10 April 2002

 

Mr. James L. Cochrane
Senior Vice President
Strategy & Planning
New York Stock Exchange
18 Broad Street
New York, NY 10019-1503

 

Mr. Cochrane:

 

On behalf of the Association for Investment Management and Research^® (AIMR^®), I am pleased to provide my thoughts to the Special Committee ("the Committee") of the Board of Directors of the New York Stock Exchange (NYSE) on the issues of corporate accountability and NYSE listing standards.

 

With headquarters in Charlottesville, Va., and regional offices in Hong Kong and London, AIMR is a nonprofit professional association of 54,000 financial analysts, portfolio managers and other investment professionals in 107 countries. AIMR's membership also includes 106 local professional societies and chapters in 29 countries. AIMR is internationally renowned for its rigorous Chartered Financial Analyst® (CFA®) curriculum and examination program, which has more than 100,000 candidates from 143 nations enrolled for the June 2002 exams. In addition, AIMR is recognized internationally for its investment performance standards, which investment firms use to calculate and report investment results, as well as for its Code of Ethics and Standards of Professional Conduct. AIMR was formed in 1990 from the combination of the Financial Analysts Federation (established 1947) and the Institute of Chartered Financial Analysts (incorporated 1962).

 

General Comments

 

Corporate governance is an elusive concept that describes the relationships between a company's management, its board of directors, its shareholders, and its other stakeholders. According to the report of the Organization for Economic Cooperation and Development's (OECD) Ad Hoc Task Force on Corporate Governance, corporate governance "provides a structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined." More simply, corporate governance can be defined as the system by which a company is directed and controlled. Regardless of the definition in use, we concur with the OECD that good corporate governance provides "proper incentives for the board and management to pursue objectives that are in the interests of [both] the company and shareholders and should facilitate effective monitoring, thereby encouraging firms to use resources more efficiently" and effectively. We wish to emphasize that, although the corporate governance relationship is between management and shareholders, company objectives must serve and forward the interests of shareholders and the company, not company management.

 

We believe that shareholders have a right to expect good corporate governance practices from the companies whose equity they own. Increasingly, we see investors including information on a company's corporate governance practices into their investment decision-making. Institutional investors are also exercising their right and fiduciary responsibility to vote proxies and participate actively in the corporate governance process.

 

While there may be no single model of good corporate governance, as the OECD report suggests, important principles can be identified upon which good corporate governance structures and processes can be based. We support the following principles that are presented in the OECD report:

 

1. Recognize and protect the rights of shareholders.
   
2. Treat shareholders equitably, including minority and foreign shareholders; provide effective processes and procedures for the redress of violations of these rights; and prohibit insider trading.
   
3. Recognize and protect the rights of other stakeholders and develop mechanisms for informed stakeholder participation in the governance process.
   
4. Make timely, accurate, and transparent disclosure of all material matters regarding the company, including financial situation, performance, ownership, and governance.
   
5. Hold the board of directors accountable to the company and the shareholders, require them to exercise due diligence and care, and to put the interests of the shareholders and the company before their own or management's interests.

 

Not all legal systems support these principles. Even where the principles are supported "in spirit," in practice, the extent to which they are implemented varies widely. We support the efforts of the NYSE, regulatory bodies, and other self-regulatory organizations to require companies within their jurisdictions to implement structures that can ensure these principles are recognized and applied.

 

Often stock exchanges, and the NYSE is no exception, are perceived to be advocates for their corporate clients, rather than the ultimate investors who use exchanges to invest. We are gratified to see that the NYSE is interested in the views of investors, and the investment professionals on whom they rely, in their efforts to improve the corporate governance structures of its listed companies. We recommend that, in deliberating enhancements to its listing requirements, that the NYSE Board strive to identify and incorporate the "best practices" for each of these principles.

 

In addition, regardless of the changes that are made, we believe that listing requirements must be applied uniformly to all listed companies. If the principles of good corporate governance that we outlined above are valid, then, regardless of their country of domicile, all companies have the same responsibility for, and all investors have the same right to, good corporate governance.

