Speech by SEC Chairman:
Remarks at the 2003 Washington Economic Policy Conference


Chairman William H. Donaldson

U.S. Securities and Exchange Commission

National Association for Business Economics
Washington, D.C.
March 24, 2003

Thanks, Commissioner Glassman, for your generous introduction, and thanks to N-A-B-E for inviting me to speak before your highly regarded organization. The economics profession should be very proud indeed that one of your own, Cynthia Glassman, is making such a profound contribution to the vital work of the Securities and Exchange Commission. Before I go any further, I feel obliged to make the standard disclaimer that the views I express today are my own and not necessarily those of the Commission, or its staff.

As Commissioner Glassman noted, this is one of my first public appearances since my swearing in as Chairman of the SEC. I have to admit that when I heard "an audience of economists" I got a little nervous. Economists? How would I ever speak inspiringly about the latest theoretical developments or forecasting techniques? I knew that if I attempted to sound like an economist, I'd only make matters worse!

But to my relief, I was told that you were interested in hearing a few thoughts about corporate governance. I believe that the inattention to good corporate governance practices over the past decade or more is at the heart of what has gone so terribly wrong in corporate America in the past few years. If significant steps are not taken to revisit and remodel corporate governance practices, corporate America will continue to attract the anger and animosity not only of disillusioned shareholders, but also of a much broader cross-section of American society.

Corporate governance is, for sure, a hot topic these days. We have all seen countless articles in newspapers and magazines discussing the subject. We've heard numerous proposals from the exchanges, public policy think tanks, shareholder advocacy groups, and individual scholars. Congress, leaders of the Administration, and the SEC have put forth their own proposals related to corporate governance as well. It's no understatement to say that there are plenty of ideas out there, almost a cottage industry, and no shortage of opinions.

For the most part, this has all contributed to a healthy dialogue about what companies can and should do to ensure that they are living up to the expectations of investors and serving as respectable participants in America's business environment.

The intense discussion of corporate governance and increased scrutiny of business has already led to changes in corporate behavior and philosophy that go beyond the new laws and regulations. The most fundamental, almost seismic, change has been the growing recognition that the for the protection of investors, the primary responsibility for guardianship of corporate governance practices must reside with the board of directors and must not be diluted by the power of the chief executive.

Over the past decade or more, at too many companies, the chief executive position has steadily increased in power and influence. In some cases, the CEO had become more of a monarch than a manager. Many boards have become gradually more deferential to the opinions, judgments and decisions of the CEO and senior management team. This deference has been an obstacle to directors' ability to satisfy the responsibility that the owners - the shareholders - have delegated and entrusted to them.

The need for such a change has, of course, been driven by a distressing array of corporate malfeasance that is all too apparent. The corporate scandals have exacerbated the roughly $7 trillion collapse in the aggregate market value of American corporations over the past few years. We are all aware of the bubble that burst, led by dot-com mania, the explosive overexpansion of the telecommunications industry, and the availability of cheap capital due to historically low interest rates and historically high equity valuations.

The names from the recent big corporate scandals are by now infamous. The SEC's enforcement division, along with the Department of Justice and other members of the President's Corporate Fraud Task Force, continue to work double time to bring wrongdoers to justice - as demonstrated by new allegations of massive fraud uncovered just last week. While over 15,000 companies report to the SEC and the vast majority of them have sound, honest management and dedicated directors, the malfeasance that has occurred makes it apparent that reforms were and still are needed.

Millions of Americans have lost their jobs, much of their savings, or both. Such devastation goes beyond just a missed paycheck or decreased balance in a 401(k) account. Their loss is profound and public outrage should not be underestimated. It is, of course, exacerbated not just by corporate malfeasance, but also by the perception, and in many cases the reality, that those at the top have not shared in their loss; that those at the top have continued to enjoy massive salaries, bonuses, and perks unrelated to performance. The modest compensation cutbacks currently underway have seemed, to many, rather underwhelming.

A central point that I would like to make is that over the past decade, even many of the most well-intentioned companies that were consistently mindful of corporate governance got caught up in the boom times. Frequently, conceptions of responsible corporate governance were adjusted to accommodate the temptations of a runaway bull market. As the band played faster and faster, standards began to erode throughout the business community.

