Last week, I chewed the fat with Professor Paul Healy, the James R. Williston Professor of Business Administration at Harvard Business School. Professor Healy specialises in disclosure, corporate governance, financial reporting and corporate finance.

We talked about Sarbanes-Oxley, and other corporate governance issues.

In this interview he warns that soaring CEO pay might be a recipe for political instability. He also says regulators should bring in rules to make private equity more transparent.

Read on:

SOX FIRST: Moves are underway in the US to wind back parts of Sarbanes-Oxley. What does the future hold for the legislation? And what's your take on the concerns that have been raised about Sarbox?

HEALY: I have to say that I don't share some of the concerns. The big concerns are that so many companies are being registered on the UK exchange. The interesting thing is if you look at those companies, they're companies that probably wouldn't qualify for registering on the NYSE or the LSE for that matter. One of the things you want is to make sure that weak companies don't end up being registered in the US, so in that sense, Sarbanes-Oxley has fulfilled its job. Sure there are a lot of companies that want to register but not all of them are good companies. The challenge is making sure that good companies can register and raise capital.

SOX FIRST: But doesn't that miss the point? The most recent figures show that it's costing US companies $6 billion a year to comply with Sarbanes-Oxley. That's a lot of money, particularly for small business.

HEALY: I'm sure there have been some excesses in Sarbanes-Oxley, particularly for smaller companies. Those things are being straightened out. The SEC has made changes that will affect that. But I'm not convinced by the evidence people point to when they say look at all the companies registering in Europe and that it's the demise of the US capital markets. Do you want to cater to the less reputed firms and attract those firms?

SOX FIRST: The problem with Sarbanes-Oxley is that was rushed through without any cost-benefit analysis. What are your thoughts?

HEALY: It was absolutely rushed through and I'm not saying that things couldn't have been done more effectively. But I think there have been a lot of positive things out of Sarbanes-Oxley and some of the costs that people talk about have gotten exaggerated because I think US companies in particular and probably throughout the world under-invested in internal controls for 15-20 years. So a big part of what happened was there was a recognition that there needed to be some catch up. The fear that I have is that you get a check-the-box mentality. People initially are very attuned to the problems and they spend a lot of time worrying about it but over time, companies start to check the box to make sure they meet these conditions and then you of end up getting not good governance. That would be my fear.

SOX FIRST: Has that already happened?

HEALY: I think there has been a decline in vigilance I would say relative to a few years ago. A few years ago there was excessive vigilance. There certainly has been a relaxation and the question is if that trend continues, then I fear you might end up with some of the same problems we saw before.

SOX FIRST: What about the big changes to auditing since Sarbanes-Oxley? What are your views?

HEALY: I don't think you can regulate good governance, in the extreme. But one of the structural changes that Sarbanes-Oxley made was the idea that the external auditor not report to management. It was a very positive change, provided the audit committee continued to be vigilant. I always felt it was bizarre that the auditors felt their boss was management.The audit profession is now overseen by the PCAOB. It remains to be seen how effective that organisation is. I personally think there are some bigger issues that the audit industry will face, for example the move to fair value accounting which is in the offing. In the US, the proposal is that when you buy another company, the goodwill that you bought would not just be what you paid but what you think that goodwill is worth. If anything, what we learned from Enron is that when you give that amount of judgement to management, it's going to get misused.

SOX FIRST: Let's just go back to what you just said, that you can't regulate good governance. Can you explain that a bit more?

HEALY: Part of the problem is that what drives good governance is a well-functioning board, a board that is able to think independently about problems, a board that is not going to just take management's opinion and judgement, a board that will think about it and discuss it and reach independent assessment, a board that empowers the auditor to do a good job, a board that takes its task of appointing a new CEO seriously and thinks about what type of individual is needed to address the problems. Now, those sorts of attributes, frankly, you can't regulate. You can't regulate someone to do a good job. You can certainly explain to them what is best practice and what doing a good job means.

