System failure, system renewal. (Governance Leadership).

How should the interests of the public be protected in a governance environment dominated neither by sinners nor saints? And, how can that protection be made available in a manner that does minimum damage to the private enterprise system? It's a tall order, but specific courses of action are clear.

CORPORATE GOVERNANCE in the United States is facing a variety of external pressures for change, many of them involving a larger governmental presence in internal business decision-making. The three most obvious sources of those pressures are (1) the downturn in the American economy in 2001, (2) the terrorist attacks of September 11, 2001, and their aftermath, and (3) the widespread public criticism of business practices resulting from the Enron bankruptcy. The third of these factors is likely to generate the most severe and lasting impacts on corporate governance.

The first adverse factor, the decline in U.S. gross domestic product, is likely to be the most ephemeral. Yet, the lingering effects of recessions invariably reduce public confidence in the private enterprise system, making it easier for the advocates of additional government intervention to gain support for their case. Thus, the coincidence of the economic downturn with the other two events is an unfortunate bit of timing.

The second factor, especially the comprehensive national response to the rise of international terrorist activities, has generated a longer-term expansion of the role of government in day-to-day business operations. The common characteristics of the great bulk of these interventions -- be they tougher anti-money laundering rules or more extensive inspections of imports or more detailed investigations of employees and customers -- is to increase the overhead costs of doing business in the United States and, to some degree, to reduce the discretion available to business managers.

Nevertheless, the need for these antiterrorist efforts is widely supported in the business community as by the public in general. Thus, we can expect business managers to respond to this second factor in the same general way that they deal with any new major element of expense. They improvise, innovate, and otherwise attempt to achieve the new objectives with minimum cost and disruptions to the enterprise.

The most troubling questions

It is the third category of public challenges to corporate governance -- those resulting from the widespread reports of corporate mismanagement and worse -- that are likely to have the most serious and lasting impacts on the conduct of the business of U.S. corporations. Numerous issues have been raised in the national media as well as in a flurry of Congressional investigations. The following appear to be the most troubling questions:

1. Have the accounting firms lost their independence and integrity in the effort to expand the scope of their operations and the profits that they receive?

2. Are lawyers failing to alert their corporate clients to the perils of using clever ways of cutting corners in meeting the requirements of law and regulation?

3. Have the boards of directors of corporations been unable to keep up with the intricacies of business finance and thus have they not adequately performed their critical role of overseers of management?

4. More specifically, have the audit committees failed in their function of providing the fiscal conscience of the corporation?

5. Has the effort to get top management to think like shareholders -- especially by using options as a major portion of compensation -- backfired?

6. Is there in effect a double standard in much of American business: Are rank-and-file employees expected to meet higher levels of integrity and ethical behavior than top management?

These are loaded questions which the typical honest American business manager must resent having to hear, much less answer. Surely, that was my personal response as a corporate director. Nevertheless, these questions -- and many others in the same vein -- reflect the growing public dissatisfaction with the state of corporate governance in the United States. The underlying resentments are not new, but they may have been submerged when the stock market was booming. The less favorable stockholder experiences of more recent times has brought these long simmering concerns to the surface.

Lessons from the past

It seems almost inevitable that the widespread damage done to employees and investors by the Enron bankruptcy and a few similar episodes will produce a new wave of government regulation of business. Under the circumstances, attention is warranted to ways that will help policymakers in writing constructive laws and regulations. Some lessons from past efforts to regulate business would seem to be a useful starting point. For example, despite all the talk about "deregulation," the fact is that the great variety, as well as complexity, of the existing array of regulation is awesome.

Anyone who has any doubts on that score should examine the many volumes of the Code of Federal Regulations. Better yet, just try to read one of the daily issues of the Federal Register. It is an eye opener just to see the number and variety of governmental regulations that are issued in a single day. It is not merely a matter of diminishing returns (i.e, very modest benefits) from this process. The most relevant "lesson" is that so often regulatory power is exercised in a manner that generates unexpected -- and frequently counterproductive -- results. A cogent case in point is the rise of the 401(k) "retirement" plans that are receiving much attention (see sidebar, "The Best Is the Enemy of the Good").

