Wednesday, August 12, 2009

Goldman's Board Too Cozy

08/12/09 - 10:01 AM EDT


Eric Jackson

NEW YORK (TheStreet) -- Financial journalists have focused a lot on Goldman Sachs (GS Quote) over the past few weeks.

Matt Taibbi of Rolling Stone kicked over a hornet's nest by calling the firm a "vampire squid," pointing out a number of facts he suggested led to the conclusion that Goldman has received preferential treatment from the government through the last year's economic debacle, and having its tentacles spread around many bases of economic and political power in what he called troubling ways.

Heidi Moore, a business writer in New York City, and Charlie Gasparino of CNBC rebuked Taibbi's take as conspiracy theorist claptrap and defended Goldman as a bunch of really smart folks who know how to make money. Goldman's second quarter's $3 billion profit confirms this point.

It's undeniable that Goldman is the whitest of white-shoe investment banks with very talented people who have been very successful. (It's noteworthy that its headcount of 30,000 employees has barely dropped since early 2007, which speaks to its confidence to market opportunities in front of it and the team it has to capitalize on those opportunities.)

Given the firm's success, some have asked me why I didn't include Goldman among my top three "best corporate boards" in my article from a few weeks ago. The simple answer is that, despite Goldman's steady and uncanny ability to churn out profits, its board governance is pretty average when compared to the others mentioned on the list (Berkshire Hathaway(BRK.A Quote), Amazon(AMZN Quote), and Johnson & Johnson(JNJ Quote)).

Goldman's board is too cozy, made up of insiders, former insiders and people who spent years paying fees to or advising these insiders. Some new outsider perspectives who are knowledgeable in Goldman's markets but not beholden to Goldman management would make this a much stronger board and better protect its shareholders.

The banks have been at the eye of this financial Category 5 hurricane that has swept over the economy in the last two years. Prior to the collapsing of the credit bubble, the banks were printing money. Therefore, no one questioned the fact that the average age of the Bear Stearns' 13-member board was 66, including two directors over 80, and two directors who were presidents of universities with no financial markets experience.

No one questioned that Dick Fuld had loaded Lehman Brothers' board with cronies and made questionable decisions such as putting director Richard Berlind (a Broadway producer) on Lehman's Finance and Risk Committee. Nobody complained about Bank of America's(BAC Quote)) board, which has been steadily dismantled by the government since its April shareholders' meeting (which we wrote about here first several weeks ago before The Wall Street Journal and others picked up on the story).

In America, as long as we are getting paid as shareholders, we can put up with a lot. These banks could have taken their leverage ratios up to 300:1 and appointed Pee-Wee Herman to their Risk Oversight committees and we wouldn't have batted an eye. It's only now -- after the crash -- that we scratch our heads and collectively ask "who was minding the store at these banks?"
With the problems of last fall behind us and as no one believes there could be a run on Goldman - just as we all thought it was similarly impossible before September 10 -- let's examine who's minding the store at Goldman.

The 13-member board has three insiders (CEO Lloyd Blankfein, president & COO Gary Cohn, and secretary John Rogers) and one ex-insider (Stephen Freidman).

The board also has five former or current CEOs who presumably paid Goldman a large amount in investment banker fees over their years in office (including current ArcelorMittal(MT Quote) CEO Lakshmi Mittal, Colgate-Palmolive(CL Quote)'s former COO, Lois Juliber, former chairman & CEO of Fannie Mae(FNM Quote), James Johnson, former CEO of Medtronic(MDT Quote), William George, and former Chairman and CEO of Sara Lee(SLE Quote), John Bryan). Goldman also has Rajat Gupta (former head of McKinsey) on the board - someone who likely gave Goldman advice over the years but who also took millions in fees for doing so, creating a non-arm's length relationship with the firm.

I'm not saying these directors aren't professionals who don't try to do the right thing for shareholders. Goldman PR would likely say: "These men and women are titans of business, whose past relationships with Goldman give them valuable insights into the inner workings of our unique firm and culture, making them more effective directors. And they all meet the strict NYSE standards for board independence."

First, the NYSE definition for an independent director is rather meaningless as it ignores all past relationships like the ones described above. The SEC would do well to require disclosure of past financial relationships between directors and the firms on whose boards they sit.

Second, I strongly believe that former clients, who have a relationship on paying Goldman for expert advice, develop a relationship for receiving but not giving advice. This is rather problematic if they later become directors of that firm and must start giving advice and acting as fiduciaries for shareholders (not for the friendly members of Goldman management with whom they've had decades of relationships).

If you disagree with this point, ask yourself: After a lifetime of taking advice from your parents, how easy would it be for you to suddenly flip the switch and start giving them advice and for them to take it?

This leaves two truly "independent" directors on Goldman's board: Claes Dahlback, an advisor to a Swedish venture capital firm, and Ruth Simmons president of Brown University. Simmons is a career academic, with no direct experience working in capital markets. I question her ability to push back on internal debates of firm strategy and risk oversight, especially when she has to go toe-to-toe against Stephen Friedman or Lakshmi Mittal.

Two truly independent directors out of 13 is clearly insufficient for a company as important to the US financial system as Goldman Sachs. At least a third of its directors should be independent from past relationships with the firm, so that they can truly question how the firm structures itself and manages its risk.

These independent directors need to have the requisite background and capital markets experience to meaningfully participate in board meetings. Goldman can't fill those four slots with four presidents of local art museums who will defer to the other business savvy insider directors.
Is Goldman heading for a fall because of poor oversight? Not necessarily. It is a great firm, with an impressive culture. At the moment, their bank status, easy access to cheap capital, a dramatic drop in the number of its competitors, and an abundance of smart people in the firm indicate that all the ducks are lined up for many profitable quarters to come for the investment bank.

Yet, forewarned is forearmed. The current Goldman board is too cozy and non-independent as currently composed

Governance really counts in all the little decisions that amass leading up to times of crisis or unexpected volatility when conventional wisdom gets tossed on its head. When I look at Goldman today, I see risk-taking mattering as much to the firm today as ever. We see that in its increased VaR (value-at-risk) at $245 million in the latest quarter, and in its current leverage ratio of 14, which although down from pre-crash levels (of 30) is higher than you might expect.

A well-functioning board isn't the be-all and end-all to risk management, but it is central to it. Goldman leads its industry in many ways. It should lead in this area by revamping its cozy board with respected outsiders who know their stuff and demonstrate to shareholders that tough questions are being asked behind closed doors.

-- Written by Eric Jackson in Naples, Fla.

At the time of publication, Jackson holds no position in GS but executes trades through Goldman Sachs Execution & Clearing, LP. 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.

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