The Dark Side of Nepotism

"Nepotism has never been unknown in American banking," Martin Mayer wrote in The Greatest-Ever Bank Robbery, his 1990 book about the savings-and-loan crisis. While Mayer was referring to American Continental, the notoriously corrupt holding company run into the ground by the infamous Charles Keating in the 1980s, his point rings true today in the case of Annaly Capital Management (NYSE: NLY  ) and its publicly traded portfolio company Chimera Investment (NYSE: CIM  ) .

Not all nepotism is necessarily bad
While few people would disagree with the idea that nepotism is a disgraceful practice at publicly traded companies -- it's totally different, of course, for privately controlled businesses, where the owners are the managers and vice versa -- there are nevertheless some less deplorable uses of it.

One example that comes to mind is Warren Buffett's Berkshire Hathaway (NYSE: BRK-A  ) .

At the end of 2011, Buffett announced on 60 Minutes that his son Howard would succeed him as chairman of Berkshire's board -- or, more specifically, as the "non-executive" chairman, meaning that the younger Buffett won't direct strategy or exercise day-to-day managerial power. His role will instead be largely ceremonial -- and, importantly, unpaid -- as that of a "guardian" over the company's "values."

It's also worth noting that even though Berkshire is the fifth largest publicly traded company in the United States, the Buffett family, together with the Bill and Melinda Gates Foundation (which acquired its holdings from Buffett), controls upwards of 25% of its outstanding common stock. On the continuum between a public and private company, in other words, it tilts in the latter direction.

Another example of benign nepotism came from a recent report that Goldman Sachs (NYSE: GS  ) had given CEO Lloyd Blankfein's 20-year-old daughter an internship in the Goldman Sachs Foundation, the "clearinghouse" of the investment bank's charitable division. Even assuming the position was paid, this hardly qualifies as an instance in which Goldman's well-known meritocracy was circumvented to the detriment of public shareholders.

How nepotism becomes harmful
The reason I characterize both of these instances as benign is that neither appears on its face to be a self-interested violation of either executive's fiduciary duty -- that is, the duty to put the company's interest above their own.

For nepotism to be bad, at least in my opinion, it must satisfy one of two tests. First, it must substitute familial bonds for otherwise necessary expertise or qualifications. Buffett would have violated this point if he had, say, appointed his son as the CEO of Berkshire as opposed to the largely ceremonial role of non-executive chairman. Blankfein would have done so by putting his daughter in charge of Goldman's compliance department -- though one could argue that doing so may actually yield improvement.

The second test concerns compensation -- that is, are family members being hired merely to pad the pockets of the executive's family at the expense of shareholders? In the case of American Continental, many of Keating's children and spouses "received top positions, paying half a million dollars or more in salary, at ages twenty-four or twenty-eight."

Given the abject impropriety of either test, one would be excused from concluding that no reputable publicly traded company -- and particularly that's a member of the fabled S&P 500 (SNPINDEX: ^GSPC  ) -- would still be engaged in practices that violate them.

Unfortunately, however, this would be wrong.

The modern-day poster child of nepotism
The company that best disproves this assumption is Annaly Capital Management. For those of you not familiar with Annaly, it's a pioneer of the mortgage REIT space and is currently the biggest in the business. It owns a nearly $100 billion portfolio of mortgage-backed securities that it finances through the short-term repo market. It is, in other words, a leveraged fund that specializes in real estate-related assets.

Beyond these activities, it also oversees a number of portfolio companies, some of which it owns outright, and at least one of which, Chimera Investments, is itself publicly traded. As Chimera's website explains it: "Chimera is externally managed by Fixed Income Discount Advisory Company (FIDAC), a wholly owned subsidiary of Annaly Capital Management." For the record, until a recent structural reorganization, FIDAC was also the entity that managed Annaly.

And herein lies the problem. Since the end of 2011, Chimera has found itself immersed in an accounting scandal of immense relative proportions. Among other things, it caused the company to miss the majority of filing deadlines over the past two years, served as the impetus for an investigation by the SEC, and threatened to have its shares delisted from the NYSE. And, to be clear, it's not out of the woods yet, as all three of these issues remain alive and well.

That it was an accounting problem implies that it happened under the watch of Chimera's chief financial officer, who, until recently, was the sister of Annaly's co-founder and now-CEO. Could these two things be merely a coincidence? Sure. But that seems unlikely. In my opinion, in other words, it's hard to view this situation as anything other than a textbook case of the damage that nepotism can wreak on a publicly traded company.

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