Chairman Sarbanes, Ranking Member Gramm, and Members of the Committee:
I am pleased to appear before you in my capacity as Co-chairman of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees ("Committee on Audit Committee Effectiveness"). This Committee was convened in 1998 by the New York Stock Exchange ("NYSE") and the National Association of Securities Dealers ("NASD") at the request of Securities and Exchange Commission Chairman Arthur Levitt. The Report we issued in 1999 addressed concerns that are closely related to the concerns about the integrity of financial reporting, the audit and accounting profession and corporate governance that are at the heart of this hearing.
At the outset, be advised that I am a senior partner in the international law firm of Weil, Gotshal & Manges LLP. Several months ago, in the fall of 2001, my firm was hired to counsel Enron in its bankruptcy restructuring. The firm was not regular counsel to Enron previously. I am not actively engaged on the Enron matter, although my partners have consulted with me from time to time on certain corporate governance issues relating to the bankruptcy. I have no knowledge of the events leading up to the bankruptcy filing other than what has appeared in the media. In addition, over the years my firm has represented Arthur Andersen in litigation and other matters unrelated to Enron. I have no knowledge of Andersen's relationship to Enron, other than what has appeared in the media.
My testimony today as Co-chairman of the Committee on Audit Committee Effectiveness does not necessarily reflect the views of Weil, Gotshal & Manges LLP or any of my partners. I have not consulted any client in regard to this testimony, and therefore it does not reflect the views of Enron, Andersen or any other client of my firm.
You have asked that I provide recommendations for legislative and regulatory responses to what appears to be an increasing incidence of high-profile financial reporting and governance failures in recent years. Throughout my career I have counselled corporate boards, managers and investors on various corporate governance and regulatory matters and have studied closely our system of corporate governance regulation. (I have also taught graduate business school courses on corporate governance at Yale, Harvard and Columbia.) Over this period, one element has remained constant: Our market system is not static; it is dynamic -- constantly changing. Our corporate governance system continuously adjusts and improves in response to failures, whether through voluntary adjustment of board practice, new listing rule requirements, amendments to SEC disclosure rules, or various related pieces of legislation, for example, in the area of tax incentives. High-profile corporate governance failures should not be interpreted, therefore, as failures of capitalism or capital markets. Rather, these failures should be viewed as cause for further adjustments and corrections to our corporate governance system. Such adjustments should focus on the factors that are key to the problems emerging in today's corporate environment: management incentives, true independence and diligence on the part of corporate directors -- who are charged with monitoring managers -- and the professionalism of those upon whose advice directors need to rely in carrying out their role. These events present a challenge for all of us to avoid overreacting, and to limit our interventions to fine-tuning a system that usually works well.
The Current Problem
I will focus today on what I consider the core of the current problem: The incentives and disincentives that can drive managers and boards and those who advise them to push to the limit, and sometimes beyond, the numbers that are meant to reflect the company's financial performance and health. We should seek incentives and disincentives that are more carefully attuned to pressures in the current environment.
I wish we could solve today's problems by urging all participants in our market system, and particularly in our corporate governance system, to act moderately and prudently, fairly and ethically. If all did so, corrective action would not be necessary. As Oliver Wendell Holmes recognized, however, humans can not be expected to act moderately, prudently, morally and ethically at all times.(1) He noted that law and regulation generally, therefore, must address, by providing countervailing incentives and disincentives, the prospect that self-interest may lead persons to act "badly." This applies to corporate governance regulation as well. Self-interest -- which a market system relies heavily upon -- can interfere with the moral, ethical and legal obligations of directors and managers to protect and enhance the assets of the corporation that are committed to their care by, and for the benefit of, others.
An effective system of corporate governance must strive to channel the self-interest of managers, directors and the advisors upon whom they rely into alignment with the corporate, shareholder and public interest.
In the last decade, management has faced increased market pressures for short-term stock price performance and corresponding pressures to satisfy market expectations on a quarterly basis. This, coupled with increasing grants to senior executives of stock options and other incentives that are focused on short-term stock appreciation, may have created incentives that tipped the balance toward the promotion of self-interest rather than the protection and promotion of long-term shareholder value. As one of the country's leading compensation experts noted recently:
"It is . . . possible that stock option grants have become so large at top management levels that they encourage high risks to reap high rewards. Perhaps the power of incentives to motivate is not linear. If stock options are good, are more stock options better? Once stock option grants have become sufficient in amount to provide the right balance between operational and market incentives, whatever that amount is, what is the purpose in granting more? Is it merely wasteful, or is it possible that it goes beyond waste to create perverse incentives that destabilize a company?"(2)
These concerns are magnified when the integrity of the independent auditors, financial and investment advisors and analysts, and lawyers upon whom directors, managers and the public rely for a fair picture of the company's performance and prospects, may also be skewed by self-interest.
