Goldman Sachs Chairman Hank Paulson Calls For Action To Restore Investor Confidence
NEW YORK – Henry M. Paulson, Jr., Chairman and Chief Executive Officer of The Goldman Sachs Group, Inc. (NYSE: GS) called today for reform within the U.S. financial system to restore public confidence in business principles and practices, in a speech before the National Press Club, in Washington, D.C.
Copies are available from the Goldman Sachs Press Office or download a copy of the speech. [PDF, 933 KB]
"I come here as an individual who believes passionately in the strength of our free market system -- a system that generates growth, creates jobs, rewards initiative and fosters innovation like no other in history," Mr. Paulson said. "In my lifetime, American business has never been under such scrutiny. To be blunt, much of it is deserved. But let's be clear, the overwhelming majority of American executives are men and women of integrity who are committed to the long-term success of their companies, and to creating value for their shareholders. And so, I see this as an opportunity to reassess our practices, renew our principles and rebuild the trust that is so fundamental to our markets and their vitality."
Mr. Paulson discussed an agenda of change in three principle areas: accounting policy, standards of corporate governance and conflict of interest.
"Long bull markets always seem to result in laxity and complacency," Mr. Paulson said, adding that investor preference for predictable earnings streams can put pressure on some CEOs and accountants to "defy gravity in an attempt to produce earnings increases quarter after quarter after quarter" - when most businesses models make this impossible. The problem is further compounded by the fact that the overly complex, rules-based approach underpinning U.S. GAAP is ripe for manipulation. To strengthen the system and restore investor confidence, Mr. Paulson suggested the following areas of reform.
Corporate Accountability: Accounting is the responsibility of corporate management and the Chief Executive Officer (CEO), at a minimum, should be required to certify that his or her company has established reasonable procedures for assessing the accuracy and completeness of its financial results and disclosures.
Auditor Independence: Board Audit Committees must develop policies and processes to ensure that there is no doubt that the company's auditors report to them and work for them. A major step in that direction would be for Audit Committees to perform a rigorous annual review that would include negotiation of audit fees and a real consideration of the factors that would cause a decision to replace the auditor.
Oversight: The Securities and Exchange Commission (SEC) must be responsible for setting and enforcing auditing standards, either by establishing an independent public regulatory organization, as the Commission has already suggested, or by taking more direct responsibility itself. In any event, current peer review process, which allows auditing firms to police themselves, should be replaced with an effective "audit of the auditors."
Reform of the U.S. Rules-Based Accounting System: This is where the most change is needed, Mr. Paulson said, with the focus on fundamental principles to ensure that all the risks and rewards of an entity are properly recorded and disclosed to shareholders. Today, U.S. GAAP accounts for the vast majority of the worlds' economic activity, and is generally viewed as the best accounting system in the world. The "European system," which is less rule oriented and more judgment based, is clearly different and successful in its own right. The goal should be convergence of accounting systems, incorporating the best from both models. To do this, we need a new approach to standard setting.
A Long Hard Look: Mr. Paulson encouraged the SEC to take a long, hard look at how accounting standards are set in the U.S., including governance of the Financial Standards Rule-making Board (FASB), selection of FASB members, the FASB standards-setting process with all of its time delays, and the overall resources at the FASB's disposal.
Fair Value Accounting: Mr. Paulson urged the FASB to review "historic cost" accounting which, he said, is hopelessly antiquated for companies primarily engaged in financial services or, for companies heavily involved with financial instruments, such as Enron. Instead of requiring such companies to record the current, fair market value of all financial assets and liabilities, the historic cost model allows them to record certain financial assets and liabilities at their historic cost. And while the value of financial instruments can vary greatly with the fluctuations of the market, institutions that use historic cost methodology -- primarily banks -- are not required to account for those movements in their financial statements. The result is that investors, regulators and the media have no way of quantifying the real economic impact of these liabilities.
