HLP Remarks

Orange County Public Company Forum

The Sutton Place Hotel

(February 26, 2004)

          Good morning.

          It’s truly a pleasure to be here with you.  Stephen Cooke and the sponsors have put together a timely and interesting discussion.  And, you’re all to be commended for getting up so early to listen to a fair amount of talk about some very somber subjects!

          The Forum’s sponsors presumably wanted a catchy title, so this year’s Forum explores “Dueling Interests.”  Now, dueling – at least if it’s going to be fair – usually entails only two participants.  A careful perusal of the conference brochure makes it clear that what the sponsors had in mind were conflicts between increasingly active shareholders (large and small) and corporate managers.  Ah, if life were only that simple.

No, the truth of the matter is that there are many different sets of duelers out there, including:

·        Institutional shareholders vs. corporations

·        Independent directors vs. senior managers

·        D&O insurers vs. corporations

·        Independent accounting firms vs. corporations

·        SEC vs. corporations

·        SEC vs. corporate officers

·        SEC vs. independent corporate directors

·        Eliot Spitzer vs. the business community

·        Eliot Spitzer vs. SEC

I’m sure you get the point.  So, I’d like to talk with you this morning about where we are, where we’ve come from, and where we’re likely headed.  As Yogi Berra likes to say, “if you don’t know where you’re headed, you’re apt to wind up someplace else.”  I’ll also try to leave ample time for any questions you may have.

          Over the past three years, we’ve witnessed scandalous behavior that’s created a feeding frenzy by those who like to attack business as a way of life.  It’s contributed to a radical decline in investor confidence.  To put it in some perspective, we’ve seen:

·        Volatile markets that respond instantaneously to “negative” or surprise information;

·        Institutional and individual investors abandoning deferred gratification and any long-term commitment to their portfolio securities;

·        Companies obscuring, fudging, misstating or downright lying about their financial results;

·        Watchdog outside directors who watched instead of acting;

·        Corporate compensation schemes that rewarded CEOs lavishly, even in the face of substandard performance;

·        Accountants who didn’t always audit competently, and weren’t subject to meaningful quality controls;

·        Lawyers who cavalierly allowed or facilitated the pursuit of improper or illegal courses of action by corporate managers;

·        Fund managers who let favored customers rip off the great unwashed.

Now, we’ve had corporate scandals before, and we’ll surely have them again.  What makes the current spate different from their predecessors, of course, is that, with booming markets creating false illusions of value, the losses this time were of a stunning and shocking magnitude.  So, where does this leave us?  Notice I say “us,” because one common mistake many senior managers of public companies make is to think that everything I’ve just described is happening to some amorphous group known as “them.”  But it isn’t; it’s happening to all of “us.”

We’re left in a very uncomfortable place.  The business community is being flogged and subjected to a plethora of new statutes, rules, prosecutions and an unsympathetic financial press that needs only nanoseconds to disseminate every peccadillo, misdeed or fraudulent act of anyone functioning in our capital markets.  The popular wisdom being purveyed is that, as a universal proposition, businesses are run by insensitive, unthinking, selfish, greedy men and women.  While we know that generalization isn’t true, the story’s being portrayed that way, and for far too many, that’s their reality.

I worry that some otherwise sensible corporate managers still “don’t get it.”  There’s a lot of grousing and whining going on out there – much of it justified – but that doesn’t change the fact that all of it is useless and counterproductive.  A question I’m frequently asked is when  the proverbial pendulum will start swinging back and the business bashing will cease.  My unpopular response is: what we’re seeing now is real and it isn’t going away.  A lot of credibility the business community used to have has been squandered and eroded. 

Worse, focusing on a mythical pendulum loses sight of what’s really important.  Many companies and their advisors today assume the reason they need to improve their governance, policies and procedures is the initiatives of legislators, regulators and prosecutors.  I think that’s wrong.  While compliance is necessary, it’s not sufficient.  Recall that all of the misconduct we’ve seen was already illegal before Sarbanes-Oxley reared its ugly head.  Sure, when new laws and rules come down, they must be understood and followed.  But those who strive to do no more than the minimum they must do to pass muster, run a real risk of finding themselves enmeshed in the same mess as so many other corporate managers who’ve preceded them.

There’s another problem with this scenario.  If honest businesses let the government set the standards and the rules about how business will be conducted – and that’s exactly what we’re witnessing – then God help us all.  As a nearly four-decade Washingtonian, I know that, when Washington tackles a problem, it often makes things worse!

