Journal of Applied Corporate Finance

S P R I N G 20 0 3 V O L U M E 15 . 3

The State of U.S. Corporate Governance: What’s Right and What’s Wrong?
by Bengt Holmstrom,
Massachusetts Institute of Technology, and
Steven N. Kaplan,
University of Chicago
THE STATE OF U.S. by Bengt Holmstrom,
Massachusetts Institute of Technology,
CORPORATE and
GOVERNANCE: Steven N. Kaplan,
University of Chicago*
WHAT’S RIGHT AND
WHAT’S WRONG?

o a casual observer, the United States Next, we discuss how important aspects of the
T corporate governance system must seem
to be in terrible shape. The business press
U.S. corporate governance system have evolved
over the last two decades and the implications of
has focused relentlessly on the corporate those changes. Again, contrary to the popular im-
board and governance failures at Enron, WorldCom, pression, the major changes in U.S. corporate gov-
Tyco, Adelphia, Global Crossing, and others. Top ernance in the past 20 years— notably, the dramatic
executive compensation is also routinely criticized as increase in equity-based pay and the institutionaliza-
excessive by the press, academics, and even top tion of U.S. shareholders—appear to have been
Federal Reserve officials.1 These failures and concerns positive overall. As we discuss below, such changes
in turn have served as catalysts for legislative change— played a central role in the highly productive restruc-
in the form of the Sarbanes-Oxley Act of 2002—and turing of U.S. corporations that took place during the
regulatory change, including new governance guide- 1980s and 1990s. But the changes did have an
lines from the NYSE and NASDAQ. unfortunate side effect. Besides spurring productiv-
The turmoil and the responses to it suggest two ity improvements, the rise of equity-based pay—
important questions that we attempt to answer in this particularly the explosion of stock options—and the
article. First, has the U.S. corporate governance system run-up in stock prices in the late ’90s created
performed that poorly—is it really that bad? Second, incentives for the shortsighted and at times illegal
will the proposed changes lead to a more effective system? managerial behavior that has attracted so much
In addressing the first question, we begin by criticism. Our view, however, is that the costs
examining two broad measures of economic perfor- associated with such incentives and behavior have
mance for evidence of failure of the U.S. system. been far outweighed by the benefits.
Despite the alleged flaws in its governance system, Having addressed where the U.S. system is
the U.S. economy has performed very well, both on today and how it got there, we finally consider the
an absolute basis and particularly relative to other probable near-term effects of the legislative, regula-
countries. U.S. productivity gains in the past decade tory, and market responses to the perceived gover-
have been exceptional, and the U.S. stock market has nance “problem.” We conclude that the current
consistently outperformed other world indices over changes are likely to make a good U.S. system a
the last two decades, including the period since the better one, although not without imposing some
scandals broke. In other words, the broad evidence unnecessary costs. In fact, the greatest risk now
is not consistent with a failed U.S. system. If anything, facing the U.S. corporate governance system is the
it suggests a system that is well above average. possibility of overregulation.

*Warren Batts, Don Chew, Art Kelly, Rick Melcher, Andrew Nussbaum, and 1. For example, see Marco Becht, Patrick Bolton, and Ailsa Roell, “Corporate
Per Stromberg provided helpful comments. Address correspondence to Steven Governance and Control,” in Handbook of Economics and Finance, G.
Kaplan, Graduate School of Business, The University of Chicago, 1101 East 58th Constantinides, M. Harris, and R. Stulz, eds. (North Holland, 2002), “CEOs Are
Street, Chicago, IL 60637 or e-mail at steven.kaplan@gsb.uchicago.edu. Part of this Overpaid, Says Fed Banker,” The Washington Post, September 11, 2002, and “After
article draws on our earlier article, “Corporate Governance and Takeovers in the 10 Years, Corporate Oversight Is Still Dismal,” by Claudia Deutsch, The New York
U.S.: Making Sense of the ’80s and ’90s,” Journal of Economic Perspectives (Spring Times, January 26, 2003.
2001), pp. 121-144.

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ACCENTURE JOURNAL OF APPLIED CORPORATE FINANCE
TABLE 1 U.S. Europe Pacific
STOCK MARKET
PERFORMANCE* From 1982 (January) 1,222% 1,145% 276%
From 1987 436% 266% 3%
From 1992 164% 113% –27%
From 1997 28% 13% –39%
From 2001 –32% –34% –32%

U.S. Great Britain France Germany Japan

From 1982 1,222% 1,223% 1,567% 595% 90%

From 1987 436% 290% 236% 93% –37%
From 1992 164% 121% 147% 84% –42%
From 1997 28% 11% 47% 5% –39%
From 2001 –32% –32% –45% –53% –34%

*Stock returns reported by Ibbotson Associates for total return on Morgan Stanley Capital International (MSCI) Indices for the
United States, Europe, Pacific, Great Britain, France, Germany, and Japan from January 1 of the given year through the end
of December 2002.

HOW BAD IS U.S. CORPORATE GOVERNANCE? It is worth pointing out two additional implica-
tions of the stock performance results. First, the
Given the volume and intensity of criticism of returns to U.S. stocks have been at least as large as
U.S. corporate governance, one would think that the the returns to European and Pacific stocks since
U.S. stock market must have performed quite badly, 2001, the period in which the U.S. corporate gover-
particularly since the scandals broke in 2001. But the nance scandals first emerged. One possible explana-
data summarized in Table 1 indicate otherwise. tion is that the effects of the governance scandals on
Table 1 reports the total returns (measured in dollars) U.S. stock values have not been particularly large
to the Morgan Stanley Capital International indices relative to other factors that have weighed on most
for the aggregate U.S., European, and Pacific stock national economies. Another possibility is that while
markets over five different time periods through the there may be some problems with the U.S. corporate
end of 2002. Although the U.S. stock market has had governance system, the problems confronting the
negative returns over the last several years, it has governance systems of other nations are even worse.
performed well relative to other stock markets, both But in our view, the most plausible explanation is
recently and over the longer term. In fact, the U.S. that while parts of the U.S. system failed under the
market has generated returns at least as high as those exceptional strain of the 1990s’ boom market, the
of the European and Pacific markets during each of damage was limited because the overall system
the five time periods considered—since 2001, since reacted quickly to address the problems.
1997, since 1992, since 1987, and since 1982. The The second important point to keep in mind
returns to the U.S. stock market also compare favorably about stock returns is that they reflect publicly
to the returns to the stock markets of the larger available information about executive compensa-
individual countries (including France, Germany, tion. Returns, therefore, are measured net of execu-
Great Britain, and Japan) that make up the indices. tive compensation payments. The fact that the
Because many factors affect stock returns, it shareholders of U.S. companies earned higher re-
would be inappropriate to claim that superior U.S. turns even after payments to management does not
corporate governance explains the differences in support the claim that the U.S. executive pay system
returns. We can conclude, however, that whatever is designed inefficiently; if anything, shareholders
the shortcomings of the U.S. system, they have not appear better off with the U.S. system of executive
been sufficiently great to prevent the stock returns of pay than with the systems that prevail in other
U.S. companies from outperforming those of the rest countries. As we discuss later, however, the higher
of the world. U.S. returns do not rule out the possibility that some

