June 2005

Chevedden Proposal to Boeing

Shareholder proposal (under Rule 14a-8) submitted to Boeing today in response to Boeing announcing that Mr. James McNerney will be Boeing’s new everything – chief executive, chairman and president.

[June 30, 2005]
3 –Chairman of Our Board to Have Oversight Responsibilities Only

Stockholders request that our Board of Directors change our governing documents to require that the Chairman of our Board serve in that capacity only and have no management duties, titles, or responsibilities.

When a person acts both as a corporation’s Chairman and its CEO, a vital separation of power and responsibility is eliminated – and we as the owners of the corporation are deprived not only of a crucial protection against conflicts of interest, but also of a clear and direct channel of communication to the corporation through our Chairman.

What stockholder-damaging conflicts of interest can be more serious than those that so often occur when overseers are allowed to oversee themselves? When a corporation’s Chairman is also its CEO, such conflicts can and do happen.

It is well to remember that at Enron, WorldCom, Tyco, and other legends of mis-management and/or corruption, the Chairman also served as CEO. And these dual roles helped those individuals to achieve virtually total control of the companies.

Clearly, when a Chairman runs a company as Chairman and CEO, the information received by directors and others may or may not be accurate. If a CEO wants to cover up corporate improprieties, how difficult is it to convince subordinates to go along? If they disagree, with whom do they lodge complaints? The Chairman?

Thus this proposal is consistent with our company’s prodigious effort to improve company ethics.

Stockholders must continue to expect the unexpected unless and until they help cause company boards to be composed of substantial majorities of independent and objective outside directors – and until those directors select a chairman those who is similarly independent of management.

Chairman of Our Board to Have Oversight Responsibilities Only
Yes on 3

Submitted by shareholder John Chevedden of Redondo Beach, Calif.

SEC Affirms Independent Chair Rule

As expected, the SEC voted to affirm a controversial rule that requires mutual fund companies to appoint independent chairmen for their funds. Reconsideration was required after the U.S. Court of Appeals for the District of Columbia questioned the high costs that would be incurred by fund companies and also ordered the SEC to consider alternatives to rule. A new study that concludes the financial burden would be minimal was presented at the hearing.

The U.S. Chamber of Commerce, which brought the suit against the SEC that put the mutual fund rule before the U.S. Court of Appeals for the District of Columbia Circuit, threatened to sue the agency again. (SEC requires independent mutual fund chairmen, USA Today, 6/29/05)

A Wall Street Journal editorial said Donaldson was flouting the law. The editorial questioned an SEC investigation of Fidelity Chairman and CEO Edward Johnson “for the oh-so-grave sin of possibly having accepted free tickets to an Olympic event from a Wall Street firm. Mr. Johnson — who has run Fidelity scandal-free for some 30 years — happens to be among the most vocal critics of the mutual fund rule. Could the leak have been an act of SEC vindictiveness?” (A Lawless SEC, 6/29/05)

Scrushy Wants Back

Acquitted on all counts of directing the HealthSouth accounting fraud, Richard Scrushy is seeking a return to his former job. His name won’t be among nominees to the board, said HealthSouth spokesman Andy Brimmer in an e-mailed statement.

Scrushy may find it difficult to mount a challenge to management’s slate of directors, said Ben Nahum, portfolio manager at David J. Greene & Co., which owned about 844,000 shares of HealthSouth. ”No one will vote for him,” Nahum said in a telephone interview. “Trust me, he has no support outside of those 12 idiots they found to sit on the jury. The man’s a criminal.” (Scrushy seeks a return to glory, Miami Herald, 6/30/05)

On Scrushy’s acquittal, “I think it’s a huge disappointment for everyone who was counting on Sarbanes-Oxley to rein in excesses in the corporate suite,” said Thomas Donaldson, professor of business ethics at the Wharton School of the University of Pennsylvania. “It proves once again how easy it is for people at the very top to isolate themselves from both knowledge and responsibility,” said Donaldson, who testified before Congress during deliberations on the Sarbanes-Oxley law and pressed for tougher criminal penalties.

Prosecutors may have made a tactical error by bringing the case on Scrushy’s home turf in Alabama, where the former executive was a popular figure for his outspoken religious views and generous philanthropy. (Scrushy acquittal a setback for US corporate crimes clampdown, 6/29/05)

Cure for CEO Psychopaths

Alan Deutschman has an interesting article in July’s Fast Company. “Is Your Boss a Psychopath?” starts out discussing Robert Hare’s “Pschopathy Checklist” and his contention that many recent corporate scandals could have been prevented if CEOs were screened for psychopathic behavior. “We screen police officers, teachers. Why not people who are going to handle billions of dollars,” says Hare. This summer, Hare and Paul Babiak began marketing B-Scan, a personality test that companies can use to spot job candidates who may have an MBA but no conscience. I’ll be interested to learn if it catches on.