So why worry about governance and transparency?  The overwhelming majority of us do the right thing because we’re convinced it’s in our own self-interest to do that.  And I’m telling you that we need to put all the grousing to one side, and realize that it’s in business’s interest to look beyond Sarbanes-Oxley and the SEC’s proposed corporate proxy access rules, and think about effecting real governance and transparency reforms.  Here’s why.

In the current mutual fund catastrophe, people are being fired, companies are being fined, some execs are going to jail, and new rules are coming into play.  That’s pretty strong stuff.  But, the sad story of Putnam makes even these Draconian consequences seem like child’s play.  Putnam experienced a drain of nearly $60 billion in assets under management.  Most funds would like to have $60 billion under management.  Just imagine losing that much.  And it happened because large and small investors voted with their feet.  Since fund managers generally make less money with fewer assets under management, the impact of this market force hit that manager where it really hurts – in the pocketbook!

Now that’s an eye-opener.  It happened even though many people who walked can’t tell you what market timing and late trading are, or why they’re bad.  But, everyone understands that these things happened because fund managers were favoring some fund shareholders over others – those who paid for the benefit, or bestowed other business benefits on fund managers.  And the Wall Street Walk approach – if I think you’re misbehaving you won’t get, or keep, my money – is proving quite an effective deterrent to that kind of conduct in the future.

Even beyond the harsh consequences of seeing investors extract their financial support from companies that mislead the public, accounting firms, D&O insurers, investment bankers, venture capital firms, rating agencies and institutional investors focused on corporate governance are all making it imperative for companies and managers that want to survive and prosper to look beyond the letter of the new laws and rules, and think about distinguishing themselves from the pack.

One consequence of the seemingly unending string of corporate implosions is the adverse economic and reputational damage that flows from such tawdry events.  These consequences are felt not just by the companies that engaged in misconduct, but by those who provide critical professional services to them as well. 

Thus, for example, outside auditors have learned that, if a client goes down, the audit firm suffers too, even if the audit firm was defrauded too.  This has caused accounting firms to ratchet up the standards for new client intake, as well as the standards for existing client retention.  As a result, many companies may not have the advantage of being audited by a Big Four accounting firm.

Similarly, investment bankers have learned – the hard way, via settlements with the SEC – that there’s a risk associated with raising capital for companies with higher risk profiles.  The concept of due diligence now has new meaning, and bankers are not going to raise capital for just anyone who walks through their doors.  They’ll need assurances that there is a very small likelihood that by raising money for a company they may wind up paying out multiples of any fees earned in settling class actions and SEC litigation.  This means that that not every company will be able to raise funds at the public trough. 

Investment bankers, and the officers and directors of acquiring companies also need to think about the consequences of the period of renewed M&A activity we’ve entered.  Just imagine the consequences to investment bankers, and the managers of acquiring companies, if they jeopardize a sound company’s position with the acquisition of a company whose financials are hiding a multitude of sins.  This isn’t theoretical.  You’ve read about companies in exactly this situation.  Is there a fiduciary obligation on the part of the acquiror’s leadership to figure out whether they should proceed with an acquisition in the face of these kinds of developments?  I think the question answers itself.

The practical implications of these developments are considerable.  For one thing, the restraints being imposed on investment bankers mean that companies will have to mature before they can count on raising funds from the public.  This, in turn, means that start-ups and companies that aren’t fully mature will be more dependent than ever on venture capital to satisfy critical funding needs.  And yet, venture capital firms want to be certain of their exit strategy before they plunk their money down.  That exit strategy is most often a public offering or an acquisition.  And so, issues of governance and transparency will become important for companies that aren’t even public yet.

The detriment to reputation also afflicts corporate directors.  The Enron Audit Committee, for example, was an “all-star” committee.  Today, those individuals, who had impeccable reputations for veracity and integrity, can’t serve on any public company boards, even if they wanted to do so.  Worse, securities class action litigation in the post-Reform Act environment is trending in a very dangerous direction.  Add to this the fact that, in its recent Chancellor case, the SEC has now targeted independent directors who don’t direct. 

These factors make one thing very clear: it takes a pretty brave man or woman to be willing to serve on the board of a public company, and an even braver person to serve on its Audit or Compensation committees.  Those companies that lack quality independent directors will suffer a denigration in the marketplace’s valuation of their securities.  But, in order to obtain the services of quality independent directors, two things are critical: the company must have excellent procedures, policies and transparency, and it must have the broadest available D&O coverage for its outside directors.

