[Economic Report of the President (2003)]
[Administration of George W. Bush]
[Online through the Government Printing Office, www.gpo.gov]


 
CHAPTER 2

Corporate Goverance and Its Reform

Corporate governance is the system of checks and balances that guides
the decisions of corporate managers. As such, it affects the strategy, operations, and performance of business firms over a large segment of
the economy: corporations during 2001 accounted for 60 percent of U.S.
gross domestic product (GDP). Corporate governance also affects the
ability of those outside the corporation--including investors--to
monitor the quality of management and its decisions and to influence
and even control some of those decisions. This observability, or
transparency, can greatly enhance a corporation's ability to raise
funds from outside investors. It can also make it easier for other
outsiders, including suppliers and customers, to transact with the
corporation, by making the incentives and abilities of its managers
and other employees more clear.

Households increasingly participated in the ownership of corporate
stock during the 1990s. Fewer than one-third of U.S. households--31.6
percent--owned corporate stock directly or indirectly in 1989. By
1992 that number had grown to 36.7 percent. More than half--51.9
percent--of households owned stock as of 2001, the latest year for
which comparable survey statistics are available. The greatest
percentage-point increases in household stock ownership appear to
have occurred in groups where it was lowest at the start of the
decade, for example among households with moderate rather than high
levels of income.

Access to well-developed financial markets accounts for some of the
success that U.S. corporations and their managers have enjoyed in
attracting capital from outside investors. U.S. securities markets
are among the best in the world. Their relative depth and liquidity
make it easier for investors to buy and sell common stock and other
corporate securities, and this makes investments in U.S. corporations
more attractive. The relative efficiency of U.S. securities markets
is not the only reason for households' willingness to invest in
corporations, however.

To compete successfully in well-developed financial markets,
corporations must win and maintain investors' confidence. To do this,
managers must provide sufficient information about their firms'
prospects to persuade investors that they can realistically expect a
competitive return on their investments. This is not always easy,
even for a seasoned corporation whose investment prospects are strong.
Part of the difficulty is that managers, as insiders, generally know
more than outside investors know about the corporation, the managers'
competence, and their likely diligence in managing the investors'
funds. Facing this information disadvantage, investors demand reliable
information about the corporation and its management. Specifically,
they seek assurance that the corporation's investment prospects--and
its managers' competence--are as good as the managers might claim.

Investors also demand assurance that managers will work diligently in
their interest. It is not generally realistic for investors to expect
managers to exercise the same diligence with funds provided by others
that they would if only their own funds were at stake. Thus some costs
of delegating decisions to management inevitably arise when managers
go outside the corporation for funds. These costs of separating
ownership from control--what economists sometimes call agency costs--are
not the same for all corporations, because the importance of
managerial discretion in decision making tends to vary across
industries, and among firms in the same industry. Diligent managers
with good investment prospects may thus run the risk of being
overlooked by investors or receiving funds on less favorable terms,
if they do not adequately meet investors' demand for information. For
their part, investors who lack reliable information can miss out on
good investment prospects.

The value to managers, investors, and other participants in
corporations of finding efficient ways to meet this demand for
assurance about the quality of corporate investment opportunities can
be high. One solution is for managers to create systems of checks and
balances that shape the conduct of their corporations and that
outsiders can readily observe. Checks and balances governing the
choice of managers and projects, for example, can commit the
corporation, through rules and incentives, to employ more talented
managers and to pursue more promising investment prospects.
Transparent systems for setting management compensation and
procedural safeguards on managers' actions can reduce the agency costs
of delegating decisions to management. By creating strong systems of
corporate governance, managers can thus improve both the efficiency
of their firms and the terms on which financing is available to them.

Strong corporate governance generally involves some form of publicly
revealed commitment to whatever checks and balances have been
instituted. This can be critical to meeting investor demand for
assurance. Typically it is not enough for managers simply to claim
that they have instituted certain systems and procedures and promise
to maintain them; investors must be able to verify that those systems
and procedures are actually in place and that the commitment to
maintain them is real. This assures investors that these arrangements
are not likely to unravel when they are not looking.

The standards for strong corporate governance are thus high.
Fortunately, managers of U.S. corporations have a solid foundation on
which to build. Nationwide markets for capital and for management
talent, together with a strong legal system and a long tradition of
sound internal corporate governance, provide managers with incentives
to innovate and powerful tools for communicating credibly with
outsiders.

One might think that laws and regulations by themselves could provide
investors the assurances they seek. Some researchers have indeed
attributed the comparative success of U.S. corporations in attracting
small investors to the relative strength of the U.S. legal system. The
capacity of the U.S. court system to provide impartial adjudication
stands in contrast with what researchers have found in some other
countries. The lack of a court system that can resolve disputes
fairly can limit the willingness of investors--especially small or
unsophisticated investors--to provide corporations with funds. This
may partly explain why, in some other countries, large institutions
such as banks play a bigger role in supplying financing to
corporations than they do in the United States, where households play
a greater role. The impartial adjudication of disputes by U.S. courts
is something many U.S. investors may take for granted.

Yet some effective corporate governance solutions have evolved in the
United States without express legal or regulatory guidance. Some
contemporary institutions whose existence is usually attributed to
certain laws appear, in fact, to predate those laws. The presence,
relatively early in the Nation's history, of strong financial
markets--such as major stock exchanges--made it easier for managers to
create strong, transparent systems of checks and balances that did
not rely on the courts. Those conditions appear to have allowed
managers and corporations to develop reputations for quality, or to
efficiently rely on the reputations of well-known intermediaries, as
means of providing assurance to outside investors. Finally, legal
solutions are sometimes limited by the fact that contracts are often
left incomplete, in the sense that they do not specify what should
happen under all possible contingencies. This reflects the potentially
prohibitive costs of writing agreements down so that a judge can later
verify their existence in the event of a dispute. It is costly not
just to anticipate possible future sources of disagreement, but also
to involve attorneys and other legal experts in drafting provisions
to deal with those eventualities, not to mention any time that might
be spent in court.

The existence of both strong markets and a strong legal system can
thus explain U.S. corporations' comparative effectiveness in meeting
investor demand for assurance. Market solutions and legal solutions
can be substitutes or complements for one another. Their comparative
strengths can change over time as market conditions change. It would
thus be a mistake to view the advantage of one over the other as
absolute. As markets evolve, the effectiveness of legal solutions can
change, and with it the comparative advantage of markets in helping
managers more closely align their actions with the shareholders'
interest and communicate this alignment credibly to investors.

Accordingly, effective corporate governance in the United States
rests on a foundation with three parts: legal institutions, external
market forces, and internal governance systems that respond to both.
The next section of this chapter explains how these parts work
together to enable corporations to develop systems of corporate
governance that are responsive to investors. It discusses how this
foundation permits corporations to make adjustments to their
corporate governance systems over time, to respond to changing market conditions.

This adaptive capacity of U.S. corporate governance has indeed been
critical to the ability of corporations--and the government--to respond
to recent changes in market conditions. During 2002, corporate
managers faced heightened demand for assurance from investors. At the
same time, allegations of misconduct by some managers and external
auditors underscored the value of updating some of the laws and
regulations that govern corporate conduct. The alleged misconduct, in
part, involved failure to provide accurate information about corporate
financial and operating performance. These difficulties--and related,
potentially severe harms to investors and employees--underscored
concerns about possible weaknesses in U.S. corporate governance that
had emerged over the past decade. Many corporations have instituted
changes accordingly. It was in this setting--and in light of the
important role that U.S. corporations, and thus U.S. corporate governance, play in the global economy--that the President in March 2002 called for
meaningful reform.

In calling for reform, the President set forth a plan that applies
three core principles of effective corporate governance: accuracy and
accessibility of information, accountability of management, and
independence of auditors. The plan recognizes the complexity of
modern corporate governance systems and their inherent flexibility.
The call for careful reexamination of private customs and legal rules
led to further changes in private sector institutions and the
creation, in July 2002, of the Corporate Fraud Task Force, comprising
law enforcement officials from the Department of Justice, the
Securities and Exchange Commission (SEC), and other government
agencies. (Table 2-1 illustrates the stepped-up enforcement efforts of
the SEC during this period and some of the results achieved during the
same period.) It also led, that same month, to the President signing
new legislation, the Sarbanes-Oxley Act of 2002, which the SEC is now
implementing through a series of new regulations being issued in
phases during 2002 and 2003. These changes constitute one of the most
significant reforms of U.S. corporate governance since the
establishment of the SEC itself in 1934.