Babiak says organizational shake-ups create a welcoming environment. “The psychopath has no difficulty dealing with the consequences of rapid change; in fact, he or she thrives on it. Organizational chaos provides both the necessary stimulation for psychopathic thrill seeking and sufficient cover for psychopathic manipulation and abusive behavior.”

Corporate psychopaths score high on factor 1, the “selfish, callous, and remorseless use of others” category, which includes eight traits:

• Glibness and superficial charm
• Grandiose sense of self-worth;
• Pathological lying
• Conning and manipulative;
• Lack of remorse or guilt;
• Shallow affect;
• Callous lack of empathy;
• Failure to accept responsibility for one’s own actions.

On factor 2, which pinpoints “chronically unstable, antisocial, and socially deviant lifestyle,” corporate psychopaths score only low to moderate. It appears that business executives are more likely to be “successful psychopaths,” in contrast to criminals who are too impulsive and physically aggressive, making them more likely to wind up in jail.

Bosses from hell listed in the article’s margins include John D. Rockefeller, the most corrupt mogul of the most corrupt era; Henry Ford, with his secret police; Walt Disney, a suspicious control freak; and Ivan Boesky, who routinely screamed at his staffers and never said he was sorry.

Deutschman then compares corporate psychopaths to “productive narcissists,” who include people like Steve Jobs, Jack Welsh, and Bill Gates. Narcissists also see people as a means toward their ends, are poor listeners, and can be touchy about criticism but in their eyes they are improving the world. In contrast, psychopaths, we are informed, are only interested in themselves and enjoy hurting others.

Europe and Asia are far ahead of the US, according to Deutschman. Europe has a growing “antibullying” movement and new laws in France and Sweden. Asian countries have long emphasized community bonds rather than individual glory. Deutschman concludes, “Unless business makes a dramatic shift, we’ll get more Enrons – and deserve them.”

But are such issues likely to be resolved by administering B-Scan or any other test to prospective CEOs? I think not. The solution isn’t picking a benign dictator.

T T Rammohan’s editorial in The Economic Times of India, Only first among equals, addresses the core issues. Rammohan discusses Morgan Stanley and their recent decision to ask its CEO, Philip Purcell, to leave. There are more detailed accounts in the Wall Street Journal but Rammohan makes the important point that “Mr Purcell’s departure was forced by a systematic campaign carried out by former executives of the firm.”

The board, “mostly handpicked by Mr Purcell, initially did what most boards tend to do. They reflexively sided with the CEO.” Then, under the threat of a proxy battle, “both the board and Mr Purcell threw in the towel.” Rammohan argues, “the Morgan Stanley board may have unwittingly underlined a hitherto neglected principle, namely, that the CEO is not everything in a firm, he is merely the most important face of the firm.”

Rammohan credits Rakesh Khurana popular book, Searching for a Corporate Savior, as highlighting the idea that the cult of the charismatic CEO is a recipe for corporate disaster. “This is because charismatic authority tends to discourage criticism, concentrate authority and pursue grandiose visions in disregard of legal or ethical norms. Such leadership thus carries within itself the seeds of future disaster.”

The remedy, according to Rammohan, is to ensure there is a “chain of succession and that power is widely dispersed.” “Boards must recognise that they cannot be guided by the CEO alone in matters relating to the corporation.” He praises the corporate governance reform that has led boards at more companies to have regular meetings without the CEO.

The success of the democratic ideal rests on the belief that the pooled wisdom of many is superior to that of any one individual. If this applies to nations, it applies to corporations as well. Ensuring that the CEO is only first among equals, not an absolute monarch, is crucial to the health of corporations.

We need more mechanisms that push corporate structures toward democracy such as:

• Independent boards who are accountable to shareholders,
• Audits that provide information necessary for shareholders to hold management accountable, instead of focusing on hypothetical future owners,
• Split chairs and CEOs,
• Majority voting requirements for electing directors, and
• Shareholder access to the corporate proxy for nominating directors.

We can’t afford to pay an Elliot Spitzer clone to watch every corporation and we can’t depend on a rare pool of former employees being ready to fund a proxy fight. Give shareholders the proper tools and corporations are less likely to be dominated by psychopaths. Power, if widely dispersed, will facilitate the important contributions of all employees, shareholders, and other stakeholders. Pooling our wisdom is a more effective long-term strategy than blindly following a leader, even if we are able to screen out the psychopaths with B-Scan.

DB Plans Down

The rate at which large companies froze or terminated their defined benefit pension plans accelerated sharply last year even as the average funding level for plans continued to increase, according to a new analysis by Watson Wyatt Worldwide, a leading human capital consulting firm.

