Tag Archives | risk

Post-Modern Portfolio Theory: IRRC Research Award Available

The IRRC Institute announced a competition for research that examines the interaction of the real economy with investment theory. Two papers – one academic and one practitioner – will receive the new “IRRC Institute Research Award” along with a $10,000 award. Of course, we would like both prizes to go to CorpGov.net readers. One of many books you might want to read in preparing your paper is Corporate Valuation for Portfolio Investment: Analyzing Assets, Earnings, Cash Flow, Stock Price, Governance, and Special Situations by Robert A. G. Monks and Alexandra Reed Lajoux.

The following panel of renowned judges with broad finance and investment experience will carefully review submissions and select two winning papers: Continue Reading →

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Believe it: Sometimes Governance is to Blame More than the Tax Code

The recent discussion in the media about the litigation around the Tribune Company LBO in 2007, is an excellent illustration of the consequences of a governance failure as well as the failure of many commentators to recognize the causal relationship. In the linked article, Holman Jenkins of the WSJ correctly notes that this deal was ill-conceived from the beginning.

To sum up a complicated situation, a bankruptcy judge has now decided that the Tribune’s unsecured creditors can sue everyone involved in the leveraged buyout, including the lending banks, on grounds that the deal was a “fraudulent conveyance”—they knew or should have known they were piling on more debt than the company could survive. Already a special examiner appointed by the bankruptcy judge has found sufficient evidence to support such a claim. 

He pins the blame on our convoluted Internal Revenue Code, specifically its provisions awarding special dispensation to Employee Stock Ownership Plans, one of the vehicles used to bring the deal to fruition.

While there is little doubt that IRC incentives played some role in the debacle, the fact remains that the deal was quite aggressive in all events. This was the case even with the most favorable tax consequences and economic assumptions, and prompted significant concern at the time by those asked to pass on the company’s solvency ex post. In other words, the deal resulted from bad decisions by both purchasers and sellers. There was simply insufficient vetting of the deal by anyone.

As we know, the corporate governance field exists in large part to cause companies to avoid such bad decisions. Caused in large part by terrible decisions in the financial sector (as well as households entering into the overly aggressive mortgages), the Great Recession attests to the fact that governance law has not worked in the intended manner and that substantive changes are required to have it work properly.

While there is no question that our IRC is sorely in need of overhaul for many reasons, it is important that its deficiencies not be used as a scapegoat for governance failures. It is important that public dialogue about what needs to be done to avoid the sorts of bad decisions that led to the Great Recession be properly focused and prominently note the role of governance and the need to change its framework so as to bring about fewer bad decisions.

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Video Friday: Risk and the Board

Interview with: Andrea Zulberti, Member of the Board of Directors, Prologis and SYNNEX Corporation. Hosted by: Don Keller, Partner Corporate Governance Practice, PwC.

What elements of corporate risk are not receiving adequate Board oversight: (1) strategic, (2) financial, (3) compliance, (4) operational, (5) technology and/or (6) unknown? Is it Management’s or the Board’s responsibility to provide assurances that enterprise risk are all appropriately addressed and within the company’s agreed-upon risk appetite and tolerances? Is it Management’s or the Board’s responsibility to make a (continuing) assessment of whether the corporation has the right controls and processes in place? Should the Audit Committee undertake the Board’s role or a separate Risk Management Committee? Should the Board oversight of “financial” risk be separated from “business” risk?

See this and other brief podcasts on the Silicon Valley NACD website.

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Transocean: Now, the Rest of the Story

I get hundreds of e-mails every day and often delete before even glancing if I am especially busy. Fortunately, Timothy Smith of Walden Asset Management also sent out an e-mail on a post by Theo Francis, of footnoted*, that had already hit my trash. We’ve all heard about Transocean’s bonuses for “the best year in safety performance in our Company’s history.”

The bonus incident speaks volumes about Transocean and the tone set at the top of the company. But so do two other details in the filings. First, the company’s board created a Health Safety and Environment Committee in August last year, some four months after the spill. Guess how often it met during the four months between then and the end of the year? Once.

Agenda Item 2 in the proxy is even more eye-opening. To hear the company tell it, the provision is an attempt to “discharge the members of the Board of Directors and our executive management from liability for their activities during fiscal year 2010,” explicitly including the rig explosion and oil spill. It would, Transocean says, not only prevent many shareholders from suing directors and officers entirely — whether by taking part in existing lawsuits or future ones — it would give other shareholders a narrow window of just six months to sue.

Those who vote for the measure give up their right to sue altogether, Transocean says. Those who vote against the measure, assuming they fail to stop it, will have just six months to sue, the company says:

“After the expiration of this six-month period, such shareholders will generally no longer have the right to bring, as a plaintiff, claims in shareholder derivative suits against our directors and executive management.”

And there’s more at Transocean’s quiet risk panel & push for immunity | footnoted.com, 4/6/2011. (apologies to Paul Harvey)

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Review: Risk Management and Corporate Governance

Risk Management and Corporate Governance: Interconnections in Law, Accounting and Tax by Marijn Van Daelen (Editor), Christoph Van Der Elst (Editor)

After the recent financial crisis more and more pension and other funds are adjusting their portfolios for risk. This book offers a fascinating look at the juxtaposition of corporate governance and risk analysis. Bob Tricker has often proclaimed the 19th century the entrepreneur’s, 20th century management’s, and 21st that of governance. It could also be the century when risk and probability finally enter everyday consciousness and is finally taught in grade school.

