Sunday, September 21, 2008

History Repeats Itself: Whither Governance? (Part 2)

In the background of the boardroom failures discussed in the previous post, it is useful to explore some of the factors involving U.S. corporate governance that may have led to this situation.

1. Dispersed Shareholding and Lack of Oversight

One of the key problems involving a dispersed shareholding model (that is prevalent largely in the U.S. and U.K.) is that the individual shareholders have relatively small stakes in companies and these do not provide sufficient incentives for them to come together and form coalitions to effectively oversee the managers of companies. This is otherwise known as the collective action problem, which results in a separation of ownership and control. While the shareholders are owners of the company, the control of the company is vested with the managers, as shareholders are unable to participate in decision-making. That gives managers a freehand in the way they manage companies without substantial oversight from shareholders.

2. Director Primacy and Managerial Superiority

Due to the problems discussed above, managers are not only in a position to control the business policies of the company, but effectively also the composition of the board itself. Shareholders usually vote on a slate of directors provided by management. Due to embedded provisions such as staggered boards and poison pills, it is difficult for shareholders (or even hostile raiders) to unseat the incumbent boards and management. All this enables self-perpetuation of management with little fear of being overthrown even in the wake of dismal performance. For these reasons, although the U.S. model of corporate governance is known as the “shareholder model”, in reality there is very little that shareholders can do to constrain managerial misdeeds.

3. Pay Without Performance

Excessive managerial influence also extends to fixing managers’ own remuneration. In a book titled Pay without Performance: The Unfulfilled Promise of executive Compensation, Professors Lucian Bebchuk and Jesse Fried state that managerial influence can lead to inefficient arrangements and perverse incentives in fixing managerial remuneration that make the amount and performance-insensitivity of pay less transparent. These have resulted in CEOs and other senior officers of large U.S. corporates being paid colossal sums of money that do not necessarily correlate with the performance of the company or the value created (or destroyed) for shareholders. Golden parachute arrangements ensure that CEOs obtain large payments even when their services are terminated for poor performance. As Nell Minow notes:

“I am a capitalist. I love it when executives earn boatloads of money. But it infuriates me when they get it without earning it.

If the executives' compensation is tied to the volume of business rather than the quality of business, we should expect dealmakers to be more attentive to the number of transactions than the value they create. This is the basis for much of the sub-prime mess, whose collateral damage is taking down the biggest firms on Wall Street.

The boards of directors approved pay that was completely disconnected to performance. This, after all, is the world of the ultimate oxymoron: the "guaranteed bonus." So we should not be surprised that executives took the money and ran.

Fewer than 13 percent of public companies have claw-back policies requiring executives to return bonuses based on inflated numbers. All of the incentives are for them to inflate the numbers, take the money, and run.

And that is why companies whose names used to be synonymous with stability and trustworthiness will live on through history and business school case studies as discredited, greedy and corrupt.”
Such arrangements for pay, whether in the form of salary, bonus or even stock options encourages short-termism that incentivizes managers to boost short-term profits of their companies and earn large sums of moneys, but at the cost of the interests of shareholders that tends to be relatively longer term. This mismatch of expectations and incentives makes managers take decisions that may in the end cause their downfall as we have seen in the recent failures.

What is even more troublesome is the fact that remuneration of directors and senior managers is fixed by the board (or compensation committee), with no approval required from shareholders for fixing such remuneration. In other words, shareholders have no “say on pay” that is mandated by law, although there are proposals on the cards for requiring shareholder approval (at least on a non-binding basis).

4. Lack of Responsiveness on the Part of Boards

Leading shareholder activist, Carl Icahn, notes on his Blog, The Icahn Report:

“What has transpired in recent weeks with Lehman Brothers, AIG, Fannie Mae, Freddie Mac and Merrill Lynch is shocking. The dominoes keep falling on Wall Street from a mismanaged credit crisis, causing economic disarray, huge job losses and pain on a global scale.

In each case, the root cause seems to be excessive risk-taking by managements, or worse, managements that weren’t sufficiently aware of the risks their companies were taking and how it may impact their businesses.

Who was supposed to be watching these managers? Where were the boards of directors that are supposed to be overseeing these executives? I’m not going to judge the individual boards of these companies in what they did or should have done, but consider the following.

All too often compliant boards are intimidated by managements in their cushy, well-paid worlds and refuse to rock the boat by asking hard questions and demanding CEO accountability. Why is this so? Because of excessive board compensation and allegiances to those who provide it.”
That leads to the issue of who were the individuals that were on the boards of these companies. Obviously, many of them were independent directors. The Financial Times has an interesting report that discusses the composition of the Lehman board:

“At a time when the financial markets’ complexity is mind-boggling even to those who work a 80-hour week on Wall Street, nine of Lehman’s 10 external board members are retired.

Lehman’s five-member finance and risk committee, which reviewed the bank’s financial policies and practices, is chaired by Henry Kaufman, the respected former Salomon Brothers economist. But Roger Berlind, a board member for 23 years, left the brokerage business decades ago to produce Broadway plays.

Another director, Marsha Johnson Evans, is a former chief of the American Red Cross and the Girl Scouts. Jerry Grundhofer, the former US Bancorp chief executive, is the only Lehman external director who has recently run a bank. But he did not sit on any board committees.

“This was not the strongest board for a company this size – in terms of age and in terms of people who have a toe in the water,” said one senior Lehman employee.”
Surely, these were highly accomplished individuals, but were they suited for the job is a different question altogether. Board independence does not seem to have instilled a strong level of monitoring on such boards.

5. Combined Roles of Chairman and CEO

Even the seeming onerous provisions of the Sarbanes-Oxley Act have failed to address one key issue: there is no mandatory separation of the Chairman and CEO on U.S. corporate boards. Most companies still have the same individual occupying the post of the Chairman and CEO. That puts such individual in a powerful position, which allows for little transparency into such individual’s acts, as they can go unmonitored until they reach irreversible proportions. On the other hand, separation of these roles and having two separate individuals serve as Chairman and CEO allows the chair to serve as a check on the CEO, thereby providing checks and balances that result in better shareholder value. Although other jurisdictions such as the U.K. have been long practising the separation of these roles, this is not mandated in the U.S., and despite several calls from corporate activists for such separation, that has not received due attention yet.

These are some of the plausible reasons for governance failures in the U.S. in the recent financial crisis. In a subsequent post, we will compare and contrast some of these governance issues as they apply in the Indian context.

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