3:00 P.M., EST
NEW YORK FOREIGN PRESS CENTER, 799 UNITED NATIONS PLAZA, 10TH FLOOR
3:00 p.m. EST
MS. GRUNDER: I’m Alyson Grunder, as many of you know, and we’re really thrilled this afternoon to have worked with the Conference Board’s Governance Center to put together quite a formidable expert panel on the topic of corporate governance. Today we have with us Donna Dabney, Executive Director of the Conference Board's Governance Center, Arthur Kohn, partner at the law firm of Cleary Gottlieb Steen & Hamilton, and Joan Lamm-Tennant, global chief economist at Guy Carpenter & Co. I sent you everyone’s biography, and I don’t want to take time away from the presentations, so I think we’ll just go right into them, starting with Donna Dabney. Let me just remind you that our panelists are speaking on their own behalf, and not representing the views of the U.S. government.
MS. DABNEY: Hello, everyone. I lead the Conference Board Governance Center. And in that capacity, we’ve been looking a lot at the balance of power between the major players in corporate governance, which are primarily the boards of directors and shareholders. And we think that the balance of power is really critical to some of the major issues that are going on in the corporate world today. Some of those issues are: rising income inequality, the financial crisis and asset bubbles, stagnant growth in the U.S., a lack of trust in business leaders, and a focus on the short-term over the long-term creation of shareholder value. So those are the issues that we’re worried about and we’re thinking about now.
The Governance Center is a think tank of people who are focused on corporate governance as exclusively as their research and commentary. We do research. We do commentary in the forms of webcasts, blogs, and public forums. We have a number of public forums where we look into these issues.
We think that maintaining the appropriate balance of power between management and directors on the one hand and shareholders on the other hand is really critical to driving economic growth, job creation, and innovation in the United States. And so we’re thinking a lot about that now. We have noted that there is a marked shift in the last decade or so towards an increase in shareholder power at the expense, perhaps, of other stakeholders in public companies. And there is a widely accepted view in the United States that the only purpose of a corporation is to increase the wealth of its shareholders. That’s probably somewhat different than you might find in Europe or Asia or other areas of the world in that, in the U.S., we have a more – as some commentators call it – Darwinian system. In other words, the strong prevail and the weak fail. And this total focus – some would call myopic focus – on creating shareholder value is a system in which oftentimes it’s done at the expense of employees, of the environment, of societal good in general, of long-term investment in innovation and research.
So how did we get to this point? Corporations – when I say public corporations, I mean corporations that are owned by issuing shares in the public market – public corporations have been the engine of growth in our economy in the U.S. since the early 20th century when they first became very prevalent. And we experienced for most of the 20th century a long-term growth and prosperity in this country. Particularly after World War II, the era of the ‘50s, ‘60s, and ‘70s, you saw a compression between the upper income and the middle income classes, and you had an upwardly mobile population. That pretty much has come to a stall in the last decade or so. And what we’re interested in looking at is: What does the effect of corporate governance, what effect does the shift to shareholder-centric corporate governance have on these phenomena that we’re all noticing in the in the aughts, as they call it?
And what we have seen is that in the early 21st century, we had a series of accounting failures by some corporations. And as a result of that, our federal government stepped up and passed the Sarbanes-Oxley Act, which basically said we think that these accounting failures and irregularities are a failure of corporate governance, and so what we’re going to do with that is we’re going to make sure that the boards of directors are independent of management, and that that independence will be a governor or a control over management running amok and doing whatever management wants to do. So that was implemented in the 2002-2003 era.
And so you have this phenomena of most boards now in the U.S. are not just majority independent, but pretty much everybody on the board is independent except for the CEO. So you have a situation where you have a number of directors who may or may not know the business very well because they’re independent.
Then you come to the financial crisis in 2007-2008, and our federal government there also believed that the financial crisis was a failure of corporate governance. And this time, instead of picking on the directors as being the oversight over what should be done to correct corporate governance failures, they picked the shareholders, and under the Dodd-Frank Act basically gave shareholders a lot of power to approve things that typically, in the past, were in the province of directors and management. So, one of the singular facts of Dodd-Frank is that shareholders now have the ability in the U.S. to approve executive compensation. And that has greatly changed the mix and the balance of power between shareholders and directors in the U.S.
Now, understand that in Europe, Australia, and the UK, that has been a factor for some years, but in the U.S., this is a major change from a management and director-centric board to one that is accountable – more accountable to shareholders. So you now have a much more shareholder-centric form of governance in the U.S. And the question now is: Is that really contributing to a short-term view? Is that contributing to some of the ills that we see in our society?
So we at the Conference Board have convened a task force to look into that, comprised of investors in public companies and directors of public companies. And we’re holding public forums to gather evidence and facts to try to create a concept for what is the optimal balance of power between directors and shareholders. And we’ll have public forums on February 27th and April 3rd, and if any of you are interested in attending those, we’d welcome your presence.
And the last thing I want to say about that is our second big issue that we’re focused on at the Governance Center is trust in business. And those of you who may have covered the World Economic Forum may have noted that the public relations firm Edelman here in the U.S. released its 2013 barometer of trust at the WEF, and they found that less than 20 percent of the general population, on a global basis, trusted business leaders. At the Conference Board, we just finished our survey of global CEOs, and in that survey we had 10 questions of what are the 10 issues that keep you as a CEO awake at night, and what are the most hot topics that you’re concerned about, and trust was the 10th out of 10 on the CEOs’ minds. So obviously, there’s some disconnect between what the public is seeing and what CEOs see for themselves.
