Remarks
"Corporate Governance as an Investment Strategy & Analyst's Tool"
New York Society of Security Analysts
The Harvard Club
27 West 44th Street
Friday, November 21, 2003
8:45 AM

Good morning.

It's a pleasure to be part of today's event, with so many distinguished speakers on the agenda. I know we all are anxious to hear their views on "Corporate Governance as an Investment Strategy & Analyst's Tool." I would like to commend the New York Society of Security Analysts for hosting this important - and timely -- conference.

It is perhaps an understatement to describe our current environment as one of uncertainty. To move forward, however, it is instructive to first take a look back.

During the 1990s, we witnessed what was essentially the democratization of the stock market. Thanks in large part to the remarkable growth of 401(k) retirement accounts and technology, buying and selling stocks, once the province of only the wealthy and institutions, became a possibility for individual investors in a wholly unprecedented way.

And those retail investors jumped right in. The last decade saw incredible growth in the breadth of this country's equity holders. In 1989, just 32 percent of U.S. households owned stock. Today, that number is 52 percent.

The boom in fact fattened the nest eggs of ordinary Americans in a way that was simply not possible for prior generations of the middle and working class. Middle class families could accumulate wealth and secure their retirement in ways that ten or fifteen years earlier were simply unthinkable.

Yet this transformation of our country into a nation of investors was not only good for individuals, but for institutions as well.

In fact, throughout the latter part of the decade, the persistent optimism of individual investors buoyed the market even during potential crises, like the Asian contagion in 1998 and the collapse of the hedge fund Long-Term Capital Market that same year. The portfolios of public pension funds, like the New York City retirement systems, which I serve as chief investment advisor, continued to grow in large part because individuals believed so strongly in the potential of the market. That resulted in greater benefits for public employees, and lower pension costs for local governments.

What was the bedrock of this faith in the market? Trust.

Every element of our capital markets is utterly dependent on trust. We trust that a broker will execute a trade according to our instructions. We trust that an investment analyst who tells us that a particular stock is a buy or a sell is doing so out of conviction and nothing else. We trust a company is telling the truth when it announces its quarterly earnings. We trust the accounting firms that audit and vouch for the validity of those earnings. And we trust that our stock exchanges and mutual funds are serving all investors equally.

Investors believed that the three pillars of our capital markets - public companies, accounting firms, and the investment banking firms who sell securities to the public - were behaving in accordance with both the letter and the spirit of the law. Without that essential assumption, the markets simply could not function.

Of course, everyone in this room is keenly aware of how this story ends. The tech bubble burst in March of 2001, and Enron's collapse amid charges of accounting irregularities and deceit a few months later triggered a series of alarming disclosures about numerous other public companies.

These disclosures, in turn, revealed that accounting firms, in tailoring their audits to the whims of their corporate clients, were in some cases willing parties to this fraud. And some financial services firms have clearly put the interests of their corporate investment banking clients ahead of the needs of the investors that their brokers and analysts purport to serve. In other words, investors' trust in the integrity of the markets was obliterated. Predictably, the stock market tanked.

Now after two years of nearly endless scandal, we are confronted with new revelations regarding two more pillars of system - the New York Stock Exchange and the mutual fund industry, whose explosive growth in the last decade has played a huge role in the growth of this country's investor class.

Individual investors cannot be blamed if they are beginning to feel as though they are being played for fools by those who control what increasingly looks a rigged game.

It's no surprise that the public has expressed its disgust with these scandals. Thousands of small investors have been forced to watch helplessly as their investment accounts vanished, their dreams of retirement, college and home ownership deferred for who knows how long. All because a system meant to serve and protect investors has utterly failed to do so.

The impact of this crisis of confidence on those of us responsible for the nation's public pension funds has been profound. The assets of the New York City retirement systems have fallen from around 100 billion dollars three years ago to around 77 billion dollars today.

The damage to the investment portfolio has driven up the amount of taxpayer money needed to shore up those retirement systems. In the current fiscal year, the City is projecting a payment of 2.55 billion dollars toward the retirement systems, an increase of 46 percent (804 million dollars) over last year. That means in the current fiscal year, which began July 1st, pension contributions will eat up roughly six percent of New York City's total overall spending.

