Eliot Spitzer’s investigations into the mutual fund and investment banking industries have made the New York State attorney general the de facto flag bearer of corporate reform. His exposure of conflicts of interest between investment bankers and research analysts in Wall Street firms led to the $1.4 billion global settlement between regulators and banking houses in 2003. His office has since made news with its revelations of misbehavior in the mutual fund industry. Spitzer is a graduate of Princeton University and of Harvard Law School, where he was an editor of the Harvard Law Review. HBR consulting editor Louise O’Brien visited Spitzer in his New York City office. In this edited conversation, he shares his thoughts on the underlying causes of the recent improprieties, reminds us that the client is more than a bottom line, and urges all business leaders to reinstill throughout their organizations the critical notion of a fiduciary duty—whether it is to the shareholder or the customer. Using the mutual fund industry as an example, he contrasts the value of enforcement with that of regulation and articulates an important—and surprisingly limited—role for government in protecting free markets. What is the nature of the problem we are seeing here? Have standards for business conduct declined, or are we just paying more attention? A decade ago, Senator Daniel Patrick Moynihan warned that the level of deviant behavior in our society had surpassed what the community could “afford to recognize,” and as a result, we have been redefining deviancy “down” so that conduct that was previously stigmatized is now acceptable. I think that is what we are really seeing in this recent rash of business scandals. There has been an incremental dissipation of standards over time. We grow more comfortable with improper behavior in steps. In the example of Enron, the first step was a single off-balance-sheet partnership that management said was not material. And technically that might have been correct. But then the number grew to five, to ten, to 100, and suddenly it was completely out of control. Where along that slippery slope did Enron cross the line? Where did the financial statements become fundamentally misleading? It can be hard to pin down exactly where the descent into the abyss occurs. But the problem is more than a few bad apples? The executives and companies that are guilty of wrongdoing are clearly a small minority. However, my office is investigating problems that are both material and pervasive. The real issue we’re looking at is conflict of interest—how it starts and how it gets institutionalized. In the mutual fund industry, the exponential growth in assets under management, combined with the fact that the assets don’t move around a great deal, probably explains how conflict of interest became institutionalized. A rational economist would say these funds should be more mobile. Investors should move their money from one fund to another depending on performance and pricing in a much more aggressive manner than they currently do. But that doesn’t happen. If you are a fund manager dealing with static assets that are growing, and you find that you can impose additional (and undisclosed) fees without losing your market share, you do it. What’s rational behavior on the part of the managers is not good for the investor, or consumer. That’s the definition of conflict of interest and should be a red flag to anyone in a regulatory position. We’re the ones who must say, “Wait a minute. The board, which should be speaking for the investor, is not fulfilling its mandate.” That’s why I’m as interested in the structure of mutual fund fees as I am now. Regulators should have been doing a better job all along of mediating these kinds of conflicts—making managers conscious of how they mix the different services they provide across product lines. I think the leaders of these entities (much to their dismay, I’ve gotten to know most of them over the last couple of years) are now well-attuned to the problem. And that’s an important first step. So the problems in mutual fund companies were not the result of free competition but an example of where competitive markets failed to function efficiently? You get that sense. If every investor got his or her money back every December 31 and needed to make a reallocation decision on January 1, you doubt that the funds would be allocated the way they are. So there is an inertia that keeps the funds where they are and that defies rational analysis. Experts in the financial services industry will tell you that an industry that began by marketing itself based on performance and attentiveness to the needs of the investor became over time an industry based on marketing, pure and simple. And the managers who in the early stages of the industry’s development were actually in charge of their own portfolios—and also in charge of the companies—lost power within the companies to the pure marketing types. That’s why 12(b)1 fees (which allow funds to recover marketing and distribution costs from shareholders) became such a revenue generator—and a point of interest—for marketers. Portfolio managers hadn’t been focused on 12(b)1 or any other fees. Unfortunately, marketing overtook fund management as the internally perceived engine of growth. Is there a link between this marketing focus and the dissipation of business standards? Yes. The customer ceases to become important once you’ve signed him up—it’s capturing the next one that’s important. In the legal and medical professions, where you’re steeped in the notion that you are serving a client or patient and you have a duty to that person, there is some check on the notion that you want to increase the return to the bottom line. But too much of an