So we’re interested in finding out what that all means. We think that there’s a link between trust in business and also those factors that are saying that – more shareholder-centric, ruthless capitalism that we’re seeing in recent times. So we are planning to put a study group together later this year to look into that trust issue as well.
And then finally, we’ve also – I’ll just mention these in case you’re interested – we have a committee on political spending, corporate spending on political campaigns in the U.S., and we have a committee working on some compensation issues. So we kind of covered the waterfront on governance, but as I said, our clear focus is some of these bigger issues affecting the American economy.
So I’ll stop there, see if you have any questions about any of that or you want to move on.
MS. GRUNDER: We’ll hear from each of the panelists, and then we’ll take your questions.
MS. LAMM-TENNANT: Hi. Thank you. Thank you, Donna, for such an excellent overview of corporate governance and what the issues are in corporate governance. Arthur and I are going to take each a specific aspect of corporate governance. I think Arthur’s going to focus on compensation, and I’m going to focus on the risk management aspect of corporate governance.
Following 2008, risk management became critical, let’s say, responsibilities of boards. And most boards, corporates and financials, set up risk committees. And these risk committees sit alongside of audit, of finance, of governance, of salary and benefit. The risk committees’ responsibilities are to understand the risk in the business, not only the ones that exist today but the emerging risk that could potentially affect the business. But in addition to that, they are responsible for ensuring that the capital that’s carried in the balance sheet is adequate to finance the risk in the business.
Now, my role – I’m on the faculty at The Wharton School, and my background is in finance, but I also am the chief economist for a financial services firm, and so I spend my days working with insurance companies, asset management companies, both life and property and casualty insurance companies. So in that world, risk is their product, okay? So they have to then start to think about, do I have the capital on my balance sheet to afford the risk in my business, where risk is my product? What’s happened is we have embraced, I’d say, fairly sophisticated risk modeling techniques. And we’ve now created a whole set of internal capital models for these financial institutions. And what these internal capital models do is think about – they stress-test the business for a variety of scenarios, and then they just say, well, how adequate is my capital to cover these scenarios?
And just to kind of simplify it, let’s just say we do a thousand, and capital covers 900 of them. Then we basically say, well, we’ve got 90 percent of them covered but 10 percent of them aren’t. Okay? So we have metrics for that, then, that says, well, which ones aren’t covered if these scenarios should present themselves? The company’s capital would not be adequate to support their promises, so they would either go insolvent or seek aid from other sources.
So then you go into a step of saying, well, but what can we do a priori? Because when I think about 2008, these balance sheets had not been stressed, and we hadn’t really thought in advance, “Well, what if the unthinkable happened? Where would we go to replenish our balance sheets?” And as we well know, many went to the government for aid, okay? And so – but it was a desperate attempt, because it had not been prearranged or thought through very cohesively.
So one of the things we do is arrange for what we call contingent capital. That’s capital that comes onto the balance sheet, subject to an event occurring. But you prearrange for it, and so therefore you’re prearranging for it in more sane times, and obviously the cost of it’s more appropriate. It’s not so high. And that’s kind of the business that I’m in, and companies are taking this very, very seriously to make sure they have adequate capital to cover the risk on their books; in addition to that, prearranged or contingent capital for that which they can’t afford using the explicit capital that’s on their balance sheet.
Now, it sounds like a serious mathematical, financial, actuarial-type exercise, and it is. It has a lot of integrity behind it. But I will tell you that we are first, maybe second generation in doing this. So I wouldn’t want to oversell it. I’d tell you that we’re still very young in developing these stress tests and in developing these internal capital models. I’m delighted, though, that boards are holding management accountable, and this becomes very much the purview of the risk committee of the board. I mean, this is the work that they review and that they embrace.
Not all risk can be seen; there’s the unknown unknowns. But a lot of what we call the unknown unknowns, well, they could have been known if we just thought about it, okay? And so that’s also very much a part of the risk committees of boards. It’s really to stretch the imagination here, and be a little bit more conscious of that which is knowable if we just give it some thought. And as I mentioned, the emerging risk is very much a part of it.
One of the concerns that we have in governance is that – who can really fill those positions? I really appreciated your remarks, Donna, about in the pursuit of independence, you start to lose the expertise on the board in the business. And that becomes even more stressed at a higher level if you’re talking about the risk of the business. So you start to find directors that may have a vague understanding of the business and even less of an understanding of the risk in the business. So I will tell you these committees are difficult to staff up with qualified individuals, and so that’s one of the aspects.
I’d like to just turn my attention to one other aspect, and that is because I’d like not to think of risk management as just accountabilities. I’d like to now kind of fold it into a value creation driver. I mean, when I think about risk, we think about, well, if you don’t manage it, you have shocks to capital, you have the potential of insolvency, or you’re thrown into pursuing capital at a very costly price. But I’d like to now kind of wind the dial backwards and say, “But how does risk management create value as opposed to avoid losses?”
If we think about value creation, it’s actually a very simple concept, and that is that your return on your capital is greater than your cost of capital. So a firm that’s making a 3 percent return, it looks good. But if their cost of capital is 10, they’re not creating value. They’re making money, 3 percent return, but they’re not creating value because their return on capital is not higher than their cost of capital.
Now, let me just kind of break those apart. The cost of capital is what the shareholders are demanding in return for having invested in the company. So it doesn’t really appear on the income statement or the balance sheet, you see, but you must meet their demands or this value of the company goes down, as does the stock price, right?
