The real governance challenges.

A major challenge to CEOs in the coming year will be to assure that their companies meet the requirements of the Sarbanes-Oxley Act and the new listing standards of the stock exchanges. Doing that will be costly and time consuming, and the requirement that CEOs affirm the accuracy of their companies' accounts will lead to unduly risk-averse behavior. But all this effort is unlikely to improve corporate governance as measured by the interests of the general shareholder. Compliance, in this sense, may not even be the central challenge if we accept the notion that a CEO's job is to create shareholder value.

The new listing requirements represent a near-complete victory for proponents of corporate reform. The movement's central premise is that most of Corporate America's problems stem from potential conflicts of interest. The characteristic prescriptions are to increase the independence of corporate boards, public auditors, market specialists and other links in the audit chain. My hope is that the measures approved in the summer of 2002 following the collapse of Enron will represent the end of the evolution toward a monitoring model of the corporate board, with the exception of a few more Securities and Exchange Commission regulations about shareholder rights.

What is one to make of this monitoring model of the corporate board? The first chastening response is that the Enron board was a model board, even by the tighter standards approved in 2002. When Enron declared bankruptcy, for example, it was in full compliance with the governance provisions of Sarbanes-Oxley, with the exception of loans to some corporate officers. Prior to Enron's collapse in late 2001, the Enron board was composed of Ken Lay, Jeff Skilling and 12 independent directors. Many had advanced degrees, some were heads of major corporate or nonprofit organizations and others had significant governmental and regulatory experience.

All of the audit committee members were independent. In 2000, the Enron board was judged one of the five best boards in the country by this magazine. Moreover, all the other major firms charged with accounting scandals through 2002 also were in full compliance, at least formally, with the standards for board and audit committee independence. In short, monitoring by independent directors has proven insufficient.

As it turns out, there is no evidence that company performance is related to the proportion of independent directors. Over the past 20 years, many studies have tested this relationship and have reached that common conclusion.

Institutional investors who pushed for more independent directors also supported the separation of the positions of chairman and CEO, but again without any evidence of a beneficial effect. A 2005 study finds that there is no significant evidence that the number of other boards on which the members of a specific board serve affects firm performance, service on board committees or the probability of securities fraud litigation.

What changes in the rules of corporate governance would make a difference? For a CEO, the place to start is to be honest with him- or herself about patterns of corporate behavior and the rules of corporate governance that may serve the interests of management but not those of the general shareholder. Two such examples have now been well documented.

One is mergers. An accumulation of studies over the past two decades indicates that mergers often reduce the share price of the acquiring firms.

One 2003 article, summarizing the findings of prior studies, concludes that the shareholders of target firms do benefit, but that gains to the acquirer's shareholders are usually close to zero--or even worse. "The 'gains' to acquiring shareholders often becomes more negative, casting further doubt on both the hypothesis that mergers generate new wealth, and on the generally used assumption of capital market efficiency," the authors wrote.

The authors' own study of 168 mergers between large firms from 1978 through 1990 finds no evidence of post-merger synergy and concludes that the typical merger reduced the wealth of the acquirers' shareholders by a large sum.

A more important 2003 article reports a study of more than 12,000 mergers between 1981 and 2001. This study estimates that takeovers by large firms have "destroyed" $226 billion over 20 years. In contrast, small firms created $8 billion of shareholder wealth through their transactions.

For whatever reasons, managements of large companies clearly have a substantial bias in favor of acquisitions that are not likely to benefit their own shareholders. Some of this problem will be reduced by the provision of the 2003 tax law that reduced the tax rate on dividends to the rate on long-term capital gains. This will increase the use of dividends as a return on equity and reduce the level of retained earnings subject to management's discretion.

CEOs, however, are best advised to protect themselves from their own hubris by proposing a rule that would require a supermajority, say two-thirds, of the non-management members of the board to approve an acquisition.

A second, closely related issue is that there has been a proliferation of takeover defenses, such as poison pills and staggered boards, that substantially restrict the market for corporate control. These defenses differ substantially, depending partly on the state in which the corporation is chartered. This variation makes it possible to test the relationship of firm performance to the number and type of takeover defenses. The results are dramatic. Another important 2003 article used a "Governance Index" to measure shareholder rights at 1,500 large companies during the 1990s. "We find that firms with stronger shareholder rights had a higher firm value, higher profits, higher sales growth, lower capital expenditures, and made fewer corporate acquisitions," the authors wrote. General shareholders are clearly paying a high price for rules that defend managements against proxy fights and hostile takeovers.

It is less clear how to unwind this snarl of takeover defenses. A corporate management and board that shared the interests of the general shareholders would do this on their own, maybe in response to a continued investor preference for shareholder-friendly firms.

I hope so, because no apparent policy response is clearly superior. This is a more urgent challenge than the necessary but unproductive efforts to comply with the new regulations such as Sarbanes-Oxley.