emphasis on that bottom line means you don’t often think of the other person, whether it’s the shareholder or someone else for whom you’re a fiduciary. The emergence of the Internet—which, of course, is the ultimate marketing medium—is making the fiduciary challenge even harder. The Internet is so atomized and so distant, it can make the relationship with the person you’re doing business with more concept than reality, so there is even less sense of a fiduciary duty. Restoring the integrity of the fiduciary relationship is absolutely essential to business at this time. What is common to all of the scandals we have seen lately is that there has been a critical violation of that fiduciary duty to somebody else because of a conflict of interest or greed. How you instill fiduciary responsibility in people and organizations is the key question—whether you do it through education, or by oath, or by some other method. Are the efforts of your office and other regulatory agencies required to instill fiduciary responsibility in business leaders? I hope not. My office got involved with the wrongdoing and conflicts of interest in the investment banking and mutual fund industries because nothing was happening. The situation was not correcting itself, and it was clear it wasn’t going to correct itself. But the last entity you want to see catching these kinds of problems is government. In an ideal world, you don’t want government to be that invasive in the marketplace. What are the checks and balances that should catch problems before they get to you? Well, obviously you have to start with ethics—the ethics of the individual worker. Above that is the first layer of management, where there has been inadequate effort to instill in the front lines an understanding of how one should behave. You cannot afford to have supervisors create even an implicit sense that unethical behavior is OK as long as you get away with it. Now, the responsibility for ensuring that middle management understands fiduciary duty—that falls to senior management. And that’s why in mutual funds, the cases that have gotten me and my fellow regulators most upset are the ones where we’ve seen senior management being tolerant of rank abuses. Because then you really know that the entire structure is rotten. When you have someone at the very bottom who has done something improper, but above that in the hierarchy there are good people with good values trying to catch it, that’s one thing. But when you have the CEO of a company trading against the interest of a fiduciary, that really tells you something is amiss. Of course, there are also checks and balances like internal compliance and company governance, as well as industry self-regulation. Reinstilling vigor in any of these layers would keep cases from getting to me. But there has been a void in values in a lot of boardrooms—not all, of course. The number that reflects that is the ratio of average CEO compensation to the pay of the average worker, which went from 41:1 to 411:1 between 1980 and 2001. This suggests that somehow the power within the corporation is being used to shift wealth toward management—another example of pervasive conflict of interest. How has company governance failed to check the conflicts and abuses we see? Trying to figure out who you want on the board of any company—and how you’re going to get those individuals to fulfill the board mandate more effectively—has probably been the single most important question facing corporate governance over the last five years as we’ve seen breakdown after breakdown. There are some who think independence isn’t the right attribute to look for. They want insiders who know the company and have lived it intimately. But they want the honest insiders. Their theory is that independent board members don’t know enough and can’t know enough. These are very smart people, whom I respect, and I hear their argument. And I don’t think we should discount the value that is added by board members who really have lived inside the company. However, I still think that the paradigm of independence is what we need. When it comes to mutual funds, having 75% independent board members is one of the critical things that must be done—and even that is not necessarily sufficient. Can we ever get truly independent board members? Yes, but it’s going to be hard. Until now, the pool of board candidates has been a limited universe of people who have been playing ball with the industry, who are all from the industry—usually from management—and these people have never had sufficient incentive to rock the boat in the way an aggressive independent board member should. This problem, by the way, is not unique to mutual funds—it’s the same whether it’s Enron or WorldCom or a not-for-profit. Just look at the NYSE and the compensation package of Richard Grasso. We’ve got to come up with a better way of choosing and giving incentives to boards. Organizations like the Business Roundtable or the Corporate Councils of America or even investor associations could put together rosters of qualified independent board candidates. Choosing boards is certainly not a role for government. As for how effective boards are, well, there’s lots of evidence that they haven’t been holding management to account. In mutual funds, for example, we found that agreements between managers and providers of basic services such as transaction processing and record keeping are not renegotiated on an ongoing basis, so cost competition can’t benefit the shareholders. But we have yet to see boards going back to the managers and firing them for not managing costs aggressively. The financial services industries you’ve investigated are heavily regulated. How did the regulatory framework fail? Was it a failure of design