The law of probabilities defined by Fermat and Pascal in 1654 started us down the road. Authors represented in this small volume bring us up-to-date regarding how far we have come on the journey from passive prisoners of providence to attempting to measure and manage all possible events.

In the 17th century the Dutch East India Company was forced by shareowners to publish balance sheet statements and profit and loss statements. Today, shareowners call on Starbucks to “Adopt a Comprehensive Recycling Strategy for Beverage Containers.” Talk about drilling down. The London city directory mentioned 11 accountants in 1799; we’ve come a long way.  The authors provide a brief tour of history, which includes a wide variety of risk models, such as Value at Continue Reading →

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Exchange Leverage

Stock exchanges can enhance corporate environmental, social and governance (ESG) disclosure and performance by applying ESG standards within IPO and ongoing listing rules, corporate governance codes, and by offering ESG-related traded products.

A September 2010 paper by EIRIS, a global provider of ESG research, reviews the increasing role that stock exchanges play in enhancing corporate transparency and performance on sustainability issues. (Hat tip to SIF for bringing this to my attention.)

Some exchanges have already incorporated ESG reporting requirements in their listing rules and corporate governance codes. China’s Green IPO policy, which requires companies in 14 energy-intensive industries to undertake environmental assessments before initiating an IPO, is a good working example. Bursa Malaysia and the Johannesburg Stock Exchange are two of the leading exchanges that have incorporated mandatory ESG reporting requirements for all listed companies. The Australian Stock Exchange has incorporated an ESG disclosure requirement on a ‘comply or explain’ basis as part of its Corporate Governance Principles.

…Among the first indices on the market, the BM&F Bovespa ISE Index, the Dow Jones Sustainability Indexes, the FTSE4Good Index and the JSE SRI Index greatly contributed to the improvement of the ESG performance of companies and implicitly to raising the international profile of responsible investment.

However it is apparent that stock exchanges can do more… In June 2010, the UK’s Financial Reporting Council (FRC) revised the Corporate Governance Code to include engagement principles for institutional investors to take the ESG risks of their investee companies into account.

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Do Independent Directors Cave to Shareowner Pressure, Creating Higher Risk?

Interesting article in The Economist (Corporate Constitutions, 10/28/2010) on the recent revolution in corporate governance.

in 2009 less than 12% of incoming CEOs were also made chairmen, compared with 48% in 2002. CEOs are held accountable for their performance—and turfed out if they fail to perform, with the average length of tenure dropping from 8.1 years in 2000 to 6.3 years today. Companies have turned to a new class of professional directors, and would-be directors sign up for bespoke courses at business schools because Sarbanes-Oxley makes them personally liable for the accounts that they sign.

While Nell Minow and other corporate governance activist point to the recent financial crisis as evidence more reforms are needed in this direction, The Economist cites research by David Erkens, Mingyi Hung and Pedro Matos, of the University of Southern California (Corporate Governance in the 2007-2008 Financial Crisis: Evidence from Financial Institutions Worldwide), which found “the proportion of independent directors on the boards was inversely related to companies’ stock returns.” Institutional owners pushed firms to take more risks and independent directors appear to be more subject to their pressure.

However, the same authors also point out that the evidence from Asia suggests that greater external monitoring has produced better performance. The Economist concludes,

Good corporate governance on its own cannot make up for a toxic corporate culture. Reformers should continue to experiment with systems of checks and balances. But they would also profit from spending less time drawing up ideal constitutions and more time thinking about intangible things such as firms’ values and traditions.

In my opinion, this provides further evidence for the value of the UK’s newly introduced Stewardship Code… something the US would do well to study and modify for our own use.

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Financial Sustainability: Restoring Market Stability, Corporate Value & Public Trust (ICGN Mid-Year 2010)

Disclaimer: Given Dodd-Frank, proxy plumbing and all those comments I want to provide the SEC, the report below doesn’t do the ICGN Mid-Year Conference justice.  I wrote this up more than a week later with poor notes and memory. Comments, corrections and substitute photos are solicited.

Sharing Perspectives Across the Atlantic. Phil Angelides, Lord McFall and moderated by David Pitt-Watson.

The Financial Crisis Inquiry Commission will report in December to give an unbiased historical accounting of the causes of financial crisis. It will be out in book form but will also be available through download.

Phil Angelides

$11 trillion in wealth was wiped away. The market took until 1954 to get back to the levels of 1929. Let’s hope this one doesn’t take as long but, more importantly will we learn the lessons necessary to prevent or minimizes future bubbles?

It was a failure of accounting and deregulation. Too many were rewarded based on volume not on performance and their was no continuity in risk (they thought) after all the slicing, dicing and creative complexity.

Lord McFall

Rewards can’t be asymmetric and function properly. This was not a natural storm; the clouds were seeded. Signs were there, such as a 2004 warning from the FBI about a housing fraud epidemic, but they were glossed over. Now, our remaining investment banks are largely trading banks, not focused on generating capital but on gaming the markets. The betting market is much larger than the real economy… with more than 85% of transactions being synthetic.

Dodd-Frank requires the investment banks to hold 5% of the securities they sell but I’m not sure what good that does since that portion of their business is now minor. We need to rethink the role of finance in our economy. Continue Reading →

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Risk, Sustainability & Responsibility

In the 21st century, corporate health and success are inextricably linked to the adequacy of security management. Poor security management can lead to operational disruptions and financial losses. For this reason, boards of directors need to take ownership of security in the same way they take ownership of other critical aspects of the business. To achieve long-term sustainability, security should be integrated into daily management activities and elevated to strategic concern… Investment in security can pay rich dividends to the organization in many ways, not only by enhancing reputation and market share but also by improving efficiency through operational cost reductions, minimized disruptions, and increased productivity.

