Harvey Pitt Is Still No Mr. Mellow
from
May/June 2006
by John Curran
Harvey
Pitt served as the 26th chairman of the Securities and Exchange
Commission from August 2001 until February 2003, winning a reputation
for abrasiveness amid a series of controversies surrounding scandals in
the corporate and accounting worlds. He now heads a consulting firm,
Kalorama Partners in Washington, D.C., which advises companies on
governance issues. Pitt shows no sign of backing down from unpopular
stances or from criticism of what he sees as lackluster performance in
the boardroom. He spoke with
Corporate Board Member
’s John Curran. Excerpts:
Let’s dive right in. What do you think of the proposed rules to make executive compensation more transparent?
My sense is that it’s long overdue. It would try to provide investors
with the ability not just to understand what people are getting paid
but to do comparisons across companies, which is what’s really
significant. You want to see how your company is doing, compare its
performance, compare its salaries, perks, and so on. That said, I think
the real problem with compensation is that it’s done incorrectly by an
overwhelming majority of companies. What they do is bring in a
compensation consultant who says, “Here are five companies that are
comparable to yours. Here is the range of what they’re paying, and you
have to pay your people at least 75% of the top level.” And so people
then get surprised when there’s compensation inflation.
There’s a better way: Rather than trying to figure out who you’re
comparable to, you ought to figure out what it is you want from a
particular officer. You want a culture of integrity; you want
compliance; you want good corporate performance—but not in terms of
earnings per share, which is a fictitious number. Then you delineate
what you expect from each person and what they’re being compensated
for. If they achieve those goals, they should be rewarded generously.
But if they don’t achieve those objectives, they shouldn’t be.
The difficulty today is that many companies are paying handsomely, but
they don’t specify what they really want to achieve. Or if they do,
they express it in terms that can be manipulated, so what winds up
happening is that the companies and shareholders don’t get any real
value from the millions of dollars they’re spending.
How explicit should boards be in describing compensation criteria?
Sometimes more is less. So if you inundate people with too much
verbiage, you run the risk that the process will not be meaningful. And
indeed, one of the concerns that I had when I went to the SEC, and
still have, is that disclosure documents are basically written by
lawyers, not to inform but to provide arguments for avoidance of
potential liability down the road. When you [a journalist] write a
story, you write it to inform your readers. That’s the way corporations
should be doing it, but they aren’t. So there needs to be detail; you
need to state what the job objectives are; you need to talk about how
you established those objectives, what the compensation is, what the
relevant factors are for each of the various objectives, and how you’re
going to measure them. And, of course, what you’re going to do in the
event that performance standards are exceeded or aren’t met. But I
don’t think it has to be written as if it were a trust indenture.
Before companies disclose more, don’t they need better protection against being sued?
Liability has run amok. When there’s a real fraud that’s been
committed, like an Enron, it’s important for the law to extract
liability. But a lot of the liability cases we see are really people
trying to second-guess disclosures that were made, particularly ones
that were made in good faith.
I think companies should be encouraged to make disclosures, even if the
disclosures aren’t necessarily precise. My view is that if you want
what is critical disclosure, you have to make it possible for companies
to do that without sandbagging them and playing what I call “gotcha” if
they talk about a trend and it turns out that the trend doesn’t
materialize. I think there has to be liability relief in order to get
the right kinds of disclosure.
When you talk about companies, you’re presumably pointing to the board as the group that calls the shots.
Yes, but there’s a disconnect there because most directors have other
jobs, day jobs. If you’re not actually running the company, I don’t
care how smart you are, I don’t care how diligent you are, if somebody
wants to defraud people, the likelihood of your catching it as a
director is very slim. People can do and do do bad things. So directors
cannot assume the overarching responsibility for making sure that
everything the company does is absolutely done correctly. But what they
do have to do is perform an oversight function. They have to make sure
that the people who are actually doing the day-to-day management are
provided with all the tools they need. The directors are there as part
of a system of checks and balances, to make sure that if something
untoward is going on, they have a shot at least of finding out about it
before it becomes a catastrophe.
Give me an example of how this should work.
Let’s say a company discovers that demand in the Southeast is lower
than anticipated, and they may lay off some workers, or they may delay
some plant activity. Well, how did the managers make that decision?
They don’t have concrete data that says, “We’re going to do worse.”
They just have trend information; they know that things don’t appear to
be going the way they’d expect them to go. They make judgments based on
that kind of trend information. That information should be given to the
directors too. If it’s important enough for the managers, there ought
to be a flow of this information to the board. Next, after directors
see this material, the question is, “How should we package it so that
our shareholders have a better idea of what’s going on with the
company?” That’s a function that directors can perform—and the good
ones do.
Is Regulation Fair Disclosure working?
I think Reg FD was a bad solution to a legitimate concern, but not
necessarily a legitimate problem. The concern that existed was that
companies might make selective disclosure. That would create
disparities of information in the marketplace. That’s unfair. But the
way to address it is not through an anti-disclosure rule, which is what
the SEC adopted. What’s so ironic and pathetic about Reg FD is that it
basically takes the approach that if you have a disclosure problem, the
way you solve the problem is that you tell nobody anything. That’s one
of the choices under Reg FD.