What changes should be made?

It likely is an exercise in wishful thinking to expect that, before it acts, Congress will carefully survey the true condition of corporate governance in the U.S. As someone who has served on a number of corporate boards of directors for over a quarter of a century, I personally am struck by the variety of circumstances that exist.

Surely, many companies are well managed. Their senior executives, boards, and outside legal and accounting firms all do the conscientious and honest job that is expected of them. Yet, as recent events have made clear, such a benign situation is hardly a universal experience. How should the interests of the public be protected in an environment dominated neither by sinners nor saints? And, how can that protection be made available in a manner that does minimum damage to the private enterprise system that generates such great magnitudes of goods and services, employment, income, wealth, innovation, and progress?

Achieving those multiple objectives is, to put it mildly, a tall order. It surely requires some modesty in recommending specific courses of action. The sensible place to begin may be the questions that were posed earlier. Let us see how responding to each of these questions may generate a useful agenda for reforming corporate governance in the United States.

1. Refocus the role of the accounting firms

Former SEC chairman Roderick Hills recently told the Senate Banking Committee, "It is increasingly clear that the accounting profession is not able consistently to resist management pressures to permit incomplete or misleading financial statements." Hills's concerns have been voiced by other knowledgeable observers. A fundamental response is required on the part of the accounting profession and its clients.

As a practical manner, the practice whereby a company uses the firm that conducts its outside audit to perform a variety of other services has fallen out of fashion. Whether or not as a matter of formal policy, a great many companies -- perhaps the majority -- are phasing out the non-audit functions of their external auditors. In some cases, these ancillary functions were not substantial or are now much smaller than was the case, say, five years ago.

There are serious difficulties in a client pursuing a policy of eliminating its reliance on its customary auditor to perform other advisory functions. For example, there is a very considerable overlap in the knowledge needed to audit a given firm and the ability to assist in the preparation of its tax returns. Where should the line be drawn? Numerous instances have been brought to light where the non-audit work dominated the agenda (and earnings) of the audit firm. Given the tendency for the non-audit work to be more profitable, the expected incentive would be for the auditors to consider the actual audit work to be a "loss leader" and to move its best people into the non-audit functions.

Without the benefit of new laws or regulations, the era of non-audit dominance appears to be ending -- although the threat of potential new statutes or rules surely was present. In any event, this situation may be an example of the information alternative to regulation. The widespread understanding of the potential conflict of interest is, by itself, resulting in an improvement of the situation.

Yet there are other troubling aspects of the role of the accounting firms that are still with us. For example, it is not unusual for the "outside" auditor also to perform all or a large part of the internal audit function. Apparently this was the situation at Enron. Despite talk about "Chinese walls" separating the two functions, I find this practice highly undesirable. Lawyers may not consider such an arrangement to be a conflict of interest, but it surely is open to that kind of challenge. Having employees of the same firms do the internal audit and then perform the outside review reduces the effectiveness of the formal checks and balances system that is designed to protect the financial integrity of the enterprise. The SEC should revoke its shameful ruling that the outside auditor can perform up to 40% of the internal audit. In this regard, the accounting profession is ahead of the regulators. The association of CPAs (the AICPA) has recommended eliminating this practice.

More fundamentally, experiences at a number of companies (Global Crossing comes to mind) raise the uneasy feeling that the auditing firms at times have been reluctant to contest the questionable practices of a major client. Compounding the concern is the rising belief that the auditors did not always have an adequate understanding of the financial transactions that they were examining.

Some observers would deal with this situation by having the federal government select and pay for the external audits of companies. That change surely would eliminate the excessive closeness between the auditors and their clients. But the politicization of the auditing functions would most likely become a stellar example of the cure being worse than the disease. Another approach, advocated by former SEC Chairman Harold Williams, is to require mandatory rotation of auditors at specific intervals, such as five or seven years. Dean Joel Seligman of the Washington University Law School would combine that notion with the requirement that the client cannot terminate the relationship during the specified period (except for obvious cause), thus virtually assuring the independence of the external auditor.

All in all, continued reliance on the information - and exposure - route seems to be the most sensible way under present circumstances.