Security as a Critical Component of Corporate Defense by Sean Lyons published as The Conference Board Executive Action Report, No. 330, July 2010, provides boards of directors, who tend to be removed from the conception and design of corporate defense management programs (CDMs), a top-down strategic approach that ensures a cohesive corporate culture attentive to defense issues. It aims to for reduce the typical silo-type mentality by promoting information-sharing procedures and collaboration across the enterprise through a four phase approach involving: Risk Identification, Risk Assessment, Risk Response, and Risk Monitoring.

Michael R. Young offers advice in The Board and Risk Management (The Corporate Board, July-August/2010). At the board level, risk management “best practices” have yet to be written. Although every company is different, “Expertise and sophistication can be strengthened by having a Chief Risk Officer report directly to the risk committee as well as to the CEO… such an approach might be the best way to capture the desired expertise and sophistication, while integrating information and perspectives.

From Transparency to Performance: Industry Based Sustainability Reporting on Key Issues, co-authored by Steve Lydenberg of Domini Social Investments, Jean Rogers of Arup, and David Wood Hauser of the Center for Nonprofit Organizations at the Harvard Kennedy School of Government, to devise a method to identify ESG factors that are most relevant to the full range of stakeholders, and can best promote improved corporate performance on vital social and environmental issues.

The report develops a system to identify key performance indicators (KPIs) by industry sector, with the goal of creating a regulatory regime with concise, comparable metrics that set a mandatory floor for sustainability reporting. The report applies this method to five sample industries to demonstrate how such a system might hypothetically be implemented within a US reporting context. These KPIs are based on three core principles — simplicity, materiality, and transparency.

To meet the dual challenges of comparability and practicability for establishing KPIs by industry and sector, the authors developed a six step method as follows:

  1. Assemble a broad universe of sustainability risks or opportunities that could apply to all industries.
  2. Select an industry classification system.
  3. Establish a definition of materiality to address non-financial issues.
  4. Apply the materiality test to the sustainability issues potentially applicable to each industry sector.
  5. Rank the materiality of these issues within each industry and establish a threshold that defines those issues that are key.
  6. Create a tailored set of key performance indicators for the most material issues for each sector.

The authors then apply the approach to six industries, chosen in order to represent a diversity of business practices. Five categories of impact were then evaluated at the sector or sub-sector level:

  1. Financial impacts/risks: Issues that may have a financial impact or may pose a risk to the sector in the short-, medium-, or long-term (e.g., product safety)
  2. Legal/regulatory/policy drivers: Sectoral issues that are being shaped by emerging or evolving government policy and regulation (e.g., carbon emissions regulation)
  3. Peer-based norms: Sustainability issues that companies in the sector tend to report on and recognize as important drivers in their line of business (e.g., safety in the airline industry)
  4. Stakeholder concerns and societal trends: Issues that are of high importance to stakeholders, including communities, non-governmental organizations and the general public, and/or reflect social and consumer trends (e.g., consumer push against genetically modified ingredients)
  5. Opportunity for innovation: Areas where the potential exists to explore innovative solutions that benefit the environment, customers and other stakeholders, demonstrate sector leadership and create competitive advantage.

Among the report’s key findings are:

  • Mandatory reporting regimes create better disclosure, which, when incorporating key sustainability performance indicators, can lead to better performance in those areas most crucial to stockowners, other stakeholders, and society.
  • Defining a limited number of KPIs that relate to core business activities can help contribute to a balanced reporting regime that serves the dual demands of comprehensiveness and practicability.
  • A method for identifying KPIs for all industry sectors that is simple, material and transparent can be developed and implemented with a reasonable degree of effort by oversight bodies.
  • Mandatory reporting on a basic of set of KPIs is ultimately necessary to fill varying disclosure needs of our diverse society and complete the convergence of financial and sustainability reporting.

Although both British Director accountability and American CEO primacy tackle the fundamental principal-agent problem, a basic comparative analysis of the British Codes and the American Sarbanes-Oxley Act reveals a relevant normative asymmetry. While the British regulations have been historically more prescriptive with the responsibilities of Executive and Non-Executive Directors, the American norms seem to point more clearly at the CEO and CFO as those ultimately responsible for corporate governance liabilities. (British Directors’ Accountability vs. American CEOs’ Primacy by Simon Kinsella, and Giampiero Favato)

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Addressing Risk in Money Market Funds

Capital Advisors Group (CAG), a leading institutional investment advisor focused on short-term cash investing,  announced the launch of FundIQ – “the industry’s first money market fund research product designed to help treasury professionals pursue investment performance by applying the firm’s new fundamental risk analysis process and an independent credit opinion to institutional prime money market funds.” (press release, 5/17/10)

Ben Campbell, Capital Advisors Group’s President and CEO noted,

The most interesting part of this research is that all of the funds we evaluate today are rated triple-A by nationally recognized ratings agencies, yet we still find notable variances in the inherent risk in the funds based on the research method we use. This deeper level of risk assessment is meant to help treasurers who simply don’t have the time or resources to conduct the level of due diligence required to support their money market fund investment decisions. FundIQ was developed in response to these treasurers’ concerns and we hope that they can now invest more confidently knowing that a research team has invested a great deal of time and effort in assessing some very specific risk factors within these funds.