Watson Wyatt found that 11% of companies in the Fortune 1000 that sponsor defined benefit plans had a frozen or terminated plan in 2004. The 11% represents 71 companies and is an increase from 7% (45 companies) in 2003 and 6% (39 companies) in 2002. Additionally, 4% of employers (25 companies) had pension plans that were closed to new hires in 2004. Still, two-thirds of the Fortune 1000 companies (63%) currently sponsor a defined benefit plan.

The analysis also found that about half of the companies that terminate their plans drop off the Fortune 1000 list the following year, indicating that the decision may often be driven by weak financial performance. About one- half of the companies that froze or terminated their plans in 2004 had credit ratings below investment grade, compared with 25 percent of firms with active pension plans.

Improved returns in equity markets and sizable cash contributions by employers helped boost the average pension plan funding ratio to 83 percent in 2004. The average funding ratio was 81 percent in 2003 and 76 percent in 2002. (Press Release, 6/22/05)

Milberg Weiss Under Investigation

Milberg, Weiss, Bershad, and Schulman, the class-action law firm, is being investigated for alleged fraud, conspiracy, and kickbacks in dozens of securities lawsuits, according to The Wall Street Journal. A grand jury in Los Angeles that was convened last October has been hearing evidence of alleged illegal payments to plaintiffs who appeared on dozens of securities class-action lawsuits brought by the firm during the past 20 years.

Michael Hausfeld, a prominent Washington plaintiffs’ lawyer, is quoted saying such a case “could taint private civil enforcement of securities law” and deflect attention from “the egregious corporate misconduct at issue in these suits.” For names, kickback amounts and the gory details, see “U.S. Pushes Broad Investigation Into Milberg Weiss Law Firm,” 6/27/05)

Cooperative Leads the Way

Co-operative Insurance Society became the first insurer to launch an ethical engagement policy based on the views of its members. The policy is the result of an extensive consultation with its five million policyholders and will govern the way the firm interacts with the companies it invests in. The new policy, which is backed by 98% of customers, will guide the group on such issues as human rights, the arms trade, environmental impact, labour standards, animal welfare and corporate governance.

The group said it would use its power as a major shareholder to make its views known at annual general meetings and to put pressure on companies. Its stance is similar to one already adopted by the Co-operative Bank, which refuses to do business with companies it deems to be unethical. (Ethics priority at insurance giant, icCoventry, 6/27/05)

Barron’s Review

In an article titled “The Governing Class” Theresa W. Carey and Kathy Yakalwith offer a “refresher course in corporate governance.” Lead mention went to Corporate Governance, “a straightforward, informative site that tracks the important developments in the field.” OfEncycogov.com, “the serious student of the field will find plenty of theory and examples here.”

Among the others, ShareholderProposals.com is a “plain, just-the-facts site that helps investors take advantage of a decades-old Securities and Exchange Commission rule that allows shareholders to include proposals in a company’s proxy materials. It takes you step-by-step through the process and provides concrete examples of good corporate governance policy statements.”

GuruFocus.com “isolated 21 investment gurus who have racked up an average annual total return of more than 15% in at least the last 15 years…Tables highlight buy and sell recommendations or actual actions over the last year or so, and recent commentaries written by each are printed or linked.” NetSteering is a terrific resource for keen watchers of insider trading.

India Inc Will Need 3,000 Directors

The government estimates corporate India will need 3,000-4,000 “independent directors” within the next six months to comply with the Securities and Exchange Board of India’s (Sebi) listing requirements.

To ensure that corporates are able to find qualified people, the company affairs ministry is facilitating the formation of databases of potential “independent directors” through professional bodies and industry chambers. (Business Standard, 6/23/2005)

AFP Calls for Greater Disclosure of Governance Rating Methods

Companies with poor governance practices may see an increase in their cost of funds and access to credit.

Association for Financial Professionals (AFP) president Jim Kaitz urged the SEC and the nationally recognized statistical rating organizations to bring more sunshine into the scoring process when he testified before the US House Financial Services Committee Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises last September.

Moody’s, Standard & Poor’s and Fitch Ratings have publicly outlined their governance rating methods. Moody’s wraps corporate governance into its risk management overview, according to Ken Bertsch, senior vice president and director, corporate governance. “We’re not scoring on corporate governance at this time. We’re doing a very in-depth risk management review,” Bertsch said.

Moody’s corporate governance assessment emphasizes board independence and management accountability to the board, board and executive compensation arrangements, management succession plans, public disclosures, legal and regulatory structures, ownership structures, governance transparency, and shareholder voting rights.