 

Responsibilities of Institutional Investors
The AIMR Standards of Practice Handbook details the Code of Ethics and Standards of Professional Conduct to which all AIMR members must adhere. In 1999, to provide guidance to members on some of their responsibilities with respect to voting of proxies, the Topical Study: Corporate Governance was added. Corporate governance was then, and continues to be, important to AIMR because, in many instances, security holders and account owners delegate their right to vote proxies to the investment professionals who manage their investments. These investment professionals must, therefore, adopt procedures to ensure that proxy issues are sufficiently noted, analysts, and considered so that their fiduciary duty to their clients is met. AIMR believes that it has the responsibility to provide adequate guidance to its members in support of that duty. The recommendations in the topical study are designed to help AIMR members and other investment professionals to establish and implement a sound proxy voting policy. Although institutional investors should follow clear and transparent general voting guidelines, available to all investor-clients, in voting their proxies, they must also recognize the need to review all votes individually and not permit minority shareholders to be treated unfairly.

 

AIMR Global Task Force on Corporate Governance
AIMR recognizes that providing guidance on proxy voting is just the beginning of its responsibility to its members and their investing clients on the issue of corporate governance. More than 80% of AIMR members are employed by institutional investors or private-client investment management firms. As a group, these investors hold about 50% of all listed corporate equity in the United States (about 60% in the largest 1,000 corporations). The largest 25 pension funds account for 42% of the foreign equity held by all US investors.

 

Institutional investors increasingly realize the potential power and influence that they, representing millions of individuals, can wield over the companies in which they hold interests is staggering. These investors are in effect "permanent shareholders" and their responsibilities to their investing clients must go beyond merely voting proxies on management proposals. Institutional investors have a right and a responsibility to participate in and vote on corporate decisions that affect the performance of the investments of their clients and to advocate improvements to corporate governance structures. To support its members and their investing clients in this endeavor, AIMR has recently initiated a project with the goal of making broader recommendations on "best practices" for corporate governance structures worldwide.

 

We believe that institutional investors should play an active role in corporate governance. The fiduciary duty of pension fund sponsors and trustees and mutual fund managers entails duties of care and loyalty to their investors and clients. It entails an obligation to add value to clients' investments and protect their interests in the long-term health of the companies in which they invest. This is particularly important for passive or index fund managers who may have significant positions in a company's securities but do not have the flexibility to influence corporate management by simply selling shares. As the founder of Deutsche Bank, George Siemens once said, "If one can't sell, one must care." We do not believe that simply voting proxies fulfills that duty.

 

We recommend that institutional investors assume a role that ensures that corporate policies serve the best interest of a corporation's investor-owners. Although we would not expect that institutional investors would seek involvement in the day-to-day operations of the companies in which they invest, we believe that institutional investors should recognize the need for conscientious oversight of, and input into, management decisions that may affect a company's value.

 

Therefore, we recommend that the NYSE adopt listing requirements that would not only permit, but facilitate, an active role by investors, particularly institutional investors. For example, we support a strict approach with respect to share-based compensation plans that requires shareholder approval, with very limited exceptions, for every plan in which directors and officers participate. With respect to plans that have the potential to dilute the value of shareholders' earnings, we support a requiring shareholder approval, even when directors and officers do not participate, if the plan has the potential to dilute shareholder interests by ten percent. We endorse the treatment of "potential dilution" adopted by the NYSE which is defined as "the maximum aggregate number of shares of stock currently authorized for issuance including both the number of shares of stock available for grants and the number of shares underlying outstanding grants (i.e., unexercised and unexpired)." We believe that these requirements recognize the right of shareholders to exercise their voice on corporate governance matters that have a direct and substantial impact on equity interests.

 

AIMR Advocacy to Improve Financial Reporting and Disclosure
Corporate governance should foster transparency: full disclosure of the conditions- risks and opportunities- to which investors in a particular market, or a particular company, are subject. At the macro level, these conditions encompass a market's various legal, financial reporting and disclosure, regulatory, and supervisory standards and regimes. At the micro level, these conditions include an individual company's financial performance and outlook, as well as full disclosure of how a company is governed, and the qualifications, responsibilities and compensation of its board of directors.