Similar scenarios have been playing out in states and cities across the country.

As a result, it is absolutely imperative that institutional investors take the steps necessary to bring small investors back into the stock market. That is why my office has been in the vanguard in seeking reforms in Corporate America and on Wall Street. As one of the largest institutional investors in the country, we wield considerable influence on both.

The good news is that those of us who have long fought for changes in how public companies govern themselves have already celebrated a few critical victories. The passage of the Sarbanes-Oxley Act by Congress last year, and the SEC's approval earlier this month of Final Corporate Governance Rules for companies listed on the New York Stock Exchange are two of the most notable examples.

Both of these measures contain crucial elements of corporate governance reform within public companies that I, as well as my predecessors, have long demanded. They mark two important steps forward for shareholders, and they have helped restore some degree of trust in the markets and in the governance of Corporate America.

Our fight must not end there, however. This year, my office launched the largest and most comprehensive shareholder proposal campaign in the retirement fund's long history of shareholder activism.

We targeted 88 different companies with shareholder resolutions and other initiatives on a wide range of crucial issues, including executive compensation, director elections, and the impact of corporate behavior on the environment and human rights.

We introduced two new proposals that were specifically designed to restore investor confidence. One called on the board of directors at selected Nasdaq-listed companies to establish a mechanism for direct communication between board members, particularly the independent directors, and shareholders. That proposal was adopted by Safeco Corp., Axciom, and Autodesk.

I am pleased that the SEC, in stating its reasons for its August 8, 2003 issuance of a Proposed Rule: Disclosure Regarding Nominating Committee Functions and Communications Between Security Holders and Board of Directors, cited the New York City pension funds' proposal. We expect the SEC to adopt a final rule that would require companies to disclose their mechanisms for direct communications between directors and shareholders. I have written to the SEC urging that the rule include a requirement that companies establish a means of direct communications between shareholders and directors.

The second proposal came as part of a national campaign we are waging demanding that companies establish a process to respond to shareholder proposals that win a majority of votes cast. In most cases, companies simply ignore this overwhelming expression of the will of their shareholders. This year Goodyear Tire & Rubber agreed to establish a mechanism to act on shareholder majority votes, and the board of directors of Pacificare and Hasbro agreed to act on the funds' shareholder proposals that won majority votes in the 2002 proxy season.

I am pleased that the issue of a company's not implementing a shareholder proposal that won majority vote is being considered by the SEC, in its Proposed Rule: Security Holder Director Nominations, as an additional triggering event that would give shareholders the right to place director nominees in the proxy materials of a company.

At the risk of preaching to the choir, let me take this opportunity to ask each participant to send a comment letter to the SEC urging adoption of a final proxy access rule that gives meaningful proxy access to long-term shareholders to nominate candidates in board elections.

Shareholder activism is not just a matter of principle. There is ample evidence to suggest that companies that give their shareholders a stronger voice in their operations tend to out perform those that do not. A 2001 survey by three economists at the National Bureau of Economic Research found that firms with stronger shareholder rights had faster sales growth, higher profits and better stock returns than those companies with weaker shareholder protections.

But reform has to go deeper. Reform must also reach Wall Street itself.

My office is now demanding that the financial services firms with which we do business be vigilant in ensuring that they have in place proper and effective protections against potential conflicts of interest. Last year, we adopted a set of Investor Protection Principles and asked that the investment banks, money management and brokerage firms with which we do business sever any links between compensation for analysts and corporate finance business, among other things. We have also asked our money managers to take into account the corporate governance of the companies in which they invest our assets. We will continue to closely monitor how the firms in our employ comply with these principles.

And because of the work of my colleague, Eliot Spitzer, we now know that mutual funds, to which millions of investors now entrust their life savings, have engaged in illegal and improper trading practices that allowed some traders to make profits at the expense of other fund investors. Investigations have uncovered illegal late trading abuses, and improper trading practices such as market timing, which can be costly to long-term investors. Indeed, a recent Securities and Exchange Commission survey found 25 percent of brokers allowed customers to engage in illegal late-trading, while 30 percent assisted customers in making market-timing trades.