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VOLUME 15 NUMBER 3 SPRING 2003
TABLE 2 U.S. Great Britain France Germany Japan
CHANGES IN REAL GDP
PER CAPITA* From 1982 (beginning) to 2000 54% 58% 37% 44% 55%
From 1987 to 2000 38% 36% 28% 29% 36%
From 1992 to 2000 29% 24% 12% 12% 8%
From 1997 to 2000 14% 11% 11% 8% 3%

*Changes in real GDP per capita for the U.S., Great Britain, France, Germany, and Japan. Calculated using the Penn World
Tables.

top U.S. executives are paid more than is necessary focus. Before 1980, corporate managements tended
for incentive purposes and that our incentive pay to think of themselves as representing not the
system can be improved. shareholders, but rather “the corporation.” In this
Overall country productivity provides an- view, the goal of the firm was not to maximize
other broad measure of performance. Again, one shareholder wealth, but to ensure the growth (or at
might expect a less effective corporate gover- least the stability) of the enterprise by “balancing” the
nance system to lead to lower productivity growth. claims of all important corporate “stakeholders”—
Table 2 presents calculations of the percentage employees, suppliers, and local communities, as
change in GDP per capita for developed countries well as shareholders.4
since 1982. The results do not suggest the pres- The external governance mechanisms available
ence of an ineffective U.S. governance system. to dissatisfied shareholders were seldom used. Raid-
From the beginning of 1992 to the end of 2000,2 ers and hostile takeovers were relatively uncommon.
growth in GDP per capita was greater in the U.S. Proxy fights were rare and didn’t have much chance
than in France, Germany, Great Britain, or Japan. of succeeding. And corporate boards tended to be
And given the strong U.S. productivity numbers cozy with and dominated by management, making
through the recent downturn, this gap has prob- board oversight weak.
ably widened since then. Internal incentives from management owner-
Again, these results do not necessarily demon- ship of stock and options were also modest. For
strate that the U.S. corporate governance system is example, in 1980 only 20% of the compensation of
the principal cause of the larger productivity im- U.S. CEOs was tied to stock market performance.5
provements. Many other forces operate at the same Long-term performance plans were widely used, but
time. The results do suggest, however, that any they were typically based on accounting measures
deficiencies in the U.S. corporate governance system like sales growth and earnings per share that tied
have not prevented the U.S. economy from outper- managerial incentives less directly, and sometimes
forming its global competitors. not at all, to shareholder value.
Partly in response to the neglect of sharehold-
CHANGES IN U.S. CORPORATE GOVERNANCE ers, the 1980s ushered in a large wave of takeover
OVER THE LAST 20 YEARS and restructuring activity. This activity was distin-
guished by its use of hostility and aggressive lever-
Corporate governance in the U.S. has changed age. The 1980s saw the emergence of the corporate
dramatically since 1980.3 As a number of business raider and hostile takeovers. Raiders like Carl Icahn
and finance scholars have pointed out, the corporate and T. Boone Pickens became household names.
governance structures in place before the 1980s gave Nearly half of all major U.S. corporations received a
the managers of large public U.S. corporations little takeover offer in the 1980s—and many companies
reason to make shareholder interests their primary that were not taken over responded to hostile

2. This is the most recent period for which data are available. 4. See Gordon Donaldson and Jay Lorsch, Decision Making at the Top (Basic
3. This section summarizes some of the arguments in Bengt Holmstrom and Books, New York, 1983), and Michael Jensen, “The Modern Industrial Revolution,”
Steven Kaplan, “Corporate Governance and Takeovers in the U.S.: Making Sense Journal of Finance, pp. 831-880 (1993).
of the ’80s and ’90s,” Journal of Economic Perspectives (Spring 2001), pp. 121-144, 5. See Brian Hall and Jeffrey Liebman, “Are CEOs Really Paid like Bureau-
and Steven Kaplan, “The Evolution of U.S. Corporate Governance: We Are All crats?,” Quarterly Journal of Economics, Vol. 112 (1998), pp. 653-691.
Henry Kravis Now,” Journal of Private Equity, pp. 7-14 (1997).

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JOURNAL OF APPLIED CORPORATE FINANCE
 Whatever the shortcomings of the U.S. system of governance, they have not been
sufficiently great to prevent the stock returns of U.S. companies from outperforming
those of the rest of the world.

