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A New Agenda for Boards of Directors

The following is excerpted from the Ira M. Millstein's keynote address at the KPMG Audit Committee Issues Conference, presented in association with the National Association of Corporate Directors and Weil Gotshal. Millstein is senior associate dean for corporate governance at the Yale School of Management, and senior partner, Weil, Gotshal & Manges.

I've had the good luck to have lived through the Great Depression and every recession since, and I'm still here, which is the good news. However, the depression of the 1930s had a lasting impact on my attitude toward life and times. I don't suppose any of us who lived through it ever fully recovered enough not to worry about money, jobs, and all the rest, no matter how we otherwise made out in life.

This particular crisis bears a resemblance—but only a resemblance—to the 1930s. Really, in my opinion it's nothing like it and won't be. Furthermore, I am confident that the lasting effect this time will be positive, not negative. Watching my grandchildren and their attitudes, I see them fully capable of resetting their goals in a very positive way. I think they will see the world as one in which real values are more important than the values we created in the 1980s and 1990s. So, I'm confident about the future, despite what follows in this speech.

The first thing we must do is restore trust in the system. This requires a new approach to proposed government regulation once the need for emergency responses subsides. Future regulation should be based on an analysis of its costs and benefits in terms of economic impact. In addition to regulatory reform, we need to take a hard look at how the private sector governs itself. To earn trust, both analysis and reform demand total transparency to convince the public at large that regulation and governance are designed to benefit the "real economy," not Washington or the executive suite.

The second theme is "resetting" the goal of these public and private efforts. The goal cannot be to get back to where we were in 2007! The public at large won't accept that—the financial "anything goes" attitude of 2007 led us to where we are now. Rather, as President Obama has stated, the goal has to be to provide jobs and put people to work. This is our immediate goal; it can evolve and shift later, but this is our guiding principle now. We should focus pragmatically, not ideologically, on what actions will best allocate capital for the creation of real jobs. This is a far better objective than ideologically, and perhaps almost mindlessly, bolstering financial institutions by relying on economic models that are no longer applicable.

Most importantly, I heard in Obama's acceptance speech what [columnist] David Brooks labeled the "politics of cohesion": a new personal and mutual responsibility and unity, supporting pragmatism. This will indeed accomplish our goal over time if, and only if, across the entire private sector institutions and individuals alike reset goals and values. For the private sector, specifically the corporates, it means fulfilling their responsibilities to society at large, as well as to their shareholders and stakeholders.

Resetting the Goal

When we begin the process of careful regulation and governance reform, we have a reset goal: facilitate the flow of capital in a way that creates jobs in those industries which together will productively and efficiently employ the most Americans. The goal can be met by a variety of initiatives, but each initiative will need to be examined with that goal in mind.

Furthermore, in assessing the economic impact of proposed regulations and private initiatives, we must make strategic choices for the economy as a whole, between innovative and lightly regulated financial markets and the stable and heavily regulated market of the post-depression period. The right balance is one that creates the most jobs and stimulates economic growth in the long term. Directors and management are in a position to play an important role in reining in over-zealous attempts to constrain the financial industry and in assessing how much is too much.

Our situation is undoubtedly precarious and will continue to be for an indeterminate time. The banking sector is apparently imploding as we speak. Indeed, some wise heads see nationalization looming. What will that do to our market model?

Where and when does it stabilize? Not clear. So we are faced with the need to legislate, regulate, and modify behavior in an imploded capital market. The almost knee-jerk past response was to "fix" the capital market, using outmoded models, and without careful concern for the negative consequences: In good faith perhaps, but too much, and exclusively, government-think. And the negative consequences have landed on President Obama's desk.

We didn't have reliable economics or financial engineering on which to base our actions. Lehman and the Troubled Assets Relief Program, for example, may have been good-faith efforts to impact capital-market institutions and market behavior based on theories (and models) which then demonstrably didn't work—and indeed, backfired. As a noted modeler recently pointed out, "…many of the predictive models taught in the classroom—models that fueled the financial industry's boom and eventual bust—simply no longer work…They are all broken."

So we go to work on all of this in a period of "pedagogical improvisation." As FDR once did, we may have to use buckshot, since we have no reliable silver bullet to fix all this. And we need to be ever mindful that our task is not just U.S.-centric—the world is watching and doing its own thing.

This, then, is the context in which we all go to work in the future to regulate and self improve: uncharted territory, a broken compass, and only a North Star—people and jobs—to go by.

Where Do We Go From Here?

