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Corporate Governance Revisited
The NYSE should lead the clean-up effort.


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From audit and accounting scandals with no one taking the blame, to hyped securities on Wall Street with no one taking the blame, to options expensing being reluctantly accepted, to market-order front-running by NYSE specialist firms . . . to what else?

Fraud and greed have always been a part of our system but they were normally contained by a multi-tiered process of checks and balances. We have always had front-running IPO kick-backs. But they were always minor in the scheme of things. Why have these shortfalls blossomed in recent years, and why are they still problems?

Maybe because these shortfalls go right to the top.

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When Sandy Weill, the CEO of Citicorp, recently turned down a request that he join the board of the New York Stock Exchange, the NYSE itself came under some long-overdue scrutiny. If the Securities and Exchange Commission is charged with protecting the individual investor, shouldn’t the NYSE also be so charged?

If you review the NYSE’s website, you will find a non-independent board (in large part) and too many groups with fuzzy reasons to exist. Why does nearly 40 percent of all NYSE “program trading” consist of bundled trades by professional traders? Where do you see the individual investor being protected in this scheme? Where is the structure, from top (the president and the SEC) to bottom, that should be in place to ensure accountability?

The situation reminds me of September 11. On the day we realized we had no homeland security, we also discovered that our government agencies were too insular to coordinate responsibility for their main missions.

When a lack of true accountability and truly independent boards appeared on the corporate level, all self-regulatory organizations that are driven by volume or revenue gains became suspect. To now know that the NYSE is probing 5 of 7 specialist firms and that 2 out of 7 firms failed to pass their annual NYSE surveillance audits last year is not a good sign that the situation is heading toward repair.

But the NYSE needs to acknowledge its own structural shortcomings. It must become more modern (e.g., an electronic matching order system that is blind to who is trading) and more sensitive to the individual investor versus the professional trader. Proprietary trading by specialist firms, along with brokerage firms that see or recommend trades, should be banned. It is a conflict of interest that is harming the integrity of the markets.

Our markets were created in a democratic/capitalist system to reward long-term investors, not speculators. That is why we should take this opportunity to foster positive change. That is why tax policy should be geared more to the long-term investors — where capital gains and ordinary income are set at the same modest rate; where indexed rates favor the investor who holds a security for five-plus years; where there are no tax advantages for not-for-profits with expense ratios greater than 5 percent; where any bankruptcy settlements automatically go first to debt holders who held the debt over five years and shareholders who held the stock over twenty years.

That is also why corporate policy should be rethought and geared explicitly to:

long-term investors

the owners of companies where the total compensation of executives and board members is fully disclosed and deemed sane by a right and wrong standard

companies with boards that are independent, capable, and varied (less of the executive-club profile)

companies where the audit committee interviews potential audit firms with management, but only recommends to the full board the firm that reports directly to the board

companies where two managing directors share audit responsibility not to exceed five years

companies where the nominating- and compensation-committee chairs have only one-year terms (and three-year member terms)

companies where board members must attend 75 percent of meetings in order to be compensated beyond normal expenses

companies where potential conflicts must be disclosed each year and agreed to (or not agreed to) by the full board for continued board membership

companies where internal audits, including potential management conflicts, are reported to the full board once a year (or more, as necessary)

companies where board approvals of gift donations are only made in the name of the company

companies that do not allow loans to executives (with the exception of housing/relocation assistance)

companies that offer no golden parachutes nor termination compensation (other than normal retirement benefits, etc.)

While some of the above items are partially agreed to by some organizations and companies, these sane changes need to be standardized for all, in a way that the principles are clear and the rules are general. The U.S. shareholder can’t wait!

— Patricia A. Small is a partner with KCM Investment Advisors, and is the former Treasurer, University of California.



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