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The conflicts of interest in the process of issuing and marketing securities in America have motivated an urgent call for comprehensive corporate and market governance reform. Reform demands the reengineering of all activities in the process of issuing and marketing securities, and the implementation of controls that guarantee that the investor’s interest is the ultimate goal of all participants in the process.

The pillars of reform should be integrity, independence, transparency, and accountability. The constituencies involved are:

• Issuers: boards of directors, corporate management, public audit firms, and employees;
• Financial markets: investment banks, mutual and hedge fund managers, self-regulatory organizations (SRO), and trading specialists; and
• Controlling parties: investors, securities regulators, and the government.

Governance reform is a people-driven process, and the top people involved in issuing and marketing securities, as well as those in the controlling constituencies, should lead the change and set the example.

Integrity

Unspoiled integrity must be the top requirement for those seeking leadership roles within corporations, financial markets, and controlling entities. Unfortunately, most of the corporate and market leaders involved in scandals are notorious for their greed and unethical behavior. The basic tools required to improve integrity among business leaders are culture, fear, and reward.

Cultural change is typically driven by personal attitude toward change and an environment that rewards individuals for embracing the new culture. By emphasizing the “fear factor” through increased penalties and strict enforcement, the latest regulatory actions by government entities fall short in addressing cultural changes among business leaders.

Preventing corporate scandals requires that those selecting business leaders focus on the integrity of candidates first, followed by their skills and competencies. A successful selection process would restrict nomination of top executives to only those board members nominated by investors. Additionally, time limits should be placed on the tenure of executives—perhaps for the length of a strategic plan cycle. Longer tenures tend to favor creation of empires that conceal improprieties and unethical behavior.

Corruption among securities market participants has proven to be more pervasive than initially anticipated. Transaction-driven compensation and lack of control over trading activities are the major causes of unethical behavior. Measures to address this are under consideration, but the issue of compensation for market intermediaries must be seriously addressed as well.

Independence

Lack of independence is a serious threat to integrity, as it hampers the ability to overcome conflicts of interest between a leader’s personal benefit and a business’s best interests. Corporate governance reform requires that change start at the top and cascade down throughout the organization. Therefore, independence must be of paramount importance to each member of the board of directors. Director selection is a key to structuring truly independent boards, and the driving force behind it should be investors, not executive management. Indeed, the process should be completely overhauled to eliminate executive management involvement, and board membership should be restricted to only the chief executive.

The effectiveness of the external audit function depends on the external auditor firm’s independence from management. Recent suggestions by the SEC to allow investor nomination of director candidates and require disclosure of particulars surrounding the selection (nomination) process are steps in the right direction, although a more aggressive stance on this issue would accelerate governance reform. For example, an outright ban on cross-board memberships, a limit to the number of directorships one can hold, and director reelection restrictions are all measures that will contribute positively to governance reform.

The Sarbanes-Oxley Act includes provisions aimed at an independent external audit function as a primary way to enhance corporate governance. Related SEC regulations adequately prevent the conflicts of interest facing auditors, which are dependent upon executive management to efficiently perform their duties. It is expected that the Public Company Accounting Oversight Board’s (PCAOB) regulatory activity will strengthen controls over the quality of audit work and determine stringent penalties for audit firms that violate audit standards.

One external audit–related issue that has not been properly addressed is the conflict of interest between efficiency and cost-effectiveness. External audit bids should be evaluated based on the amount of work provided by seasoned personnel and not by the overall cost. Additionally, part of the auditor’s remuneration should be directly related to the quality of the audit work, as measured by the auditor’s contribution toward preventing fraud and restatements.

For corporate executives, independence requires a firewall separating their personal interest from the best interest of the investors.

