Rules for a New Capitalism
November 1 2002 by Jennifer Pellet
Does your chair feel warm? As one high-profile leader after another resigns in the face of public scrutiny or succumbs to charges of securities fraud or obstruction of justice, it’s clear that CEOs are in the hot seat, now more than ever before. When even Jack Welch, the undisputed heavyweight champ of value creation, is being vilified by disgruntled investors and a scandal-hungry media, no one is safe.
At the same time, efforts to reassure skittish investors with corporate reform legislation and public exchange requirements make the CEO’s responsibilities in assuring that his or her firm is in compliance murky at best-and the task of leading a company more complicated than ever.
“Companies are being told to expense stock options without any single standard about how to do it,” points out Michael McCallister, president and CEO of Humana, at a Chief Executive roundtable held in partnership with the law firm Foley & Lardner. “It’s ridiculous.”
In discussing the challenges of coping with the increasingly complex legal and social environment, several CEOs expressed concern that the pendulum will swing too far, breeding a business arena in which executives and their boards choose caution at the expense of risk.
“Sure, there have been some excesses, and they should be corrected,” says John Shalam, chairman and CEO of Audiovox. “But I’m very concerned that with all our efforts to regulate, and with all these different rules, we are going to stifle entrepreneurship.”
How can today’s business leaders take the risks necessary to pursue rapid growth without also chancing the wrath of disappointed shareholders-and potentially devastating legal action? Clear, straightforward communication, CEOs agreed, is the key.
“Most corporations are basically honest, and if people tell their stories the way they tell them to employees-clear, concise and brief-the public will appreciate that,” asserts Claude Lamoureux, president and CEO of the Ontario Teachers’ Pension Plan. “Simple disclosure will win at the end of the day.”
Participants at a roundtable held in partnership with Foley & Lardner at The Carlyle hotel in New York.
Setting the scene
Gregory Bruch (Foley & Lardner): Looking at the newspaper on the flight here, I saw six articles relevant to today’s topic. I saw an article about the Tyco board approving a $45 million severance package for the CFO at a time when he was under a grand jury investigation. Now he’s been indicted and criminally charged. The newspaper reported that the Enron CFO may be charged criminally; the assistant to Martha Stewart’s broker has agreed to a criminal plea agreement; and executives of Homestore.com agreed to plead guilty to a collusive arrangement with America Online. The WorldCom comptroller has agreed to plead guilty, and the New York attorney general intends to seek or to consider seeking disgorgement of IPO profits from top executives who received IPOs from Salomon Brothers on the theory that it was commercial bribery.
It’s an unusual time when you see political risk, legal risk and business risk converging like this.
Clearly, we have a crisis of investor confidence. Whether it’s a crisis beyond that is a much harder question-and one Congress, in its rush, has not adequately addressed. Is it a crisis of perception? Is it a few bad apples? Is it insufficient regulation? Do we not have enough enforcement? Or is this simply, at some level, just a harsh reality of a bear market?
We’ve seen a tremendous amount of regulatory action, including the Sarbanes-Oxley Act and new rules from the New York Stock Exchange and other listing organizations. The states are getting into it. So every public company may potentially have to deal with not just one regulator, but many regulators. The potential ramifications for those who do business in the 50 states are tremendous.
The SEC’s budget for law enforcement has doubled within the past year. Everyone wants to get in on the act now. You will see criminal interest in areas that you never thought would have been criminal. If the facts alleged in these headline-grabbing cases are true, then that’s probably not shocking news.
But what should give us all greater pause is the extent to which criminal law enforcement agencies are looking into the business judgment of board members and of management. That’s the area that has the potential to paralyze what you’re doing and the hope of finding an audit committee member.
We’d all like to think that if you conduct yourself honorably and decently and fairly, you’ll never come under attack. But let’s not be naÃ¯ve. A time will come when you’ll get a call from the government or a plaintiff’s lawyer and it will be very unpleasant. At that time you hope that you’ve had the right systems and people in place, documented everything you’ve done and conducted yourself properly.
J.P. Donlon (The Dilenschneider Group): What do you anticipate the plaintiff’s bar will do?
Bruch: This is a feeding frenzy for the plaintiff’s bar. They will use the money they obtain from this the same way they’ve used tobacco money. The plaintiff’s bar is probably an important and necessary evil of regulation. It certainly creates a certain kind of discipline. Not all suits are frivolous. But the plaintiff’s bar-and maybe institutional shareholders will help to change this eventually-is really not interested in change. They’re interested in paying the attorneys, because the plaintiffs themselves rarely receive a financial reward commensurate with the aggravation of being a plaintiff.