These revelations of widespread fraud in the mutual fund industry, which serves some 54 million individual investors with 7 trillion dollars in pooled assets, is a major setback to all of our recent efforts to restore investor confidence in the U.S. financial markets.

As a result, the New York City Retirement Systems terminated its relationship with one of the firms under scrutiny, Putnam Investments. Putnam managed 725 million dollars for three of the City's retirement systems. We're not alone; investors have withdrawn more than 14 billion dollars from Putnam since regulators accused the company of wrongdoing.

We are also taking a hard look at our relationships with other firms under investigation for these alleged practices.

But simply firing these firms is not enough. We must find ways to ensure that this behavior ends. That is why the New York City Retirement funds have adopted a shareholder proposal that requires mutual fund companies in which we invest to establish a Mutual Funds Review Committee, composed of independent directors, to examine sales and trading practices, as well as supervisory and compliance systems. The primary aim of this proposal is to prevent improper and illegal trading practices that have shattered investor confidence in mutual funds. The proposal also asks companies to issue a report summarizing their findings and recommendations for improving their systems.

It is absolutely essential that we find ways to repair a system that is so plainly broken. For years, individual investors have been told that the best way to invest in the stock market is to buy shares in mutual funds. Millions have heeded this advice. We cannot expect them to continue to do so if they have good reason to believe the system is not serving their best interests.

Corporate governance failures, of course, have also reached deep into the heart of the U.S. financial system and a New York City institution - the New York Stock Exchange.

Since its founding more than 200 years ago, the Exchange has played a critical role in making the U.S. capital markets the envy of the world. The Big Board remains the most efficient method by which to buy and sell stocks.

For all its storied history, however, it is clearly an institution in serious need of reform. The process by which the NYSE board of directors authorized its former chairman and chief executive's outrageous pay package revealed serious flaws in the exchange's corporate governance procedures.

This week, the Exchange's membership voted to accept the reform proposals made by interim chairman John Reed.

While some of the adopted reforms are encouraging, I do have some concerns. In reforming the NYSE, two key issues must be resolved: The Board of Directors must be made much more independent, and the NYSE's regulatory function must be made separate from the NYSE's operations.

On these two fronts, the adopted reforms fall short. In particular, the proposal contemplates that the newly constituted board of directors include just one representative from the institutional investor community - and not a single representative from a public pension fund. This is clearly inadequate.

The Special Committee on Governance of the NYSE, headed by my good friend Carl McCall, proposed that the NYSE board of directors include four institutional investor representatives. This would be far more helpful in establishing the independence of the board.

And the reform proposal does not separate the NYSE's regulatory function from its business functions. This is a mistake. To restore public confidence, and in keeping with the dramatic changes to securities markets in the past decade, the status of the NYSE as both an Exchange and a Regulator must end. I call on the new Board of Directors to move quickly to address these concerns.

Confidence in the institution must be restored for its own sake, and for the sake of the millions of investors who trade stocks on the world's pre-eminent exchange.

In recent months, we have seen some improvement in the performance of the markets. This, of course, is encouraging, and we must do all we can to maintain our momentum.

We must remember, however, that over the long-term, the stock market's recovery, and the health of the financial services industry, rely upon the trust and confidence of investors. And as the last few years have made clear, that trust is fragile, and easily lost.

Given the events of the last two years, it is safe to say that investors are scrutinizing corporate governance in ways they never have before. It is now a critical element in evaluating the long-term health of a company. And any investor who adopts an investment strategy that fails to take governance into account does so at his own risk.

That is why restoring confidence in the markets is so crucial. Investors must be certain that when they put their savings in the hands of professionals, they can rely on their integrity and honesty. And they must be certain that the companies whose stock they are buying are operating in a wholly transparent and aboveboard manner.

Sadly, in this day and age, investors can no longer assume that the companies they own or the mutual funds they buy meet those criteria. Every pillar of our financial system must work hard to regain that trust.

I would again like to thank the New York Society of Security Analysts for convening this conference. This organization has long recognized the importance of sound governance practices for both the financial community and the overall health of the United States economy - before it became fashionable. In keeping with tradition, today's conference will no doubt produce an engaging, substantive and topical dialogue regarding some of the most critical issues before the financial services sector.

Thank you.