The President's plan targeted the underlying causes of concern about
investor confidence. The suggestion of a crisis in investor
confidence, which captured the attention of policymakers during 2002,
followed a substantial increase in the number of earnings and other
financial restatements--corrections to previously



issued statements--by U.S. public corporations, dating back to the
mid-1990s. There are sometimes good reasons for corporations to
restate earnings. Yet a Federal agency report noted that financial
restatements by large, well-known public companies ~~``have erased
billions of dollars of previously reported earnings and raised
questions about the credibility of accounting practices and the
quality of corporate financial disclosure and oversight in the
United States.''  The occurrence of so many restatements, in
combination with high-profile allegations of misconduct, created an
impression that abuses in financial reporting had become widespread.

Restatements of financial reports raise concern because they can leave
investors doubting the quality of the restated reports or, worse,
those of other companies that have not issued restatements. Similarly,
although relatively few restatements appear to be linked to management
misconduct, innocent managers can suffer from the perception that a
few managers create about the quality of management generally. The
appearance of widespread restatements or misconduct can thus create a
misimpression about the conduct of corporations nationwide.  In fact,
most large U.S. corporations have shown no signs of having to restate
their earnings or otherwise warranting scrutiny from the SEC, the
entity charged with enforcing U.S. financial disclosure rules. This
remains true even after investors, enforcement officials, and managers
not implicated in any offenses stepped up their efforts to expose
misconduct, following the President's call for reform in March 2002.

During the late 1990s the number of companies that filed earnings
restatements grew dramatically. After averaging 50 a year from 1991 to
1997, the number of restatements increased to 96 in 1998, 204 in 1999,
163 in 2000, and 153 in 2001, according to one study of certain types
of restatements, compiled through a keyword search of news databases.
About 10 percent of companies listed on major stock exchanges issued
restatements from January 1997 through June 2002, according to another
study using a similar method. The implication is that about 90 percent
of public corporations, which have been the focus of concern, stuck
with their original financial reports during that period. Moreover,
signs of error or misconduct in financial reporting have not been
randomly distributed among U.S. corporations but rather have tended
to concentrate in certain industries. Earnings restatements have
occurred with greater frequency among technology companies than among
other companies, for example.

The more frequent occurrence of restatements in some industries may
reflect the unusual challenges those industries faced during the
second half of the 1990s. Those circumstances may have created valid
reasons for restating earnings but may also have created new
opportunities for misconduct, which the markets and legislators have
moved quickly to correct. Governance structures themselves also tend
to vary across corporations. The different experiences of corporations
in different industries, under different market conditions and at
different times, underscore the importance of exercising caution
before applying any one governance solution to all corporations or
unduly locking corporations into inflexible regulatory solutions.

The rest of this chapter is in two main parts. The first part surveys
the economic foundation of corporate governance and its reform.
Corporate governance was once solely the province of law: legal
scholars and practitioners generated much of what was written on the
subject, not to mention most of the governance advice that
corporations received. However, advances in economic research over the
past few decades, primarily in corporate finance, have shed light on
the critical role that corporate governance can and does play in
enhancing corporate efficiency and in increasing the depth and
liquidity of financial markets. The second part of the chapter
provides an overview of recent reforms and their anticipated
contribution to the quality of corporate governance, with special
attention to new Federal legislation passed during 2002. This is
followed by a brief discussion of the relation between corporate
governance in the United States and that in other countries, an issue
that is receiving greater attention as markets become more global.

As empirical research has evolved, its focus has shifted to add
richness and depth to the understanding that economists now possess of
how good corporate governance can promote investors' interests,
corporate efficiency, and economic efficiency more generally. Two
decades ago, empirical economic research into corporate governance
focused on how and whether the entrenchment of managers might lead
corporations to change their internal governance practices and
structures in ways that might benefit the managers at undue expense
to shareholders. More recently, as markets have become more global,
research has turned to the differences between countries' systems of
corporate governance and whether those differences have grown or
diminished in recent years.

These shifts in focus reflect the evolution of markets and the demands
they place on researchers to provide practical insights and, in some
instances, guidance. The result has been an increase in the scope and
depth of economists' understanding of how corporate governance systems
build on the foundation that markets and the law provide, as indicated
by the discussion below of some legal rules that appear to undermine
the effectiveness of U.S. corporate governance. Specifically,
regulations that may once have had a beneficial effect now appear to
place undue restrictions on investors in their ownership of stock and
their exercise of the rights attached to ownership. As a related
matter, some rules that seek to influence the ability of small
investors to obtain information appear to rest on an incomplete
understanding of the production and distribution of information,
particularly as it affects small investors. The emergence of economic
research on the role of information and on the economic foundations of
corporate governance has complemented the development of corporate
governance policy both in the private sector and in government.

Foundations of Corporate Governance

Businesses that organize themselves as corporations are better able
than other kinds of businesses to raise capital from outside
investors. This advantage is supported by corporate law, which allows
individuals and organizations to invest in a corporation without
incurring unlimited liability for the corporation's actions or bearing
the costs of participating directly in its management, in order to
share in the business's profits. Limited liability also accounts for
the ease with which stock can be traded. When stock is bought and
sold, voting rights typically change hands, and this causes market
forces to affect the outcomes of shareholder votes in ways that do not
apply to other kinds of elections. This transferability of rights
distinguishes the voting rights of stockholders from those of
citizens.

Yet strong legal institutions cannot alone account for the success
that the corporation has enjoyed as an organizational form in the
United States. When investors supply external financing, they delegate
key decisions about the use of those funds to managers. The cost of
this separation of ownership from control can be high, to the point of
limiting a corporation's profitable access to outside financing. Even
very detailed provisions in laws and contracts cannot realistically
eliminate this cost: closing all the relevant loopholes in those
provisions, updating them to keep up with changes in market conditions
and technology, and enforcing them against violation would be
prohibitively costly.

Accordingly, managers and investors can have powerful incentives to
discover or invent other ways to reduce these remaining costs of
separating ownership from control, for if they succeed, the
corporation can grow and investors can participate in the resulting
higher profits. However, these costs can vary markedly across
corporations and industries and over time. This creates incentives for
managers and investors to monitor existing solutions and continue to
seek new means of reducing the costs of separating ownership from
control.

It is here that the three-part foundation of corporate governance in
the United States becomes important. The first part comprises the
external markets that put pressure on managers to perform, bringing
their incentives more closely into alignment with the shareholders'
interest and creating incentives for them to develop new strategic or
institutional means of reducing the costs of separating ownership
from control. The second is the internal governance structure of the
corporation, which adds a complementary set of rules and incentives
to align management's actions with the shareholders' interests.
Finally, the legal system provides investors and other participants
in the corporation's affairs with a means of impartial dispute
resolution. Related to this is the role that regulation plays in
shaping corporate governance solutions. Some features of contemporary
corporate governance may indeed be built upon preexisting regulations
or other legal rules. The opposite may also be true, however: some
contemporary features of U.S. corporate governance predate modern
securities regulation. Market, legal, and regulatory solutions
interact and can complement one another in aligning the incentives of
managers and the interests of shareholders.

Market-Imposed Discipline:
External Governance Mechanisms

The market institutions that have emerged in the United States to
align managers' and investors' interests tend to complement the legal
discipline that the courts provide. They do this by overlaying a more
flexible yet fairly standardized system of checks and balances onto
the more rigid system of court-enforced rules and laws.

As U.S. corporate governance has evolved since the mid-20th century,
experts in economics, finance, and law initiated extensive study of
how the sometimes-hidden forces of the marketplace operate on the
corporation. The result is that competition in at least three distinct
external markets is now recognized as shaping the governance
structures of corporations:

   Competition in the market for corporate control
   Labor market competition
   Product market competition.

