FROM THE OFFICE OF PUBLIC AFFAIRS

Good evening.   The Conference Board has been a leader in corporate governance reform.   It deserves the appreciation of shareholders, directors, managers, and the public at large for that service.

Tonight, I'd like to take this opportunity to review the state of corporate governance in the United States, especially as it pertains to the capital markets.

Following the corporate governance scandals that emerged from the 1990s stock market bubble, those of us who care about economic prosperity and freedom have learned serious lessons.  We've seen that investor confidence lies at the heart of capital markets and that confidence is based on trust.

Investors trust that the people in charge play by the rules.  And those rules call for honest numbers and honest people.

Today's large and diverse corporations have many subsidiaries.  They have complicated balance sheets.  There is no conceivable way that investors can directly verify that the reported numbers are accurate.  Investors don't have the capacity to perform personal audits.  They have to rely on trust. They must be able to trust that managers, boards of directors, auditors and law firms are diligently and effectively protecting shareholder interests.

 That trust, which underlies corporate capitalism, was badly damaged by the corporate scandals we have seen.  With painstaking effort, that trust is returning.  But more remains to be done.  Every instance of excess, every case of misbehavior delays and weakens the return of investor trust.   Speaking of the investor, it’s important to note we are now a nation of shareholders and that over 50% of Americans own stock. 

Many American families watch the markets closely, and many derive a sense of their personal wealth from the condition of the markets.   So this issue of corporate accountability truly affects Main Street, in addition to Wall Street.

America's system of corporate governance is without any doubt the best in the world.  We have greater corporate accountability and more focus on rewarding shareholders than anywhere else I know.  But we also have to acknowledge that by the late 90s, our system had become unbalanced.  It wasn't working as intended.  The problem was not limited to the egregious, scandalous and criminal conduct that made the headlines.  Some of the basic tenets of corporate capitalism were not being honored.  What Alan Greenspan called "infectious greed" had gotten out of hand.

The corrosive influence of these forces was not limited to a relatively few outliers.  What we discovered in the wake of these scandals was that commitments to the basic tenets of good corporate behavior were fraying. The center was no longer holding.

Now, that's not to say that most companies were party to the behavior that produced the scandals.  Far from it.  Most companies are well and honorably run; and most make shareholder interests their paramount concern.  Most played by the rules and unfortunately they too were tarnished by what happened.

But I think it fair to say that in too many instances, corporate governance practices needed tightening-up, and the values of corporate governance needed to be reaffirmed.  The failure to do so would have put the system of corporate capitalism in serious peril.  And this system which has been such a powerful engine for the advancement of civilization needed to have its moorings shorn up.   Fortunately that has been happening and broadly speaking the reforms are working - credibility is being restored and our system of capitalism is being anchored by good responsible actions.

What is the meaning of corporate capitalism?  At its heart it is a compact between owners of capital and the managers of that capital.  The shareholders make their capital available to a corporation.  They expect that their capital will be managed in their interests. Managers, in turn, have a fiduciary duty to the shareholders.  The managers must pursue the best interests of the corporation, which generally means maximizing the shareholders' discounted returns.  That is, the managers maximize the long-term value of the enterprise.

Since shareholders cannot directly monitor management, boards of directors are appointed for that purpose.  Boards of directors are charged with ultimate accountability.  They oversee the direction of the organization. They see that management pursues the best interests of the company.  To do that, they need access to the numbers; they need good accounting and good auditing.  The corporate board, and the shareholders it represents, needs honest accounts of the state of the enterprise.

In a fundamental way, then, the system depends on honest disclosure.  At the very least, "honest disclosure" means not manipulating the numbers; it means not misleading the Board or the public.  It means giving an accurate rendering of the accounts of the business.

Another major tenet of corporate capitalism is a reasonable and fair sharing of the benefits of the enterprise between investors and management.

Here too, serious fissures have emerged in the compact; these fissures reflect failures of managers, boards, compensation committees and the consultants they rely on to set executive compensation.

There is plenty of blame to go around here.  In retrospect, the whole mess might be understood in part at least as an extension of efforts to tie management compensation to corporate performance.  That was the original rationale for most stock option grants, and options serve a good purpose, up to a point.  But somewhere along the line they got out of hand. Stock options came to be viewed as a "freebie," and every economist knows that anything free will be consumed to excess.

Then, of course, we had the irrational exuberance of the stock market in the late 90s, which led to option payouts far beyond the grantors – or grantees -- imaginations.   Over-reliance on options and the market bubble created the "perfect storm" for corporate America.

I do not mean to indict stock options.  There is a role for options.  But options were intended to motivate long-term behavior.  They were meant to tie executive compensation to the long-term success of an enterprise. Instead, they too often became a vehicle for near-term cash payouts. Unfortunately in many cases they shortened the time horizon of management and accentuated the "short-term-itis" that addicted the markets in the 90s.

Their original purpose was twisted, and in many cases managers and boards failed to show the common sense or judgment to back down from the excesses.