S&P assigns scores from 10 (very strong practices) to one (very weak practices) to the four individual components that contribute to overall sound governance. According to 2002 and 2004 reports, these elements include: ownership structure and influence of external stakeholders, investor rights and relations, financial transparency and information disclosure, and board structure and process.

Fitch uses a rating tool that ranks companies based on criteria such as board independence and quality, presence of related-party transactions, integrity of the audit process, executive compensation, and different ownership structures (in particular majority-controlled and family-owned companies).

Dominion has no written policy, but the company has included corporate governance factors in its rating process for nearly 30 years. As the newest nationally recognized statistical rating organization approved by the SEC, Dominion has been rating US companies for less than one year. (Looking Beyond the Numbers – Governance Concerns in Scoring Process, AFP, 6/20/2005)

ABA Seeks Comment on Majority Elections

The American Bar Association (ABA) Committee of Corporate Laws has issued a 32-page discussion paper on majority elections for corporate directors and invites public comment. Resolutions have been voted at more than 50 companies so far this year. The average level of support has been around 45% of votes cast, according to the The ISS Friday Report.

The ABA paper outlines four options and discusses their potential benefits and problems:

• Retain the current plurality vote default rule.
• Change to a majority vote default rule.
• Adopt a default plurality rule requiring that a director must be elected by at least a “minimum” plurality vote, such as one-third.
• Leave the plurality vote default rule in place but specifically authorize against votes with consequences where a director achieves a plurality vote but more against than for votes. These consequences could include, for example, shortening the term of that director, unless the board acted within a specified time frame to confirm the director’s election, or giving the board the authority to remove that director.

Comments should be sent by Aug. 15 to: E. Norman Veasey, Chair, ABA Committee on Corporate Laws, or by snail mail to 1201 N. Market Street, Suite 1402, Wilmington, Delaware 19801. We urge readers to cc the publisher of Corpgov.net: James McRitchie.

Pfizer announced that it would require any director who receives a majority of “withheld” votes at the annual election of company directors to offer to resign. The company’s shareholders can vote “yes” or “withhold” when they vote on a director. The company has said that investors were concerned that some directors could be elected with only a few positive votes from a handful of shareholders.

Pfizer officials said the company has been a leader in corporate governance issues, such as the election of directors and anti-takeover provisions. Pfizer was one of the first companies to dump its “poison pill” takeover defense, which would have made a takeover unattractive because of special “poison” provisions that would have greatly added to the cost of such a takeover. In addition, Pfizer now requires that all directors be elected to one-year terms.

The selection of a replacement Director would still be within the power of those who selected the Director found to be unacceptable to Shareholders.  “Under the amendment to Pfizer’s corporate governance principles, any director who receives a majority of withheld votes must submit his or her resignation to the board. The board will in turn consider the resignation and make a recommendation.”

Governance Premium in Hong Kong

Researchers studying the corporate governance of 168 of Hong Kong’s largest listed companies have found a positive and significant correlation between corporate governance scores and price-to-book ratio. (seeWebb-site.com for details and links) Here is a highlight:

A significant and positive relationship is found between CGI and MTBV after taking account of a comprehensive set of control variables. Results show that a worst-to-best change in CGI, from 32.86 to 76.34, implies a 147% increase in MTBV. The transparency-related performance is significant in explaining variations in firm value as well. After comparing the regression results between China-related firms and Hong Kong firms, we find that corporate governance practice matters more for China-related firms.

Chevedden Report

Caterpillar finally pastures its poison pill on June 30, about 17 months ahead of its scheduled termination date of Dec. 11, 2006. This topic won an impressive level of shareholder support at Caterpillar – a 59% yes-vote at the 2005 annual meeting. Additionally the Caterpillar shareholder level of support ranged from 48% to 55% in each year from 2000 to 2004 based on yes and no votes. Each of these proposals was sponsored by John Chevedden.

Corpgov Bits

Managing ERISA Risk; Denali FM offers an online fiduciary training course re Risk Management in 401k Plans. Minority owners acquire more rights in Hong Kong.

Corporate governance costs climb 33%. The cost of being a public company in 2004 was a third higher than it had been a year earlier, shows a study by a national law firm. Average audit fees for companies with fewer than $1 billion in annual revenue climbed 96 percent to $1 million in 2004. Costs of corporate governance have gone up 223 percent since the government enacted Sarbanes-Oxley in 2002.

Conference Board Issues a “Definitive” Report on Corporate Governance Practices. It calls on corporate directors to redefine their roles with management, strengthen their independence, and improve practices and processes in their companies’ key audit, compensation, and governance committees. The report focuses on best practices covering legal, regulatory, and stock exchange requirements and precedents established by the influential Delaware courts.

