—Benjamin Graham and David Dodd, Securities Valuation, 1934

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On April 14, 2003, the Securities and Exchange Commission announced it would consider changes to proxy regulations “to improve corporate democracy.” The SEC would examine “procedures for the election of corporate directors,” and issue a report after consulting with “pension funds, shareholder advocacy groups, business and legal communities.” The resulting dialogue focused on “proxy access”— the idea that shareowners should be allowed to place their own board nominations on the proxies distributed by management, much as they are already allowed to place their own proposals on those proxies.

New rules were expected to be in place by the 2004 proxy season. After eight years, three attempts and a major setback in court, it appears proxy access is finally on the way. Last year the SEC adopted:

• Rule 14a-11, which would require a minimum level of proxy access under specified circumstances.
• Amendments to Rule 14a-8(i)8, which would allow shareowners to submit access proposals company- by-company.

The U.S. Court of Appeals for the D.C. Circuit found Rule 14a-11 “arbitrary and capricious.” The decision could provide a blueprint for challenging many other Dodd-Frank Act rulemakings, since the three-judge panel took a very strict approach to the agency’s analysis of costs and benefits.

Changes to Rule 14a-8 were not challenged but were stayed by the SEC since related disclosure amendments were “entangled with” Rule 14a-11. The petition filed with the Court addressed Rule 14a-11 “and associated amendments to the Commission’s rules.” After the court decision, the Federal Securities Regulation Committee of the American Bar Association urged the SEC to retain the stay, set to expire when the court decision was finalized, and “either repropose the amendments to Rule 14a-8 or reopen the comment period.” Instead, the SEC let the stay expire; private ordering begins.

Before speculating on the future, let us briefly examine recent history.

Critical Years
In 1977, the SEC held a number of hearings to address corporate scandals. At that time, the Business Roundtable recommended amendments to Rule 14a-8 that would allow access proposals, noting that such amendments “…would do no more than allow the establishment of machinery to enable shareholders to exercise rights acknowledged to exist under state law.”

Soon, we saw several proposals. In 1980, Unicare Services included a proposal to allow any three shareowners to nominate and place candidates on the proxy. Shareowners at Mobil proposed a “reasonable number,” while those at Union Oil proposed a threshold of “500 or more shareholders” to place nominees on corporate proxies.

One company argued that placing a minimum threshold on access would discriminate “in favor of large stockholders and to the detriment of small stockholders,” violating equal treatment principles. The California Public Employees’ Retirement System (CalPERS) participated in the movement, submitting a proposal in 1988 but withdrawing it when Texaco agreed to include their nominee.

These early attempts to win proxy access through shareowner resolutions met with the same fate as most resolutions in those days. As of 1986, only two proposals of the thousands submitted had been approved— but the tides of change were turning. A 1987 proposal by Lewis Gilbert to allow shareowners to ratify the choice of auditors won a majority vote at Chock Full O’Nuts Corp., and in 1988 Richard Foley’s proposal to redeem a poison pill won a majority vote at the Santa Fe Southern Pacific Corp.

In 1990, without public discussion or a rule change, the SEC began issuing a series of no-action letters on access proposals. The SEC’s about-face may have been prompted by fear that “private ordering,” through shareowner proposals, was about to begin in earnest.

Tensions over this giant leap backward rose until AFSCME v. AIG (2006). That case involved a 2004 bylaw proposal submitted by the American Federation of State, County and Municipal Employees (AFSCME) to the American International Group (AIG) requiring that specified nominees be included in the proxy. AIG excluded the proposal after receiving a no-action letter from the SEC and AFSCME filed suit.

The court ruled the prohibition on shareowner elections contained in Rule 14a-8 applied only to proposals “used to oppose solicitations dealing with an identified board seat in an upcoming election” (also known as contested elections). The SEC subsequently adopted a rule banning proposals aimed at prospective elections, but in 2010 adopted both a widely discussed federal mandate in Rule 14a-11 and less discussed amendments to Rule 14a-8(i)(8) to allow access through private ordering.

What does the future hold? My own personal past may offer perspective on the push for more democratic corporate elections.

Turning Point on the Road to Democracy
On a 1987 trip to China, I met my wife’s uncle who was touring universities advising a gradual approach toward democracy. He cautioned students about that “funny period” when Red Guards broke his arms, thinking engineers weren’t needed to design or build dams. Tiananmen Square protests followed in 1989; knowledge, freedom and democracy were again repressed.

In May 2002, I addressed an Asian Development Bank conference in Shanghai. Corporate governance in a post-Enron America, I argued, required greater democracy both at the top, in the accountability of boards and CEOs, and at the bottom, in the form of increased ownership and participation by employees. America, too, had its democratic challenges. I told participants, one of our most sorely needed reforms was proxy access. As a sociologist, I had learned how labeling and socialization “harden” the objectivity of socially constructed worlds. We begin to see our institutions and laws as fixed, even though they are of our own making. Now, after expressing the need for reform to an audience halfway around the world, I knew I should be making more of an effort to bring about proxy access at home.

On August 2001, I petitioned the SEC with Les Greenberg, who was largely responsible for the first Internet proxy campaign (at Lubys Inc.). We argued that “entrenched managers and directors will only improve corporate governance when they can be held accountable, e.g., voted out of office and replaced with directors chosen by shareholders.” Our proposal was summed up in one sentence: “The intended effect of the suggested modifications is that the solicitation of proxies for all nominees for director positions, who meet the other legal requirements, be required to be included in the company’s proxy materials.”

According to the Council for Institutional Investors, our petition “re-energized” the “debate over shareholder access to management proxy cards to nominate directors.” Indeed, shortly thereafter, the SEC proposed a rule that began the current journey toward proxy access.

Getting Proxy Access Right
When Chairman Mary L. Schapiro announced that the SEC would not appeal the Court’s decision to vacate Rule 14a-11, she reaffirmed her commitment to “finding a way to make it easier for shareholders to nominate candidates to corporate boards.” While that leaves open the possibility of a broad federal mandate, “private ordering” on a company-by-company basis under Rule 14a-8 will prevail for the foreseeable future.

Proxy access will now join the litany of proposals for majority voting, declassified boards, separation of CEO and chair, the right to call special meetings and other governance matters. Access is seen by many as a fundamental right and a form of insurance that can save both shareowners and companies money.

In most cases troubled companies have already lost substantial value by the time they face a contested board election. Costs for contests involving changes in control are generally estimated to range from 2 percent to 4 percent of firm value. Defensive measures often destroy more value. Takeovers and transitions back to profitability are expensive. There may also be heavy transaction costs to employees as well as communities.

In contrast, the cost of proxy-driven board transitions has run considerably below 1 percent, according to Patrick McGurn, executive director of Institutional Shareholder Services. Competition for board positions has traditionally stimulated share value. Firms with stronger shareowner rights have higher firm value, higher profits, and higher sales growth, lower capital expenditures and fewer corporate acquisitions. Investors who bought firms with the strongest rights and sold those with the weakest rights would have earned abnormal returns of 8.5 percent per year, according to a widely cited study by Paul Gompers and Andrew Metrick.

Jill E. Fisch, a professor at the University of Pennsylvania Law School, recently wrote a paper, The Destructive Ambiguity of Federal Proxy Access. After examining the 70-year history of efforts to obtain proxy access and offering a searing critique of SEC efforts, Fisch reaches a similar conclusion to our 2002 petition: “The SEC should amend Regulation 14A to require the issuer to disclose, in its proxy statement, all properly-nominated director candidates…provide comparable disclosure in the proxy statement for all director candidates…[and] require the issuer’s proxy card to give shareholders the opportunity to vote for any of the candidates included in the proxy statement.”

One of the major flaws in the SEC’s now-vacated Rule 14a-11, according to the D.C. Court of Appeals panel, was its failure to fully analyze the cost of proxy access to companies. The Court cited comments from the Chamber of Commerce predicting that boards would incur substantial expenditures through “significant media and public relations efforts, advertising…mass mailings and other communication efforts, as well as the hiring of outside advisors and the expenditure of significant time and effort by the company’s employees.”

Yes, some companies will spend a fortune to keep their boards fully intact. We saw that in 1991 when Sears budgeted $5.5 million over and above its normal proxy solicitation expenses to keep one board seat from Robert A. G. Monks.

We have learned many lessons in the last 20 years. One is that half measures are unlikely to appease. For example, by proposing their own proxy access standard, subject to shareowner vote, companies may exclude conflicting shareowner proposals from their proxy under Rule 14a-8(i)(9). However, if no dialogue has taken place, know that war may come. Shareowners expect authenticity, fairness, transparency and good faith. Distrust can lead to disaster.

In November, I worked with members of the United States Proxy Exchange (USPX) to develop a Model Proxy Access Proposal, which has already been submitted to several corporations.

Standard rules of procedure, including Robert’s Rules, allow any member of an assembly to nominate. This reflects the philosophy that, although the majority decides, all should be encouraged to participate and to be heard. The challenge should lie in the election, not the nomination. Our model proposal is designed to ensure that long-term shareowners could participate through one of two tracks. One track—mostly suited for larger institutional shareowners— allows any group of shareowners that has continuously held 1 percent of the company’s stock for two years to nominate. The other—more suited to individual shareowners or smaller institutional shareowners—allows any group, 100 of whose members satisfy the Rule 14a-8 eligibility requirements for shareowner proposal submission, to nominate.

Our reasoning is that shareowners with a demonstrated commitment to holding a substantial stake in a company will be motivated to nominate quality candidates for its board, as will shareowners who must invest considerable effort to nominate.

Changes in control should generally be pursued through independent proxy solicitations, not through proxy access. The Model proposal ensures this through a variety of impediments that make it an unattractive alternative to an independent proxy solicitation for such purposes. For example, each nominating group is limited to one nomination (or a number of nominations equal to 12 percent of board seats, if the board has more than 16 members). Multiple parties are prohibited from coordinating efforts. Unlike either typical control or short-slate contests, proxy access would allow split votes, further reducing the likelihood of capture by any “special interest,” including entrenched incumbent boards.

In short, we have developed a Model Proxy Access Proposal that can be presented to poorly governed corporations. We encourage experimentation with company-specific approaches to determine what works best.

Reflections on Freedom and Democracy
Knowledge has surpassed machines and capital as the driving force behind the world economy. It has long been recognized that workers add more value if they are able to participate in meaningful decision making. The same is true for shareowners.

Social networking platforms will soon move shareowner forums well ahead of those envisioned by former SEC Chairman Christopher Cox to virtual deliberative bodies with consensus-building mechanisms and the ability to transfer and compile unsolicited voting rights. Shareowners, customers and employees will conspire for change through tools on their desk, in their purses and pockets.

The movement to more democratic forms of corporate governance is important not only for creating wealth; it cuts directly to our ability to maintain a free society. Corporations that embrace participatory democratic systems should be better equipped to create wealth, compete in global markets, and solve the highly complex problems of the third millennium by unleashing the wealth-generating capacity of “human capital,” which is based in the skills and knowledge not only of corporate managers but of boards, employees and shareowners alike.

James McRitchie is publisher of CorpGov.net, an online resource for news, commentary and transformation that he started in 1995 to help diversified long-term investors exercise their rights and responsibilities as owners.

Illustration by J. T. Morrow

Robin A. Ferracone: You’ve proven from your experience and track record that you don’t shy away from the hot seat. So given that we just finished our first proxy season with the partial implementation of Dodd-Frank, now is a particularly good time to reflect on executive compensation. What have you seen that has changed?

Arthur C. Martinez: The spotlight clearly has moved to the compensation committee, and that’s not unwarranted. There have been numerous—I would say serial—excesses in CEO and executive compensation, which have served to inflame regulators, the media and the general public. And while the regulation may feel and seem heavyhanded, there’s no question that the only thing that is rewarded in any meaningful way is performance. The early going on Dodd-Frank has been pretty benign, and demonstrates that most companies do act in a responsible way and most compensation committees do provide appropriate oversight. There are a number of implementing regulations still to come on areas like proxy access, which could be more problematic.

Ferracone: One of the things that didn’t happen this year was investors voting against compensation chairs. They did use their say-on-pay “no” votes to voice their opinion about whether they liked the compensation program, but they seemed to be reserving their director election “no” votes for next year, if needed. How are compensation committee chairs responding to the demands created by say on pay?

Martinez: There’s no question that the time demands have gone up pretty geometrically in terms of monitoring pay practices inside the company, taking a more active role with the management team, designing the programs that are relevant and appropriate for the company, and serving as the lead, if you will, for the rest of the committee and being able to distill complex matters into relatively straightforward proposals. I think you’re quite right that investors have given comp committee members and chairs a little breathing room here.

