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Incompetent Guardians: Commentary
We've created quite a mess for ourselves. Depending on your point of view, you can blame the mortgage lenders, the investment banks, the credit rating agencies, homeowners that overextended themselves, or even the U.S. government for its lack of regulation and oversight.
-Ron Gross, IV Newsletter.
Ron pointed out some players in the blame game. I agree there is plenty to go around, but I stand firm on assertions that I have made in many past posts regarding fiduciary responsibility of a corporate board of directors to stockholders or stakeholders and the lack of evidence of competent corporate governance. The board of directors should set the overall risk management strategy, including the purposes for which derivatives may be used.
Derivatives are neither good nor bad, but without transparency for the less savvy, they become toxic bad actors. Warren Buffett dips his toe into selected derivatives.
How do you manage risk that is out of kilter with economic rationality is a question Gloom and Doom Marc Faber was asked. "Well, I think that the problem is how do you manage that kind of a risk? And senior management and the board of directors had no idea. So essentially the banks, what they did is they packaged garbage products and they sold to their clients and thought they were smart because they earned very big fees. Essentially, they buried themselves and that serves them right."
Same old story, garbage in and garbage out, no quality control.
Quick move the Hill on Tuesday in Washington, lawmakers were coming to grips with a phrase that has rarely entered the Congressional record: "counterparty risk". Folks, therein is where the crux of problem occurred. From FT.com "There is a strong consensus among policy makers that one of the key weaknesses in the financial system was the lack of a central clearing counterparty (CCP) system for the OTC markets."
That is not because of a catastrophic failure of such products. Indeed Robert Pickel, chief executive of the International Swaps and Derivatives Association, told the Senate hearing on Tuesday: "To say that [credit default swaps] were the cause, or even a large contributor, to that turmoil is inaccurate. There is little dispute that ill-advised mortgage lending, coupled with improperly understood securities backed by those loans, are the root cause of the present financial problems."
"Rather, it is the lack of a CCP in the OTC markets that means regulators simply do not know the extent of market participants' potential liabilities if things go badly wrong."
Greed and Fiduciary Duty
That being said, the Capitalist system has the board of directors responsible to shareholders so they do not loose their shirts. Why would you allow a ‘game' to be played if you do not understand the rules or lack thereof or those toxic securities?
Accounting distortions occurred that should have raised red flags to those charged with oversight. Fannie and Freddie when placed in conservatorship found the board of directors and executives dismissed, it would seem more should follow in this credit crisis.
The core behavior throughout this whole mess of a credit crisis is related to self-gratification and I hate to say it - stupidity. Now there is a crisis in confidence that means trust evaporated in the banking industry related to excessive risk-taking. So the governments are pumping money into the monetary system to raise ‘trust' levels.
We have witnessed a corporate culture of pride and greed supported by failure of corporate boards to observe basic fiduciary duties in the first part of this decade. This has managed to produce a credit crisis packaged with a decorative bow of personal decadence. And that is a very strong indictment, I know. I say that because, in my view, the board is the last line of defense to obfuscation of truth about the performance of a corporation.
Bill George at the WSJ asked "Where Were the Boards?" As the financial crisis continues to whipsaw the markets, the question we need to ask is: "Where were the boards of directors of Lehman, AIG, Bear Stearns, Countrywide Financial, Merrill Lynch, Wachovia, Washington Mutual, Fannie Mae and Freddie Mac?" (Bill George, author of "True North," is a management professor at Harvard Business School and the former chairman and CEO of Medtronic. He is a member of the boards of directors of ExxonMobil, Goldman Sachs, and Novartis.)
Failure of Duty
My rant remains tied to the guardians at the home office of corporations, the board of directors who are charged with oversight of the CEO and executives and the reports they prepare filtered to investors. Directors failed in their duties of loyalty and care as stewards with their fiduciary responsibility in a legal relationship of trust and confidence with shareholders - they simply did not ask the right questions or lacked judgment in assessment skills. Of course outside auditors should have looked deeper,
My analogy is that of a family, rules exist in society and neighborhoods but the interpretation and implementation happen in the homes of families. Dads and Moms carry a great deal of influence in homes by interpreting what is acceptable behavior. Could not the Board of Directors perform this function?
