FROM THE OFFICE OF PUBLIC AFFAIRS

June 1, 2005
JS-2481

The Honorable John W. Snow Prepared Remarks NYU Center for Law and Business
New York, NY

Good evening, and thank you so much for having me here. It is an honor to speak with you about a subject that is near to my heart, and one that, by a necessity, became a hallmark of the Bush Administration.

Before I begin, I'd like to put the subject in the context of some recent history – economic history, to be specific.

Four years ago, we would have seen two great towers just south of here. We would have walked in their shadows on our way here tonight. And when our enemies felled those towers, our already-struggling economy was further battered, and all-important jobs were shed for months.

Corporate scandals – which I'll talk more about in a moment – weakened trust in markets and the timing of those eruptions literally kicked us when we were down.

Four short years later, this incredible, resilient American economy is once again the leader and the envy of the world.

Well-timed tax cuts, combined with sound monetary policy set by the Federal Reserve Board, got our economy moving when we needed it most. They gave business and industry the room you needed to grow, and you took over from there. As a result, economic growth was 4.4 percent last year, the strongest in five years.

We have had terrific news on jobs – 23 straight months of job growth. On the first Friday in May, the Labor Department announced that 274,000 jobs were created in April. The economy has created a total of 3.5 million new jobs since May 2003. That's great news – the best news – for 3.5 million families.

The American system of corporate capitalism is a key ingredient of our success. Modern American corporations are leading the world. They are a key source of innovation, modernization and advancement, and are essential to our success.

The continuing vitality of the corporate sector – making sure corporations can function effectively to carry out their critical role – is essential to our long-term prosperity.

It has been said often that after 9-11 the world will never be the same again. The same might be said for the world of corporate governance after the revelations of widespread misconduct that rocked the investment world in the spring of 2002. The scandals threatened to destroy this nation's confidence in corporate leadership and in those entrusted to safeguard our system of corporate capitalism.

Corporate leaders who had been lionized in the nineties came to be vilified. The corporate sector lost a large measure of its legitimacy and moral authority, and with that a large measure of its claim to national leadership. The American public was understandably angered at what it saw as a massive breach of trust. People in authority, people charged with overseeing the interests of shareholders were found to be far more interested in advancing their own interests at the expense of those shareholders they were supposed to have been protecting. Corporate capitalism itself was being called into question.

Public support for the system of corporate capitalism, which had served our country so well for so long, was hanging in the balance. The system had been found wanting, and the guardians of the system had been found wanting. A clear, strong response became a political imperative in the summer of 2002.

Was the public reaction appropriate? After all, the scandals occurred in a relatively small number of public companies. Most of corporate America took their fiduciary duties seriously. If they had not, the economy could not have performed as well as it did throughout the nineties. GDP grew at a strong rate throughout the period. The real output of the economy was expanding. Jobs were being created, corporations were growing and investing and putting capital to good use. The strong results for the economy as a whole is completely at odds with the view that corporate malfeasance dominated corporate behaviors.

One could also argue that the market itself would have adjusted to the misconduct, with capital being diverted from firms with bad reputations to those known to play by the rules. It is also clear that the bulk of the misconduct was punishable under existing fraud statutes. Moreover, we know from long experience that misconduct is to be found in all aspects of human experiences and it cannot be legislated out of existence.

But as intellectually intriguing as these economic arguments might sound, on a practical level they were simply beside the point. We faced a crisis of confidence in those who were charged with the responsibility to oversee the corporate sector. Trust had been broken and trust is a precious thing. Trust under-girds our capital markets. It is perhaps the one single element without which an impersonal capital market cannot operate. Investors are both willing and able to invest on the basis of whether or not they think a particular business will make money. But they cannot, and will not, make that investment if they have no reliable information about the business. If we can't trust the numbers how can capital markets function, how do you know where to invest?

It would be difficult to overstate the importance of the role that corporations play in both the American economy and the American culture. They are creatures of the state and given a privileged position. By allowing large numbers of investors to combine their resources, corporations serve as vehicles to create vast pools of capital capable of exploiting economies of scale and scope. And investors will put their money into corporations based on the belief that those in charge of the corporation, the board of directors and the senior management, are bound both legally and ethically to use those combined investments for the benefit of the shareholders.

Investors can't be expected to vet the numbers themselves. They need to rely on CFOs and audit committees to give them accurate information, and they look to outside auditors and agencies like the SEC and stock exchanges to insure that the information is accurate.

So when the public trust is breached on such a spectacular scale in a system that is crucially dependent on trust, the political process calls out for answers; it calls out for a response.