In a general sense, these are not new concerns. The key issue in corporate governance regulation throughout the history of the joint-stock corporation, as recognized by Adam Smith in 1776, reiterated by Adolph Berle and Gardiner Means in 1932,(3) and repeated by numerous observers since, has focused on the "agency problem": It is a given that directors and managers are fallible human beings (like all of us). Therefore, they may not always subordinate their self-interests to the interests of those on whose behalf they are acting. And this is true of auditors, analysts and lawyers as well. This "agency problem" should be periodically reassessed to account for the circumstances of each era.
Over the past decade and a half, these issues have gained considerable attention as they relate to publicly traded corporations. In particular, added emphasis was given to the importance of board composition, as well as to increased transparency about corporate governance processes and structures. With respect to board composition, the theory is that a board of directors comprised of a majority of knowledgeable individuals who are not members of management and who lack business or family ties to management will be more likely to provide effective oversight of the managers, and circumscribe the "agency problem."
A number of recommended corporate governance best practice guidelines have issued from various sources.(4) In addition, the tax code now provides tax incentives for certain performance-based compensation decisions when made by a committee of outside directors.(5) Notably, within the past two years, listing rules of the NYSE, AMEX and NASDAQ were amended to require that every listed company have an audit committee comprised of at least three independent members.(6) At the same time, SEC disclosure requirements were amended to require a significant amount of disclosure by audit committees, including disclosures about audit committee consideration of auditor independence.
We have had only one year of experience under the new listing and SEC rules, so it may be premature to determine whether these improvements have had the intended impact. Nonetheless, we should now dig down and address root causes of the problems that have arisen.
One matter that requires attention is, as noted above, the possible over-reliance on compensation devices for managers and directors that are unduly linked to short-term stock market price performance. This link may cause managers and directors to focus too heavily on their own self-interest in short-term stock appreciation. As long as the investing public focuses on short-term stock price performance rather than long-term growth -- and this is not something that will readily change (and analysts and bankers play a role here) -- we cannot expect corporate managers to be fully resistant to market pressures. This pressure is exacerbated when managers receive compensation that permits, and even induces, taking advantage of short-term rises in stock price.
The markets tend to pressure managers to "make the numbers," and self-interest compounds the problem. Boards and regulators need to keep this in mind. They can and should focus on creating countervailing incentives. This same concern extends to those advisors whom directors must rely on to carry out their crucial oversight role.
Another leading compensation expert predicts that boards are learning that heavily concentrating compensation on short term market priced incentives, rather than on "real" economic performance, is not good for the business -- and that boards will self-correct:
"Re-balancing executive pay will be a major theme, as companies seek to reduce their reliance on the stock market and re-align their compensation programs to pay for "real" strategic and financial performance. There will be a new appreciation that successfully growing and running a business are of greatest value to shareholders in the long run, even if those efforts are not reflected in short-term stock price movement. This realization will result in some shift of compensation dollars from options to long-term incentives and to full-value stock grants earned on a performance basis."(7)
Even if this prediction about the developing trend in management compensation is accurate, in today's environment many may question whether this change will be broadly enough felt to deter future corporate governance failures without a push from regulators and/or legislators.
The Central Role of the Board in Controlling the "Agency Problem".
The board is the focal point of our corporate governance system. Pursuant to state statutes, it is elected by and accountable to the shareholders, and is charged generally with directing the affairs of the corporation.(8) The board fulfills its role by delegating managerial authority to the managers, which it hires, monitors incentivizes (compensates) and replaces when necessary. The board also is charged with oversight of the company's financial reporting and legal compliance. To do all this, it can -- and must -- reasonably rely on advice from professionals. Under our system, while management is responsible for maintaining the corporation's financial records and completing its financial reports, it is the outside auditors who provide assurance that the financial reports comply with generally accepted standards. The board selects the outside auditors and is charged with ensuring auditor independence necessary for attaining that assurance. The board also has available the advice of legal counsel to help assess the company's disclosure and other compliance obligations.