Now, if you manage risk, those demands go down, so all of a sudden, that hurdle for you to become value accretive is lower if you have judicious risk management disciplines in place. Because remember, what an investor is going to say is, “I’m happy with a low return if it’s a low risk. I want a high return if it’s a high risk.” So firms that have good risk management in place, their cost of capital is lower, therefore they can be value accretive at a lower hurdle, okay?
The other aspect of this which I think is very interesting is when we do return on capital, because remember, that has to exceed the cost of capital. Well, if you’re a good risk manager, you do not need to hold as much capital on your balance sheet to afford the unforeseeable because you have managed the unforeseeable. Do you see what I’m saying? So you get to denominate your returns against a smaller base, making it more likely then that your return on capital will exceed the cost of capital, okay?
So what I’ve really done for you in a very short minute here, and I hope I haven’t glazed your eyes, I’ve gone through just the basics of corporate finance. But instead what I’ve done is imbed a risk perspective to the basics of corporate finance.
Now, we’re very good at reporting our returns on capital and we celebrate if they’re greater than zero. But really, we should be only celebrating if they’re value accretive, in other words, they’re clearing our cost of capital. And that’s what we’re attempting to do, recognizing that more returns are better than less, but you can reduce your capital, you can reduce your cost of capital, if you manage risk. So risk becomes a part of the value driver and not just the avoidance of losses.
Thank you for your attention.
MR. KOHN: Thank you. So I’m going to take just a few minutes of time now to talk about one of the thorniest issues in corporate governance today and in the recent past, which is executive compensation, or to use a simpler term, how companies should figure out how much to pay their most senior executives for their services, for their good – hopefully good – services.
I’ve been a practicing lawyer in the area of executive pay for about 25 years at the Cleary Gottlieb firm, and I’ve also, for the last couple years, have been teaching a course in taxation of executive compensation at NYU. So that’s my perspective.
In my lawyer capacity, I represent both companies in helping them design the pay packages that they provide to executives, in helping them figure out what they have to disclose to the public and their shareholders about those pay packages; and I sometimes represent the other side of the table, the executives, in negotiating for a particular pay package, seeking to maximize the wages that they get for their services.
Why is executive pay among the thorniest issues in corporate governance? Most people will, I think, cite to two factors. The first is that it implicates in an interesting and serious way the conflict of interest issues that Donna talked about. Management is responsible to a very large extent for running the business, for making decisions about whether to grow and how fast and in what directions, what kind of risk to take and what kind of risk to avoid, and a large number of other decisions that could impact their own pay. And so in that sense, they have some kind of a conflict. They also are involved in helping to select, both as a legal matter and as a practical matter, who the members of the board will be. And the members of the board, of course, are the individuals who will then turn around and set the pay of the executives.
And finally from a conflicts perspective, we in the U.S., as Donna alluded to, have had a system under which shareholders have not been, at least until very recently, integrally involved in some of the detailed decisions that corporations make, including decisions about executive compensation. So we don’t have a group of – an individual or a small number of individuals who can at least, as I say, historically, up until the very recent time, who can exercise influence on pay decisions. And that permits the kinds of – the other conflicts that I alluded to, to create the tensions that we see.
So that’s one set of factors that makes compensation a thorny issue. The other fact or circumstance that I think makes compensation a thorny issue in the U.S. and elsewhere is that the market for executive talent is not a very liquid and well-functioning market. We don’t have an exchange where a company can go and say, “I don’t like or I’ve overpaid for the management I have, I’m going to go find some other management,” or where a company can say, “If you just pick up the newspaper, you’ll see how much it costs to employ a CEO for a year and that’s what we’re going to pay you.” This doesn’t exist. It’s not the nature of labor markets generally and it’s especially not the nature of markets for – of the labor market for executive talent.
And so what we have is individual negotiations. And as you might expect in a free market economy with individual negotiations, we have management negotiating hard to maximize the return for their services. And there is some difficulty in assessing whether companies on the other side of that negotiation have done a good job or have done a less than excellent job in negotiating those pay packages.
So those are the two factors that make – in my view, structural factors that make compensation a difficult governance issue. On top of that, what we have over the last 15 years or so is what some would describe – not everyone, but what some would describe as a significant change in the nature of executive compensation, namely that it has grown significantly. In particular, the factor that many press reports allude to and others outside the press, which is the multiple of average CEO pay to average pay of – to the median pay of the workforce, which is, depending on kind of how you run the numbers, has grown over the last 15, 20, 25 years from a multiple of about 50 or 100 to 1 to a multiple of 450 or 500 to 1, something like that. Those are the numbers that get thrown around. And those are big order-of-magnitude changes in, again, the ratio of CEO – median CEO pay to median worker pay. In other words, the CEOs are getting paid more relative to the average worker than they used do, and the question is why. And that’s been notable.
And it has, of course, been mostly notable particularly because the issue is framed not just in relation to the 500 CEOs of the Fortune or the S&P 500 companies, but it’s a trend that seems to be – exist in our society in general, the growing inequality between pay at the very top, the 1 percent issue and the 99 percent issue. And so people have focused on that.
What have people done over time? Well, there have been many efforts to try to address these perceived issues. Historically, the law that applied to these questions was corporate – state corporate law, most notably Delaware, the state of the Delaware, where most U.S. corporations are incorporated, which has a rule that’s commonly referred to as the business judgment rule, which basically says that directors are protected in making decisions, including decisions about how much to pay their management, as long as they exercise due care, as long as they’re loyal to the company, and as long as they act in good faith.