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Banking on Governance

Leverage and Risk in US Commercial Banking in the Light of the Current Financial Crisis (available from SSRN) by Christian C.P. Wolff and Nikolaos I. Papanikolaou examines the relationship between leverage and risk in US commercial banking market. From their abstract:

Our findings indicate reliably that both on- and off-balance-sheet leverage contributes to (systemic) risk, which implies that large banks do not maintain a level of leverage that could allow for equity capital to act fully as a buffer, absorbing losses and enabling the business to continue in case of financial distress. In a similar vein, a direct link between short-term leverage and risk is reported, showing that leverage is one of the main factors responsible for the serious bank liquidity shortages that were revealed in the current crisis. We also find that those banks that concentrate on traditional banking activities typically carry less risk exposure than those that are involved with new financial instruments. The latter finding could play a role in the current discussion about a possible revival of the Glass-Steagall Act. Overall, our results provide a better understanding of the main causes of the present crisis and contribute to the discussion on the reinforcement of the existing regulatory framework.

Reforming Governance of ‘Too Big to Fail Banks’ – The Prudent Investor Rule and Enhanced Governance Disclosures by Bank Boards of Directors (available at SSRN) by Michael Alles and John Friedland looks at the governance challenges posed at boards of large banks, since they have proven inadequate to the task of controlling risk. From the abstract:

We propose a two step procedure to improve bank governance. First, we give bank directors an explicit standard to assess the outcome of their actions: the Prudent Investor rule which is the requirement for trusts, but has been replaced in the last hundred years by the less stringent Business Judgment rule. Adopting the Prudent Investor rule would return to director’s responsibility to control the risks of banking activities. To enforce the higher standard, we propose to use disclosure as a disciplining mechanism. We base the new disclosure regime on Section 404 of the Sarbanes Oxley Act that requires managers to implement controls over the firm’s financial reporting processes and to publicly attest to their effectiveness. This section failed to prevent the credit crisis because it was too narrowly focused. We recommend that the provision be broadened to encompass governance controls in general, and that responsibility for disclosure be placed on the bank board rather than on managers.

Ah, if only academics had a bigger role in ruling the world.

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CEO Pay & Risk Reduction

In Reining in Excessive Risk Taking by Executives: Experimental Evidence, researchers Mathieu Lefebvre and Ferdinand Vieider find that excessive risks are likely to be reduced by aligning executives’ interests with those of shareowners. (paper available at SSRN, March 2010) Abstract follows:

Compensation of executives by means of equity has long been seen as a means to tie executives’ income to company performance, and thus as a solution to the principal-agent dilemma created by the separation of ownership and management in publicly owned companies. The overwhelming part of such equity compensation is currently provided in the form of stock-options. Recent events have however revived suspicions that the latter may induce excessive risk taking by executives. In an experiment, we find that subjects acting as executives do indeed take risks that are excessive from the perspective of shareholders if compensated through options. Comparing compensation mechanisms based on stock-options to long-term stock-ownership plans, we find that the latter significantly reduce the uptake of excessive risks by aligning the executives’ interests with those of shareholders. Introducing an institutionalized accountability mechanism consisting in the requirement for executives to justify their choices in front of a shareholder reunion also reduces excessive risk taking, and appears to be even more effective than long-term stock-ownership plans. A combination of long-term stock-ownership plans and increased accountability thus seem a promising direction for reining in excessive risk taking by executives.

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CorpGov Bites

“In many ways, 2010 is the Foundation Proxy Season. By next year, the world will be changed. It is likely that both say-on-pay and proxy-access measures will be mandated. Directors will undoubtedly face greater scrutiny and more challenges than ever before. As a result of these impending challenges, boards must use the 2010 season to lay a strong foundation that prepares them for the future. That means building relationships with investors and strengthening management teams and boardroom rosters.” (This Proxy Season: Bowling for Ballots, Directorship, 2/11/10) Like always, Patrick McGurn provides the best insights into this year’s proxy season.

For excellent analysis of Citizens United, see Jay Brown’s theRacetotheBottom.org. Rallying place for action seems to be Shareowners.org.

For companies trying to figure out how to address the new disclosure requirements related to board qualifications, leadership structure, risk oversight, etc., Broc Romanek has you covered, offering up samples at TheCorporateCounsel.net Blog. (Samples: Companies Complying with the SEC’s New Rules, 2/11/10)

Ceres, in collaboration with Bloomberg and UBS, launched a new benchmarking study today called Murky Waters: Corporate Reporting on Water Risk.” The report (available here) ranks 100 publicly-traded companies in 8 water-intensive sectors on their water risk disclosure: beverage, chemicals, electric power, food, homebuilding, mining, oil & gas, and semiconductors.

Senate Bill 1007, by Democratic Sen. Loni Hancock of Berkeley, would require candidates for board seats with the California Public Employees’ Retirement System and the California State Teachers’ Retirement System to file ongoing campaign contribution and spending reports during and after an election. (Bill would boost CalPERS, CalSTRS election transparency, From The Capitol, 2/10/10)

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A Fistful of Dollars: Lobbying and the Financial Crisis

On December 31, 2007, the Wall Street Journal reported that Ameriquest Mortgage and Countrywide Financial spent respectively $20.5 million and $8.7 million in political donations, campaign contributions, and lobbying activities from 2002 through 2006 to defeat of anti-predatory lending legislation. Such anecdotal evidence suggests that the political influence of the financial industry contributed to the 2007 mortgage crisis, which, in the fall of 2008, generalized in the worst bout of financial instability since the Great Depression.