How exactly do we accomplish the reset goal? What are the new models now that it seems existing financial-capital market models are broken? In early January, hundreds of economists attended the annual meeting of the American Economic Association and, as a group, agreed that a profound shift has occurred. Why the shift in thinking? Because economic models are built on the assumption that people act rationally. However, irrational behavior appears to have played a significant part in the financial crisis. Maybe we start at the beginning with Adam Smith—not with The Wealth of Nations, but with The Theory of Moral Sentiments. Even Adam Smith's world of competition and maximizing self-interest may not suffice, because the market does not exist in a world made up of people of prudence, of self-control, and beneficence.

So as academics, economists, theorists, and philosophers go back to their "pedagogical improvisation" and attempt to construct viable models, I suggest that, for now, we use President Obama's pragmatic goal and mutually responsible approach as the guiding principle: What can the government and the private sector do to allocate capital away from the self-enrichment of special sectors and toward the production of goods and services for the creation of jobs? We should insist that such a test be applied. It may turn out not to be simple in application, but it's a place to start each analysis.

The guideline, then, for future legislation and regulation: Does it serve the national interest in making capital transparently and fairly available to enterprises that create jobs in America?

We can no longer allow financial engineering, as important to the functioning of the market as it certainly is, to continue to be the tail wagging the dog of the real world of producing the goods and services which provide the jobs and economic growth vital to the whole world's well-being.

Dysfunctional capital markets, which had a life of their own and became an end in themselves—rather than an instrument of solid economic development and job creation—are at the heart of this crisis. It is therefore critical that any and all responses to this crisis revert to the recognition that capital markets should be treated as an instrument, but only an instrument, to restore trust and promote real economic growth.

Cost/Benefit Analysis

It is too soon to tell the exact shape that the forthcoming regulatory overhaul will take. A crisis of this magnitude would not have been possible without a combination of multiple flaws in the regulation and deregulation of our financial system—and it will take some time to design effective remedies. Such remedies necessitate a set of strategic choices regarding where along the spectrum— between innovative, lightly regulated financial markets susceptible to crisis, and more stable, heavily regulated financial markets—is the optimum?

There will be many people pushing for a stripped-down sort of financial sector not given the freedom to create the next paper economy or shadow-banking industry that may prove inefficient in the long term. Indeed, some groups seem to suggest a return to old-fashioned commercial banking—taking deposits and lending to business, industry, and homeowners, on a closely regulated basis. However, there is another view—that innovation and risk-taking are a source of wealth and should not be stifled. But with such innovation and risk, and consequent potential instability, you need trust, trust that financial activities will support social productivity and the creation of jobs. How do we go about balancing and designing the right kinds of regulation that restore trust? How can we know that any governmental proposal satisfies its requirements? The customary message of our recent past—"because I'm telling you so" or "because disaster will otherwise ensue"—will not do for long-term solutions.

There is an old-fashioned way. Any future proposal for regulatory reform or governmental assistance should undergo a rigorous cost-benefit analysis in terms of economic impact, one that carefully weighs the expected benefits to the goal of growth and job creation against expected costs, potential risks, and negative market impact—all factors in assessing the economic impact— before it is adopted.

Moreover, the main considerations involved in this economic impact analysis should not be the exclusive province of government bureaucrats; transparency to the private sector and the public at large is essential. With participation by the private sector, only proposals which pass this stringent and transparent economic impact analysis should be allowed to go forward.

This is hardly a revolutionary suggestion. As long ago as 1979, an American Bar Association Commission published a scholarly report titled, "Federal Regulation—Road to Reform." Its theme, just as applicable today, is that regulation should not be undertaken without adequate analysis and evaluation of its impact—an analysis that must have participation by impacted parties. Corporate leadership must step into the gap left by failing or teetering institutions and speak up to ensure that we don't over-regulate and that our public and private reform efforts are supporting the production of goods and services and the creation of jobs.

What Regulation Makes a Difference?

As Obama and his economic team go about crafting legislation and designing specific regulations, it seems their efforts are being guided by what is known as the "Group of 30 Report," which provides suggested guidelines for regulating the financial industry (including those industries, like private equity and hedge funds, that have historically, at least in part, been unregulated). The Group of 30 is a not-for-profit body of senior representatives from government and the private sector. Larry Summers, the head of the White House's National Economic Council, is said to be preparing a blueprint of proposed regulatory changes to the financial industry, which will in large part be based on the Group of 30 Report.

Now, let's turn to a few specific proposals and apply a simple test: let's ask ourselves whether proposed regulation encourages the allocation of capital in a way that creates jobs. What follows are off-the-top-of-my-head examples—for which others may have different reactions. But that's where analysis comes in.

Regulatory Reorganization: Greater coordination or some form of financial oversight reorganization by and among the Commodity Futures Trading Commission (CFTC), the Securities and Exchange Commission (SEC), the Financial Industry Regulatory Authority (FINRA), the Federal Reserve, and other federal agencies.