Beginning in about the 1980s, the government decided that it would try to take some steps under law to address pay inequalities at the top. They passed a set of rules called the golden parachute rules in the early ‘80s which addressed the question of how much management gets paid if a public company is taken over. They address more generally senior executive pay in the early ‘90s, one of Clinton’s first initiatives, which was to limit the amount that companies can deduct for their executive pay. They addressed executive pay again in the early 2000s in the wake of Enron’s collapse by making it more difficult for companies to have flexible deferred pay programs, programs where executives get paid later for the work that they do today.
None of these have worked. Academic studies and practitioners will tell you virtually uniformly that none of these governmental efforts have achieved their objectives. In fact, most of them have been counterproductive. They’ve tended to increase pay rather than decrease pay.
Another set of efforts has revolved around disclosure; that is, government mandating corporations disclose – public companies disclose more about how they pay their executives. That effort came to its peak in 2006 when the SEC prescribed new rules. Those new rules were also counterproductive. What they basically did was show every executive how much all their buddies at other companies were earning and what kinds of perks they got, and it encouraged managers to ask for more. It’s demonstrably counterproductive. And of course, when I sit on that side of the table I rely on those – on that data that I otherwise wouldn’t have all the time. So I can tell you as a practical matter that that’s how things work.
The government tried some independence rules to which Donna referred since basically – which date also to the beginning of the 1990s, the idea being that if you had independent directors setting management’s pay, that the conflict issues that I described earlier would be less severe. I think few, if any, observers, academics and practitioners would say that the independence rules have tended to decrease executive pay or to put a limit on executive pay.
And so where we are today is we’ve looked to shareholders. We’ve replicated the systems in the UK and some other countries to give shareholders what we call a say on pay, an opportunity to cast a vote about whether management is being paid too much, in the hope that that will help – in the hope of those who think that we have a problem will help moderate the growth in executive pay.
And activists in the area are, to my mind, acknowledging that their efforts that I’ve described, that I’ve summarized over the last 20, 30 years have largely not worked and are trying to go back and figure out what they can do that will further their cause. And so at this point, we’re really – we’re weighting some rules and we’re in a rethinking stage. It’s hard to say where it’s going to go or whether any of these efforts that have been made are in the right direction. By contrast, one might argue that the nature – that the market is just acting like a rational market would act. And therefore, that these kinds of efforts are inevitably doomed not to be successful. And I think we’ll have to wait and see where we end up.
MS. GRUNDER: Thank you very much. I think the panel has really covered a range of issues, plus provided an overview. So let’s turn to your questions.
QUESTION: Stephan Alsman from Danish Economics Weekly. For you, Joan and risk perspective – I don’t know if you read this. I have – my secret agenda is that I’m focusing a little bit on the financial industry. And I don’t know if you read that article in The Atlantic in January where they sort of rip off an example of a U.S. bank and say we have this large body of reporting, but we don’t know where the risk is; we don’t really have insights to the risk involved, really. So what I want to ask you is, you gave the perspective of – from 2008 and what has happened until now. Do we know what risks are in financial companies?
MS. LAMM-TENNANT: Yes. We have different regulatory regimes, obviously, depending on the country. And I’d like to just talk about solvency too in Europe for just a moment, because that’s where I’m seeing that the better – let’s say more transparency on risk and a better understanding of risk and financial institutions. Solvency II has three aspects to it, or Basel III. It has three aspects to it. The first aspect really is the governance. The second aspect is those internal capital models that I talked about, so it’s a – but the last aspect is the reporting.
And so what you’re beginning to see amongst firms that are governed by Solvency II or Basel III, you’re seeing a much better and more transparent and comparable reporting standards on risk across those institutions. They’re also reporting their economic capital, in other words how much they need relative to finance the risks on their books versus how much they have. And so they’re actually putting hard metrics around it as well.
U.S. companies are not subject to Solvency II unless they have operations in those territories. And so you’re seeing different reporting, and I’d call it more anecdotal reporting. And so it’s not as uniform, it’s not as comparable from carrier to carrier.
Now one of the things that we debate a lot is that Solvency II has not – it’s been delayed, and so we’re now targeting – we’re talking 2014 for it to actually be enforced, but many firms are already in compliance. It’s very costly, and so some are saying that European firms are going to be at a disadvantage because this has been very costly for them, and in addition to that, many of them are short capital, so they’re now scrambling to get capital. Others are saying no, American firms are going to be the disadvantage because they don’t have these risk disciplines, and so without them they won’t make effective value accretive risk choices, you see, because they’re not thinking about if they make a risk choice, are their returns adequate enough for the capital they have to hold to finance that choice. You see, they just don’t have the disciplines.
So when we look at it in the future, I will say that the – it’s quite different, and we’re yet kind of confused as to who’s going to be at the greater advantage, okay? Will it be the European firms or will it be the American firms? So --
QUESTION: Do you see risk as being disclosed at a much more --
MS. LAMM-TENNANT: I do. Yeah. With European firms, I do. Yeah, I do. Because the ones that have moved forward in Basel III, Solvency II, it’s prescribed. And what’s being reported is – let’s just say it’s also comparable across carriers. So I would say we’ve made some great strides, less so though amongst U.S. companies.
QUESTION: Thank you. Well, I’ll try to be very brief, because my question just covers the three areas we’ve just been briefed about.
First, Donna, you mentioned that the mindset is maximizing shareholder value, which there is no disagreement about. It’s basics of capitalism. But then what’s interesting is the lack of R&D, the lack of spending on R&D. How can be the shareholders – who are just individuals or maybe institutional, just with some money, wants to have a high return, as Joan highlighted – be in charge of decisions regarding the continuity and the future of a corporation? Without R&D, we won’t have Microsoft, we won’t have Apple, we won’t have any of the big names, global brands that we have. How can this be ratified in a way?