pressure with internal restructurings that made them- markets were becoming more powerful because of
selves less attractive targets.6 increased stock ownership by large institutions. It
The use of debt financing by U.S. companies was the potential for improved corporate perfor-
was so extensive that, from 1984 to 1990, more than mance, combined with the increased ownership of
$500 billion of equity was retired (net of new equity institutional investors, that gave birth to the take-
issuances), as many firms repurchased their own overs, junk bonds, and LBOs of the 1980s. In some
shares, borrowed to finance takeovers, or were cases, the capital markets reversed ill-advised diver-
taken private in leveraged buyouts (LBOs). As a sification through “bust-up” transactions (such as
result, corporate leverage ratios increased substan- KKR’s acquisition of Beatrice Foods in 1986). In other
tially. Leveraged buyouts were extreme in this cases, the financial markets effectively forced man-
respect, with debt levels typically exceeding 80% of agers to eliminate excess capacity (as in Chevron’s
total capital. leveraged acquisition of Gulf Oil in 1984). More
In the 1990s, the pattern of corporate gover- generally, the capital markets disciplined managers
nance activity changed again. After a steep but brief who had ignored shareholders for the benefit of
drop in merger activity around 1990, takeovers themselves and other stakeholders. As we discuss
rebounded to the levels of the 1980s. Hostility and below, the incentive and governance features of
leverage, however, declined substantially. At the LBOs are particularly representative of the discipline
same time, other corporate governance mechanisms that the capital markets imposed.
began to play a larger role, particularly executive The initial response of U.S. executives was to
stock options and the greater involvement of boards fight takeovers with legal maneuvers and to attempt
of directors and shareholders. to enlist political and popular support against corpo-
The preponderance of the evidence is consis- rate raiders. Over time, these efforts met with some
tent with an overall explanation as follows: In the legislative, regulatory, and judicial success. As a
early 1980s, the wedge between actual and potential result, hostile takeovers became far more costly in
corporate performance became increasingly appar- the 1990s than in the previous decade.
ent. In some cases, changes in markets, technology, But the accomplishments of the 1980s were by
or regulation led to a large amount of excess no means forgotten. By the 1990s, U.S. managers,
capacity—for example, in the oil and tire industries. boards, and institutional shareholders had seen what
In others, it became apparent that diversification LBOs and other market-driven restructurings could
strategies carried out in the late ’60s and ’70s were do. With the implicit assent of institutional investors,
underperforming.7 The top managers of such com- boards substantially increased the use of stock
panies, however, were slow to respond to opportu- option plans that allowed managers to share in the
nities to increase value. As mentioned above, limited value created by restructuring their own compa-
ownership of stock and options gave managers little nies. Shareholder value thus became an ally rather
monetary incentive to make major changes that than a threat.
might weaken their “partnership” with other corpo- This general embrace of shareholder value
rate stakeholders. But perhaps equally important, helps to explain why restructurings continued at a
some corporate leaders persisted in their conviction high rate in the 1990s, but for the most part on
that growth and stability were the “right” corporate amicable terms. There was also less of a need for high
goals and they simply refused to believe what the leverage because deals could now be paid for with
capital markets were telling them. This appears to stock without raising investors’ concerns that man-
have been true, for example, of the U.S. oil industry agers would pursue their own objectives at the
in the early 1980s, when oil companies traded below expense of shareholders.
the value of their oil holdings because of industry- The merger wave of the 1990s also appears to
wide overinvestment in exploration. have had a somewhat different purpose than the
At the same time that many U.S. companies wave of the 1980s, representing a different stage in
were failing to maximize value, the U.S. capital the overall restructuring process. The deals of the

6. See Mark Mitchell and Harold Mulherin, “The Impact of Industry Shocks on 7. See Jensen (1993), cited earlier, and Andrei Shleifer and Robert Vishny, “The
Takeover and Restructuring Activity,” Journal of Financial Economics, pp. 193-229 Takeover Wave of the 1980s,” Science, Vol. 249 (1990), pp. 745-749.
(1996).

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VOLUME 15 NUMBER 3 SPRING 2003
1980s were more of a bust-up wave whose main year period from 1980 to 1994, the average compen-
effect was to force corporate assets out of the hands sation of CEOs of large U.S. companies tripled in real
of managers who could not or would not use them terms. The study also concluded that the average
efficiently. The transactions of the 1990s, by contrast, annual CEO option grant (valued at issuance) in-
had more of a “build-up” effect in which assets were creased roughly sevenfold and, as a result, equity-
reconfigured to take advantage of growth opportu- based compensation in 1994 made up almost 50% of
nities in new technologies and markets. This logic total CEO compensation (up from less than 20% in
also fits with the increased use of equity rather than 1980).9 Moreover, as reported in a more recent study,
debt in funding the deals of the 1990s. this trend continued from 1994 to 2001, with CEO
The move toward shareholder value and in- pay more than doubling and option-based compen-
creased capital market influence has also been sation increasing at an even faster rate.10
apparent in the way corporations have reorganized Overall, then, CEO compensation appears to
themselves. For example, there has been a broad have increased by a factor of six over the last two
trend toward decentralization. Large companies have decades, with a disproportionate increase in equity-
been working hard to become more nimble and to based compensation. The effect of the increase in
find ways to offer employees higher-powered incen- equity-based compensation has been to increase
tives. At the same time, external capital markets have CEO pay-to-performance sensitivities by a factor of
taken on a larger role in capital reallocation, as more than ten times from 1980 to 1999.11
evidenced by the large volume of mergers and These increases in executive compensation,
divestitures throughout the ’90s. During the same particularly options, have generated enormous con-
period, the amounts of funds raised and invested by troversy. The recent scandals and stock market
U.S. venture capitalists—who help perform the key declines have led some observers to argue that such
economic function of transferring funds from mature increases represent unmerited transfers of share-
to new high-growth industries—also increased by an holder wealth to top executives with limited if any
order of magnitude over the 1990s.8 beneficial incentive effects. For example, one recent
In sum, while corporate managers still reallo- survey of corporate governance concludes: “It is
cate vast amounts of resources in the economy widely recognized...that these options are at best an
through internal capital and labor markets, the inefficient financial incentive and at worst create
boundary between markets and managers appears new incentive or conflict-of-interest problems of
to have shifted. As managers have ceded authority their own.”12
to the markets, the scope and independence of their There are several reasons to be skeptical of
decision-making have narrowed. these conclusions. First, as we have already pointed
We now focus more specifically on changes in out, the performance of the U.S. stock market and the
three key elements of the U.S. (and indeed any) strong growth in U.S. productivity provide no sup-
corporate governance system: executive compensa- port for such arguments.
tion, shareholders, and boards of directors. Second, the primary effect of the large shift to
equity-based compensation has been to align the
Changes in Executive Compensation interests of CEOs and their management teams with
shareholders’ interests to a much greater extent than
The total pay of top U.S. executives, particularly in the past. Large stock option grants fundamentally
option-based compensation, has increased substan- changed the mind-set of CEOs and made them much
tially over the last two decades. For example, a study more receptive to value-increasing transactions. The
published in the late ’90s reported that during the 15- tenfold increase in pay-for-performance sensitivities

8. See Raghu Rajan and Julie Wulf, “The Flattening Firm,” Working paper, study compares equity ownership by officers and directors in 1935 and 1995 and
University of Chicago (2002), and Paul Gompers and Josh Lerner, “The Venture finds that equity ownership was substantially greater in 1995 than in 1935; see Cliff
Capital Revolution,” Journal of Economic Perspectives, pp. 145-168 (2001). Holderness, Randall Kroszner, and Dennis Sheehan, “Were the Good Old Days
9. Hall and Liebman (1998), cited earlier. That Good? Changes in Managerial Stock Ownership Since the Great Depression,”
10. See Brian Hall and Kevin Murphy, “Stock Options for Undiversified Journal of Finance, pp. 435-470 (1999).
Executives,” Journal of Accounting and Economics, pp. 3-42 (2002) and Brian Hall, 12. See Becht, Bolton, and Roell (2002), cited earlier. See also Lucian Bebchuk,
“Six Challenges in Designing Equity-Based Pay,” in this issue of the JACF. Jesse Fried, and David Walker, “Managerial Power and Rent Extraction in the
11. The levels of executive compensation and managerial equity ownership Design of Executive Compensation,” University of Chicago Law Review, pp. 751-
appear to be high not only relative to 1980, but also relative to earlier periods. One 846 (2002).