______________________________________________________________________
Box 2-1. Do Bad Bidders Make Good Targets?

During the 1980s, interest grew in the use of hostile and friendly
takeovers as means of disciplining bad management and of helping to
reallocate management and other resources among competing uses.
Research on this topic indicated that takeovers have favorable or
at worst neutral consequences for shareholders, on average. Yet some
bidders paid higher prices than others. This raised questions about
whether the disciplinary reach of the market for corporate control
might extend to corporations whose managers bid for other firms too
aggressively. The evidence is that corporations whose shareholders
appear most likely to have been harmed by their managers' overly
aggressive acquisitions are indeed more likely to become acquisition
targets themselves.  After a completed acquisition, managers appear to
face a greater chance of being replaced. Moreover, managers of
targeted corporations often face market discipline whether or not the
takeover bid succeeds. Takeover targets are often poor performers,
and  management turnover appears to occur more frequently after the
defeat of a takeover bid if the target is a poorly performing
corporation.

Merger and acquisition activity can in some instances strengthen
corporate governance by committing the corporation to the issuance of
more debt, ensuring the payout of free cash flow and closer
monitoring by debtholders. Although research from other countries,
such as Japan, indicates that there, too, the threat of takeover can
strengthen managers' incentives to act in the shareholders' interest,
evidence of a well-functioning market for corporate control has been
more visible in the United States. For all these reasons, economists
view the market for corporate control as an important source of
management discipline, complementing the beneficial effects of other
market forces and regulatory oversight. Mergers and acquisitions have
a useful role to play in corporate governance. In the market for
corporate control, bad bidders make good targets.
----------------------------------------------------------------------


Each of these sources of market discipline contributes to managers'
incentives to act in the interests of shareholders. This market
discipline in each instance can take the form of reputational
sanctions: managers will bear losses in their own expected future
income if market participants decide to revise downward their beliefs
about the quality of the corporation or its managers in response to
unfavorable news about their conduct.

The pressures of these distinct markets are most readily apparent at
different times in different industries and corporations (Box 2-1).
Striking evidence on the role of external markets in disciplining
managers--and in reallocating assets among competing uses--emerged in
the 1980s, for example. During this period, changes in technology and
in regulation led many corporations to substitute external financing
for internal financing. This also exposed the managers of some of
these corporations to the real chance of being removed, as outside
investors acquired significant amounts of equity and debt. Helping in
this transition was the emergence of individual investors who
specialized in acquiring companies even against the express wishes
of incumbent management. Many of the so-called hostile takeovers of
the 1980s occurred in a few specific industries such as oil and gas.
The opportunity to improve corporate performance through restructuring
made many of these transactions profitable.

Mergers and other corporate control transactions play a valuable role
in redistributing assets among alternative uses. By facilitating
competition between management teams, and between organizational
forms, the market for corporate control continuously affects the
structure of corporations and the way managers do their jobs.
Transactions in this market tend to occur in waves and to concentrate
in specific industries, however, largely because the gains from
corporate control transactions often derive from industry-specific
technological and regulatory change, as Chart 2-1 illustrates.

Although managers continued to face pressure from the market for
corporate control during the early 1990s, relatively few transactions
occurred, as data on tender offers in Chart 2-2 illustrate. Economic
research at that time documented some of the other external market
forces and internal governance mechanisms that help align managers'
incentives with the shareholders' interest. Evidence on CEO turnover
illustrates the contribution of the labor market toward this alignment.

Managers face the threat that poor performance will cost them their
jobs, independent of the level of activity in the market for corporate
control. Research from the late 1980s and early 1990s indicates that
CEOs were significantly more likely to lose their jobs following poor
performance of their firms than at other times--a reflection of market
discipline, in this case labor market discipline. Board members of
companies that violated financial reporting rules also appear to
suffer losses. The number of other directorships held by its directors
appears to decline significantly after a firm is charged with
accounting fraud. Indeed, evidence from a recent study suggests that
individual employees often lose their jobs after their contributions
to corporate misconduct become known. All of this illustrates the
practical importance of the labor market as a source of discipline on
management's performance, apart from the market for corporate control.

Finally, product markets are an important source of discipline for
managers, with a lasting and pervasive effect on the conduct of
business of all sizes. If corporations fail to deliver goods and
services of suitable quality at a competitive





price, consumers will not buy from them. This gives managers powerful
incentives to put their efforts into marketing good-quality products
at reasonable prices. Product market competition is so critical to
the performance of corporations that laws have been passed and remain
vigorously enforced to prevent it from being extinguished by collusion
or merger.  In fact, product markets can in some instances provide
discipline against abuses by corporations against consumers, in
addition to the discipline that the courts provide.




Internal Governance Mechanisms

External market forces shape not just management conduct but also the
design of mechanisms internal to the firm. For example, to avoid being
subjected to a hostile takeover or to the threat of a proxy fight,
managers have integrated outside observers into their internal
decision processes and have taken other steps to improve the quality
of their firms' internal governance. They have also divested assets
that have higher value in applications outside the corporation.

Internal features of corporate governance can be difficult to discern
from outside the corporation. Were it not so, managers would not
exercise as much discretion as they often do over the corporation's
choices, and the agency costs of separating ownership from control
would not be as high as they are. Yet a few features of internal
corporate governance are strikingly visible from without. Examples
include the distribution of voting rights attached to stock ownership,
the relation between debt and equity in the firm's financial
structure, the composition of the board of directors, and, to some
extent, the compensation of managers.

All features of internal corporate governance have the potential to
affect corporate efficiency. Only those features that outsiders can
readily observe--and that managers cannot easily alter--directly affect
outside investors' beliefs about their likely returns from investing
in the corporation. Debt finance provides one example. By taking on a
significant amount of debt, such as bank debt, managers can publicly
commit to having a reputable lender monitor the conduct of their
business more closely and more often than might otherwise occur.

The attachment of voting rights to stock provides a means of
influencing the actions of management that is independent of any debt
that may exist. The distribution of voting rights among shareholders
is indeed important to internal governance, as are the rules governing
how and on what issues shares may be voted. By exercising their voting
rights, shareholders ratify managers' choices about some of the more
transparent features of internal corporate governance, such as the
composition of the board. Shareholders' exercise of their voting power
became a focus of economic research during the 1990s, following
changes in State laws that appeared to make it more difficult for
individual large shareholders to unseat ineffective managers. This
period saw growing demand from institutional investors for guidance
on how best to exercise voting rights held as fiduciaries.

Shareholders: Ownership and Control

When a corporation decides to go public, its current investors must
decide what ownership and control rights to retain for themselves and
what to offer for sale to new investors. Going public can, of course,
generate substantial agency costs related to separating ownership from
control. Prospective new investors anticipate these potentially high
costs. Their willingness to acquire stock as part of a new issue
accordingly reflects the quality of the steps taken by the incumbent
owner-managers to commit the corporation to a strong system of
internal governance. Research suggests that the value of such a system
is far greater in those industries, and under those market conditions,
where the costs to outsiders of monitoring the actions of management
are relatively high.

One way for the incumbent owner-managers to make a commitment to good
governance is to retain a large fraction of the corporation's stock.
The effect is to increase the sensitivity of the managers' own wealth
to changes in the wealth of shareholders. Because the incumbent
management has greater control over the firm's decisions than do
other shareholders, the effect of increased managerial ownership is to
bring the incentives of management, and thus the actions of the
corporation, more closely into alignment with the shareholders'
interest (Box 2-2).

Observed differences in the concentration of management's stock
ownership across companies indeed appear traceable to differences in
the costs of eliminating barriers to external influence, and the value
of doing so. Managers possess relatively large ownership stakes, on
average, in corporations that operate in volatile markets or in
industries where management's discretionary actions affect shareholder
wealth yet are difficult for outsiders to observe and evaluate. They
tend to possess relatively small ownership

______________________________________________________________________
Box 2-2. Who Owns Corporations?

In the United States, a corporation's stockholders are its ultimate
owners. Possession of common stock and related equity securities
confers two fundamental rights of ownership: the right to participate
in the corporation's future profits and the right to vote on certain
decisions of the corporation, such as the appointment of directors.
Stockholders learn what issues are up for a vote by reading the proxy
statement that they receive by mail before each shareholders' meeting.
Meetings usually occur annually. These rights are established by State
law and reinforced by Federal laws and regulations, such as disclosure
laws, that obligate corporations to keep current and prospective
future shareholders informed.