Bernard Rethore (Flowserve): Whether it’s the plaintiff’s bar or politicians, we risk crafting obstacles to the future success of our enterprises at a time when the world is increasingly demanding economic success. We can’t afford the competitive disadvantage of living in an unreal world of legislation. We run a significant risk of hobbling the effectiveness of an open market and entrepreneurial environment that has been unparalleled in history.
If you count all of the crises we’re aware of in individual companies, I wonder how the number compares to the thousands of public companies that exist, or even the less than several thousands that are listed on the New York Stock Exchange?
Ralph BÃ¶er (Foley & Lardner): The problem is that perception has become reality. The various surveys floating around from McKinsey, BusinessWeek and The Wall Street Journal are frightening. Seventy-five percent of respondents believe fraud is rampant at public companies, for instance. Fifty-four percent say it’s not just a few bad apples. Eighty-two percent say CEOs put themselves first and are excessively compensated. Only 48 percent think CEOs are honest.
One of the things public companies can do is communicate what they’re doing to assure proper governance. It’s important to get across that there are thousands of companies doing all the right things.
Claude Lamoureux (Ontario Teachers’ Pension Plan): But if you look at the kind of numbers we’re getting as investors today, a lot of reported earnings are not necessarily giving the right picture. And how much money do you need to motivate people? Doctors work really hard and how much do they make? Why should a CEO make $40 million?
Gerard Roche (Heidrick & Struggles): It’s supply and demand. For 20 years, Jack Welch, who could have run anything anywhere, was one of the hottest guys in terms of demand. It’s a free market system that makes this capitalistic engine work.
Lamoureux: I’m not talking about Jack Welch. Many dot-coms produced essentially nothing, went from zero to zero in a span of three years, yet a lot of CEOs made millions and hundreds of millions.
John Shalam (Audiovox): In a bull market a lot of excesses are forgiven, and this market thrives on greed. The public and the investors are greedy. They see their stocks moving up and they’re willing to overlook anything. When the market crashes, everybody starts trying to point the finger at who took advantage. The bottom line is that you can pass all the Sarbanes-Oxley acts that you want, but you really cannot legislate morality. In the ’90s we suffered from incredible excesses in the corporate world and a stock market boom that created an environment of anything goes. That’s what we’re paying the price for today.
Marty Albertson (Guitar Center): We’re hopefully experts at the parts of our businesses that drive revenues or profits, but we’re not all experts at accounting. We’re not all experts in the law. So we trust our advisers. But our accountants are offering us interpretations of accounting law, because it’s not all black and white. If it were all black and white, we wouldn’t need them.
So what keeps CEOs up at night is, “Do I really believe that this is the right interpretation? Ten years from now, am I going to be raked over the carpet because of this interpretation?”
Leigh Abrams (Drew Industries): Things that we never think twice about can be wrong. In a discussion with our attorney, I said, “We do everything right.” And he said, “Well, you really don’t. You have split-dollar life insurance, don’t you? We think that constitutes a loan to you and is therefore improper because the regulations are not out yet on the interpretation of the laws. You should stop payment premiums immediately.” So we stopped.
Sy Syms (Syms): When I went public, I felt I was under a microscope and that my quarterly reports had better be right. I’ll certainly be happy to sign reports. I was mentally signing my quarterly reports anyhow.
Farooq Kathwari (Ethan Allen): I think CEOs will get more involved in running a business and understanding their businesses and no longer [focus on being] deal makers. Because today if you sign all that stuff that we are supposed to sign, you’ve got to have an understanding of what your business is about.
One of our biggest challenges is to make sure our own people believe we have credibility. We have 10,000 people in our company. We’ve got to create internal credibility.
Rethore: But if the culture of your organization makes clear to every employee that you don’t break the law, cheat, steal or go for bad numbers, then your employees already know that you’re honest. And you can build on that. I am disappointed in some of our institutional groups. Where has the Business Roundtable been?
Norg Sanderson (Student Loan Finance): Every one of us has the ability to start giving people some good news locally. Hopefully somebody will pick that up and start publishing that there are some good things going on.
Michael McCallister (Humana): The public media has spent the last decade and a half destroying managed care as a business concept. In our trade groups, I’ve said that we ought to tell them the good things we’re doing, to fight those accusations. But it doesn’t sell in the media. It gets no traction.
