By Eric Jackson
02/24/09 - 12:01 AM EST
C , BAC , GE (Cramer's Pick) , HD
A couple of weeks ago, I co-authored an op-ed on Forbes.com about the problem of bad corporate boards in America.
In it, Sydney Finkelstein and I laid the primary blame for the wheels coming off our economy in the past year at the feet of our corporate boards. There is no question that others, like politicians, CEOs, banks and consumers all had a hand in this mess.
We don't absolve anyone of their justifiable blame. But ultimately, it was the corporate boards of Citigroup(C Quote - Cramer on C - Stock Picks) , Lehman Brothers, Bank of America(BAC Quote - Cramer on BAC - Stock Picks) and others who gave the green light for excessive risk-taking based on assumptions that housing prices would always rise.
Boards are usually an afterthought for most in the media and public. When asked to explain the problems of the past year, there has been a lot of focus on CEO pay and "Wall Street greed." Most people view boards as nothing more than "window dressing" for a company. They are seen as a group of mostly retired execs, bankers, lawyers and accountants who get together once a quarter and rubber-stamp the desired corporate actions of the CEO.
It's certainly true that these groups have been too friendly over the years in allowing CEOs to run businesses as they saw fit. Quite often, directors feel beholden to the CEOs who appoint them and are well paid for serving as a director, so they do not push back on issues when the CEO is a firm believer. Of course, there's also always a friendly consultant that a CEO can trot out to give some third-party support for whatever the initiative is.
Yet it doesn't have to be this way. Boards are responsible at every company for hiring and firing the CEO. They are also the only interface the shareholders have with the running of a business. Every year (except in the case of staggered boards), shareholders have the ability to vote "for" or "against" each director being re-elected to the job. Sadly, many shareholders don't even bother to vote during these elections. For those who do, they overwhelmingly support the incumbent board, as re-election percentages are usually on the order of 90% to 95%.
If shareholders truly were to become engaged with the voting process, the result would be a much more responsive board of directors on their toes to represent their constituents and not just be in the back pocket of the CEO who appointed them.
Tougher questions would be asked at board meetings, and potential excessive risk-taking would be challenged earlier on. If only boards had been doing their jobs over the last six years instead of cheerleading and rubber-stamping, our economy wouldn't be facing such dire circumstances.
Sarbanes-Oxley Not the Answer
After the last bubble, when formerly billion dollar entities such as Enron, World Com, and Adelphi were shown to be shams, the U.S. government swooped in to improve corporate governance and overall financial and operational fiduciary oversight. The result was the Sarbanes-Oxley law, which required CEOs and CFOs to personally attest to the veracity of financial statements, prevented auditors from also consulting with businesses and supposedly improved the quality of boards of directors.
To have better boards, SarbOx suggested that the roles of chairman and CEO be split, that there be more "independent" directors on every board, and that boards avoid becoming too large so that meetings resembled something more like a United Nations get-together. Of course, none of those changes, even if they were followed (which wasn't required), seemingly did anything to make Lehman's board any better.
Let's consider the Lehman board in detail. About half of the 11-member board had an average age of 77. Seven of the 11 had been on the Lehman board an average of 15 years -- not exactly fresh eyes. Nine of the 11 directors were effectively retired -- many for several years. One director (Roger Berlind) was a former Broadway producer. Another director (Marsha Johnson Evans) was the former head of the American Red Cross and, before that, Girl Scouts of the USA.
There are many types of backgrounds, tenures and ages that make for an effective director. Yet, in looking at this makeup of the Lehman board, you have to ask yourself: Were these people who were going to (or even had the knowledge and experience to) challenge Dick Fuld about the firm's aggressive risk-taking and scenario-planning in the event of a major housing slowdown?
Of course, CEOs, pro-business leaders and their lobbying groups, such as the Business Roundtable and Conference Board, have complained that SarbOx did nothing to stop the breakdown of 2008. Just last week, Ken Langone, supreme capitalist and compensation committee member of the NYSE for Grasso, Home Depot(HD Quote - Cramer on HD - Stock Picks) for Nardelli, and GE(GE Quote - Cramer on GE - Stock Picks) for Welch, made the case on CNBC that the breakdown proved that CEOs should be less fettered by legislation like SarbOx rather than more.
I would agree with critics that SarbOx and other laws that seek to improve the quality of boards and board governance are ineffective. If you switch over a board so that it is 100% independent, how is it going to be knowledgeable enough about the business to challenge the CEO? So, if things like SarbOx aren't the answer, what is a solution for better boards?