Ferracone: How does that differ from past practice?

Martinez: In the past, frankly, their only remedy was to vote against comp committee members when director elections were held. That’s still in the wings if problematic pay practices exist or companies that did not receive a large majority vote on say on pay don’t do something to reform their pay programs— that is the ultimate tool for investors. While everybody used to talk about financial liability for directors, I think the bigger liability is public humiliation.

Ferracone: I think that’s right. Now that we’ve talked about what’s changing, I think an equally important question is, what’s not changing?

Martinez: Mainly, the drift away from plain vanilla stock options. And that’s been in the making for two or three years, with more performance-based stock awards and performance cash awards coming into long-term compensation plans. Investors and proxy advisory services often feel that those at-themoney stock options are not as performance-driven. I think it’s an argument worth considering: an equivalent reward with straightforward and very measurable performance statistics to work against is preferable. Secondarily, I would say that there’s been a reasonable cap on the growth of the base salaries for CEOs in the current business environment.

Ferracone: Yes. Those things aren’t changing because they were trends that were happening before Dodd-Frank as well. Investors have told us that they’re very focused on pay and performance alignment, and that alignment factored heavily into their say-on-pay voting decisions. In addition, we’re waiting for new disclosure requirements around pay and performance from the SEC. So how do you think the pay and performance considerations are factored into the decision making for your compensation committees?

Martinez: There is a clearer link than there’s ever been. In the past, too much option-based compensation could be influenced by a rising tide and not the performance of the enterprise. Performance metrics need to be made clear whether it’s EBITDA growth, earnings-per-share growth, ROIC or cash flow—the metrics that seem right for the company in its market and its competitive situation. The awards can no longer be purely timevested, but must be delivered on the achievement of specific goals with a reasonable threshold and a very reasonable maximum. The rewards are no longer uncapped. It’s up to each comp committee to figure out exactly what are the right metrics, but it’s a relatively short list.

Ferracone: Comp committees also have to get clear philosophically on how they’re going to respond to unintended consequences. Are they going to play by the numbers? Are they going to use some discretion? How do you handle it when management does all the right things but the financial and stock price performance doesn’t reflect their performance?

In addition, I noticed that an interesting performance concept in PepsiCo’s CD&A is “performance with purpose.” Can you comment on this as a way to gauge executive performance and pay?

Martinez: “Performance with purpose” was the opening rallying cry for Indra Nooyi when she took over as the CEO, now almost five years ago. PepsiCo has always had very strong performance metrics and a long record of successful delivery of financial results. And Indra’s feeling was we certainly couldn’t—and shouldn’t—consider abandoning our focus on performance, but in a larger context there is more to running a business than financial results. Her belief is that talent sustainability is the bedrock of any enterprise—the quality of the people and how they are managed, treated, incentivized and developed. Then you also have to consider environmental sustainability, as we all live on this big ball they call Earth and we have a role in ensuring that it remains a healthy place for our families and future generations. Human sustainability—our communities require food, water, all of the things required to sustain life, if you take a true holistic view of a corporation’s role in the ecosystem of the world.

That rallying cry touched a nerve inside the company. It motivated and excited a younger generation of executives. What we have done at the comp committee is to integrate the purpose metrics into our evaluation and compensation decisions about our senior executives—as in the past with diversity, if it wasn’t built into your business objectives and into your rewards system it didn’t get a lot of attention. This has now become a set of strong internal beliefs that drive the organization. And we have taken all of that into account as we’ve made comp decisions.

Ferracone: Investors have communicated with us through our research that they feel the value of these types of measures should play a role in compensation programs. They help express the personality and the strategy of the organization while not necessarily giving up on the financial results.

Martinez: Make no mistake about it, PepsiCo has not lost its focus on financial performance as a key driver of shareholder wealth creation. It continues to have an admirable record in that regard.

Ferracone: Yes. And so that’s exactly why strategic measures don’t substitute for financial measures, but they can play an enhancement role. Let’s switch gears. One of the things that Dodd-Frank was intended to do was give the compensation committee the power to hire its own resources and to empower the compensation committee a little bit more in general. I was just wondering, in your view, whether the comp committee does have more power in the process.

Martinez: The comp committee has more powers, and the dynamics have reset the balance in some ways between management and the compensation committee. One of the key elements is the use of independent consultants. The mandate is that the consultants do no work for the company and that they are solely accountable to and hired by the compensation committee. Looking back over five or 10 years, it was more of a management-led process than a committee-led process. I think we’re in a much healthier balance right now.

Ferracone: Now we call that being collaborative, yet independent. We like to work in concert with our comp committees and management, but at the end of the day we still feel it’s our job to make sure that we’re providing an independent opinion. Comp consultants today need to come to the table with a number of skills that they may not have had in the past, because they need to understand not just the compensation subject matter in-depth but also their clients—that is, the company’s strategy, its culture and its people. There’s a sensitivity there that wasn’t required in the past. As a result, I feel that not only has the role of the comp committee changed, but the role of the compensation consultant has changed as well.

Martinez: I would add the word “trust” there, in the sense that the management team has to trust the objectivity and the good intentions of the comp consultant, and not treat them as an adversary.

Ferracone: I think trust on all sides is important, and consultants have to earn that trust by behaving in a transparent way. We hear stories that certain people will say one thing to management but something different to the committee, and that is exactly the way to destroy trust.

Martinez: It’s also a very good way for the comp consultant to get fired.

Ferracone: Agreed. What are the things you would advise a new compensation committee chair to do?

Martinez: Have a clear appreciation of the workload and commit to it. Then develop a clear understanding of the compensation culture at the company. Unless you’re a very new company, every company has built up a series of practices and expectations about what gets rewarded and measured, and there are nuances and quirks in the compensation culture of the company.

I would recommend to a new chair that he or she sit down with all of the executive officers and ask, “What do you think about our programs? What would you do if you were in my position to change those programs? What do people in the company think about these programs? What are the things that drive them crazy?” Understand the attitudes that are brought to the table by the other members of the committee. Everyone is a product of his or her own experience, and sometimes, frankly, you’re a prisoner of your own experience.

Finally, be very sure that you’re comfortable with your comp consultant. Make sure they understand what’s going on in the marketplace and in the company, its strategy, the business, the culture, and can respond or react appropriately to management’s proposals and that they’re there for the committee whenever they’re needed. It’s a daunting deep dive from day one.

Ferracone: What you’re saying is that someone really has to forge a partnership with external resources—the comp consultants in particular— but there are also the internal resources sitting down with management and discovering what’s on their minds and what’s on the minds of the other compensation committee members.

Martinez: We also need to recognize that we are in one of the more difficult and challenging macro situations that anyone has seen in the last several years, and so we must be sure that compensation programs take into account a dramatically changing and volatile environment.

I think the one thought I’d leave for compensation committee members and chairs at this point in time would be to be sensitive to the macro environment but not compromise principles.

Ferracone: What I will take away from our conversation today is that the comp committee chair is truly in the middle these days—between shareholders and management—and needs to be made of and do the hard work of steel to get so close to the flame without being burned.

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Speaking at the NACD’s recent National Compensation Advisory Council, Robin Ferracone, executive chair of Farient Advisors, an executive compensation and performance consulting firm, said that while the challenge of evaluating and setting CEO and executive compensation is becoming more of a lightning rod, companies that can pass the “red-face test” will have a relatively easy time with the new disclosure and say-on-pay rules. Those that cannot may be treated harshly.

Those attending the meeting highlighted several issues that need to be addressed, both in the fundamentals of setting pay and in the way those pay decisions are communicated to shareholders and to the wider community. Perhaps the most important questions to emerge from the discussion were: Why are some CEOs pilloried for their compensation while others—even those who may make more— are held up as heroes? There is little, if any, consequence for underperformance—in fact, CEO pay never seems to go down. How should directors really measure performance, and how can compensation structures and policies be best communicated to shareholders, the media and the general public? Until these issues are addressed, there can be no meaningful discussion of the role of the compensation committee.

Some participants questioned the premise that the compensation system is “broken,” and even the need to have the conversation. Why is such a dialogue important, they asked?

Ken Daly, NACD president and CEO, answered succinctly: “If we don’t do something about this, then Congress will do it for us. If directors only do what is mandated [in terms of curtailing CEO pay], then we are going to get stronger regulation. Up to this point Congress has generally been happy changing behavior by increasing disclosure, but their patience has run out and they are starting to take a far more aggressive approach. If we don’t get ahead of issues and concerns around compensation— real or perceived—then we will lose control of the discussion.” In short, regulatory overtone is filling the gap in board leadership.

Several hours of sometimes-heated conversation resulted in a handful of steps and resolutions that boards should take in order to take control of the issue and become leaders of compensation strategy.

1. The board must be the leader of the compensation process. While in theory it is the job of the compensation committee (and ultimately the entire board), in reality, many boards feel that the CEO dominates the conversation while the board is reduced to a reactionary role.

The board needs to regain primacy on compensation philosophy, metrics and planning. The compensation committee must set the tone and own the process. This may require the compensation committee to adopt a different tone or approach than other committees that provide oversight and work collaboratively with management. The compensation committee should be less collegial, and realize that this is one of the few areas in which it has total responsibility. They shouldn’t act like dictators but, as one chairman pointed out, “You should remember that the CEO is really just an employee. This will assist greatly in setting the tone for compensation conversations.”

2. Tie pay to performance and define the metrics. Ferracone cautioned that assessing pay and performance is tricky. Perhaps the most common mistake made is looking at the grant value of long-term incentives rather than the value of long-term incentives after performance has happened. To achieve the Holy Grail of pay—i.e., tying it to long-term performance— use forward-looking metrics rather than backward-looking responses to past performance. The board should conduct a robust discussion of how pay aligns with strategy. This should be a formal agenda item. Nonfinancial metrics should also be considered because they can have a tangible impact on both short- and long-term value. Broaden the scope of what is considered value creation and sustainable growth. Consider the impact the company has on the wider community. Some companies are including metrics such as workplace safety, reliability of service and customer satisfaction.

Stephen Brown, director of corporate governance at TIAA-CREF, suggested linking any increase in CEO pay to pay within all levels of the organization. “You could match the CEO compensation story with employees, shareholders and others,” he said. “If CEO pay goes up 20 percent but general employee pay only goes up 2 percent, you are likely to have a problem.” In other words, it can be very difficult to justify this type of increase, not just to the media but also to the workforce.

The board must also create a structure that outlines negative consequences for poor or nonperformance. Variability in executive pay is acceptable. The compensation committee should not be constrained by legacy metrics. It is easy to get trapped in a steady stream of upwardly ratcheting pay—CEO pay never really seems to go down. Noted Arthur Martinez, director at AIG, PepsiCo, IAC/Interactive, Liz Claiborne and International Flavors & Fragrances, there is a “lack of true variability in pay at top levels. It is very hard to have the conversation that we can’t tell them their bonus will be 75 percent lower than last year. CEOs don’t always take that well. It’s the responsibility of those of us on committees to have that discussion and to introduce a real sense of variability.”

Gary Hourihan

Berkshire is far from an isolated case. In the month following Mark Hurd’s resignation from Hewlett-Packard, again without a clearly designated successor, HP stock fell about 11 percent relative to the Dow and S&P and has yet to regain the loss. In fact, it currently stands at a relative loss of close to 30 percent since Hurd’s departure. Similarly, Apple’s stock price has lagged the S&P ever since Steve Jobs announced his intention to play a less prominent role due to health issues. And, in the aftermath of AIG CEO Robert Benmosche’s cancer diagnosis and lack of an obvious successor, the price of AIG stock has declined close to 40 percent despite a rise in the Dow of nearly eight percent. Benmosche had doubled AIG’s shareholder value in his first 17 months on the job. Are these cases all coincidences? Maybe, but doubtful.

While the adverse market reactions of Berkshire Hathaway, HP, Apple and AIG may be extreme examples due to the high-profile nature of their CEOs, they provide evidence that succession planning does matter in the eyes of investors. What is particularly disturbing about these situations is that the vast majority of companies do not appear to take succession planning seriously. As evidence, the National Association of Corporate Directors recently cited a study by David Larcker and Stanford’s Rock Center for Corporate Governance indicating that 46 percent of executives say their companies are not actively grooming CEO successors.

This being said, all isn’t gloom and doom. According to Wards Auto Week, Ford CEO Alan Mulally claims that Ford is devoting considerable attention to succession planning (arguably a very good idea since Mulally is widely credited with Ford’s recent success). To quote Mulally, “In every position, we didn’t try to have one plan, but to identify all the talent so we could go in multiple ways.” In January, The Men’s Wearhouse announced a succession plan for the orderly transition of executive leadership in fiscal 2011, including founder, Chairman and CEO George Zimmer.