Russian state companies are not transparent, according The Standard & Poor’s international rating agency survey. Their average level of information provision is 47%. This means that they fail to disclose information as readily as Russia’s private companies of the same level do (52%) and considerably worse than their overseas counterparts (63%). However, this is not a bad result for a country where norms of corporate governance were only introduced recently and the Code of Corporate Conduct appeared only a couple of years ago.

Oregon to Go DC?

Kevin Mannix, the GOP candidate for governor of Oregon, has proposed moving new public employees to a 401(k) plan style retirement program. The 2003 Legislature enacted a hybrid pension plan for newly hired public employees that offered a scaled-down guaranteed pension plus a 401(k)-style plan.

Mannix said he wouldn’t take away current employees’ guaranteed pensions under the Public Employees Retirement System. Instead, he would encourage them to switch to the 401(k)-style plan through incentives. Mannix’s comments came after chief GOP rival Ron Saxton co-wrote an article suggesting that all Oregon public employees could be temporarily fired to terminate their contractual right to PERS benefits, then rehired under a less-costly retirement plan. (Mannix endorses 401(k)-style plan, Statesman Journal, 6/17/2005)

Undermining the Statutory Audit

In “Undermining the Statutory Audit: The Damaging Effects of Adopting IFAC-IAASB Standards on Auditing (ISAs), June 2005, UK’s Morley Fund Management argues the move to create international standards should not be pursued by means of US derived ISA since the approach will undermine the “true and fair view” basis of audits established under the Companies Act. The shift away from public interest/shareholder audits to a process driven by a technical compliance assurance more limited in scope will have the principal effect of reducing the scope of the auditor’s role and exposure to risk. The Morley paper argues strongly against making the directors/management the “client” instead of shareholders.

It appears the Audit Practices Board is moving forward with this ill-advised shift in without proper consultation or regulatory impact assessment. Again, the impact of US standards is being obfuscated by denying words their normal meaning. While the words “true and fair view” are retained, they now simply mean compliance with IFAC-IAASB. Enron would have been a clear audit failure under the current regime but not under the US standards. The paper contains an excellent appendix, which highlights the differences between the frameworks. One of the most important, from our standpoint, is that fundamental notion that UK audits are conducted for current shareholders and in the “interest and protection of the public,” instead of with the board or appropriate representatives of senior management, with whom the auditors agrees on the terms of engagement and any variation.

CalPERS Sets Standards for Consultants

On May 16th the SEC’s released its Staff Report Concerning Examinations of Select Pension Consultants. Effective June 13th, CalPERS established a new protocol to:

(1) assure that the information and advice CalPERS receives from its Consultants is impartial;
(2) to outline a system whereby Consultants disclose to CalPERS those circumstances that may create actual, potential or perceived Conflicts of Interest; and
(3) to set forth a process for CalPERS to evaluate the disclosures to determine whether assignments should be precluded.

To read more about the policy, see their June 13 press release and a pdf version of the policy.

Chevedden Report

Pep Boys (PBY), redeem or vote poison pill, 75% yes-vote, proponent John Chevedden. This is the 3rd consecutive year that this proposal topic has won more than 60% support.

General Motors, cumulative voting shareholder proposal, at least 48.8% yes-vote, proponent John Chevedden. GM continues to refuse to state the no-vote which may be less than 48%. In any event the GM Chairman, Richard Wagoner said at the annual meeting that this was an all-time record high voting percentage for a GM shareholder proposal.

Morningstar’s Innovation

The Wall Street Journal reports the investment-research firm says it will hold monthly “forums” to answer questions about its business from any investor or prospective investor. Investors submit written questions by email, fax or mail. Morningstar’s director of investor relations digs up the answers and reports to shareholders and the SEC. The first forum, released June 3, featured 21 questions about Morningstar’s estimates for long-term growth, hiring plans, potential for acquisitions, stock-option expensing, corporate governance and other matters.

Joseph Carcello, University of Tennessee’s Corporate Governance Center, praised Morningstar’s first effort, saying its responses were candid and specific, including providing a breakdown of its revenue by new and renewal business, information that many companies prefer not to disclose for competitive reasons. Alyssa Machold Ellsworth, Council of Institutional Investors, agreed, “this a really good example of proactive shareholder communications.”

WSJ terms the move “Democracy in Action.” It certainly is something of an innovation in reporting but if it wanted to be a true leader in democracy, Morningstar would take measures which actually allow shareholder to act like owners. For example, they could allow potential auditors to place their proposals in the proxy and allow selection by shareholders. They could allow shareholders to place the names on director nominees on the proxy. Steps such as those would truly be democracy in action. (Morningstar Shines Light on Itself, 6/15/05)

Are You in the TIAA-CREF Retirement System?

If not, you can still help. Do you want our money to help build housing and businesses in low-income communities? To support socially and environmentally responsible products and services?

