Reconciliation of the Values and Practices in the Financial World

Speaker A Question should be asked what is there that one can do about it? The first place to start is unquestionably to note the fact that the business world and financial world are simply riddled with many major conflicts of interest. The kind of conflicts of interest that would never be tolerated in public life for a minute. People are on both sides of every problem. Let us take something simple like appointing a board of directors. If we go back in history, boards of directors were appointed by the investors who founded the company and they would then, between them choose a manager. And in the early days of capitalism, as we well know, the manager might very well never have attended a board meeting. Gradually it becomes apparent that managers should be on the board. And then eventually, when savings are institutionalized, that we no longer have individuals and powerful families owning companies, but we have millions, even tens of millions of people owning. It becomes sensible for people to channel their savings through investments because they get a better spread and they hope to get professional expertise. Something you just can't do as an individual. At least most of us can't. But with that comes the fact that there is now a gap between the investors on the one hand and the management on the other. Until if we fast forward to the present situation and perhaps we ought to look at North America as the best example of this, we reach a situation where the management are all powerful and the investors haven't any power at all. So let us go back to boards of directors. Now, boards of directors are essentially either appointed by the CEO from other CEOs mainly, or even if there's a nomination committee, the CEO has an effective veto. And therefore you have congenial boards, collegiate boards. And this isn't necessarily in the best interest even of the CEO, never mind the underlying investors. Now, if you take the situation in the United States, it has reached a ridiculous situation where investors actually have no rights at all. They can vote for the company's slate of director candidates. If they vote against it. The vote against doesn't count in law. Now, in the United Kingdom, 10% of the shareholders can get together at any time, call an extraordinary general meeting and fire any or all of the board. And occasionally they do just that happened on the Channel Tunnel last year. So ultimately the management are answerable to shareholders. But in the United States it's the other way around. And any attempt by the securities and Exchange Commission to give shareholders even a residual right to appoint one director occasionally if something's gone wrong for several years has been fought tooth and nail. So we now have a situation where there's this massive conflict of interest whereby those who are to be monitored choose their own monitors. The CEO of a company in effect, chooses the auditor. Now, the two main checks upon CEOs and their colleagues. Their management colleagues are auditors and directors. They choose both. And all the scandals we've seen have come from the fact that boards of directors have not done a very good job. They have only turned on managements and heaved them out when somebody else has found them out. And it's absolutely patent they can't hang on any longer. Now, that's one conflict of interest, but let's look at another. Let's look at investment banks. Investment banks are on every side of every major transaction. They promote small companies, they give away the shares when they're first floated on favorable terms to secure other business. They give general advice to the public. They lend money to hedge fund managers. They are on practically every side of every transaction. And the conflicts of interest seem to be something that they say, well, we manage them, we have Chinese walls. If you really manage the conflicts of interest in an investment bank, there would be no reason for the different the stockbrokers, the fund managers, the people who promote companies, the people who tip stocks, there would be no reason for them to be under the same flag. None whatsoever. And no one's going to tell me that, well, the economy comes, that we can rent space more cheaply. I mean, that's the only economy you can think of. So wherever you look, look at auditors. Auditors are supposed to report to the general public and to creditors. But auditors, as we well know, have been under the influence of the people who choose them and who decide their remuneration. The CEOs want to report high annual earnings. Perhaps they have performance bonuses entirely based on that. All of us who've worked in business know there is quite a lot of flexibility in how you decide the profit figure for any single year. You can change the depreciation. You can write things off or not write them off, or write them off more slowly. There's all kinds of changes you can make. You can say, this is actually an asset and I don't have to write it off at all. You can do all of these things. So an auditor beholden to a CEO anxious to make a certain profit figure is under terrible pressure. He's not free to report fearlessly and objectively. And most of the problems that auditors have got into have come from this sort of pressure. So the solutions are very, very simple. In theory. The solutions are that you must not allow major conflicts of interest. Auditors must be appointed independently. There must be some independent shareholder input to appointing some nonexecutive directors. A board that is self perpetuating, which is claimed to be an independent board, is an oxymoron if ever there was one. How can you be in that situation? Let us again look at the powers that CEOs have in America particularly. They have them here and in Europe as well. But America is the best example. They have unlimited use of the company's funds to fight shareholders on anything at all. And we've seen the tremendous fight they put up against Sarbanes Oxley. We've seen the tremendous fight they put up against the SEC Commissioner Donaldson, who wanted to bring in limited rights. So they are funded, if you like, inexhaustible funds to use shareholders'money against shareholders. Now, this cannot be right, because if I translate that into a political situation what political situation am I describing? I'm describing the Soviet Union. I'm describing Saddam Hussein's, Iraq. Imagine no one could stand for office in the United States to be a senator or a congressman unless they're approved by Bush's existing administration. What sort of system would that be? But that is a system of United States companies. So the conflicts of interest have to be eliminated. How do you do that? Well, there's several things you have to do. First of all, you have to enforce the law of trust which governs all trustees and all fiduciaries. So that an investment institution, any investment institution, can only act in the interests of its beneficiaries, solely for them, for the exclusive purpose of maximizing their benefits. That must be their rule. This means they cannot carry favor. If a CEO has embarked on a ruinous series of takeovers and mergers, and the statistics are clear that two thirds of them are bad value for shareholders, then they must do so. If they think the CEO hasn't got long term incentives or is being paid too much, or for the wrong things, they must have the power to do something about it. Now, needless to say, the conflicts of interest, the pressures of management giving them business are still there. So if you're in that situation, and the law is going to be enforced, its existing law has been for hundreds of years, it's going to be enforced, then you will delegate your voting rights to a specialist institution who doesn't have your conflicts of interest. You turn to the management and say, look, the law requires me to do it. I can't do it without a conflict of interest. I've given it to this perfectly respectable firm here, and I'm now free to deal with you, free of my corporate governance duties. It also requires that the investment institutions are prepared and able to appoint some nonexecutive directors so that there's some genuine independence on the board. It means that only independent nonexecutive directors I mean independent because they've been appointed by shareholders, not because they meet some corporate governance rule. Only they should decide on long term incentives and management remuneration. Only they should appoint the auditors and recommend them to shareholders. It is these kind of things we have to identify every major conflict of interest and then find an independent way of responding to it. Then, and only then, would we solve the problem. But how do we solve the problem? Well, in a way that ought to appeal to free enterprise. America, Canada, Britain, europe, you name it, by creating a market demand for good governance. Now, the other important thing to know, and it's not widely known, is that the evidence that now exists that well governed firms perform very much better is now incontrovertible. And if you take the much smaller class of evidence about well owned companies, the companies who'd have a critical shareholder, a knowledgeable committee shareholder like Berkshire Hathaway, the performance is higher again. So there is a huge economic prize here for everybody, including, interestingly enough, CEOs. Of course. If you're a really competent CEO, would you rather be employed under today's conditions where you're judged short term and often unfairly, or would you rather have the chance to perform on the longer term and have shareholders and directors who'd back you up for the long term? You don't have to be a genius to know how to answer that question.