or enforcement? It was a failure of regulatory behavior. I’m not sure the regulations as such were wrong. But the regulators who were supposed to see unethical behavior clearly didn’t. In the mutual fund context, it was a failure of enforcement, not rules. Late trading, timing—these practices were clearly against the rules. So that was an enforcement problem. In investment banking, where the issue was the work of research analysts, the problem was more that the banks’ business model was flawed. And the regulatory entities that were supposed to catch that didn’t do so. The rules that were supposed to be there didn’t catch it. The problem arose because inside the investment banks, research didn’t have a revenue stream attached to it. The only way to make research pay for itself was by embedding it in investment banking and using it as bait for corporate clients. But that compromised the research that investors should have been able to rely on. And when we finally woke up to that fact, every investment bank was doing it. It could be considered a failure in regulation, although we hesitate to say that because we don’t want to excuse those who were committing the offenses. The actors should have understood that they were violating some principles of fair dealing. When you’re putting out research that you think is flawed, you shouldn’t say, “Well, no regulatory action can be taken; therefore, we’re OK.” The proper response should be, “What has happened to the core integrity of our research?” And those questions were not being asked. The reason that a lot of this happened is that quantum increases in scale can create conflicts if left unchecked. Mutual fund assets are now at $7 trillion. Twenty or 30 years ago nobody reasonably would have predicted either the proliferation of funds or the size of the funds. Yet, this growth happened by design. The changes in regulatory policy—the repeal of Glass Steagall and other barriers—were designed to create financial sector companies with deeper capitalization that were better equipped to compete with European and Asian financial entities. Now, having fully integrated financial services companies may make sense. Looking back on it, deregulation should probably still be viewed as a good thing, but you might do it differently. Glass Steagall was finally repealed in 1999, but it had been administratively dismantled over a period of 20 to 30 years before that. What had once been a rigid barrier separating banks from brokerage and insurance was becoming Swiss cheese—almost to the point of incoherence. Some redefinition of how the different pieces needed to interact was necessary. Whether we should have simply lifted the barriers and said, “Go at them,” without installing some additional protections, I don’t know. I think there’s a case to be made that this was not a smooth transition—just look at the number of scandals we’ve had. What is the appropriate role for government and the law? Are you charting new territory? The correct role for government is to intervene, when necessary, to make the market work properly. Where we see flaws in the marketplace’s functioning, we need to step in to say, “Wait a minute—why is the market broken down, and what can we do to fix it?” I think there has been a fair bit of confusion over how I justify some of the things we’ve done—either with investment-bank research or with mutual funds. Some people are saying, “You’re trying to fix prices,” or, “You’re trying to define what is good research or bad research.” Not at all. Last year with the investment banks, we were trying to ensure that the conflict of interest that almost inevitably would taint research (when research was essentially embedded within investment banking) was at least addressed, if not overcome, by pulling research out of investment banking and, at a minimum, pulling compensation for analysts out of investment banking. Government is the last recourse for addressing significant breakdowns in free-market functioning. People who simply lapse into the rhetoric of “Let the market deal with it” don’t really understand what the marketplace is doing successfully or failing to do. Because if mutual fund fees were set in a world of perfect competition and perfect rational behavior (as the Chicago School economists presume), then the fees would be substantially below where they are right now. And so we need to look perhaps at disclosure as it relates to pricing, disclosure as it relates to performance, and how fees are set. I don’t think our office is breaking new ground—we are merely pursuing the same objective in a different business context. Take antitrust laws—they’ve been around for over a century and are driven by the notion that we believe in a competitive marketplace and that monopolistic behavior is counter to the economic model we believe in. Government stepped in to say there is almost inevitably a desire to move to monopoly behavior, and therefore we want to stop that—to ensure that the free market can survive. So defining those rules of free-market behavior through antitrust enforcement is as old as our understanding of the current marketplace and has worked reasonably well. Sure, there are always going to be debates about antitrust doctrine, but in principle, our antitrust laws have worked well, and that is agreed upon whether you’re Milton Friedman or Judge Posner or someone far to the left of either of them. So what we’re doing here by defining rules of behavior that ensure competition, transparency, and the free flow of information is conceptually no different. It just happens to be imposed upon a conflict of interest, or type of behavior, between research analysts and investment bankers, as opposed to two competitors who sit in the back room and fix prices. But