The response we got of course is the Sarbanes-Oxley legislation. Considering the context in which it came about, Sarbanes-Oxley actually is in most respects quite a measured response. Despite its celebrated status as the most far-reaching capital market legislation since the creation of the SEC in the thirties, the fact is it essentially reaffirms established norms and codes of corporate governance, albeit with criminal penalties.

It underscores the need for corporate executives and boards to take their duties seriously. It calls for board independence. It reaffirms things that we had long taken to be the case – that boards should oversee the corporation; that the audit committee should retain the outside auditors; that the nominating committee, not the CEO, should select the board members; and so on.

Nothing here is revolutionary. Nothing here changes the fundamental norms of corporate governance that some of us learned about in law school decades ago. The overall thrust is to add specific procedures to insure that those traditional fundamental norms are followed. Not only is Sarbanes-Oxley a reasonable response, it was also in my view essential legislation to hold the system together. As somebody who spent most of my professional life in the corporate world, I am a great believer in our form of corporate capitalism. Anything that endangers it puts our prosperity, our national wealth and our future wellbeing in peril.

Our corporations are a unique American institution. They lie at the center of our enormous economic success. America simply could not be what it has become without a dynamic corporate sector that is continually marshalling capital and allocating it to promising uses. Putting capital to good use lies at the heart of economic success and rising living standards.

Using capital well is the essential function of corporations. Paraphrasing Adam Smith, while the modern corporation seeks to advance its shareholders' interests, it achieves far more than it intends. By putting capital in the right places and withdrawing it from the wrong places, by continuously making good judgments about how investments should be made, corporations lie at the center of the wealth creation process.

In fact, I think it is not an exaggeration to say that the modern American corporation ranks at the very forefront of all institutions that are shaping the world today. It is hard to think of any institution that is more adaptive or flexible, more innovative or creative, more focused on continuous improvement, more accountable for results.

They bring us new technologies, new products, new services, new management structures, new ways of organizing labor and capital, and they are under relentless pressure to continually produce better results, better products, better management structures, to widen their vistas.

Corporations today are the modern explorers. They are taking their management techniques, their capital and their resources to all the corners of the globe. They are continuously expanding the reach of the principles of comparative advantage. In the process they are uplifting the economic level of the entire world.

I would argue that there are no institutions in modern life that are more dynamic, more creative or more central to the kind of world we are today and the kind of world we will be tomorrow. In short, the modern business corporation is the most innovative, adaptive and flexible major institution of modern life.

With privileges go responsibilities. No institutions or set of institutions can survive if they lack integrity, if people don't play by the rules and rules aren't seen to be fair and appropriate to the overriding goals of the institution. The role of formal rules, though, in my view is of necessity secondary. A system that depends on outsiders to enforce rules and catch wrongdoers is not a system that encourages public support and investment. Ultimately, what holds the system together is not rules as such but trust, ethics, virtue. To flourish, corporations need to be rooted in the culture of high ethical behavior. They must exhibit the habits and practices of virtue.

Corporate cultures reflect the tone at the top. They reflect the ethical outlook of the people who run the institutions. They reflect their values. The scandals of 2002 did not occur in those great enterprises of America that had long exhibited a culture of ethical behavior.

And that brings me back to my principle point: Sarbanes-Oxley was an absolute necessity. It played the crucial rule of giving the public confidence that somebody was in charge, somebody was looking out for their interests, and somebody would hold corporations accountable.

But the subtlety of Sarbanes-Oxley is that it did all of this by reaffirming the basic rules of corporate governance, not by transforming them.

Let's take a minute and look at what I call the basic rules. We start with the proposition that the shareholders, the owners, are owed a duty of loyalty by the managers of the enterprise. The group we know as professional managers today became commonplace of our culture a century or so ago when enterprises became too large to be overseen by the original owners. The owners in effect retained people to manage the business on their behalf. This has the huge additional advantage of allowing investors to become partial owners in a business without themselves needing to have the time and the right skills to manage that business.

Managers are supposed to run the enterprise primarily in the interest of shareholders; otherwise, the system would lack fundamental integrity; it would not hold together. How could capital markets function if investors didn't have confidence that their interests were being served?

Another fundamental proposition gives boards of directors the ultimate responsibility to oversee the corporation, its management and the strategic direction of its business. A corollary here of course is that to do this properly the directors must be independent. The role of the board is critical. Without a responsible board the system would lack integrity because management would lack accountability to anyone who could effectively oversee their conduct.

To perform its role, the board must act collectively. No single director has the authority to set corporate policy or take corporate action. While we need to be careful of cronyism, we also need to be sure that the board is capable of working together effectively as a collective body. The appointment of directors with individual agendas is less likely to result in better governance than it is to result in an uncooperative, deadlocked board that fails to provide effective direction for the corporation.