Using detailed information on lobbying and mortgage lending activities, Deniz Igan, Prachi Mishra, and Thierry Tressel find that lenders lobbying more on issues related to mortgage lending (i) had higher loan-to-income ratios, (ii) securitized more intensively, and (iii) had faster growing portfolios. Ex-post, delinquency rates are higher in areas where lobbyist’ lending grew faster and they experienced negative abnormal stock returns during key crisis events. The findings are robust to (i) falsification tests using lobbying on issues unrelated to mortgage lending, (ii) a difference-in-difference approach based on state-level laws, and (iii) instrumental variables strategies.

These results show that lobbying lenders engage in riskier lending. The authors conclude their study provides some support to the view that the prevention of future crises might require weakening political influence of the financial industry or closer monitoring of lobbying activities to understand the incentives behind better.

Igan, Deniz, Mishra, Prachi and Tressel, Thierry, A Fistful of Dollars: Lobbying and the Financial Crisis (December 2009). IMF Working Papers, Vol. , pp. 1-71, 2009. Available at SSRN: http://ssrn.com/abstract=1531520

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How Politics Shaped the Political Economy of Global Finance

The Political Economy of Global Finance Capital by Richard Deeg and Mary O’Sullivan review 6 influential books on the topic in light of the recent financial crisis.

The most important developments highlighted:

  • the move from a predominant focus on state-centered patterns of regulation to a more comprehensive understanding of the role of states and private actors in building a transnational governance regime that mixes public and private regulation;
  • the intensified effort to understand the causal forces that shape the political economy of global finance based on more complex models that allow for an interaction among interests, institutions and ideas; and
  • increased attention to new sources of systemic risk in the global financial system, as well as a greater consideration of the consequences for domestic politics of interactions with the global financial system.

They argue that we must do more to understand the behavior of actors who enact the rules of global finance, not just those who generate the rules. More must be done to assess the costs and benefits of financialization at the global and national levels.

Some interesting points highlighted:

  • The financial crisis emanated not from the periphery but from the very core of the system.
  • Facilitated flows from poor countries to rich countries, rather than the historically opposite direction.
  • Coordinated market economies that rely on welfare production regimes for promoting and protecting the investment by firms in skill sets and specific assets may have a competitive advantage with financial globalization, the opposite of conventional thinking.
  • These protections inhibit convergence in corporate governance.
  • Financialization, where maximization of short-term shareowner value through dashboard metrics, has compromised the interests of other stakeholders and corrodes the coordinated system of capitalism.
  • Extraordinary incentives contributed to willingness to pursue aggressive strategies without due attention to risks.

How is it that false illusions were conferred sufficient legitimacy to deafen alternative views and stymie reform? In our thinking, a lot may come down to the power held by CEOs and their organizations like the Business Roundtable and the Chamber of Commerce. They can spend shareowner money like there is no tomorrow in defending a system that still gives CEOs virtually dictatorial power. On the other side, institutional investors are held to fiduciary duties that limit such lobbying efforts, even by the few that don’t have direct conflicts of interests, such as in trying to attract those 401(k) accounts from CEOs.

Happy Holidays: More, More, More: Gifts For the CEO Who Has Everything (clip from Nightly Business Report via The Corporate Library Blog, 12/24/09)

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January 2009 Special News Supplement: Directors Forum 2009

The conference opened with a great dinner and a fascinating keynote speech by Jim Chanos, founder and managing partner of Kynikos Associates, the world’s biggest short-seller. In introducing him, conference co-host Larry Stambaugh proudly held up a copy of the Financial Times from two days earlier that had Chanos’ picture not only above the fold but above the headlines. (View from the Top, 1/26/09) In the FT interview Chanos said of the banks, "there is still a lot of damage on these balance sheets that has not come out." Asked if America’s financial shift is Chanosmoving from New York to Washington, he said, "power is beginning to shift… anyone who doesn’t see that is kidding themselves." He thinks the next target for regulation is likely to be private equity funds.

Short positions represent only a small portion of hedge fund activity, according to Chanos. Take out 3-6% being arbitraged and that leaves only about 0.5-1% of pure shorts. Although short-sellers are often viewed as "skunks at the garden party," "we’re not your enemy." In fact, short sellers are needed for efficient markets. He told of the case of three Irish banks that lost 40% of their value and had to be nationalized when short-sellers were required to disclosure their positions.

Short sellers are "real-time financial accountants," whereas the SEC reviews are more like "archeology." He advised that when short-sellers attack, directors should ask their CEO or CFO why. If they don’t know, they’d better find out, because they are usually doing so based on real evidence of problems. He questioned why the SEC has so few staff with real world experience, suggesting that at least one commissioner should be someone with trading desk experience. He thought it was a good time to short the rating agencies and questioned how senior executives of Wall Street banks could be so clueless. Perhaps they weren’t, because many were shorting their peers.

Chanos sees that any company still distributing analog products is likely to be in trouble, given the marginal costs of distribution over the Internet. Expect a shakeout of firms as the giants go digital. On a more global scale, he seems to be shorting Mexico, seeing a crisis coming. He covered an enormous amount of ground and took lots of questions. No, he’s never been called by a director to find out why he is shorting a company. Ask your CEO or CFO. He’s usually found some accounting issues that show bad judgment.