2. Don't let the legal profession wiggle out of its share of the responsibility for the shortcomings in corporate governance

It is fascinating to see how successful lawyers have been in ensuring that so much of the liability for the current problems of corporate governance falls on the accounting profession and so little on the members of the bar. To add the proverbial insult to injury, at the same time that attorneys are so actively urging that accounting firms rid themselves of their non-audit functions, they are campaigning vigorously to expand and strengthen the "multidisciplinary practices" of their own firms.

It is poor form for so many members of the bar to look down from Olympian heights and to castigate those other mere mortals for their shortcomings. The concern with maintaining high levels of legal ethics surely should extend to the advice that lawyers are providing to the corporate decisionmakers who have done such a great disservice to investors, employees, and the public generally.

The concern extends beyond the age-old notion that what is sauce for the CPA goose should also be administered to the LLB gander. Rather, the point is far more fundamental: So many of the highly criticized financial actions by managements and auditors alike had been blessed in advance by their house counsels, outside law firms, or both. To state the matter mildly, there is enough criticism to go around and the onus for bad performance needs to be shared fairly and more widely.

3. Put more onus on boards of directors

As a longtime corporate director, I note with a great sadness instances where boards of directors seem to be asleep at the switch. At a time when public criticism of business is rising, the independent (i.e., outside or nonmanagement) members of corporate boards have a more vital role than ever in assuring shareholders and the society as a whole that the business is being responsibly managed. In my personal experience, most directors take their responsibility very seriously. However, it is the lapses from good practice that attract public attention and that give business in general a "black eye."

Given the general practice for the CEO also to serve as the chairman of the board of directors, it is difficult for the individual director to seriously question the major decisions of the company. Yet, when we consider the disgrace that has been heaped upon some of the Enron directors, it seems clear that exercising independent judgment is not just a prerogative of the outside directors. The attitude of independence is a basic way of protecting the individual's integrity as well as that of the enterprise.

In that regard, several director selection practices should be frowned upon -- such as "celebrity" directors who do not understand the basics of corporate governance, overly committed directors who serve on eight, 10, or more boards while holding down a "regular" job, personal friends of the CEO, and directors who simultaneously serve as high-priced consultants or suppliers to the corporation.

The limitations of any board must be kept in mind. Despite its latent power derived from the shareholders (owners) of the business, no committee can effectively run an organization. The successful board operates in the middle, avoiding the extremes of becoming either sycophants or rivals to the management. The board's basic task is advising and questioning the management rather than trying to second-guess it.

4. Wake up the audit committees

A recent analysis by investigative reporters of the Chicago Tribune revealed the extent to which the financial watchdogs did not bark. Of the 207 publicly traded companies that filed for bankruptcy in 2001, many lacked an audit committee or had current or recently departed company executives on the committee. In two instances, a former employee of the auditor chaired the audit committee. In a dozen cases, the audit committee did not even meet during the year prior to the bankruptcy. Another 28 only met once.

The major stock exchanges have rules prohibiting most of these practices. The NewYork Stock Exchange, for example, requires each listed company to establish an audit committee consisting entirely of outside directors. Nevertheless, it seems quite clear that the effectiveness of audit committees is, to say the least, uneven. Enron's audit committee met all of the formal NYSE and SEC requirements. Yet it failed to blow the whistle on some of the most outrageous financial practices ever perpetrated on unsuspecting shareholders.

In a world of increasingly sophisticated financial techniques, the company's audit committee -- as well as the entire board -- seemed to have violated one of the most elementary rules of management: If you don't understand something, don't approve it. To cite Roderick Hills again, "The audit committees of too many boards are not exercising the authority given to them or the responsibility expected of them:'

Audit committee members need to show a spirit of inquiring independence. An arm's-length relationship between the audit committee and the company management is essential in establishing and maintaining that independence. TIAA-CREF has provided a good working definition of independent directors which readily relates to the requirements of serving on the audit committee: "No present or former employment by the company or any significant financial or personal tie to the management which could interfere with the director's loyalty to the shareholders:'

A reasonable extension of the power of the audit committee is to vest in it the sole authority to hire and set the fees for the outside auditing firm. At present, management tends to do that, only subject to the approval of the committee. Such a seemingly technical and operational shift would help both bolster the authority of the committee and strengthen the independence of the external auditors.