Well-developed financial markets have allowed U.S. public corporations
to distribute their stock widely. Already in the 1930s, concern arose
that the diffuse ownership of U.S. public corporations might undermine
their efficiency. One study famously expressed the view that
professional managers lacked adequate incentives to serve the
shareholders' interest, and that shareholders with small ownership
stakes had little incentive or ability to monitor and, when necessary,
intervene to correct the situation. Fifty years later, research into
the market forces and other mechanisms that guide managers' actions
intensified. This work revealed that top-level managers of large
public corporations owned significant blocks of stock in their firms.

Indeed, management ownership of stock in U.S. public corporations
appears to have increased since the 1930s. One study reports that the
proportion of shares owned by managers of public corporations
actually grew between 1935 and 1995, from an average of 12.9 percent
to an average of 21.1 percent. This increase appears to have occurred
between the 1930s and 1970s: little change occurred between 1980 and
2001, according to recent research.

Consistent with the incentive-aligning value of stock ownership,
management's ownership stake is typically smaller in companies where
management discretion plays a less critical role and where external
oversight is less costly or easier to achieve--this is the case in
static or low-volatility market environments and in heavily regulated
industries. Managers' ownership of stock in companies in the utilities
industry and other regulated industries is less concentrated than it
is in other industries, on average, and this pattern was present in
both 1935 and 1995. This evidence is consistent with the views of many
economists that an important function of management ownership of stock
is to reduce the cost of separating ownership from control by aligning
management's incentives more closely with the investors' interest in
ways that outsider investors can readily observe.
______________________________________________________________________


stakes in corporations that operate in less volatile markets and in
regulated industries where managerial discretion matters less to
shareholder wealth. This suggests that management's stock ownership
responds at least in part to the market's demand for an appropriate
alignment between managers' incentives and shareholders' interests.

One alternative to concentrated managerial stock ownership is for one
or more investors who are not managers to accumulate a significant
block of shares. Corporations that have such outside blockholders
can be easier to acquire, because some of the transactions costs of
concentrating ownership in the hands of one or a few investors have
already been borne. The presence of a large blockholder can thus
increase management's risk of ouster due to poor performance. This can
in turn deter shirking and other bad management practices, even if
the blockholder does not directly exercise his or her rights of
influence or control.

Blockholders who own voting stock in the corporation can, of course,
influence the strategy or management of the corporation directly, by
exercising their voting rights. Blockholders have greater abilities
and incentives to exercise these rights than do smaller shareholders,
for two reasons. First, ownership of more voting rights in the
corporation gives each blockholder a greater chance of influencing
the outcome of any shareholder vote or related decision. Second, the
entitlement to a greater share of the corporation's future cash flows
that comes with block ownership can make it significantly more
profitable for an outside blockholder to incur the upfront costs of
seeking to influence the outcome of a vote or other corporate
decision. These features indicate that the presence of outside
blockholders can significantly affect the quality of discipline that
managers receive from the market, and the quality of corporate
governance generally.

Research on corporate blockholders has considered the possibility
that they, like managers, might have idiosyncratic interests that
conflict with the interests of shareholders generally. Concerns that
large investors might treat themselves preferentially have arisen in
the context of research into the source of the premium at which voting
stock tends to trade over other, nonvoting stock, for example. The
many different kinds of outside investors that appear to exist and the
nature of their incentives remain to be fully explored by economic
research.

Suppliers of Venture Capital

Venture capitalists differ from some other stockholders in that they
tend to follow a dual strategy, acquiring large ownership stakes while
also participating actively in the governance of the corporation.
Their large stakes can allow them to capture enough of whatever gains
accrue from their intervention to cover the high cost of the effort
that successful intervention can require. Venture capital investors
play a greater role in corporate governance in countries, such as the
United States, where stock markets are relatively well developed. The
presence of such markets makes it easier for venture capitalists
eventually to sell their stakes to other investors who wish to own
smaller stakes and be less involved in the strategic or the day-to-day
decisions of the corporation. The emerging corporations that make the
best use of venture capital firms' resources tend to be relatively
risky, with high rates of failure. Thus, when venture capital
investments succeed, the returns can be very high, even though the
expected return on any individual investment may be relatively low.
Chart 2-3 illustrates changes in the level of venture capital activity
that have occurred over time in response to shifts in the demand for
the financing and expertise they bring to emerging businesses.

Recent studies indeed call attention to venture capital as a good
source of financing for corporations that face especially great
difficulty in credibly communicating their businesses' future
prospects to potential investors. Such corporations include those
whose value derives primarily from future growth opportunities and
those that have difficulty obtaining loans because they cannot readily
meet the collateral and other requirements of banks or other lenders.
Rather than try to satisfy a prospective lender, such firms often
concentrate equity ownership with the entrepreneur and a venture
capitalist. This may pave the way for some dispersed outside equity
ownership.




Institutional Investors

The ability of shareholders other than managers to exercise their
voting rights in the firm can also play an effective role in aligning
management's actions with the shareholders' interest. During the 1970s
and 1980s, institutional investors accumulated equity stakes in U.S.
corporations of a size not seen in the last half-century, as Chart 2-4
illustrates. As their ownership has grown, so has the visible role of
institutional investors in corporations. In the 1980s these
institutions--which include pension funds, mutual funds, and insurance
companies--were often seen as passive participants in corporate
governance, and evidence supports this view. This changed during the 1990s. Yet constraints on the role of institutional ownership have remained.

For example, the Investment Company Act of 1940 substantially
restricts the ability of institutions to discipline corporate
management on behalf of households and other investors. These
restrictions appear to have arisen from a desire to promote the
diversification of institutional holdings and to limit institutions'
influence over corporate management. Modern economic research,
however, has clarified the conditions that must prevail for
diversification to be adequate. It appears that the Investment Company
Act's notion of diversification would not stand up to modern economic
theory: the act requires excessive diffusion of funds across firms
without ensuring true diversification. For example, a mutual fund that
invests all its assets across a large




number of software companies would conform to the letter of
the act but would not actually be diversified. The act may thus impose
costs on investors--and on modern corporate governance--without
providing countervailing benefits to investors or to the functioning
of the market generally.

Research has also brought to light the critical role that the prospect
of shareholder intervention in the corporation's affairs can play in
disciplining management. This valuable discipline can often be
achieved without actual intervention, the necessary condition being
that managers recognize the threat of intervention. The Investment
Company Act assures managers that the ability of institutions to step
in and take direct disciplinary action against any misconduct will be
limited. It thereby limits both the direct and the indirect roles of
institutions in aligning the actions of corporate managers with the
shareholders' interest. (Table 2-2 reviews other legal constraints on
the role of institutional investors.)

Boards of Directors: Insiders and Outsiders

One way for managers to commit to a closer alignment between their
incentives and the interests of their shareholders is to publicly
surround themselves with reputable advisers. They can accomplish this
by appointing to their boards of directors persons known for speaking
out in the boardroom and, if necessary, taking action to prevent or
remedy managerial misconduct. Boards serve two important roles. First,
they constitute a panel of knowledgeable people who can offer the CEO
timely advice in response to unforeseen developments in the
marketplace that the CEO or other managers may be ill equipped to
address on their own. Second, they can review the quality of
recommendations that the CEO receives from other members of the
corporation's management. An important challenge in the ongoing
evolution of U.S. corporate governance is to find ways of improving
the quality of the commitment that directors themselves make to act
diligently in the shareholders' interest.

This challenge had already attracted the attention of researchers even
before the events of last year put the issue on the front pages.
Because boards of different companies differ in their composition,
researchers have been able to evaluate statistically whether
corporations with certain kinds of boards tend to perform better or
worse than others. The evidence from this research is instructive,
although not as consistent in its findings as the evidence on the
incentive-aligning role of insider ownership.