Everyone I talked to learned a lot from Chanos. He wasn’t a "skunk at the party" at all, at least not at Directors Forum 2009. Those of you who were unable to attend might glean the much of essential message from Short Sellers Keep the Market Honest. (WSJ, 9/22/09) Of course, you’ll have missed a great deal of wit and charm. See also, IIROC releases two studies on marketplace trends related to short sales.

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Cynthia Richson moderated the first panel of the Forum’s program on the topic "Shareholseatingder Hot Topics." Richson co-founded the Directors Forum and has been a dynamic figure in corporate governance well before creating the Directors’s Summit for the State of Wisconsin Investment Board, which the Forum used as something of a model. Panelists were among the most distinguished in the field: Richard Ferlauto, Peggy Foran, Mike McCauley and Pat McGurn. The auditorium was modern and comfortable. (right) Here, I’m not going to report individual comments either here or as I discuss other panels, since that could stifle frank debate at future Forums.

Needless to say, there was a lot of speculation concerning the role the Federal government will take at financial companies coming under the TARP. Shareowners will be taking a laser light to executive compensation, especially repricing. There are expectations that holding periods will extend beyond tenure. Investors expect stronger succession planning. Compensation should be built around developing and meeting strategic plans and leadership expectations.

Shareowners will be more proactive. Corporations should talk to their major investors before taking controversial actions. Companies expect investors to talk with them before submitting resolutions. Panelists expressed concern over both short-term shareowners and CEOs. They briefly discussed recommendations of the Group of Thirty, the Aspen Institute’s Principles, the shift to independent chairs, and many other issues. One colorful bit of advice that I think all would agree with came from Pat McGurn. "Engagement is critical. Don’t get in a defensive fetal position."

John Wilcox, Chairman of Sodali, previously with TIAA-CREF and Georgenson, moderated the panel, "Do You Know Who Your Shareholders Are? The Changing Face of Activism." Distinguished panelists included William Ackman, Brian Breheny, John Olson and Frank Partnoy. Short-selling was again discussed, including the issues of disclosure, share lending, voting by short-sellers, etc. Readers might want to review ICGN’s best practices from 2007.

Another topic discussed was the fact that so many investors are short-term holders, rather than long-term owners. Panelists appeared to agree that companies shouldn’t take action to placate shareowners by generating short-term gains that would impair long-term value. However, they couldn’t agree on requiring something like a one year holding period before being eligible to vote.

Again, it was another far-ranging discussion about disclosures, the need to create forward looking risk models, the problem of real property prohibitions against foreign ownership above 5%, the desire of shareowners to be able to talk with their elected representatives (directors), the use of Reg FD as an improper excuse not to engage (see interpretive release), and much more.

The final Monday morning session was on "The Future of Corporate Governance: the Next Five Years?" Henry James HaleduPont Ridgely, Steven A. Rosenblum, Richard Ferlauto, and Sara Teslik were moderated by James Hale. (picture on right) Again, lots of disagreement among this group. However, they all appeared to agree that technology is leveling the playing field. Just as it helped Obama win office, it is changing the way corporate governance is pursued.

Another development that could have lasting impact is the Delaware Supreme Court’s agreement to accept questions certified to it by the SEC. The first questions involved AFSCME’s proposal to CA, Inc. The Court knocked that decision out in twenty days. There was general agreement that dialogue is needed but disagreement as to how big of a stick shareowners need to get into the conversation. Majority vote provisions for director elections have been tremendously effective. Future actions may focus more on directors, rather than symptomatic issues that are often addressed in shareowner resolutions. When shareowners can speak with one voice, that facilitates agreements.

Directors need to focus on process with regard to risk. Bad outcomes don’t equal bad faith but bad documentation can certainly lead to trouble. There was a good discussion around split chair/CEO movement, including mention of Millstein’s recent attention to the topic. Yet, when the chair wants to actually be the CEO, the split might not work as well.

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Almost on cue, the keynote speaker for lunch, Rex D. Adams, discussed their transition to separating out the role of chairman. At that time Invesco was a UK company and the idea was pushed by investor groups, such as the Association of British Insurers. Invesco kept the structure when the moved to a New York Stock Exchange listing but is now reexamining their position. He acknowledged good arguments that a single position strengthens the focus of accountability on one person and ensures against distraction. However, he thinks the split provides greater transparency with respect to roles and puts the board in a better position to evaluate the CEO and management team. As chairman, he sets the board agenda and governs allocation of the board’s time but does so in close collaboration with the CEO. There were several questions from the audience and Adams did a good job of detailing his experience with split roles.

Charles ElsonThe afternoon broke into concurrent sessions. I missed "IFRS: Sound Principles — Or More Room for Manipulation?" Here’s a recent update from Business Finance – Regulatory Strategy 2009: What to Watch Right Now. Instead, I opted for the more popular, "Compensation: Pay Practices Under Fire, with panelists Karin Eastham, Charles Elson (left), JoAnn Lublin, Robert McCormick, and Anne Sheehan, moderated by David Swinford. Much of the discussion centered around repricing options, most of which are currently underwater. Movement now is to rethink the base vs bonus with more emphasis on restricted shares.

Directors were warned to tread carefully. Investors have a sense of betrayal and compensation packages may be the best place to regain trust… or lose it altogether. A good explanation goes a long way. I heard it in the panel and elsewhere that more investors are focusing on pay equity within the enterprise. Does the comp committee even look at it? Too often, CEO pay is driven totally by comparisons with other companies with no look within the organization. Employees won’t be motivated if CEO pay gets too far out of alignment. Few boards appear to be cutting back on board pay… maybe because directors are putting in so much more time and effort.