Does the SEC have a big enough budget to do its job effectively?
The SEC could use more muscle in some areas. But it also has a lot of
excess—not muscle, but flab—which it could pare away to become more
streamlined, more efficient. For example, instead of creating more
examiners, the SEC should start to outsource the examination function.
How would outsourcing work?
Take mutual funds. What you would do is have every major mutual fund,
every major investment adviser, go out and hire somebody completely
independent and competent to do inspections. The very biggest fund
companies would do this annually, and the smaller ones would do this
every other year—you’d require it. The SEC would define the inspections
and what the inspections would look for. And then you would require a
written report by all these companies, both to the boards of the mutual
fund companies and to the SEC. Now, if problems were uncovered, the SEC
would have the ability to home in on what the real issues were instead
of sitting there waiting for issues to arise.
If the SEC outsourced more of the initial inspection process and
focused on dealing with problems that were uncovered, setting
standards, and so on, then you’d have a very useful interplay between
what the government should do, which is facilitate law compliance, and
what the private sector does, which is pay its own way. Why should we
have 900 people at the SEC inspecting 18,000 mutual funds, 6,000 hedge
funds? Just think about it—it’s impossible, you can’t do it.
I think we obviously need the SEC to be an effective regulator and an
effective enforcer. But I also think that we can use the resources of
the private sector better, and the SEC could be a very profitable
agency.
Are boards doing enough to unearth tomorrow’s scandals before they become scandals?
You know, one of the problems most companies face today—and this is
true of directors in particular—is that they’re a lot like my mother.
Fifteen years ago my mom passed away from stomach cancer, and she
claimed that she was never sick a day in her life until she went to the
doctor and he told her that she had stomach cancer. So for many
companies, it’s very simple; they say, “If I don’t know I have a
problem, if I don’t know that there is some malignancy in the company,
I’m not sick.” Then, of course, a problem springs to life at the worst
possible time, and then it becomes life-threatening.What you need is to
facilitate a climate in which companies are encouraged to look for
problems before they actually become problems. The SEC is trying to do
that, and I think they’ve made some good strides, as in the
corporate-penalty release put out in January under [SEC] Chairman
Christopher Cox. [The release identified the circumstances under which
the SEC would impose fines on corporations as well as, or instead of,
individuals.]
Is there something boards can be doing to increase the odds of discovering such problems before they become big problems?
Yes. But you need to have a culture in which the outside directors are
not merely followers but leaders. I’m not talking about any kind of
adversarial relationship, because that would just destroy public
companies. But I’m talking about the way most companies operate, which
goes something like this: Senior management dictates what the agenda
is, they dictate what the issues are, they dictate when it will come
up, and then the board members spend a couple of hours reading the
papers they’re given and then vote, and they think they’ve done their
job. But that is not the complete job of directors. That is a very
important part of the job, but what the outside directors need to do at
the start of each year is to develop their own agenda: “What are the
issues that we want to look at on our own?” After they’ve decided that,
they should then ask management to provide them with data. For example,
“We want to look at our compliance. We want to look at compensation. We
want to look at how our disclosure is working.”
One thing that my company recommends to audit committees—I’m sorry to
say many of them don’t follow our advice on this—is that every three
years or so they should commission a forensic audit. Now, when you say
that to some people, they look at you as though you’re nuts. But think
about it: Bad things do happen to good companies, and you may not know
about it. But if you’ve commissioned a forensic audit by a firm that
has real expertise, and they come out and show that you’re clean, that
there are no major problems, you’re in good shape. And now suppose
there was a major problem that nobody could see—your outside auditors
couldn’t see it and your forensic auditors didn’t see it. In the face
of that, those outside directors will never be asked to pay damages out
of their own pocket. They will have no liability, because they will
have been proactive.
It’s not adversarial for outside directors to propose this; it’s
constructive. Even so, most outside directors are shocked when you tell
them that they should have their own agenda.
Do you believe that the chairman and CEO jobs should be split?
The whole argument over whether the chairman of the board should be
independent is really an argument over cosmetics. What’s really
important is, is there a lead outside director? And by “lead,” I mean
is there somebody who will marshal the outside directors’ thought
processes to craft their own agenda?
Where do you expect the next scandal to appear?
It’s hard to say, but there are potential candidates. We have not yet
seen all the scandals that will erupt in the portfolio-management
industry, and that includes a wide swath covering mutual funds, hedge
funds, private equity funds, and so on. And the reason for that is,
people aren’t really sensitive to the scope of conflicts that can
exist.
For example, let’s say that I’m a fund-management company and you’ve
invested in my secured-debt fund, while your friend has invested in my
equity fund. Let’s suppose that a company in which both these funds
invested is now in financial difficulty and might go belly-up. The
equity investor would say, “Please don’t pull the plug on this company,
because I want to get out with my money.” But the secured-debt investor
might well say, “Pull the plug on this company. My money is well
protected.” So now the same money manager has two different funds, two
different potential approaches, and even though the manager didn’t
think at the time he made these investments that he had a conflict, he
really does.