I am not aware of anyone coming up with a viable alternative to boards for overseeing management. Theoretically, perhaps, the government could serve as an effective watchdog over management, but we would not have corporate capitalism as we know it. We would have something else, something that would be inherently dangerous for a free society, something fundamentally at odds with the system that has served us so well for so long. Only the board of directors, which establishes the basic business policy and goals, has the necessary perspective to insist not only on scrupulous honesty but also on the achievement of the economic goals that were the real reason shareholders invested in the first place.

This brings us to a third tenet, that the shareholders get fairly rewarded from the wealth created from the activities of the business. Again, it is a matter of basic integrity. If managers can rig the game to gain a disproportionate share of the spoils, then the system falls apart and investors won't want to be part of it. The game won't be played.

It is also important that in our effort to reward shareholders, we don't confuse the goals of a few particular shareholders with the goals of shareholders as a whole. Whether you subscribe to the Lipton/ NYU school of thought or your personal economic corporate philosophy runs more to the Chicago school, everyone agrees that at its core the corporation is an economic engine.

As a whole, shareholders invest in the hopes of a financial return, and a corporation that decides to pursue other goals, however worthwhile some group may feel those goals are, needs to look hard at whether it is keeping faith with its shareholders. In fact, corporations that don't pursue economic objectives – that are not concerned with returns on capital – will find it hard to attract capital and survive. This is the discipline of the game of corporate capitalism. Only those who play it well in the interest of shareholders can survive.

Finally--and this lies at the core of Sarbanes-Oxley--for the system to work well it is essential that the reported financial results of the enterprise reflect its true condition; in other words the numbers have to have integrity. Here is where CFOs, audit committees and outside auditors play a crucial role in making the system hold together. Again, if you can't trust the numbers the system falls apart. Investors won't have confidence and capital markets will be diminished.

Now what I have just laid out is the basic compact that underlies corporate capitalism – the basic duties and responsibilities of the various participants in the huge undertaking we call corporate capitalism.

In the context of the capital markets in the summer of 2002, two things stare out at you from what I just said. First, at every point key parts of the system were fraying badly and only would have gotten worse if we had not seen the spectacular implosions at some specific companies. A form of Gresham 's Law would come into play under which bad management practices drop out good management practices, at least in the short run.

I well remember being on the board of a major telecommunications company where we continuously wondered how a particular competitor could be doing so much better on its costs. Then we found out that it had nothing to do with superior management and everything to do with failure to live by the norms of accounting. Just think of it, at every juncture of the compact things broke down:

1. Managements forgot their duties to the corporation and its shareholders, running the corporation for their own benefit, and, in egregious cases lying to investors about the financial results.
2. Boards, sometimes blinded by conflicts of interest, failed to provide the required oversight, either in establishing business goals or seeing that they were really achieved.
3. Audit committees, compensation committees, CFOs and outside auditors, all fell far short in the special responsibilities that had taken on to look out for investors and to insure that the numbers were reported honestly.

The second large point I want to leave you with is the fact that Sarbanes-Oxley--important and celebrated as it is--has not altered the fundamental norms of good corporate governance. It has added criminal penalties. It has set up a separate oversight for the audit profession. But it essentially reaffirmed the norms of good corporate behavior and in doing so it made a critically important contribution at a critical point to restore confidence in the system and insure it would hold together.

Today we are still going through the learning process with Sarbanes-Oxley. Boards and managements are working their way through the requirements. All through corporate America it is clear things have changed. Boards are much more serious. The meetings are longer. Today there is no such thing as a 30 minute audit committee meeting. So in many ways things are getter.

At the same time, we need to maintain balance in our enforcement. We need to make sure the emphasis is on substance and not form. We need to make sure that innocent mistakes are not criminal. No one can know the future, and no one is right about every business decision. But there is a crucial difference between approving a project that turns out to be a business failure, on the one hand, and "cooking the books" to make a bad project look good, on the other. We must keep that fundamental distinction in mind. Mis-forecasting is not a criminal offense; misrepresenting the numbers is.

This is more than just a matter of fairness to the individuals involved. Our corporate system cannot work if boards of directors are so afraid of civil or even criminal liability that they simply refuse to make the tough business decisions, if they become so risk averse that only business plans with no possible downside get approved. The board has always played the dual role of both providing direction to the corporation and making sure that management was performing properly. If we allow the system to be so skewed that all of the serious effort goes into oversight and second-guessing management, then the corporations will be hamstrung, legitimate business opportunities will be abandoned, and we will all suffer for it.

The American corporation has been and continues to be an extraordinary engine for economic development, innovation and change. Sarbanes-Oxley was a much needed and timely tool for keeping that engine on track and running properly. We need to make sure it is not inadvertently applied in a way that cripples that engine. I believe we can and will do just that.

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