As far as risk management, don’t you agree that there is a new tier in the corporate structure of any company that’s been created, while at the same time it can be outsourced more effectively to think tanks, for example, like The Conference Board or other similar organizations, rather than focusing on it, on a single entity perspective. And I don’t know if corporations nowadays have the diversified talents to assess risk outside of the equatorial perspective from the mathematical models.
As far as compensations, my favorite case is AIG, after they took the bailout money and then we all heard that their executives were getting compensated in hundreds of millions of dollars for their previous year work. Although if there was probably risk management, their pay would have been upheld. How come a company, a corporation such as this mammoth size can avoid falling into this pitfall, which could have caused a financial catastrophe worldwide? And as far as the lack of transparency with the boards with regard to compensation, what’s the shareholder power in that area, and how can this be ratified?
And as far as lack of the executive talent in the labor market, lack of models to compare to it, wouldn’t it be better to go back to revert to Adam Smith’s classical economists – demand and supply, where the demand meets the supply, then hence the price is determined? Thank you. And I’m sorry for the extended question. (Laughter.)
MS. DABNEY: Shall I begin?
MS. LAMM-TENANT: Do you want to go ahead and --
MS. DABNEY: Okay. (Laughter.) Well, the question of not investing in the long-term value of the corporation is one that is a critical question today. And there are a number of commentators that say that the quarterly earnings cycle that we’re on, and the close connection between asset managers’ compensation – you have an individual like you or me who invests in the stock market usually through some intermediary like a mutual fund or some other kind of institution – the asset managers of these institutions are compensated on a quarterly basis. They’re compensated on what they’re producing now. And a lot of their – a lot of these investment firms win or lose business on the basis of their quarterly or very short-term performance.
So on the investment side, you’ve got a lot of short-term sort of focus. They put pressure, in turn, on managers to have a short-term focus because they want to make sure that the companies they invest in also meet earnings expectations. And those earnings expectations are not set by the companies; they’re set by analysts who kind of establish that call. So then you also have the fact that since the 1980s, when we discovered stock options as a form of compensation for management, the phenomena was that we paid CEOs, and it was at that point in time between 50-100 times what an average worker made. That was in cash. But then there was pressure from institutional investors at that time to align pay with performance. And the concept was that if you got managers to own stock, then their interests would be the same as shareholders for increasing the stock price.
So what happened was you layered on stock options on top of the cash, and so now, back in the 1980s, virtually zero percent of CEOs had stock compensation. Today, 66 percent or so of their compensation is based in some sort of stock-related compensation. So the majority of the compensation of senior managers is aligned with shareholders. And that was deemed to be a good thing, but they are totally focused on increasing the share price for their own personal reasons, for their company reasons, for pressure that they get from their shareholders.
So sometimes companies will make the decision to not invest in R&D, to not invest in employees, to not – to reduce cost, because cutting cost increase profits. And so there’s an extreme pressure to reduce costs not only for global competition, and that is a major factor, but also from these factors that we were talking about having to do with governance. So you do find some companies doing those kinds of things. I think that you will find the best run companies resist that kind of pressure and continue to invest in the future, and what you need to find are boards of directors. And I think there are a number of companies with good, strong boards of directors who have the strength to stand up to these pressures and to say we’re here to support long-term shareholder value; we’re not here for the quarter. We’re here for the century. And you can name the kind of companies that have that philosophy. But there is a lot of pressure for this short-termism.
MS. LAMM-TENNANT: Can I just say something about R&D and then answer the question that you directed to me? The interesting thing about risk in R&D is that we have some very legitimate academic research on firms that have a shock to capital. In other words, it wasn’t anticipated, so they weren’t good risk managers. That in essence, what they do – first thing they do is they pull back on R&D, right? It’s a great way to replenish, cut expenses, the easy expense to cut is R&D. Okay. So – and the relationship is one – for every dollar shock to capital, R&D is cut by 30 cents. That’s a big number. For every dollar shock to capital, R&D is cut by 30 cents.
The other piece of research that we know in this area is that firms that have stability in their earnings – okay, so it’s again a sign of good risk management – that their expenditures or their investments in R&D is significantly higher than median. Okay. So we know that those who invest heavily in R&D are those who have stable earnings.
Okay. So that’s kind of, again, a plug for the value of risk management, because you’re able to sustain your investments in research and development. So really, what it does is it becomes a driver for profitable growth. Risk management is a driver for profitable growth. But to answer your question, then, specifically about outsourcing the risk management function, why we’re setting risk management functions up at the board level and within the organization, identifying the chief risk officer who’s a direct report to the CEO, and giving him or her a staff, the ultimate – to be honest with you – is that the men and women that run the businesses are risk officers. I mean, as opposed for risk to be managed – we want it to be managed indigenous to the business. So in a way, we look at this as an interim because it’s creating the risk awareness, creating the risk tools, the risk reporting, the risk accountability. But the goal is for these CROs and their staff to eventually push this into the business units. And every business man or woman would be a risk manager along with product development, et cetera. And that’s the goal.
Now, we do outsource. I mean, accountability is in-source, but where do you start to get the knowledge, the expertise? And Conference Board is very important in this. There are many think tank centers at universities that have set up exceptional risk and research groups on risk. And then there are also trade associations like the Chief Risk Officer Forum or M200, which is bringing the chief risk officers together for the top 200 firms around the world so they can start to share best practices.