5. The effort to get top management to think like shareholders has not only failed -- it has backfired

Many corporate executives have learned how to use arcane financial methods -- which may (or may not) meet the minimum requirements of existing laws and regulations -- to manipulate corporate reporting and in the process generate unprecedented rewards for themselves.

Simultaneously, boards have blithely approved extremely generous stock option plans that often bear little relation to the contribution of the senior management to the returns to shareholders. As we have learned in the case of government accounting, activities that are off-budget are more likely to spiral out of control. Putting option awards into the company's financial statements will help. But there is no substitute for the compensation committee and the full board being more cautious in awarding large numbers of options to any individual executive.

Like the audit committees, the compensation committees of boards of directors would benefit from a greater degree of independence. Like the audit committee, the compensation committee should consist entirely of truly independent directors (as it often does). Moreover, the selection and pay of the outside compensation advisers should be determined by the committee and not by the management that is to be rewarded. Here is another example of the inability of corporate legal advisers to detect and blow the whistle on what, at least to a layman, appears to be a blatant conflict of interest: management selecting the folks who draw up its compensation plans and who advise the board on those same compensation matters.

As a firm advocate of incentive compensation, I am dismayed, however, by the numerous examples of generous payments for poor performance. For example, there is little justification for the all-too-common practice of rewarding management for below-average increases in stock prices.

6. The levels of integrity and ethical behavior expected of the tank-and-file should be extended to senior management At first blush, this recommendation sounds insultingly needless. Yet, on reflection, a double standard often exists -- and in numerous ways. To cite a few examples, many companies which are reluctant to permit lower-level executives to engage in outside business activities are far more generous in letting more senior managers do so. I don't mean merely serving on other corporate boards -- which, within reason, can be very useful both to the individual and to the company. Rather, I have in mind actually running other businesses.

A less dramatic but more frequently encountered example is the difference in the treatment of expense accounts. Consider the meticulous nature of the review of minor expenses by a low-level manager and the perfunctory check of the far larger expenses of more senior executives. Without going into needless (and perhaps somewhat embarrassing) details, I must report some personal experiences along these lines. Unfortunately, these two examples do not exhaust the array of differences in the treatment up and down the corporate hierarchy.

The challenge now

At its best, America's system of private enterprise delivers an unparalleled combination of rising living standards, attractive employment opportunities, and technological innovation. It would be most unfortunate for the nation's future if the powerful benefits of the business system were obscured by uncorrected shortcomings. The challenge to American business now is to respond promptly and constructively to the severe challenges to corporate governance before they expand into crisis proportions.

RELATED ARTICLE: 'The best is the enemy of the good'

In the case of Enron, many culprits were involved, not the least of which was the well-intended ERISA (the Employee Retirement Income Security Act).

Congress enacted ERISA in 1974 after hearing dramatic cases of workers losing their pensions after many years of service. As would be expected, Congress responded by enacting a host of statutory "protections." Why make a point of that? Because, back in 1974, most company-sponsored pensions were of the "defined benefit" variety, where the employer was on the hook to pay specified pension benefits to its retiring workers.

In retrospect, the ERISA experience exemplifies the old notion that "the best is the enemy of the good." ERISA imposed so many paperwork and other costly burdens on employers that thousands of pension plans were quickly terminated (about 10% of existing plans). More importantly, over the years that followed, companies and other employers learned the advantages (at least to them) of getting out from under the burdens of ERISA altogether by shifting to "defined payment" arrangements such as 401(k) plans. Under this approach, the employer may set up a retirement plan but it does not necessarily have to make a financial contribution (or that contribution can be in the form of company stock). Under the "defined contribution" plans, the employer is not responsible for the payment of any specific level of retirement benefits. The basic risk in retirement financing shifts from the employer to the employee. Most company retirement plans are now of the "defined payment" type and not subject to the rigors of ERISA!