Corporate America developed a short-term focus, fueled by an obsession with quarter-to-quarter earnings and the pervasive temptation inherent in stock options. The game of earnings projections, and analysts who focused on achieving self-forecasted results (or a firm's failure to achieve those results) created an atmosphere in which "hitting the numbers" became the objective, rather than sound, long-term strength and performance. The perception that uninterrupted earnings growth was the hallmark of sound corporate progress made it irresistible for far too many managers to make little adjustments in financial reports to meet targeted results. Many times, such bad or questionable business decisions were rewarded with the afore-mentioned compensation packages that often bore no relationship to what I would call "real management performance."

Of course, it was not only corporate boards and executive management that allowed their standards to devolve. The gatekeepers who operate within and work for corporate America were very much a part of the problem. As the markets grew steadily higher, the appeal of getting in the game was irresistible. Suddenly, professional accounting firms and legal and financial advisors were offering new services designed to offer "value added" services for enhanced compensation where rigorous professional and ethical standards were tested, strained and sometimes broken.

When the steady market increases came to a halt, and the dishonesty of some in corporate America came to light, shareholders were often left holding the bag.

As a result of all this, as your conference program suggests, we may be on the verge of another activist economic policy regime similar to that of the 1930's, which resulted in the founding of the SEC and the 1933 and 1934 securities and exchange acts. My only amendment to the program's statement would be that in response to the events and revelations of the past few years, we have already entered such an activist policy regime. Sweeping new legislation has been enacted and expectations of corporate America and Wall Street have changed.

As we move forward, companies, their management, their directors and the gatekeepers who serve them must look beyond just conforming to the letter of the new laws and regulations. They must redefine corporate governance with practices that go beyond mere adherence to new rules and demonstrate ethics, integrity, honesty, and transparency. The recent shifting of primary corporate governance responsibilities to the Board of Directors demands that directors be the true stewards of corporate governance, and their actions must demonstrate their dedication to this stewardship without interference from the CEO.

Corporate governance means different things to different people, and it is in this philosophical area that I would like to direct a few thoughts.

Now, I don't want to beat up lawyers. In my new job, I'm more dependent on lawyers than I have ever been, and I have to be careful what I say or I could be in big trouble when I get to the office! But several weeks ago, I saw an ad in the pages of a daily newspaper that exemplified the possible risk of asking directors to simply comply with a static set of governance criteria. The ad was for a law firm offering its expertise to navigate the new corporate governance landscape. Among other things, the law firm promised to increase shareholder confidence, improve public perception, and reduce the likelihood of litigation and SEC investigation.

Such a "check the box" approach to good corporate governance will not inspire a true sense of ethical obligation. It could merely lead to an array of inhibiting, "politically correct" dictates. If this was the case, ultimately corporations would not strive to meet higher standards, they would only strain under new costs associated with fulfilling a mandated process that could produce little of the desired effect. They would lose the freedom to make innovative decisions that an ethically sound entrepreneurial culture requires.

As the board properly exercises its power, representing all stakeholders, I would suggest that the board members define the culture of ethics that they expect all aspects of the company to embrace. The philosophy that they articulate must pertain not only the board's selection of a chief executive officer, but also the spirit and very DNA of the corporate body itself - from top to bottom and from bottom to top. Only after the board meets this fundamental obligation to define the culture and ethics of the corporation - and for that matter of the board itself - can it go on and make its own decisions about the implementation of this culture.

This definition of culture - of what kind of company they want to be - will influence all their decisions, including what criteria they use when selecting a CEO, what criteria the CEO will use to select other management, how the board will function, what characteristics new directors should demonstrate, what the committees or instruments of the board should be, and what kind of leadership structure should be installed. This is, in my view, not a one-size-fits-all exercise.

Some practices and determinations are imperative in all cases. For example, it must be clear by now that boards of directors must demand the highest standards of integrity and dedication to investor interests in any candidate for chief executive. The tone at the top of an organization is perhaps more vital than anything else, and the chief executive will set that tone under the oversight of the board.

Sarbanes-Oxley addressed another absolutely essential aspect of good corporate governance when it mandated that all audit committees be composed entirely of independent directors. There is no doubt in my mind that the mandate of independence and the defined responsibility of the audit committee are essential to the new central role of the board.

Beyond this requirement, I believe we should go slowly in mandating specific structures and committees for all corporations. I applaud the work of many institutions, organizations and individuals, including the exchanges and other commentators on issues related to board structure in particular. Independence is a vital feature on boards, and on the important components that carry out board responsibilities, such as nominating and compensation committees. We should be seeking clear assurances of independence without excessive rigidity. There are vast differences in the function, structure and business mandate of the thousands of corporations struggling with the issues of good corporate governance. I believe that these differences dictate that once the board determines the ethical culture that is to prevail, each company board should be afforded a level of flexibility to create their own approach to its structure.

