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Best Business Books 2004: Governance

Perverse Incentives
More ruthlessly analytical than either the scattergun approach of The Naked Corporation or the genial semiautobiographical approach of Authentic Leadership is MacAvoy and Millstein's The Recurrent Crisis in Corporate Governance. Their admirably terse and lucid work has two particularly interesting dimensions. First, they put the evolution of better corporate governance into a historical context. Second, they pay close attention to the evidence that better governance leads to better financial performance.

On the historical front, the authors point out that this is not the first time American corporate governance has been under the microscope. In the 1960s and 1970s, aggressive acquisitive managers seized power from the board and built overstaffed, overdiversified empires through a process of excessive acquisition. The problem, the authors argue perceptively, was the reverse of that of the late 1990s: Then, managers used shareholder returns to overbuild the company and depress share prices; in the recent crisis, the problem was the overinflation of share prices. Then, corporate America paid its most important leaders like bureaucrats, as argued in 1990 by Michael Jensen, a Harvard finance professor, and Kevin Murphy (now at the University of Southern California); in response to such criticisms, corporate America now gives leaders too high a stake in the performance of their corporation's stock.

Before the Internet bubble, MacAvoy and Millstein confess, they thought that governance had reached "an enviable pinnacle of excellence." Now, they doubt whether the extensive reforms in the Sarbanes-Oxley Act of 2002 and the new rules introduced by the Securities and Exchange Commission and the New York Stock Exchange have done enough to make boards undertake their duties properly.

Why, though, does it matter whether companies are well governed or not? Obviously, it is important that companies not break the law, and shareholders prefer not to lose money. But MacAvoy and Millstein have a chapter titled "The Ambivalent Results of Extant Research on the Impact of Strong Corporate Governance." In a fine survey of the literature, they conclude that the best proof of the efficacy of good governance is the clear undesirability of the alternative: Few would argue that companies would perform better if they were once again governed by their management, with mere rubber-stamping by the board.

To reinforce this view, the authors have done a couple of studies of their own, one in 1997 and one recently. Their latest finding is that stronger corporate governance practices have delivered better performance in those large corporations that adopted them. It would be nice to believe that their finding is true. But it is at least possible that good governance and good management merely go hand in hand.

Like Bill George, Paul MacAvoy and Ira Millstein focus on the independence of the board of directors. "Where Was the Board?" they ask, in the scandals of the late 1990s. The key problem, they argue, was that the most troubled companies did not have adequately independent boards. But unlike George, they see the separation of the roles of chairman and chief executive as crucial to board independence. They also want the board to satisfy itself that the company's management information systems are good enough to ensure that public financial statements are accurate, and they want sophisticated evaluation of management performance, used to monitor effectiveness and to set compensation.

Such a list of objectives places huge demands on board members. Wise Sir Adrian Cadbury, in his modest but persuasive Corporate Governance and Chairmanship, is more gentle toward the board. He praises the Anglo-Saxon unitary board over the German two-tier model, but he sees significant differences in the way American and British boards operate. There is little doubt which he thinks is more effective. On American boards, he says, the CEO is normally in charge, supported by the board. In Britain, the board is unquestionably in charge. "It is essentially a collegiate body reaching its decisions by consensus, and the CEO reports to it," he writes.

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