 

AIMR understands, as did its predecessor organization the Financial Analyst Federation, the importance of high quality financial accounting standards. Our advocacy efforts are active in this regard. In the United States, the Financial Accounting Policy Committee provides input to, and responds to initiatives of, the Financial Accounting Standards Board, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants and the Security and Exchange Commission, among others, with the goal of improving the information that all investors have available to them for investment decision-making. In Canada, the Financial Reporting Subcommittee of the Canadian Advocacy Committee accepts that responsibility and the Global Financial Reporting Advocacy Committee works with the International Accounting Standards Board. Members of AIMR management support member volunteers in these endeavors. We serve on the International Financial Reporting Interpretations Committee and the Canadian Accounting Standards Oversight Council. These advocacy efforts reflect the importance that financial reporting information has to AIMR members' professional responsibilities. AIMR comment letters on a wide variety of financial reporting issues are available on the AIMR website: www.cfainstitute.org.

 

We believe that the NYSE should include issues related to financial reporting and disclosure in its project on corporate governance. This issue has wide spread influence and affects not only existing shareholders, but also prospective shareholders who may be relatively disadvantaged in acquiring information.

 

Although there are many areas of financial reporting that warrant improvement. There are several key areas with deficient rules that we believe must be addressed immediately if investor needs are to be met. If the NYSE does not believe that addressing these deficiencies is within its purview, we urge it to support the efforts of standard setters and regulators to address them. We believe that this would be an important opportunity for the NYSE to support investor interests.

 

We offer the following examples:

 

• Consolidations and off-balance sheet assets or liabilities
  For the past 20 years, AIMR has advocated that all off-balance sheet activities be reported in the parent company's financial statements. This includes activities such as leasing transactions as well as consolidation of subsidiaries, special purpose entities, joint ventures, and partnerships. Current accounting rules are inadequate because they have "bright lines" that allow companies to tailor their transactions to be on- or off-balance sheet. For example, subsidiaries are not consolidated unless the company owns more than 50%. Consolidation on an SPE requires more than 97% ownership. Partnerships and joint ventures can escape consolidation altogether. Rules for recognition of liabilities under leasing arrangements allow companies to keep significant assets and liabilities off the balance sheet and can distort the reporting of operating cash flows and earnings.
  
• Financial assets and liabilities
  As the market in derivatives and other complex financial instruments has grown, we have argued for reporting of financial assets and liabilities at fair value, rather than historic cost. Given the volatility of these instruments, we believe that reporting these assets or liabilities at their fair value is the only way to understand their risks and rewards. Corporate objection to this change has been fierce. The resulting standards require some instruments to be recorded at fair value but others not; some changes in value are recorded in earnings but others not. Even when fair value changes are recorded in earnings, companies need not disclose in what income statement item they appear. This situation turns financial analysis into an impossible game of hide-and-seek.

  Investors also need more informative disclosures regarding financial assets and liabilities. In response to rule proposals by the Securities and Exchange Commission (SEC), AIMR argued for disclosure of sensitivity analysis to allow investors to understand fully the potential risks of these instruments to changing market conditions. Companies lobbied heavily against improved disclosures. The Senate Committee on Banking, Housing, and Urban Affairs held hearings at which the FASB, SEC and AIMR testified in support of the SEC rule proposal, but corporate issuers opposed the improved disclosures. The regulations that were implemented give companies too much flexibility in the type of disclosure. They are generally so simplistic as to be all but useless to investors.

• Share-based Compensation
  Stock options and other equity-based compensation have become an important part of executive compensation in the U.S., particularly in new and growing industries. Such compensation should be a way to align management and shareowner interest, but unfortunately has led to earnings manipulation to improve share price. Contrary to what managements would have investors believe, stock options are not "free" or of "little or no value." If so, why would management accept them in lieu of cash? In fact, exercise of executive stock options reduces external shareholder interest and increases management's interest, generally on unfavorable terms to shareholders. Nor do these options better align management and shareholder interests, since research shows that managers are more apt to sell the shares they receive when options are exercised.

  In 1994, to its credit, the FASB was prepared to issue a new rule to require recognition of compensation expense for stock options. Heavy corporate lobbying and legislative intervention, however, led FASB to allow footnote disclosure rather than recognition. Disclosure is no substitute for recognition and measurement. A recent AIMR survey shows that 83% of responding fund managers and analysts support recognition and believe that current disclosures are inadequate and difficult to use.
  