Other examples that provide hope include CVS Caremark, which in January announced the next stage of its transition plan for CEO Thomas Ryan; eBay, whose proxy discloses that “the company conducts an annual review process that includes succession plans for our senior leadership positions”; and U.S. Bancorp, whose proxy reports “a defined board process for succession with respect to the chairman and CEO roles as well as other senior positions.”

Interestingly, in direct contrast to the negative market reaction to CEO succession issues, the stocks of both Men’s Wearhouse and CVS Caremark have performed well since their CEO succession plans were announced. The prices of both stocks have slightly outperformed the Dow since the announcements, giving additional credence to a recent comment by Stephen Mills, vice chairman of the executive search firm Heidrick & Struggles. In reference to AIG’s succession issues, Mills said, “The company needs to demonstrate to investors that it has the processes in place to find the next CEO when the time comes.”

So where are we heading? Are the surveys that find effective succession planning sorely lacking a cause for concern, or is the tide turning in the right direction? An important question is whether compensation committees can structure executive compensation packages that encourage and support proactive succession planning practices for the company. As the Dodd-Frank Act focuses investor attention on pay and performance alignment, executive reward design has an important role to play in succession planning. In this regard, the following example is illuminating. It demonstrates both what I believe to be trends in succession planning as well as best practices.

The board of a Fortune 500 firm not typically associated with progressive leadership planning undertook a process to assess its entire senior management team in response to the CEO’s expected transition in two to three years. The process encompassed the development of a “success profile” that incorporated the behaviors, values and skills considered by management and the board to be essential to the company’s strategy, culture and the demands of the role. In turn, the success profile was to serve as the basis for candidate evaluation. Once this profile was in place, an assessment of each executive’s behavioral characteristics, values, background and experience was conducted through interviews and a 360-degree assessment completed by the executive’s boss, peers and subordinates. The work resulted in the identification of internal and external candidates. The company decided that the two internal candidates should be mentored by the current CEO and “groomed” through assignments to address gaps in their experience. The company also identified candidates who would be able to fill the current roles of the two potential CEO successors.

William B. Chandler III

The process of choosing Chandler’s successor got underway in May when the Delaware Judicial Nominating Commission, chaired by Andre G. Bouchard, managing partner at Bouchard Margules & Friedlander, issued a public notice soliciting candidates. The court is required by the state constitution to be bipartisan, and all candidates must be Delaware residents. Following interviews, the JNC would refer any finalists to Gov. Jack Markell, who would then recommend one candidate to the state Senate for approval.

The 60-year-old Chandler, the subject of a cover story in NACD Directorship (December 2010/January 2011), notified the Delaware governor in April he planned to resign to seek opportunities in the private sector. His last day on the court was expected to be June 17.

Franklin, Hockaday to Co-Chair BRC on Lead Directors
A group of more than 20 corporate directors and governance thought leaders convened this spring to initiate the 2011 Report of the NACD Blue Ribbon Commission on the Lead Director. Hosted by the NACD, the commissioners will leverage their years of experience to develop recommendations that will define and clarify the role of the lead director in the boardroom. The commission is co-chaired by Barbara Hackman Franklin, former U.S. Secretary of Commerce, and currently a director for Aetna and the Dow Chemical Company and chairman of the board for NACD; and Irvine Hockaday, director for Ford Motor Company, Estée Lauder and Crown Media Holdings. Holly Gregory, corporate partner at Weil, Gotshal & Manges, will serve as governance counsel to the commission.

“As boards rise in accountability and visibility, the role of the lead director has become increasingly important. Lead directors play a critical role in ensuring independence of thought and oversight, and help build consensus in the decision-making process,” said Ken Daly, president and CEO of NACD. “The diversity and depth of experience represented on this year’s commission provide a unique opportunity to study leading practices for the lead director position.”

The new commissioners will meet once more in June as they continue to collaborate on their recommendations. The report is scheduled for release at the NACD Annual Board Leadership Conference on October 2-4 in Washington, D.C.

Delaware VC Cuts Plaintiff Lawyer Fee
What did shareholder plaintiffs lawyers achieve in their litigation over an abandoned tender offer for shares of Sauer-Danfoss? Not much, according to a recent decision by Delaware Vice Chancellor J. Travis Laster. In fact, Laster found that the plaintiffs lawyers did so little of value that he slashed their fee request by 95 percent and awarded them just $75,000 of the $790,000 they asked for, according to Morris James’ Delaware Business Litigation Report. Wrote Laster: “Plaintiffs never engaged in meaningful litigation activity.”

Heidrick Study Finds Number of Directorships in Decline
New director appointments decreased 22 percent from 2009 to 2010, according to the new Heidrick & Struggles Board Monitor Fortune 500 quarterly trend report, with 279 new directors at the studied companies in 2010, down from 356 in 2009. In addition, only one-third of these appointees had non-CEO or –CFO backgrounds, reflecting the growing post-Dodd-Frank disclosure requirements. “The ongoing economic uncertainty is causing companies to lean towards those with top-job experience when they do make an appointment,” said Bonnie Gwin, the leadership advisory firm’s vice chairman and head of the North American Board Practice. Average director age remained at 57, and female placements increased slightly from 17.9 percent to 19.3 percent.

Outside CEOs Cost More, Perform Worse
CEOs promoted from within are more cost-effective and outperform their external counterparts, according to a study conducted by The Kelley School of Business at Indiana University in conjunction with A.T. Kearney, that examined 36 companies that had promoted internally between 1988 and 2007. It compared their performance with other S&P 500 companies that had chosen external candidates. The study found that none of the external CEOs’ companies performed better than the 36 identified companies, and the external CEOs commanded salaries that were 65 percent higher than those of CEOs recruited from within.

Transocean Execs Donate Safety Bonuses to Victims’ Families
After sparking public ire by rewarding executives with safety bonuses, five Transocean senior executives will donate $250,000 collectively to a fund for the families of victims of last year’s Deepwater Horizon explosion in the Gulf of Mexico. Transocean had given safety bonuses because the company had reached two-thirds of its safety target, despite the deaths of 11 workers in the explosion and the subsequent massive oil spill. Overall, the five executives received about $900,000 in incentive bonuses; 25 percent of the bonus equation is determined by safety performance. Transocean reported that 2010 was its “best year in safety performance.”

Judge Orders Borders Bonus Plan Changes
Bankrupt bookseller Borders Group was ordered by U.S. Bankruptcy Judge Martin Glenn to revise its executive bonus plan after the lawyer representing unsecured creditors, Bruce Buechler, notified the judge that the plan rewarded executives for staying with the company though its bankruptcy. The plan had proposed giving the top five executives $4.9 million if unsecured creditors were paid at least $95 million, and a $1.8 million bonus if creditors received $73 million. Glenn instructed the retailer to include a provision that would apply if less than $73 million were returned to creditors.

Basel Establishes Criteria for Globally Essential Banks
The Basel Committee on Banking has established criteria designating banks that must maintain extra capital reserves because they are essential to global financial stability. The international regulatory committee did not compile a list of firms that these rules would affect. Banks will be evaluated based on “size, interconnectedness, substitutability, global activity and complexity,” said the committee’s secretary general, Stefan Walter, who noted that the Basel committee would monitor hedge funds, money market mutual funds and other securitization structures to help prevent another financial crisis.

Class Actions Lose, Arbitrators Win in Supreme Court Ruling
In a ruling expected to provide businesses with significant protections against class-action lawsuits, the Supreme Court ruled that state laws couldn’t override contract clauses that require customers to present complaints to private arbitrators individually. The case in question, AT&T Mobility v. Concepcion, fought over a $30.22 sales tax charge on phones that AT&T had advertised as “free.” The ruling makes arbitration clauses more attractive to companies in consumer contracts, and is expected to apply to employers in employee contracts under the Federal Arbitration Act of 2001.

Geronzi Resigns, Faces Ruling
Cesare Geronzi resigned as chairman of Italian insurer Assicurazioni Generali after the board threatened a vote of no confidence. He was awarded a payoff of 16.6 million euros ($24.3 million) upon leaving Europe’s No.3 insurer, according to Reuters. The controversial Italian financier has in succession chaired three of the country’s most important financial institutions: Capitalia; Mediobanca, which is Generali’s top shareholder; and Generali itself. Separately, a Rome court is due to rule on whether Geronzi contributed to the 2003 bankruptcy of Italian food group Cirio. Prosecutors are seeking an eight-year sentence for Geronzi, who has denied any wrongdoing.

Wall Street Banker Pay Falling
An unnamed Wall Street paymaster told The Wall Street Journal recently that the median banker pretax salary is currently $1.6 million, down from $2.2 million before the financial crisis hit. The pre-crisis pay was approximately 60 percent cash payments, with bankers taking home about $700,000 a year after taxes. Now, however, more bankers receive deferred compensation rewards, which brings their median aftertax take-home pay to about $380,000.

Director Shortage
Despite median director compensation increasing from $45,000 in 2001 to $119,500 in 2010, Canadian companies are having increasing difficulty finding directors to fill their boards. Spencer Stuart found “a definite increase in the number of first-timers joining boards,” said Andrew MacDougall, president of Spencer Stuart Canada. Over the past three years, almost 25 percent of all directors appointed were joining their first board. One-third of the newly appointed directors in 2010 were from the United States—the highest proportion since Spencer Stuart began tracking Canadian directorship trends. In addition, female board members increased to 20 percent in 2010, from 13 percent in 2009.

Top Paid CEOs in 2010
1. Philippe P. Dauman – Viacom
2. Lawrence J. Ellison – Oracle
3. Leslie Moonves – CBS
4. Martin E. Franklin – Jarden
5. Michael White – DirecTV
6. John F. Lundgren – Stanley Black & Decker
7. Richard C. Adkerson – Freeport-McMoRan Copper & Gold
8. Robert A. Iger – Disney
9. Donald J. Stebbins – Visteon
10. Jeffrey L. Bewkes – Time Warner
11. Alan Mulally – Ford Motor
12. Brian L. Roberts – Comcast
13. John H. Hammergren – McKesson
14. Samuel J. Palmisano – IBM
15. David M. Cote – Honeywell
16. Laurence D. Fink – BlackRock
17. James Dimon – JPMorgan Chase
18. David N. Farr – Emerson Electric
19. Thomas M. Ryan – CVS Caremark
20. Rex W. Tillerson – ExxonMobil
Source: The Wall Street Journal Survey of CEO Compensation

Corporate Reputations
Best:
1. Google
2. Johnson & Johnson
3. 3M Company
4. Berkshire Hathaway
5. Apple
6. Intel Corporation
7. Kraft Foods
8. Amazon.com
9. General Mills
10. The Walt Disney Company

Worst:
11. AIG
12. BP
13. Goldman Sachs
14. Citigroup
15. Chrysler
16. Bank of America
17. General Motors
18. ExxonMobil
19. JPMorgan Chase
20. Delta Airlines
Source: 2011 Harris Interactive

Charles “Ed” Haldeman (left) and John Koskinen

Managing through the turmoil that engulfed the corporate world in 2008 and navigating the rapidly changing governance environment was—and remains—a complicated task. The first priority of the company’s new owners—the U.S. government—was finding leadership. It turned first to John Koskinen, a corporate reorganization specialist who had turned around several companies in his career, making him chairman of the board. CEO Charles “Ed” Haldeman joined the mortgage giant the following year. Together, the pair has identified a path from government life support to recovery.

Haldeman’s approach focuses heavily on people, understanding that a talented and ethical workforce is vital in achieving governance and performance goals. Since taking the helm, Haldeman has seen Freddie Mac bring home a slew of diversity and workplace awards, a fact he believes is a significant factor in the company’s recent success.

Political turmoil and uncertainty continue to exacerbate management’s task, but the board remains focused on fulfilling its obligation to U.S. taxpayers. Managing through the uncertainty while improving governance standards and boosting profitability is made more complicated by having the government as the majority shareholder. The board and management not only must work together, but they must answer to the company’s conservator and primary regulator—the Federal Housing Finance Agency— plus Congress, the U.S. Treasury Department and the Department of Housing and Urban Development.

In an interview with NACD Directorship, Haldeman and Koskinen shared their experiences on working in this unique environment, improving governance and managing in crisis.