Let me illustrate with a few priority issues that a board might consider as early steps in a review of its organization. On the matter of board leadership - should the Chairman be non-executive; should the CEO be prohibited from being Chairman too; should there be a lead director? I would say that there is no one answer to these hotly debated questions for the single reason that at any particular point in the development of a corporation, one or another of these approaches may be appropriate. To insist on one rule for all belies the dynamics of the fast changing business and corporate environs and the nature of varied business situations. In particular, we must all remember that the honest and dedicated chief executives must have the freedom to run the corporation under the oversight of the board, and do so in a way that permits leadership, entrepreneurship and the taking and management of risks that have been characteristic of successful American business.

I mentioned compensation a moment ago. In my view, compensation is a key area where strong corporate governance is now essential. Directors should examine their dependence on management and compensation consultants when making decisions about compensation for the chief executive and other senior management. The conventional wisdom of many corporate boards these days has become that in order to remain competitive, executive compensation must be in the top quarter of companies in their industry. But we don't live in Lake Wobegon, where as Garrison Keillor says, "All the women are strong, all the men are good looking and all the children are above average." Such a description makes you think long and hard about moving to Minnesota. But obviously, it's literally impossible for everyone to be above average or, in this context, for every company to be in the top quarter. It is the job of the board to set appropriate compensation that is related to the goals and performance of top management, not the pressure to meet an artificial standard informed by outside consultants who do not share the responsibility of being board members.

In addition, each director and the board as a whole must make an honest assessment of how many boards and committees he or she and, for that matter, board candidates can serve on while maintaining the dedication and responsibility that is demanded of them these days. Anything less would be a disservice to other board members, company employees and, of course, the shareholders and stakeholders.

If such an assessment by all sitting directors limits their availability to serve as directors or audit committee members for as many companies as in the past, there will be vacated board seats to fill. For a long time, corporate America has depended on many of the same sorts of people to fill director slots: CEOs called on other CEOs, friends called upon friends. I understand that well over a majority of directors of New York Stock Exchange companies are CEOs. In my view, that represents excessive reliance on one model of outside director. Finding good, qualified directors is no small task, but it is time that we expand the talent pool and create a new generation of directors.

In this regard I have been pleased to see the growth of new efforts to educate new potential directors through training programs around the country. I commend business schools, law schools and organizations such as the New York Stock Exchange and others for their commitment to establishing these programs, and I encourage them all to be creative in their approaches. SEC Commissioners and staff have been involved in a number of these programs, and I pledge that the SEC will help in any way possible to accelerate these efforts.

Just as there is no one prescription for corporate governance, there is no one correct way to train a new cohort of directors. I encourage those who conduct director training programs to look beyond the traditional methodologies and include not only a study of law and business practices, but also an examination of the interpersonal human dynamics that influence a board and its decision making. One of the most interesting evaluations of a board that I ever read was not done by a lawyer or an MBA, but by an organizational behaviorist.

As business economists, your interest in corporate governance likely goes well beyond the few ideas I've discussed today. Your interest probably lies in the economic effects that new corporate governance practices will have on your individual companies. I hope that you might, as time goes on, add your voices to the debate underway and your analytical expertise in evaluating the actual results of the different approaches that will be taken.

Let me conclude by saying that the American financial system and our markets are the strongest in the world. I am proud to have been a participant in American business for most of my professional life. Although we are in a period of economic stress and uncertainty, the fact that we are undergoing the type of open and positive approach to rectifying the mistakes of the past is the hallmark and strength of our system. Taking further steps to strengthen business by reaffirming our commitment to transparency, accountability and shareholder interests is essential to restoring investor confidence and can only make us stronger. It's true, there may be costs associated with doing so, but the costs of turning a blind eye will be far greater in the long run.

I hope that you will agree that the most important first step for a board grappling with the issues of corporate governance is not debating the issues of structure. Rather, it is defining the parameters of an inviolate corporate culture, by answering simple questions: "What kind of moral compass do we want guiding this corporation? What ethical standard do we want embedded in this corporation's DNA? How will we demonstrate it in our every action? How can we protect the long term interests of our investors?"

Thank you very much for having me here today. I'll be happy to take a few questions from the audience.