The Solution for Better Boards
There are two ways to improve the quality of boards in corporate America today. The first is self-improvement: Boards need to fix themselves. The Securities and Exchange Commission or members of Congress can't be a fly on the wall to all boards to tell them whether they are debating issues enough. Therefore, boards must do it themselves. The massive value destruction in real capital and reputational capital that we've witnessed in the last year in firms like Citi, Bank of America and Lehman should send shivers up the spine of every public company director.
We hope that this spurs them to action and to seek out advice from other directors or consultants who have seen these changes successfully put in practice.
It would be nice if boards actually did take it on themselves to improve the quality of their governance. However, I am cynical enough not to expect that Vikram Pandit and Ken Lewis are putting such an effort at the top of their corporate to-do list. This brings us to a second solution, which does have some teeth to it.
The second solution is called "proxy access." The SEC has kicked the can on doing something on this for mor than a decade now. After 2008, there's no excuse for Mary Schapiro not moving ahead on it now.
Today, if any public company shareholder wants to nominate any one or more candidates to be elected by all shareholders to a company's board of directors, that shareholder must foot the bill and jump over an extraordinary number of hurdles to do so. The out-of-pocket costs are at minimum a million dollars (for lawyers, mailing, and proxy solicitors). They must run against an incumbent board's campaign paid for entirely by shareholders.
"Proxy access" would allow shareholders, if they were able to demonstrate that they held shares in a company for a certain period of time, to nominate one or more individuals to be elected to the board on the company's own proxy (so the challengers wouldn't have to pay the freight costs of mailing out the proxies). If the challengers make their case on why they should get a seat at the table as opposed to an incumbent, they should have a seat at the table. May the best directors -- not only the friends of the CEO -- serve.
Shareholder activist Carl Icahn supports this initiative but wants to limit the right to nominate a director to shareholders holding a 5% stake in the company. That's not a problem for him of course, but it defeats the whole notion of "proxy access," which is that if you hold one share in a company, you have a right to air your views and suggest a legitimate candidate to run.
Opponents of proxy access basically make the case that shareholders aren't smart enough as management to nominate people to serve on the board. They say groups such as the AFL-CIO and Teamsters will "hijack" the process and seek to use it to further their "extremist" views. They also like to criticize shareholders calling for change as not having the "long-term interests" of other shareholders in mind.
Citi was criticized for having an obfuscated corporate structure and lack of corporate strategy years ago. The company responded by saying critics were being short-sighted when the stock was in the $50s. "Let our vision for a financial supermarket play out," they said. They repeated the same thing when the stock was in the $40s, $30s, and $20s. Last Friday, the stock dipped below $2. Are shareholders supposed to still shut up and sit on their hands waiting patiently for the all-seeing and all-knowing Citi managers to dig themselves out of this mess? Of course not.
These criticisms have no merit. Any potential director up for re-election to a board of directors -- incumbent or challenger -- should make his or her case on why they deserve the seat. Shareholders can judge for themselves. Large shareholders like Capital Research, Legg Mason(LM Quote - Cramer on LM - Stock Picks) and Vanguard regularly spend a lot of time and effort studying how to vote. Other large shareholders aren't as fastidious, but hopefully that will improve over time. Shareholders can tell if a potential director is a crackpot, an extremist or simply a pawn of the CEO who will do nothing more than rubber-stamp decisions.
When the SEC allows "proxy access," my prediction is that it won't result in a huge number of shareholders rushing to use the power they've been given. Inevitably, some will, and they'll be successful. These few litmus-case examples will do more for improving corporate governance in America than any SarbOx-like legislation could.
There are other changes the SEC could make to improve corporate governance. For example, any director on a board for a company that goes bankrupt or sees its stock price drop by more than 90% in 12 months (like the aforementioned Lehman directors) should have to resign any other corporate boards he/she sits on and not be able to take any future directorships on a public company for the next 10 years.
The risk of being fired by shareholders through proxy access will always be in the back of the minds of corporate directors. This will indirectly lead to incumbent directors asking tougher questions and better corporate governance. And that will benefit all shareholders in the long-term.
At the time of publication, Jackson had no positions in stocks mentioned.
Eric Jackson is founder and president of Ironfire Capital and the general partner and investment manager of Ironfire Capital US Fund LP and Ironfire Capital International Fund, Ltd.
Tuesday, February 24, 2009