Failure of Corporate Governance is Killing U.S. Corporations…

In 2003 Warren Buffett wrote to the Shareholders of Berkshire Hathaway Inc. on the subject of Board of Director’s passivity.  “Warren Buffett … confessed … “after sitting on 19 boards in the past 40 years”… “Too often I was silent when management made proposals that I judged to be counter to the interests of shareholders.  In those cases, collegiality trumped independence,” Buffett said.  “A certain social atmosphere presides in boardrooms where it becomes impolitic to challenge the chief executive.”

“Who guards the guards?” ~ Plato

There are many different models of corporate governance around the world. These differ according to the variety of capitalism in which they are embedded. The liberal model that is common in the U.S. and U.K. tend to give priority to the interests of shareholders. The coordinated model that one finds in Europe and Japan also recognizes the interests of workers, managers, suppliers, customers, and the community. Each model has its own distinct competitive advantage. The liberal model of corporate governance encourages radical innovation and cost competition, whereas the coordinated model of corporate governance facilitates incremental innovation and quality

In the article How Inept Boards of Directors are Ruining Once Great American Companies by Daniel Gross writes: “The failure of the financial system in 2008 wasn’t simply a massive failure of common sense, regulation, and leadership. It was also a failure of corporate governance. In theory, the corporate boards at Lehman Brothers, Bear Stearns, AIG, and General Motors were paid handsome sums to oversee the activity of the executives and protect shareholders’ interest. In practice, they slept as the CEOs ran the companies into the ground…

In the articleFailure of Corporate Governance by James Kwak writes:  “In the great consensus of the past twenty years, government regulation was unnecessary because the free market would prevent companies from abusing their customers, while corporate governance would prevent them from abusing their shareholders. In an article by  McClatchy (news outlet) on what went wrong on Moody’s, the bond rating agency, warnings about the toxic assets it was rating by . . .and firing the people making the warnings:

In the words of an executive on a Moody’s risk committee “My question; “Where the hell has the board(board of directors) been? I would have expected, sitting where I was, that I would have got a lot more calls from the board. I got none of that.” Another Moody’s executive added, There was no (corporate) governance at the firm whatsoever. I met the board, I presented to them, and it was just baffling that these guys were there. They were just so out of touch.”

Board members often serve at the pleasure of the CEO, who controls who receives the perks of board membership. The result is often, but not always, boards that rubber-stamp the decisions of the CEO and his or her inner circle. Court precedents make it difficult to hold board members personally liable for anything, and companies buy liability insurance for their board members just in case. As Lynn Turner, former chief accountant of the SEC, said to McClatchy, “I personally think until law enforcement agencies start holding these boards accountable, . . . you’re probably not going to get a lot of change.”

In the article “Failure of Corporate Governance” by Ari Weinberg writes: Lax corporate governance at the New York Stock Exchange and several mutual funds enriched insiders at the expense of small investors. Since both entities fall outside the scope of 2002’s Sarbanes-Oxley corporate governance reforms, the stage is set for new rules with a lasting impact on stock trading and investing. No question that the stakes are high: $16 trillion worth of corporate securities trade on the NYSE and $7 trillion in assets are managed by U.S. mutual funds.

At the NYSE, a close-knit board full of representatives from Wall Street firms… run the exchange in the best interests of specialists, brokerage firms and, of course, himself. As a self-regulated organization, the offense was doubly egregious. Under pressure from the Congress, the SEC and pension funds, and the entire board was replaced. State and federal regulators have teamed up to expose exclusive trading agreements that allowed certain shareholders to profit at the expense of others. Overburdened fund directors were either in on it or asleep at the switch, prompting the SEC to consider new rules for fund trading and governance…

In the book Money for Nothing: How the Failure of Corporate Boards Is Ruining American Business and Costing Us Trillions by John Gillespie and David Zweig write: …“Our sense of the entire issue was that the CEOs have gotten most of the attention as the cause within these companies, when they’re supposed to be reporting to boards of directors… the board members are supposed to represent shareholders…but in practice they are more like a private club…

Several executives at Lehman Brothers told us… the board was a joke and a disgrace… Another example of a decline and failure that was much longer in the works was General Motors. There the CEO and Chairman (CEO fills both roles), which is a problem itself, actually told a reporter a few years ago:I get good support from the board. We say here’s what we’re going to do, and here’s the time frame, and they say, Let us know how it comes out.” So even though the company pursued a disastrous strategy … the board didn’t push back. The board should have been there asking tough questions instead of being cheerleaders.