The board is not positioned to (and hence does not) manage, audit, practice law or render advice on the short- and long-term reactions of the market. Rather, it delegates to management, and then monitors the management and performance of the company, all on behalf of shareholders and the company.(9) In so doing, the board is entitled to reasonably rely on information and advice provided by managers, auditors, lawyers, bankers and others.
However, the board faces constraints in its monitoring ability that it must take into account related to pragmatics, capacity and context:
· Managers need flexibility to take the reasonable risks that are at the heart of entrepreneurialism; directors who constantly second-guess management's reasonable business judgments risk stifling management performance.
· Boards are comprised, increasingly, of directors who are not members of management, with good reason. However, this means that, as stated above, boards must place considerable reliance on managers for information about company affairs and performance and, therefore, there will always be some risk of both intentional malfeasance and unintentional failure going undetected at the board level for some period. This highlights the legal and practical importance of the reports that management (and professional advisors) make to boards. In the investigations now going on, sufficient attention should be given to this and to the consequences of inaccurate or misleading reports to directors.
· Much of what impacts company performance and can effect manager incentives may be outside the board's control, including the market's short-term focus and occasional "irrational exuberance."
The Committee on Audit Committee Effectiveness and Ensuing Reforms
Throughout the mid to late 1990s, the SEC expressed increasing concern about the integrity of financial reporting by publicly-traded corporations, fueled by a perception that corporate managers faced ever increasing pressures to match or exceed market analysts' expectations. The expressed concern was that this pressure would lead to increased corporate efforts to "manage" earnings -- to push the boundaries of Generally Accepted Accounting Principles in preparing the company's financial reports, and thereby obscure the true condition of the company. In 1998, the SEC encouraged the NYSE and the NASD to convene a private-sector Committee on Audit Committee Effectiveness to study the issues and make recommendations for encouraging greater financial reporting oversight by audit committees. I had the honor of co-chairing the committee with John Whitehead. (A copy of our Report and Recommendations (the "Report"), which includes a full list of committee members, is attached as Exhibit C.) Our Report contained ten recommendations, focusing on:
· Strengthening the independence of the audit committee;
· Improving audit committee operations; and
· Improving mechanisms for discussion and accountability among the audit committee, the outside auditors and management.
Our premise was that if boards and their auditors accepted a clear delineation of responsibilities for financial reports and the reporting process, and then acted diligently, the problem would self-correct. Our recommendations aimed to support a culture of integrity and independence. Soon after the Report was released, the vast majority of our recommendations were adopted. (They are attached hereto as Exhibit D.)
Audit committees of large publicly traded corporations appear to be abiding by the new rules. To the extent that corporate culture has been resistant to change at some companies, the current widespread concerns about auditor independence and the quality of financial reporting combined with media attention and the fear of shareholder litigation and reputational effect, are likely to shock audit committees into action. It may be premature to determine whether these improvements have yet had the intended impact. Nonetheless, it is appropriate to take a hard look at whether additional legislation, SEC regulation or listing rules could strengthen independence, provide more appropriate incentives and thereby help to restore investor confidence.
Significant legislative initiatives are already underway -- at last count, Westlaw listed over fifty pieces of Enron-related legislation.(10) In addition, the SEC has proposed certain disclosure-related reforms and is considering others. Recently, it asked the NYSE and NASD to review corporate governance listing requirements.(11) The suggestions that follow incorporate and build upon a number of suggestions advanced by others that I believe bear consideration:
Board Independence
Further and more serious consideration needs to be given to the issue of board independence, including the issue of independent board leadership. Providing objective judgement as to managerial performance, compensation, incentives and all other oversight matters is at the heart of what boards are supposed to do. Best practice recommends that, to ensure objective judgment in assessing management, boards of listed companies be comprised primarily of outside directors who in form and substance -- relationships, attitude and perspective -- are independent of management.(12) Attitude and perspective cannot be regulated, but conditions can be set to reduce the possibility that certain relationships between managers and directors will taint objectivity, and other conditions can be set to create an environment in which the right attitude and perspective is promoted. Other than the listing rules pertaining to audit committees (and certain tax incentives applicable to compensation committee decisions(13)), there is today no mandate regarding board independence and no widely applied definition of independence.
