A Failure of Corporate Governance

By James Kwak

(I’ve gotten several great articles forwarded to me via email by readers. It may take a few days to do them justice. Here’s one.)

In the great consensus of the past twenty years, government regulation was unnecessary because the free market provided better tools for constraining private companies. One force was the market, idealized by Alan Greenspan, who believed that counterparties could even police effectively against fraud. The other force was shareholders, who would punish managers for acting contrary to their interests. The market would prevent companies from abusing their customers, while corporate governance would prevent them from abusing their shareholders.

For those who still believe in the latter, McClatchy has a good (though infuriating) article on what went wrong on Moody’s, the bond rating agency that, we previously learned, responded to warnings about the toxic assets it was rating by . . . firing the people making the warnings. In the words of an executive on a Moody’s risk committee:

“My question the whole time has been, ‘Where the hell has the board 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.”

The story that Kevin Hall tells about Moody’s has been told many times before. 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.”

This is why I am skeptical of proposals to, for example, increase the number of independent board members. There’s nothing wrong with it, but I think it betrays a certain amount of naivete over what independent board members actually do.

11 responses to “A Failure of Corporate Governance

  1. If you spent your life in the corporate world, the first observation about Boards’s of Directors is that directors are there only because they subscribe to the groupthink of the corporate culture. Even if that is not true from time to time, new boards over time inculcate their groupthink into the corporation. This is particularly the case when the Chairman is a powerful dominating leader. He wants ” yes people”. Congressional factions hire people in their bailiwick that are ” yes people”. The phenomenon is natural. What better comparatives than the Board of GM dominated by Alfred Sloane and forever afterwards in a decadent manner. The same is demonstrably true of the FBI under Hoover with decadence ever after. Another major example was the supply and logistics arm of the US Army before and during WWII. Look at AIG under Greenberg and the aftermath.

    Look at the angst at the GM board when Ross Perot was a director. Had Perot been able to dictate the GM Board to his desires we would now be talking about the GM of Perot and decline ever afterwards. The great leader exhausts and groups without great leaders are exhausted.

    At some point, the groupthink malaise must turn very active , as with political coups and such, to energize a group to be dominant enough to have other groups join the pecking order at lower level. There seems to be times when their are too many challengers lower down to disturb the dominant group. So the group either capitulates and joins or is defeated . The defeated then wither away.

  2. Groupthink doesn’t handicap an otherwise effective system. Corporate governance is groupthink, if not worse, in the US. It’s possible to do CG differently – through regulation. German law dictates the composition of many AG oversight boards: in some cases capital and labor split the seats evenly, in others an impartial member is included. Management is typically not present in threatening numbers. CEOs cultivate relationships with labor because they need the support of labor representatives on the oversight board. The Betriebsrat, or workers’ council, is another matter. The Chair of the Betriebsrat is often one of the representatives of labor in the oversight board.

  3. The more important governance reforms that are being considered expand the rights of shareholders to oversee boards. Allowing shareholders a vote on compensation as well as the right to nominate director candidates will give them some ability to oversee management and boards who ostensibly represent them. Of course, this assumes that shareholders will actually take this responsibility seriously. However, a good percentage of equity assets are held by pension funds, insurance companies and mutual funds who do have long time horizons and an interest in monitoring the performance of boards. Time will tell if these shareholders will devote resources to governance, but there seems to be more awareness of the need to do this among large investors over the last couple of years.

  4. Would broader representation of capital in boards have prevented the asset stripping associated with LBOs?

  5. Mr. Kwak wrote”

    “In the great consensus of the past twenty years, government regulation was unnecessary because the free market provided better tools for constraining private companies. One force was the market, idealized by Alan Greenspan, who believed that counterparties could even police effectively against fraud….

    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.”

    “I guess I should warn you, if I turn out to be particularly clear , you’ve probably misunderstood what I’ve said.”

    Alan Greenspan

    Warning, approaching, “…tangential quotes”.

    Chairman Ben S. Bernanke said:

    At the 43rd Annual Alexander Hamilton Awards Dinner, Center for the Study of the Presidency and Congress, Washington, D.C.

    April 8, 2010 – excerpt

    Economic Policy: Lessons from History

    “I’ll conclude with the cautionary fourth lesson–history is never a perfect guide. It is a principle acknowledged by the words etched on the wall of the Center’s conference room, attributed to Mark Twain,

    “History does not repeat itself, but it can rhyme.”

    http://www.federalreserve.gov/newsevents/speech/bernanke20100408a.htm

  6. Mr. Kwak wrote”

    “In the great consensus of the past twenty years, government regulation was unnecessary because the free market provided better tools for constraining private companies. One force was the market, idealized by Alan Greenspan, who believed that counterparties could even police effectively against fraud.”

    On megabanks:

    “I think they should be broken up. . . . We’ve provided this support and allowed Too Big To Fail and that subsidy, so that they’ve become larger than I think they otherwise would. I think by breaking them up, the market itself would begin to help tell you what the right size was over time.”

    e e cummings wrote”

    “I’m living so far beyond my income that we may almost be said to be living apart.”

  7. Filtered on a Friday. That ain’t right Kwaky Bro, dat ain’t right Kwaky Bro,

  8. Institutional investors do not need to literally sit on boards to have influence. It is enough that boards know that they can be fired by shareholders if they do not competently represent their interests. That having been said, whether investor pressure leads to a longer term vision or short termism depends on who the investors are – pension funds have different interests than the kind of hedge funds or private equity firms that might be more likely to sacrifice the company for short term gain. I’ve seen a fair amount of evidence that shareholder activism on balance tends to improve the performance of companies over time.

  9. Alan Greenspan was convinced the markets self-regulate. I believe it was Herbert Hoover who said: “The only problem with capitalism is the greedy capitalists.”. I suspect that Hoover’s sentiment is closer to the reality than Greenspans’s as we have seen in the last two decades.

  10. Unlikely. Boards are usually quite diligent when it comes to an LBO/MBO, because, IIRC, they can be individually sued if they don’t do their job. Moreover, their job is ensuring that the final deal is the one that gets the best value for shareholders- if that involves selling off assets, then under the existing framework, that’s no problem.

  11. I think the problems are ones of scale, but not in the sense of ‘too big to fail’. It’s clear that the scale of markets (due to globalization) and the scale of companies (due to size and complexity) have outpaced the mechanisms to manage the risks effectively by the insiders and outpaced the mechanisms to regulate them effectively by legal authorities.

    It hasn’t helped that half the country has been actively sabotaging the other half’s capability to attempt effective regulation.

    There are simply too few actors – accounting firms, rating agencies, bank regulators – to fulfill the missions they have been assumed to be doing. The captains of industry, being smarter than the average Joe, have grasped that it was much easier, and much more rewarding, to game the system for personal profit that actually create value by acting in the shareholder interests.

    One key fact in corporate governance that has yet to be acknowledged is shareholder apathy. For ideological, time mgmt, or other reasons shareholders just don’t see themselves as responsible to hold managers responsible for their actions. They are not a proactive check on corporate management. Depending on them to drive reform is willful ignorance.

    The regulators need to scale up or they need to have the tools to scale the regulated down, not because of the financial bailout risk but because resource allocation is being distorted by gamers with too much cash to corrupt the system. And there are no checks to that power to game the system right now. Not shareholders, not rating agencies, not regulators, not independent auditors.