In this global era, my focus is on those closest to our source of our pain, those who could have taken action in the past decade of decadence to put some control on the risks taken by corporate executives. Though they would have been painful then, the repercussions would not mount to what those financial weapons of mass destruction have handed us,
Quis custodiet ipsos custodes? ( Who guards the guardians?)
For many a moon, totaling years, I have castigated those in the boardroom of a corporation who are inept at director fiduciary duties of care and loyalty. The duty of oversight means directors must exercise care in both overseeing the business as well as evaluating risk controls. I repeat the necessity of EVALUATING RISK CONTROLS.
I apologize for the shout, it bears great relativity to where we managed to get ourselves today. Boardrooms have lost control in many corners. The theme throughout credit crisis was denial of accountability and control at all levels.
The number of companies with debt trading at distressed levels, a leading indicator of default rates, hit a five-year high at the end of the third quarter as the deepening financial crisis put further pressure on prices, according to Moody's Investors Service.
The strength of U.S. capital markets is in large part based on effective corporate governance.
Without it, retirement vehicles are at risk and oh so much more as we have seen as the DOW and other indices whipsaw and equities slide downward. This is indeed, a unique market, none like it to behold and compare with from the past says veteran investor Laslow Biryni.
The paramount duty of the board of directors is to select a CEO and oversee that CEO and other senior management in the competent and ethical operation of the corporation on a day-to-day basis. (businessrountable.com) On the flip side of competence is the offerings and information at corporateboard.com on ways to avoid corporate director liability traps such as shareholder lawsuits. This is where great effort is made to stave off institutional investor rage.
Ayn Rand: "Ethics is not a mystic fantasy-nor a social convention-nor a dispensable, subjective luxury, to be switched or discarded in any emergency. Ethics is an objective, metaphysical necessity of man's survival-not by the grace of the supernatural nor of your neighbors nor of your whims, but by the grace of reality and the nature of life."
The ethics of the fiduciary relationship between principals and agents in the financial industry is based on the principal of trust. The principle hires an agent means the stockholder hires the board to watch out for his best interest.
Today we often have we heard about lack of trust between lenders.
The credit crisis turned into a global meltdown. Banks did not want to loan to each other, now the question is will countries lend to each other. Iceland's meltdown sees them looking to Russia as others have not come forward. Iceland has had to nationalize three of its banks in the past three weeks. A resolution to this crisis will come once enough money is thrown at the problem. How much that is, is undetermined?
I return to the idea that Americans have fine-tuned ethics on self-gratification and financial excesses. The consumer is steeped in debt just as the government is, none escapes blame at different levels. We return to oversight by directors in big corporations in the business of finances.
Corporate Internal Oversight Questioned
It was said in 1998 that a recent federal district court case, involving a failed savings and loan, suggested that directors of a financial institution have a higher duty of oversight. Interesting, indeed. http://lawweb.colorado.edu/profiles/pubpdfs/loewenstein/98MayTCL-Loewenstein.pdf
No matter where you cut responsibility, accountability of board big wigs remains to the shareholder or the stakeholders. The failure of accountability in the boardrooms of Lehman Brothers, AIG, Fannie Mae, Freddie Mac and Merrill Lynch is shocking. The storyline in each case seems to be that management was willing to take undue risk or management had no clue what risks their workers were taking. And that scares the hell out of me, taking action without understanding consequences, is that risk?
And the government nationalized failure by those who should know better but did not exercise ethical judgment in landing in a pool of debt. The old Ken Lay answer of "I didn't know' rings hollow today when you play with my money.
Where were the boards of directors that are supposed to be overseeing these executives? Total director remuneration at the largest American corporations is running over $1,000 per hour, according to the study by Steven Hall & Partners. What are some of these guys doing besides showing up for four or five meetings a year? We, the shareholders, are in many instances not getting the most bang for our buck.
