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U.S. Securities and Exchange Commission

Speech by SEC Chairman:
Remarks at the Inaugural Lecture of the JD/MBA Lecture Series


Chairman Harvey L. Pitt

U.S. Securities and Exchange Commission

Kellogg Graduate School of Management
and Northwestern Law School
Chicago, Illinois
April 4, 2002

These remarks reflect solely the personal views of Mr. Pitt, and do not necessarily reflect the views of the Commission, the individual members of the Commission, or its Staff.

Thank you.

I was honored, and flattered, when Bill Brodsky, my friend and regulatory partner, asked me to deliver the inaugural address in this lecture series sponsored by the Northwestern JD/MBA Fund. Bill and his wife Joan established the Fund to honor their children and their spouses who, in the aggregate, have amassed eight advanced Northwestern graduate degrees. As a father of four, I am in awe of Bill and Joan's decision to continue writing checks to Northwestern after putting their children through multiple University graduate schools. I guess they just couldn't break the check-writing habit!

Bill and Joan obviously passed their passion for learning on to their children. Joan is a teacher. Bill, the Chairman and CEO of the Chicago Board Options Exchange, inherited his interest in business and law from his father, who was a 60-year Wall Street veteran. Bill and Joan have graciously made this lecture and others possible, and in so doing they pass along to all of us their love of learning. So, thank you, Bill and Joan, for your generosity and your spirit.

I have a special affection for Chicago, as a city, and Northwestern as a wonderful and rightfully esteemed educational institution. My professional mentor and "father" was Ray Garrett, Jr., a prominent Chicagoan and a distinguished Chairman of the agency I am now privileged to Chair. Ray loved Chicago, and through his eyes, I came to do the same. Each day, I find myself imbued with more of Ray's interests, preferences, idiosyncrasies, and avocations, and it is a special honor for me to hold the same position he held three decades ago. I only wish Ray were here as I try to follow in his rather large footsteps.

My affinity for Northwestern goes back several decades. The Law School's current Dean, David Van Zandt, is a friend and has been a collaborator in many CLE endeavors that Northwestern underwrites, organizes and presents. Of course, prior to my association with the current Dean David, I spent many years working with and admiring the original Dean David - David Ruder - who also happens to be my predecessor, thrice removed, as SEC Chair. I still talk frequently to David, who is a source of intelligence, wit, knowledge and inspiration. David wanted to attend, but I couldn't compete with a well-deserved vacation arranged long ago.

In preparing for this lecture, I happened upon a Newsday article about Bill Brodsky; it said he became fascinated with options in the early seventies, soon after graduating from Syracuse Law and joining the securities brokerage firm of Model, Roland.1 According to Newsday, at the firm's behest, Bill took an exam in 1972 to qualify as the firm's representative on the Chicago Board Options Exchange, which was being formed at the time.2

I was, then, Chief Counsel of the newly formed SEC Market Regulation Division, where we helped nurture and birth what was then the CBOE "pilot project." Newsday reported that, "because 1972 was a slow year in the brokerage business, [Bill's] wife . . . suggested he turn the year to good use by writing a paper on the exchange."3 Bill's article was published in 1973, the year the CBOE opened and, according to Newsday, it "established Brodsky as an expert in the budding options industry."4 This month, the CBOE celebrates its 29th anniversary under Bill's expert guidance.

There are many lessons to be learned from this story, but I'll point out only three. First, it demonstrates the impact hard work and scholarship can have on one's career. Second, it shows how successful your career can be if you pursue fields that fascinate and stimulate you. Finally, and most importantly, it shows that often our best ideas come from loved ones. Certainly, that's what my mother always told me! So, to the students and prospective students here this evening, I offer you this advice: Even if you are the only one in your family working toward an advanced Northwestern degree, listen to your loved ones, and don't be afraid to follow their advice.

In the current environment, in which accountants, lawyers and business people are often bashed and vilified, some prospective students (and their families) may be asking, what self-respecting person would want to major in accounting, enroll in law school or attend business school, let alone work up a great sweat to graduate from a joint degree program?

The short answer is that the need for people of integrity in accounting, law and business is stronger than ever. That's not because the accounting, legal and business worlds lack people of integrity. You need only look around this room to reassure yourselves that the accounting, legal and business worlds are full of bright, energetic, hard-working, honest and dedicated people. But, recent events have refocused our attention on the need to instill in current and future students fundamental tenets of professionalism, ethics and integrity. And, you can never have too many people of integrity!

