The Truth in Lessig's Critique of Transparency

October 23rd, 2009
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Contributed by: Eric Jackson, Ironfire Capital
Lawrence Lessig's recent thought-provoking article in the New Republic, “Against Transparency: The perils of openness in government,” challenges the assumption that more sunlight is always a better disinfectant for corruption and bad behavior than less.

Although his primary focus is on how more transparency doesn't always lead to better political outcomes, there are obvious implications of his argument to the world of corporate governance and executive compensation.

The critique, entitled "Against Transparency: The perils of openness in government," offers a partial explanation of why, even after Enron and Worldcom when everyone agreed that corporate boards screwed up in overseeing their companies, boards failed again in the recent mortgage bubble. It also suggests what must change now to finally improve corporate governance and executive compensation.

Lessig's argument is that it's become accepted wisdom on both sides of the political aisle in recent years that more transparency is always better. And, in an age of super-computers and ubiquitous access of the Web, it has become easier than ever to make data available.

The assumption many make is that making information available will curb bad behavior before it happens, because the actors will know they are subject to being called out.

Lessig challenges this by using the example of publishing a politician's calendar online. Does this level of information really help the public better judge his or her actions? Does it encourage the politician to behave more justly, knowing others will see his or her breakfast meeting took two hours instead of one last Thursday?

Lessig worries that more information disclosure can have the pernicious unintended consequence of making market actors believe that they don't have to worry about particular problems because they have been disclosed.

Yet, more of a data dump doesn't mean that the data will be processed and acted upon correctly. In fact, more data dumps -- especially in areas like corporate governance that aren't well-understood -- probably make it less likely that bad behavior will be singled out than many would assume.

Lessig is not arguing against transparency in favor of us returning to the crony capitalism world of back-room deals and Russia-style payoffs. He is arguing against a Pollyanna-ish view of the benefits of "naked transparency." Anyone in favor of better corporate governance and aligned executive compensation with performance would be an ostrich not to critically review Lessig's article and think about its implications.

The world of corporate governance is not well-understood by the public or general business journalists. Who but general counsels and governance wonks really understand how corporate by-laws, board selection, and governance-related disclosures in SEC filings work?

There are relatively few people around to actually challenge governance matters in companies -- and a majority of them are already working as general counsels at companies protecting them from criticism.

In terms of more data not always being better, think of the Securities and Exchange Commission's landmark decision in the early 1990s to require companies to disclose executive compensation. As Lessig points out, instead of resulting in shame keeping a tamper on things, more transparency has inspired jealousy and creativity from compensation consultants and tax attorneys, further accelerating the stratospheric climb of executive compensation.

You can't put toothpaste back in the tube. Transparency and disclosure are here to stay and they certainly do help keep bad behavior in check. But, clearly, some changes need to occur as bad corporate behavior continues apace.

If you think general business journalists will save us, keep waiting. Lessig points out that one of the effects of the decline of mainstream media's traditional revenue sources has been the elimination of investigative reporting.

Less than 10% of large U.S. newspapers employ four or more investigative reporters -- and of those, it's likely scant few of those reporters have any background in corporate governance or executive compensation to be able to take on this topic. Forty percent of large newspapers have no investigative reporters.

If not journalists, who could challenge corporate governance and executive compensation transgressions? Institutional shareholders will only speak to companies privately and on a limited basis. Retail shareholders don't have the time, inclination, or expertise to do this regularly. Research analysts want to curry favor with management. Employees want to keep their jobs.

I actually believe it is the proxy advisory firms (like RiskMetrics (RMG), Proxy Governance and Glass Lewis) and credit ratings agencies (like Moody's (MCO) and Standard & Poor's, a subsidiary of McGraw Hill (MHP) that are best positioned to play this role. However, to do so effectively, they would have to eliminate conflicts of interest in their own firms.

RiskMetrics, formerly ISS, is the market leader in the proxy advisory space. Many institutional investors use RiskMetrics or other proxy advisory firms as cover for how they vote their proxies. If the pensioners for XYZ pension fund ever raised hell that their fund voted in favor of re-electing a board of directors for a future Enron or Lehman, the fund can blame RiskMetrics for telling them to do so. RiskMetrics happily accepts these fees for being investors' most preferred scapegoat.

The problem here is that RiskMetrics has its fingers in too many pies. They sell consulting services to public companies to tell them how to improve their internal practices (and presumably be viewed in a better light at proxy voting time). They also have started selling corporate governance ratings tools to companies and investors to better understand how to improve their corporate governance practices.

Companies will sometimes tout in press releases how the RiskMetrics Corporate Governance Quotient tool assigned them a 95% rating on corporate governance. They'll later complain if the proxy advisory side of RiskMetrics recommends against some or all of the board at a future meeting.

Others have complained that RiskMetrics' unchallenged clout leads to unfair judgments. One activist investor involved in a battle at a small-cap Canadian company recounted how he was given 15 minutes to brief a 20-something analyst from RiskMetrics at 4:30 p.m. on a Friday before a long weekend. RiskMetrics came out the next week in favor of the incumbent board, despite many good reasons for withholding votes.

On the other side, one corporate director recently complained to me that Glass Lewis had recommended against his re-election based on his age and that he served on too many boards -- even though the majority of his other boards were subsidiaries of his main board. He claimed that they didn't require substantial additional time demands of him. "I was never contacted by them before they made their recommendation and I have no idea who I call to complain now," he said.

The simple solution here for the proxy advisors is to break up the consulting services from the ratings services, so there is no conflict. Ensuring there is sufficient competition will also help them keep their quality up.

The problems of credit ratings agencies' poor ratings and a pay-to-play business model are well-documented. Yet, these groups have the infrastructure, reputations, and could build up the expertise in corporate governance to level judgments against companies. Like proxy advisory firms, market actors would pay attention to their views if they could get their house in order.

Some will advocate for a government agency to bridge the gap here on being a domain expert overseer on topics like corporate governance and executive compensation. However, Ken Feinberg's tenure as pay czar -- however well-intentioned -- makes me skeptical that such a solution could really be effective in the long-run.

Those of us in favor of better corporate governance and tighter links between executive pay and performance need to see the truth in Lessig's critique of transparency. More data dumps into the backs of SEC filings won't fix anything. We need domain experts looking at every board, every deal, and every potential transgression, rendering judgments. Fixing the proxy advisory and credit ratings firms is the best way of doing that.

Disclosure: At the time of publication, Jackson did not have any positions in the equities mentioned.
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