So we need to be acting with integrity, ethical at every turn, and time will take care of this. If you get a chance to say something good, then say it. But I wouldn’t put a whole lot of faith in a lot of great, positive stories changing people’s minds. That data is very damning and those negatives are so large it will take a while.
BÃ¶er: What’s wrong with the current regulatory evolution is that CEOs and boards of directors are becoming insurers of financial results. And that will get you where Europe has been, where you have the separation between governance and management and the message basically is, “Let’s be safe, let’s not take risks.”
What’s always been so great about American capitalism is that entrepreneurs take risks. Sometimes risks don’t pan out. As a leader, you’re not an insurer of results. But Congress, the SEC and the exchanges are pushing this upstream to the board of directors, which will never be equipped with enough information to make judgments. That will destroy the American system of running companies. Checks and balances means checks and balances; it doesn’t mean micromanagement.
Abrams: American entrepreneurs are not going to give up taking risks. A board of directors can say we did what was right, we followed the process. Yes, we put a new product out and it failed and we lost a lot of money, but we did everything we should have done.
The certification says “to the best of our knowledge,” and we have to be careful not to put ourselves in a cocoon, close our ears and say we don’t know anything. We have to go down into the organization and make sure people report up to us. We’ve then fulfilled our obligation. If you take as many prudent steps as you can to get the information but you’re lied to and something happens, you will be protected from an individual standpoint. A board of directors has to work on that basis as well.
After the SEC announced that they wanted the 950 largest companies to sign an oath, my chairman, myself and our CFO voluntarily signed, even though with $300 million in sales we didn’t fit into that category.
Rethore: One of the CEOs of a company I sat on the board of was not required to certify because his company was below the size limit. His instinct was to certify to make a positive statement, but outside counsel said, “Thou shalt not unless you’re willing to assume a greater degree of personal risk.” Because you’ve now gone beyond the law to make this statement, and your risk profile for the plaintiff’s bar has just gone up dramatically if you do it.
Abrams: Our attorney told us the same thing.
Stephen Marcus (The Marcus Corp.): By that standard, soon we’ll never have anybody willing to be a CEO of a public company. The thing that concerned me the first time I had to sign was, “Have I really done enough due diligence to pass good judgment?” I knew I’d be spending some time with our attorneys, who I always thought were too tough about stuff like this. Now I’m glad they were because some of the changes we need to make internally are not all that draconian to us. So that first time around will probably be burdensome. Later on it gets easier.
Roche: There’s no question here that there’s been abuse and that abusers should be identified and locked up. But public companies are at the core of the free enterprise system. Seventy-six percent of our welfare system is provided for by taxes. General Electric is the largest taxpayer in the world. They also employ 400,000 people who pay taxes. They also provide products and services. Taking away that engine or turning it into a recluse is just absolutely the worst thing that could happen. We can’t burn down the orchard because of the bad apples.
Bruch: The theory of securities regulation is one of disclosure. You can sell any product to anyone if they want to buy it, but you can’t lie about it. What we’re seeing is people who said, “My God, I lost so much money in Pets.com.” But, in fact, the disclosure suggested there were no revenues, there were just eyeballs.
Shalam: I’m concerned that with every CEO so busy right now trying to cover his tail, signing affidavits and things like that, nobody’s out there creating enterprises. We’re all too afraid to do anything.
My company could have never gotten to where it is without having access to public money. I strongly believe in that and that it’s the cornerstone of the capitalism that has made this country so successful.
Ed Kopko (Butler International): I was with the CEO of a large private company recently, and he was saying, “I have a multi-billion-dollar company. I don’t have to answer to four independent directors who are going to tell me whether I can continue to run my business that I own a bunch of stock in. I don’t have to answer to all these different laws.” And I walked away kind of jealous.
Albertson: Everybody has his or her 15 minutes in the sun. And being public CEOs in the ’90s, we had our time in the sun. Our time in the sun will come again.
Shalam: I don’t know how many of us will survive. You can’t even get someone to serve on your board of directors. Everyone’s scared to death.
BÃ¶er: On disclosure, Arthur Levitt, who’s been highly critical of corporate America, has said, one, do it in plain English. Make sure people understand the risks. Put it in your 10Ks, in your annual reports. And two, look at the tone you set at the CEO level, the tone the board sets, how you conduct board meetings and whether you have checks and balances. Do you have constructive dissent in the boardroom? Do you provide enough information so that your board members can make informed decisions?