So the answer is yes, that your firms are seeking expertise outside of their own domain.
MR. KOHN: Okay, let me see. I’m going to go in reverse order of what I think were your three questions to me and start with the question that I take to be a question about why – how the negotiations between management, between an executive and a corporation work and why they don’t follow the simple law of supply and demand.
The pay package for the CEO of a public, more or less, complex company is not a simple widget which – for which you can find a supply curve and a demand curve in a particular market setting and see where it ends. Why is it not a simple widget? Companies may need CEOs with different qualities at different points of time. They may have different opportunities to hire different people. They may have internal situations that affect how much they’re willing to pay a CEO. For example, they may want – they may have a person who’s the successor and who needs to be paid to stick around so that they don’t leave. But the CEO is not yet ready to retire and the CEO is going to demand something more than the successors; they may have issues like that. Or they may have issues where they don’t have a successor and they need to ensure that they have this CEO to stick around, because basically their supply for the foreseeable future isn’t there. It’s many factors.
We also have companies that change strategy. Their industries may change. And so we may have a pay package that was designed for one situation and then the situation changes greatly. We may have economic times that change, either growth in the stock market generally, or a fall in the stock market. There’s all these kinds of factors that affect the pay of a CEO.
The complexity therefore makes it difficult in the current environment for a company to simply say, “I will pay you a million dollars or 10 million dollars or 15 million dollars, whatever you want, whatever number you want to put on it, for your services next year, and that’s it. No, that’s the price where the supply curve hits the demand curve. That’s what I’ll pay you. If you don’t like it you can leave and if you don’t want to leave, if you’re happy with that pay, you’re welcome to stick around.” Just doesn’t work that way.
So in my view, those complexities are what drive the ultimate negotiation and a pay decision. Why do we then come out with some pay decisions that seem in retrospect to have been irrational or unreasonable or perhaps just stupid? You cited the AIG example where, after the company collapsed, executives had claims for compensation that they – that had been earned in prior years and not yet paid and that they were expected to get paid. Well, sometimes we have changes in the business – in business, in the markets, that make lots of decisions, not just pay decisions, seem like they were bad decisions. We have the risk issues that we were talking about, we have companies that invest in projects and then it turns out that the projects are a waste. The change that we had in 2007 and 2008 that led to the downfall of AIG is, I think, a good example, if not a paradigm example, of the business community being surprised by developments. Wasn’t just the business community, and – it was many others. Not everybody, but many others. And that from my perspective is what led to the situation at AIG, which in retrospect is hard to defend.
If that – we have the – as a result of that fact, the practices have changed. And in fact, a large majority of U.S. public companies today have in place what is referred to as a clawback policy, which would permit a company in the AIG situation not to pay the compensation that had been promised in prior years.
An interesting aspect – to illustrate my point about complexity, I think it’s interesting to just – to spend one more minute on the clawback policy situation because our Dodd-Frank legislation – the 2010 legislation in response to the financial crisis – included a requirement that all public companies adopt a clawback policy and directed the SEC to implement rules about what the clawback policy ought to say. To date, those rules have not been implemented.
Why is that? It turns out that even a simple policy like a clawback policy, which everybody who looked at the AIG situation would know – anybody who was really thinking would know – we all around the table, we’re reasonable people, we would know that you ought to have a clawback – when it comes time to actually write down what it ought to say, it’s not that easy. The SEC has not been able to get out those rules in two and a half years.
Why is it not easy? Well, the question is: How long after you get paid for performing your job during the course of the year ought you to be at risk? How long of a period should the company have the right to come back to you and knock on your door and say, “Sorry, you know all that good work we thought you did in 2012? It actually turned out not to have been that good, and we want the money back?” Right? How long?
Now, you might say, well, if you bring a company like AIG to its knees, maybe it ought to be forever, perhaps, I don’t know. But if you put yourself in the employees’ shoes now and you say, well, I earned that money and I was going to spend it on whatever – on education or a house or a boat, an airplane, whatever – when do I get to spend it and not have to worry that the government or the company’s going to come back and knock on my door and say we want it back? And there are places – as I said, the majority of companies have figured out where to draw that line and they’ve come up with a rule and it’s not impossible. But it’s complex; it’s not that easy.
And so the SEC hasn’t figured out what to mandate yet, and as I said, I think it’s just an illustration of some of the difficulty of these issues.
QUESTION: Thank you. It’s interesting, however, that you spend your money on buying a boat, plane, or a house, but a lot might spend their money just going on vacation. (Laughter.)
MR. KOHN: My job is not to argue that CEOs are underpaid. (Laughter.)
QUESTION: Yeah. Perhaps this question will go to Ms. Dabney. You mentioned the (inaudible), it’s not a huge pressure from shareholders and short-term – short-sighted shareholders. Now we’re seeing lots of corporations sitting on a huge amount of cash, and at the same time, we’re seeing companies going private, delisting their shares. Just recently we saw example of Dell and Heinz, maybe Best Buy is also considering it.
Do you think at least part of the reason for companies sitting on a pile of cash or going private due to this short-sighted pressure from shareholders? And if that is the case, is there any ways to address this problem in the perspective of governance?
MS. DABNEY: Well, I don’t know any facts other than what I read in the paper about Dell or the Heinz situation, but I think that is true. I think that management generally feels besieged under these circumstances that we operate in today. And so – well, Mr. Dell himself said he wanted more flexibility without shareholders looking over his shoulder as to what’s next; what are they going to do with the company. So I don’t know if leveraging up the company and putting it – putting a huge amount of debt on it is going to give him any more flexibility, but that’s apparently what – the direction he’s heading.