Can you talk a little about managing through the economic crisis and the emerging recovery? What’s been your strategy for managing the board and the company during this period?
John Koskinen: The government took over on a weekend in September 2008, and I was asked to then put the board together. Our challenge was to find intelligent and capable people who would sign up for the board of a company in an interesting situation. Our goal was to get people who were knowledgeable about various aspects of Freddie Mac’s business—mortgages, housing, urban development— and people who understood the unique challenge and opportunity the company faced.

Freddie Mac and Fannie Mae were effectively the first companies to be impacted in that short crisis period, followed by Merrill Lynch being bought by Bank of America, Lehman Brothers folding, AIG getting government assistance—all of which happened in about 10 days.

It was a volatile period. What was the main concern of the regulator when it first stepped in?
Koskinen: I think the most significant challenge the regulator, the FHFA, was concerned about that weekend, in the middle of chaos and crisis, was how to create as stable a working environment for people as possible and to let people know that even with everything swirling around them there was a future. In the meantime, the important thing was to pay attention to the critical mission of the company to support the nation’s housing market. This continued to be the primary concern, I believe, for the two and a half years since then.

How well did that message resonate with the employees at the time, and did you have any challenges retaining and attracting talent?
Koskinen: We were concerned then— and continue to be—about employee retention. It was a problem during the crisis to some extent, although the economy was collapsing, so there weren’t as many options and alternatives for people then as we knew there would be as the economy recovered.

Throughout it all the goal has been to give people a sense of perspective about where the company fits vis-à-vis the major problems in the economy.

Did this also apply to the CEO position?
Koskinen: We faced unique challenges and had a new CEO who decided after six months that all of the government involvement and oversight and the complicated relationships were not what he had signed on for, and he departed. So I became the interim CEO for six months while we searched for a replacement.

We understood that the new CEO would have to see the situation and the government involvement as an interesting and exciting challenge rather than a burden. We were delighted and fortunate to find Ed, and it didn’t take too much convincing to have him join us. It was important to demonstrate that we could find an extremely qualified, experienced executive who was excited about coming here.

Ed, what was your initial focus when joining the company in 2009?
Haldeman: To John’s point about government involvement, this would not be the right place for a CEO who is an old-school autocratic person who makes a decision and then wants to get right on and implement it. The situation calls for a CEO who is accustomed to the notion of building consensus and realizes there is a gauntlet of approvals that one has to go through. I came in with my eyes open and accustomed to working with a board in a partnership way and knowing that my job is to suggest a course of action, but then the board has to agree to it and then we have to go to our regulator and get them to agree with it, and sometimes we even have to go to Treasury and get them to agree too.

To your other point about how we managed through this adversity, the whole focus has been to try to get the employees to focus on the present, as distinct from the past or the future.

Back then, and now, there were a huge amount of distractions. The political environment is such that there’s a lot of interest in the past. Many politicians spend their time trying to figure out the past, what went wrong, and how can we fix it. There could be a tendency for management and employees and maybe the board to spend a lot of time being defensive and trying to explain the past. Similarly, the future is quite interesting. There are a lot of people who want to spend a lot of time thinking about what the best business model is going forward, for Freddie Mac. The Treasury put out a position paper on February 11 that talks about the future. I think our challenge at the company has been to not let those distractions take us away from the focus on the present and the important mission of the present.

Remaining in the present is important, but a board must look to the future. What does the short term hold for Freddie?
Koskinen: From the start, it seemed clear to me that the greater risk to the economy, not just to the company, was that out of swirling debate, finger pointing and an attempt to figure out who to blame for the economic downturn, you got a knee-jerk reaction to “fixing” the government-sponsored entities that would be to the detriment of the housing market, the mortgage market and the economy.

Having spent a lot of time in Washington, it seemed to me that our best strategy, and the best contribution we could make to the public good, would be to never have an answer to the question of “What should the future look like?” This is kind of counterintuitive, because the natural inclination of anybody with an interest in these subjects is to try to figure out what the right answer is, to the business model, to the structure, to the political equation. But the problem with having an answer is your views on any other options are automatically discounted.

What we have of great value here is a tremendous amount of experience and data from the past 40 years on how the housing and mortgage markets work. A minimum threshold of success would be to provide data and information to people so that whatever structure the Congress ultimately choses, the system would actually be able to be managed. It’s a complicated business, and it’s pretty easy to get it wrong.

Will the current political wrangling over the budget have an impact on the way Freddie Mac does business?
Koskinen: So we have spent a lot of time and it’s worked reasonably successfully, at the board level and at the management level, being open, trying to become the honest broker of information and analysis. We have spent a lot of time with the Administration and are beginning to have conversations with people on the Hill analyzing the implications of various options.

I think there’s a growing comfort level on the part of decision makers that we don’t have an axe to grind. That if they want to talk about totally privatizing the market, we can tell them what that looks like. If they want to get rid of retained portfolios, if they want to get rid of the government guarantee, for securities, we’ll give you our best judgment based on 40 years of experience as to what the market would look like, what the business would look like, what the housing industry would look like.

So we continue to have a dialogue of our own every once in a while at the board level, “Is it time for us to say, in the middle of the political dialogue, here’s what we really think you ought to do?” But in a lot of ways, as I’ve said to the board, we’re kind of at half time. The game is now being played up on the Hill, but there’s a ways to go. There are a lot of options being bounced around Congress but it’s probably unlikely that any final conclusion will be reached before the Presidential election, which means that over the next year and a half or two, we’re going to have the continued challenge of managing in a time of uncertainty in terms of what the future brings.

It sounds like what you’re talking about is basic risk management. How would you describe your risk management processes at Freddie Mac? Have you created a specific risk committee like many other companies have done?
Koskinen: In the last two and a half years, everyone has become much more sensitive to risk. There is a debate in boardrooms about how best to address risk—at the audit committee, forming a risk committee or as a full-board responsibility. To some extent, the answer depends on the nature of your business and the nature of the risk you face. We’ve decided that it’s a full-board responsibility because risk is inherent across our business. Our setup is that we have a business and risk committee, and we have an audit committee, and the way it’s turned out is all of the board members are on one or the other.

In addition to regular two-day board and committee meetings, we hold a joint meeting of the audit and business and risk committee, which is, in effect, a meeting of the whole board. But we treat it as a joint meeting of audit and business and risk, to continually remind everyone that the risks include things you would normally think of in the audit committee; things you would normally consider in the business and risk area, and they cross over and overlap in a lot of ways. Ed’s made a significant number of changes as to how the company analyzes and manages against those risks at the management level.

Haldeman: Our structure right now has a chief risk officer and a chief credit officer, both of whom report directly to me. Actually, it was my predecessor who split them out as direct reports, and I like that model. I’m not sure you have to have that in all financial companies, but I think it highlights that we have this one risk—being credit—that is ever present, and then we have a number of other risks under the chief risk officer that would include market risk and operational risk. We also have a credit oversight team within our risk function, so in a sense we have credit there as well in an oversight capacity. Part of the answer to managing risk is the structure, but it’s also cultural and how much stature the chief risk officer has in the company.

There are some companies where the risk job is kind of a check-the-box job, a necessary evil to go through. We’ve tried hard here for the culture to feel different and to have risk officers be a real part of the team, part of the process. We’ve tried to embed the senior risk people in transactions and processes, so that any concerns can be raised early on and mitigated as we’re going through the process.

With the government—and, by extension, taxpayers—being your major shareholder, what is your approach to investor relations?
Haldeman: I think of the taxpayer as having a stake in the company, and as such they are a constituency to which we owe a fair amount of openness. We have many constituencies to whom we owe some responsibility, but the taxpayer probably takes precedence. That influences us in lots of different ways. A lot of judgments we are making have to do with what we can do to reduce the draw from the Treasury and make sure the taxpayer is getting a good deal.

Koskinen: We’re an interesting hybrid of sorts. We’re in a private-sector business, with the government as a major shareholder. But ultimately, as the regulator continues to remind everyone, including the Congress and us, it’s a conservatorship, so by definition, we’re trying to conserve and protect the assets for the shareholders and the taxpayers.

It is an unusual business model. What is the main focus of the board, and how is the company doing lately?
Koskinen: One challenge with communications is that there is a misunderstanding of the situation, which can make it hard to tell the company story. There’s some concern on occasion on the Hill that we’re doing things that are non-productive or spending taxpayer funds in a way that would be different if they had a say in it. The real measure of our success is how much of a draw do we take from the government, which is really about how profitable we are. In other words, what the net equity in the company is. So when you get done with it all we are focused on making money, within the context of conservatorship and or mission.

What is often ignored when people assess our performance is that, because we were one of the first out of the box in terms of getting government support, we ended up with a 10 percent dividend against the government’s preferred stock. Most other companies that followed us saw the dividend reduced to five percent because they realized that 10 percent makes it very difficult to pay off the obligation.

The government has not dropped our rate to five percent. However, for the past few quarters the amount of our draw has been less than the amount of our dividend.

If you look forward, barring another major downturn in the next couple of years, it’s possible that with virtually all of the draw we have, we will be able to pay the dividend. There will be some quarters where we make enough money and have enough equity to pay the dividend without any draw at all. We’ve moved from fairly significant draws in 2008, 2009, and the first quarter of 2010, to more modest draws since then, so I think that by the end of this year the discussion on the Hill is going to be more focused on whether the model of the government giving Freddie money [through the draw] just for them to give it back, makes sense.

Haldeman: So, to put numbers on John’s point, in the second half of 2010, we paid a preferred dividend to the federal government of $3.2 billion—that’s half of the $6.4 billion annual payment. In order to do that in the third quarter we had a draw of $100 million, and then in the fourth quarter, $500 million, so that for the two quarters combined, our draw was only $600 million compared to that $3.2 billion check that we wrote for dividends. In the first quarter of 2011 we actually had no draw despite paying another $1.6 billion in preferred dividends to the Treasury.

How do you deal with media relations, especially the reputational risk of things being written about you, at the board level?
Koskinen: Ultimately, managing media relations is a responsibility of the management, but with the working relationship that the board has with management, there have been numerous discussions. We’re constrained by the conservatorship about how much we can do: We certainly are not allowed to do any lobbying or presentations on our behalf with the Congress. But we’re also working with the regulator to make sure we’re within their comfort zones in terms of what outside media relations we’re doing.

The discussion at the board level has been, almost from the start, how to appropriately communicate information that will give people the correct picture of what’s actually happening here. And so we have some discussion and debate back and forth among various members of the board.

The board has, over the past couple years, seen us get to the point where the facts begin to explain themselves, and we could, in our disclosures and conversations, focus on what we are really achieving. That story is that, recently, we are not drawing as much money and the company is starting to do better. The board does not define media policy, but it does consider the question: “How do we get the message out?”

So what is your feeling about the portrayal of Freddie Mac in the media, and how do you think the public views the company?
Haldeman: I would say our board has been equally as frustrated as management on our seeming inability to get an accurate portrayal of the company in the public’s mind. We would both like to be more aggressive in getting the message out but sometimes are constrained by our regulator with regard to not advocating, not lobbying, not advertising. You know, we wish the story we just told you about our draw over the past nine months could get out there, but the way journalists write that is, “Freddie has another draw, Freddie goes to the Treasury again,” right? That is simply not a realistic reflection of what is actually happening.

On the compensation front, the journalists are right that I get paid a lot of money. There’s no denying that $5 or $6 million is a lot of money. The context one would put around that, I think, would be that if we take a look at our top-15 highest-paid executives here, compensation is down about 35 or 40 percent from peak levels, and at the same level almost precisely, that it was 10-12 years ago. I think another contextual point we would make is that last year, that is, 2010, we reduced our overall G&A [general and administrative expenses] spending by about $88 million, so we took five percent of the cost out in one year. We further reduced G&A spending by another 10 percent in the first quarter of 2011. This indicates that we do focus a lot on doing the right thing for the taxpayer and trying to keep our expenses down.

Speaking of the regulator, how much influence does it have on setting compensation, and for that matter, on board-level decisions?
Koskinen: When I started, one of the questions was what would be the delegation of authority to the board from the regulator, who as conservator basically had total authority. We had a very good but somewhat lengthy discussion for a couple of months, and ultimately, with a handful of exceptions, compensation being one of them, the board was delegated authority and therefore the management had authority over the normal, run-of-the-mill issues. A significant percentage of what we do, 80 or 90 percent of it, is run as if it were a normal corporation.

The compensation committee and the board approved our compensation program, and the regulators had the final say. So all of these figures, all of these programs, short-term and long-term compensation, were approved by the regulator and by the Treasury and by Ken Feinberg, special master for executive compensation under the Troubled Asset Relief Program, when he was there.