What should Congress do? Before it starts to write new statutes, Congress should make sure that the existing laws are being fully enforced. Judging from widespread media reporting, at least some of the people involved in the Enron fiasco broke the law. To the extent that any of them violated statutes or regulations, the extensive law enforcement and judicial powers of the federal government should be fully utilized to "throw the book" at them. Heavy fines and long jail sentences, when the law calls for them, are a strong signal to the rest of us that the highly criticized conduct is not acceptable to society.

Subsequently, after making sure that the country needs some new laws, the Congress should -- without the theatrics of recent hearings -- sit down in quiet committee sessions and go about the serious business of writing new legislation. Contrary to the standard treatment in the civics books, the actual process of writing the laws does not get as much Congressional attention as it deserves or as the public thinks. Without the TV cameras and press coverage, many committee members are off doing something else -- especially if the alternative to the difficult chore of legislative drafting is participating in another publicized hearing. The result, more often than not, is a hastily drawn law that passes the buck to a regulatory agency. If that sounds too harsh, consider how frequently new laws written under great pressure are followed a year or two later with a "corrections" bill trying to fix the mistakes in the earlier bill.

Governmental decisionmakers also need to take into account the important changes that corporations and auditing firms are now making voluntarily so that they will not have to endure an Enron-like experience. My personal forecast is that -- whether or not Congress passes a law on the subject -- fewer and fewer companies will repeat the Enron blunder of hiring the same accounting firm to do both the internal audit and the external audit. Moreover, many companies are limiting their accounting firm to performing the traditional audit function or at least severely restricting the amount of consulting work that they can do for the company.

Murray Weidenbaum 

NYSE recommendations for 'truly meaningful reform'

The New York Stock Exchange in June released recommendations from its Corporate Accountability and Listing Standards Committee, which proposes new standards and changes in corporate governance and disclosure practices of NYSE-listed companies. The committee report also makes recommendations to Congress and the Securities and Exchange Commission on various policy and regulatory matters.

In the committee's comprehensive, four-month information gathering process, it reached out to investors, listed companies, trade associations, the financial services industry, and other Exchange constituents. Based on its findings, recommendations include:

* Increasing the role and authority of independent directors.

* Tightening the definition of "independent" director and adding new audit committee qualification requirements.

* Encouraging a focus on good corporate governance.

* Giving shareholders more opportunity to monitor and participate in the governance of their companies.

* Establishing new control and enforcement mechanisms.

* Improving the education and training of directors.

"Reassuring investors about the integrity of the corporate governance and disclosure process alone is not enough," said NYSE Chairman and CEO Dick Grasso. "Investors demand and deserve truly meaningful reform and substantive change to restore their trust and confidence in our publicly traded companies, our regulatory authorities and our markets. The measures proposed by the NYSE Corporate Accountability and Listing Standards Committee go a long way in addressing investor concerns and expectations. They represent an opportunity to strengthen the governance at NYSE-listed companies, truly the world's best, and the checks-and-balances among investors, issuers and the NYSE market."

Central to the report is a provision that boards of NYSE-listed companies have a majority of independent directors (listed companies would have a two-year transition period to satisfy this requirement). In addition to an expanded role and greater authority of independent directors, the committee report calls for:

* Increasing the responsibilities of board audit committees.

* Mandating that shareholders vote on all equity-based compensation plans, including stock option plans.

* Requiring audit, nominating, and compensation committees to consist solely of independent directors, with a requirement that the chair of the audit committee have accounting or financial management experience.

* Tightening the definition of an independent director, including a five-year cooling-off period for former employees.

* Mandating that director compensation represent the sole remuneration from the listed company for audit-committee members.

* Granting the audit committee sole authority to hire and fire auditors and to approve any significant non-audit work by the auditors.

* Requiring the CEO of NYSE-listed companies to attest to the accuracy, completeness, and understandability of information provided to investors.

* Mandating that listed companies adopt and publish corporate governance guidelines and a code of business conduct and ethics.

* Establishing a Directors' Education Institute to assist directors in their responsibilities.

* Allowing the NYSE to impose additional penalties, including public reprimand letters, in addition to suspension and delisting.