It looks efficient , but will it result in a more appropriate allocation of capital? Perhaps one hand at the tiller is too much central control and not enough room for competing ideas.

• Will some form of bank nationalization change the whole equation? How?

Executive Pay: President Obama has called Wall Street bonuses "shameful" after a report found that financial executives received an estimated $18.4 billion in bonuses in 2008.

• Limits on executive pay in the financial industry will encourage a flow of highly skilled labor out of that sector and into those sectors that produce jobs, or into regulatory or enforcement positions that will help regulation and oversight keep pace with the inevitable innovation that always finds the gaps in regulation.

Credit Rating Agency Reform: High on SEC Chairman Mary Schapiro's list?

• Having SEC examiners at credit rating agencies, or lifting the near-monopoly created by the SEC's Nationally Recognized Statistical Rating Organization (NRSRO) designation, or creating something akin to the Public Company Accounting Oversight Board (PCAOB) to oversee the credit-rating agencies.

• Will this help allocate capital more efficiently? Maybe by ridding the credit rating business from perceived conflicts, there possibly will be more candid assessments of risk, and capital would flow to the most efficient uses. But are the "solutions" simply theoretical and not practical? Are there downsides?

Hedge Fund Regulation: Another item on Schapiro's to-do list.

• Insisting on hedge fund registration would provide great transparency around hedge funds and the size and nature of their investments. This may help the allocation of capital to its most productive uses, but what risks does it present to the system in general?

• Other proposals include regulation of short selling (including more aggressive enforcement of rules against naked short selling, public disclosure of short positions, reinstatement of the "uptick rule," and prohibitions on short selling). Are these just facial cleanups and how do they impact capital flows to enterprises that create real jobs?

Risk-Based Capital Requirements: Yes, probably. Capital requirements encourage creditors to do business with financial institutions, by giving them protection, which, in turn, gives financial institutions additional capital to invest in productive ways. What are the downsides to job creation?

The Glass-Steagall Act: Should this and other barriers between commercial banks and other investment-banking services be reinstated?

• By removing incentives to act in the interest of themselves and the generation of business and bonuses, banks might allocate capital to its most productive use. Perhaps this is already underway, but has it been thought through on an economic-impact analysis? Again, does some form of bank nationalization change this equation?

Financial Reporting: In an article titled, "How to Restore Trust in Wall Street," former SEC chairman Arthur Levitt and former SEC accountant Lynn Turner described the need for improving the quality, accuracy, and relevance of financial reporting in the effort to restore trust. In defending fair-value accounting as making the risk profile of an institution more transparent, the authors argued, "[W]e should be pointing fingers at those at Lehman Brothers, AIG, Fannie Mae, Freddie Mac, and other institutions who made poor investment and strategic decisions and took on dangerous risks. Blame should not be placed on the process by which the market learned about them." Are they right?

International Financial Reporting Standards: Shift global regulators, including the SEC, to a single set of accounting standards. A uniform set of accounting rules seems to promote the efficient flow of capital internationally and further enhance financial-market coordination. But which standard encourages appropriate capital allocations, and which might cloak it?

These are just a few of the proposals on the table. It's my goal to seek a formal and rigorous economic-impact analysis as to whether each regulatory reform seeks to reset the capital markets to facilitate the flow of capital to the real economy, to well-performing enterprises that create jobs and economic growth; abjures a self-enriching financial system; and does not have serious adverse consequences.

We have a long way to go to financial recovery, but we know economic growth depends on trust in the functioning of the capital market and in the people responsible for running financial institutions and our productive corporations. We know the government and private sector have important roles to play in our economic recovery.

The private sector, along with public regulators and lawmakers, must insist that government action is aimed at resetting the capital markets to their original purpose—to facilitate the flow of capital to corporations that create economic value in the long-term and provide jobs. Every rule, new and old, must be examined and tested to ensure that it serves the national interest in making capital transparently and fairly available to enterprises that create jobs in America.

Moreover, the private sector is uniquely positioned to restore trust in the capital markets. It is at the very place regulation ends that individuals are asked to make discretionary decisions about the use of capital in the interest of their beneficiaries. It's here in the gray areas that self-regulation and prudent corporate-governance practices are absolutely necessary. It's in the boardroom that independent oversight is necessary, especially in the area of risk management, to instill market confidence.

The Recurrent Crisis Recurs

Boards and shareholders have ducked on compensation. Our individual savings generate the entire capital market, either through direct investment in public corporations, or indirectly through intermediaries such as pension funds, IRAs, mutual funds, savings banks, investment banks, insurance companies, and the like. Indeed, the government itself is an intermediary as it redistributes our taxes as the source of the recovery program. All intermediaries are dealing as fiduciaries for other people's money, ultimately—ours. No matter how long the ownership chain, we are still the principals.

