Corporate governance — the establishment of appropriate norms for the way corporations are governed, including independent directors and audit committees — is fashionable right now, both in emerging markets, where it is a major push of aid-sponsored economic “reform” and in the United States, where we are told that a better audit committee could have avoided the Enron disaster. It’s therefore worth taking a look at what corporate governance can and can’t do.
The Asia Foundation and the Carnegie Endowment for International Peace held a lunchtime seminar last week on Asian corporate governance, attended by corporate governance experts from South Korea, the Philippines and China. The seminar was highly informative, if not quite in the way the sponsors intended — it led one to question the value of corporate governance as a whole.
In South Korea, corporate governance reform has moved slowly, even though it is strongly backed by the Kim Dae-jung government. Its main rationale is that it allows the Kim government to reduce the power of the family-controlled chaebol business groups that have dominated South Korean business for the last 50 years.
Recently, the chairman of the Samsung chaebol was compelled by a South Korean court to pay $72 million out of his personal funds to Samsung shareholders. According to the South Korean government, improved corporate governance is the best way to fight corruption.
In the Philippines, American codes of corporate governance have made great progress. Independent directors are required on all boards, and must form a majority of the audit committee. Accounts must be certified by the president of the company and by the board as a whole. Of course, there is one difficulty in the Philippines in that unlike in South Korea, nobody trusts the Philippine court system, which is corrupt and dominated by special interests.
It was generally agreed by the seminar participants that China had made most progress in corporate governance. China has 1,160 publicly listed (on the Shanghai and Shenzen stock exchanges, available for trading by domestic Chinese investors) state-owned enterprises, each of which is being pushed towards a board-of-directors structure with more independent directors, a third of the board by June 2003.Control of management remuneration and the audit process will be handled by non-executive directors in the future.
Violation of China’s securities laws is being vigorously prosecuted — by the Ministry of Public Security.
For the suspicious-minded, this last provision will perhaps cause a twitch of worry. Currently, all of these 1,160 companies are majority owned by the Chinese state. Hence corporate governance, far from providing protection for minority shareholders, is in fact simply providing a mechanism whereby the state can prevent enterprise management from stealing from it.
Naturally, the Ministry of Public Security is very interested in this problem, which is endemic in the Chinese system. Solving the problem, however, will not make China an open economy, nor will it make investment in Chinese state-controlled enterprises a “level playing field” as long as the state remains the majority owner in the companies concerned.
In China, therefore, corporate governance is a “Potemkin village.” Potemkin villages, for those not familiar with the phrase, consisted only of elegant frontages, with filthy hovels behind, built in the Crimea by Catherine the Great’s minister Grigori Aleksandrovich Potemkin, in order to impress Catherine with the wealth and contentment of his conquests in the region. “Potemkin villages” of one kind or another, were of course much used to impress gullible leftist foreigners in the Soviet era, and have been a staple of centrally planned economic systems ever since.
In China, the new corporate governance rules and structures are highly impressive to foreign observers, in this case particularly from the foreign aid community and the international agencies, but they provide no real protection for investors or freedom for the Chinese economic system. Instead, they are simply an additional means of state control of production.
In the United States, the need for better corporate governance has been thrown into relief by the Enron debacle. In December 1999, the Securities and Exchange Commission issued regulations strengthening the independence of audit committees in public companies. According to these regulations, audit committees were supposed to consist only of non-executive directors, internal audit staffs were supposed to report only to the audit committee and not to top management as a whole, and the company’s external auditors were supposed to be appointed by the audit committee and the board of directors together (subject to shareholder confirmation) and not by the board alone.
As Enron demonstrated, these regulations were ineffective. Auditors continue to be appointed by consensus of the board of directors, including insider management. As far as I know, there have been no cases of an audit committee appointing auditors of which management disapproved, and I would not expect to see such a case in the near future. Enron’s audit committee allowed conflicts of interest that it should clearly not have done in the management — benefiting side companies. And the audit committee itself naturally consisted of those eminent members of the business community known to and liked by Enron’s top management, Kenneth Lay and Jeffrey Skilling — including Wendy Gramm, who also served as Chairman of the Commodity Futures Trading Commission, one of Enron’s most important regulators.
As I take it, the main purpose of corporate governance regulations is to ensure that company profits actually get to shareholders, without being diverted by management. As Enron demonstrated, even in the United States, they are pretty ineffective in achieving this end. If corporate governance is ineffective in the most complex and highly regulated market in the world, then it is clearly absurd to expect it to achieve much in emerging markets, where in general, regulatory effectiveness and respect for the rule of law are so much less well established.
