The Hindu Business Line : Corporate governance — Private and public sector responses

IT has been a busy time for the SEC since I joined the Commission in January 2002, and it is a good time to be talking about the respective roles of government and the market in regulating the markets, and in responding to crises. In keeping with that subject, today I will discuss some issues arising out of both the public and private reaction to the corporate governance scandals. I will also discuss two areas — namely, managing conflicts of interest and overseeing executive compensation — where market participants need to take meaningful action to prevent the perception that additional government response is needed.

As a general matter, given a choice between a public and private response, my strong preference is to let markets operate unimpeded. Having said that, however, I realise that regulators play an important role in ensuring integrity in the markets, especially in the context of a market crisis that reveals possible systemic issues. In the face of significant financial scandals it is necessary to do some root-cause analysis to determine whether the markets are in fact functioning properly, and, if not, to try to provide meaningful solutions. That is really where the public and private sectors intersect.

One reason for my preference for market-based solutions is that, as a general matter, corporate governance reforms driven by regulators give rise to a heightened possibility of unintended consequences. The nature of regulations is that they have general applicability, and it is difficult to consider and craft a response that is appropriate to all situations. One of the great strengths of our capital markets — the number and diversity of issuers who participate in them — also presents one of the greatest challenges in formulating a response to the recent financial scandals. For example, rules designed for the Fortune 100 are not necessarily appropriate with equal force to a startup company with a small, concentrated investor base. I should note that, in looking at how the new rules are being implemented, it is important to distinguish between truly unintended consequences, and intended consequences that market participants just don't like. With respect to the former, I encourage people to continue to bring them to our attention so we can evaluate how the rules are affecting the marketplace.

These are encouraging signs that the markets are driving reforms, and I hope the trend will continue. I would like to talk about two areas, however, where I would encourage market participants to step up to the plate in a much stronger way. The first is managing conflicts of interest. The second is overseeing executive compensation.

When we talk about the market's role in driving reform, directors and officers of public companies obviously have a vital role to play. Senior management needs to take potential conflicts into account in formulating and managing business strategies. The Board, for its part, must be vigilant in gaining comfort that adequate controls are in place to prevent harm to investors, customers and the markets. The Board should not tolerate management that does not act decisively to stem potential conflicts of interest before they manifest themselves in the type of conduct we saw in the analyst enforcement actions.

If the private sector allows conflicts to operate unchecked, and to develop into systemic issues, the predictable result will be a call for additional government-imposed reforms. While there are degrees of government intervention, the analyst settlements demonstrate that even appropriate remedies can be intrusive. With respect to conflicts of interest, an ounce of market-based prevention can avoid pounds of regulatory cure.

A second area where I would hope for a stronger market response is in the oversight of executive compensation. There seems to be a disconnect between performance and executive compensation that is a red flag that there is something wrong. There are several principles of good governance that should go into executive compensation decisions. For starters, the compensation committee should be comprised solely of independent directors. Investors should demand, and Boards should ensure, that the compensation committee is truly independent. Collectively, they should look with a jaundiced eye at directors who have personal relationships with the executives whose compensation they have to determine — what I would call an "old Board network". Those relationships, while not expressly prohibited in all cases, call into question whether the individuals have the comfortable distance from the decision that gives the market confidence they will be truly objective. In addition, performance-based compensation should be truly performance based; that is, there should be objective factors that are sufficiently defined and verifiable as to provide a reliable benchmark against which to judge performance.

Finally, performance goals and the overall compensation package should not be a get-rich-quick scheme, but rather should be designed to provide proper long-term incentives. Hopefully companies hire their senior executives for the long-term and, if that is the case, then the pay package should be aimed at compensating them fairly over the full term of their employment.

In sum, it should be clear from the recent scandals that there is a risk that some executives will manage to short-term performance goals to maximise their compensation. But even beyond fraud or illegality, the Board's compensation decisions should remove — rather than contribute to — any ambiguity about the level of integrity demanded from management.

In conclusion, I can't walk away from any discussion of corporate governance without stressing that the most important aspect of reform comes from market participants working proactively to foster an ethical culture in business. This highlights the importance of market-based reforms because ethics is an area where the government frankly cannot legislate or regulate. Only if officers and directors follow the spirit as well as the letter of the new rules, will investors again place their full confidence to the markets. Convincing the public that meaningful changes have occurred will take decisive action, not just words. It brings to mind the story of a businessman who had become known for his sharp and hardnosed business practices. The man once remarked in Mark Twain's presence that, "Before I die I mean to make a pilgrimage to the Holy Land. I will climb to the top of Mount Sinai," he exclaimed, "and read the Ten Commandments aloud at the top."

"I have a better idea," Twain replied. "Why don't you stay right at home in Boston and keep them?"

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