One finding of this research is that directors who are not employees
of the corporation may be less susceptible to the internal pressures
that can undermine managers' incentives to act in the shareholders'
interest. Research into what drives CEO turnover, for example, shows
that outsider-dominated boards more frequently terminate CEOs
following poor corporate performance than do insider-dominated
boards (Box 2-3). Other research tells a




similar story. Firms facing SEC enforcement actions tend to have fewer
outsiders on their boards, according to another study. The appointment
of outside directors also has been associated with stock price
increases, even among companies whose boards are already
outsider-dominated, although companies with more outsiders on their
boards appear not to perform significantly better than other
companies, on average. Evidence that outside directors affect
corporate conduct includes one study's finding that banks with more
outside directors during the 1920s provided higher quality
underwriting services, and that investors recognized this: banks with
more outside directors were found to obtain higher prices than other
banks for the securities they underwrote. These findings are
consistent with the view that insider-dominated boards face some of
the same incentive conflicts that can diminish the incentives of the
CEO and other managers to act in the shareholders' interest.

It would be premature, however, to conclude that shareholders always
benefit from adding outside directors, or that maintaining an
outsider-dominated board is good for shareholders in all corporations.
Studies of the benefits to shareholders of having outside directors
sit on corporate boards have not consistently demonstrated that their
presence improves shareholder wealth. These mixed results may occur
because the effects vary from one

_____________________________________________________________________
Box 2-3. What Incentives Do CEOs Face?

Two important incentives for CEOs to act in shareholders' interests
come from the labor market and from the provision of incentive-based
compensation. The role of the labor market is apparent in the fact
that CEOs often lose their jobs after their corporations perform
poorly: one study found that departure rates for CEOs at firms with
poor performance relative to their industry exceeded those at firms
with good performance in all but 3 of 26 years studied. Actual CEO
firings can be difficult to identify, given that underperforming firms
tend to quietly encourage their CEO to leave rather than make a
public spectacle of the event. Nevertheless, proxies for
dismissal--such as measures of departure rates that exclude
departures that were likely due to retirement--indicate that job
loss is a powerful disciplinary mechanism for CEOs in poorly
performing companies. For example, one group of researchers found
that executives in poorly performing companies tend to depart at
younger ages: 34 percent of CEOs at such companies left before age 60,
compared with only 24 percent of CEOs at better performing companies.
Finally, one would expect underperforming firms to be more likely to
look outside the company in order to break with the poor management
practices of the past. Consistent with this, research that used press
reports to qualify departures as either forced or voluntary found
that outsiders replaced 49.6 percent of CEOs who had been forced from
their positions, but only 9.9 percent of those who had departed
voluntarily.

This practice of terminating CEOs following poor corporate
performance appears to have stronger incentive effects on young CEOs
than on older CEOs who are nearer retirement. This is not surprising:
young CEOs have more future compensation to lose. Corporations appear
to compensate for this. Older CEOs receive pay that is more sensitive
to corporate performance than do younger CEOs, on average. One study
associates a 10 percent change in shareholder wealth with a 1.7
percent change in compensation for CEOs within 3 years of retirement,
but only a 1.3 percent change for those more than 3 years from
retirement, for example. The threat of job loss and the provision of
performance-based pay thus appear to be substitute means of providing
CEOs with incentives to act in the shareholders' interest.

Stock ownership also helps align CEO incentives with the shareholders'
interest. It enables the CEO to participate in any improvement in
shareholder wealth that may arise from his or her performance, and it
compels him or her to share in any losses. Options similarly allow the
shareholder to participate in the gain, yet with limited exposure to
downside risk. Options became an important part of executive pay
during the 1990s and thus have received special attention during
recent efforts at corporate governance reform. As a form of long-term
compensation, options have some attractive features. Unlike
traditional bonus packages, which depend on accounting-based
measures of profits and corporate performance, the compensation that a
CEO or other manager receives from options depends on the market's
appraisal of the corporation's performance. This is reflected in the
price of the corporation's stock. Specifically, stock options give the
holder the right to buy stock at a set price. When the market price
of the stock rises above that price, the option's value to the holder
also rises. Option-based compensation, like restricted stock grants,
can thus allow CEOs and other officers to participate in the growth
in shareholder value that occurs during their tenure.

In addition to helping to align the CEO's incentives with the
shareholders' interest, incentive-based compensation can be a good
way to attract high-quality managers, because it rewards talent and
effort. Research on compensation by U.S. banks, for example, reveals
that compensation of bank CEOs tends to be both higher and more
sensitive to changes in profits in States where deregulation has
occurred; managerial discretion is arguably more important in such
States, which appears to explain the difference in compensation
patterns.
---------------------------------------------------------------------


corporation to the next, for example because market conditions are
different for different corporations. Moreover, it can be difficult
for shareholders to identify the incentives that each outside
director brings to the corporation.

To summarize, corporations have sought in several ways to improve the
quality of their board's commitment to serving the shareholders'
interest. They have added members to their boards who neither are
employees nor have other business dealings with the corporation--such
relationships can create conflicts of interest and otherwise undermine
directors' incentives to oppose an entrenched or ineffective
management team. The supply of qualified independent directors is
limited, however, and their quality may vary; therefore this strategy
is not likely to come without a cost. One way to avoid unduly trading
off quality for independence is to change the procedures that the
board follows, rather than its membership. Boards have tried various
procedural solutions in an effort to improve the quality of their
commitment to shareholders. One is to appoint someone other than the
CEO to be the chairman of the board. Another is to change directors'
committee assignments so that more outside directors are appointed to
committees that make such critical decisions as the setting of CEO
compensation and the selection of the corporation's outside auditor.

An alternative strategy would be to enlist an outside organization
(for example, a stock exchange or a government regulator) to monitor
certain specific aspects of the firm's internal governance. This
shifts some of the burden of monitoring from the board--and from
shareholders generally-- onto the outside organization. Yet this
strategy, too, has its limitations. Many of the challenges of
designing effective internal governance systems arise from the fact
that it is costly to monitor managers' actions in a timely manner from
outside the corporation. Outside organizations can face many of the
same obstacles that boards can face in making and enforcing rules to
ensure good management.

Legal and Regulatory Institutions

Strong legal institutions are widely recognized as providing a solid
foundation for economic growth, including the emergence of a strong
corporate sector. Their contribution is seen as twofold. First, solid
legal institutions provide a reliable, impartial means of resolving
disputes. Although parties sometimes rely on private means of dispute
resolution, such as arbitration, the reliable supply of dispute
resolution through the courts remains a valuable, if notcritical,
input to effective corporate governance. Courts have indeed been
called upon to enforce shareholders' voting rights, including the
right of individual large shareholders to obtain internal governance
reforms, such as changes in board composition, that may benefit
shareholders generally at the expense of incumbent management.

The second contribution of legal institutions is regulation.
Securities regulation in the United States predates the 1930s. Its
evolution accelerated rapidly, however, after the passage of the
Securities Act of 1933 and the Securities Exchange Act of 1934, which
created the SEC and delegated to it the task of writing and enforcing
securities regulations. The Congress similarly authorized the SEC to
delegate some, but not all, of this task to specialized institutions.
Stock exchanges, such as the New York Stock Exchange (NYSE), operate
under SEC oversight as self-regulatory organizations. The SEC has
also delegated certain responsibilities for setting and maintaining
accounting standards to the Financial Accounting Standards Board.
Under the Sarbanes-Oxley Act, the SEC is overseeing the creation of a
new organization, the Public Company Accounting Oversight Board, whose
task will be to develop, maintain, and enforce the standards that
guide auditors in their monitoring and certification of corporate
financial reports. An extensive set of laws and regulations has thus
arisen to supplement and complement the role of the market in shaping
corporate conduct. Like private contracts, these rules are enforceable
through the courts (Box 2-4).