* Requiring non-U.S. issuers to disclose how their practices differ from NYSE rules and procedures.

The committee's recommendations to Congress and the SEC include:

* Establishing a new private-sector organization, funded separately from the accounting industry itself, to monitor and govern public accountants.

* Calling for the SEC to evaluate the impact of Regulation FD on earnings guidance and to consider reforms.

* Asking Congress to allocate additional resources to the SEC to increase the agency's monitoring and enforcement activities.

* Prohibiting relationships between auditors and their clients that would affect the fairness and objectivity of audits.

* Calling for Congress to establish a public/private panel to study the concentration of employee 401(k) holdings in company stock.

* Giving the SEC the authority to permanently bar officers and directors from holding office again after violating their duties to shareholders.

* Calling on the SEC to require companies to report complete GAAP-based financial information before any reference to "pro forma" or "adjusted" financial information.

* Calling for the SEC to exercise more active oversight of the FASB to improve the quality of GAAP and the speed of FASB actions.

* Asking the SEC to improve management's discussion and analysis disclosure on critical accounting alternatives and assumptions.

* Requiring the prompt disclosure of insider transactions.

The committee urges policymakers to avoid imposing additional liability on directors, or reducing the protections currently available through director and officer liability insurance and state-law exculpation provisions. The report also urges them to avoid repealing or weakening the Private Securities Litigation Reform Act.

Following public comment on its recommendations, the committee plans to seek approval of the report at the NYSE board of directors' Aug. 1 meeting.

Source: New York Stock Exchange

Business Roundtable CEOs issue 'best practices' roadmap

The CEOs of approximately 150 of the country's largest corporations announced core principles to help American public companies meet their corporate governance responsibilities more effectively. The Business Roundtable (BRT) in May issued best practices in corporate governance, with the Roundtable's member CEOs strongly encouraging all U.S. public companies to adhere to these guidelines to help restore public trust in American business.

"America has the best corporate governance, financial reporting and securities market systems in the world, but we can further strengthen the system," said Franklin D. Raines, chairman and chief executive officer of Fannie Mae, and chairman of the Corporate Governance Task Force of the Business Roundtable. "These recommendations represent a roadmap for excellence in corporate governance that we urge all companies to follow."

The BRT's 2002 Principles of Corporate Governance call on companies to adopt a number of best practices in corporate governance, including:

* Require stockholder approval of stock options and restricted stock plans in which directors or executive officers participate.

* Create and publish corporate governance principles so that everyone from employees to potential investors understand the rules under which the company is operating.

* Provide employees with a way to alert management and the board to potential misconduct without fear of retribution.

* Require that only independent directors may sit on the board committees that oversee the three functions central to effective governance: audit, corporate governance, and compensation.

* Ensure that a substantial majority of the board of directors comprises independent directors both in fact and appearance.

* Ensure prompt disclosure of significant developments.

* Establish a management compensation structure that directly links the interests of management to the long-term interests of stockholders, which includes a mix of long-and short-term incentives.

* Require the audit committee to recommend the selection and tenure of the outside auditor and consider what policies should be adopted by the company with respect to changing the outside auditor, rotating the audit engagement team personnel or limiting the hiring of such personnel.

These new guidelines build on the work the Business Roundtable has done on corporate governance issues for 25 years. The BRT is an association of chief executive officers of leading corporations who are committed to advocating public policies that foster vigorous economic growth and a dynamic global economy. A copy of the BRT's 2002 Principles of Corporate Governance can be obtained by visiting the association's Web site at www.brt.org.

Source: Business Roundtable

Murray Weidenbaum is the Mallinckrodt Distinguished University Professor at Washington University in St. Louis, where he also is honorary chairman of the Weidenbaum Center on the Economy, Government, and Public Policy. He serves on a number of public company and advisory organization boards, including Tesoro Petroleum Corp. and the Center for Strategic and International Studies. His past corporate board service includes Beatrice Foods, Contel, May Department Stores, and Medicine Shoppe. Known for his research on economic policy, taxes, government spending, regulation, and international trade, he is the author of eight books, the latest being the sixth edition of Business and Government in the Global Marketplace.