Spend five minutes to support Social Choice for Social Change. In the 1980s, Campaign for a New TIAA-CREF lobbied the pension giant TIAA-CREF (TC) for five years to set up a socially responsible fund, the Social Choice Account. Now Campaign for a New TIAA-CREF is pushing for an improved fund with practices that are becoming standard in socially responsible investing. Their effort has been endorsed by many academic and activist groups, and individuals like Noam Chomsky and Howard Zinn. Here’s how you can help:

• Contact TC and ask them to modify the Social Choice Account by investing in low-income area community development and in social venture capital for companies pioneering socially responsible products/services. Thank them for agreeing to vote their shares in corporate stock in a socially responsible manner, and ask them to otherwise lobby those companies to be socially responsible. If you are a participant, let them know that. Call CEO Herbert Allison at 800-842-2733; 212-490-9000 (monthly, if you can) or email him atHAllison@tiaa-cref.org (but calls are preferable. You will be asked to leave a message with an assistant.)
• Receive Campaign Updates (every two to four weeks). Contactnjwollman@manchester.edu to be added to the list.
• Forward this message with a short personal endorsement to listserves, organizations, and your colleagues and friends nationally.

Campaign for a New TIAA-CREF is also part of a national coalition of activist groups, Make TIAA-CREF Ethical, that is pushing for TC to be more socially and environmentally responsible in its various investments. For further information, contact Neil Wollman, Ph.D.; Senior Fellow, Peace Studies Institute; Professor of Psychology; Manchester College, North Manchester, IN 46962.

Audit Independence

Robert Monks graciously sent me a copy of Tim Bush’s recent paper,Divided by Common Language, which I found very helpful in explaining the origins and differences between financial reporting in the UK and the US. For years I’ve been told the UK approach is more principles-based and ours is more rules or check-box based. However, after reading this paper I am finally beginning to grasp what this means and how the differences shape corporate governance in each country. Fundamentally, the problem may be that the duty of care for auditors in the US is not to shareholders but is to buyers and sellers in the market. Our audits are better designed for day-traders than long-term owners.

Bush points out the UK Companies Act “requires that auditors are appointed by and report to shareholders as a obligation of the privilege of incorporation,” although it appears that in actual practice they are selected by the board. However, at least the accounting goal is to ensure that financial statements are relevant and as free of self-serving bias as possible for shareholders. In contrast, under the US 1933 Securities Act, US audits are primarily concerned with market-pricing. The objectives are to ensure an efficient secondary market and an efficient primary issue market.

Bush points out, a company that is incurring expenditure beyond the economic needs of the business may not be defrauding the secondary market by strict federal legal definition. If earnings are depressed due to operational inefficiency the market price may reflect this but the interests of shareholders are not well served, nor are they given access to information needed to remedy the problem. “Efficient markets and efficient companies are not the same thing.”

He provides an example of an insurance company disclosing the company is exposed to asbestos-related liabilities. In the US, they could leave it at that. In the UK the auditor would have to include other relevant facts, such as that liabilities arose as a result of a relatively recent acquisition by the current board. The UK model does not insulate investors from risk, but it does appear to give owners better information to allow them to hold directors accountable. The US model encourages owners to sell or sue when audits find problems.

Bush notes, “shareholder value is created from serving the prime objective of earning a surplus in excess of the cost of capital, not setting one’s prime objective as ensuring accurate reporting for market regulators.” The US scheme is particularly ineffective when companies generate most of their capital from profits, rather than from new issues, which may have been the presumption in the early 1930s when the legal framework was set.

Anyone who truly wants to address the issues surrounding audit independence would do well to read Bush’s paper, along with How US and UK Auditing Practices Became Muddled to Muddle Corporate Governance Principles by Shann Turnbull. Turnbull argues that establishment of an audit committee with “independent directors” cannot remove the conflicts of interest which are only exacerbated by the US Sarbanes-Oxley (SOX) and the UK Combined Code. Along with Roberta Romano, he believes SOX has enshrined in its statute the cause of the problem it was supposed to eliminate, since “audit committees provide a more intimate and frequent basis for bonding the external auditor to the directors rather than to the shareholders who use the information.” Some European countries avoid these conflicts by having the auditor controlled by a shareholder committee or “watchdog board.”

Turnbull’s paper provides a history of how we got here, as well as a compilation of several alternatives. Like him, I am “overwhelmed with the plethora of codes of conduct, ethics, and professional behavior and so called “best practices.’” “They represent intrusive prescriptive complex band-aids that do not address the fundamental flaws of the dominant governance systems.” What is required are self-governing mechanisms of the type found in natural systems and simple thermostats.

