The purpose of corporate governance structures and practices is not only to reduce the incidence of financial fraud and scandal. However, this typically becomes the single-minded focus of corporate reforms in the period after a boom has turned to bust; this pattern has repeated in our own time. It is not an excuse, but what came to light in the wake of the popping of the most recent stock market bubble was typical. History is clear that as an empirical matter, booms induce fraud and swindling.

Resident Fellow Alex J. Pollock

Then comes the bust. In the psychology and behavior of the aftermath of the bust, all changes. The focus is then on punishment and humiliation of the swindlers. In reaction to the scandals, many new controls are imposed. The Sarbanes-Oxley Act is a current legislative example, but its predecessors go back to the Bubble Act of 1720. New regulations, rules, accounting procedures, and reports of Blue Ribbon committees and commissions try to guarantee good financial behavior will follow, all with the theme of ensuring that “this will never happen again.” Of course, when the next boom comes, it happens again anyway. Will Sarbanes-Oxley controls prevent fraud and scandal during that next boom? History suggests they will not.

The safekeeping self versus the experimental self. What society wants from corporate governance in the aggregate is maximum production of economic well-being. This requires innovation, experimentation, and seizing opportunities; it also requires control, probity, and risk management. How much experimentation and innovation is it sensible to give up in exchange for how much reduction in fraud and scandal? How much protection from loss in exchange for how much sacrifice of upside possibilities?

George Prince, writing on the psychology of creativity and the behavior of organizations, suggests that each of us is composed of two competing selves: the “safekeeping self,” dominated by fear of loss, and the “experimental self,” oriented to possibilities:

• Safekeeping self--censors, is alert to possible danger, avoids surprises and risks, makes rules, punishes mistakes, and is serious, cautious, suspicious, and fearful.
  
  
• Experimental self--takes risks, breaks rules, recognizes patterns, is curious, sees the fun in things, makes impossible wishes, and is intuitive and impetuous.

It is easy to see which side describes the prevailing traits of accountants, auditors, lawyers, regulators, bureaucrats, examiners, IRS agents, and authors of corporate governance checklists; and which side describes traits of entrepreneurs, marketers, innovators, and visionary leaders. Both are necessary; the issue is how to achieve the right balance and interaction between the two. This is true for a board of directors as well as other groups.

Independence. The most diligent directors cannot possibly match the detailed and specific knowledge of an enterprise, its operations, risks, and opportunities that a competent management must have. If they did, they would be the management, not the board. To acquire a corresponding knowledge, they could not serve part time, and therefore could not be independent.

However, directors should bring a general knowledge relevant to the business in question, sufficient stature to confront and address problematic situations, and sufficient experience to be meaningful counselors in matters of importance. It depends on a combination of relevant knowledge and independence of the right kind.

Warren Buffett has given us a clear statement of what the latter means: “True independence--meaning the willingness to challenge a forceful CEO when something is wrong or foolish--is an enormously valuable trait in a director. It is also rare. The place to look for it is among highgrade people whose interests are in line with those of rank-and-file shareholders--and in line in a very big way.”

In other words, the governance principle leading to meaningful independence is for the director to be a significant shareholder in the company, with significant personal assets at stake. This is a different and far better concept of “independence” than contained in typical discussions of the term in the aftermath of the bust. The single most effective governance reform would be to ensure that all corporate directors have significant personal holdings of the stock of the company of which they are directors. This means outright ownership of shares, not stock options.

Society does not want to be defrauded or swindled or to have the swindlers go unpunished. It will especially demand punishment in the aftermath of burst financial bubbles. But much more importantly, it needs continuous innovation, risk-taking, and creativity, which are the source of its economic growth and well-being.

Burdens imposed on everybody in fevered response to the malefactions of a few have to be constrained by their monetary and opportunity costs. Structures and practices of corporate governance have to balance between trying to avoid mistakes, whether of dishonesty or honest error, and creating opportunities.

Alex J. Pollock is a resident fellow at AEI.