AUGUST 2006

Tackling Corporate Governance

Managers, directors, and investors are all blamed for corporate missteps. David Larcker, who heads the School’s new corporate governance program, says GSB researchers are positioned to temper strong opinions with more facts.

by Deborah Lohse

Prof. David Larcker
Photo by Oliver Laude

After more than 20 years of researching corporate governance and executive compensation issues, David Larcker is unconvinced that a simplistic set of dos and don’ts can be slapped onto the boards, managers, and auditors of the thousands of publicly traded companies in the United States. That’s not to say that the director of the new corporate governance program in the Business School’s Center for Leadership Development and Research doesn’t believe in imposing rules to force managers or boards to do the right thing for shareholders. But this 55-year-old accounting professor, who rides motorcycles and favors the music of the Grateful Dead, has spent decades rigorously testing which corporate governance tenets actually improve a company’s stock price or its long-term growth prospects—and which don’t.

• Do you recall that post-Enron warning about never letting a company’s auditing firm also do consulting work? That’s not really a big problem for the vast majority of companies, Larcker found and reported with a colleague in 2004.

• If the board of your favorite company meets the latest criteria for being independent from management, it can be counted on to pay the CEO objectively, right? Probably not if it’s one of the 5 percent of boards studied by Larcker where undisclosed board interrelationships seem to result in outsized executive pay.

• What about the theory that the more stock a CEO holds in his own company, the more his interests are aligned with those of shareholders? Not necessarily true. Chances are some CEOs with a lot of stock are quietly hedging away 20 percent or more of their holdings, according to a study under way by the School’s Alan Jagolinzer, an assistant professor, and Larcker, the James Irvin Miller Professor of Accounting.

The rise of corporate governance as a topic of study, many say, traces back to a seminal study in 1932 by lawyer Adolf Berle and economist Gardiner Means, who laid out in The Modern Corporation and Private Property the way in which the stockholding owners of powerful corporations, such as automobile makers, had become separated from the controllers, or management, of the corporations. The pair warned, presciently, that managers often had different incentives for how to spend corporate assets than shareholders. And boards of directors, who were supposed to be the voice of the shareholder, were often complacent or too cozy with management to step in.

But rather than serving as a call to arms for shareholders to exercise their power for change, Berle and Means’ work was met with a “what-can-you-do?” reaction, says Nell Minow of the Corporate Library, a corporate governance research and analysis firm.

“The accepted wisdom was the Wall Street rule: You vote with management, or you sell the stock,” she says. Those who might have wanted changes to any unfriendly shareholder practices found it insurmountably difficult to get pertinent corporate information, launch a proxy fight, or otherwise exert influence over managements or boards.

Insulated from investors, then, and not yet laden with the levels of debt that would later force companies to focus on return on investment, corporate leaders went on an acquisition binge in the 1960s and early 1970s. Part of the impetus was that novice investors were picking stocks on relatively simplistic measures like earnings per share—and CEOs got paid on size. That helped lead to the era of conglomerates like International Telephone & Telegraph, which owned everything from car rental outfits to frozen food companies.

The new conglomerates led to two things that became highly controversial in the early 1980s and which proved pivotal in corporate governance history: Corporate leaders started to make previously unheard-of seven-figure salaries, and corporate raiders like T. Boone Pickens saw that they could buy unwieldy conglomerates, often financed with debt, and sell off the pieces for fat profits.

“In the eighties, there was a lot of discussion about compensation, and this sounds silly now, but people started getting queasy about the whole ‘this guy’s making a million dollars in cash money’ thing,” Larcker says. “But there really wasn’t any developed body of research where people said ‘OK, so what? Is there any pay for performance?

If you see these people change from one type of contract to another, does it really matter?’”

Having spent his early academic career writing on a wide array of managerial accounting and auditing subjects, Larcker began turning his focus to executive compensation in the 1980s, especially to whether the financial incentives or motivators implemented by companies really did improve spending decisions and long-term stock prices.

In 1983, he wrote an influential paper that helped confirm the value of a new breed of compensation called long-term performance plans.

“Basically, what you found out was once companies instituted this long-term stuff, managers did act a lot more long term,” he says. “They spent more on capital expenditures, and the stock price bumped up.”

During this time, too, corporations were scrambling to fend off raiders: One researcher found that about half of all corporations got a takeover offer, and those that didn’t felt they had to put up defenses against them. Among the corporate measures that raised the hackles of investors were messy “poison-pill” plans that made a takeover costly for acquirers by flooding the market with new shares in the event of unwelcome share offers.

Research at the time focused on the wisdom of the corporate defenses. Larcker wrote what he believes was the first such paper on so-called golden parachutes, the severance packages that would pay fat sums to executives if their companies got taken over. Derided at the time as being grabby payoffs for failed managers, Larcker found that in fact, golden parachutes served a useful purpose: removing a CEO’s incentive to sabotage a good takeover because of concerns that he or she would be ousted in the deal.