SOX FIRST: One of the big issues facing companies now is the concentration of power in audit. The Big Four have enormous market power. Is that sustainable? Can that concentration of power be be unwound?

HEALY: I think it's going to be difficult to do that frankly. I think that you will eventually end up with some others, the next tier firms, becoming larger and more viable. Companies certainly dislike that they have such little choice, they want there to be more options and the only way for that to happen in a free market is for some firm like Grant Thornton to move up the standings.

SOX FIRST: The big corporate governance issue now is executive pay. How should companies handle this and what sort of future developments do you see happening in this area?

HEALY: I fear that there will be some regulation that will not be very helpful. It could be that regulation might be that shareholders get to vote on the compensation package. I don't know whether that would slow things down or not because there is so much apathy among shareholders. I don't know if shareholders would be willing to take a stand on it. Unfortunately we live in a society where it is more and more winner take all. You can look at any occupation, the top person in that profession or job ends up making a lot of money. I'm not sure there is an easy answer. But at the extreme, when you think of economies like Australia or the US, there is a very large middle class that feel they can work within the system because they see there is some upside opportunities for them and their children to have a good way of life. If you look at other economies that have an elite and very wealthy and extreme part of the population and then a lot of very poor people, then the political processes in those countries tends to be a lot less stable. My fear would be that our economies would become less politically stable.

SOX FIRST: Let's get this right. Are you saying that if the executive compensation problems isn't fixed we could go the way of places like Mexico or Russia?

HEALY: We could end up looking like those. It may take some time to do that. The point is it's not just CEOs. There are people who become enormously wealthy. Look at sports stars, look at entertainment stars. A few people make enormous amounts of wealth and others don't. What I would worry about is that you end up with a very elite class of very wealthy and the middle class finds it increasingly difficult to make ends meet and to have the sort of lifestyle that they thought they would be entitled to or thought they were going to have. And that's a recipe for political unrest. I don't know how long that would play out but you can see it playing out in other countries and my fear would be that we end up going that way.

SOX FIRST: The other big corporate governance issue is private equity. What are your views on that?

HEALY: I don't think private equity is that new. Go back to the '80s and it was leveraged buyouts. But the form of financing now is different. The financing back then was junk bonds and now it's wealthy individuals who are able to put their money into these private equity funds and invest in these things. I guess my concern is less about governance and more about performance. I think private equity today is the venture capital of five years ago. If you look at venture capital of the late '90s, there was a huge amount of money chasing after venture capital business. There was more money chasing opportunities than there were opportunities so we got this crazy pricing in the market for technology stocks and the reason was that many investors felt that venture capital was a great way of investing. It generated great returns and allowed a lot of people to get very wealthy in the early '90s. Venture capital had an economic rationale and had a place. I think private equity is the same. There is a very strong economic rationale for why you might have it in our marketplace. There are firms that can be better managed outside the public arena and debt has a great way of disciplining management and making sure costs get squeezed out and poor performing companies have a chance to be restructured and put back into the public market. The thing I worry about is because of their visibility, because people have looked at the great returns that have been generated by some of the largest most powerful private equity firms over the last five to 10 years, that it's going to keep happening. There's lots of money flowing into this industry and probably there will be some deals that won't generate returns for shareholders and some people will end up getting burned, in the same way that happened with leveraged buyouts in the '80s. These innovations that happen in the market, many of them have a strong rationale. My only caution is for people to be careful because the average investor is not going to invest in the great private equity firms. Your average investor isn't going to get to invest in the great private equity firms. It's going to be the people with big money, the institutions that will have a chance to invest in those. There may be more opportunities to invest in less effective private equity firms. My view is it's buyer beware. But you have to make sure that people are aware that there are risks with investing and they need to be careful. Where regulation is required is for more transparency, transparency of returns, transparency of performance for these investment vehicles, because I don't think it's that transparent at the moment At least then you will be likely know which funds are going to be the ones you want to put your money in and which ones aren't."