Last month, the Financial Times reported Dean Jain is placing leadership at the top of the Kellogg School's agenda. I applaud this initiative. Financial Times quoted him saying, "I tell students that in five to 10 years' time I would not want to hear from an employer: 'As a professional no one can touch you; as a person no one would touch you.'"5 In his own way, Dean Jain echoes Martin Luther King's sentiment when he said "Intelligence plus character . . . is the goal of a true education." Making character and leadership a priority of education is laudable in any environment - but is especially critical in the current one.

Over the last few months, institutions and professions have been rocked by the taint of misconduct and greed. It is in this context that I would like to spend a few minutes talking to you about one facet of our society implicated in the Enron aftermath - corporate governance.

Our system of corporate governance requires that corporate leaders be faithful to the interests of shareholders and act with both ability and integrity. The most important challenge to corporate governance today is to restore the preeminence of these values. This is as much a moral imperative as a legal one. A re-examination of business ethics is a good place to start.

In a 1995 article, two basic questions were asserted to lie at the heart of business ethics: "What is the right thing to do (in this situation)? and What sort of person must I become to be able to do the right thing?"6 The article noted that the emerging discipline of business ethics spends "a great deal of time and effort on the first question, but very little on the second. Yet the second poses a considerable challenge. . . ."7

I am heartened to learn that Northwestern is addressing this second question by creating an environment that stimulates students to develop a strong sense of professional responsibility in addition to a strong set of marketable skills. This will enable Northwestern graduates to put their very excellent educations to genuinely good use.

Beyond the classroom, we need to revisit whether our system of corporate governance is set up to assist corporate leaders in making rational determinations about what the right thing to do is, and then figuring out how to do it. Recent events underscore the need to craft responsible guidance for corporate directors and senior officers to follow. There are a number of ways current corporate governance standards can be improved to strengthen the resolve of honest managers and the directors who oversee management's actions and make them more responsive to the public's expectations and interests. We think the best way to do that is a two-fold approach: first, make certain that officers and directors have a clear understanding of what their roles are, and second, apply serious consequences to those who do not live up to their fiduciary obligations.

In considering these reforms, it is important for me - a federal government official - to make clear to you, and those who may read my words here tonight that, traditionally, corporate governance issues and standards have been, and should be, left to the states to develop and enforce. We do not propose to change the basic division of responsibilities between the states and the federal government. Nonetheless, because our capital markets are national and international, not solely intrastate, and because the consequences of a lack of meaningful and cohesive corporate governance reform are dramatic, we at the Commission are devoting considerable attention to the ways in which our system can be improved. Corporate governance impacts the quality of financial statements and the stability of exchange-listed companies, matters over which the SEC has longstanding interest, and a legitimate obligation to address.

Thus, we have asked the New York Stock Exchange and Nasdaq to work with the corporate and shareholder communities to review their corporate governance and listing standards, including important issues of officer and director qualifications and codes of conduct of public companies. In addition to posing specific topics for them to consider, our hope is that they will think expansively, in concert with the corporate and shareholder communities, and determine whether companies that list in their respective market places meet the highest ethical and practice standards. We also separately asked Financial Executives International to review its code of ethics in light of recent developments. The responses to date have been incredibly gratifying, with the best yet to come.

Which leads me to add a word about how standards of business ethics and integrity should be articulated, and by whom.

It won't surprise you to learn that I strongly favor a partnership between government regulators and private sector initiatives. One reason for that preference, and the reason we turned to the NYSE, Nasdaq and FEI, is that private sector initiatives can, if done properly, expand the scope of obligations imposed upon, and assumed by, corporate governors. Government - either in the form of statutes or regulations - is necessarily constrained. It can outlaw things like fraudulent practices, and require appropriate disclosures, but it cannot easily legislate integrity or ethics. Moreover, because government moves ponderously, as it should when affecting the rights and defining the obligations of its citizens, government pronouncements tend to be written in stone; once so inscribed, these edicts are modified or amended only cumbersomely. So, to go beyond the merely illegal, we need the private sector to impose additional layers of best practices, ethics and corporate integrity. We would like to facilitate a "race to the top."

Our primary concern is to ensure that management's interests are aligned with shareholders' interests. This is tougher than it sounds. For example, for years, conventional wisdom was that granting corporate managers stock options would align their interests with those of their shareholders. We now know that that is not necessarily so. Options can align those interests, but if managers can reap profits from their options while shareholders are losing some or all of their equity stake, the options create conflicting, not aligned, interests.

The key, in my view, is to ensure that, if a company chooses to grant options to corporate managers to create incentives to build value in the company, the options actually work as intended, rather than create an unearned windfall for those managers. There are, in my view, several components to this.

First, I believe that stock option plans (and other equity compensation plans) for officers and directors should be approved by shareholders. Making equity incentive compensation available to management is in the interest of shareholders, but because it is (or is supposed to be), companies should be required to make full disclosure and submit such plans to a shareholder vote as a fundamental first step.