What is the day-to-day level of interaction between the regulator and yourselves? Do you talk to them on a weekly basis, daily basis?
Haldeman: I visit with the director [of FHFA] weekly and he’s totally available by phone if we need to talk something over. But I think you should have a sense that the regulator is very connected throughout all levels of the company, and there are many, many people from the regulator here today and every day. I would suspect that there could be 20 to 50 people from the regulator here today in various functional areas of the company. There are some finance people, accounting people and lawyers who supervise us closely.

If you work to develop a cooperative relationship, it turns out that that can work. It can take a little longer sometimes to get decisions made, but I think the board meets with the FHFA director twice a year, once in his capacity as regulator and once in his capacity as conservator. I think the board feels that there is a workable relationship; I don’t think that we have anybody that thinks that it’s dysfunctional or a major problem.

What does the future hold for Freddie Mac?
Koskinen: I think one of the ways to conclude the discussion is that when we started out, it was a very positive signal for the members of the management team and the employees that there was going to be a board, because they wanted the company to continue to function as much as it could, even under conservatorship, as if it were a corporation, not a government agency. The board was seen as a real board, with real authority: We wouldn’t have been able to sign up the people we have if it didn’t have that authority.

The employees derive great comfort and satisfaction from the fact that, on a day-in and day-out basis, the company really runs like a normal corporation— there’s a board, there’s a chairman, there’s a CEO. The other side of that coin, to Ed’s point, is that it’s clear that we haven’t been turned into a government agency. The company still is really being run as a competitive private-sector enterprise. It’s just that the major shareholder happens to be the federal government and the American public.

Author Urmi Ashar

Panelists were the Hon. Cynthia A. Baldwin, general counsel of Pennsylvania State University, director of Koppers Holdings, and immediate past chair, Association of Governing Boards of Colleges and Universities; William Hernandez, a director of Albemarle, Black Box, Eastman Kodak Company and USG Corp.; George Long, chief governance counsel and corporate secretary, The PNC Financial Services Group; and George L. Miles Jr., director of AIG, HFF, Harley-Davidson, WESCO International and EQT.

Rising Value of Reputation
The meaning of “reputation” depends on the context. In the context of risk management and value creation, a useful definition for reputation is an impression held by stakeholders that creates both a future expectation and a present behavior. “Reputation is the way that others see the company,” said the Hon. Cynthia A. Baldwin.

How stakeholders view a company’s actions is the primary force behind the company’s reputation. Specifically, stakeholders consider how well a company fosters an ethical environment (internally and externally), promotes innovation, conforms to standards of quality and meets expectations for safety, security and sustainability. A positive reputation drives positive behaviors with internal and external stakeholders, making it easier to command preferential terms in the purchase of goods and services in the supply chain, attract talent, secure affordable financing and command a price premium in the marketplace. A positive reputation raises equity value, as shown by the consistent observation that companies with superior reputations outperform their peers.

Click here to view the embedded video.

The value of reputation has risen over the past two decades. “It’s an intangible (asset),” noted Hernandez. The rise of reputational value parallels the rise of the amount by which enterprise value exceeds tangible book value. As per Steel City Re’s analysis, in the 1980s, the average intangible asset value of a constituent member of the S&P 500 Index was around 20%. In 2010, the average intangible asset value was around 80%. After Lehman Brothers filed for bankruptcy former Chairman Alan Greenspan observed: “In a market system based on trust, reputation has a significant economic value.”

Reputation’s increasing contribution to enterprise value has not been overlooked by the the world of corporate governance and in popular public opinion. In addition, the relationship between reputation and corporate director liability is now finding its way into the courts. Historically, director liability came into play only in cases involving conflicts of interest. However, in its 1996 In re Caremark decision, the Delaware Court of Chancery ruled that the fiduciary duty of corporate directors includes having a process in place to ensure that they are informed of information sufficient to allow them to oversee the company’s business performance and compliance with law.

A decade later, the Delaware Supreme Court’s 2006 opinion in the case of Stone v. Ritter highlighted that the board’s duty of oversight applies to all corporate assets, including intangible assets. The Court stated that director oversight liability may be predicated on facts showing that either: “(a) the directors utterly failed to implement any reporting or information system or controls; or (b) having implemented such a system or controls, consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention.”

On December 17, 2010, a shareholder group brought reputation into the mix when it filed a lawsuit against Johnson & Johnson’s directors and managers, alleging failure to uphold their duty of oversight, and breach of their duty of loyalty, by allowing adverse events to cascade which inevitably “destroyed the company’s hard-earned reputation.”

There are two issues that should be of particular concern to directors related to reputation loss liability. First, the Johnson & Johnson filing is the first known case that attempts to impose liability on directors based on a decline in a company’s reputation. This case will be of particular interest to Delaware corporations, as Delaware law does not permit corporations to indemnify officers and directors against personal liability for breaches of the duty of loyalty. Second, “[t]he collapse of a company’s reputation can stain its directors,” observed George Miles. There are connections between a company’s reputation and the individuals associated with the company. Adverse events, even linked to questionable issues, may have a spill-over effect on other boards and may attract public and shareholder scrutiny. Empirical data indicate that the number of board seats held by independent directors drops three years after a shareholder lawsuit has been filed.

AIG named director Robert “Steve” Miller as its new chairman, after Harvey Golub resigned amid tensions with CEO Robert Benmosche. Miller was elected to the board in June last year. Miller is chairman of MidOcean partners. He retired as executive chairman of Delphi Corp in 2009.

KeyCorp, one of the nation’s largest bank-based financial services companies, announced  that Barbara R. Snyder has been elected to KeyCorp’s board. The election increases the size of KeyCorp’s board of directors to 16 members.

Glowpoint, a global provider of managed services for telepresence and video conferencing  announced that its board of directors has named Joe Laezza as CEO and president effective immediately.

E5 Systems, a U.S. technology service company, announced that Mike Summers, a seasoned-veteran in health care and IT management, has joined E5 Systems as their new chief technology officer and corporate vice-president.

AIG recently announced that William N. Dooley has been elected AIG executive vice president, financial services. The board also elected Mark Herr AIG vice president, corporate media relations, and Tal Kaissar AIG vice president and director of taxes.

Richard Boulay has been named to the board at Moneta Porcupine Mines. Boulay is a geologist with over 40 years of experience.

Appointed to the Treasury post by President Barack Obama shortly after he become president, Feinberg rules over the compensation of the top 25 corporate officers at each of those companies—there are now only five—that took TARP funds. Executives from each of those five—General Motors, GMAC, Chrysler, Chrysler Financial and AIG—were not among the guests invited to the private dinner arranged by Kirkland partner Jay Lefkowitz, with whom Feinberg worked closely when he served as administrator of the 9/11 Victim’s Compensation Fund while Lefkowitz was a senior White House official.

“We wanted to offer a forum for our public company clients to have a real give and take with Ken Feinberg on issues relating to executive compensation and to get a chance to understand from Ken how the work he is doing for the Treasury Department offers insights into compensation practices more generally in the current governance environment,” said Kirkland partner David Fox.

After dinner, Directorship took the opportunity to question the special master on his role in corporate reform and compensation. The conversation was informative, and, like Feinberg himself, highly animated.

How would you define the scope of your role?

Firstly corporate governance – the whole issue out there about the power of shareholders, the role of independent compensation committees, the role of boards of directors – none of those corporate governance issues are on my watch. Those issues are addressed by the administration by other initiatives.

I have a very limited statutory mandate now down to five companies and my role is just to determine compensation packages for the top 25 corporate officials at each of those companies. I do have some other statutory roles to play but the actual determination of compensation in individual cases is limited.

Is it realistic for you to cap compensation given the range of highly creative ways companies can pay their executives?

Yes, it is. For the people who are subject to my jurisdiction, the total compensation packages are to be determined by the office of the special master. That does not just mean cash salaries, but includes all stock, perks, severance packages and retirement benefits.

How do you evaluate what a certain package may be worth, especially if it includes options – which are notoriously hard to evaluate?

The simple answer is that options are prohibited. There should be no guaranteed compensation other than modest cash-based salary of under $500,000 annually. The rest should be in the form of stock, which cannot be redeemed except over a two, three or four-year period: no perks beyond $25,000 without approval from me: No golden parachutes. No severance packages that are a subterfuge to get around lower compensation.

You recently sent letters to all 419 TARP companies requesting information about employees that received more than $500k in 2008/9. Are there any concerns that directors and/or compensation committee members at these companies should have in the event that you determine the pay packages they approved are excessive or ‘counter to the public interest’?

The statute prohibits any attempt by me – other than through the use of the public bully pulpit – to force these companies to do anything. I have no enforcement authority to file lawsuits. I have no authority to subpoena records or anything like that.

I do not feel that is exposes boards to litigation arising out of my specific look back review and we will see whether there is in fact any need for me to claw back salaries.

Like it or not, what you are doing is being projected onto a much broader set of companies. The media, the public and several hundred Congressmen are evaluating other pay practices by your standards. With that in mind, what should comp committee members in general be doing?

What they have to start thinking about, I would hope, is to look at the prescriptions that the Treasury has promulgated under its mandatory jurisdiction and to decide whether in the context of their own companies, they should be adopting some those prescriptions taking into account the situation at their company and its particular culture and history of compensation. It is important to remember, that one size does not fit all but I would hope that boards would be voluntarily trying to see whether the prescriptions and rules fit for them.

Do you have any feelings on what the right mix of compensation should be?

Yes. We think that the right mix is roughly 45 percent cash and 55 percent stock. For the people I deal with that stock cannot be restricted or conditioned (or options) except one third of the total package can be subject to bonus restrictions. The base cash salary cannot be in any way conditioned.

You mentioned early the use of the bully pulpit for aiding you in achieving compliance at companies beyond you direct legal jurisdiction. With this new project how much do you think you may need to do this?

It is still too early to tell. We are not sure if we are doing anything right now, but it does remain on option.

What’s next for Ken Feinberg?
Ken Feinberg will be long gone from Treasury before all of these five companies can repay their debt. I will probably be long gone period. But the law is clear that as long as they owe the taxpayer money their top people will have their pay determined by treasury.

How do you keep so fit?

Exercise mostly every day.

Were you pleased that Attorney General Cuomo announced he was dropping the charges brought by former Governor Elliot Spitzer?

The fact is that we have won most of everything, but one or two issues are left hanging.  But this attorney general is not that different from Spitzer. Why he is keeping this alive, I can’t imagine. I find it outrageous. I have some hopes it will be resolved shortly.

You have always been a builder of businesses so what are you doing now that gets you excited?

Both CV Starr and Starr International are our private companies, both are very significant enterprises and they go back a long way. CV Starr, of course, is named after the founder of AIG, and as a matter of record, we operate a number of general insurance agencies that predate AIG. Since I left AIG, we have been building a very global organization, and have created operations across the U.S., Europe and Asia. We have a new venture in China we are really excited about.

Anything outside insurance that interests you?

We have a significant investment business outside of traditional insurance. We operate a private equity portfolio as well as make direct investments. We operate as a private merchant bank that has been the model for successful investing since JP Morgan.

How did you finally fare with your AIG holdings?

We lost a great deal of money after the collapse as we were the largest shareholder. While that was unpleasant in the extreme, there may be a misconception about our position. When we sold our shares, the media neglected to mention that we maintained the right to repurchase our shares at the same price plus two-percent interest.

In perpetuity?

Let’s say for a long time.

What about the intrusion of government into your business under the former Attorney General?

Our story is straightforward. It became convenient for Eliot Spitzer to try to destroy a business publicly in order to further his own political career, and he took the opportunity. We pride ourselves on preaching the rule of law to everyone around the world. We should be looking in a mirror. This should trouble people; I know it does me.

Why does the New York attorney general hold such power over the financial service industry?

New York’s Martin Law gives the state’s attorney general the broadest law-enforcement powers without any need for proof of intentional or negligent activity. There is a serious question as to whether the law is even constitutional.

Could you start over and rebuild a similar organization today?

I don’t see how it could be done today. Remember, AIG operated in 130 countries many of which we basically opened. China, Russia, many of the emerging markets, you can’t do that a second time. And it is my belief the business environment that encouraged entrepreneurship doesn’t exist any more.

What other factors under your leadership played a major role in the company’s success?

We had an organization with the best compensation structure in the industry. It is the model the investment activists are talking about today. No one made a lot of cash compensation, we all had shares, and we kept them until retirement. In effect, we had the best of all worlds. The entrepreneurship you usually find in a private company where management is an owner but with the responsibility of a public company to its broader shareholders.

So without high cash compensation–which most companies claim they need for retention –how did you manage to keep people?

