ADAM SMITH didn't spend much time on corporate governance. In his day, and up until around 1900, nearly all companies were run by their owners, which made life simple. But the rise of the joint stock company separated ownership from management, raising a question about how to protect owners' rights -- including their right to honest numbers on their firms. The supposed solution is the board of directors, a body elected by shareholders to watch over the management. But directors have proved ineffectual. Far from acting as a check on the chief executive, they are usually his cronies. It is not just auditors, in other words, who are insider outsiders.
The question, in the wake of Enron, is whether boards can ever change. In an ideal world, boards would appoint audit committees filled with genuinely independent directors; these committees would hire and fire the auditors, who would therefore feel less beholden to the managers whose books they vet. In such a world, moreover, the other reforms proposed in this series would become less urgent: Auditors would avoid accounting tricks, even if loopholes in the rules persisted; they would do the right thing because their audit committees would be watching them. Precisely because audit committees hold out the hope that other change may be less necessary, reluctant reformers often stress their confidence in them.
But there's a steep hill to climb here. In 1986 Carl Icahn gave this account of a directors' meeting at a big company: "Literally, half the board is dozing off. The other half is reading the Wall Street Journal. And then they put slides up a lot and nobody can understand the slides and when it gets dark they all doze off."
There are, to be sure, some obvious ways to strengthen boards' performance. Right now some don't even have audit committees, and most such committees merely recommend auditors rather than appointing them. Companies should not be allowed to co-opt committee members with consultancy contracts or payments to their favorite charities, as happened at Enron and elsewhere. The exchanges should also require more transparency about how often boards meet and who attends. If investors knew that an audit committee met once annually, and then only briefly, they might treat its accounts with due suspicion. And that might change attitudes. In the words of Nell Minow, a shareholder activist, "boards of directors are like subatomic particles -- they behave differently when they are observed."
But the basic reason for boards' failure to stand up to managers is that managers chose them. The voting process by which directors get elected makes butterfly ballots seem beautiful: Managers get to put forward their candidates to shareholders, and opposition candidates aren't offered. If it looks like shareholders may vote No anyway, managers don't hesitate to spend the company's (i.e., the shareholders') money to get their cronies in. Just last month, shareholder activists failed to eject Frank Savage, a discredited Enron board member, from two other boards he serves on. If even the most compromised director can survive like this, the rest needn't care about the shareholders' interests.
In principle, you could change board elections and curb managers' control. Yet even this reform, which is unlikely, would leave unsolved a second reason for boards' weakness, which is that full-timers know more than they. Even if audit committees were diligent and independent, how would they respond to an auditor who said their firm's accounts were aggressive but ultimately legal? The auditor is the expert, and he has spent months reaching his conclusions. If he says the accounts are legal, what committee is going to demand that they be restated anyway?
In the aftermath of Enron, there are already signs that audit committees will resist new responsibilities. Headhunters report that it's harder to persuade qualified people to accept board seats, and the price of director's liability insurance has gone up. Even more telling, recent company disclosures have included a new kind of disclaimer. Audit committees are stating for the record that they aren't themselves the auditors and can't promise that the auditors have done their job. Both points are true, unfortunately. There is no alternative, therefore, to tough audit reform.