economist Benjamin Hermalin on President Bush's speech
9 July 2002
Bonnie Azab Powell, Public Affairs
Benjamin Hermalin, the interim dean of the University
of California, Berkeley's Haas School of Business, has
a joint appointment with Haas (where he is also the Willis
H. Booth Professor of Banking and Finance) and the Department
of Economics. The recipient of many awards for teaching
and research, including two National Science Foundation
grants, Hermalin has studied optimal executive compensation,
the negotiation of incentive contracts, factors that affect
turnover of directors, and the relationship of board structure
to financial performance. Shortly after President Bush's
July 9 speech to Wall Street, he talked about the pros
and cons of the reforms proposed for publicly held companies.
President Bush proposed a lot of changes for corporate
America in his speech today. How effective will they be
in curbing fraud?
A lot of it was just window-dressing. I don't think there
was very much substance in his proposed reforms. There
are three ways to think about fighting crime. Consider
drugs. California can put more police on the street, which
will certainly catch more people. Or we could stiffen
penalties for the drug laws. Or we could enact serious
reform in terms of clinics, treatments, and providing
other opportunities to make the system work better. What
I think we heard in the president's speech is just more
policemen and tougher penalties, but very little reform.
would be antithetical to the Republicans to interfere
with that freedom. Instead he's asking the stock
exchanges to do so.
It's also very curious that the reforms he called for
are voluntary on the part of the companies, or voluntary
on the part of the stock exchanges. If he were to back
them up with law, he would be violating the precepts of
a laissez-faire economy, in which we have freedom of contract.
It would be antithetical to the Republicans to interfere
with that freedom. Instead he's asking the stock exchanges
to do so.
What's so important about 'freedom of contract'?
Right now an executive's compensation contract is one
between him and the company he works for, represented
by the directors of the company. That's a private contract.
Generally economists would think there's no reason for
the government to involve itself.
There are exceptions, like when there is an asymmetry
of information or Party A and B have entered into a contract
designed to hurt Company C. But in this case, although
we may not like the contracts between certain CEOs and
their directors, I don't think the exceptions apply. Asymmetry
of information between directors and officers does not
really exist. You might claim that the directors and officers
are conspiring against the shareholders, except shareholders
generally are the ones who appointed the directors, and
have the power to remove them. So the only justification
you have for requiring these new laws is that we just
don't like what these people are doing but that's
the whole reason we have freedom of contract.
Will the stock exchanges follow through in making
these changes disclosure of compensation packages,
independent boards, etc a requirement for
If they think this will improve confidence in the markets,
they'll want to do it. The other reason they might is
if the Democrats push even more severe reforms
then the exchanges will think that going along with Bush's
suggestions will take the wind out of their sails. These
are not big reforms, in the sense that we've been seeing
this movement toward more nominally independent directors
in the last 20 years. Many companies already require stockholder
approval for certain compensation plans, and many states
require companies to disclose anything that would dilute
shareholders' existing shares. So it's not clear how big
an impact the stock exchange's following suit would have.
Let's step back for a moment. Can you trace this current
rash of corporate wrongdoing to any particular catalyst?
There have been considerable changes in many aspects
of corporate governance in the last 20 years. Even before
the Internet bubble and the boom of the 1990s, a lot of
academics were encouraging a greater tying of executive
compensation to performance, in the form of direct stock
grants or stock options. And whenever you change incentives,
if the new incentives increase the temptation to behave
badly - to be more focused on earnings and perhaps therefore
do things that are illegal or on the margin of what's
ethical - initially you'll find a certain rise in bad
behavior. Some people are going to be tempted, whether
to manipulate earnings or something else. Does that mean
there is a general rise in crookedness? Well, no. We've
always had bad apples. Not that long ago there was the
S&L debacle. Pick any period of time and you'll find
other spikes of bad behavior.
the president do something wrong? Well, if the facts
are correct, then it would seem he was the beneficiary
of inside information when making his trade. So
yes, he did.
Most of these executives are claiming that rather
than being crooked, they just "didn't know."
Could that be true?
Anything is possible. Do I believe their defense? No.
It's a tradeoff. You can admit guilt and go to jail, or
you can say you didn't know what was going on and basically
claim incompetence. That way at least you have a defense.
There certainly have been instances in business when
terrible things have happened to firms and the people
at the top really didn't know, like the Barings Bank disaster,
where an underling did something wrong, disguised it,
and brought the whole bank down. That doesn't mean the
bank wasn't culpable, in the sense that it should have
had better oversight and controls, but the management
didn't do anything criminal.
However, when we're talking about the heads of Enron,
Andersen, WorldCom, or whatever, I think they're not being
honest. But they have no other defense available to them.
What's your take on the renewed scrutiny of President
Bush's 1990 Harken stock sale?
It's a political matter more than anything, just like
Whitewater or the issue of Hillary Rodham Clinton's commodities
trading. I'm pretty sure it's past the statute of limitations.
Did the president do something wrong? Well, if the facts
are correct, then it would seem he was the beneficiary
of inside information when making his trade. So yes, he
did. But to go into it again after the statute of limitations
has passed is just a political issue.
So his and Vice-President Cheney's previous dealings
Well, they're in a bad situation politically in that
this issue has been getting a lot of attention from the
press. And to varying degrees, both of them are under
suspicion for having engaged in questionable business
practices. You don't want that on the front page right
now. They can either hope it gets pushed off the news,
or they can play the reformed-sinner strategy: get out
there and really push hard for reform, because then it's
very hard to tar you as being beholden to corporate America.
In fact, the reformed-sinner strategy may cause the Bush
administration to actually work harder on reform.
Has the Securities and Exchange Commission in fact
done an adequate job policing these companies?