it’s the same objective: to make the market work well. Securities laws that were passed as far back as the early 1930s—New York State’s Martin Act, for example—preceded the federal securities laws. Everybody says, “You dredged up the Martin Act,” but it was the predecessor of the federal securities laws. It was about the same principles of transparency, fair disclosure, and honesty. That’s all we’re trying to do. It is conceptually identical to what has been done as far back as Teddy Roosevelt when he broke up the steel trust and sugar trust. Same concept, just a different business structure that we have to look at. Your office has become the leader of the reform movement. Is there a reason New York’s attorney general has been able to accomplish goals that other government agencies could not? When Arthur Leavitt was chairman of the SEC, he tried to raise the alarm about the conflict of interest between the audit and consulting arms of the big accounting firms. But the AICPA [American Institute of Certified Public Accountants] stepped in and was able to wield significant persuasive powers on Capitol Hill, to the point where members of the Senate and the House would call Arthur and say, “Hey, if you do that, you’re going to get your funding cut.” When some good ideas were floated about mutual fund reform, the ICI [Investment Company Institute] stepped in and complained. When we were going after some improper practices at the investment houses, the SIA [Securities Industry Association] lobbied for preemption down on the Hill. So, federal agencies such as the SEC are hampered by the lobbying efforts of what I call these alphabet entities that are there to represent the status quo and the powerful voices in the financial services sector. Our office has not traditionally been lobbied in the same way, although I’m not ready to say we’re beyond it. It may be that now that they’ve taken notice of other players—AG offices and state securities regulators—they will start to pay attention to us in a way that might dissuade some of us from pushing for reforms. But because we are not a rule-making body, and we’re not a legislative body, we have less contact with lobbying groups, and theoretically we’re not as susceptible to them. I think it is also hard to keep regulatory agencies in any sector as nimble and tough as they should be over a period of many years. That’s why you see agencies going through periods of appropriate vigor, and then they become unfortunately quiet. How do you keep an agency like the SEC—or even my agency—on its toes? I like to think we’re being pretty aggressive now, although properly modulated and all the rest, but there are times when I’m sure this office needs to be awakened and pushed in certain areas. How you do that is still one of those management mysteries we’re working on. So have you found an alternative to traditional regulation that is a more effective way to use the law? For some kinds of cases, I think so. Sending CEOs to jail works as a deterrent. Sarbanes-Oxley is viewed by those who don’t like it as a process response to a values issue. And they say process will never teach values. On the other hand, what Sarbanes also does is create exposure and give other regulators the capacity to impose penalties that really will shake up the corporate boardroom. And that is good. I may be Pollyannaish, but I think there’s been a real change in the way boards are operating. Is it because of Sarbanes? Or is it because Waksal’s now in jail and there is a litany of trials pending? It’s not altruism, and it’s probably not the paperwork. It’s enforcement. One jail term is worth a lot of compliance officers. And it doesn’t require you to create a whole new bureaucracy. It’s why I like what we’re doing. “It’s not altruism, and it’s probably not the paperwork. It’s enforcement. One jail term is worth a lot of compliance officers.” We use the same logic in criminal law. We bring criminal cases and civil actions all with an objective of general deterrence and sending messages to the marketplace. A lot of what we have done in the last couple of years has been to try to follow a strategy to use our limited resources and limited enforcement power strategically—to send signals about what is and is not permissible. We have been criticized for settling in some cases, but sometimes you choose to settle because the other side concedes everything. We’ve taken a fair number of pleas in the criminal cases we’ve brought in the mutual fund business. When they agree to plead guilty to a felony, we’ve made our statement, and a sentence will be imposed. Somebody is off to do one to two years state time. There will be more. That is unambiguous victory. Other times you settle and save yourself the resources of litigating if you can establish the rule of law that you want the marketplace to see and can lay out the facts so everyone understands what happened. I think the global deal last year with the investment banks pretty much got us to that point. Way back, in fact, in the negotiation with Merrill, the critical factor that prevented a settlement early on was its demand that we seal all the records. That would have eliminated the general deterrence value—and also the educative value of laying out to the public what had happened—and would not have permitted us to build on that case. So in that instance, I refused to settle. That kind of settlement becomes merely internalization of a cost of doing business, and they go on doing what they were doing. Because we were more aggressive—and I think rightly so—we laid out the facts over the course of a number of months and hopefully got the appropriate change in the rules. But just to state the other side—not that I agree with it—at the end of the day, concern about