• Pro Forma Earnings
  Another creative way in which managements mislead investors and manipulate investor expectations is by communication of "pro forma earnings," company-specific variations of earnings, or "earnings before the bad stuff." With all its deficiencies, we believe that earnings data based on Generally Accepted Accounting Principles (GAAP) are still the most useful starting point for analysis of a company's performance. Analysts and other investors at least know how GAAP earnings are computed and, hence, there is some comparability across companies. We believe that GAAP earnings should always be displayed more prominently than non-GAAP earnings data.

 

Unfortunately, just the opposite seems to be the norm, particularly in press releases where pro forma earnings get the most emphasis and GAAP earnings may not be mentioned at all. GAAP earnings and associated balance sheet may only become available to investors in SEC filings one to two weeks after pro forma earnings are announced. While pro forma earnings can be helpful supplemental information for analysts, the practice of providing pro forma earnings is widely abused. Companies selectively exclude all sorts of financial reporting items, including depreciation, amortization, payroll taxes on exercises of options, investment gains and losses, stock compensation expenses, acquisition-related and restructuring costs. John Bogle, the respected investment professional, recently noted in a speech to the New York Society of Securities Analysts, "In 2001, 1,500 companies reported pro forma earnings- what their earnings would have been if bad things hadn't happened." We recommend that either the FASB or SEC curtail this practice or ensure that pro forma earnings data never have more prominence than GAAP earnings in company communications.

 

Finally, we recommend that the NYSE vigorously enforce existing financial reporting and disclosure standards for its listed companies. Enforcement of these standards is a vital element of a high quality financial reporting regime. We believe that the Securities and Exchange Commission has insufficient resources to enforce these standards effectively. It is certainly within the ability of the NYSE to demand no less of its listed companies than adherence to the financial reporting and disclosure standards required under the United States securities laws, regardless of a company's country of domicile.

 

Boards of Directors
A good corporate governance framework must encompass the duties, responsibilities and powers of the board of directors, the procedures for selecting members of the board, and the process for making those decisions that materially impact a company's value. Such decisions include whether to merge with a competitor, to divest certain assets, or to repurchase equity. Essentially, frameworks or codes for corporate governance must be designed to help boards fulfill their fiduciary duty- doing the right thing, even when no one is looking- thereby earning the trust, confidence and capital of investors, especially outside investors. A good corporate governance framework must also provide evidence to shareholders and potential investors of the independence of the board of directors.

 

We believe that best practice frameworks exist and can be applied. Describing these best practices in detail is part of the charge of the AIMR Global Task Force on Corporate Governance mentioned previously. We believe that, even markets, such as the United States, that already recognize the need for good corporate governance can benefit from improvement to their frameworks.

 

Even before the Task Force completes its work, we can recommend several best practices with respect to boards of directors and shareholder voting rights:

 

• At least half of the directors should be independent, non-executive officers of the corporation, even if one group owns the majority of outstanding equity shares. (We recommend that the NYSE strengthen its definition of an "independent director.")
• Shareholder voting rights and meeting rights should ensure that one share has one vote, and decisions are not made by a show of hands.
• The following three independent committees should be appointed by the Board, and not management:
  • Audit
  • Nominations
  • Compensation

 

Standard-setting bodies increasingly recognize that, to govern effectively, board members need to have a relatively high level of knowledge of the corporation's business activities, as well as its financial condition. For example, the National Association of Corporate Directors has issued a set of new guidelines for enhancing the professionalism of board members. We support the following qualifications and responsibilities for directors and recommend their adoption:

 

• Directors should be active participants and decision-makers in the boardroom, not merely passive advisers or "rubber stamps" for management proposals.
  
• Directors should limit their number of board memberships
  
• Directors should limit their length of service on a board to 10 to 15 years so that new directors with fresh insights and a renewed independence can be elected.
  
• Directors should immerse themselves in both the company's business and its industry while staying in touch with senior management.
  
• Directors should know how to read a balance sheet and income statement and understand the use of financial ratios so they can do their own analysis of the company's performance and detect early warning signs of emerging problems.
  