First, I set the example. I did not have a contract, nor did anyone else in management. Our contract was with the company as shareholders. Then let’s not forget the intangibles. We had an entrepreneurial spirit that attracted the right kind of people. It was an exciting and prestigious place to work. People came there because of our tradition of innovating new products all the time, opening new markets. We were trailblazers.

Aggressive?

Of course. We managed our aggressiveness rationally.

How did you manage to keep tabs on all the risk activity?

Let’s establish that there is a great difference between a company that is managed properly versus a one-man show. We had a process that evolved over the years but which came to provide real transparency into the company’s workings. Every Monday, I held a meeting of the top 15 leaders in the company. Every fact of our business was discussed. Everyone left that meeting, including me, knowing what was happening in the company worldwide. Then monthly, we had a larger meeting of roughly 30-40 people and discussed everything from business regulation to new products, acquisitions, new markets, everything that could be known was discussed, and every question that could be asked was asked. Everyone was informed. I shudder to think about the stories of these investment banks where the CEO delegated all of risk management to mid-level employees and traders. Not on my watch.

Much has been written about the London subsidiary.

Too much has been made of the fact that there was this smaller group on London acting apart from the company. We always had a subsidiary in London. After I left, the company lost its AAA rating. The CEO was Martin Sullivan who was in the job to make sure risk management was functioning as it had previously. The significant move into credit default swaps was both unfortunate in terms of timing as well as volume. When I was there, our business in these instruments was smaller but, more importantly, closely supervised by senior management.

As for financial services, what’s the verdict, more regulation?

We had sufficient regulation in place before. The problem was that regulators failed to do their job, not too little regulation. That’s just a convenient excuse.

What have you learned about dealing with adversity?

Be stubborn, I suppose. Everyone handles it differently. I am just unable to choose expediency over integrity, which is what I was asked to do. I just can’t settle an issue when it is about something I did not do. So I am willing to fight an uphill battle, and I happen to have the courage and tenacity to do so. I think that is the right thing – the only thing – that I can do for myself, my family, and frankly, my country. I will never give in to get out of the way.

How much a factor was your AIG wealth in going into battle against the attorney general?

I never sold a share of AIG stock while I was at AIG.

What did you do to get through some of the more frustrating periods?

Exercise. Tennis. It is possible I even argued once or twice with my wife.

Matt Prohaska was appointed CEO of Smartclip. Prohaska most recently served as vice president of North American sales and account management for AOL.

Henry S. Miller, chairman of Miller Buckfire, has joined the board of directors at AIG. Miller is a former vice chairman at Dresdner Kleinwort Wasserstein.

Zix named Maribess L. Miller to its board. Miller was previously with Pricewaterhouse Coopers.

SRA International elected W. Robert Grafton to its board of directors. Grafton served as chairman of Arthur Andersen and as managing partner of Andersen Worldwide.

Lynn Wunderman was appointed to the board of directors at ARC Wireless Solutions. Wunderman has more than 30 years of experience in direct marketing, database marketing, communications, consulting and general management.

The 2009 letter to Goldman Sachs shareholders, released yesterday, and signed by Chairman and CEO Lloyd C. Blankfein and President and COO Gary D. Cohn.

By the end of 2009, owed in no small part to actions taken by governments to fortify the system, conditions across financial markets had improved significantly and to an extent few predicted or thought possible. Equity prices largely rebounded, credit spreads tightened and market activity was revitalized by investors seeking new opportunities, all of which imply renewed optimism, if not the beginnings of a potential recovery.

While improving financial conditions are often a precursor to better economic ones, the economy nevertheless remains fragile. Unemployment is high, consumer spending tepid and access to credit for many smaller businesses continues to be elusive. The effects of unwinding leverage embedded in the system may linger for some time. As the global economy works its way to recovery, the roles that we play for our clients become even more important as companies and investors position themselves to emerge stronger following the crisis.

The firm’s focus on staying close to our clients and helping them to navigate uncertainty and achieve their objectives is largely responsible for what proved to be a year of resiliency across our businesses and, by extension, a strong performance for Goldman Sachs. In 2009, the firm generated net revenues of $45.17 billion with net earnings of $13.39 billion. Diluted earnings per common share were $22.13 and our return on average common shareholders’ equity was 22.5 percent. Book value per common share increased 23 percent during 2009, and has grown from $20.94 at the end of our first year as a public company in 1999 to $117.48, a compounded annual growth rate of 19 percent over this period.

This past year, clients came to Goldman Sachs because of our ability to integrate advice, financing, market making and investing capabilities with sophisticated risk management. Importantly, during the crisis, we were able to commit capital when market liquidity and capital were scarce. Our duty to shareholders is to protect and grow our client-focused franchise by remaining true to our teamwork and performance-driven culture. Our shared values have allowed us to be nimble and reactive, yet governed by prudent, long-term thinking.

In this year’s letter, we will address some of the steps Goldman Sachs took to further strengthen our capital, liquidity and competitive position in 2009. We will discuss the firm’s client franchise and our contribution to well-functioning markets in times of distress and, on an ongoing basis, by operating at the center of global capital markets. We also will report to you on how our integrated business model, diverse revenue streams and risk management practices serve as the core of our strategy. Importantly, we will focus on how our people and culture have been and remain fundamental to the firm’s success. Finally, we will review the regulatory reform agenda as well as certain developments that attracted considerable attention over the course of the year.

Extraordinary Measures
Looking back on 2009, it is impossible to know what would have happened to the financial system absent concerted government action around the world. Institutions were hoarding cash and were unwilling to transact with each other. This had extreme consequences for even the healthiest of financial institutions and companies. Through aggressive measures ranging from liquidity and funding facilities to direct investment programs, the government arrested the contagious fear that had engulfed the global financial system and averted more acute circumstances. We believe such efforts were absolutely critical to protecting the financial system and ensuring the continued viability of the global economy. Goldman Sachs is grateful for the indispensable role governments played and we recognize that our firm and our shareholders benefited from it.

In June 2009, the firm repaid the U.S. government’s investment of $10 billion in Goldman Sachs as a participant in the U.S. Treasury’s TARP Capital Purchase Program, which was designed to promote the broader stability of the financial system. We subsequently repurchased the warrants acquired by the U.S. Treasury in connection with that investment which, when combined with preferred dividends paid, represented an additional $1.4 billion, or an annualized 23 percent return for U.S. taxpayers.

Conservative Financial Profile
In light of the events of the last two years, we believe it is important to highlight for our shareholders that Goldman Sachs did not and does not operate or manage our risk with any expectation of outside assistance. Given our roots as a privately-held partnership, we have always focused on maintaining a conservative financial profile and view liquidity as the single most important consideration for a financial institution.

Having steadily increased our Global Core Excess pool of liquidity for several years, it stood at roughly $170 billion in cash or highly liquid securities, or almost 20 percent of our balance sheet at the end of 2009. Keeping this pool of liquidity is expensive, but, in our judgment, it is money well-worth spending. Leading up to 2008, we reduced our exposures even though it meant selling at prices many thought were irrational. When the crisis hit, we raised nearly $11 billion in capital—$5 billion of preferred equity from Berkshire Hathaway and $5.75 billion in common equity—without any knowledge that TARP funds would be forthcoming.

While the past two years have validated our conservative approach to liquidity and to managing our risk, they have also prompted significant change within our organization. Specifically, we have embraced new realities pertaining to regulation and ensuring that our financial strength remains in line with our commitment to the long-term stability of our franchise and the overall markets.

We became a financial holding company, now regulated primarily by the Federal Reserve and subject to new capital and leverage tests. Since May 2008, our balance sheet has fallen by approximately one-quarter while our capital has increased by over one-half. Over 90 percent of our shareholders’ equity is common equity. The amount of level 3—or illiquid—assets is down by 40 percent representing less than 6 percent of our total assets. In 2009, our Basel I Tier 1 capital ratio increased to 15 percent, well in excess of the required minimum.

Important Roles We Play on Behalf of Our Clients
Maintaining a sound financial profile is vital if we are to be effective in meeting the needs of our clients. Among the roles we play for our largely institutional client base are advisor, financier, market maker, asset manager and co-investor.

Strategic Advice
Our advisory business serves as our primary point of contact with our clients and is often the genesis for sourcing other opportunities to serve them. In some instances, business garnered from our long-standing investment banking relationships is captured from a financial reporting perspective in the revenues reported within other segments, particularly within our Trading and Principal Investments segment. For instance, we have been successfully building our risk management solutions business within investment banking—encapsulating our strategy of integrating advice, capital and risk management expertise. Since 2005, revenues from this business have grown 32 percent compounded annually. This trend is consistent with our business model and operating philosophy which are predicated on the firm functioning as an integrated whole.

While classic advisory revenues in 2009 reached a near cyclical low, the latter half of the year yielded greater levels of strategic dialogues, reflecting an improvement in CEO confidence. Although it is difficult to predict what types of transactions or which industries will rebound most quickly, our broad and deep franchise allows Goldman Sachs to remain knowledgeable and relevant across multiple sectors, and poised to serve our clients. Over the past five years, Investment Banking has advised over 1,000 clients in 67 countries, solidifying our leading market share position and allowing us to retain industry-leading positions in cross-border, acquirer, target and strategic defense advisory league tables.

Financing for Growth
Our investment banking relationships are also the basis for most of our financing mandates. As a financial intermediary, Goldman Sachs acts to match the capital of our investing clients with the needs of our corporate and government clients, who rely on financing to generate growth, create jobs and deliver the products and services that drive economic development. Since the beginning of 2007, we have underwritten over $750 billion in corporate debt and over $450 billion in equity and equity-related products across approximately 1,900 offerings for 800 clients globally.

We have a long history of helping states and municipalities access the capital markets. Since entering the public finance in business in 1951, Goldman Sachs has been one of the most significant industry participants and over the past decade has helped states and municipalities raise over $250 billion in capital. In 2009, we were the number one underwriter for the Build America Bond program, which allows states and municipalities to meet their borrowing needs and invest in infrastructure projects. We also helped finance over $28 billion for nonprofit institutions including education services, healthcare and government entities.

Market Intermediary
Through our role as a market maker, we commit and deploy our capital to ensure that buyers and sellers can complete their transactions, contributing to the liquidity, effi ciency and stability of financial markets. Throughout the crisis, we made prices when markets were volatile and illiquid and extended credit when credit was scarce. Fixed Income, Commodities and Currencies (FICC) and Equities, our market intermediation businesses that comprise our Securities Division, were meaningful drivers of our strong firm-wide performance last year.

By remaining close to our clients, we were able to direct our human and financial capital to those businesses within our market making franchise that most reflected clients’ interests and needs. Another important component of growth has been the dynamic that, as clients grow in size, the scope of the business that they execute with the firm also increases. In 2009, 2,500 of our clients were active across both Equities and FICC products, which is up 25 percent from 2006.

Client-Driven Risk Exposures
Given concern by some over the nature and level of risk that financial institutions undertake, it is important to note that for Goldman Sachs, the vast majority of the risk we take and the revenues we generate is derived from trades that advance a client need or objective.

By way of example, in 2009, an energy consumer asked us to help protect it against a rise in the cost of fuel, concerned that an increase would affect its ability to grow. To accomplish this, Goldman Sachs structured a long-term collateralized hedge facility. We then entered into hedges to offset the fuel price risk that we had assumed. As part of our normal accounting and risk management, we regularly revalue the amount of collateral necessary to be posted when fuel prices declined during the life of the transaction. We also routinely hedge our client counterparty risk in addition to receiving collateral. In the end, we were able to structure the transaction at a fair price for our client and generate an attractive risk-adjusted return for the firm and our shareholders. This is representative of the risk we assume and manage daily to allow our clients to focus on their underlying businesses.

Co-Investing
Co-investing is another way we directly align the firm’s interests with those of our clients. Two-thirds of our corporate investing opportunities are sourced from our investment banking relationships. In addition, the vast majority of money committed to our investing funds comes from our clients, who seek to partner with us. While returns fluctuate based on equity market performance and other factors, our merchant banking businesses have provided much needed capital to our investment banking clients and achieved strong returns for our investors and shareholders over the long term. This business generates management fees as well as incentive fees based on the funds’ performance. As a result, our merchant banking business helps diversify the firm’s revenues.

The focus of our funds spans the capital structure, including senior debt, mezzanine and private equity funds. During periods of 2009 when public market liquidity dried up, our senior loan and mezzanine funds, in particular, extended needed capital to a variety of companies whose growth opportunities would otherwise have been limited.

There also is significant diversity within the funds themselves. Our corporate equity fund portfolio represents eight different industry groups with no one industry contributing more than 25 percent. Looking ahead, we remain well-positioned, together with our clients, to invest in attractively priced assets.