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JOURNAL OF APPLIED CORPORATE FINANCE
 The corporate governance structures in place before the 1980s gave the managers of
large public U.S. corporations little reason to make shareholder interests their
primary focus...Since the mid-1980s, the American style of corporate governance has
reinvented itself and the rest of the world seems to be following the U.S. lead.

implies that a one dollar increase in a company’s that incentives have been a critical ingredient in the
stock price was ten times more valuable to a CEO at success of LBOs.
the end of the 1990s than at the beginning of the Two other aspects of compensation contracts
1980s. As we noted earlier, this shift played a designed by LBO sponsors for the top executives of
significant role in the continued restructuring of their portfolio companies are worth mentioning.
corporations in the 1990s.13 It also helps explain the First, the equity and options held by those top
1997 decision of the Business Roundtable—a group executives are typically illiquid—usually by neces-
of 200 CEOs of the largest American companies—to sity because most of the companies are private—
change its position on business objectives (after unless and until the company has clearly succeeded
years of opposition and ambivalence to shareholder through an IPO or a sale to another company. This
value) to read “the paramount duty of management means that top management cannot trade in and out
and the board is to the shareholder and not to...other of the stock (nor can it easily hedge its positions).
stakeholders.” Second, neither LBO sponsors nor venture capitalists
A third reason to be skeptical of the criticism of typically index the executive compensation con-
U.S. top executive pay practices is that both buyout tracts they employ to industry performance or mar-
investors and venture capital investors have made, ket performance. If non-indexed options and equity
and continue to make, substantial use of equity- grants were so inefficient, as critics of executive
based and option compensation in the firms they compensation have argued, we would expect to see
invest in. A 1989 study by one of the authors reported more indexing of private equity contracts.
that the CEOs of companies taken private in LBOs Unfortunately, while the greater use of stock-
increased their ownership stake by more than a based compensation has likely been a positive
factor of four, from an average of 1.4% before the development overall, critics of the U.S. governance
LBO to 6.4% after. The study also found that manage- system are correct in pointing out that higher-
ment teams as a whole typically obtained 10% to 20% powered incentives have not come without costs.17
of the post-buyout equity.14 More recent research First, as executive stock and option ownership has
and anecdotal evidence suggest that such levels of increased, so has the incentive to manage and
managerial equity ownership are still typical in manipulate accounting numbers in order to inflate
today’s buyout transactions.15 stock market values and sell shares at those inflated
This feature of LBOs is particularly notable. LBO values.18 This arguably was important in the cases of
sponsor firms such as KKR, Texas Pacific Group, and Global Crossing and WorldCom, among others.
Thomas Lee typically buy majority control of the Second, and related to the first, much of the
companies they invest in through the partnerships compensation of top U.S. executives is fairly liquid—
that the sponsors manage. The individual partners of and, as we argue below, considerably more liquid
the LBO sponsors have strong incentives to make than shareholders would like it to be. Unlike LBO
profitable investments since the sponsors typically sponsors, boards do not put strong restrictions on
receive 20% of the profits of a particular buyout the ability of top executives to unwind their equity-
partnership, and the sponsors’ ability to raise other based compensation by exercising options, selling
funds is strongly related to the performance of their shares, or using derivatives to hedge their positions.
existing investments.16 And the fact that such spon- And finding a workable solution to the problem of
sors also insist on providing the managers of their optimal liquidity for top executive compensation is
companies with high-powered incentives suggests an important challenge faced by today’s boards.

13. For additional evidence consistent with this conclusion, see John Core and 17. Other critiques are offered in Lucien Bebchuk, Jesse Fried, and David
David Larcker, “Performance Consequences of Mandatory Increases in Executive Walker, “Managerial Power and Rent Extraction in the Design of Executive
Stock Ownership,” Journal of Financial Economics (2002), who find that option Compensation,” University of Chicago Law Review, Vol. 69 (2002), pp. 751-846;
grants or increases in equity ownership are related to improvements in stock and Becht, Bolton, and Roell (2002) cited earlier; Brian Hall, “Equity-Pay Design for
accounting performance. Executives,” Working paper, Harvard Business School (2002); and Tod Perry and
14. See Steven Kaplan, “The Effects of Management Buyouts on Operations Marc Zenner, “CEO Compensation in the 1990s: Shareholder Alignment or
and Value,” Journal of Financial Economics, pp. 217-254 (1989). Shareholder Expropriation?,” Wake Forest Law Review (2001).
15. P. Rogers, T. Holland, and D. Haas, “Value Acceleration: Lessons from 18. See Jeremy Stein, “Efficient Capital Markets, Inefficient Firms: A Model of
Private-Equity Masters,” Harvard Business Review (June 2002). Myopic Corporate Behavior,” Quarterly Journal of Economics, Vol. 104 (1989), pp.
16. See Steven Kaplan and Antoinette Schoar, “Private Equity Returns: 655-669 for a model explaining this behavior. See also Joseph Fuller and Michael
Persistence and Capital Flows,” Working paper, University of Chicago (December Jensen, “Just Say No to Wall Street,” Journal of Applied Corporate Finance, Vol. 14,
2002). No. 4 (2002).