Of course, CEO pay remains the hot button issue and Forum panelists are in the news commenting. "This is different. The arguments against curbs don’t make sense any longer. My friends will bring up the issue even before I do. Opinion has been galvanized," said Robert McCormick. (CEO pay cuts: Not just for banks, CNNMoney.com, 2/4/09)

I then missed "Risk Assessment: Questions Directors SHOULD be Asking." Here are materials on that subject from Deloitte. Instead, I attended a session on "Corporate Governance "Lite" for Smaller Companies." The panel consisted of Janet Dolan, Gregory P. Hanson, William McGinis and Deborah Rieman, moderated by Scott Stanton. Panelist discussed some issues common to small companies, like too often trying to rely on board members as adjunct staff experts. Again, there was discussion of split chair/CEO positions and at what stage that transition might take place. They discussed SOX, the fact that small companies have thin or no coverage from analysts and their stock price is more vulnerable to attack on shareholder bulletin boards. The most fascinating discussion for me was of founders who don’t want to let go of the reins. What made it even more so, was discussion from audience members in that position.

That evening at dinner, we heard from New York Times columnist Joe Nocera. His speech was short and highly entertaining. He took a lot of questions from the audience on wide-ranging topics from the "great unwinding" that would have happened if Bush had been successful in privatizing Social Security, to the likelihood of credit card debt forming the next crater. One thing he was definitely sure of, each generation discovers its own cycle of "fear and greed." The cycles seem to be accelerating.

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Former SEC Chairman Christopher Cox (right) made a plea for an "exit strategy" from government ownership and Christopher Coxinvolvement. The speech was very similar to one he delivered to a joint meeting of the Exchequer Club and Women in Housing and Finance last December. He spent some time on how we got into the mess, explained the economy goes through cycles and although he did not discount the need for intervention, his main message was that we shouldn’t conflate the role of market regulator with market actor. He said Congress does two things well, "nothing and overreacting."

Interestingly, he made no mention of reinstating the leverage limits the SEC removed on 2004 under William Donaldson. For years, financial institutions could lend 12 for every 1 dollar they held in reserve. "Using computerized models, the SEC, under its new Consolidated Supervised Entities program, allowed the broker dealers to increase their debt-to-net-capital ratios, sometimes, as in the case of Merrill Lynch, to as high as 40-to-1." (Ex-SEC Official Blames Agency for Blow-Up of Broker-Dealers, New York Sun, 9/18/08)

The 2004 decision gave the SEC authority to review the banks’ increasingly risky investments in mortgage-related securities but the program was a low priority for Cox. Seven staff, without a director, were assigned to examine the companies, with assets more than $4 trillion. As of September 2008, "the office had not completed a single inspection since it was reshuffled by Cox more than a year and a half ago." "The commission’s decision to effectively outsource its oversight to the companies themselves fit squarely in the broader Washington culture of the past eight years under President George W. Bush" according to U.S. regulator’s 2004 rule let banks pile up new debt, International Herald Tribune, 10/3/08.

Bill George was next up. He’s the type of inspirational leader conferences often put at the beginning to fire up those in atBill Georgetendance, but it works just as well to end on a high note. The themes of his advice to directors have broad appeal:

  • Board independence is critical. Executive sessions were the most important thing to come out of SOX.
  • Board composition should reflect their customer base — a diversity of life experiences and thought. Strongly favors self-evaluations and a mechanism to ensure directors rotate off.
  • The form of board leadership isn’t so important — it doesn’t guarantee results.
  • Time and commitment are important. He also favors totaling the location of board meetings for context/access.
  • Board chemistry is important and is often improved by offsites or other informal occasions that result in honest conversations and straight talk about values and strategy.
  • Increase interactions with management, not just the CEO. The company’s future may depend on it.
  • On executive compensation, look internally as well for equity issues. How is pay for performance viewed from the inside?
  • Ensure the corporation’s reputation through transparency. Employees should hear it from the company first, not the newspaper.
  • Maximizing short-term shareholder value will destroy the company — focus on the next 10 years. Don’t forecast earnings — let the analysts do that.
  • Remember that government charters companies to do something of value. Ensure you a fulfilling society’s mission and instill values in those coming up. People are not just motivated by money. Search for meaning and significance, being part of something special.

Continuing the theme of ending with a bang, the last panel of the Forum was "Selecting & Training Directors — the Role of the Governance/Nominating Committee." The moderator was Richard Koppes. Panelists were Bonnie Hill, James Melican and Kristina Veaco. Whereas some might argue that Christopher Cox spoke too long and left too little time for questions, that certainly wasn’t the case here. The audience had every opportunity to ask for advice on issues that concerned them. Hill spoke on lawsuits, risk issues and culture… much around how Home Depot had learned its lessons the hard way with shareowners. Melican talked about working with clients, such as CalPERS, about the needs of a particular board. With proxy access coming, proxy advisors may be placed in such a role on a more routine basis. Veaco got right into the grit of reference binders, policies, contracts, charters, etc., emphasizing the Bonnie Hillneed for new director orientation and the benefits of being assigned a mentor. Plan ahead and get items on an annual calendar… two to three years ahead. Now that’s planning!