Information and Disclosure

The central feature of modern U.S. securities regulation is the
series of SEC-enforced rules under which market participants must
disclose information to the public. Reflecting this fact, the
Securities Act of 1933 is sometimes known as the ~~``truth in securities
law.'' To the extent that investors have good information, they can
fine-tune their investment decisions, shifting capital to those
corporations that offer more or less risky investment opportunities,
depending on their risk preferences. Better availability of
information allows corporations whose managers do a good job or that
offer low-risk investment opportunities to gain access to capital at
a lower price than other, lower quality corporations or those whose
offerings are relatively more risky.

In requiring disclosure, securities regulations supplement both the
law and the market forces that create incentives for corporations to
keep investors informed. Corporate managers have incentives to
supply favorable information because, in doing so, they can
distinguish themselves from other managers who lack favorable
information to report. Enforcement of anti-fraud laws can beneficially
strengthen this signal. Managers and corporations that commit fraud
also risk costly market sanctions and loss of reputation, in addition
to any court-imposed sanctions.

Examples: Does it Matter How Investors Get Information?

Controversy often surrounds regulations that seek to control the
production and distribution of information. Regulation of information
in securities markets is no exception. For example, the question of
whether SEC-enforced

______________________________________________________________________

Box 2-4. Markets, Accountability, and the Enforcement of Rules

The announcement of a court-imposed sanction can be a dramatic event,
particularly when it is for commission of a white-collar crime such
as the intentional and harmful dumping of toxic substances, or fraud
against a customer or investor. Yet the most important effects of
the court system are hidden. Court-enforced sanctions shape
management conduct by creating a credible threat to impose punishment,
much as the threat of being pulled over for violating the traffic laws
shapes the conduct of drivers on the road. Good managers, like good
drivers, follow certain principles of conduct not only because they
are good people but also because they know that, if they do
otherwise, they risk being detected by enforcement authorities and
subjected to sanctions. There are indeed two different ways to
discourage--or deter--people from committing offenses, according
to economists. One is to step up detection efforts, so that offenders
face higher probabilities of sanction. The other is to increase the
total sanction that offenders receive upon detection. The level of
deterrence depends on the would-be offender's expected sanction--the
product of the probability of detection and the size of the total
sanction.

The total sanction that corporations--and managers--receive for
detected misconduct depends not just on the courts but also on the
market's reaction to the news of misconduct. For example,
corporations can bear significant market, or reputational, sanctions
for fraud against customers or suppliers, as when news of fraud
against one or a few customers leads other customers to take their
business elsewhere, possibly driving the offending corporation into
insolvency. The size of the court sanction necessary to generate a
given total sanction--and, thus, the level of deterrence--is of
course higher for offenders and offenses where no market sanction
is present. Two types of offenses for which market sanctions on the
corporation appear not to be good substitutes for court sanctions
are environmental offenses that harm third parties and frauds
committed by managers against shareholders.

Whatever the source and size of the total sanction, deterrence
depends on managers or employees who are in a position to influence
corporate conduct believing that they will be held accountable for
any harms that arise from misconduct, should it occur, with a high
enough probability to deter the offense. Accordingly, recent reforms
highlight the importance of clarifying management accountability and
putting more resources into enforcement. Accountability and diligent
enforcement are necessary for laws and regulations to do their work
of promoting good corporate governance. Economic research has drawn
attention to the fact that the effectiveness of rules generally
depends on the effort put into their enforcement, in addition to the
size of the penalty.

----------------------------------------------------------------------


disclosure rules actually improve the quality of
information that investors receive remains a subject of debate among
researchers almost 70 years after the SEC's creation. One study of
the effects of disclosure regulations made use of the fact that,
although access to information was not as good in 1933 as it is now,
investors did have better access in those days to information about
corporations whose stock had been traded for many years or was traded
over the NYSE than about other firms. If the new disclosure
regulations implemented under the 1933 act had any effect, one would
expect that effect to be greater for new, unseasoned securities and
for securities of corporations that were traded over the smaller,
regional exchanges, which lacked the strong listing standards and
the following of brokers and investment advisers that the NYSE had
by then accumulated. That study, which examined the effects of
initial disclosure requirements under the 1933 act, concluded that
there was such an effect: the act's passage contributed to a
significant decline in the dispersion of securities prices,
particularly among unseasoned non-NYSE securities.

A growing number of federally mandated disclosure rules have been
issued over the decades since passage of the 1933 act. During the
1970s and 1980s, economists intensively examined the role of
information in financial markets. They came to understand that
information is a kind of commodity: it is costly to produce and
has value to those who possess it. Modern economic research on the
effects of disclosure regulation accordingly considers not just the
effect of requiring disclosure on whatever information is produced,
but also how the requirement to disclose information affects the
incentive to produce information. Contemporary research on the
effects of disclosure regulations thus focuses on how those rules
affect the net quality, or value, of information produced.

The Williams Act of 1968. Evidence on the effect of the 1968 Williams
Act amendments to the Securities Exchange Act of 1934 provides a
good illustration of how disclosure regulations can have unintended,
adverse consequences that offset and potentially cancel out the
benefit they are designed to confer. During the 1960s, concerns arose
that, in corporate takeover attempts, shareholders were being
pressured to sell, or tender, their shares without being given enough
time or information to make an informed decision. To address these
concerns, the Williams Act introduced regulations under which
acquirers today must disclose certain information, such as their
intention with regard to the target company, within 10 days of
obtaining 5 percent of any class of a company's voting securities.
This can enable investors to do a better job of selecting the
acquirer from among the alternatives, conditional on any acquirer
making an offer.

Yet research into the consequences of the Williams Act uncovered a
more subtle effect through which the act makes investors worse off.
By requiring disclosure and delay, the Williams Act reduces the
value of searching for socially valuable acquisition prospects.
It does this by enabling others to free-ride on an innovative
acquisition bid, tendering their own offers and thereby raising the
price that the innovator must pay and reducing its share of the total
value of the acquisition. This is reflected in the increased premium
that acquirers paid to the shareholders of target firms after passage
of the act: from 32 to 53 percent of the pre-offer stock price, on
average, over the ensuing decade. (Related State laws accounted for
an additional increase: from 53 to 73 percent of the pre-bid price.)
Moreover, these increased premiums appear to have come at the cost of
a reduced supply of takeover bids, as some (but clearly not all)
prospective bidders shifted their resources to other pursuits. Some
shareholders thus appear to have benefited at the expense of others:
those who still received bids after the act was passed got larger
gains than they would have otherwise, yet those who did not receive
bids that would have been offered had the act not been passed got
nothing, and a valuable source of market discipline was lost.

Financial Analysts' Reports. Most recently, regulators have confronted
the fact that some investors--including small investors--receive
information about corporations from financial analysts' reports.
Given the extensive disclosure requirements that corporations already
face, it might seem surprising that analysts' reports could have
anything new and informative to offer. Research into how stock prices
respond to the release of those reports, however, suggests that they
are informative. Stock prices tend to increase when analysts issue
new ``buy'' recommendations or raise their ratings of corporations,
and decline when analysts issue new ``sell'' recommendations or lower
their ratings.

Concerns have been raised that some analysts may face conflicts of
interest that could lead to biases in their reports. Conflicts can
arise when an analyst is writing a report on a firm that has done a
significant amount of business with the analyst's employer or that
faces the strong prospect of doing so in the future. Research
suggests that investors tend to take analysts' affiliations into
account when deciding how to use the information in their reports:
investors appear to place less weight on reports of analysts whose
employers may present them with these conflicts. How and to what
extent investors take into account the potential for conflicts when
evaluating analysts' reports--and the corporate governance context
in which analysts prepare their reports--is an important area of
ongoing research. The findings are expected to shed light on the
appropriate direction for corporate governance reform as it affects
the supply of information to investors.


Corporate Governance Reform

One of the perennial challenges of running a business is adapting to
change. As businesses have grown in size and complexity, this
challenge has grown as well. To keep up with changes in the
marketplace, corporate participants--including both managers and
investors--must confront the demands associated with new technology,
changing consumer preferences, and the requirements of the public
sector. As technology and changes in the structure of markets in
Europe and elsewhere have made it easier to trade across
international boundaries, new challenges have emerged. Some of
these developments have placed U.S. corporations and the laws and
regulations governing them under relatively close scrutiny over the
past decade, as other governments have turned to the successful U.S.
corporate governance system as a possible template for creating new
systems or modifying old ones. The ability of U.S. corporations to
adapt readily to change is critical to their profitability and,
accordingly, their ability to continue operating as independent
enterprises.