The modern era of corporate governance debate has focused on the gigantic payouts that have stemmed from moving so heavily to stock-based compensation and the high-profile governance failures in which a small number of executives managed to twist the system for their own eight- or nine-figure windfalls. Congress, legislators, and researchers have scrambled to impose, assess, and justify new rules to prevent repeats of corporate outrages such as Enron or WorldCom.

In a 2003 paper Larcker tackled a subject near and dear to Silicon Valley—stock options. He found that, contrary to the Valley battle cry that broad-based stock option grants build a loyal workforce, corpo-rate performance is not measurably improved by granting options below a certain employee level.

Some of the biggest rule changes, which he wants to test for effectiveness, are in the Sarbanes-Oxley Act of 2002. The law imposed strict new rules and liabilities on executives, boards, board audit committees, outside auditors, and others. “It would be great to do a really rigorous study quantifying the costs and benefits of Sarbanes-Oxley,” he says.

Former commissioner of the Securities and Exchange Commission Joe Grundfest says that Larcker, who worked briefly as an engineer before his academic career, is “one of the leading people in the field of analysis of executive compensation, option compensation, and a host of management accounting issues.” Now a Stanford law professor, Grundfest is codirector with Larcker and Law School Professor Robert Daines of the new Rock Center for Corporate Governance.

In March, just eight months after Larcker made the move from Wharton, Stanford announced the formation of the Rock Center, which was funded with $10 million from Valley entrepreneur Arthur Rock and his wife, Toni Rembe.

The clout of the center became apparent in early 2006, after the Securities and Exchange Commission (sec) announced its most extensive proposal in 14 years for disclosing executive pay. Within a month of its founding, Rock Center leaders had convened a daylong seminar in Washington, D.C., attended by dozens of the top experts on the subject, including investors, consultants, researchers, company executives, and regulators. They spoke for hours to three of the four sec commissioners following a kickoff speech by chairman Christopher Cox.

“They have such tremendous Rolodexes,” says David Chun, formerly a student of Larcker’s at Wharton, now CEO of compensation re-search provider Equilar. “With a month’s notice they decided they were going to do a conference, and all these people showed up. It shows their access to thought leaders.”

As the Business School’s new lead man for a program designed to make headway on many fronts of corporate governance, Larcker says he is pleased that nearly two dozen School faculty members have an ongoing interest in this area. The Rock Center and the GSB’s corporate governance program are likely to involve more than a dozen Business School faculty, in addition to faculty from the schools of Law, Engineering, and Humanities and Sciences.

Many legal researchers and advocates for reform tend to assume, without rigorous research to back it up, that the rules will effect change at all corporations in mostly the same way. Larcker is hoping the Stanford team’s interdisciplinary research will broaden the thinking of regulators, shareholder advocates, and others to look at corporate governance not having a uniform solution.

He also feels better results will come from starting from scratch with an “agnostic” approach that includes getting inside companies and testing. For that, Larcker hopes to enlist the help of Business School alumni who lead corporations, including those at private companies. Even without a stock price with which to measure performance, he says, researchers can study how private companies instill governance checks and balances and how nonprofits cope with conflicts of interest between those who donate money, say, and those charged with managing and dispensing it.

“My view is we’ve learned a lot, but we haven’t progressed that far in understanding corporate governance,” he says. “We can do this at Stanford because the alumni are very tied to the School.”

The inside-out approach is one Larcker has used before, says former Wharton colleague Bob Holthausen. “One of the things that Dave’s been very good at is getting himself inside organizations,” Holthausen says.

Besides studying companies that are doing well, Larcker wants to do postmortems on corporate blowups. “Let’s find cases when there were problems and ask, ‘Was that really a governance thing, and what did you do in response—other than firing the CEO and CFO?’”

Good governance needs to focus on all areas of a corporation, Larcker feels, which is where Stanford’s multiple disciplinary research will contribute. How do performance goals set by a company’s operations departments affect the ability of a CEO to meet goals set by his board, for instance? What does behavioral research by noted professors like the Business School’s Charles O’Reilly and Jeffrey Pfeffer reveal about how employees react to change, and how should that be incorporated by those setting standards for corporate governance?

“One thing that’s pretty exciting on our end is that we think the governance analysis and ideas actually have the possibility of forcing a lot of people—OB [organizational behavior], accounting, operations, marketing, finance—all the groups within a company or within the research community to actually work together,” he says. “It’s not one size fits all.”

Larcker dreams of having a dynamic, changing set of rules, best-practices lists, or standards that would rise up or recede for a given company or set of companies depending on what years of research show is most effective. No more, perhaps, would regulators look for simple answers to executive pay, like discouraging cash pay over $1 million by making it non–tax-deductible to the corporation, as Congress did in 1993.

Instead, rigorous back-testing of corporate practices might show that pay boundaries should depend on the corporate profile. Corporations should probably limit the pay of a “caretaker” CEO running a company that has changed little in risk or business model in decades, Larcker hypothesizes. But what about the CEO hired to take big risks and move a company into uncharted technologies or countries?