Managing Assets
Managing our clients’ assets remains an important growth opportunity for Goldman Sachs and we continue to allocate signifi cant time and resources to building our asset management businesses within our Investment Management Division and expanding our portfolio management capabilities. At the time of our IPO in 1999, our goal was to double assets under management (AUM) over fi ve years. We were successful, and by May 2008, we had doubled AUM once again. Our success follows a track record of strong investment returns for our clients.

As with all of our businesses, our client base is diverse, numbering 2,000 institutional clients and third-party distributors, and over 25,000 private wealth management accounts. Our range of products across money markets, fixed income, equity and alternative investments is offered through distribution channels to institutional, high-net-worth clients and third-party retail clients around the world.

To advance our strategy, in 2009, we doubled our third-party distribution sales force and significantly increased our institutional and private wealth management coverage. Included in our expanded coverage focus are government sponsored organizations, corporate pension funds, insurance companies and growth markets such as Brazil, the Middle East and China.

Investments in Growth

BRICs and Emerging Markets
We continue to believe that this will be the century of the BRICs and other high growth markets. They have helped lead the global recovery and, in our minds, are even more compelling now. As a result, the emerging markets remain integral to our growth strategy.

At the beginning of the crisis, many wondered if or to what extent the BRICs and other growth markets would be able to decouple from the more established economies. Such a decoupling had little precedent. Today, it appears that the growth markets are helping lead the recovery in the global economy. They continue to attract capital from abroad and, also, are making signifi cant, long-term investments to position themselves for the future.

We believe Goldman Sachs is similarly well-positioned to expand our franchise in step with these countries’ growth. We remain focused on implementing a familiar strategy—expand our advisory client coverage, build underwriting capabilities, develop sales and trading expertise and grow our wealth management business.

Investing in People and Communities
While Goldman Sachs serves a wide range of clients with individual needs and goals, we also believe that financial institutions have a larger obligation to the financial system, the broader economy and the communities in which their employees work and live. For us, this means helping new enterprises succeed and grow, catalyzing economic development and financing community projects that create a better quality of life for more people. Given that our firm is most successful when economies and markets thrive, this is in our interest and that of our shareholders.

The firm’s Urban Investment Group is helping to create thousands of affordable housing units and funding businesses in underserved communities, helping to bring together money and innovative ideas to revitalize cities across the United States. By making investments, loans and grants, and through service initiatives, we are working to transform distressed neighborhoods into vibrant and sustainable places of opportunity. As one example, with a $61 million investment in the New York Equity Fund, Goldman Sachs is providing 569 units of much-needed affordable housing for low-income New Yorkers as part of a wider effort to rehabilitate 47 buildings across Harlem, the South Bronx and Brooklyn.

We are pleased to report that our 10,000 Women initiative, which we introduced to you in last year’s shareholders letter, has exceeded our own expectations and is today providing underserved female entrepreneurs with a business education through partnerships with more than 70 academic institutions and nonprofits in 20 countries, including India, Brazil, China, Afghanistan, Rwanda and the United States. Our early experience is confirming research by the World Bank, Goldman Sachs and the United Nations that educating women can lead to real economic growth and healthier, safer and better-educated communities.

10,000 Small Businesses
Based on the results of 10,000 Women, Goldman Sachs announced in 2009 a new effort called 10,000 Small Businesses. This $500 million, fi ve-year program aims to unlock the growth and job-creation potential of 10,000 businesses across the United States through greater access to business education, mentors and networks, and financial capital. It is based on the broadly held view of leading experts that a combination of education, capital and support services best addresses the barriers to growth for small businesses.

The program’s business and management curriculum is supported by a $200 million commitment to community colleges and universities to build educational capacity and to provide scholarships to under-served small business owners. Goldman Sachs has committed $300 million through a mix of lending and philanthropic support to Community Development Financial Institutions to help get capital flowing to small businesses. The program’s critical support services will connect small business owners with mentoring, networking and advice available through our various 10,000 Small Businesses partners.

As with 10,000 Women, the people of Goldman Sachs will give freely of their time and professional skills to serve as mentors and guest lecturers, as well as to participate on selection committees. We believe this approach is in keeping with the best tradition of our firm, aligning our philanthropic and growth development efforts with our core competencies and expertise.

Goldman Sachs Gives
We also announced a $500 million philanthropic contribution to the firm’s donor-advised fund, Goldman Sachs Gives, which was established in 2007. The firm’s compensation for partners was reduced to fund this charitable contribution, reflecting the firm’s tradition of philanthropy.

We have asked our partners to recommend charitable organizations that focus on the critical areas of creating jobs and economic growth, building and stabilizing communities, honoring service and veterans and increasing educational opportunities.

Our People
While an often used phrase, it is true in every way at Goldman Sachs: Our people are our most important asset. We do not have material “property, plant and equipment” assets. Rather, we have talented, entrepreneurial professionals who are dedicated to the firm’s mission of supporting economic growth. In 2009, our people sat on 1,500 nonprofi t boards, and 23,000 of us volunteered for over 800 local nonprofits through our Community TeamWorks program. In short, our people are central to who we are, to the cohesiveness of our culture, and to our ability to generate attractive returns for shareholders.

Throughout 2009, we stayed true to our focus on people. Every member of our management committee participated in on-campus recruiting, while another 120,000 recruiting hours were undertaken by people across the firm. Through GS University, we provided 350,000 hours of training and leveraged our senior leaders as faculty to provide learning opportunities to our people more broadly. Last year, for example, over 5,000 courses were taught by the firm’s managing directors and vice presidents.

As demonstrated in the way we source opportunities and serve our clients, Goldman Sachs operates with a one-firm philosophy. Our people are rewarded for their accomplishments by how they work and succeed in teams, with the long-term interests of the organization always coming before those of the individual. We believe this partnership ethos, which reflects the firm’s long-standing business principles, is a competitive advantage that drives the company’s overall performance.

Pay for Performance
Providing the best advice and execution to our clients means, in turn, providing our people with attractive career opportunities and long-term incentives. We have not been blind to the attention on our industry and, in particular, on Goldman Sachs, with respect to compensation. We have adopted very specifi c compensation principles, which we presented at our 2009 Annual Meeting of Shareholders to ensure an even stronger relationship between pay and performance.

These principles are designed to:

• Encourage a real sense of teamwork and communication, binding individual short-term interests to the institution’s long-term interests;

• Evaluate performance on a multi-year basis;

• Discourage excessive or concentrated risk taking;

• Allow us to attract and retain proven talent; and

• Align aggregate compensation for the firm with performance over the cycle.

Consistent with our principles, in December, we announced that for 2009 the firm’s entire management committee would receive 100 percent of their discretionary compensation in the form of Shares at Risk which have a five-year period during which an enhanced recapture provision will permit the firm to recapture the shares in cases where an employee engaged in materially improper risk analysis or failed sufficiently to raise concerns about risks.

Enhancing our recapture provision is intended to ensure that our employees are accountable for the future impact of their decisions, to reinforce the importance of risk controls to the firm and to make clear that our compensation practices do not reward taking excessive risk.

The enhanced recapture rights build off an existing clawback mechanism that goes well beyond employee acts of fraud or malfeasance and includes conduct that is detrimental to the firm, including conduct resulting in a material restatement of the financial statements or material financial harm to the firm or one of its business units.

In addition, our shareholders will have an advisory vote on the firm’s compensation principles and the compensation of its named executive officers at the firm’s Annual Meeting of Shareholders in May 2010.

Finally, Goldman Sachs does not set aside an actual pool for discretionary compensation or “bonuses” during the course of the year. We accrue an estimate of compensation expenses each of the first three quarters. Only at year end, with the visibility of our full-year performance, do we make final decisions on compensation. While the previous quarters’ accruals attract much attention, our full-year compensation and benefits to net revenues ratio ultimately represents the firm’s compensation expense. In 2009, that ratio was the lowest ever since we became a public company—35.8 percent.

While 2009 total net revenues are only 2 percent less than the record net revenues that we posted in 2007, total compensation and benefit expense is 20 percent lower than in 2007, equating to a nearly $4 billion difference in compensation and benefits expense between the two periods. Our approach to compensation reflected the extraordinary events of 2009.

Regulatory Reform
Goldman Sachs has pledged to remain a constructive voice and participant in the process of reform, and has been forthcoming in recognizing lessons learned and mistakes made. We have provided a number of recommendations concerning how large financial institutions should account for their assets, how risk management processes can be enhanced, and how new regulations can keep pace with innovation.

Given that much of the financial contagion was fueled by uncertainty about counterparties’ balance sheets, we support measures that would require higher capital and liquidity levels, as well as the use of clearinghouses for standardized derivative transactions. More broadly, we support proposals that would improve transparency for investors and regulators and reduce systemic risk, including fair value accounting. In short, we believe that sensible and significant reforms that do not impair entrepreneurship or innovation, but make markets more efficient and safer, are in everyone’s best interest.

During our history, our firm has demonstrated an ability to quickly and effectively adapt to regulatory change. As an institution that interacts with thousands of entities, we benefit from the general elevation of standards, and will continue to work towards meaningful changes that improve our financial system.

Our Relationship with AIG

Over the last year, there has been a lot of focus on Goldman Sachs’ relationship with AIG, particularly our credit exposure to the company and the direct effect the U.S. government’s decision to support AIG had or didn’t have on our firm. Here are the facts:

Since the mid-1990s, Goldman Sachs has had a trading relationship with AIG. Our business with them spanned a number of their entities, including many of their insurance subsidiaries. And it included multiple activities, such as stock lending, foreign exchange, fixed income, futures and mortgage trading.

AIG was a AAA-rated company, one of the largest and considered one of the most sophisticated trading counterparts in the world. We established credit terms with them commensurate with those extended to other major counterparts, including a willingness to do substantial trading volumes but subject to collateral arrangements that were tightly managed.

As we do with most other counterparty relationships, we limited our overall credit exposure to AIG through a combination of collateral and market hedges in order to protect ourselves against the potential inability of AIG to make good on its commitments.

We established a pre-determined hedging program, which provided that if aggregate exposure moved above a certain threshold, credit default swaps (CDS) and other credit hedges would be obtained. This hedging was designed to keep our overall risk to manageable levels.

As part of our trading with AIG, we purchased from them protection on super-senior collateralized debt obligation (CDO) risk. This protection was designed to hedge equivalent transactions executed with clients taking the other side of the same trades. In so doing, we served as an intermediary in assisting our clients to express a defined view on the market. The net risk we were exposed to was consistent with our role as a market intermediary rather than a proprietary market participant.

In July 2007, as the market deteriorated, we began to significantly mark down the value of our super-senior CDO positions. Our rigorous commitment to fair value accounting, coupled with our daily transactions as a market maker in these securities, prompted us to reduce our valuations on a real-time basis which we believe we did earlier than other institutions. This resulted in collateral disputes with AIG. We believe that subsequent events in the housing market proved our marks to be correct—they reflected the realistic values markets were placing on these securities.

Over the ensuing weeks and months, we continued to make collateral calls, which were based on market values, consistent with our agreements with AIG. While we collected collateral, there still remained gaps between what we received and what we believed we were owed. These gaps were hedged in full by the purchase of CDS and other risk mitigants from third parties, such that we had no material residual risk if AIG defaulted on its obligations to us.

In mid-September 2008, prior to the government’s action to save AIG, a majority of Goldman Sachs’ exposure to AIG was collateralized and the rest was covered through various risk mitigants. Our total exposure on the securities on which we bought protection was roughly $10 billion. Against this, we held roughly $7.5 billion in collateral. The remainder was fully covered through hedges we purchased, primarily through CDS for which we received collateral from our market counterparties. Thus, if AIG had failed, we would have had the collateral from AIG and the proceeds from the CDS protection we purchased and, therefore, would not have incurred any material economic loss.

In this regard, a list of AIG’s cash flows to counterparties indicates little about each bank’s credit exposure to the company.

The figure of $12.9 billion that AIG paid to Goldman Sachs post the government’s decision to support AIG is made up as follows:

• $4.8 billion for highly marketable U.S. Government Agency securities that AIG had pledged to us in return for a loan of $4.8 billion. They gave us the cash, we gave them back the securities. If AIG hadn’t repaid the loan, we would simply have sold the securities and received the $4.8 billion of value in that way.

• An additional $2.5 billion that AIG owed us in collateral from September 16, 2008 (just after the government’s action) through December 31, 2008. This represented the additional collateral that was called as markets continued to deteriorate and was consistent with the existing agreements that we had with AIG.

