The Failure of Corporate Governance
A reckless pattern of behavior was common to the massive failures at Fannie Mae (FNM), Freddie Mac (FRE), AIG, Lehman (LEHMQ.PK), Merrill, Bear Stearns, Citigroup (C), Wachovia, Countrywide and Washington Mutual, et al.
They all had Boards of Directors who as fiduciaries were charged with oversight responsibility through a duty of care obligation, but who presided over operations that: i) bet the business on a massive leveraging of minimal enterprise equity; ii) used such leverage to produce extraordinary non-cash “profits” that ended up as toxic assets on the balance sheet; and iii) then authorized generous bonus payments – substantially in cash – to senior management for the production of those illusory non-cash balance sheet “profits”.
While reasonable people may disagree on the proper role of the Board in the management of the enterprise, even advocates of a minimalist approach would acknowledge that: i) enterprise risk management and ii) executive compensation are core responsibilities.
It's difficult to see the collapse of these entities as anything other than a failure of the respective Board's duty of care to protect the well being of the enterprise and its shareholders and to fairly and equitably administer executive compensation.
Congress Lurches Toward Corporate Governance Reform
It is nearly impossible to overestimate the magnitude of the public anger relating to the combination of failed enterprises requiring tax dollars for survival and generous pay packages to the executives that inflicted the damage.
Predictably, when the “public mob” gets riled up, Congress feeling pressure from voters weighs in. And as usual, while pandering to the angry mob, Congressional action is prone to embrace appearance over substance, and to be enlightened by hindsight and not foresight.
Recent action (March 19, 2009) by the US House of Representatives when it voted by a margin of 328-93 to impose a 90% tax rate on bonuses paid to recipients of TARP funds, illustrates a simple principle: when Congress gets involved in decision making, its decision will be driven by political considerations, not economic ones. Allowing political considerations to drive the governing reforms of Corporations – essentially economic entities – is a prescription for disaster.
Corporate Governance Standards Is Routine Business at NYSE
NYSE listed companies are subjected to listing qualifications. Some of these are quantitative – minimum number of shareholders, minimum stock price, minimum book value and minimum market capitalization to list a few. Some are qualitative in nature such as “nature of a company's business, market for its products, reputation of its management, historical record and pattern of growth, financial integrity, demonstrated earnings power, and future outlook.”
Additionally, NYSE listed companies must conform to a set of corporate governance requirements that include Director Independence, Audit Committee Charter and composition and Executive Compensation to list a few. Annually, NYSE listed companies are required to certify compliance.
In effect, the NYSE is already in the business of imposing corporate governance standards on its listed companies. By aggressively enhancing this effort, in a high profile and public way, the NYSE can claim ownership of the issue and drive common sense corporate governance reform. A successful effort will benefit the NYSE, its listed companies, public confidence and the global economy. It also offers an opportunity to preempt Congress, get politics out and restore sanity to the reform effort.
Interests of NYSE, Listed Companies and Free Market Capitalism Intersect
It's a fair question to wonder why a listed company would welcome more robust corporate governance standards imposed by the NYSE?
A recent Rasmussen survey published on February 18, 2009 found that only 22% of Americans have a favorable opinion of the CEOs of America's largest companies – an historic low. They rank even behind the US Congress at 26% favorable. It's as though Americans intuitively know that corporate governance has failed and the big public company CEO is the face of that failure.
The discontentment revealed in the survey shows why Congress went head long into the issue of executive compensation. Having usurped the role of Compensation Committees, the “camel's nose” is now under the tent. Unless private actors can reverse the public sentiment, Congress's “reform” effort will expand.
If private actors fail to pro-actively address the failure of corporate governance, and don't champion a substantive common sense reform effort, the resulting vacuum will be filled by Congress. Private actors will then rue the day they failed to act, having implicitly invited Congress in for a politically motivated effort.
Listed companies that consent to a more rigorous NYSE imposed common sense corporate governance standard, will make a significant move toward restoring public confidence in: i) their enterprise; ii) the NYSE; and iii) free market capitalism.