13
VOLUME 15 NUMBER 3 SPRING 2003
 Third, most options are issued at the money ship declined from 70% in 1970 to 60% in 1980 and
because accounting rules do not require the cost of to 48% in 1994.20)
such options to be expensed. It is plausible that There are at least two reasons public com-
because the cost of the options does not appear as pany shareholders are likely to monitor manage-
an expense, some boards of directors underestimate ment more effectively today than in the 1980s.
the cost of an option grant. It is undeniable that the First, the large increase in the shareholdings of
size of some of the option grants has been far greater institutional investors means that professional
than what is necessary to retain and motivate the investors—who have strong incentives to gener-
CEOs. In 2001, for example, the ten most highly ate greater stock returns and are presumably more
rewarded CEOs in the S&P 500 were granted option sophisticated—own an increasingly large fraction
packages with an estimated average value (at time of of U.S. corporations.
grant) of $170 million per person. Even if some of Second, in 1992 the SEC substantially reduced
these grants represent multiyear awards, the amounts the costs to shareholders of challenging manage-
are still staggering. It is particularly disconcerting that ment teams. Under the old rules, a shareholder had
among the executives receiving the largest grants in to file a detailed proxy statement with the SEC before
the past three years, several already owned large talking to more than ten other shareholders. Under
amounts of stock, including Larry Ellison of Oracle, the new rules, shareholders can essentially commu-
Tom Siebel of Siebel Systems, and Steve Jobs of nicate at any time and in any way as long as they send
Apple. It is hard to argue that these people need a copy of the substance of the communication to the
stronger shareholder incentives. An obvious expla- SEC afterward. The rule change has lowered the cost
nation is that they have been able to use their of coordinating shareholder actions and blocking
positions of power to command excessive awards. management proposals. (Not surprisingly, the Busi-
Even so, it would be a mistake to condemn ness Roundtable and other management organiza-
the entire system based on a few cases. That such tions were extremely hostile to this rule change
cases are far from representative can be seen from when it was proposed.)
the pronounced skew in the distribution of CEO Consistent with these two changes, shareholder
incomes. In 2001, for example, the same year the activism has increased in the U.S. since the late 1980s.
top ten U.S. CEOs received average option grants The evidence on the impact of such activism, how-
of $170 million, the median value of total compen- ever, is mixed. For example, a 1998 summary of the
sation for CEOs of S&P 500 companies was about results of 20 empirical studies of the effects of formal
$7 million. Thus, U.S. executive pay may not be shareholder proposals and private negotiations with
quite the runaway train that has been portrayed in managements reported evidence of small or no
the press.19 effects on shareholder value.21 When interpreting
such evidence, however, it is important to keep in
Changes in Shareholders mind the difficulty of measuring the extent and
effects of shareholder activity, in part because so
As mentioned above, the composition of U.S. much of this activity takes place behind the scenes
shareholders also has changed significantly over the and is not reported. And the fact that a recent study
past two decades. Large institutional investors own reported that stock returns over the period 1980-
an increasingly large share of the overall stock 1996 were higher for companies with greater
market. For example, from 1980 to 1996, large institutional ownership suggests that our large
institutional investors nearly doubled their share of institutions may indeed be playing a valuable
ownership of U.S. corporations from less than 30% monitoring role—one that translates into higher
to more than 50%. (Conversely, individual owner- stock prices.22

19. A part of the problem is that the press has traditionally reported the value 21. Jonathan Karpoff, “The Impact of Shareholder Activism on Target
of exercised options instead of the value of options at the time they have been Companies: A Survey of Empirical Findings,” Working paper, University of
granted. This is changing, too. Washington (1998).
20. See Paul Gompers and Andrew Metrick, “Institutional Investors and Equity 22. Paul Gompers and Andrew Metrick, “Institutional Investors and Equity
Prices, ” Quarterly Journal of Economics (2001), and James Poterba and Andrew Prices,” Quarterly Journal of Economics, Vol. 116 (2001), pp. 229-260.
Samwick, “Stock Ownership Patterns, Stock Market Fluctuations, and Consump-
tion,” Brookings Papers on Economic Activity, pp. 295-357 (1995).

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JOURNAL OF APPLIED CORPORATE FINANCE
 While the greater use of stock-based compensation has been a positive development
overall, critics of the U.S. governance system are correct in pointing out that
higher-powered incentives have not come without costs.

Changes in Boards of Directors 1994,26 a trend that also appears to have continued.
The same study reported that CEO turnover was
In an influential study of U.S. corporate boards more sensitive to poor performance—as measured
in the second half of the 1980s, Jay Lorsch and by reductions in operating income—during the
Elizabeth MacIver pointed out a number of deficien- 1989-1994 period than in earlier years.27, 28
cies and offered several recommendations. Chief On the negative side, however, anti-takeover
among them were the following: (1) board selection measures such as poison pills and staggered boards
by a nominating committee rather than the CEO; (2) have increased substantially in the past two decades.
more equity compensation for directors; and (3) And recent research finds that during the 1990s,
more director control of board meetings through companies with a high level of anti-shareholder
appointment of a lead director or outside chairman, provisions experienced substantially lower returns
annual CEO reviews, and regular sessions with than firms with a low level of such provisions.29
outside directors only (“executive sessions”).23 Despite the improvements noted above, the
Since the publication of that study in 1989, the recent events at companies like Enron, Tyco, and
boards of U.S. companies have made progress in WorldCom suggest that the boards of U.S. compa-
implementing all three of these recommendations. nies continue to exhibit less than the optimal amount
U.S. companies have significantly expanded the use of independence and oversight. The Senate report
of nominating committees and lead directors. Execu- on Enron’s board is particularly critical in this
tive sessions are increasingly common (although, as respect. When a company is not doing well, every-
suggested below, not as common as directors would one pays close attention—lenders and investors as
like). Boards of U.S. companies now include a larger well as board members. But when a company
percentage of independent and outside directors, appears to be doing well, as was the case with both
and have become somewhat smaller over time Enron and Tyco, investors and the board are likely
(smaller boards are thought to be more effective in to be less critical.
disciplining CEOs and tend to be associated with A recent survey of more than 2,000 directors by
higher valuations).24 Also encouraging, directors Korn Ferry in early 2002 (and thus before the passage
today receive a significantly larger amount of their of Sarbanes-Oxley and the issuance of the new NYSE
total compensation in the form of stock or options. and NASDAQ regulations) is very interesting in this
For example, one study reported that stock-based regard. The directors who responded to the survey
directors’ compensation increased from 25% in 1992 consistently favored more monitoring than was the
to 39% in 1995, and that trend has since continued.25 practice on the boards on which they served. For
The CEO turnover process—one of the most example, although 71% of the directors said they
widely used measures of the effectiveness of a believed boards should hold executive sessions
governance system—suggests that the CEO labor without the CEO, only 45% said their boards actually
market has become broader and, arguably, more did so. And whereas almost 60% felt their boards
efficient. One recent study of CEO turnover for large should have a lead director, only 37% reported that
companies from 1971 to 1994 found a marked their boards had one.
increase in both forced CEO departures and the Our bottom line on boards, then, is that the
hiring of new CEOs from outside the company. structure and operating procedures of U.S. corporate
Within the study, the incidence of forced turnovers boards have improved since the 1980s, but they are
and outside succession was highest from 1989 to still far from perfect.