On the other question of sitting on a hoard of cash, I think that that goes to the long term/short term thing. For some companies who are cyclical, sitting on a lot of cash makes a whole lot of sense to them after having gone through the financial crisis where a number of companies really had a serious cash flow issue, and the reason was that the markets just froze up. And so unless you had – the way companies were operating in 2007 was they were doing the short-term rollover of – they do their payroll on 30-day credit borrowing, and this would always roll over, roll over, roll over, and all of a sudden, one day it didn’t roll over. So you got to come up with it, and where is it? And I think it made a lot of companies aware that they needed to keep more cash on the – in the company.
But second, companies like Apple, gosh, they probably need a lot of money to do things. Now, whether they need that huge pile of cash, who knows, but shareholders are after it because they think that they deserve it. And what you see from a lot of the – shareholders aren’t a monolithic group. You have different kinds with different philosophies in how they invest. The ones who are activists, who engage in financial engineering, tend to have only like three or four financial engineering principles when they come after a company. Give us your cash back, increase the dividend, special dividend, split off one of your – spin off one of your divisions, sell the company as a whole, or buyback shares. And buyback shares has been really a huge use of capital. There’s been a huge flow of capital from companies to shareholders in the share rate purchase area, and that was very true of the end of 2012.
QUESTION: I see. Thank you.
MS. GRUNDER: Could people state their name and their news organization?
QUESTION: I’m sorry, (inaudible), Nikkei.
QUESTION: I’m still Stephan from – (laughter) – anyway, I have one question with this regarding – I mean, so when you look at this risk management and you look at governance and you look at pay structures – it seems like both Europe and America is in a process of some sort of trench war as to where the limits should be drawn. And, well, I find it hard to keep up with what is going on America, what’s going on and how far are they. And, well, my question is really: What dynamics do you put into play when you have different sets of regulations in different geographies?
MS. LAMM-TENNANT: Well, we already have it today. We have different taxing structures, right? And it’s not unheard of for companies to re-domicile into a territory where the taxing structure is more friendly. I think you’ll continue to see that, that with global governance gaps, that you’re going to find a flight to where governance requirements are more consistent with what management wants to play out. And so that’s part of the reason why we look to establish some basic principles across country on governance. And that’s very, very important, because we don’t want to find ourselves in a governance arbitrage world, right? Yeah. So I think it’s very, very important that we close those gaps.
QUESTION: What do you see happening? Do you see this governance arbitrage actually happening? Is that a real fear, or is it – are we working towards sort of a homogonous –
MS. LAMM-TENNANT: I think it’s a potential. I don’t say I see it happening today. You certainly see tax arbitrage happening, okay. But I say it’s a potential.
MR. KOHN: In the comp area, I would say that you do see some arbitrage, including cross-border movements for senior executives, especially in the financial services area, not just senior executives, but traders. And you also see arbitrage in the U.S., at least, in – at least as I use the term, as I think you’re using the term arbitrage in – of employees of financial services firms moving from the publicly traded global multiline firms to the hedge funds, where the regulatory environment is different.
If I could just comment on your broader question, also call to mind an article I read – I was asked to comment on maybe four, five years ago, that inferred from the situation with executive pay in the U.S. that – I’m going to paraphrase, but not by much – that Americans were greedy culturally. And that struck me as a mistaken inference. We have a large number of legal and historical elements that affect the way that public companies in the U.S. govern themselves. Among those are the tax system, the general free market nature of our economy, the fact that we have, I think, a greater distance for most public companies between shareholders and management and the board than you find in many European jurisdictions. The fact that we don’t have a heavy government involvement in the private sector as you have in other advanced countries, and all of those things, I think, lead us to where we are. And they’re not going to change easily.
And so I don’t think that we’re going to have a very substantial convergence going either way, either other countries moving towards a U.S. model, or the U.S. moving towards a non-U.S. – one of the non-U.S. models.
QUESTION: I have – my name’s Gerben van der Marel. I’m a Dutch journalist. I have a few question. Credit rating agencies, is that within your expertise? To augment three questions for each of you.
First, maybe for you, the restoring of trust in the financial world and the corporate world. I was surprised, actually, by the government action against Standard & Poor’s, because it seems to be a little bit late and it might actually damage the restoring of confidence. A question for you is: Do we really need rating agencies if you want to manage risks – risk, and how to solve the conflict of interest that banks, financial institutions are paying credit rating agencies since (inaudible)?
This (inaudible) already, but do we need an independent rating agency? And maybe from your perspective, how – because you are a lawyer, maybe this is not – you’re not an SEC expert, but a civil case like this one that has started by the Justice Department, is that special, since it’s a justice case, but it’s civil, it’s not that people would go to jail? How – can you explain that a little bit to me?
MS. DABNEY: Well, I think the wheels of the legal machinery turn slowly. (Laughter.) And so what you – the reason why the cases haven’t been brought yet is because, I’m sure, the government is trying to make its best case and develop the facts. So that does affect trust because we get in the newspaper daily a reminder of what happened in the financial crisis. And that’s not just in this S&P case, but that’s across the board for financial institution litigation and various other things.
So I think, yes, it does affect trust because you have this drumbeat in the news about issues that many people would like to put behind them. I don’t know if there’s anything that can be done about that. I think it just has to work its way out.
QUESTION: But you’re not blaming the news or the news media or (inaudible)?
MS. DABNEY: I would never blame the news media, no. (Laughter.)
QUESTION: I just want to make sure that (inaudible).