If there's one lesson of the recent meltdown, the collapse in confidence, caused by a few bad actors, has adverse consequences for enterprises that behaved honorably including: i) reduced economic activity resulting in reduced sales and profits; ii) lower stock prices and enterprise values; and iii) reduced availability of investment capital.
Restoring confidence in the US financial and economic system is the bedrock of a brighter future and an NYSE led common sense reform effort could play a pivotal role toward restoring confidence in the private sector, free enterprise and global capitalism.
Rigorous But Common Sense Reforms
Common sense reform needs to be substantive and the non-negotiable driving principle must be to end the cozy relationship between management and the board and to more closely align the board with those that it represents through election – shareholders. Coziness between the Board and management undermines the Boards ability to provide substantive oversight. Proposed “common sense” reforms are summarized below.
Require Independent Chairman of the Board
It is a conflict of interest for the CEO who heads the operation, to also lead the Board-- the shareholders body responsible for oversight of the operation. Combining the titles effectively gives the CEO oversight responsibility of its own operation.
As a practical matter, with a dominant CEO and Chairman, it takes only one bad actor to take down an enterprise. With divided leadership, a proactive, Independent Chair offers an enhanced probability that the oversight body will identify and mitigate enterprise threatening risks before they materialize.
Limit Director's Term to Maximum Two Years Between Elections
Self serving, entrenched Boards can theoretically be removed by irate owners who fight and prevail at the ballot box through a proxy fight. The difficulty of prevailing at the ballot box is a function of the length of term between elections. For example, Boards that have terms of length of three years, only have one third of its Directors standing for election annually.
For dissident owners to gain a majority of the Board through proxy, they will need to prevail in at least two election cycles. As a practical matter, the path of least resistance for disgruntled shareholders is to sell their shares, take losses and move on.
Permit Majority of Shareholders to Select / Relocate State of Incorporation
With corporate law generally the jurisdiction of the states, and management substantially in control of deciding which state to incorporate in, a perverse “market” dynamic exists today that encourages state governments to erect management friendly corporate law for competitive advantage. Management then decides to incorporate in states most friendly to its interest and conversely most unfriendly to shareholders. It's a management lead race to the bottom for the shareholders of the enterprise.
If a majority of shareholders were permitted to decide – through proxy – the state of incorporation it would fundamentally alter the “market” dynamics for corporate law. By empowering shareholders to decide the issue, a shareholder lead race to the top will ensue. States could gain competitive advantage by approving shareholder instead of management friendly corporate laws, then compete for the affection of newly empowered shareholders.
Limit Debt to Equity Ratio to Fifteen to One (quantitative standard)
It is nearly incomprehensible that the “best and brightest” financial institutions levered up to nearly forty to one and were “shocked, shocked” by subsequent events. When one considers the resulting balance sheet: i) composed of liabilities of substantially fixed amounts; ii) offset by assets subjected to fluctuating market values; iii) all supported by a minuscule 2.5% equity cushion, it is a clear and present danger to the enterprise.
It's just a question of when the enterprise will fail. It was a clear and present danger in the 1920s and will be again, should another credit bubble somehow be unleashed at some point in the future.
While the SEC controls net capital rules – effectively limiting leverage – the implication of excessive credit is far to destructive to rely on a single point of failure to prevent future bubbles. When the SEC approved an exemption from the net capital rule in 2004, it inadvertently unleashed over $4 trillion in both borrowing and bidding power within the big five investment banks (Goldman Sachs (GS), Morgan Stanley (MS), Merrill Lynch, Lehman Brothers and Bear Stearns) alone and assured that systemically important institutions would be at the center of the impending financial storm.
With $4 trillion in new borrowing and buying power the action assured: i) that asset prices would artificially inflate and simultaneously ii) that balance sheets populated with these inflated assets would become precarious and fragile.
An NYSE listing standard limiting debt to equity – including committing to institutional memory within Listing Qualification the lesson of the certainty of calamity that will follow an excessive credit bubble – would give subsequent generations an additional opportunity to pause and reflect before heading down the inevitably destructive credit bubble path.
Disclosure: No Positions