Second, the decision to grant options to senior management, and the terms of those grants, should be entrusted to a committee of independent directors. The decision to grant options should, in most cases, be entrusted to a formal compensation committee, which would have the same authority over compensation matters that audit committees today have over financial matters and reporting. The core function, and key benefit, of the independent directors is to help prevent management practices that may deliberately, or inadvertently, misalign shareholder and management interests. Overall, the role of all independent directors is critical to good corporate governance, and should be strengthened.

Third, it seems to me that options are potentially troublesome if they are structured to reward, or are capable of rewarding, short-term performance. Corporate boards would do well to consider whether officers should be required to demonstrate sustained, long-term growth and success before they can actually exercise any of their options. This would help abolish perverse incentives to manage earnings, distort accounting or emphasize short-term stock performance. The award of options would seem to be most compatible with shareholder interests if they are tied in the main to the long-term performance of companies.

Fourth, as President Bush has suggested in re-establishing the true accountability of corporate leaders, CEOs should be prepared to certify to their shareholders that everything investors should know about the company has been disclosed, completely, fairly and in understandable format. And, as a corollary, they should be prepared to certify that anything that hasn't been disclosed to shareholders wouldn't be important to them in assessing the value of their shareholdings and developing their investment strategy. This means that companies should have a defined process for causing information to flow from various corporate outposts to a central disclosure locale to which the CEO has access.

Fifth, audit committees, which have been much improved in recent years, can be made even better. Audit committee members should question and test the disclosure and financial reporting processes. This means they need to understand the company's critical accounting principles and how they are applied, as well as urge continuous improvement to systems of internal control. It also means they must be free to hire their own independent counsel and accounting experts in instances where they reasonably think there is a need to enhance the quality of corporate disclosures. While shareholder approval of outside auditors is now a well-established part of corporate governance, I believe we should also explore whether the audit committee should be vested with the initial decision about which firm is recommended to the shareholders. I also believe that audit committees should have the authority to fire outside auditors (or prevent management from firing them). We have asked the NYSE and Nasdaq to consider whether audit committees should be vested with the sole authority for assessing the quality and independence of their companies' outside auditors, including the extent to which their audit firms can perform other functions.

Most of these ideas, and they are just that, go well beyond what the federal government should be asked, or expected, to do. And, they are by no means the only ideas worth pursuing. As I have said, in light of the recent events shaking investor confidence, everything is on the table for consideration. We should, of course, be careful not to overreact, not to regulate for regulation's sake and especially not to adopt regulations that run significant risks of doing more harm than good. And, there is no way that anyone can articulate a set of standards that should apply in all instances to all corporations. But, caution should not preclude sensible action. If ideas of this kind are subscribed to by the bright and creative minds of those enrolled in programs like the Joint JD/MBA program here at Northwestern, American companies will continue to be the envy of the world, and the confidence of the investing public will continue to rise.

We have witnessed how critical leadership, character and reputation are. All Americans have felt, and continue to feel, the consequences of the events of September 11th, the bankruptcy of Enron and, just last month, the indictment of Andersen. As Carl Sandburg made clear in his poem, Chicago, this City has long shown the country how to face other challenges and not merely survive, but prosper. Sandburg challenged us to "Come and show [him] another city with lifted head singing so proud to be alive and coarse and strong and cunning." "Bareheaded, Shoveling, Wrecking, Planning, Building, Breaking, Rebuilding . . . ." This is Chicago's history, and also our collective future. As we work together to improve corporate governance, financial disclosure and reporting, and accounting regulation - building, breaking, rebuilding - we must accept the timeless truth that, in matters of this nature, there are no perfect answers, there is no absolute truth.

Our system can be improved and modernized. True reform requires rigorous analysis, respect for competing views, compromise and statesmanship, by all concerned. We are up to the task, but only if we are able to tap our best minds to produce our most creative solutions, and only if we are able to discuss these issues openly, honestly, without inflammatory rhetoric. The SEC is committed to that end, and we seek participation by everyone with an interest in our capital markets. Together, we can make a difference.

Thank you.

1 Susan Harrigan, "Exercising All of His Options: Friends Explain Secret to William Brodsky's Success" Newsday, December 21, 1997, at F6.
2 Id.
3 Id.
4 Id.
5 Della Bradshaw, "Placing Leadership at the Top of the Agenda," Financial Times (Mar. 18. 2002) (emphasis supplied).
6 Robert G. Kennedy, Virtue and Corporate Culture: The Ethical Formation of Baby Wolverines, 17 St. John's University Review of Business 10 (Dec. 22, 1995).
7 Id.





Modified: 04/04/2002