"The U.S. system of corporate governance - though not perfect - is the best in the world," Mr. Paulson said. "And no form of corporate governance - no matter how well designed - will guarantee there won't be future failures. In the final analysis, the most important thing will be the quality of the people involved - their competency, their experience and their integrity."
Mr. Paulson added that much good work is being done in the area of Corporate Governance, and stressed that the key was to move quickly to implementation. He outlined a ten-point plan that reflects best practices:
First, public companies should describe to shareholders, either in the Annual Report or the Proxy Statement, how its system of corporate governance works to ensure their interests.
Second, all listed companies should have a majority of independent directors, both in substance and appearance.
Third, the Board of Directors should be required to determine that no "independent" director has any relationship that the Board believes may impair or appear to impair, the exercise of that director's independent judgment. Additionally, the nature of that director's relationships should be fully disclosed to shareholders.
Fourth, non-management, independent directors should be required to meet periodically without the "insiders", including the CEO, being present.
Fifth, both Audit Committees and Compensation Committees should consist entirely of independent directors.
Sixth, executive officer compensation should be aligned closely with shareholder interests by making equity a very material portion of such compensation, and compensation committees should be encouraged to develop guidelines that require that equity be held for significant periods of time.
Seventh, all compensation plans granting stock, options or other company securities to directors or executive officers should be approved by both the Compensation Committee and by shareholders.
Eighth, all "compensation" or other financial relationships with the company and its executive officers or directors should be fully, fairly and promptly disclosed.
Ninth, all transactions in company securities by executive officers or directors should be disclosed within 48-hours.
Tenth, while "insider" selling in advance of bad news is already illegal, in the case of CEOs, we should mandate a one-year "claw back" in the case of bankruptcy, regardless of the reason.
Conflict of Interest
The final area that Mr. Paulson discussed was conflicts of interest.
"Conflicts are a fact of life in many, if not most, institutions, ranging from the political arena and government to media and industry," he said. "The key is how we manage them: the disclosures we make, the systems or firewalls we put in place and the judgments used to balance competing interests.'
"For an integrated investment bank such as Goldman Sachs, conflict management has always been a core competency because it is critical to our reputation and a key to our success. But, particularly in the context of the technology and telecom bubble of the late 1990s, we have not done as good a job as we might have in preserving and protecting the appearance of independence of our research analysts who play a vital role in the investing and capital allocation process."
To address this challenge, Mr. Paulson said, the firm recently announced a number of important steps, beginning with the positive reaffirmation of the principles of integrity, independent thought, analytic rigor and transparency - which were codified into a statement of Investment Research Principles.
In addition, the firm appointed an Ombudsman who is available to promptly address any conflicts that may arise, and instituted new oversight responsibilities for the Audit and Compensation Committees of its Board of Directors.
Goldman Sachs will continue its efforts to better its fundamental analysis and avoid being caught up in market exuberance. Mr. Paulson said: "The most important thing for any investment research department, regardless of whether that department is part of an integrated investment bank or a specialized boutique, is that analysts reflect the opinions they believe." He called the sweeping changes recently approved by the SEC, and the Merrill Lynch settlement with the New York State Attorney General's Office, as critical to reinforcing investor confidence in the integrity of our markets.
Mr. Paulson closed by saying that: "Integrity is the cornerstone, if not the bedrock, upon which all financial markets are based. I am confident we can move beyond finger pointing to attain real progress on meaningful reform. Having seen how we, as an industry and a nation, responded to the terrible attacks of September 11th, how could I not be an optimist? I am certain that, working together, we can restore investor confidence and emerge from this period of uncertainty with our financial system and economy stronger than ever."
Goldman Sachs is a leading global investment banking, securities and investment management firm that provides a wide range of services worldwide to a substantial and diversified client base that includes corporations, financial institutions, governments and high net worth individuals. Founded in 1869, it is one of the oldest and largest investment banking firms. The firm is headquartered in New York and maintains offices in London, Frankfurt, Tokyo, Hong Kong and other major financial centers around the world.