is often necessary, you cannot effectively
run a corporation with differing authoritative voices espousing
opposing corporate goals. It has to be one or the other. If the board is riven
with conflicting interests, corporate governance will suffer. If directors cannot
agree with the CEO's strategy, they should replace him. Corporate dissonance,
of course, is unavoidable in periods of transition. But it is not a
value to be pursued for its own sake. A cacophony produces only red ink.
The notion of enlisting representatives of a corporation's various stakeholders
on the board—unions, community representatives, customers, suppliers,
and so forth—has a nice democratic ring to it. But it is ill-advised and
I strongly suspect it will not work. Today's highly competitive world needs
each corporation to execute plans from a single coach, as it were. A vote by
the whole team on each big play is a recipe for defeat. I assume that eventually
some of the more abrasive edges of Sarbanes-Oxley, especially Section
404, will be honed down.
As good as American corporate governance, with all its warts, has
proved to be over the decades, adjustments to the ever-changing global environment
have exposed gaps that require attention. Accurate accounting
is central to the functioning of free-market capitalism. If the signals engendering
allocation of a nation's resources are distorted, the markets will be
less effective in fostering rising standards of living. Capitalism expands
wealth primarily through creative destruction—the process by which the
cash flow from obsolescent, low-return capital coupled with new savings is
invested in high-return, cutting-edge technologies. But for that process to
function, markets need reliable data to gauge the return on assets.
Stock-option expensing is a case in point. In 2002,1 joined the battle
432
CORPORATE GOVERNANCE
over this arcane, but critical, aspect of the dot-com boom of the 1990s. My
good friend Warren Buffett, no neophyte in corporate evaluation, had
joined the fray earlier. High-tech corporations in particular were engaged in
a massive shift from paying wages, which subtracted from net income, to
granting stock options, which at that time did not. This made a large difference
in the results of some companies. In 2005, for example, Intel reported
a net profit of $8.7 billion; by Intel's own reckoning, if the cost of options
had been factored in, that figure would have been $1.3 billion smaller. I
argued that options, which attracted skilled people—real resources—to a
corporation, were, in principle, indistinguishable from cash wages or other
forms of payment.
Accurate profit evaluation requires accurate cost accounting. Labor costs
need to be recorded correctly or corporate management will be misled as
to whether a corporate strategy is paying off. Whether it is paid as cash, an
option grant, or access to the executive dining room should be of no consequence.
The corporation needs to know the market value of the newly
hired employee. The employee, by accepting a compensation package (including
options), is effectively setting his market wage. And that market
wage conveys the price of the labor resources required to produce a profit.
In an economy as large, diverse, and complex as ours, the accurate measurement
of corporate performance is essential if our nation's resources are
to be directed to their most efficient uses. Accurate input costs are essential
for determining whether the corporation earns a profit from its current activities.
Changes in balance-sheet valuations based on uncertain forecasts
have become an increasingly important element in determining whether a
particular corporate strategy has been successful. The basic principle of
measuring profit as the value of output less the value of input is not altered
by the complexity of measurement.
To assume that option grants are not an expense is to assume that the
real resources that contributed to the creation of the value of the output
were free. Surely the shareholders who granted options to employees do
not consider the potential dilution of their share in the market capitalization
of the corporation as having no cost to them.
Options are important to the venture-capital industry, and many in
high-tech industries argued strenuously against making any changes to
433
THE AGE OF TURBULENCE
then-current practices. They maintained that the use of options is an exceptionally
valuable compensation mechanism (correct); that recognizing
an expense associated with these grants would reduce the use of options,*
harming high-tech companies (possibly); that the effect of options on "fully
diluted earnings per share" is already recognized (irrelevant);+ and that we
cannot measure the costs of options with sufficient accuracy to justify their
recognition on financial statements (wrong).*
This seemingly arcane accounting matter is, in fact, critically important
for the accurate representation of corporate performance. Some thought
not having to expense option grants was a major aid in raising capital to finance
the rapid exploitation of advanced technologies. While the vital contribution
of new technology to the growth of our economy is evident to all,
not all new ideas create value on net. Not all new ideas should be financed.
During the dot-com boom, substantial capital was wasted on enterprises
whose prospects appeared more promising than they turned out to be.
Waste is an inevitable by-product of the risk taking that generates the
growth in our economy. However, the amount of waste becomes unnecessarily
large when the earnings reports that help investors allocate investment
are inaccurate.
Stock-option grants, properly constructed, can be highly effective in
aligning the interests of corporate officers with those of shareholders. Regrettably,
many of the particular grants were constructed to be self-serving.
