Ira Millstein on Greed governance and selfcorrection

Monday, 01 April 2002


    Whenever corporate scandals occur the system of corporate governance comes under scrutiny.

    Legislators, investors and the public quite rightly question whether this system is working appropriately. In his testimony to a US Senate Committee, Ira M. Millstein* makes some observations on how the corporate governance system can be improved.

    Throughout my career I have counseled corporate boards, managers and investors on various corporate governance and regulatory matters and have studied closely our system of corporate governance regulation. 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. 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. These concerns are magnified when the integrity of the independent auditors, financial and investment advisers 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 recognised by Adam Smith in 1776, reiterated by Adolph Berle and Gardiner Means in 1932, 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. In addition, the tax code now provides tax incentives for certain performance-based compensation decisions when made by a committee of outside directors. 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. At the same time, audit committees, including disclosures about audit committee consideration of auditor independence, amended SEC disclosure requirements to require a significant amount of disclosure. 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 advisers 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 realisation 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." (Pearl Meyer & Partners memorandum re: Executive Pay Trends)

    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 board and 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. The board fulfills its role by delegating managerial authority to the managers, which it hires, monitors incentivises (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. 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 advisers) 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 audit committee

    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. 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. 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.

    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 judgment as to managerial performance, compensation, incentives and all other oversight matters are 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. 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), there is today no mandate regarding board independence and no widely applied definition of independence.


      • 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
      • 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 formalised 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--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 advisers for support. It may be fruitful for some staff resources to be explicitly devoted to supporting the work of the board.

    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. 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.

    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 realisation 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. 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 generalised stock market performance.
      • 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. (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. 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." (Cook) And directors should be discouraged from selling stock in the company during their tenure.

    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 recognise 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.

    Professional advisers

    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 realised. 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 judgment based approaches. 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. 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.


    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.) The great strength of our system is its ability to correct - sometimes by self-correction, sometimes with assistance from 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 . . ." 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.

    * Ira Millstein is the co-chairman of the Blue ribbon Committee on Improving the Effectiveness of Corporate Audit Committees, sponsored by the New York Stock Exchange and National Association of Securities Dealers, 1998-99. A senior partner in international law firm Weil, Gotshal & Manges, he has also taught corporate governance at Yale, Harvard and Columbia Universities


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