Yet the objective that corporate governance is intended to achieve remains an essential one. In the long run, a system that depends on the raising and deployment of third-party capital to achieve economic ends cannot survive in a healthy form if providers of capital do not have some assurance that capital is in fact being used for the purposes they provided it. The mafia can break your kneecaps if you don’t pay them back; ordinary stockholders have no such safeguards against malfeasance by corporate management.
To achieve that objective, there are a number of steps that can be taken, the most important of which are to bring accountancy back in line with common sense, and to re-increase the salience of dividends as an element in investor returns.
One corporate governance step that could be taken to bring accountancy back in line with common sense is to ensure that auditors are genuinely chosen by the stockholders, not by management. As the Enron experience showed, selecting auditors by audit committee is not sufficient, because management more or less selects the audit committee, and communications between the audit committee and management are necessarily close.
Hence, as I have written before, all proposals by qualified auditors to audit a company’s accounts (the question as to whether an auditor is qualified could reasonably be settled by the audit committee, under threat of lawsuit by an auditor they wrongly excluded) should be put to a general meeting of stockholders, with the proposals themselves available for inspection on the company’s Web site.
In that way, stockholders each year would have a variety of audit proposals to choose from, not just one which had been blessed by the audit committee. This is technically corporate governance, but in reality it puts the vote away from the corporation, and back with the stockholders, where it belongs.
In the auditing area, I would strongly support the bill recently introduced by Senator Carl Levin, D-Mich., which requires stock options to be fully expensed at the time the options are exercised. This is better than using a Black-Scholes valuation, because it replaces a flawed mathematical “black box” with a valuation method which is instantly comprehensible to the average stockholder.
It will also tend to deflate profits radically in years when the stock market takes off, which is usefully counter-cyclical, and will quickly expose greedy managements who award themselves excessive options. (Even though the options are not exercisable for several years, Wall Street analysts will calculate the dilutive effect of the options as they are issued, and institutional shareholders will react appropriately negatively.)
Further accounting reforms which need to be taken urgently are on pensions, to prevent companies from ceasing to expense pension liabilities in bull stock markets, and on restructuring costs, to ensure that in almost all cases these are brought within operating earnings and not expensed “below the line.”
The pressure of public opinion is already being brought on Wall Street analysts, not to rate companies on earnings which bear no relation to reality; the published figures need to be brought properly into line with a conservative view of reality, to remove analysts’ ability to do this.
As important as a reform in accounting practices, however, is a reform in investors’ return methodology. Increasingly since the middle 1980’s, investors have valued companies, not on their actual or potential dividend yield, but on the price somebody else might be prepared to pay for them in the future. This application of the “greater fool theory” to stock market investment in general has been accompanied by, and has indeed to a large extent caused, a huge run-up in stock prices in the last 10 years, which seems to be re-igniting judging by the two-day rally Friday and Monday.
It is not however a sound methodology; it will inevitably produce huge swings in stock prices, as investors swing from unfounded optimism to unfounded pessimism and back again, since they have no real basis on which to make an economic valuation of their holdings.
The Japanese real estate market in 1989, which inspired similar ratiocinations, was, we now know, overvalued, and it was, we now know, absurd that the Imperial Palace grounds were worth on paper more than the state of California. The correction of this absurdity has taken more than a decade, and it is not clear even today that the end of the downturn is in sight.
As a step towards increasing the salience of dividends, Congress should take steps immediately to remove the double taxation of dividends, at the corporate and investor level, and allow corporate dividends paid to be deductible for tax purposes from corporate earnings. This is far more important than a reduction in the capital gains tax rate, since dividends are currently taxed at a top rate of 61 percent (35 percent corporate, compounded by a top individual rate of 39.6 percent) whereas long term capital gains are taxed at 20 percent or less.
If the Levin reform might be thought of as “business-bashing” then this reform could very easily be combined with it, to produce a neutral package. The cost of removing double taxation of dividends would be about $55 billion in the first year, but that would be counterbalanced by the (small) extra tax yield from the Levin reform and by the increase in business efficiency and consequently greater taxes that would result from the combined package.
Of course, since the dividend yield on the Standard and Poors 500 Index is currently around 1.2 percent, the stock market would have to drop sharply, maybe by about half, even with an increase in the dividend payout rate, to make dividends once again the major portion of investor returns.
But then, that’s going to happen anyway.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
This article originally appeared on United Press International.