Well, economists like me tend to take a laissez-faire
attitude. That is, we have a lot of faith in the markets.
One of the places we know markets can break down is when
you have informational asymmetries, meaning people are
trading but they don't have the same information. And
that's a huge problem in the stock market. Because without
regulation, you can easily find yourself trading against
people who are so much better informed than you - like
insiders at the firm - that you're certain to lose. If
you're going to have a well-functioning capital market,
you have to make sure that someone is out there as a referee.
It's a game that can't self-regulate.
The SEC certainly could be doing a better job, but there
still seems to be a reasonable amount of faith in the
workings of the stock market. If there were a real erosion
in confidence, we'd see a lot of capital leaving the markets.
We are seeing some - the stock market is falling - but
not a wholesale movement.
Do we need the greater penalties that Bush has proposed?
Do you think any of these CEOs charged with criminal,
not just civil, wrongdoing will actually do jail time?
Some will, if only because the public would not be satisfied
if no one went to jail. We can ask ourselves whether the
criminal penalties are strong enough: obviously if they
were, they would have been a good counterincentive to
this behavior. On the other hand, a lot of top executives
are full of hubris. They may believe that they can get
away with it. We have stringent penalties for many crimes
and yet we still see them committed in society.
The way to make the threat of criminal prosecution a
deterrent is to increase the odds that you catch the criminal,
increase the punishment, or some combination of both.
If we could increase the chance that we catch these people,
that will really help to restore some confidence.
Which of the reforms being debated would actually
increase those odds?
More oversight would certainly help. With auditing, there
are two reforms that would be very effective. First, a
real prohibition against providing consulting services
to any firm you're also auditing.
The second one is a little more complicated. We should
enforce a rotation of auditors and their clients. So Deloitte
& Touche can audit a given firm for four or five years,
say, and then the firm has to pick a different auditor.
Right now, auditors have a real conflict. You have a responsibility
to tell the truth if the numbers are not OK, but if you
do, the reward is you don't get rehired. If you knew that
you were only going to have a short tenure with this company
anyway, it would strengthen the incentive to do the right
What do you think of the idea that executives should
be forbidden from selling their shares until they retire?
That's really interfering with freedom of contract. It
would also have unintended consequences in the sense that
it would likely make managers really risk averse, which
may not be what the shareholders really want. Also, if
they are denied that form of compensation, they'll demand
other kinds: we'd see them getting more cash, more bonuses
tied to performance, and these would incur their own problems.
Is there any way to salvage stock options as acceptable
Boards of directors have to ask themselves the question,
are we being responsible in granting these options? If
they think about it carefully, in many cases they might
say we've misused them. So perhaps one way of restoring
confidence in them is to make them seem less like a giveaway.
We also have to have much more prompt disclosure of all
transactions involving options and executive sale and
acquisition of stock. Take the "form four,"
which executives are supposed to fill out and submit when
they trade stock in the company. You can do it electronically,
which is very quick, or you can fill it out on paper and
it takes weeks to process. We have the heads of some of
the world's greatest tech companies filling it out on
paper, not because they can't be bothered to fill it out
electronically, but because they want to have that delay.
That has to go.
there's a real trend toward having more outside
representation. That doesn't always mean the board
is more independent.
What effect would the stock exchanges' requiring that
company boards be headed by an independent chairperson,
not its CEO, have on fraud?
There are some studies of firms that split responsibility
between inside and outside people. They tend to suggest
that perhaps they do a little bit better than firms that
don't. But generally most studies that look at how the
board is structured have had a difficult time finding
any relationship between the board itself and the firm's
performance. Usually what you see is that the board's
structure matters in extraordinary circumstances, like
when you need to fire a CEO or deal with an acquisition,
but not really in the day to day.
However, there's a real trend toward having more outside
representation. That doesn't always mean the board is
more independent. For instance, say Company A puts the
CEO of company B on its board, and Company B puts Company
A's executive on its board. They're not going to be terribly
independent. Twenty or more years ago, there was a lot
more management representation on boards than there is
today. So you might think all today's firms should be
better, given they're supposedly more independent. But
we haven't really seen that.
One of the reasons we should be suspicious of all these
exogenous fixes to the board is that if they're so grand,
why haven't people done them already? Some of my work
tries to come up with reasons why individual boards would
evolve in ways that are less than optimal. But remember,
we've been complaining about boards for 200 years. Go
back to Adam Smith and The Wealth of Nations and
there's a line about how boards of directors can't be
Any chance we'll actually see some of these changes?
There's public outrage, but it doesn't seem to be translating
into a real public call for action just yet. We're seeing
it in the op-eds, people saying we need this or that reform,
and sure, if you did a Gallup poll, people would say that
change is necessary. But are they about to go out and
vote that way, or scrutinize the candidates on these issues?
I don't think so. Meanwhile, corporate America is going
to be pushing its lobbyists to water down and drag out
things, even if not overtly. They have an advantage with
the House and Senate held by different parties. There's
incredible inertia right now.
The one caveat to all this is that if investors seem
to become unnerved and the markets really start to move
downward. And that hasn't happened yet. The market has
been drifting more sideways than downward. If we'd seen
a 600-point drop instead of a 6-point drop after WorldCom,
then people might have said, 'Gee, maybe we're our own
worst enemy - maybe we do need reforms to restore confidence.'
We'll certainly see some aspects of corporate America,
like the investment community, which relies on people
having faith in the market, starting to push for reforms.
They're losing out because of this. But that will be counteracted
by the corporations themselves, unless something changes.
reach Benjamin Hermalin for comment, please contact Ute
Frey at the Haas School, 510-642-0342, or Meredith LaCorte,