That is where I believe Mark Latham’s work comes into play. Although he doesn’t address the fundamental purpose of audits, such as informing shareholders rather than protecting secondary markets by calling for a change in statutes, his proposals would address even those fundamental questions in practice. If shareholders could select the auditor, as he proposes, it is likely they would choose one which places a high priority on informing shareholders about corporate inefficiencies.

Latham introduced his “Auditor Independence” proposal for inclusion in the proxy at several US firms. However, the SEC has consistently allowed management to omit them from the proxy. One of the primary arguments is that selection of the auditor is part of “ordinary business” operations. How this can be held out year after year in light of Enron and the demise of Authur Andersen is beyond me. I can only conclude that Latham needs the help of an attorney familiar with all the recent case law and we need SEC commission members who believe in guarding the interests of shareholders. Arguments on both sides of the proxy inclusion debate are linked at corpmon.com/ProposalSubmissions.htm for the companies Fleetwood Enterprises and SONICblue.

Bush, Turnbull, and Latham present the problem, as well as offering reasonable solutions. Meanwhile, as Turnbull notes, “every effort should be taken by countries around the world to resist the hegemony of the fundamentally flawed US auditing practices.” Don’t let the contagion spread!

Pension Plan Advisors Conflicted

With the resignation of Donaldson, and Cox being named to head the SEC, many seem to have missed the SEC’s May 16th Staff Report Concerning Examinations of Select Pension Consultants. Investment advisers owe their advisory clients a fiduciary duty and are required to “eliminate, or at least expose, all conflicts of interest.” Investment advisers registered with the SEC typically make such disclosures to advisory clients in their Form ADVs. Additionally, advisors registered with the SEC are required to designate a Chief Compliance Officer and to maintain written procedures designed to assure compliance with the Advisers Act.

The SEC conducted focused examinations of a representative sample of 24 pension consultants who are registered investment advisers to determine their level of compliance. Conflicts of interest among pension consultant are worse than even cynics assumed. Here are a few highlights of those they reviewed:

• Many pension consultants do not consider themselves to be fiduciaries to their clients.
• More than half the pension consultants provided products and services to both pension plan advisory clients and money managers on an ongoing basis. For some of these consulting firms, the compensation received from money managers comprised a significant part of their annual revenue.
• More than half have affiliated broker-dealers or relationships with unaffiliated broker-dealers, allows the pension consultant to obtain payment for its services with brokerage “commission recapture” programs. Two failed to disclose these compensating relationships, although the SEC was unable to “fully analyze whether pension consultants ‘skewed’ their recommendations to favor certain money managers.
• Many have affiliates that also provide services to pension plan clients. These relationships create disclosure and conflict of interest issues that have not been addressed by pension consultants.
• More than a third employ advisory representatives that are also registered representatives of a broker-dealer.
• Based on the recommendation of their pension consultant, many pension plan clients choose to utilize an affiliate of the consultant to provide various services, including investment management, brokerage execution, and transition management. Of the 19 consultants or their affiliates that provided products/services to money managers, three (or 16%) provided no disclosure of these other services, and 16 (or 84%) provided limited disclosure.

Here is the closest the SEC comes to enforcement. “We conclude that consultants should enhance their compliance policies and procedures to include those policies and procedures that will ensure that the adviser is fulfilling its fiduciary obligations to its advisory clients.” What would Elliot Spitzer have done? What the SEC does is provide a list of good tips for plan sponsors.

Alternative Structures

PricewaterhouseCoopers is running a series on corporate governance. Part 1 is entitled Emerging Companies and Boards of Directors: What Works Best? and it includes a good discussion of alternative structures, including an advisory board and a two board structure.

So Yesterday

Corporate governance reforms are “soooo yesterday, dude,” according to a report in the Toronto Globe and Mail. First, the U.S. Supreme Court overturned the 2002 conviction of Arthur Andersen on obstruction of justice. Second, President George W. Bush nominated pro-business congressman Christopher Cox as new chairman of the SEC. (U.S. corporate governance is yesterday’s news, 6/4/05)

In other words, the official charged with cracking down on corporate shenanigans will be the same guy who has repeatedly opposed tougher enforcement of boardroom antics, including abuse of stock options, and vigorously pushed for a law making it harder for shareholders to sue companies.

One has to admit, there is a certain logic to Mr. Bush’s recent nominations: Iraq-war champion Paul Wolfowitz as boss of the nice-roads-for-poor-people institution, the World Bank; sabre-rattling unilateralist John Bolton as U.S. ambassador to the United Nations; and now the poacher Mr. Cox to be Wall Street gatekeeper.

