Corporate Governance

David Larcker: Regulations Are No Quick Fix for Corporate Failures

In their latest book, corporate governance experts assess which governance practices really work.

July 24, 2013

| by Stanford GSB Staff

Corporate misdeeds seem to grab headlines every day and, if you look behind the scenes, what most of these offenses have in common is a breakdown in corporate governance. Not surprisingly, Professor David Larcker at Stanford Graduate School of Business says there is good reason for us to be worried about how corporate governance is being practiced today.

Research shows that approximately 8 percent of publicly traded companies each year have to restate their financial results due to previous manipulation or error, and approximately 10 percent of Chapter 11 bankruptcy cases involve allegations of fraud. And these are just the egregious cases we know about.

In their latest book, “A Real Look at Real World Corporate Governance,” Professor Larcker and his coauthor Brian Tayan come to grips with the messy, real-world state of corporate governance, defined as the processes and procedures that are supposed to ensure company management acts in the best interests of shareholders. As they demonstrate, reality is often quite different.

Their concise book is designed to help current and future business leaders, shareholders, and government regulators navigate critical issues relating to the board of directors function, accounting and internal controls, CEO succession planning, and executive compensation. For each, the authors dissect the underlying forces at play, provide case studies that show how and why governance can break down, and invite discussion about the many judgment calls that corporate leaders and boards must make.

Far from providing a prescription for success, the book and its authors contend that the complexity of corporate governance and the idiosyncrasies of each company cannot be distilled into a few easy-to-follow rules or regulations. In fact, Larcker argues that regulatory reforms aren’t the quick fix that many people hope for after major corporate disasters such as the collapses of Enron or Lehman Brothers.

While the problems of corporate governance might be obvious . . . the solutions to these problems are not.
David Larcker, professor of accounting

“While the problems of corporate governance might be obvious — repeated instances of accounting scandal, entrenched management, disengaged boards of directors, excessive compensation, and poor oversight — the solutions to these problems are not,” he says. “Meanwhile, many of the so-called ‘best practices’ promulgated by governance experts and subsequently adopted by regulators have created an unintended emphasis on procedure over substance.”

Instead, Larcker and Tayan provide practical, research-based analyses of which corporate governance approaches are effective and which are not. For example, they observe that most of the “best practices” about board size, composition, independence, and compensation do not have any measurable effect on corporate performance. What really matters, they say, is the quality of the board; namely, the “expertise of its individual members, their engagement and dedication, and the manner in which they work together and with executives to arrive at well-informed decisions.”

This tension between form and substance became apparent after the collapse of Lehman Brothers, which failed in part because of ineffective board oversight. From a structural standpoint, such as whether the directors were independent, there was nothing unusual about the Lehman board, which had much in common with the board of Goldman Sachs. However, the failings of Lehman’s board became clear when considering more subjective factors such as the professional background of its board members and their engagement. Among many other problems, there was a marked absence of financial services expertise on the Lehman board, and the finance and risk committee met only two times a year, which is egregiously low for a company whose business model is built on financial risk.

Perhaps one of the book’s most surprising observations relates to CEO succession planning — or rather, most boards’ failure to plan effectively for the departure of their chief executive, arguably one of its most important functions. Boards only dedicate two hours to the subject of succession planning each year, even though approximately 10 to 15 percent of companies change CEOs annually, and bumpy CEO transitions can have a negative impact on a company’s market value.

“What’s clear is that corporate governance matters, so our goal is to help readers contend with its fundamental complexities,” says Larcker. “Even though it would be convenient to apply a one-size-fits-all formula, we’ve found that the best solutions for governance problems can only come from well-informed corporate shareholders and stakeholders with a deep and honest understanding of governance practices — and their limitations.”

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