It isn’t brain surgery. The problem goes back to the business judgment rule. You play the football game on Sunday, not on Monday morning when the armchair quarterbacks say, “Well, you had a wide receiver open on the 20-yard line, you should have passed to him.” It’s 20-20 hindsight that makes business judgment such a critical issue.
Lamoureux: But a lot of the errors have been gross errors. People were misleading investors, especially individual investors. I don’t feel too sad for the informed investor. It’s the individual investor who has problems. Some proxies are meant not to be understood. They are pages and pages of gobbledygook. Even we sometimes have to hire experts to help us figure out compensation plans. Some are unbelievably complex. The same for annual reports. With Enron, everything was there, you just had to find it.
Have you ever seen [Warren] Buffett’s annual report? His proxy is about 10 pages. And Buffett talks to people in English. He’s the only guy that answers questions all day without a script, without his lawyer telling him what to do. The public appreciates it, and now there will be a premium for people who do that. Why is GE doing it suddenly? Because they know it pays.
Rethore: Before any of this started there was a movement underfoot to improve the quality of governance. There’s been a shift toward smaller, more focused boards with more independent directors. Unfortunately it gets lost in the shuffle and the commotion of what’s in the public arena today.
Donlon: That’s a good point. The European boards have been smugly saying that our system is superior because they don’t have any Enrons or WorldComs.
BÃ¶er: But now you have Deutsche Telecom, Vivendi and others. So they aren’t quite as pure and smart as they were. There’s a much more concentrated system of management and of governance in Europe. The so-called supervisory board is totally independent, but, frankly, it rubber stamps; it doesn’t provide checks and balances.
Rethore: In the U.S., the board has really two jobs. One is to pick and oversee the activities of the CEO, and second is to make sure that CEO has a sensible plan for the enterprise going forward and to ask a lot of tough questions along the way. That’s it. Nose in, fingers out. When you say management, I get a little concerned. Having been a CEO, the thought of a board managing a company and estate scares the hell out of me.
Work in progress
Sanderson: It seems to me the system’s working. This intense fire of public opinion works. It makes us check whether or not we’re still able to use those values and principles that got us here. That’s good. When this all gets done we’re all going to be better for it.
BÃ¶er: The system isn’t broken, but there are lots of people who think it’s broken. We haven’t seen the full swing of regulation. There’s a real danger that Congress, for example, can and will get into the business of regulating compensation. There are a number of proposals that would cap, for example, executive compensation as a multiple of average production line compensation, which would be a disaster.
Marcus: It seems to me that we need to embrace and practice correct corporate governance as a value. And parallel with that we need to make sure that we don’t get the kind of legislation that’s terribly damaging for the free enterprise system. Doctors have a saying: Do no harm. And there are a whole variety of ways, various trade associations and so forth, that can help in getting that message out to the legislators so they don’t go too far overboard. We’ll need to be diligent to make [the legislation] come out right.
Peter Crist (Korn/Ferry): We’re going to see more unintended consequences. We’re already seeing the shortening of the CEO tenure. That will continue. One positive unintended consequence is what I call the return of the operator. In almost every search we’re in now clients are looking for the operators, rather than deal-makers. The operator is coming back.
McCallister: I worry about boards. Most people don’t serve on a public board for the money, so why would you want to throw yourself into a storm for what little you get from it? I think those in the recruiting business are going to have a real interesting year or two trying to place people into board positions.
Crist: I’m doing five searches right now for audit committee members and we’re striking out right and left.
Albertson: It sounds like the pay at the audit committee will go up. The cost of a board is getting ready to rise.
Bruch: Fundamentally it always comes back to sound, basic skills, integrity, good disclosure, timely reporting, a culture of honesty. You simply have to add a little element of being defensive there to protect yourselves, your boards and your companies. Because the costs of being ensnared in any kind of scandal are extraordinary, whether or not it’s ill-founded. So be prepared to do a bit more on compliance so that when the bad time comes you’re prepared to defend it, and you’ll get out of there as painlessly as possible.
Albertson: The attitude of CEOs today should be, “What else would you like?” There isn’t much left that isn’t disclosed. There are lots of different ways to interpret the information that we put out there, and certainly every institutional investor we have has got reams of analysts that interpret it in 9,000 different ways. Our job is to provide the information to them so they can analyze it, do their calculations and come up with their return on equity or their return on capital.
If you go to our shareholders with that attitude, hopefully they’ll recognize that you’re doing everything that you possibly can to give them what they need to make intelligent, educated decisions on whether or not they’d like to invest in your company. At the end of the day that’s the end of our responsibility to the shareholder community as a CEO