Duffy is Back

The Turnaround Tactician is Maureen Nevin Duffy’s new vehicle to report on activist or relational investors.  These are typically “value” investors who don’t buy and wait. They buy and use their governance know-how to turn companies around by unlocking that value, sometimes working with management, sometimes pushing back.  Want to know what Relational Investors, Providence Capital, and others are up to?  Duffy is the closest we have to a journalist on the front lines of corporate governance investing.  She gives you the straight scoop and we can’t wait to see her latest venture take off. Click here to see a sample issue. Then click on Buy Now; you won’t be dissapointed.

Donaldson Steps Down: 
Expecte Rollbacks Under Cox

SEC Chair William H. Donaldson, who took office in the wake of massive corporate scandals and the resignation of securities lawyer Harvey Pitt and aggressively stepped up the agency’s focus on fraud and good governance, announced he’s resigning at the end of the month. Pitt initiated serious reforms, including requiring that mutual funds report on the voting policies and votes. Donaldson went a step further but failed on the most important reform to open up the corporate proxy, if even in a token way, to shareholder nominees.

He was a much more strident reformer than many expected. US Chamber of Commerce President and CEO Thomas Donohue is suing the SEC over a rule pushed by Donaldson that requires 75% of mutual fund board directors to be independent. He noted that the chairman “came to the SEC at a critical time — his job was to restore trust and confidence in our capital markets. “His successor will need to focus on ensuring the future competitiveness of our markets.”

President Bush named Rep. Christopher Cox, R-Calif., a conservative veteran of 16 years in Congress, to succeed Donaldson. Cox has long been an ally of business groups and who helped rewrite securities laws to make investor lawsuits more difficult to file. He supported efforts to repeal the estate tax, the capital gains tax on savings and investment, and taxes on dividends.

Harvey J. Goldschmid, is expected to leave in the coming weeks to return to a teaching position at Columbia University. Senate Democrats have proposed that his seat be filled by Annette L. Nazareth, a senior staff official. The term of another Democratic member, Roel C. Campos, expires this month, although he hopes to be nominated for a second term. (Bush Nominates Congressman to Replace Donaldson at S.E.C., NYTimes, 6/2/05)

“This likely portends a very dramatic shift in the direction of the SEC,” Joel Seligman, dean of the Washington University Law School in St. Louis, told Reuters. “You’re more likely to see an SEC that the Chamber of Commerce and the Business Roundtable are more comfortable with.” “He’ll be a formidable chairman, but it will be a major change in direction,” Columbia University Law School Professor John Coffee told Reuters. “If Cox had written our securities laws, the executives at WorldCom and Enron wouldn’t have any legal troubles,” Damon Silvers, general counsel of the AFL-CIO, told Bloomberg News.

The first rollback? Earlier this year, Cox co-sponsored a House bill, H.R. 913, that would delay implementation of the Financial Accounting Standards Board’s expensing rule by at least three years. Instead of expensing options, the bill calls on the companies to disclose additional information on their option plans and directs the SEC to study the issue for three years. (The ISS Friday Report, 6/3/05) We expect the period of reform at the SEC has come to an end for the duration of the Bush Administration.

Review: Governance and Ownership

Governance and Ownership, Robert Watson, editor (Edward Elgar, 2005). This is an excellent collection of 20 papers, most published in the late 1990s, enhances our understanding of the relationships between ownership corporate ownership governance. Issues investigated include:

• diversity of ownership forms and corporate control implications
• effectiveness of such forms in influencing executives to enhance corporate value
• role of owners in appointing and removing executives
• influence of ownership structures on corporate restructuring, mergers and acquisitions
• motivation of various classes of owners – their ability and willingness to influence corporate decisions

Many of the findings are interesting and run counter to common assumptions in the field. For example, the La Porta et al. (1999) study found that contrary to Berle and Means, companies in most countries (the US included) have “controlling” (10%) shareholders (generally the State or families). Families control about 35% of the largest firms in the richest economies, compared to 24% held by the State. Monitoring and protection of minority shareholder rights take on new meaning.

Wahal (1996) examines pension fund activism in the US and finds, contrary to other studies, no evidence of long term performance improvements. Wahal concludes pension fund activism is no substitute for an active market for corporate control.

Holland (1998) examined fund managers in the UK and finds that institutional voice is typically highly constrained by relative powerlessness and a general unwillingness to interfere, especially during times of good corporate performance. Quasi insider knowledge was typically held “in reserve” until performance took a downturn. Are the costs of monitoring justified if they are only going to be used to accelerate sacking the CEO in times of financial crisis?

David et al. (1998) views the struggle between CEOs and owners over pay. They find that institutional owners that have only an investment relationship with the firm are able to influence CEO compensation, whereas those that also depend on the firm for business are not. (No surprise there, but considers factors not always taken into account by other studies.)

In general, this book has much to recommend it, especially to complacent investors and over-confident executives. Governance and Ownership provides a ready reference to studies that will continue to influence scholarship and practice over the next decade.