As to the issue of board leadership, we need to reconsider whether a corporate executive can adequately serve the board leadership function while heading up the management team that the board is charged with monitoring and incentivizing. Generally, managers disfavor separating the Chairman and CEO titles. In the U.S., the expectation among CEOs is that the culmination of a successful career includes the title of "Chairman and CEO." (Note, however, that this was the expectation in the U.K. as well, until the Cadbury Code -- and now the Combined Code -- recommended that two individuals hold the positions. Disclosure of the degree of compliance with these Codes was mandated by the listing rules of the London Stock Exchange. In the past decade, the practice of combining the titles -- and related expectations -- have changed significantly in the U.K., due solely to the pressure of this disclosure requirement.) Leading the board and leading the company are two very distinct and important jobs. Certain aspects of the board's leadership role -- those concerned with leading the review of management performance, including compensation, and potential management transactions with the corporation -- present a conflict of interest that makes it difficult, if not impossible, for a company executive to fulfill that role. Therefore:
· Boards of publicly traded corporations should be required (through listing standards) to include a majority -- I'd call for a substantial majority -- of "independent" directors under a strict definition of independence (ideally the same definition that applies to the audit committee, albeit with some refinement as described below).(14)
· The definition of director independence provided in listing rules (for audit committee purposes) should be reviewed to determine whether it adequately addresses all the relationships that may reasonably be expected to reduce independence. In particular, this review should consider relationships between directors and charities and educational institutions that receive significant grants from the corporation, and any consulting or other fee arrangements (other than regular compensation, within a usual range, for serving as a director) between directors and the corporation.(15)
· Boards of publicly traded corporations should be required (through listing standards) to constitute a compensation committee (much as they are currently required to have an audit committee) with entirely independent directors, using the strict definition of independence.
· Boards of publicly traded corporations should be encouraged through SEC disclosure requirements (or even required through listing requirements) to separate the position of CEO from that of board leadership. Board leadership should be provided by a non-executive director; one who is independent in all aspects. I would urge that this independent leadership be formalized in the position of Chairman, but title can be left to each board to decide.
· As a matter of best practice, independent directors and independent board committees -- including the audit committee and ideally the compensation and nominating/ governance committees -- should play a larger role in setting the "tone at the top." They should bear responsibility for company culture vis-à-vis financial reporting and "making the numbers," compensation and incentive decisions, management stockholding and trading policies, and policies concerning management transactions involving conflicts of interest.
· Although, the tone at the top cannot be mandated, the boards of listed companies should be required or encouraged (through SEC disclosure and listing requirements) to adopt, regularly review and disclose a corporate code of conduct that addresses conflicts of interest and management and director stockholding and trading policies. Clearly, the board should be responsible for overseeing its implementation and actions taken by boards to implement these policies should be disclosed, including any exceptions granted under the policies and the reasons therefore.
· It may be time to consider whether boards should be encouraged to rely on a small full time staff or regularly use outside advisors for support. Board work, for larger corporations, requires significant information, time and attention. For the board as a collective group of individuals who convene on a part-time basis to fulfill all that we expect may require more support than traditionally has been available. It may be fruitful for some staff resources to be explicitly devoted to supporting the work of the board. We should consider ways to encourage boards, or the independent directors as a group, to have available some staff and counsel resources of their own, distinct from staff and counsel hired by management, especially where potential conflicts with the interests of management are apparent (i.e., audit and compensation).
Changes along the lines outlined above would encourage boards to be more vigilant and diligent in protecting shareholder value and in devising the best means to deal with the risk that self-interest will diverge from the corporate, shareholder and public interest.
In considering these and similar measures, one should keep in mind the variety within the universe of publicly held companies in the U.S., not to mention the tremendous variety among companies in the rest of the world who compete in what is rapidly becoming one global capital market. In a market economy, variety and diversity can be a source of strength. We should be careful that any norms that are established be flexible enough to accommodate this diversity. Experience with corporate governance listing standards in the United Kingdom and Canada, suggest that often a "comply or explain" regimen is sufficient to induce widespread adoption of recommended practices without undue restriction on diversity.(16) Specifically, under such a system, a company is required to publicly disclose whether it follows the normative, yet voluntary, standard and to explain the reasons for any non-compliance. This allows flexibility while still asserting reasonable pressure for compliance. It also provides investors significant amounts of information about the governance of companies, which can be used for investment and voting decisions. It may be time to consider what should be embedded in mandatory listing requirements and what should be encouraged through flexible "comply or explain" disclosure requirements. But more yet may be needed.