Parceled out pay packages
A media report on this past week listed out 12 top bankers of Wall Street who collectively took home over one billion dollars in the past five years including Lehman Brothers' Chief Richard Fuld. These pay packages were parceled out by a Compensation Committee with the kiss of approval of the Board of Directors in all cases.
What are we doing paying all this money to the directors at failed institutions who voted egregious pay packages to executives at the same time failing to monitor the business?
How does the shareholder bring accountability to the board of directors and thus, the executive suite?
AIG, after the bailout, held a weeklong retreat at the pricey St. Regis Resort in Monarch Beach, Calif., where rooms can cost more than $1,000 a night. Invoices distributed by the House committee show AIG paid more than $440,000 to the resort, including nearly $7,000 for golf and $23,000 in spa charges. The Fed will loan an additional $37.8 billion to American International
Group bringing the total nearly $123 billion. This to me may well be indicative of the need for more money than the $700B allotted as this debacle unravels.
What does justifying that expense at AIG by current CEO say to you about fiduciary duties in corporate behavior?
When questioning powers that be at AIG, they explained the package was planned in 2007 to reward ‘workers' with only four(?) employees attending and was not canceled considering current economic conditions. White House press secretary Dana Perino said, "It's pretty despicable to realize how callous somebody might be as they go through this -- how some might be reacting to this crisis."
Despicable as it is, it falls into a travesty to faith in corporate's ability with decision-making. This really has me steamed, as it is a breach of ethics much less picking my pocket.
This all brings back to mind the book, Barbarians at the Gate, a description of the largest leveraged-buy out of the 80's. It reminds us that corporate behavior has not changed.
Excessive risk-taking, Excessive leverage, Excessive compensation
Been in this game one-hundred years, but I see new ways to lose 'em I never knew existed before. - Casey Stengel
"There should be no doubt that executive compensation lies at the root of the current financial crisis," Paul Hodgson, a senior research associate with research firm The Corporate Library, wrote last week.
"There is a direct link between the behaviors that led to this financial collapse and the short-term compensation programs so common in financial services companies that rewarded short-term gains and short-term stock price increases with extremely generous pay levels."
From Stephen Leeb's Market Forcast
"Make no mistake... we are in the midst of a crisis.
? Practically the entire investment banking industry has vanished overnight. Lehman Brothers, Goldman Sachs, Morgan Stanley, Citi - all gone or becoming shadows of their former selves.
? America's biggest mortgage lenders, including Fannie Mae and Freddie Mac, are being taken over by the government.
? Congress has coughed up $700 BILLION dollars to prop up the financial system - which means government debt will rise more than 50%.
? Inflation is at generation highs, and set to skyrocket thanks to the oil prices and outrageous government spending.
? The markets are rocking like a palm tree in a hurricane - down 505 points one day, up 410 the next. And not just stocks. Gold, oil, the dollar - everything is becoming more volatile."
Looking forward, stocks will continue to struggle until normalcy starts to return to the credit markets.
Where were the guardians early on? And I lay a great deal of responsibility on corporate governance, or the lack thereof in the boardrooms as a first line of defense. What is happening today is reflexive behavior, those trying to save their butts, credit markets and hedge funds. Naturally, we are told it is now all to our benefit
The most important thing for you the investor to remember is to understand risk in investing, even if the guardians don't.
What to do
People are made to be loved and things are made to be used.
There is so much confusion in this world because people are being used and things are being loved. unknown author
Corporate wrongdoing transcends what can be reached by legislation, the reach exceeds the grasp when trying to legislate corporate responsibility says former U.S. Attorney General Richard Thorburgh. We are left with Gatekeepers in the form of lawyers, accountants, outside auditors, directors to steer a failure of corporate management. The directors failed in fiduciary duties owed shareholders, and these are the ultimate, firstline gatekeepers in my view.
However, Washington Post's Henry Kaufman calls for new standards for the management of financial institutions. Specifically to boards, members should be subject to tougher standards. Qualifications should include sound working knowledge of accounting as well as literacy with quantitative risk analysis techniques and proficiency with information technology. Directors should be assessing information streams that include straightforward data and candid analysis of the scale and scope of transactions with affiliated companies and of assets and debts transferred to (off-balance-sheet) special-purpose entities.