There’s probably an ideal mix of rewards and incentives that could be proven to be effective in such cases, Larcker expects. And what about the situation that confounds most compensation experts: that of a founding CEO like Oracle’s Larry Ellison, who reaped a controversial $74 million last year in pay and stock gains. Case studies would likely prove that “the truth of the matter is … he’s worth whatever he wants to get paid,” Larcker says.

Larcker also believes that the impact of operational risk—normally the purview of researchers of strategic management and organizational behavior—can’t be left out of any studies that aim to set best practices for how a board should be run, how managers should be paid, and what governance rules a company should set for itself. He defines operational risk as the “what-if-something-goes-wrong questions,” which boards, not just managers, need to consider, he says. At banks, for instance, “if you’ve got a glitch in processing transactions, it could have tremendous ramifications for the return of the bank.” A company’s inadvertently leaving itself exposed to such costly risks—which Congress tried to fix by requiring a tedious cataloging under Sarbanes-Oxley’s Section 404—could certainly negate all the purported good effects of having the right number of board meetings or any other corporate governance, Larcker reasons.

Can an integrated research approach be accomplished? “I hope so,” Larcker says. “If you can’t do it with the kind of talent you have here at Stanford across the board, it’s just hard to imagine it can be done anywhere.”

New Research Directions

Look for research from Business School corporate governance researchers in these areas:

• A study of the labor market for CEOs, to figure out if the rising tide of CEO pay is a natural or unnatural market phenomenon. “Maybe it’s the case that the labor market for CEOs is really broken,” Professor David Larcker says. “If that’s the case then, you can’t really rely on that market to provide any kind of discipline on pay matters.”

• An analysis by professors Alan Jagolinzer and Larcker of how CEOs and other executives don’t really own the level of stock they appear to own because of complex hedging strategies that aren’t easily discerned from corporate documents. Already, research is indicating that above certain ownership levels, CEOs often have nullified 20 percent of their holdings through offsetting investments.

The interesting question, Larcker says, is “are they hedging because they want to diversify a concentrated level of ownership in their company’s stock, or are they hedging because they don’t think the stock will outperform the market?” Early indications are the latter, he says: Hedging appears to be a sign that executives believe “the stock price may go up, but not as much as if you were in a market portfolio.”

• A study by doctoral student Christopher Armstrong, Jagolinzer, and Larcker into the true cost to 10 companies of granting stock options to employees. By examining the actual, not assumed, rate at which employees exercised their option grants, the research is showing that traditional option measurement tools overstated the cost of options to some employees by 30 percent to 50 percent.

• Projects aimed at discovering the characteristics of corporations that are more likely than others to commit fraud.

One project would take proprietary data from two of the four largest auditing firms and examine where and how they internally identify companies that are at risk of fraudulent or overly risky behavior. Then, Larcker wants to see how they change their audits in response.
“The sec is super-interested in this,” he says. “If you found out that there are certain kinds of board structures, ownership structures, or audits that are conducive to fraud, that would be something you could identify and presumably you could fix.”

Another study, by Maureen McNichols, the Marriner S. Eccles Professor of Public and Private Management, would look at speech patterns of CEOs for signs of when a CEO is covering up. “Do they use first-person pronouns? Is it passive tense? How complex is the story?” says Larcker, who said the aim could be to come up with an “obfuscation index.” He and McNichols codirect the School’s executive education program for board members of publicly traded corporations.

Deborah Lohse is a city hall reporter for the San Jose Mercury News who has previously covered business and corporate governance topics.

FEATURES IN THIS ISSUE

Historic Dates

Key Dates in U.S. Corporate Governance History

1933–1934
In the wake of the 1929 market crash and the Great Depression, Congress creates the Securities Act of 1933, which requires registration and disclosures about stocks and bonds being sold to investors, and prohibits deceit in the sale of securities. The Securities Exchange Act of 1934 creates the Securities and Exchange Commission as the nation’s securities industry regulator.

1968
The Williams Act imposes new rules on tender offers for companies by requiring bidders to pay the same price to all shareholders and disclose the source of cash. It also gives shareholders time to make up their minds.

1970s
States pass anti-takeover laws requiring more notice and giving state regulators power to delay takeovers. Many laws are later struck down by the U.S. Supreme Court.

Mid-1980s
Institutional Shareholder Services and the Corporate Library are formed to create corporate governance ratings and analysis of publicly traded companies.

1993
Section 162(m) of the Internal Revenue Code forbids corporations from deducting from their taxes compensation over $1 million for the CEO and top four executives unless that compensation is performance based.

2002
After Enron and WorldCom implode, the Sarbanes-Oxley Act imposes new rules on boards of directors, new disclosure and personal liabilities on CEOs and CFOs, and more recording and testing of corporate risk factors.

2006
The Securities and Exchange Commission considers broad new disclosures about executive pay, including details of severance and retirement plans and perquisites.
Sources: Websites of the Securities Industry Association, Institutional Shareholder Services, the Corporate Library, and the Securities and Exchange Commission.

Sources: Websites of the Securities Industry Association, Institutional Shareholder Services, the Corporate Library , and the Securities and Exchange Commission.

Stanford Business