The recent reforms of the U.S. corporate governance system are indeed
the latest in a history of dramatic changes going back over a century.
These include changes arising from five distinct merger waves
(including those of the 1980s and 1990s), from the introduction of the
SEC in 1934, from the imposition of constraints on institutional
stock ownership through the  Investment Company Act of 1940 and
other legislation, and from the continuing modification of regulations
under the securities laws.

The recent reforms were marked by a speech by the President on March
7, 2002. The President announced a ``Ten-Point Plan to Improve
Corporate Responsibility and Protect America's Shareholders,'' calling
for a concerted response to the emerging news that some of the
Nation's largest corporations had not truthfully reported their
earnings and that this would harm investors, including employees
whose pensions were invested in the company's stock. This plan applies
three core principles of effective governance: accuracy and
accessibility of information, management accountability, and auditor
independence.

The private sector's response was almost immediate. Individual
managers and investors undertook a careful reexamination of the
governance practices of their corporations; the resulting changes
received widespread public attention in many cases. The most visible
private sector initiatives were undertaken by the self-regulatory
organizations whose rules public corporations must follow as a
condition for the public trading of their securities. Table 2-3 shows
how some of the specific initiatives undertaken by two such
organizations, the NYSE and the Nasdaq, implement the core principles
underlying the President's plan for reform. The table reflects
proposals that were announced between April and June of 2002 and then
updated during late 2002 and early 2003 to account for SEC-initiated
regulatory changes under new Federal legislation passed during July
2002.

As regulators, self-regulatory organizations, corporations,
investors, and others responded to this call for action, the President
in July signed into law the Sarbanes-Oxley Act of 2002. This
legislation provides the courts and Federal agencies with new tools
to strengthen the ability of outside investors to verify the quality
of managerial decision making. The act applies the core principles
underlying the President's plan. It addresses each of the points of




that plan, as Table 2-4 illustrates. In doing so, it accompanies the
actions that many others have begun to take, and continue to take,
to strengthen each of the key elements of a strong U.S. corporate
governance system.




Information Accuracy and Accessibility

Virtually all aspects of recent corporate governance reform seek to
promote investors' timely access to information about the financial
performance and operations of public corporations. Better informed
investors can more readily limit their exposure to losses stemming
from the agency costs of separating ownership from control and can
more quickly act to remove underperforming managers as warranted.

The Sarbanes-Oxley Act promotes the accuracy and timeliness of
financial information in several ways. First, the act introduces
new disclosure requirements. It requires that directors, officers,
and principal investors disclose their transactions in company stock
more quickly than before: by the end of the second day after the
transaction, rather than 10 days after the close of the calendar
month as previously required. This enables investors to react more
quickly to the information contained in such disclosures. Indeed,
more rapid disclosure strengthens the capacity of outsiders generally
to act on news of insider trading. The act also requires that
corporations make more information available about the quality of
their internal control structures, including whether they have
special ethics rules in place to guide the actions of senior
financial officers, and whether their board of directors' audit
committee includes any financial experts (and, if not, why not).

Financial analysts and auditors are also expressly required to make
certain disclosures under the act. Each must publicly disclose to
investors whether any conflicts of interest might exist to limit
their independence from influences other than the desire to serve
the interests of shareholders. This provides an additional check
against any conflicts that might remain even after the other
provisions of the act, and the other reforms accompanying the act,
are taken into account.

Second, the act seeks to improve the effectiveness of the many
existing U.S. securities disclosure regulations by dramatically
increasing some of the sanctions for violating them. In promoting
deterrence, these sanctions complement the higher probability of
detection that violators face from stepped-up Federal enforcement
under the Corporate Fraud Task Force. The act provides for a fourfold
increase in the maximum prison term for criminal fraud--to 20 years
rather than 5 years--and an even higher maximum term of 25 years for
securities fraud. Both of these increases in prison terms are in
addition to fines and other, nonmonetary sanctions. Recognizing that
penalties cannot be imposed without evidence that a violation has
occurred, the act also increases the maximum sanction for destroying
documents, allowing courts to impose fines and terms of imprisonment
of up to 20 years for this offense. The most severe penalties, such
as imprisonment, tend to apply only to violations found to have
occurred knowingly, with the stiffest sentences reserved for
violations that are both knowing and willful.

Finally, the act creates new rules and institutions that are designed
to shape managers' and auditors' choices concerning the accuracy
and timeliness of corporate financial reporting. In doing so, the
act promotes compliance with existing disclosure rules, in addition
to strengthening managers' and auditors' incentives generally to act
in the interests of investors. (These provisions apply the principles
of management accountability and auditor independence and will be
discussed in greater detail under those headings.)

Management Accountability

The second core principle of the President's plan is the promotion
of management accountability. The managers of public corporations
initially oversee the preparation of the financial reports that their
companies file periodically under existing securities regulations.
Holding them accountable for the quality of those reports can thus
serve as a further check on their accuracy and completeness.
Management accountability has implications beyond the quality of
financial reporting, however. Managers who expect the quality of
their companies' performance to become known to investors face more
powerful incentives to serve the investors' interest.

The Sarbanes-Oxley Act promotes management accountability by
clarifying the roles and responsibilities of various corporate
officers, by introducing new sanctions for managers who fail to live
up to those responsibilities, and by requiring that corporations
adjust their internal governance structures so that outside investors
can more readily verify the strength of management's incentive to
serve the shareholders' interest. For example, the act requires that
CEOs and chief financial officers (CFOs) certify the accuracy and
completeness of the financial reports that their companies file
periodically under existing securities regulations. The act makes it
a Federal criminal offense, subject to fines of up to $1 million, to
knowingly engage in false certification of these reports. In the
extreme case where a CEO or CFO knowingly and intentionally provides
false certification, the maximum sanction climbs to $5 million. In
case this is not enough to deter false certification, CEOs and CFOs
who falsely certify financial reports are also required to forfeit
any bonuses, incentive compensation, or other gains that they might
have received from the company during the year after the issuance of
a false report.

The act also clarifies the roles and responsibilities of other
corporate officers besides CEOs and CFOs. It expressly charges
corporations' audit committees with responsibility for overseeing
the selection and compensation of the company's outside audit firm.
As already mentioned, audit committees must reveal whether any of
their members are financial experts, and if not, why not. A
corporation's attorneys are expressly held responsible for reporting
any evidence they might receive of a violation of the act, a breach
of duty, or other violation to the chief legal counsel, to the CEO,
or to the audit committee or other independent directors (if other
parties appear not to respond to the information in a timely manner).
This increased accountability is supported by substantial sanctions
for violations of rules under the act.

Auditor Independence

The creation of a special, national board to oversee the auditing of
public companies' financial reports is perhaps the most visible
corporate governance reform under the Sarbanes-Oxley Act. In creating
this new board, the Public Company Accounting Oversight Board, the
act introduces a new check on the quality of audit services supplied
to public corporations whose securities are listed on U.S. exchanges.
The economic role that the board will play in overseeing public
accounting companies is to strengthen the auditors' incentives to do
their jobs properly and with integrity, even in the face of pressure
from managers who might in some instances prefer not to accurately
report their companies' performance.

Under the act, the oversight board will promote the independence of
auditors in several ways. To increase the chance of detecting any
future misconduct by auditors, each public accounting firm must
register with the board and submit to periodic reviews of its
performance. The board is given the authority to act upon any
evidence of auditor misconduct by undertaking investigations. Upon
registering with the board, each registered public accounting firm
agrees to cooperate with the board's investigations. Such cooperation
includes retaining audit work papers and other documents for a
minimum of 7 years and providing those records to the board on
request.

When the oversight board discovers evidence of misconduct, it has the
power under the act to impose sanctions. It can impose fines on
individual auditors and the auditing firms that employ them. It can
also bar auditors from supplying their services to any U.S.-listed
corporation, temporarily or permanently. The combined effect of
this new monitoring effort and these newly instituted sanctions is
to increase the expected cost of misconduct to any registered
accounting firm or employee.