They talked about the importance of resources, like The Corporate Library, the Society of Corporate Secretaries and Governance Professionals, and Stanford Directors College. Hill (pictured at right) spoke of the importance of getting to know the directors before you join a board and the need for boards to think ahead, keeping a reserve of potential directors in the pipeline. She stressed the importance of peer evaluations… and the need to shred the written component. Melican suggested evaluations should be conducted by a third party rather than in-house staff. Veaco preferred evaluations have a written component as well as an oral interview and that the most sensitive questions/answers would occur orally, but that in any event the questionnaires would not be kept and only summaries of the results would be provided.

Hill advised shareowners they don’t have to submit a proposal before getting a hearing. Have the conversation prior to submitting proposals. Veaco seconded that, saying discussions should go on all year, not just during proxy season. Corporate secretaries should be reaching out to top shareowners.

Hill spoke of the increased time commitment directors are making and the use of conference calls and tools like BoardVantage. Again, split chair and CEO came up as a topic as it did so often at this year’s Forum. Hill described their use of a lead director at Home Depot. Pay was also touched on again. Home Depot has moved away from a per meeting charge, using a flat retainer. Veaco said in her experience directors are paid meeting fees, even when they are called on to attend a large number of meetings, and the amount is the same for telephonic as for in-person meetings, but companies can handle this differently. Melican stressed the need to look beyond compensation to what shareowners might view as perks. This is not the time for junkets in Paris or to line up the limousines. Look at your charitable contribution match. Think of eliminating meeting fees and address the issues before they hit the press. (see also Nominating/Governance Committee Roundtable)

Of course, much of the essence of the Forum were the encounters that happened outside the formal confesettingrence. The beautiful setting, wonderful food, small number of participants to speakers, the high quality of both, and the importance and timeliness of the topics all contributed to a very successful program. I’m sure Linda Sweeney has already begun planning Directors Forum 2010.

This year’s steering committee did a great job. Three cheers to each of the following:

Comments From Attendees

Putting Jim Chanos on the agenda on the first evening was absolutely brilliant. The theme of the meeting was the focus on shareholders. Many of us, including me, had never heard a talk by a short seller! Bill George was very inspirational and a wonderful way to top off the meeting. — Julia Brown, Targacept, Inc.

It’s always useful to understand what the latest issues are from a shareholder’s (or shareholder activists’) point of view. That helps us as management to be mindful of those as we make decisions and communicate with the shareholders. And, the exchange of ideas with other attendees was invaluable in helping improve our own companies’ performance on an ongoing basis. — Bruce Crair, Local.com

The planning and organization of the event left nothing to chance making it an outstanding experience. The Forum brought together people with diverse thinking and backgrounds but all dedicated to improving corporate governance throughout the United States. I was proud to attend and be part of the conference. — Richard A. Collato, YMCA of San Diego County; Director Sempra Energy, WD40, Pepperball Technologies and Project Design Consultants

The highlight for me was Bill George’s presentation – concise, insightful and practical. — John F Coyne, Western Digital Corporation

It was the best one yet – I really enjoyed listening to all the speakers — Lynn Turner, former SEC chief accountant

The conversational format, close to the audience, was much better than the usual sitting up high on a stage all lined up on a panel — Kristina Veaco, Veaco Group

My second Director’s Forum – again this year, very worthwhile. — Lou Peoples, Northwestern Corp.

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Pre-Conference Bonus Session

Even before Directors Forum 2009 began, there was a very worthwhile "Pre-Conference Bonus Session," entitled The Latest Research in Corporate Governance, presented by the Corporate Governance Institute at San Diego State University. There were two concurrent sessions. I attended Management and Law reviews. Therefore, I missed Finance and Accounting. All bibliographies and presentations are available on the CGI’s Post Conference Materials page.

Lori Ryan did a great job of touching on some of the highlights of studies published in 2008 on "management" topics. Following are a few of the many findings that struck me.

Professor Paul Graf‘s bibliography highlighted some important recent court decisions and articles but his presentation honed in more on common threads and direction, which I find difficult to summarize. Much of his talk centered around the concept of "good faith," which can’t be indemnified. The duty to act in good faith is "intertwined" with the duty of care, but it is different. It is "shrouded in the fog of hazy jurisprudence, grounded in the duty of loyalty, but it does not involve self dealing." "It is more culpable than a breach of the duty of care—gross negligence."

Sounds a bit like a Zen koan. In Disney, failure to act in good faith is 1) where the fiduciary intentionally acts with a purpose other than that of advancing the best interests of the corporation, 2) where the fiduciary acts with the intent to violate applicable positive law, or 3) where the fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties. The last was emphasized by Graf, who went on to quote several other attempts to surround the concept of good faith, including Nowicki’s notion that courts are focusing on bad faith, instead of defining good faith. I liked his distillation of Hill and McDonnell. "On the continuum of liability from duty of care to duty of loyalty, good faith occupies the vast middle ground." Apparently, ill defined ground.

From what I gathered, the duty of care is morphing into the duty of good faith in recent cases such as Stone v. Ritter and Ryan v. Lyondell. Plaintiff alleged the directors knew that they had a known duty to act to ensure an offer was the highest available but they chose not to act. Therefore, good faith was implicated for purposes of the motion to dismiss. What was crystal clear was the need to document "actions" taken, even if they would otherwise be viewed as non actions, since if the board "acts," its actions are reviewed under the more favorable business judgment rule.

In sessions I did not attend, David DeBoskey provided a review of 2008 in Accountancy and Nikhil Varaiya reviewed Finance. You can find their bibliographies and presentations on CGI’s Post Conference Materials page.

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