The State of U.S. Corporate Governance: What's Right and What's Wrong?

The U.S. corporate governance system has recently been heavily criticized, largely as a result of failures at Enron, WorldCom, Tyco and some other prominent companies. Those failures and criticisms, in turn, have served as catalysts for legislative change (Sarbanes-Oxley Act of 2002) and regulatory change (new governance guidelines from the NYSE and NASDAQ). In this paper, we consider two questions. First, is it clear that the U.S. system has performed that poorly; is it really that bad? Second, will the changes lead to an improved U.S. corporate governance system? We first note that the broad evidence is not consistent with a failed U.S. system. The U.S. economy and stock market have performed well both on an absolute basis and relative to other countries over the past two decades. And the U.S. stock market has continued to outperform other broad indices since the scandals broke. Our interpretation of the evidence is that while parts of the U.S. corporate governance system failed under the exceptional strain of the 1990s, the overall system, which includes oversight by the public and the government, reacted quickly to address the problems. We then consider the effects that the legislative, regulatory, and market responses are likely to have in the near future. Our assessment is that they are likely to make a good system better, though there is a danger of overreacting to extreme events.

The State of Corporate Governance 2004

The U.S. corporate governance system has recently been heavily criticized, largely as a result of failures at Enron, WorldCom, Tyco and some other prominent companies. Those failures and criticisms, in turn, have served as catalysts for legislative change (Sarbanes-Oxley Act of 2002) and regulatory change (new corporate governance listing standards from the NYSE and NASDAQ). In this paper, we consider two questions. First, is it clear that the U.S. system has performed that poorly; is it really that bad? Second, will the changes lead to an improved U.S. corporate governance system. We first note that the broad evidence is not consistent with a failed U.S. system. The U.S. economy and stock market have performed well both on an absolute basis and relative to other countries over the past two decades. And the U.S. stock market continued to outperform other broad indices after the scandals broke. Our interpretation of the evidence is that while parts of the U.S. corporate governance system failed under the exceptional strain of the 1990s, the overall system, which includes oversight by the public and the government, reacted quickly to address the problems. We then consider the effects that the legislative, regulatory, and market responses are likely to have in the near future. Our assessment is that they are likely to make a good system better, though there is a danger of overreacting to extreme events.Technology and Industry, Regulatory Reform

LAPM: A Liquidity-based Asset Pricing Model

The intertemporal CAPM predicts that an asset's price is equal to the expectation of the product of the asset's payoff and a representative consum substitution. This paper develops an alternative approach to asset pricing based on industrial and financial corporations' desire to hoard liquidity to fulfill future cash needs. Our corporate finance a determinants of asset prices such as the distribution of wealth within the corporate sector and between the corporate sector and the consumers. Also, leverage ratios, capital adequacy requirements, and the composition of savings affect the corporate demand for li The paper first sets up a general model of corporate demand for liquid assets, and obtains an explicit formula for the associated liquidity permia. It then derives some implications of corporate liquidity demand for the equity premium puzzle, for the yield curve, and for the state-contingent volatility of asset prices. Finally, the paper looks at some macroeconomic implications of the theory. It shows that government may be able to boost aggregate liquidity and enhance economic efficiency by promoting job and asset price stability. On the liability side, long-term deposits and equity investments, which depend on the consumers' endogenously determined liquidity needs, contribute to creating a feedback effect between employment prospects and equity-like investments. On the asset side, orderly sales of real estate by liquidity-squeezed institutions may generate a Pareto improvement

Aggregation and Linearity in the Provision of Intertemporal Incentives

One of the main findings of the principal-agent literature has been that incentive schemes should be sensitive to all information that bears on the agent’s actions. As a manifestation of this principle, incentive schemes tend to take quite complex (non-linear) forms. In contrast, real world schemes are often based on aggregate information with a rather simple structure. This paper considers the optimality of linear schemes that use only aggregated information. The hypothesis is that linear schemes are to be expected in situations where the agent has a rich set of actions to choose from, because richness in action choice allows the agent to circumvent highly nonlinear schemes. We show that optimal compensation schemes are indeed linear functions of appropriate accounting aggregates in a multi-period model where the agent can observe and respond to his own performance over time. Furthermore, when profits evolve according to a controlled Brownian motion (with the agent at the controls) the optimal compensation scheme is linear in profits. The optimal scheme can be computer as if the principal could only choose among linear rules in a corresponding static problem. Applications of this ad hoc principle appear quite promising and are briefly illustrated

A Theory of Firm Scope

The existing literature on firms, based on incomplete contracts and property rights, emphasizes that the ownership of assets - and thereby firm boundaries - is determined in such a way as to encourage relationship-specific investments by the appropriate parties. It is generally accepted that this approach applies to owner-managed firms better than to large companies. In this paper, we attempt to broaden the scope of the property rights approach by developing a simple model with three key ingredients: (a) decision rights can be transferred ex ante through ownership, (b) managers (and possibly workers) enjoy private benefits that are non-transferable, and (c) owners can divert a firm's profit. In our basic model decisions are ex post non-contractible; in an extension we use the idea that contracts are reference points to relax this assumption. We show that firm boundaries matter. Nonintegrated firms fail to account for the external effects that their decisions have on other firms. An integrated firm can internalize such externalities, but it does not put enough weight on the private benefits of managers and workers. We explore this tradeoff in a model that focuses on the difficulties companies face in cooperating through the market if the benefits from cooperation are unevenly divided; therefore, they may sometimes end up merging. We show that the assumption that contracts are reference points introduces a friction that permits an analysis of delegation.

Managerial Incentives and Capital Management

In Holmstrom (1982) an example is given, which shows that a manager’s concern for the value of his human capital will lead to a natural incongruity in risk-preferences between himself and the owners, even when no effort considerations are involved. In this paper we present a formal model of this channel of incongruity based on learning about managerial talent. We also explore the nature of an optimal incentive contract in the case where the manager may withhold but not misrepresent information about investment returns. The optimal contract is an option on the manager’s human capital value with a possible bonus for investing. The optimal investment rule accepts fewer investments than under the cost of capital — a commonly observed real world feature. Another phenomena the model helps explain is the extensive use of capital budgeting and rationing schemes in place of linear or non-linear price decentralization, which are shown to be less efficient modes of allocation