As new board members are elected, they should meet with regulators to understand how the board's responsibilities are viewed. Thereafter, new directors should join seasoned board members in regular meetings with regulators to review the results of examinations and to discuss FFOA recommendations and compliance. Independent directors should hold separate, periodic meetings on growth aspirations, risk policies, succession planning and other critical issues. (President of Henry Kaufman and Co. and the author of "On Money and Markets: A Wall Street Memoir." )
Enron was a failure in corporate governance and somebody keeps striking up the band while the beat goes on for a breach in fiduciary responsibility.
The historical evolution of the board supports the conclusion that managing is an important component of board function. Berkshire Hathaway has an antiquated board judged by modern standards, but has demonstrated accountability. Studies show that controlling stockholders are able to provide effective monitoring and entail fewer agency costs. (Representing the Corporation, $477.00 at Amazon.com)
It is conceded that boards must be tailored to individual corporate needs, but accountability should remain throughout.
Thanks to blogger Dougon, he quotes Warren Buffett's requirements for his Board of Directors. Buffett's rules are very simple and are designed to align the director's interests with the shareholders:
(1) the director must be a longtime shareholder,
(2) a substantial shareholder, and
(3) must only receive minimal compensation.
Do you think many would be takers for the director's job with those rules?
I plan to look even more closely at those who occupy the boardroom as we go forward analyzing stocks/businesses. I intend to assess with more emphasis the amount of stock held by a director. I intend to look for succession planning. For the most part in the past, ownership by directors has not been remarkable, selling granted options has been a hallmark in many instances.
One lesson to be learned from this credit crisis is to clarify the roles and responsibilities of fiduciaries along with standards for transparency to put an end to a perpetual boom-bust cycle with amplified volatility. Good decisions begin with good information and I must say the board directors should have accurate/transparent reports to help it perform its fiduciary responsibilities just as shareholders deserve unfettered reports.
Guardians at the gate need to implement stronger controls of risk management. They need to raise questions to clarify hidden traps. Board members are supposedly leaders in their field, how is it they loose critical thinking while in the comfy board seat in a well appointed boardroom possibly intimidated by the CEO?
"Call for derivatives clearing intensify." http://www.ft.com/cms/s/0/39ce5062-9a1c-11dd-960e-000077b07658.html
Quis custodiet ipsos custodes?
"A Failure of Corporate Governance" http://yesandnotyes.com/blog/2008/09/a-failure-of-corporate-governance
"We pay so much for so little." http://www.icahnreport.com/report/2008/09/we-pay-so-much.html
"Where were the boards?" http://online.wsj.com/article/SB122391155600528747.html?mod=googlenews_wsj
Shareholder Files Derivative Complaint against Management and Board Members of Artes Medical, Inc. http://biz.yahoo.com/bw/080910/20080910005691.html?.v=1 http://finance.boston.com/boston?GUID=6531906&Page=MediaViewer&Ticker=ARTE
"Improve Corporate Governance: Protecting Investors by Strengthening Gatekeeper Roles." http://www.brookings.edu/papers/2007/0228corporategovernance_Opp08.aspx
"Overseeing Finance's New Era." http://www.washingtonpost.com/wp-dyn/content/article/2008/10/10/AR2008101002613.html
"Now Publicly Available: SEC's Executive Compensation Comments and Responses"
Berkshire is included here.
"Lessons from the Credit Crisis." http://staticorigin.seekingalpha.com/article/61792-lessons-from-the-credit-crisis
Previous posts of mine:
"The Myth of Corporate Accountability - Part 2 - Boardroom Interpersonal Influenza"
Example of reviewing a board:
2004 Big Cheese Training and Support, Pt. 1 (metaphor BOD and CEO)
2004 Big Cheese Training and Support, Part 2
Includes Relationships: The Omnicare Board Members: Talent, Experience, Maybe a Couple of Toads http://boards.fool.com/Message.asp?mid=21785699
[This post is from our Inside Value premium newsletter discussion boards. For more great reading, click here to take a no-risk thirty-day free trial.]
Incompetent Guardians: Commentary