having too many regulatory agencies cannot be ignored. It is not a frivolous issue to think through a rational business structure for regulation. Is public exposure an integral part of your reform strategy? Absolutely. If we had settled the Merrill case, and it had faded into oblivion, or settled the Canary case with Eddie Stern under a cone of silence—those cases would have been just isolated pin dots, as opposed to becoming part of an overall picture of change in behavior and market rules. So that is where these cases become strategic vehicles. On an individual level, threat of prison works as a deterrent, but so does shame—the fear that even if they don’t send me upstate, my name and my company will be splashed across headlines. So creating that concern of public embarrassment can be a very good motivator. The fact of the matter is journalists are often way ahead of regulators and also have—and should have—lower standards of proof. You need less support to write an article than to indict someone, so it’s easier for journalists to move information out into the public. What advice would you give leaders of public companies to make sure they don’t have Eliot Spitzer coming after them? Well, first and most important, I think business leaders have to make it clear throughout their companies that there is a zero tolerance standard—one infraction of a real ethical mandate and you’re gone. There are no excuses, and there are no explanations. It may sound harsh, but in order to recoup what we’ve lost, we need to begin with this approach. Second, I’m sure I don’t need to remind business managers that conflict of interest can be bad for business. For example, when a business partner says, “We’ll give you a $2 billion line of credit if you bring underwriting business to us,” it may sound good on day one, when you get the underwriting fee. But then you’ve got a $2 billion line of credit out there. And when it’s drawn down by a party like WorldCom that goes bust, suddenly your balance sheet doesn’t look so good. So there are business reasons not to permit conflicts to drive judgments. Finally, I don’t believe corporations can fully regain the public trust without addressing the issue of executive compensation. As long as the public sees what it believes to be greed, there is a problem. The public is pretty discerning about what is over the line. I don’t think the public in any way resents Bill Gates’s income or wealth, because there is a core understanding that it was his equity, he created it, and we reward that. That’s the beauty of our system. There is a different attitude toward managers who are taking for themselves wealth that should have gone to the shareholders. I think the public gets that. They may not talk about it in terms of fiduciary duty, but they understand conflict of interest. In many cases, executives are carving out more than they are entitled to and getting away with it because of a system of compensation committees and consultants who say, “I want my CEO to be in the 75th percentile.” It’s like grade inflation—everyone goes through the roof! The system is busted. There is also a lesson there about the law of unintended consequences—because options, which were supposed to be the miracle answer (give management options so that they do well if and only if shareholders do well) turned out not to be so good. Those who argue that this is nothing more than a free market for talent are presuming that the decisions about how to value that talent are being made in an arms-length fashion, based upon real value added to the fiduciary. Instead, we have board compensation committees that are self-selected and interwoven—it’s a rigged marketplace. I’m not saying government should ever tell a CEO what he or she should be paid, any more than we should set the fees for mutual funds. But let’s make the market work and get rid of the conflicts of interest. It would be interesting to see what the world would look like if CEO pay packages had to be submitted to shareholder votes. At under $10 million, they would probably pass. But at $150 million? People would call the printer and say, “You put extra zeros in here, why didn’t anyone catch it?” “It would be interesting to see what the world would look like if CEO pay packages had to be submitted to shareholder votes.” Somehow we’ve created this managerial class apart from equity stakeholders that has empowered itself in a whole host of ways. Restoring the fiduciary relationship will return power to the shareholders. I say institutional shareholders have failed to step up to the plate. They are the last hope, in a certain sense. Small shareholders can’t do it—we know that. But you get your major pension funds and mutual funds, which control the equity, and instead of putting the time and energy into management and reining in management, they trade out of their positions and say, “It’s not my problem any more. Boom. Clear out of that company.” And so we have this power void into which CEOs have stepped. Not long ago, I gave a lunch talk to institutional shareholders. They loved the first half because I was pointing the finger at the investment banks, boards, and auditors. Then I said, “Let’s not kid ourselves. You’re the problem because you have the power to do this unilaterally. You don’t need a regulator to step in to support you. You can just stand up and say, ‘We own you.’” If Calpers and ten other pension funds got together and said to companies, “We won’t buy your shares if you don’t cap CEO compensation and require a shareholder vote on anything that goes above the cap,” the companies would have to do it. Equity can trump state corporate law and the SEC because it is equity. And that is the power institutional shareholders have failed to exercise.