Compensation Issues - The Core
The growing practice of compensating managers with stock and stock option grants, which managers are then allowed to sell or exercise within a relatively short period of time -- and during their tenure at the company -- can, as noted above, create inappropriately short-term and stock-price focused incentives, and thereby exacerbate the agency problem in the context of a short-term oriented market. Performance compensation based on a snapshot of stock market performance at a single point in time chosen by the manager may not provide incentives for the kind of management activity that is "good" for the company and shareholders as a whole in the long run.
Over the past decade, companies have turned increasingly to stock-based compensation both as a form of pay-for-performance and as a means of aligning the self-interests of managers with the interests of shareholders. Indeed, I was among those who urged stock compensation as a method of aligning the interests of management (and directors) with shareholder interests. However, when managers are compensated with significant stock awards or stock options and are allowed to trade in that stock in the short-term (subject only to insider trading restrictions), their self interest in relatively short-term stock market fluctuations may conflict with their need to focus on both the long-term viability of the company and improvements in its long-term profitability. In particular, the focus on stock-based compensation, without conditions linking stock awards to realization by managers of long-term performance goals, may have put in place incentives that promote managerial self-interest to diverge from the corporate, shareholder and public interest. In some cases, such compensation may have crowded out other more traditional means of compensation that supported a longer term view, thereby producing an imbalance in incentive compensation that is especially counterproductive.
In 1996, Yale economist Paul W. MacAvoy and I co-authored a paper entitled "The Board of Directors in the American Corporate Form as the Instrument for More Effective Governance."(17) (A copy is attached as Exhibit E.) In it, we discussed the use of stock in pay-for-performance schemes and, in particular, the inappropriate incentives that linking such schemes solely to short term movements in stock price might create. We said:
"stock [based compensation] plans should be further refined to motivate the managers to achieve longer term growth and to sharpen their concern for the value added from improved strategies. Stock grants can be programmatic, but with sales restrictions, or even postponement of sales until retirement, so as to focus incentives on the long term."(18)
Directors should seriously rethink stock-based compensation that creates short-term incentives to raise stock price rather than long-term incentives to improve performance and enhance value appreciation. It is with these concerns in mind that I recommend the following for consideration:
· Pay-for-performance programs should be linked to measures of profitability or economic value added rather than short-term changes in stock market valuation. In any event, they should be designed to consider company performance relative to peer group performance, and not simply generalized stock market performance. Although I have some reservations about the use of the tax laws to further corporate governance policy, consideration could be given to creating a stricter definition of what constitutes "performance based" compensation for purposes of Section 162(m) of the Internal Revenue Code.
· Mechanisms should be developed to encourage executives and directors to hold stock they receive, whether in the form of stock grants or stock options, for a significant period of time. Ideally, companies should restrict or discourage sale of company stock during a director's tenure and require or encourage significant holding periods for executives.(19) (Of course, some flexibility may be required for special circumstances, for example, for start-ups that lack sufficient cash to pay executives what they are worth.) Again, while tax solutions pose concerns, consideration could be given to creating tax incentives designed to encourage executives to hold stock. Such incentives could include, for example, gradually reducing over some period of years the tax rate for grants of stock or exercise of options from the rate applicable to ordinary income to the most favorable rate for long-term capital gains. Alternatively, tax incentives could be created to encourage companies to contractually restrict the ability to transfer stock in grants of stock and stock options.
· Prompt disclosure of all transactions in the company's stock by corporate executives and directors should be required.(20) At the very minimum, the current rules that allow for once-a-year disclosure of sales of stock back to the company should be eliminated.
· Directors should be compensated fairly for the time necessary to fulfill their responsibilities. As a matter of best practice, however, stock options should be avoided altogether -- especially those exercisable within a short period. "The motivation of directors are and should be different from those of management. Directors are not strategic partners with management in creating value for shareholders; they are guardians of shareholders' interests." (21) And directors should be discouraged from selling stock in the company during their tenure.
These recommendations may seem a bit draconian, given what became the widely accepted compensation trend in the 1990's. However, before wide-spread use of such compensation devices, United States corporations and the economy succeeded -- and with considerable might -- by compensating high-performing managers with salaries, bonuses, and some long-term stock opportunities.