I guess I shouldn't have been surprised when high-tech industry lobbying
phalanxes found their way to the Fed. I had several visits from groups of
CEOs, often led by the canny Craig Barrett of Intel. The visiting CEOs had
not counted on my quarter century of experience as a corporate director. I
*This would be true if the option recipient had been fooled as to the company's true profit
performance.
tThis adjustment corrects only the denominator (the number of shares) of the earnings-pershare
ratio. It is the estimation of the numerator (earnings) that the accounting dispute is all
about. Option grants do have the potential of increasing the number of shares outstanding and
accordingly, decreasing earnings per share.
+The means of estimating option expense is approximate. But so is a good deal of all other
earnings estimation. Moreover, unless options are expensed, every corporation already implicitly
reports an estimate of option expense on its income statement. That number for most companies,
of course, is exactly zero. Were option grants truly without value or cost to the firm?
434
CORPORATE GOVERNANCE
enjoyed countering their arguments. I often was tempted to ask Craig,
whom I had gotten to respect and like, or any of the lobbyists for one cause
or another who arrived on my doorstep: "If I could convince you that your
arguments are wrong, would you be allowed, in your current employment,
to change your view?" I never asked. It wasn't necessary. I was in the same
position in 1994 when I engaged China's then premier Li Peng in a debate
on capitalism versus communism (see chapter 14).
The argument in favor of expensing options eventually prevailed. In
December 2004, the FASB changed its rules to require expensing of stock-
option grants starting in 2005. The new rules went into place only after
nearly being blocked by Congress, responding to the arguments of high-
tech entrepreneurs.
Even before the scandals of 2002, there was much political angst about
the rise in executive compensation in comparison to the pay of the average
production worker. As I explain in chapter 25, the inexorable growth in the
proportion of our GDP that is conceptual, especially technological, has increased
the value of intellectual power relative to the value of human
brawn many times over many generations. I am old enough to remember
when physical prowess on the job was the source of legend and reverence.
A large statue of Paul Bunyan, the mythical logger, still oversees the northern
Minnesota lake country. Stevedores of a century ago were extolled for
their brute strength. Today, the activities once carried out by stevedores are
often run by young women at a computer console.
Relative compensation in our society is market determined, and reflects
the value preferences of all participants in our economy. Is there a
better arbiter? An equally consistent, but never successfully applied, standard
is that all workers should share equally in the results of their collective
efforts. By that ethos, all wage disparities are unjust. But averring that a
certain set of income disparities is too large or too small requires a standard
by which to judge. "Too large" accepts the premise that inequality at some
level is justified. Why shouldn't it be lower? Or higher, for that matter?
I argue in chapter 21 that income disparities are politically destabilizing
to society. But a cure that involves government wage controls, as opposed,
for example, to helping lower-wage workers acquire more valuable
skills, is too often worse than the disease. Even given the flawed aspects of
435
THE AGE OF TURBULENCE
corporate governance, executive salaries are ultimately and, one must assume,
voluntarily assented to by the company's shareholders. As I noted
earlier, there should be no role for government in this transaction. Wage
control, like price control, invariably leads to grave unexpected distortions.
G
G
iven the shareholder-management divide, the autocratic-CEO para
digm appears to be the only arrangement that allows for the effective
functioning of a corporation. We cannot get around the authoritarian im
perative of today's corporate structure. But we can make sure nonperform
ing CEOs are removed, if not by current shareholders, then by making
takeovers easier. A step in that direction would be to ease the rules of ac
cess to shareholder lists, currently largely controlled by incumbent manage
ment. Shareholders who seek anonymity can be protected by listing in
street names.* Mergers, acquisitions, and spin-offs are a vital part of compe
tition and creative destruction. The emergence of private equity funds ap
pears to be a market response to the unwillingness of pension funds
and other large institutional investors to engage in the owner oversight of
corporate management that was a hallmark of earlier generations. Private
equity funds investing in undervalued assets, and thereby achieving above-
average rates of return on capital, furnish evidence that the capital had not
been allocated appropriately in our economy. Shifting those assets to inves
tors who manage them appropriately contributes to economic growth. En
hanced shareholder control would no doubt limit management's self-serving
"golden parachutes," outsized bonuses, backdating of options, and postem
ployment perks now provided at the shareholders' expense.
Ultimate control of American corporations by their shareholders is essential
to our market capitalist system. In corporations, as in most other
human institutions, delegation of authority leads to a degree of authoritarianism.
The proper balancing of effective control in governing corporations
will never be wholly without controversy.
*"Street name" is the expression used when securities are held in the name of a broker or other
nominee, rather than that of the shareholder.