The act goes beyond direct oversight of auditing firms, however, to
address the conditions under which external auditors are chosen and
employed. First, a corporation's choice of auditor must be made by
a committee of independent directors who are not employees of the
company and have no relationship with it other than as directors.
This provision is designed to limit the influence that managers who
prepare financial reports exercise over the choice of auditor. Second,
for each of its clients, the accounting firm that does the audit must
periodically assign a new person as the lead audit partner on each
client's account. Both of these provisions limit the opportunities
for collusion between auditor and client. Finally, registered public
accounting firms are no longer permitted to sell certain services
other than auditing to their audit customers. This addresses the
concern that an auditor might choose to overlook problems in a
company's financial reports if it believes that the company might
reward it with nonaudit business. Any exceptions to these basic rules
must be disclosed to investors, for example through the filing of
reports by the audit committee with the SEC.

To summarize, the Sarbanes-Oxley Act applies the principle of auditor
independence in two basic ways. It increases the sanctions that
auditors can expect to face if they engage in misconduct, thus
encouraging them to comply with certain professional standards to be
set forth by the new oversight board. The act also recognizes that
some forms of compliance rely on the strength of the auditor's
incentive to serve the investors' interest. It strengthens this
incentive by requiring that public accounting firms and their clients
eliminate potential conflicts of interest by making certain
fundamental and verifiable changes in their business practices.

The principle of independence is also relevant to the conduct of the
oversight board. To serve as an effective monitor and enforcer of
the supply of independent audit services, the board must itself be
free from conflicts between the interests of investors and those of
specific auditors and audit clients. Accordingly, the act requires
that a majority of the board's members be drawn from outside the
accounting industry: members must not have supplied audit services
to any client in recent years. The requirement that exactly two of the
board's five members be drawn from the accounting profession reflects
a tradeoff between the value of specialized expertise and the value
of independence from the possible incentive conflicts that such
expertise can represent. This tradeoff is similar to that which
public corporations face in selecting members for their boards of
directors.

Corporate Governance and the Global Economy

The change currently taking place in U.S. corporate governance is but
one wave in a sea of change internationally. This change is shaped in
part by globalization, which encourages countries to adopt positive
features of other systems while retaining the best features of their
own. International competition fosters good corporate governance by
favoring the best corporate governance systems. In many respects,
private and public sector institutions in other countries are moving
toward corporate governance systems that look more like that of the
United States--a tribute to the merits of the U.S. system. At the
same time, the U.S. Government recently lifted some of the legal
rules that had previously restricted bank participation in the
underwriting of equity, which has been commonplace in some other
countries.

The growing similarity among different countries' systems of
corporate governance has captured the attention of researchers
interested in how economic and legal systems interact. Their findings
illustrate the importance of market forces in shaping the institutions
of corporate governance, in addition to their role in guiding the
strategic and the day-to-day decisions of investors and managers.
Researchers have found, for example, that European and Japanese
corporations tend to have relatively concentrated ownership
structures, with a relatively few persons or institutions often
controlling large blocks of shares. In contrast, corporations in
the United States and other common law countries, such as the United
Kingdom, tend to have relatively dispersed ownership, an outcome
facilitated by strong securities markets, rigorous disclosure
standards, transparency, and relatively active markets for corporate
control. One study found that, in the United States, only 4 of the
20 largest corporations have a single shareholder who possesses 10
percent or more of the voting rights on the board; in Germany, in
contrast, 13 of the 20 largest corporations have such a shareholder.
Yet these differences are shrinking. Both the value of outstanding
stock as a percentage of GDP and the value of equity raised through
initial public offerings as a percentage of GDP rose substantially in
European countries during the 1990s. Over this period the market for
corporate control became more international. One study reported that,
between 1985 and 1999, takeovers involving a European party went
from 11 percent to 47 percent of the total market value of all
transactions worldwide.

Meanwhile, in the United States, the enactment of the Gramm-Leach-
Bliley Act in 1999 relaxed previous prohibitions against bank
participation in the ownership of stock. Banks in other developed
countries, such as Germany and Japan, appear to use the information
they obtain as lenders to play a more effective role as stockholders
in monitoring corporate management. Banks' participation in U.S.
corporations as both lenders and shareholders may similarly improve
corporate efficiency. To the extent investors view increased bank
participation in both lending and stock ownership as committing
corporations to stronger performance, the effect may be not just more
efficient monitoring of management but better investor assurance as
well.

Conclusion

Corporate governance systems, by establishing checks and balances
that influence the decisions of corporate managers, affect corporate
efficiency and, by implication, economic growth. To the extent that
these systems are observable--that is, transparent--to outsiders
such as households and other prospective investors, they can affect
their willingness to do business with the corporation. Strong
managers who seek growth for their corporations thus stand to gain
by creating strong corporate governance systems. In doing so, they
can distinguish themselves and their corporations from others with
less promising prospects.

Major changes in the legal institutions that support U.S. corporate
governance occurred last year. These changes and many private sector
reform initiatives illustrate the application of three core
principles underlying a plan for corporate governance reform that
the President set forth in March 2002. These principles are familiar
to economists: information accuracy and accessibility, management
accountability, and auditor independence. The Sarbanes-Oxley Act of
2002, by strengthening certain legal institutions, promotes greater
accuracy and accessibility of information and addresses concerns
about the independence of external auditors. The establishment of
the Corporate Fraud Task Force in July 2002, along with new
enforcement initiatives by the SEC, acts on the principle of
management accountability by subjecting offending managers and their
organizations to a higher probability of getting caught and greater
sanctions when they do get caught. The Sarbanes-Oxley Act further
strengthens management accountability by allowing the courts to
impose stronger sanctions on white-collar offenders and instructing
the U.S. Sentencing Commission to update related sentencing
guidelines to ensure their consistency with current information on
the seriousness of the offense and with the new statutory increases
in maximum sanctions.  The act indeed implements each of the 10
points of the plan for reform that the President articulated in his
March speech.

Perhaps the most important reforms along the lines of the President's
plan, however, have occurred in the private sector. Many managers--and
management teams--have instituted improvements in the internal
governance of their corporations; their actions are apparent in
numerous press releases and in disclosures to the SEC. The appropriate
reform for each corporation ultimately depends on the specific market
conditions that it faces. Changes specific to individual corporations
include replacement of top managers and auditors and adjustments in
the compensation of top management and how it is reported. More
dramatic and far-ranging are the proposals by the NYSE and the Nasdaq
to tighten the standards that public corporations must meet in order
for their stock to be listed and traded on those markets. Some of
these proposals follow early action taken by the Chairman of the SEC
to request that these and other private self-regulatory organizations
revisit and revise their standards in early 2002, following the
President's call for reform. The SEC and other Federal agencies will
implement reforms under the Sarbanes-Oxley Act in phases over the
next several years.

U.S. managers, investors, and regulators are thus embarked on making
changes to U.S. corporate governance of a scope not seen since the
creation of the SEC itself. The current push for reform will make use
of new knowledge gleaned from recent events and will apply this
learning toward improving the quality of managers' and board members'
commitments to act in shareholders' interest. Despite their scope,
however, these changes do not fundamentally depart from the
evolutionary process that U.S. corporate governance has followed over
the past century. The fundamental building blocks of corporate
governance remain unchanged.

Competition will continue to shape the evolution of  U.S corporate
governance. This competition will affect different corporations
differently, depending on the nature of the markets in which they
operate. Many of these markets have become more global in recent
years, and this globalization will continue to place pressure on
managers, investors, and public officials to confront the issues that
changing markets and technology can raise. The capacity of individual
corporations and of the Nation's markets and public sector
institutions to promote increasingly effective resource utilization
will depend on their continuing success in committing corporate
managers to act in the best interests of shareholders and other
investors, so as to limit the agency costs of separating ownership
from control. In so doing they will continue to foster the efficient
growth that the corporate sector of the economy has enjoyed through
its ongoing access to deep and resilient financial markets.