Conflicts of Interest
Transactions between the corporation and its managers, directors or large shareholders are rife with potential conflicts of interest. Most large publicly traded corporations have codes of conduct for addressing such conflicts that recognize that some conflicts are inevitable. While that may be so, the corporate culture should view transactions that involve conflicts -- especially with members of senior management or directors -- as highly suspect, and to be avoided if at all possible. Therefore, as alluded to above:
· The boards of publicly-traded companies should be required or encouraged to adopt, regularly review and disclose a corporate code of conduct that addresses conflicts of interest, and management and director stockholding and trading policies. The actions taken by boards in implementing these policies should also be reported on, including disclosure of any exceptions granted under these policies and the reasons for the exceptions.
· SEC rules should be amended to mandate prompt disclosure of transactions between the corporation (or its affiliates) and members of senior management, directors or controlling shareholders.(22)
Professional Advisors
To obtain a fair picture of corporate performance and prospects, the shareholding public relies on managers and directors as well as on auditors, analysts, and those who advise the company, all of who are susceptible to self-interest. Appropriate incentives and disincentives are required to protect against self-interest from overcoming the professional responsibilities of auditors, analysts and lawyers.
Obtaining the appropriate balance in the relationship between the board, the auditor and management is key to audit integrity and both the auditors' and the board's ability to perform the role expected. Significant efforts to improve auditor independence were recently undertaken by the SEC, and it is not yet clear whether the intended outcome is being fully realized. In particular, as noted above, it is only within the last year that audit committees have been required to both determine and report on auditor independence. Nonetheless, numerous recommendations for additional reforms have already been floated. They range from bright line prohibitions, for example, absolute limitations on the provision of non-audit services to audit clients and requirements for auditor rotation, to more judgement based approaches.(23) While bright line approaches are attractive because of the certainty they create, careful consideration needs to be given to the potential for unintended consequences.
· Consider whether instead of asking the audit committee simply to review the possibility of conflicting relationships after the fact, it might be preferable to ask the audit committee to start with the decided presumption that audit and consulting don't mix. (The industry is already considering eliminating the mix, voluntarily.) Then, leave it to the audit committee to decide on creating an exception when it deems an exception necessary and desirable for the company and its shareholders.
Analysts and investment bankers also have potential conflicts of interest. The NASD has proposed changes to the rules for addressing conflicts of interest that arise when analysts are employees of investment banking or other firms having business relationships with, or who themselves own securities of, the company involved. Among other things, the proposal would mandate increased disclosure of conflicts in analyst reports and prohibit the investment banking arm from supervising or controlling research analysts or approving analyst reports. It would also prohibit approval of analyst reports by the subject company, prohibit a link between analyst compensation and specific investment banking transactions, and require disclosure in analyst reports if analyst compensation is based in part on investment banking revenues.(24) Some observers may prefer bright line prohibitions against analyst coverage of any stock in which the analyst has an ownership interest or in which the analysts' firm is engaged in a transaction.
I would be remiss if I did not discuss lawyers and their self interests. Lawyers play a critical role in both supporting the governance efforts of boards and assisting managers to structure transactions while abiding by legal requirements. A classic dilemma is posed, however. Lawyers often identify with the management team and view themselves as strategic partners in achieving the client's business goals. And they may well perceive that the more effective they are in helping to achieve management's goals, the more likely it is that they will receive additional business. Yet lawyers also are expected to provide professional judgment and counsel management about the legal boundaries and, in particular, to view their clients as more than just management, and to include the corporation and its shareholders. I would urge the American Bar Association to review ethical conduct rules and, in particular:
· Consider whether ethical conduct rules give lawyers sufficient guidance in balancing these roles; and
· Consider encouraging a set line of reporting for in-house counsel to bring to the board concerns not otherwise acted on by management.
I support SEC Chairman Pitt's recent call for both lawyers and accountants to "move away from wooden, rigid, literalism," and "adopt a bias in favor of the needs of the investing public."(25)
Conclusion
My suggestions can be boiled down simply to this: diligent independent directors, properly led, informed and assisted, can circumscribe the agency problems. If managers are not overly motivated by options to seek short-term market price appreciation, they should be less likely to -- consciously or unconsciously -- push the numbers, push their auditor and push the analysts. (Other compensation means are available to handsomely reward managers for true performance successes.) If auditors, analysts and lawyers remove the conflicts that stand in the way of the true professionalism the public expects, they are more likely to resist.