23. Jay Lorsch and Elizabeth MacIver, Pawns or Potentates (Harvard Business Kevin J. Murphy, “Executive Compensation,” in O. Ashenfelter and D. Card (eds.),
School Press, 1989). Handbook of Labor Economics (North Holland, 1999), pp. 2485-2525.
24. See David Yermack, “Higher Market Valuation of Companies with a Small 28. Rakesh Khurana in Searching for a Corporate Savior: The Irrational Quest
Board of Directors,” Journal of Financial Economics, Vol. 40 (1996), pp. 185-202. for Charismatic CEOs (Princeton University Press, 2002) has argued that the CEO
25. For a summary of these changes, see Ben Hermalin and Michael Weisbach, labor market is flawed because it is overly focused on outsider, charismatic CEOs.
“Boards of Directors as an Endogenously Determined Institution: A Survey of the The operating performance evidence in Rakesh Khurana and Nitin Nohria, “The
Economic Literature,” Economic Policy Review (2003). Effects of CEO Turnover in Large Industrial Corporations: A Study of the Fortune
26. See M. Huson, Robert Parrino, and Laura Starks, “Internal Monitoring 200 from 1978-1993,” Harvard Business School (1997), however, is not consistent
Mechanisms and CEO Turnover: A Long-Term Perspective,” Journal of Finance, with such a conclusion.
pp. 2265-2297 (2001). 29. Paul Gompers, Joy Ishi, and Andrew Metrick, “Corporate Governance and
27. On the other hand, research shows that CEO turnover is less sensitive to Equity Prices,” Working Paper 8449, NBER, 2001.
industry-adjusted stock performance from 1990 to 1995 than in earlier years; see

15
VOLUME 15 NUMBER 3 SPRING 2003
International Developments penalty on executive stock options, and a 2002 study
based on Towers Perrin’s yearly surveys reported
Indirect evidence of the effectiveness of the U.S. that the rate of adoption of stock options in Europe
governance system is provided by changes in corpo- has matched that of the U.S. in the 1990s.31
rate governance in other countries. In recent years, In sum, the conventional wisdom on corporate
as the forces of deregulation, globalization, and governance has changed dramatically since the
information technology have continued to sweep 1970s and early 1980s, when the U.S. market-based
across the world economy, other countries have system was subjected to heavy criticism and the
begun to move toward the U.S. model. Traditionally, bank-centered systems of Japan and Germany were
European and Japanese firms have reallocated capi- held up as models.32 Since the mid-1980s, the
tal from sunset industries to sunrise industries mainly American style of corporate governance has rein-
through internal diversification. External market vented itself and the rest of the world seems to be
interventions of the sort seen in the U.S. were almost following the U.S. lead.
unheard of. In the late 1990s, however, Europe
experienced a sudden rise in hostile takeovers. In RECENT REGULATORY CHANGES
1999 alone, 34 listed companies in Continental
Europe received hostile bids, representing a total The Sarbanes-Oxley Act (SOX), which was
value of $406 billion (as compared to 52 bids for just enacted in the summer of 2002, mandated a number
$69 billion over the entire period 1990-1998).30 of changes in corporate governance for publicly
These transactions included Vodafone’s bid for traded companies. The NYSE and NASDAQ also
Mannesmann, TotalFina’s bid for Elf Aquitaine, and mandated corporate governance changes for firms
Olivetti’s bid for Telecom Italia. listed on their respective exchanges. In this section,
Shareholder activism has also been on the rise, we discuss the likely effect of these changes on U.S.
with strong support from American institutional corporate governance.
investors. For example, Telecom Italia’s attempt to
split off its wireless unit (at an unacceptable price) Sarbanes-Oxley
was blocked when TIAA-CREF put pressure on the
Italian government. In France, shareholder activists SOX mandated changes that will affect execu-
managed to defeat a poison-pill proposal by Rhone- tive compensation, shareholder monitoring, and,
Poulenc. European universal banks also have begun particularly, board monitoring.
to pay more attention to the value of their financial One provision requires the CEO and CFO to
stakes than to their positions of power. These actions disgorge any profits from bonuses and stock sales
appear to have been very much influenced by the during the 12-month period that follows a finan-
U.S. model of market intervention and by the fact that cial report that is subsequently restated because of
more than $1 trillion of U.S. funds has been invested “misconduct.” (We assume this provision also
in Western Europe in the 1980s and 1990s. covers any hedging transactions the CEO or CFO
Another way in which companies can make use undertakes.) Until “misconduct” is clearly de-
of the market to reallocate capital more effectively is fined, this provision increases the risk to a CEO or
to repurchase their own shares. In the last several CFO of selling a large amount of stock or options
years, Japan, France, Germany, and several other in any one year while still in office. Some CEOs
countries have relaxed prohibitions or restrictions and CFOs will choose to wait until they are no
on share repurchases, and companies in those longer in those positions before selling equity or
countries have responded by buying back increasing exercising options. To the extent CEOs and CFOs
numbers of shares. Finally, the use of stock options behave this way, their equity holdings become
for executives and boards is increasing around the less liquid and they will care less about short-term
world. Japan recently eliminated a substantial tax stock price movements. This would be a positive

30. Rick Escherich and Paul Gibbs, Global Mergers and Acquisitions Review, 32. See, for example, Michael Porter, “Capital Disadvantage: America’s Failing
JP Morgan (April 2002). Capital Investment System,” Harvard Business Review, September-October (1992),
31. Brian Hall, “Incentive Strategy II: Executive Compensation and Ownership pp. 65-83.
Structure,” Harvard Business School, Teaching Note N9-902-134 (2002).

16
JOURNAL OF APPLIED CORPORATE FINANCE
 At this point, the Sarbanes-Oxley Act has probably helped to restore confidence in
the U.S. corporate governance system. Apart from that, the Act’s expected overall
effect is as yet unclear.

