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Illustrations by James Yang
Since the stock markets peaked in 2000, a series of accounting and financial scandals at publicly held firms have shattered public confidence and spurred legislators and regulators to act. Measures like the Wall Street research settlement and the Sarbanes-Oxley Bill were aimed at rooting out some of the conflicts of interest embedded in the corporate governance system. Some critics charge that the reaction has gone too far, while others believe much more work needs to be done. On May 29, 2003, as part of the first Directors’ Institute, a distinguished panel gathered to discuss the issues surrounding corporate governance. It included: Richard Fuld, Jr., (Stern MBA ’72), the chairman and chief executive officer of Lehman Brothers; Felix Rohatyn, the long-time Lazard Freres partner who served as chairman of New York’s Municipal Assistance Corporation from 1975 to 1993, and as U.S. Ambassador to France from 1997 to 2000, and who currently runs his own advisory firm and serves on several European corporate boards; and Paul Volcker, who in a public career that spanned the administrations of every president from John F. Kennedy to Ronald Reagan served as an undersecretary of Treasury, president of the Federal Reserve Bank of New York, and chairman of the Board of the Governors of the Federal Reserve system from 1979 to 1987. Volcker, the first Henry Kaufman Visiting Professor at Stern in 1998-1999, currently chairs the International Accounting Standards Committee Foundation. Stern Dean Thomas Cooley moderated the discussion. Thomas Cooley: A lot of observers have argued that the malaise of the U.S. economy, the tepid recovery, the decline of the dollar, and the sluggish stock market may all have much to do with the widespread loss of confidence in the governance of U.S. corporations. How important is governance to the economic situation? Richard Fuld: The truth of the matter is investors lost $8 trillion. The accountability clearly would never rest with them. It has to rest with somebody else. So we have to shore up the system so that doesn’t happen again. That would be a very difficult task in itself if it’s just about corporate governance, because it’s not. For us to get a real turnaround, we need clarity on the economic environment, on homeland security, on geopolitical issues like Iraq, Iran, and North Korea. Of course, corporate governance does matter. CEOs and investors for pension funds know that they have a responsibility to deliver a return. A lot of them are frozen, because they look at these complicated economic and geopolitical issues and they say, number one, I’m suppose to control risk. If you talk to a trader, the trader will invariably say, if he has a 55 to 60 percent shot of being right, that’s terrific. But for many of you that sit at the top of your companies, if you have a five percent chance of losing your firm on a bad decision, that’s the part you’re going to focus on. Rebuilding confidence will be tough, and it will require best practices, board independence, strengthening individual board committees, having senior management be more accountable, and increasing disclosure. A lot of it has to be self-regulation, just making sure we all don’t put our foot in our mouths and say and do stupid things. Felix Rohatyn: There is a direct link today between our defense posture, our overseas security posture, and the issue of corporate governance and the safety and protection of the capital markets. Today we need $1.5 billion a day coming in from overseas to finance our deficits. The dollars come in as foreign direct investment, which is the most long-term investment, or as portfolio investment. After the Euro came into being, there was a $300 billion inflow into this country in 1998 and 1999. Last year there was $50 billion. We cannot afford to lose the foreign investors, just at the time when our deficits are getting bigger. In addition to which we’re getting this foreign investment to fight wars from countries that don’t want us to fight these wars. The view from overseas, especially Western European countries, which have most of the money here, is by and large the perspective of “casino capitalism.”
The scandals involve 12, 13, 14 companies, which is certainly not a majority of the thousands of companies that are publicly owned. But what about all these companies on the NASDAQ that collapsed and cost their stockholders huge amounts of money? The question is, where were the regulators, where were the directors? Let’s say a director is sitting on the board of a company that is not making money, and that sells at $270 on the Exchange. There is a question of whether they have any action that they can take when they see a company’s securities totally outrunning any reality that might be delivered in terms of value, and where a lot of people are going to get hurt. We have the best capital market system in the world. And we have two bookends. On one side is a very sophisticated regulatory system, and on the other side is a sort of Protestant ethic. The combination of the two has served us well over the years. But over these years, both of these bookends began to fray.