As I said at the outset, the great strength of our system is its ability to correct -- sometimes by self-correction, sometimes with assistance from the SROs, the SEC, the legislative bodies both state and federal, and the courts. If self-correction by the private sector will not suffice (and in many respects it does not appear likely to fully address the current concerns), then look to the listing bodies and their contractual power to bind listed companies, together with greater SEC disclosure requirements. When that won't suffice, look to legislative solutions. We must remember, however, as recently well-put by the Financial Times, that "no set of regulations, no matter how detailed, can outmanoeuvre a really determined manipulator. . . ."(26) The great conundrum is that notwithstanding all our efforts for corrections, ultimately, to considerable degree, we are left to rely on the integrity of individuals.
1 Oliver Wendell Holmes, "The Path of the Law," in The Path of the Law and its Influence: The Legacy of Oliver Wendell Holmes, Jr., 333, at 335 (Steven J. Burton, ed., 2000).
2 Frederick W. Cook & Co., Inc. Memorandum re: The Implications of "Enron" for Executive and Director Compensation at 2 (February 6, 2002) ("Frederick W. Cook Memorandum"). (A copy is attached as Exhibit A.)
3 Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, Vol. II at 264-65 (E. Canaan edition, 1776); Adolph Berle & Gardiner Means, The Modern Corporation and Private Property, at 123 (1932).
4 See National Association of Corporate Director ("NACD"), Report of the NACD Commission on Director Professionalism (1996, reissued 2001); The Business Roundtable, Statement on Corporate Governance (1997); American Federation of Labor and Congress of Industrial Organizations ("AFL-CIO"), Investing in Our Future: AFL-CIO Proxy Voting Guidelines (1997); California Public Employees; Retirement System ("CalPERS"), U.S. Corporate Governance -- Core Principles & Guidelines (Apr. 13, 1998); Teachers Insurance and Annuity Association -- College Retirement Equities Fund ("TIAA-CREF"), TIAA-CREF Policy Statement on Corporate Governance (2000); Counsel of Institutional Investors, Core Policies, General Principles, Positions & Explanatory Notes (2001). See also Organisation for Economic Cooperation and Development (OECD) Ad Hoc Task Force on Corporate Governance, OECD Principles of Corporate Governance (May 1999), available at www.oecd.org/daf/governance/ principles.htm (setting forth international principles of corporate governance.)
5 I.R.C. § 162(m).
6 See Order Approving Proposed Rule Change by the NYSE, Exchange Act Release No. 42233, File No. SR-NYSE-99-39; Order Approving Proposed Rule Change by the AMEX, Exchange Act Release No. 42232, File No. SR-Amex-99-38; Order Approving Proposed Rule Change by the NASD, Exchange Act Release No. 42331, File No. SR-NASD-99-48.
7 Pearl Meyer & Partners Memorandum re: Executive Pay Trends: Looking Forward and Back at 2 (February 2002) ("Pearl Meyer Memorandum")
8 See e.g., Del. Gen. Corp. Law § 141 (CSC 2002).
9 See American Law Institute, Principles of Corporate Governance: Analysis and Recommendations § 3.02 (1994).
10 A complete list of proposed legislation is available from the Enron-bills database found at http://www.westlaw.com, searching the terms "House" or "Senate."
11 See Press Release, Securities and Exchange Commission, Pitt Seeks Review of Corporate Governance, Conduct Codes (Feb. 13, 2002), available at http://www/sec/gov/news/press/ 2002.23.txt.
12 See supra note 4.
13 I.R.C. § 162(m).
14 The SEC has asked the listing bodies to review corporate governance requirements. Press Release, Securities and Exchange Commission, Pitt Seeks Review of Corporate Governance, Conduct Codes (Feb. 13, 2002), available at http://www/sec/gov/news/press/ 2002.23.txt. See also The Fall of Enron: How Could It Have Happened?: Hearing Before the Senate Comm. on Governmental Affairs, 107th Cong. (2002) [hereinafter Governmental Affairs Hearings] (statement of Arthur Levitt Jr., Former Chairman, Securities and Exchange Commission (1993-2000)), available at http://www.senate.gov/~gov_affairs/012402levitt.htm ("[S]tock exchanges, as a listing condition, should require at least a majority of the directors on company boards to meet a strict definition of independence). The current independence definitions applicable to the audit committees of listed companies can be found in the sources listed in Note 6.