And yet, D&O carriers know, as do corporate directors, the painful truth that costs of settling securities class actions are rising exponentially.  Insurance companies can’t long survive if they wind up paying out more in litigation expenses and settlement fees than they take in by way of premiums!  This isn’t rocket science.  As a result, D&O carriers are reassessing who gets coverage, and whether they can extend their broadest coverage to firms or directors that pose higher risk potentials than carriers reasonably should assume.

At the same time, rating agencies are evaluating governance and quality of management in affixing public company ratings.  The prospect of liability for giving inflated ratings to companies with serious governance problems is driving rating agencies to require those they rate to undergo serious governance reviews. 

All this rethinking is buttressed by growing evidence that companies able to demonstrate they’re responsible, ethical and run by people with integrity outperform their core peer competitor groups.  Thus, the independence of audit committees, the full ventilation of issues, the timely disclosure of critical information, are factors that promise less liability and greater profitability.  Access to capital markets and the ability to obtain and retain quality directors are the rewards for adhering to good corporate ethics and morality.  In essence, we’re seeing a new form of “Corporate Darwinism,” where only the fittest companies with the best governance survive and prosper.  These factors have created a need for strong internal governance at public companies, and the ability of public companies to distinguish themselves from the “pack.”  More than any government regulation or prosecution, these factors are driving the push toward better governance, more independence, and greater transparency.

With this in mind, I thought I’d offer you my list of ten things public companies should keep in mind to avoid becoming the next cautionary tale splayed across the front page of the Wall Street Journal.  Bear in mind, of course, that I always have more than ten thoughts, but who’d listen if I said I had fifteen or sixteen?

·        Eschew the old wives’ tale that looking for problems is foolish; if you don’t, the problems will surely find you.

·        Learn the art of constructive co-existence; it serves no one if outside directors are unduly pliant, or unduly strident.

·        Being a director is not an innate or inherited skill, it’s a learned trait; outside directors need to be trained pragmatically to learn how to direct.

·        Shareholders should not be treated as if they’re the enemy, for the simple reason that they’re not; smart companies will maintain regular contact with their shareholder base, and attempt to develop a rapport and dialogue.

·        A sound system of internal controls will cause companies that can afford it to upgrade their internal audit function to ensure that problems are caught before they turn into problems.

·        Companies should seize the obligation arising out of S-Ox to create a state-of-the art anonymous complaint mechanism; learning about problems before they’ve surfaced means averting a crisis.

·        Just because it appears that your company is doing better than its competition doesn’t necessarily mean that it is; doing better, or worse, than your competition is something you should understand and be able to explain with great facility and accuracy.

·        Transparency – both internally and externally – is critical; making sure that the company’s various constituencies know at the earliest moment of potential concerns is the best way to preserve the franchise.

·        Compensation of senior executives has to be rethought to reward them for the right things, and to closely align their interests with those of the shareholders.

·        In a crisis, waiting for things to get better (or more defined) before making appropriate disclosure is like waiting for Godot; assume that regulators will insert themselves into potential problems far more rapidly than ever before.

·        Always ask yourself what would you want to know if you were a shareholder, in deciding what and when to disclose and how to grapple with a problem; and

·        It’s important not only to do the right thing, but also to be able to prove that you did the right thing.

I realize that the ability to deal with this new environment has become extremely complicated, and is daunting.  And yet, the rewards for forward thinking are enormous.  In this context, I’m reminded of a story from my college days.  In the sixties, those of us who used to cut our hair frequented two competing “cheapie” barber shops situated right across the street from one another.  For us, the only thing that mattered was price.  The two barber shops got into a price war.  Eventually the first shop lowered the cost of a haircut to ninety cents.  The shop across the street dutifully followed suit.  Not content, the first shop cut its price to seventy-five cents.  The second shop either couldn’t, or wouldn’t, go to seventy-five cents.  To most of us, that meant the end of the second barber shop.  But we woke the next day to see a huge sign in the second shop’s window, which read “We repair seventy-five cents haircuts”!

          The lesson was clear.  No matter how difficult your situation, with thoughtfulness, creativity, patience and exacting care, you can surmount almost any obstacle.  In a difficult environment, tough standards, exacting procedures and policies will be rewarded.  Count on it.

Thank you.