Gillespie and Zweig write: We’ve spoken to a lot of disillusioned board members who are completely captured by the CEO in most companies. CEOs either have selected you, or approved your being on the board. They control your re-nominations, your perks, and your pay, almost all the information that goes to you, your committee assignments, and your agendas. Unfortunately, boards are a narrow group who come from the same backgrounds as the CEOs. They tend to therefore see the world the same way the CEOs do.

At both Bear Sterns and Lehman Brothers they had folks who either weren’t paying attention or, in the case of Lehman, who were deliberately selected because they were unqualified. Lehman’s risk committee only met twice a year, and five of the directors were in their 70s or 80s. They had a person who was the former head of the Girl Scouts, a television-company executive, an art-auction-company executive, and an actress and a socialite who’d been on the board for 18 years…

Carl Icahn writes: “it is difficult to see how one could reach any conclusion other than that the boards of directors of a number of these imploded financial firms utterly failed to successfully implement some of their primary tasks – to oversee management and monitor and evaluate risk controls.” Icahn continues: “First there is the problem that these board members are most likely paid far too much for doing far too little. The board seat might even constitute a substantial portion of the board member’s total salary.

With high compensation, it is little wonder that a director would not want to challenge management lest he or she be terminated and lose that easy money.” Warren Buffett’s requirements for his Board of Directors: Align the director’s interests with the shareholders: (1) must be longtime shareholder, (2) substantial shareholder, and (3) only receive minimal compensation.

In the article “The Current Board of Directors System Must Go” by Odysseas Papadimitriou writes: … The job of the directors is to act in the best interest of the company’s investors, to hire executives so as to further those interests, and to make decisions so as to keep the company healthy. The board system has failed at these tasks because it inclines members to work towards other interests even when those interests run contrary to those of the investors.

The system, simply put, requires a complete overhaul.” Such failure at the top is a problem because it sets the tone for the rest of the company… An incompetent board will hire incompetent executives who will surround themselves with incompetent subordinates. Moreover, if an incompetent board of directors allows executives to keep their jobs despite poor performance, it creates a corporate environment in which there are no repercussions for bad decisions.”

“The current problems stemming from the board of directors system now demand solutions… What is required is a revision that creates direct linkage between shareholder representation and board representation.  Whatever is done to revise the system, we must first acknowledge that the current system of the board of directors has failed and as a result, corporate incompetence and greed has been allowed to flourish.”

In the article “The Failure of Corporate Governance” by Steve Vanechanos, American Stock Exchange Board of Governors from 2005 – 2008, writes: A reckless pattern of behavior was common to the massive failures at Fannie Mae, Freddie Mac, AIG, Lehman, Merrill, Bear Stearns, Citigroup, 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.) 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.

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 board’s ability to provide substantive oversight.

In its ‘Global Investor Opinion Survey’ of over 200 institutional investors first undertaken in 2000 and updated in 2002, McKinsey found that 80% of the respondents would pay a premium for well-governed companies. They defined a well-governed company as one that had mostly out-side directors, who had no management ties, undertook formal evaluation of its directors, and was responsive to investors’ requests for information on governance issues… Other studies have linked broad perceptions of the quality of companies to superior share price performance, and companies with the highest rankings for governance had the highest financial returns.

Failure in corporate governance is a real threat to the future of every corporation. Corporate governance as a business ethics issue is a hundred times more powerful than the internet or globalization and can destroy your business in a week. To make matters worse, standards of corporate governance are changing rapidly in response to random events which capture public imagination. In business ethics, what was good is becoming bad and what was considered bad is now good. Standards for corporate governance that have worked for decades are looking old fashioned or immoral while other practices that raised questions are becoming totally acceptable.

“What a CEO really expects from a board is good advice and counsel, both of which will make the company stronger and more successful; support for those investments and decisions that serve the interests of the company and its stakeholders; and warnings in those cases in which investments and decisions are not beneficial to the company and its stakeholders.” —Kenneth Lay, former Chairman and CEO of Enron Corporation

“Enron is not just the hundred year flood of fraud, but is in fact a warning that there are fundamental weaknesses that require immediate attention.” —William T. Allen