When I used to go to Washington, I would talk about the stock market with my driver. He had owned stock in this company out in Virginia where the stock went from two to $300, and he sold it at $240. Now it’s at $4.70. I asked what made him sell it. And he said, ’I kept taking these people out there and I would look at them in the rear view mirror and they looked like bad people.’ I thought that this guy was right. You look at the people either who are going there or who are running it, instead of looking at pieces of paper that are wrong. I don’t think markets should have a philosophy of caveat emptor. The financial markets are such a huge part of our economy and our social life. They determine how underfunded or overfunded pension funds are. They determine whether cities and states are going to cut their budgets. Capital markets and capital values today are completely integrated into our society on every level. To me, I guess, that is the most interesting and the most debatable aspect of a lot of these things. Paul Volcker: The last time I was in this room was in the spring of 1999, addressing a group of second-year MBA students about to graduate – and we had stocks increasing for the last 15 years at an annual rate of 17 percent – I asked how many thought the stock market would rise an average rate of 10 percent a year over the next 10 years? Every hand went up. My friend Mr. Rohatyn underestimates the problem. There are only 250 working days in a year. We are running a $500 billion a year current account deficit. We export let’s say $200 billion in capital a year. That is $700 billion a year. To finance that you’ve got to get in $3 billion a day. Rohatyn: Well, I wasn’t counting weekends. Volcker: And it’s not flowing in spontaneously these days. Most of our deficit is being covered by central bank purposes in Asia, and that’s not exactly the kind of thing you think of as a spontaneous reinforcement of the glories of American capitalism. We’ve been very proud, and rightly so, of our capital markets and our economy. But I think all our failures of corporate governance – and they are clear, and they are not limited to a handful of people – are representative of a wider malaise. There are deficiencies that are rather widespread in corporate governance that have been revealed. I don’t know anybody else that has a very good substitute, but we have given an argument against the anti-globalists and the anti-capitalists that is unfortunate. I find myself wobbling between the feeling that there is somewhat a sense of denial in the business community, and a feeling there is a sense of overkill. There is a lot of emphasis on the distinction and the two roles of the board as an oversight body and the management as a management body. But it’s a distinction that hasn’t been made in the reality of running many businesses. In my experience, boards of directors tend to be a collegial body. They are looked upon to participate in the business decisions and the strategic decisions of the company. It’s hard to offer a critical different opinion, and stand aside a little bit from management, when you are so involved in the decision-making yourself. How can I quiz the chief executive about things that might be going wrong and making sure that he’s got a control system in place? You don’t want to be the guy at the board meeting who is always raising questions and appearing to be out of the spirit, the collegial spirit, of the management of the institution. I don’t think all this talk about independent directors is going to be very effective unless there is some leadership among the independent directors that recognizes a responsibility for appropriately questioning the actions of the management and maintaining some control over the agenda of board meetings. I come to the conclusion that for a big, widely held public company, where there is no natural ownership interest that expresses itself in a very direct way, there ought to be a non-executive chairman who clearly has the responsibility for leading independent discussions as necessary among the independent directors.
Audience Question: I’ve been a director of a very large corporation, and I’m beginning to see some of the overkill from the directors that have law degrees becoming the heroes. We’re asking fewer questions about business management ideas five and 10 years out. I think if we develop a "we" versus "them" attitude on the board, it’s not going to function well. Don’t we have to be careful so the independent directors don’t get so independent or get full of our own power? Volcker: Getting the balance right is the heart of the matter. I guess I just conclude that if the balance tips too far to the collegiality, you have no leadership of the board other than the chief executive officer himself. If you have an independent chairman who is too intrusive, then you’ve got dual leadership of the management and you get in trouble. I have been on boards where you have non-executive chairmen, and it has worked well. Back when I was a banking regulator, occasionally I’d run into a bad bank, and the chairman was reluctant to respond. So occasionally I’d go to a director and say something. The answer that I frequently got was don’t go to me, I’m just a director. Go to the chairman. Well, he was the last guy you wanted to go to. Rohatyn: I don’t believe there is any such thing as an independent director, nor do I believe there should be necessarily. I think all directors essentially are management directors. If they’re not, they probably shouldn’t be there. The financial institutions that own 70 percent of the capital in this country should be on boards of directors and shouldn’t just take the position that they’ll just sell this stock if they don’t like what’s happening. I sit on some European boards where you have this set-up of a non-executive chairman. With their culture, it works. I’m not sure it would work here. They also have supervisory boards as well as management boards with different responsibilities. There is something to be said for a board whose sole responsibility is advisory and of people who are non-management people. Fuld: The boards are clearly supposed to be there to provide that check and balance. But if anybody really thinks that individual board members are qualified to dig into the businesses and really understand the day-to-day functioning of financial service companies, they’re mistaken. You can have a collegial board, by the way, where your directors do ask questions. Henry Kaufman, who a lot of you know, sits on my board. He is not shy at all and is not retiring, and loves to ask a question. But I approach it from a very different way. He is there covering me, because if he asks the right questions and we don’t have those answers, we’d better get them. I gave a presentation to my board about three months ago. We spent three and a half hours going through all $250 billion of our balance sheet, line by line. At the end I said let me tell you now how we can theoretically change the value that we showed you at risk. In seven minutes, I went through four line items saying here is where I could hide derivatives, volatility trading, and high-beta transactions and private equity. We increased the risk from one billion in the vulnerable zone to $72 billion in the vulnerable zone. Then, one of the directors asked how they are supposed to know where we stand? I responded that if I’m a bad guy, I’m going to get you. The directors are not going to have the capability to understand the real inner workings if somebody wants to hide a trade or change the accounting. And so I think to rely on the board as the ultimate watchdog is not valid or fair. |
Given all that’s happened, something
has to be done about the auditing and accounting side. I recognize
that the Sarbanes-Oxley
bill has elements of detail and overkill in it, but overall I think
there was a need for some mechanism beyond self-regulation to impose
a discipline on the accounting and auditing process. It puts an enormously
heavy burden on a board of directors and particularly the auditing
committee, and that is requiring an adjustment in boards of directors
and auditing committees in particular. If you were a responsible
chairman of an auditing committee prepared to carry out the mandates
of Sarbanes-Oxley, you better be prepared to spend at least a week
a month on your duties as your part-time director.