• $5.6 billion associated with a fi nancing entity called Maiden Lane III, which was established in mid-November 2008 by the Federal Reserve to purchase the securities underlying certain CDS contracts and to cancel those contracts between AIG and its counterparties. The Federal Reserve required that the counterparties deliver the cash bonds to Maiden Lane III in order to settle the CDS contracts and avoid any further collateral calls. Consequently, the cash fl ow of $5.6 billion between Maiden Lane III and Goldman Sachs reflected the Federal Reserve paying Goldman Sachs the face value of the securities (approximately $14 billion) less the collateral (approximately $8.4 billion) we already held on those securities. Goldman Sachs then spent the vast majority of the money we received to buy the cash bonds from our counterparties in order to complete the settlement as required by the Federal Reserve.

While our direct economic exposure to AIG was minimal, the financial markets, and, as a result, Goldman Sachs and every other financial institution and company, benefited from the continued viability of AIG. Although it is diffi cult to determine what the exact systemic implications would have been had AIG failed, it would have been extremely disruptive to the world’s already turbulent financial markets.

Our Activities in the Mortgage Securitization Market
Another issue that has attracted attention and speculation has been how we managed the risk we assumed as a market maker and underwriter in the mortgage securitization market. Again, we want to provide you with the facts.

As a market maker, we execute a variety of transactions each day with clients and other market participants, buying and selling financial instruments, which may result in long or short risk exposures to thousands of different instruments at any given time. This does not mean that we know or even think that prices will fall every time we sell or are short, or rise when we buy or are long. In these cases, we are executing transactions in connection with our role of providing liquidity to markets. Clients come to us as a market maker because of our willingness and ability to commit our capital and to assume market risk. We are responding to our clients’ desire either to establish, or to increase or decrease, their exposure to a position on their own investment views. We are not “betting against” them.

As a market maker, we assume risk created through client purchases and sales. This is fundamental to our role as a financial intermediary. As part of facilitating client transactions, we generally carry an “inventory” of securities. This inventory comprises long and short positions. Its composition reflects the accumulation of customer trades and our judgments about supply and demand or market direction. If a client asks us to transact in an instrument we hold in inventory, we may be able to give the client a better price than it could fi nd elsewhere in the market and to execute the order without potential delay and price movement. This inventory represents a risk position that we manage continuously.

In so doing, we must also manage the size of our inventory and keep exposures in line with risk limits. We believe that risk limits are an important tool in managing our firm. They are established by senior management, and scaled to be in line with our financial resources (capital, liquidity, etc.). They help ensure that regardless of the opinions of an individual or business unit about market direction, our risk must remain within prescribed levels. In addition to selling positions, we use other techniques to manage risk. These include establishing offsetting positions (“hedges”) through the same or other instruments, which serve to reduce the firm’s overall exposure.

In this way, we are able to serve our clients and to maintain a robust client franchise while prudently limiting overall risk consistent with our financial resources.

Through the end of 2006, Goldman Sachs generally was long in exposure to residential mortgages and mortgage-related products, such as residential mortgage-backed securities (RMBS), CDOs backed by residential mortgages and credit default swaps referencing residential mortgage products. In late 2006, we began to experience losses in our daily residential mortgage-related products P&L as we marked down the value of our inventory of various residential mortgage-related products to reflect lower market prices.

In response to those losses, we decided to reduce our overall exposure to the residential housing market, consistent with our risk protocols—given the uncertainty of the future direction of prices in the housing market and the increased market volatility. The firm did not generate enormous net revenues or profi ts by betting against residential mortgage-related products, as some have speculated; rather, our relatively early risk reduction resulted in our losing less money than we otherwise would have when the residential housing market began to deteriorate rapidly.

The markets for residential mortgage-related products, and subprime mortgage securities in particular, were volatile and unpredictable in the first half of 2007. Investors in these markets held very different views of the future direction of the U.S. housing market based on their outlook on factors that were equally available to all market participants, including housing prices, interest rates and personal income and indebtedness data. Some investors developed aggressively negative views on the residential mortgage market. Others believed that any weakness in the residential housing markets would be relatively mild and temporary. Investors with both sets of views came to Goldman Sachs and other financial intermediaries to establish long and short exposures to the residential housing market through RMBS, CDOs, CDS and other types of instruments or transactions.

The investors who transacted with Goldman Sachs in CDOs in 2007, as in prior years, were primarily large, global financial institutions, insurance companies and hedge funds (no pension funds invested in these products, with one exception: a corporate-related pension fund that had long been active in this area made a purchase of less than $5 million). These investors had significant resources, relationships with multiple financial intermediaries and access to extensive information and research flow, performed their own analysis of the data, formed their own views about trends, and many actively negotiated at arm’s length the structure and terms of transactions.

We certainly did not know the future of the residential housing market in the first half of 2007 any more than we can predict the future of markets today. We also did not know whether the value of the instruments we sold would increase or decrease. It was well known that housing prices were weakening in early 2007, but no one—including Goldman Sachs—knew whether they would continue to fall or to stabilize at levels where purchasers of residential mortgage-related securities would have received their full interest and principal payments.

Although Goldman Sachs held various positions in residential mortgage-related products in 2007, our short positions were not a “bet against our clients.” Rather, they served to offset our long positions. Our goal was, and is, to be in a position to make markets for our clients while managing our risk within prescribed limits.

Looking Ahead
We want to recognize the extraordinary focus and commitment of our people despite the turbulence and challenges of the past year. In many ways, our financial performance masks the considerable pressures and distractions that we had to confront. Of course, in this way, we are no different from many other organizations that are coping with a complex and difficult environment. But, our people stayed focused, they worked together, and, today, we are well-positioned to continue delivering strong returns for our shareholders.

Heading into 2010, we are gratified that our core constituencies—our shareholders, our clients, and our people—remain close and committed to Goldman Sachs. Our shareholders continue to convey a strong belief in our business model and strategy, and in the importance of protecting the quality of our franchise. Our clients look to us to advise, execute and co-invest on their most significant transactions, translating into strong market shares. And our people remain as committed as ever to our culture of teamwork, to the belief in their responsibility to help allocate capital for the benefit of clients, and to the firm’s tradition of service and philanthropy.

As the last two years demonstrated, no one can predict the future. While we are encouraged by the prospects for a sustainable economic recovery, we continue to place a premium on conservatism and prudence. At the same time, we are focused on opportunities that can continue to grow our business and generate industry-leading returns through the strength of the firm’s core attributes. We have a clear strategy to integrate advice and capital with risk management for our clients. We have a diverse set of businesses. We have an expanding global footprint. We have established a proven culture of risk management. And, we have deep client relationships with a broad range of companies, institutions, investing organizations and high-net-worth individuals.

We are keenly aware that our legacy of client service and performance, which every person at Goldman Sachs is charged with protecting and advancing, must be continually nurtured and passed on from one generation to the next. To our fellow shareholders, we are pleased to report that we have never been more confident of that commitment or long-term outcome.

The SEC announced that Kathleen M. Griffin will serve as the agency’s first CCO. Griffin was vice president, senior compliance manager, and deputy code of ethics officer at Putnam Investments.

Edward L. Pagano was elected CEO of ENGlobal. Pagano comes to ENGlobal from WorleyParsons Group.

Pacific Office Properties named James R. Wolford CFO. Wolford is the former CFO of Bixby Land.

Vincent A. Paccapaniccia joined CSS Industries and will serve as the company’s CFO. Paccapaniccia recently served CFO of ICT Group.

InterDigital appointed Jeffrey K. Belk to its board of directors. Belk is the former senior vice president of strategy and market development at Qualcomm.

Do we, in your opinion, have a good rationale for when we bail out institutions?

The short answer is that we’ve bailed out too many institutions. If we had a good rationale, then we might decide that there are 10, 20 or even 30 financial institutions that are too big to fail. But we’ve recapitalized over 600 institutions. We need an articulated rationale for these bailouts.  In my view, there are two good reasons for rescuing a troubled bank. First, if it is critical to the functioning of the payment system—the processing of checks and wires—and, second, if the insolvency of this institution would probably cause widespread failures in the entire financial system. That probably was true in the cases of Freddie Mac and Fannie Mae.

We also need a more disciplined process. Right now, if you yell systemic risk in a crowded room, we bail you out. The Treasury Secretary needs to write down on a piece of paper the specific reason for bailing out this institution, and make that public. Then we should have an independent body like the GAO do a review of every bailout after the fact. Through that process, we could start to develop some sense of whether these bailouts achieved their objectives.

It also seems that when we do these bailouts, Treasury is taking preferred stock with warrants. Does that make sense, particularly from a taxpayer perspective? Is that something we all should be concerned about?

This is one of the main themes of my book. I call it one-way capitalism. If taxpayers are going to bail out these institutions, we own the downside. However, we really don’t own much of the upside…If we’re going to bail out institutions in the future, the Treasury should take back a lot of warrants, or perhaps in some cases common stock. When JP Morgan redeemed the Treasury’s preferred stock, the Treasury realized almost $1 billion of profit on its warrants.  But we as taxpayers should have received more than six times the amount of warrants and six times the amount of profits. We need those profits on the successful rescues to offset the losses that taxpayers are likely to incur on AIG and Bear Stearns.

How much blame do the boards have for what went wrong in the financial crisis?

I don’t think that the boards bear the most blame for the financial crisis. There are a lot of other groups and a lot of other factors that were more important. But on the specific question of the compensation system, a lot of boards dropped the ball.  They approved a lot of bonuses based on one-year performance, and that performance soon evaporated. They didn’t require deferral of cash bonuses in many cases, and they often went along with guaranteed contracts and golden parachutes regardless of performance.

So, let’s say we get it right, and boards are composed the right way. Can they alone hold management accountable, particularly in financial services?

When we think about holding management accountable, we need to think about both the bondholders and the shareholders, as well as boards. One of the most unfortunate things about this financial crisis is how we’ve taken bondholders out of play. Financial institutions have issued $340 billion of guaranteed debt, in which the government is guaranteeing 100 percent of their debt. We have bailed out the Bear Stearns’ bondholders, some of the most sophisticated investors in the world. We’ve also directed AIG to pay out 100 cents on a dollar to very sophisticated investors on the other side of its credit default swaps.

If large bondholders never take a loss, they are going to stop being careful in choosing bonds; they are not going to push management to avoid excessive risks. This is moral hazard in the worst sense. If we want to hold bank executives accountable, we need to bring large bondholders back into action. That can best be done by requiring all large banks to issue subordinated debt, which would not be protected by the federal government if such a bank became insolvent.

The most important change in the shareholder area is one that’s already happened—stricter rules on when brokers may vote the shares held in the accounts of their customers.  In most public companies, the “broker vote” involved 30 to 40 percent of the outstanding shares. Under prior rules, the brokers didn’t need instructions from their customers, and they tended to vote for management. Now, under the new rules, brokers can’t vote without their customers’ instructions, and therefore, they usually won’t vote. So that means a substantial shift of power from management to institutional investors, who normally vote their shares in every corporate election. Hopefully, institutional investors will use that new power intelligently.

What you’re suggesting relative to smaller boards and more focus on the business, is that applicable to boards across the board?

I would think that the new model should apply to very large and very complex companies. If you’re a     director of such a company, you really should spend a lot more time on the board, and you should try to get on top of what the company is doing.  In such a company, the board should be more professionalized.

There’s been a lot of discussion about the failure of the boards of mega-banks to adequately assess risk.  How serious a problem is this?

The directors of many megabanks do not seem to have fully understood the risks being taken by these banks. In part, this may have happened because of undue reliance on internal risk models like VAR (variance at risk). VAR measures a bank’s risk exposure over a very short period, like a day or a week.  Moreover, VAR covers risks only to a 98% degree of profitability. In other words, it does not deal with risks beyond the second standard deviation in a normal distribution curve.

However, the most important risks often materialize over much larger time periods, such as a year.  And some of the most catastrophic risks have a probability of less than 2%, but they can destroy a company.  So directors should not be lulled into complacency by risk models like VAR. Similarly, under Basel II, regulators currently allow large banks to set their own capital requirements based on their own internal assessment of the riskiness of their assets.  This approach has at least three flaws. First, Basel II has a built-in conflict of interest – banks have an incentive to set their capital requirements at relatively low levels.

Second, the internal risk models of many banks turned out to be wrong – for example, some assumed U.S. housing prices would fall only once in 50 years. Third, these risk models are so complex that they cannot be understood by most bank directors, unless he or she happens to have a PhD in math from MIT.

Directors should insist on a clear delineation of all the assumptions underlying these risk models, and then push back hard on the validity of these assumptions.  In the final analysis, quantitative models are not substitutes for common sense.

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