We thank Professor Bainbridge for letting us post his comments on this blog. The referenced Closer Look is found here.
What would happen if the NCAA adopted Dodd-Frank? Professor Bainbridge, 10/3/2011
Stanford business law professors David Larcker and Brian Tayan have conducted an interesting thought experiment:
In recent years, NCAA football has been rocked by a string of high-profile violations, including those at USC, Ohio State, the University of Miami, and Auburn. In many ways, these violations were similar to the governance breakdowns at financial and other corporations leading up to the financial crisis of 2008 and 2009.
In the corporate world, Congress responded to the financial crisis by enacting the Dodd-Frank Wall Street Reform Act, which among other things imposed various governance requirements on all publicly traded companies.
What would happen were the NCAA to adopt these same provisions and require them of all universities and their football programs?
In this fictitious tale, we explore what such a set of rules would look like. We ask:
* If these requirements would not work in an athletic setting, should we expect them to work in business?
* Why are the governance provisions of Dodd-Frank legally required, rather than voluntarily adopted by individual companies?
* Why does Dodd-Frank place such emphasis on executive compensation and disclosure? Will its compensation requirements reduce governance failures?
The NCAA Adopts ‘Dodd-Frank’: A Fable (September 14, 2011). Rock Center for Corporate Governance at Stanford University Closer Look Series: Topics, Issues and Controversies in Corporate Governance No. CGRP-20. Available at SSRN:http://ssrn.com/abstract=1927108
There is an odd disconnect between the internal logic of Dodd-Frank’s governance provisions and the back story of the financial crisis.
Consider, for example, the question of executive compensation. Regulators identified executive compensation schemes that focused bank managers on short-term returns to shareholders as a contributing factor almost from the outset of the financial crisis. As was the case with almost all public U.S. corporations, banks and other financial institutions shifted in the 1990s to a much greater reliance on equity-based pay for performance compensation schemes. The rationale for such schemes is that they align the risk preferences of managers and shareholders. Because managers typically hold less well-diversified portfolios than shareholders, having significant investments of both human and financial capital in their employers, they tend to be much more averse to firm specific risk than diversified investors would prefer. Pay for performance compensation schemes that link managerial compensation to shareholder returns are designed to counteract that inherent bias against risk and thus align managerial risk preferences with those of shareholders.
Shareholder activists long have complained that these schemes provide pay without performance. This was one of the corporate governance flaws Dodd-Frank was intended to address, most notably via say on pay.
The trouble, of course, is that shareholders and society do not have the same goals when it comes to executive pay. Society wants managers to be more risk averse. Shareholders want them to be less risk averse, for the reasons just discussed. If say on pay and other shareholder empowerment provisions of Dodd-Frank succeed, manager and shareholder interests will be further aligned, which will encourage the former to undertake higher risks in the search for higher returns to shareholders. Accordingly, as Christopher Bruner aptly observed, “the shareholder-empowerment position appears self-contradictory, essentially amounting to the claim that we must give shareholders more power because managers left to the themselves have excessively focused on the shareholders’ interests.”
In sum, the shareholder empowerment measures adopted before the crisis did nothing to prevent it and may well have contributed to it. The new provisions included in Dodd-Frank thus are unlikely to prevent another such crisis and may even increase the odds of some similar crisis induced by excessive risk taking.