MS. DABNEY: No, I mean --
QUESTION: You’re more worried about the drumbeat in the news than what happened – what was come out of the (inaudible)?
MS. DABNEY: Well, I think you have to – no, no, you have to report it. And the fact that – the difference between when an event happens and when a case is brought is usually a significant time lag. So you’re just – when you report it, of course you need to report it. It is newsworthy. But it just reminds people of the issues and brings it forward. So to a casual reader, it might suggest that there’s still all this malfeasance going on out there that is actually hopefully isolated to a time period.
QUESTION: Thank you.
MS. LAMM-TENNANT: So you ask a really good question. And I will say that that – the rating agencies were very much a part of the crisis, and their business models are very much being questioned and rethought. And that’s a good thing. But one of the things that I see, what’s happening in S&P, Moody’s is following in their footsteps. But actually, what S&P is now doing is they are rating the risk management function of these financial institutions, and they’re rating it on, I think, like five or six different aspects. So the governance of risk, the internal capital models and the legitimacy of the internal capital models, the extent to which these internal capital models are influencing decisions, they call it the use test. And so this is a whole different type of rating, basically, where you’re actually giving a letter grade to the risk function.
So – and those are actually very helpful, because you can read the reports that says, “My economic capital is adequate to cover my risk, but how do I really know that you have legitimate modeling done behind that,” and so having this independent rating of your internal capital models and your risk function. So I think what you’re going to start to see is that these rating agencies’ business models will morph and change, but that having an outside independent view, whether it comes from a regulatory body or a rating agency, is going to be very – or a public accounting firm, that’s going to be very important.
QUESTION: I may have a follow-up on this particular point. Wouldn’t that be – that would require more transparency from the corporations?
MS. LAMM-TENNANT: Oh yes, and it does. And it does. I mean --
QUESTION: But, I mean, how the boards are accepting it? I mean, if they don’t disclose the compensation – the full compensation for their executives, how are you going to disclose their capital structure?
MS. LAMM-TENNANT: Yeah. Well, actually they’re highly incented because, as I brought into play, that risk management is a value driver. And so they very much want a high score on their risk management function. Do you see what I’m saying? Like, they’re highly incented to do what they need to do to get a good score on risk management because it’ll lower their cost-to-capital. Do you see? So it is to their benefit. And so the information asymmetries, the incentive is for them to disclose and provide valid information. I’m not so sure the information asymmetries are – why they exist on compensation. The motivation to disclose may not necessarily be there.
MR. KOHN: There is actually an interesting analogy, and let me just start out by answering the question, which I can do very quickly. You’ve asked a question that’s well outside my area of expertise. (Laughter.) I could give you the view of someone who went to law school for three years, but it wouldn’t be very valuable. (Laughter.)
On the symmetry point, though, we have something which you could argue in the comp area is roughly analogous to the rating agencies, which are what are referred to as our proxy advisory firms. ISS, or Institutional Shareholder Services, is the largest one, and then there’s one called Glass Lewis. And the analogy there is of an outside entity; they’re both profit-making, independent institution – independent of the companies that they cover. And they assess the compensation practices of public companies – any large public company’s going to have an assessment by both of those firms – for the purpose of making recommendations to their clients, who are institutional shareholders, about how to vote on pay proposals. And companies, by and large, are, as you said, as you suggested – and it’s true, if you put the right motivation or incentive on people, they’ll do what you ask them to do – companies are quite motivated to ensure that ISS and Glass Lewis have accurate information about what they purport to be assessing.
And in fact, companies will go to considerable lengths to ensure that those do – the proxy advisory firms do have the accurate information. They’re not – companies are not anxious to give people more information or to have ISS ask for more information. But when ISS says we need to know this in order to make a recommendation or else we’re going to recommend no, companies will generally give the information out because it’s in their interest.
MS. GRUNDER: We’re sort of running out of time. Is there a last question?
QUESTION: I have a follow-up, one follow-up question about – imagine that a company would have, like, a AAA rating because their risk management is state of the art. And then a fraud case comes out after the company had sent its stock down. That would affect this new business of the rating agencies pretty heavily, I suppose. It’s – well, their own reputation is really at risk because they gave a great mark for risk control while they – it’s not that easy actually to – well, to – it’s actually very hard to really rate the state of risk management of the company. Would that – well, could be a backlash as well for rating agencies, that they go into this new business of grading companies in their risk management.
MS. DABNEY: Well, I think that when they’re grading them, they’re grading everything from – there are different characteristics. They’re not just saying that there’ll be no risk. They’re just saying that their controls are of utmost order. That doesn’t necessarily mean that risk is eliminated. Now, if it was a fraudulent event, and after the fact it was just blatantly obvious that the controls should have been in place, that you purported were in place, that would be definitely reputational. That would definitely be reputational.
But I don’t want to suggest that by having a score of 90 on a scale of 1 to 100 on risk management that you’re going to eliminate all incidences of risk, because we have to acknowledge there’s the unknown unknowns.
MS. GRUNDER: This is really unusual for the Foreign Press Center to have three such experts in the room at the same time; I really hate to cut you off, but I know you’re busy people with other things on your schedules.
MS. DABNEY: Thank you.
MS. GRUNDER: So I just thank you so much for doing this today.
MS. DABNEY: Yes. Thank you. You’re important to us, so --
MR. KOHN: Thank you. Thank you. Thanks very much.
MS. DABNEY: Yes. You’re very important to us, so thank you for inviting us.
MS. LAMM-TENNANT: Yes. Thank you very much.
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