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Berkeley economist Benjamin Hermalin on President Bush's speech about corporate responsibility
9 July 2002

By 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.


It 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.


Benjamin Hermalin, Interim Dean of the Haas School of Business
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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 listing?

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.


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.

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 aren't relevant?

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 thing.

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 management incentives?

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.


However, 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 trusted.

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.

To reach Benjamin Hermalin for comment, please contact Ute Frey at the Haas School, 510-642-0342, or Meredith LaCorte, 510-643-9690.