Concerning market intermediaries, independence will be achieved if the following conditions are met:

• Market and credit analysts work independently and are not subject to pressures from other departments of the investment bank for which they work. Regulators should foster the growth of independent market and credit analysis firms.
• The compensation of investment bankers, mutual fund managers, and traders is structured to reward return to investors, not transaction quantity or portfolio size.
• Market exchanges progressively eliminate human participation in determining the best price offered to investors for securities purchases or sales.

A cultural change in the approach by government officials, regulators, and investors toward governance reform is long overdue. The emphasis must now be on proactive control over securities issuers and marketers, with a focus on preventing conflicts of interest arising from a lack of independence. Enforcement and punishment of violators is important, but stronger preventive measures will ensure the effectiveness of governance reform.

Transparency

The core of transparency is the fair, comprehensive, timely, and clear disclosure to the investor community of important business activities by securities issuers and marketers.

Although present regulations have resulted in an increase in the amount of reporting, corporations and regulators have given little attention to clarity. Investors must require that business information be provided in plain English. It should include an assessment of present business conditions, as well as a future outlook with a sensitivity analysis.

The assessment of present business conditions should include not only a description and explanation of business performance during recent periods, but also a trend analysis of the key drivers of profitability, cash flow, and financing; a status report on the achievement of strategic goals; and measures taken by management to correct any deviations from the strategic plan and previous earnings guidance. The business outlook and the corresponding sensitivity analysis must present a clear picture of future trends consistent with present performance, along with a sensitivity analysis focused on contingencies that may affect future performance.

The SEC’s recently published “Commission Guidance Regarding Management’s Discussion and Analysis of Financial Condition and Results of Operations” (Release Nos. 33-8350; 34-48960; FR-72, effective December 29, 2003) addresses the presentation as well as the content and focus of management’s discussion and analysis (MD&A), which is considered the main vehicle for business leaders’ communication with the investor community.

The following objectives for MD&A set by the SEC are adequate and consistent with the aforementioned transparency requirements:

• Provide a narrative explanation of company’s financial statements that enables investors to see the company through the eyes of management;
• Enhance the overall financial disclosure and provide the context within which financial information should be analyzed; and
• Provide information about the quality of, and potential variability of, a company’s earnings and cash flow, so that investors can ascertain the likelihood that past performance is indicative of future performance.

The SEC also mandates that the primary focus of the MD&A should be key indicators of financial condition and operating performance, materiality, material trends and uncertainties, and analysis.

SEC Release 33-8350 is a step toward transparency. If all corporations adopt the spirit of this release, communication of business performance and outlook will be enhanced substantially. The SEC has proposed additional objectives for the communication of fees and market activities that are expected to be released soon.

The same transparency needed for securities marketing activities is also important to the communication between investors and the business community:

• All fees paid by investors to market intermediaries must be publicly disclosed.
• Investors should be informed and be allowed to effect all market transactions.
• The relationship between fees paid and investor wealth should be made public.

Accountability

Corporate accountability requires a process that permits investors to expeditiously restructure boards of directors that fail to fulfill their duties. It also requires that business leaders be compensated based upon performance. Corporate executives’ compensation should be significantly variable, and the variable portion should be directly linked to stockholder wealth creation and granted at the end of a strategic planning period to prevent a short-term focus. More important than limiting compensation is the executive sharing in both success and failure. Presently, many executives are overly rewarded for success and are not penalized for failure. Generous farewell packages with no link to performance should be eliminated, and a process allowing the audit committee to periodically evaluate the integrity of executives should be established.

Similarly, external auditor compensation should be significantly variable and related to performance, as measured by the reduction in fraud and restatements.

Making market participants accountable requires that the compensation of market intermediaries be directly related to performance rather than the volume or value of transactions. Today, traders, fund managers, and investment banks are transaction-driven. Because their compensation is not tied to investor wealth creation, their interests are not aligned with their investors’ interest. Investors and regulators must take a proactive role in fostering accountability. Investors should request a direct role in structuring the governance bodies of corporations and mutual funds. Regulators should focus on changing the culture of investment banks and traders to one that promotes investor wealth creation.