Together "we," the whole investment chain, are the owners of corporate America and we should act like it. "We" have ducked our responsibility to halt compensation excesses in the financial sector and, to a certain extent, sections of the rest of corporate America. Now that compensation has come front and center in the wake of a crisis which has not only exposed its flaws, but did so on national network television, activation is essential. Not just because compensation at excessive levels is unacceptable to most of the beneficiaries—us—(which is reason enough), but because compensation is a politically attractive ground for regulation.

We should act now to re-establish the public trust in business and our enterprises. If we do not, we will face a regulatory response that can never accommodate all the unique individual circumstances of every company and industry. I believe any regulation will be so "swiss cheesed" in content, or by innovative interpretation, as to be ultimately ephemeral and ineffective.

But unless we act swiftly, history teaches that regulation seems inevitable given the public anger at excessive compensation. This is not just because it is a part of the economic downturn, but because it is the part the public understands best.

There seems to be a natural recurrent cycle for corporate governance crises: crisis, regulation; another crisis, more regulation; yet another crisis, and still more regulation. Today's crisis involves the one issue the public is in total agreement about—excessive executive compensation. Naturally, regulation is hovering.

The regulation which has followed each crisis could have been avoided: Boards of directors would have needed to be attuned to, or at least just aware of, the temper of the times and perhaps, simply, a common sense of right and wrong.

Examples abound, but I will mention just two. The Foreign Corrupt Practices Act of 1977 was enacted following an SEC investigation and subsequent public disclosures of bribery. Was a statute carrying criminal penalties needed to convince boards that bribing was not an acceptable method of doing business? More recently, the regulatory response to crisis included passage of the Sarbanes-Oxley Act in 2002, an event which is particularly painful to me. Just a few years before Enron, John Whitehead and I chaired a Blue Ribbon Committee on "Improving the Effectiveness of Corporate Audit Committees." The Committee unanimously recommended improvements in audit committee practices to reform the growing bookkeeping gyrations that were in use at the time. The recommendations were not generally adopted. Then came Enron and the congressional hearings that ensued. What began as our suggested voluntary practices quickly became legislated "musts" for board audit committees.

And here we are again. Who didn't know that compensation practices had grown out of hand? Certainly the public did and complained, to no avail, as did a number of major shareholders often derided as "activist" troublemakers who were essentially ignored. Meanwhile, all forms of compensation in and beyond the financial sector continued to grow, as did the distance in compensation between executive management and the factory floor.

Why did so many boards fail to respond? Principally because, I believe, they chose to be tone deaf and paid little attention to the too-quiet voice of shareholders. Instead, they were complicit, relying on the easy "everyone else is doing it" excuse during the high-flying era, which has just collapsed.

Now the new crisis, and the bonus practices of some top-drawer bankers have brought in a troubled President ready to act on our behalf. The President, quite understandably, set forth new regulation containing direct-compensation caps and related restrictions for bailed-out corporations.

Moving forward, it would be useful for us to remember that the end of the ownership chain is the board of directors, the ultimate fiduciary for shareholders of every stripe. Compensation has always been the board's responsibility. If they cease to be tone deaf, boards across the corporate spectrum will pick up the challenge and voluntarily bring compensation back to earth, before Congress, which isn't tone deaf on this issue, moves in with broader "reforms."

What will it take to develop a spine in the boardroom on the compensation issue? First and foremost, pressure from the institutions that represent all of us as their beneficiaries. Those institutions, individually and as a group, generally own enough stock, directly or indirectly, to be "heard" by their investees. And we, the provider of savings to the institutions, have the voice and legs to encourage them to be heard.

Communication with boards is available to the institutions informally and through more formal means such as proxy resolutions. Majority voting is available to shareholders of many corporations to remove compensation committee members. Public bullhorns are effective. A nudge from government may come in legislated rights for shareholders to have a "say on pay" which I believe is useful, but not critical, for those institutions that seriously want to communicate with a board. Those institutions need not await legislated "access" to place their own directors on a board, if they are serious about protecting us, their beneficiaries, rather than the boards and managements of their investees.

We know that all shareholders and taxpayers have the voice to act on compensation now.

Do they have the will?

Provided by Directorship—The Leading Publication for Boardroom Intelligence

Ira M. Millstein is the senior associate dean for corporate governance at the Yale School of Management, and senior partner, Weil, Gotshal & Manges. He is a member of the board of the National Association of Corporate Directors and has lectured and written extensively on corporate governance.

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