15 Id.
16 See London Stock Exchange Committee on Corporate Governance, The Combined Code: Principles of Good Governance and Code of Best Practice (July 1998), available at www.ecgn.org; Toronto Stock Exchange Committee on Corporate Governance in Canada, "Where Were The Directors?": Guidelines For Improved Corporate Governance in Canada (Dey Report) (December 1994), available at www.ecgn.org.
17 Paul W. MacAvoy & Ira M. Millstein, "The Board of Directors in the American Corporate Form as the Instrument for More Effective Governance," in The David Hume Institute: The First Decade (1996).
18 Id at 7.
19 Holding restrictions could apply to all stock received, or just apply to a high percentage (80 to 90 percent). See Cook, supra note 2, at 4 (discussing retention ratios in the context of company ownership guidelines or policies).
20 See Accounting and Investor Protection Issues Raised by Enron and Other Public Companies: Oversight Hearing Before the Senate Comm. on Banking, Hous., and Urban Affairs, 107th Cong. (2002) [hereinafter Banking, Hous. and Urban Affairs Hearings] (statement of Richard C. Breeden, Former Chairman, Securities and Exchange Commission (1989-1993)), available at http://banking.senate.gov/02_02hrg/021202/ breeden.htm (suggesting that disclosure of all stock transactions by senior corporate executives be sped up); see also Legislative Solutions to Problems Raised by Events Relating to Enron Corporation Hearing Before the House Subcomm. on Capital Markets, Ins. and Gov't Sponsored Enter., 107th Cong. (2002) (statement of Harvey L. Pitt, Chairman, Securities and Exchange Commission), available at http://www.sec.gov/news/testimony/020402tshlp.htm ("One area of possible legislation already identified is the need to require corporate insiders to make public their trading activities more quickly than current law requires").
21 Cook, supra note 2, at 6.
22 See Press Release, Securities and Exchange Commission, SEC To Propose New Corporate Disclosure Rules (Feb. 13, 2002), available at http://www/sec/gov/news/press/2002.22.txt (announcing that the SEC will propose rules that will "provide accelerated reporting by companies of transactions by company insiders in company securities including transactions with the company").
23 See Banking, Hous., and Urban Affairs Hearings, supra note 20 (Statement of Richard C. Breeden) ("One means of insulating the audit firms from the pressure of keeping the audit engagement would be to provide for mandatory limits on audit engagements to a specified period of time, such as 5-7 years."); Governmental Affairs Hearings, supra note 14 (Statement of Arthur Levitt, Jr.) ("I also propose that serious consideration by given to requiring companies to change their audit firm - not just the partners - every 5-7 years to ensure that fresh and skeptical eyes are always looking at the numbers."); Banking, Hous., and Urban Affairs Hearings, supra note 20 (statement of Harold M. Williams, Former Chairman, Securities and Exchange Commission (1977-1981)), available at http://banking.senate.gov/02_02hrg/021202/williams.htm ("I would urge the [Securities Exchange] Commission to consider a requirement that a public company retain its auditor for a fixed term…"); Harrison J. Goldin, Editorial, Auditor Term Limits, N.Y. Times, Feb. 1, 2002, at A25; Banking, Hous., and Urban Affairs Hearings, supra note 20 (statement of Roderick M. Hills, Former Chairman, Securities and Exchange Commission (1975-1977)), available at http://banking.senate.gov/02_02hrg/021202/hills.htm (stating that the "ultimate weakness" of the financial reporting system is that it "suffers from too many rules" and should be instead allow auditors to make their own judgements "drawn from a conceptual framework").
24 National Ass'n Sec. Dealers, Inc., Proposed Rule Regarding Research Analyst Conflicts of Interest, File No. SR-NASD-2002-21, filed with Securities and Exchange Commission Feb. 7, 2002, available at www.nasdr.com/analyst_guide.htm; see also S. 1895, 107th Cong. (2002).
25 Public Statement by SEC Chairman Harvey L. Pitt at the SEC Speakers Conference, Washington, DC, February 22, 2002.
26 "Reforms to Restore Confidence in Business," Financial Times, February 19, 2002, at 14.
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