• Directors should own a significant equity position in the company.

 

Audit Committees
The AIMR Financial Reporting Advocacy Committee (FAPC) responded to requests for comments on the Blue Ribbon Committee report, Improving the Effectiveness of Audit Committees. We believe that the FAPC's comments are pertinent to the NYSE in reviewing their definition of an independent director and the requirement for independence of those directors who serve on the audit committee.

 

The members of the FAPC discussed at some length the concept of "independence" and those factors that constitute an independent director. They believe that "independent" may not be the appropriate term to describe the relationship that must exist between management and the directors who sit on the audit committee, and recommend instead that directors be characterized as either "non-management" and "management" or "outside" and "inside" directors. In addition, FAPC members believe there is a critical distinction between financial and intellectual independence. For example, they believe that it is extremely difficult, if not impossible, to ensure that directors retain a level of intellectual independence throughout their tenure. A director may begin his or her term of office with little or no relationship to corporate management or other directors on the audit committee. However, intellectual relationships between management and directors are healthy, and ongoing dialogues between these two groups are often essential to completing the relevant tasks assigned to them. Directors are also responsible for evaluating management. In order to assess properly the effectiveness of corporate managers, directors must have a keen understanding of their function, style, and value to the enterprise; they must, in essence, know management. Such intellectual relationships are necessary and should not be discouraged. However, audit committee members should not be dependent on management when assessing accounting issues or practices and recommend that the various relationships be reevaluated on a regular basis to prevent possible "tainting".

 

The FAPC wishes to emphasize, and we concur, that audit committee directors must distance themselves financially from corporate management, retain their objectivity, and be able to comment on issues without affecting their self-interests. Financial independence is, however, in direct contrast to the intellectual independence discussed above and must not be breached. A breach may occur if, for example, the directors appointed to the audit committee were (1) family members of corporate management or (2) major suppliers, customers, or consultants. Under these circumstances, directors' biases may influence their decision-making ability; a level of objectivity may be compromised due to the conflicts of interest that may ensue.

 

We also believe that all members of the Board of Directors should be financially literate, but that a background in accounting or finance should not be the "necessary and sufficient" criteria for qualification. Formal degrees are only loosely correlated with knowledge. All members of the Board should be able to understand a company's financial statements. However, a formal degree in finance or accounting is not essential in that regard. Many individuals without these formal, academic credentials can be as insightful (or in some cases more so) than those with a strict, academic background in finance and accounting. For instance, many corporations have effective internal training centers or affiliations with independent executive institutes. These resource facilities can provide fine educations to employees, managers and directors. In addition, many individuals garner a level of experience and practical knowledge that cannot be matched solely by an understanding of theoretical concepts.

 

We also believe that shareholders have the right to assess independently the extent of the relationships between directors and management. The only effective way to accomplish this assessment is through full and fair disclosure of these relationships (including relationships with director nominees), preferably in the annual report to shareholders. This information is material to investment decision-making and should include specific and detailed information about personal, professional, and financial relationships.

 

Concluding Remarks

 

We believe that effecting substantive changes to corporate governance generally ideally requires a private-public partnership of investors, financial industry participants, self-regulatory organizations, and government regulators that would unite to help eliminate market barriers by establishing, implementing and maintaining corporate governance standards that mandate transparency, timeliness and accuracy of corporate financial reporting. For these standards to work and offer real investor protection, there must also be enforcement of fiduciary laws and standards through effective market monitoring and surveillance by regulators as well as self-regulatory organizations, such as the NYSE. The standards and their enforcement work together to create a level playing field for all market participants- foreign and domestic- and to encourage competition in the market. The end result is better protection for investors, instilling them with confidence, and giving them more and better investment choices and increased access to opportunities.

 

We wish to thank the NYSE for the opportunity to present our thoughts on its listing requirements to improve corporate governance and shareholder accountability. I look forward to discussing these views with the NYSE Board. If you, the Board or a member of your staff has any questions on these views, please contact me by phone at 1.434.951.5315 or by email at patricia.walters@cfainstitute.org.

 

Respectfully,

 

Patricia Doran Walters, PhD, CFA Senior Vice President Professional Standards & Advocacy