change. In addition, the rule will act as a deterrent Tyco, and WorldCom. Furthermore, the Enron scan-
to negligent or deliberate misreporting.33 dal brought the costs of such misreporting into sharp
Shareholder-related provisions include changes focus before the passage of SOX. No CEO wants to
in restrictions on insider trading regulation and be the CEO of the next Enron. And no board member
enhanced financial disclosure. Executives will now wants to be on the board of the next Enron.
have to report sales or purchases of company stock There are two potentially significant dangers
within two days rather than the current ten days, associated with SOX. First, the ambiguity in some of
which will have the effect of making executive the provisions, particularly those that overlap with
shares somewhat less liquid. SOX also requires more and even contradict aspects of state corporate law,
detailed disclosure of off-balance-sheet financings will almost certainly invite aggressive litigation. The
and special purpose entities, which should make it fear of such litigation will lead CEOs and CFOs to
more difficult for companies to manipulate their direct corporate resources to protect themselves
financial statements in a way that boosts the current against potential lawsuits. Fear of litigation is also
stock price. making it harder to attract qualified board mem-
SOX also includes a number of provisions bers—certainly an unintended consequence of all
meant to improve board monitoring. These focus the effort to improve board effectiveness. The sec-
largely on increasing the power, responsibility, and ond, broader concern is that SOX represents a shift
independence of the audit committee. SOX requires to more rigid Federal regulation and legislation of
that the audit committee hire the outside auditor and corporate governance, as distinguished from the
that the committee consist entirely of directors with more flexible corporate governance that has evolved
no other financial relationship with the company. from state law, particularly Delaware law.34
Finally, SOX increases management’s and the At this point, SOX has probably helped to
board’s responsibility for financial reporting and the restore confidence in the U.S. corporate governance
criminal penalties for misreporting. The increased system. Apart from that, the Act’s expected overall
responsibility and penalties have clearly increased effect is as yet unclear. Our guess is that the effects
the amount of time that executives of all companies will be positive for companies with poor governance
must spend on accounting matters. For companies practices and negative for companies with good
that are already well governed, that extra time is governance practices. Because some of the addi-
unnecessary and therefore costly. At least initially, tional costs of complying with SOX are fixed rather
some of the extra time meeting SOX’s requirements than variable, the effects will be more negative for
will be time that could have been devoted to smaller companies than for larger ones. At the
discussing strategy or managing the business. SOX margin, this may lead some public companies to go
has also caused companies to increase their use of private and deter some private companies from
outside accountants and lawyers. But part of the going public. And because of companies’ initial uncer-
resulting increase in costs is likely to be recouped in tainty about how to comply with the Act, we expect the
the form of valuable new information not previously effects of SOX to be somewhat negative in the short
available to some CEOs, CFOs, and boards. Further- term, with compliance costs declining over time.
more, the additional time and costs should decline
as companies become more efficient at complying NYSE and NASDAQ Corporate Governance
with SOX. Proposals
So, what has the new legislation really accom-
plished? The provisions of SOX deal both directly In 2002, both the New York Stock Exchange and
and indirectly with some of the deficiencies of U.S. NASDAQ submitted proposals designed to strengthen
corporate governance. But many U.S. companies the corporate governance of their listed firms. Both
would have instituted some of these changes any- exchanges will require the following:
way. The law already punished fraudulent reporting, (1) shareholder approval of most equity compen-
including the misreporting uncovered in Enron, sation plans;

33. This provision could lead to a modest substitution of cash compensation entirely through salary increases because cash bonuses are also subject to the same
for equity-based compensation. However, this would have to be accomplished disgorgement provisions.
34. We thank Andrew Nussbaum for suggesting this possibility.

17
VOLUME 15 NUMBER 3 SPRING 2003
 (2) a majority of independent directors with no circumstances that led to the abuse of stock op-
material relationships with the company; tions—the equivalent of a “Perfect Storm”—and then
(3) a larger role for independent directors in the makes the following recommendations:
compensation and nominating committees; and (1) compensation committees should be indepen-
(4) regular meetings of only nonmanagement dent and should avoid benchmarking;
directors. (2) performance-based compensation should cor-
Compared to SOX, these proposals address U.S. respond to the corporation’s long-term goals—“cost
corporate governance deficiencies both more directly of capital, return on equity, economic value added,
and with lower costs. The three provisions relating to market share, environment goals, etc.”—and should
board monitoring are particularly noteworthy in that avoid windfalls related to stock market volatility;
they directly address some of the concerns men- (3) equity-based compensation should be “reason-
tioned by Lorsch and MacIver in 1989 and by outside able and cost effective”;
directors in the recent Korn Ferry survey. (4) key executives and directors should “acquire
The closest historical parallel to these proposals and hold” a meaningful amount of company stock;
is the Code of Best Practices (based upon the and
recommendations of the Cadbury Committee) that (5) compensation disclosure should be transpar-
was adopted by the London Stock Exchange (LSE) ent and accounting-neutral—that is, stock options
in 1992. The Code included recommendations that should be expensed.36
boards have at least three outside directors and a Overall, we have a mixed reaction to these
nonexecutive chairperson. Although the Code is recommendations. Several are clearly beneficial. In
voluntary, the LSE requires companies to state particular, greater transparency and appropriate
whether they are in compliance. expensing of options will make the costs of options
There is evidence that the Code can make a more clear not only to shareholders but also to
difference. A recent study of all LSE companies boards. It also will “level the playing field” for options
reported that both CEO turnover and the sensitivity versus other forms of equity-based compensation.
of CEO turnover to performance increased following Requiring key executives to hold a meaningful
the adoption of the Code—and that such increases amount of company stock will reduce the temptation
were concentrated among those firms that had adopted to manipulate earnings and stock prices in the short
the recommendations. Furthermore, the changes in term by making executive stock holdings less liquid.
turnover appear to have been driven by the increase Typically, stock options vest in one to four years,
in the fraction of outsiders on the board rather than which is short given that most options are exercised
the separation of the chairperson and CEO.35 and sold fairly soon after vesting. Economic logic
Overall, then, the NYSE and NASDAQ changes suggests that boards should encourage longer-term
should prove to be unambiguously positive. holdings and a build-up of sizable executive stakes.
The Commission also endorses indexation of
The Conference Board Recommendations some kind to eliminate windfall gains. Indexation
has been recommended by economists for a long
In response to the recent scandals, the Confer- time, yet practitioners have not adopted it. It is true
ence Board—an association of prominent U.S. com- that there has been an important accounting disad-
panies—put together a Commission on Public Trust vantage to indexation in that indexed options must
and Private Enterprise with the aim of advising be expensed. But the fact that indexed options are
companies on best practices in corporate gover- rarely used by LBO investors and venture capitalists
nance. The first report by the Commission, released also suggests that there are hidden costs to index-
in September 2002, provides a set of principles to ation or that the benefits are low.
guide boards in designing top executive compensa- While it may be useful to experiment with some
tion. The report begins by noting the exceptional forms of indexation, we think it would probably be

35. J. Dahya, J. McConnell, and Nickolaos Travlos, “The Cadbury Committee, 36. Andy Grove, Chairman of Intel, disagreed with the majority in not
Corporate Performance, and Top Management Turnover,” Journal of Finance, Vol. recommending expensing of stock options, while Paul Volcker, former Chairman
57 (2002), pp. 461-483. of the Board of Governors of the Federal Reserve System, argued that fixed-price
stock options should not be used at all. Both filed dissenting opinions.