Public reaction was predictable when managers walked off with millions upon millions after exercising options in companies that then proceeded to unravel -- companies such as Enron, WorldCom, Global Crossing, and Tyco - once darlings of Wall Street.   Corporate America suffered a setback from which it is still reeling.  Today, the issue of compensation is center stage. Compensation policy has not yet been fully and appropriately addressed.  Addressing it must be a priority for every corporate board.
Doing so is the unfinished business of the whole corporate governance reform agenda.

While compensation issues remain unresolved, we have made real progress on other fronts.  With Sarbanes-Oxley, the issues of financial manipulation and honest reporting have been addressed head-on.
 CFOs and CEOs are now personally accountable for seeing that their quarterly numbers "fairly and accurately" represent the condition of the enterprise.  The accounting profession has returned to its roots, and has been granted far more independence.  Accountants are now expected to focus on auditing the numbers, and they will have far less non-audit engagement to distract them.

The profession has a strong, independent overseer in the Public Company Accounting Oversight Board.  The days of reliance on self-regulation are behind us.

The oversight duties of boards have been spelled out with greater clarity, and the need for director independence has been underscored.  Boards of directors today should have no doubt that they are accountable.  Management reports to the board, and the board is the ultimate authority in the corporation -- not the CEO.  That's been made absolutely clear.  The nominating committee, not the CEO, makes the final decision as to who should be elected to the board, and that is as it should be.

If the system is to have legitimacy, everyone must have a boss. CEOs can no longer dominate the board selection process, or be perceived that way. Similarly, audit committees must retain the outside auditor, and the audit committee owes its allegiance to the corporation, not to management.  That is now clear.  The lawyer's obligation to the ultimate client - the corporation and its interests, not the management - is also clear.

In many regards, the rules of corporate accountability have been strengthened and improved.  Boards and managers are continuing to work through the new set of relationships.  But something more fundamental has occurred.  The days of passive boards are over.  The days of the 30-minute audit committee meeting are over.  Over, also, are the days of the badly-conflicted audit firms, in which non-audit consulting fees dwarf the audit engagement.

Corporate capitalism can only work -- can only have legitimacy – when boards do their duties.  A well functioning board is the cornerstone of the system.    Board members must take their responsibilities seriously.  At the same time, they cannot be hostile to management.  Directors should not undermine management's role, or try to subsume management's role.  Rather, directors must be attentive to their unique responsibilities. 
Boards are the ultimate representatives of the shareholders, and they must continually satisfy themselves that management is pursuing shareholders' true long-term interests.  Boards are the ultimate source of corporate authority.  They are the ultimate keepers of corporate legitimacy.

That brings me to the subject of compensation.  Here, I think more work remains to be done, and serious dangers lurk.  What are those dangers?

The greatest risk I see is that the compensation arrangements of the future simply build upon the flawed arrangements of the past.  Short-sighted reform would take the norms of stock option compensation, but would substitute cash and equity for options under otherwise similar terms.  That would be a grave mistake. Despite all their flaws, at least options have an element of risk - poor performance could put them underwater.  The move to equity grants, phantom shares, and restricted stock in lieu of options takes the risk out of executive compensation.

What is needed is common sense, uncommon though it sometimes seems.  Boards must ask themselves a basic question - is this compensation really appropriate?    If shareholder interests cannot justify a compensation plan, the plan should be dropped.

Before I take your questions, let me touch on the President's plan to create jobs and economic growth.  President Bush is following a clear and consistent economic strategy, and I'm confident about the future of this economy.  Last month, the economy exceeded forecasts and added net new jobs.  Inflation is low.  After-tax incomes are rising.  Homeownership is at record highs.  Productivity is high and it is rising.  Factory orders, particularly for high-tech equipment, have risen over the last several months.

Our strategy has set the stage for sustained growth.  By reducing taxes, the President kept a promise, and we did the right thing at the right time for the American economy.

We're moving forward, but we are not satisfied.  We can't be satisfied so long as we have fellow citizens who are looking for work.  We must act boldly from this point forward to create jobs for America.  And acting boldly, we are: President Bush is asking Congress to enact a six-point plan to encourage job creation.

First, we must help small businesses grow and hire by controlling the high cost of health care.  Second, we must confront the junk lawsuits that harm a lot of good and honest businesses.  Third, we must have a sound national energy policy -- we must keep the lights on, and make America less dependent on foreign energy.  Fourth, we must continue to cut useless government regulations that choke job creation.  Fifth, we must work for a free trade policy that opens up markets and levels the playing field for American workers and manufacturers.

Finally, we need to make sure the tax relief we passed isn't lost in future years.  The tax cuts that we passed are scheduled to vanish unless we act. When we passed tax relief, we knew most Americans did not expect to see higher taxes come back through a back door.  We also understand that for job creation, it's important to have certainty in the tax code.   Businesses and families have to be able to plan for the future.  If Congress is really interested in job creation, they will make the tax cuts permanent.

Thank you for your attention this evening, and thanks again to the Conference Board for your kind invitation.  I will be delighted to take your questions.

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