18
JOURNAL OF APPLIED CORPORATE FINANCE
 Many corporate boards will decide to expense options and equity compensation
even if they are not required to do so...Expensing will provide the additional signal
to sophisticated investors that the board and the company are serious about
compensation and corporate governance.

just as effective and more transparent to index problem with executive pay levels is not the overall
implicitly by granting stock-based incentives more level, but the extreme skew in the awards, as we noted
frequently and in smaller amounts. Mega-grants earlier. To deal with this problem, we need more
covering several years at a fixed price have proved effective benchmarking, not less of it.
too unstable; the options may go underwater and Despite good intentions, then, we see poten-
then need to be bailed out (to maintain incentives), tially serious flaws in the recommendations of the
making it hard initially to determine the true ex- Conference Board. It is also important to keep in
pected cost of the incentive plans. In general, the mind that good incentive designs are sensitive to
incentives from stock options are more fragile than economic circumstances and to the desired perfor-
those provided by restricted stock, a problem that more mance. One size does not fit all. And because each
frequent, smaller awards would help alleviate.37 situation requires its own compensation plan, the
We are also skeptical of the recommendation to need to customize that plan will often conflict with
use performance-based compensation tied to a long the goals of benchmarking and transparency.
list of potential long-term goals, including cost of
capital, return on equity, market share, revenue WHAT WILL THE FUTURE BRING?
growth, and compliance and environmental protec-
tion goals. Such performance plans would appear to Working together with normal market forces,
take us back to the 1970s, an era that few incentive the Sarbanes-Oxley Act, the new NYSE and NASDAQ
experts remember fondly. If the problem is windfall regulations, and the guidelines offered by groups
gains, then indexed stock options or, more simply, like the Conference Board will significantly influ-
frequent (quarterly) issues of stock options are much ence U.S. corporate governance.
preferred. If the problem is manipulation of the Board behavior will be most strongly affected
market, it should be evident that accounting mea- by these measures. External pressure will lead most
sures of the kind endorsed by the Conference Board boards to monitor top management more aggres-
are very problematic. It was in large part because of sively. Yet the relationship between boards and
their vulnerability to manipulation that standard directors need not become more adversarial. The
performance plans were replaced by stock-based new regulatory requirements provide cover for a
incentives in the 1980s. This is not to say that more independent and inquisitive board. Actions
accounting-based incentives should never be used, that in the past might have been construed as hostile
just that they should not form the core of a CEO’s will now be interpreted as following best practice.
incentive plan. The mandated changes may in fact help reduce the
We are also somewhat skeptical of the recom- tension inherent in the dual role boards play as
mendation that the compensation committee “act monitors of management, on the one hand, and as
independently of management...and avoid advisors and sounding boards, on the other.
benchmarking that keeps continually raising the In addition to the changes in oversight and
compensation levels for executives.” First, dictating monitoring, boards also are likely to change their
terms without consulting with the executives about approaches to executive compensation (even though
their preferences goes against efficient contracting SOX and the exchanges did not address executive
principles; contracting is a two-sided affair. Second, compensation directly). In particular, boards will
the intent seems to be to give individual compensation increasingly restrict top executives’ exercising op-
committees the responsibility for the overall level of tions, selling stock, and hedging their positions. As
executive compensation. But it is hard to see how pay noted earlier, some of the incentives for the execu-
levels can be set in a fair and efficient way without tives at Global Crossing, Tyco, and WorldCom to
benchmarking. Prices, including wages, are ultimately manage earnings came from their ability to sell
set by supply and demand, and benchmarking is shares when their stock prices were overvalued.
nothing more than looking at market prices. The main Restrictions on such selling reduce the incentive to

37. See Brian Hall and Thomas Knox, “Managing Option Fragility,” Harvard exercise price should rise with the cost of capital). Given the problems of fragility,
NOM Research Paper 02-19, Harvard Business School (2002). It is interesting that this takes us in exactly the wrong direction. Restricted stock (an option with a zero
fairness arguments often lead people to advocate options with exercise prices set exercise price) is more appealing, because its incentive effect is robust to variations
well above current market price (for instance, Michael Jensen argues that the in the stock price.

19
VOLUME 15 NUMBER 3 SPRING 2003
manage short-term earnings. While such restrictions CONCLUDING REMARKS
have costs, particularly in the form of lack of
diversification, the benefits in terms of improved Despite its alleged flaws, the U.S. corporate
incentives arguably outweigh them. Private equity governance system has performed very well, both on
firms routinely impose such restrictions on the an absolute basis and relative to other countries. It
managements of their portfolio companies. Further- is important to recognize that there is no perfect
more, CEOs typically are wealthy enough that the system and that we should try to avoid the pendulum-
benefits of diversification may not be so great. like movement so typical of politically inspired
Many corporate boards will decide to expense system redesigns. The current problems arose in an
options and equity compensation even if they are not exceptional period that is not likely to happen again
required to do so. We suspect that boards will soon. After all, it was almost 70 years ago that the
discover that investors and the stock market have corporate governance system last attracted such
neutral or even positive reactions to such expensing intervention.
(in contrast to the predictions of many executives). The fact that the American public and political
Sophisticated investors already know the extent system became outraged and involved in corporate
of option issuance from its disclosure in footnotes. governance does not mean the system was broken.
Expensing will provide the additional signal to The U.S. public and the political system are part of
these investors that the board and the company the broader system of corporate governance. At the
are serious about compensation and corporate same time, an effort to regulate the system so that
governance.38 such outrage will never again occur would be overly
Boards of directors and compensation commit- costly and counterproductive. It would lead to
tees also will begin to change their behavior in inflexibility and fear of experimentation. In today’s
issuing options and equity-based compensation. uncertain climate, we probably need more organiza-
This will be particularly true of boards that decide to tional experimentation than ever. The New Economy
expense options. Expensing the options will make is moving forward and, in order to exploit the
their costs more clear and will reduce the size of potential efficiencies inherent in the new informa-
option grants, particularly large, one-shot grants. tion technologies, new business models and new
Moreover, some companies that do expense equity organizational structures are likely to be desirable
compensation will choose to issue restricted stock and valuable. Enron was an experiment that failed.
rather than options. Restricted stock grants have the We should take advantage of its lessons not by
advantages of being easier to value, providing withdrawing into a shell, but rather by improving
incentives that do not vary with stock price move- control structures and corporate governance so that
ments, and thus being less vulnerable to repricing.39 other promising experiments can be undertaken.

38. The argument that options cannot be expensed because no one knows stock options will influence the information content of reported earnings. The
their true value is wrong. On that basis, one could argue that we should not never-ending debate over the best way to handle depreciation suggests that
depreciate assets because it is impossible to measure the assets’ true rate of expensing options is going to be discussed for years to come.
depreciation. Nevertheless, it remains to be seen how fluctuations in the value of 39. See Hall (2002), cited earlier, for a detailed discussion.

BENGT HOLMSTROM STEVEN KAPLAN

is the Paul A. Samuelson Professor of Economics at MIT’s Sloan is the Neubauer Family Professor of Entrepreneurship and
School of Management and a Research Associate of the National Finance, at the University of Chicago’s Graduate School of
Bureau of Economic Research. Business. He is also a Research Associate of the National Bureau
of Economic Research.

20
JOURNAL OF APPLIED CORPORATE FINANCE
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