Out of Control
THIS IS WHAT HAPPENS when a corporate giant collapses and dies.
All eyes are on the CEO, who has gone without sleep for several days while desperately scrambling to pull a rabbit out of an empty hat. Staffers, lawyers, advisors, accountants, and consultants scurry around the company headquarters with news and rumors: the stock price fell 20 percent in the last hour, another of the private equity firms considering a bid has pulled out, stock traders are passing on obscene jokes about the company’s impending death, the sovereign wealth fund that agreed to put in $1 billion last fall is screaming at the CFO, hedge fund shorts are whispering that the commercial paper dealers won’t renew the debt tomorrow, the Treasury and the Fed aren’t returning the CEO’s calls about bailout money, six satellite trucks—no, seven now—are parked in front of the building, and reporters with camera crews are ambushing any passing employee for sound bites about the prospects of losing their jobs.
In the midst of this, the board of directors—the supposedly well-informed, responsible, experienced, accountable group of leaders elected by the shareholders, who are legally and ethi-cally required to protect the thousands of people who own the company—are . . . where? You would expect to them to be at the center of the action, but they are merely spectators with great seats. Some huddle together over a computer screen in a corner of the boardroom, watching cable news feeds and stock market reports that amplify the company’s death rattles around the world; others sit beside a speakerphone, giving updates to board colleagues who couldn’t make it in person. Meetings are scheduled, canceled, and rescheduled as the directors wait, hoping for good news but anticipating the worst.
The atmosphere is a little like that of a family waiting room outside an intensive care unit—a quiet, intense churning of dread and resignation. There will be some reminiscing about how well things seemed to be going not so long ago, some private recriminations about questions never asked or risks poorly understood, a general feeling of helplessness, a touch of anger at the senior executives for letting it come to this, and anticipation of the embarrassment they’ll feel when people whisper about them at the club. Surprisingly, though, there’s not a lot of fear. Few of the directors are likely to have a significant part of their wealth tied up in the company; legal precedents and insurance policies insulate them from personal liability. Between 1980 and 2006, there were only thirteen cases in which outside directors—almost all, other than Enron and WorldCom, for tiny companies—had to settle shareholder lawsuits with their own money. (Ten of the Enron outside directors who settled—without admitting wrongdoing—paid only 10 percent of their prior net gains from selling Enron stock; eight other directors paid nothing. A number of them have remained on other boards.) More significant, the CEO who over shadowed the board will hardly hurt at all, and will probably leave with the tens or even hundreds of millions of dollars that the directors guaranteed in an employment contract.
So they sit and wait—the board of directors of this giant company, who were charged with steering it along the road to profit and prosperity. In the middle of the biggest crisis in the life of the company, they are essentially backseat passengers. The controls, which they never truly used, are of no help as the company hurtles over a cliff, taking with it the directors’ reputations and the shareholders’ money. What they are waiting for is the dull thud signaling the end: a final meeting with the lawyers and investment bankers, and at last, the formality of signing the corporate death certificate—a bankruptcy filing, a forced sale for cents on the dollar, or a government takeover that wipes out the shareholders. The CEO and the lawyers, as usual, will tell the directors what they must do.
THIS IS NOT JUST A GLOOMY, hypothetical fable about how an American business might possibly fail, with investors unprotected, company value squandered, and the governance of enormous and important companies breaking down. This is, unfortunately, a real scenario that has been repeated time and again during the recent economic meltdown, as companies have exploded like a string of one-inch firecrackers. When the spark runs up the spine of the tangled, interconnected fuses, they blow up one by one.
Something is wrong here. As Warren Buffett observed in his 2008 letter to Berkshire Hathaway shareholders, “You only learn who has been swimming naked when the tide goes out—and what we are witnessing at some of our largest financial institutions is an ugly sight.”
Just look at some of the uglier sights. Merrill Lynch, General Motors, and Lehman Brothers, three stalwart American companies, are only a few examples of corporate collapses in which shareholders were burned. The sleepy complicity and carelessness of their boards have been especially devastating. Yet almost all the public attention has focused on the greed or recklessness or incompetence of the CEOs rather than the negligence of the directors who were supposed to protect the shareholders and who ought to be held equally, if not more, accountable because the CEOs theoretically work for them.
Why have boards of directors escaped blame? Probably because boards are opaque entities to most people, even to many corporate executives and institutional investors. Individual shareholders, who might have small positions in a number of companies, know very little about who these board members are and what they are supposed to be doing. Their names appear on the generic, straight-to-the-wastebasket proxy forms that shareholders receive; beyond that, they’re ciphers. Directors rarely talk in public, maintaining a code of silence and confidentiality; communications with shareholders and journalists are invariably delegated to corporate PR or investor relations departments. They are protected by a vast array of lawyers, auditors, investment bankers, and other professional services gatekeepers who keep them out of trouble for a price. At most, shareholders might catch a glimpse of the nonexecutive board members if they bother to attend the annual meeting. Boards work behind closed doors, leave few footprints, and maintain an aura of power and prestige symbolized by the grand and imposing boardrooms found in most large companies. Much of this lack of transparency is deliberate because it reduces accountability and permits a kind of Wizard of Oz “pay no attention to the man behind the curtain” effect. (It is very likely to be a man. Only 15.2 percent of the directors of our five hundred largest companies are women.) The opacity also serves to hide a key problem: despite many directors being intelligent, experienced, well-qualified, and decent people who are tough in other aspects of their professional lives, too many of them become meek, collegial cheerleaders when they enter the boardroom. They fail to represent shareholders’ interests because they are beholden to the CEOs who brought them aboard. It’s a dangerous arrangement.
On behalf of the shareholders who actually own the company and are risking their money in anticipation of a commensurate return on their investments, boards are elected to monitor, advise, and direct the managers hired to run the company. They have a fiduciary duty to protect the interests of shareholders. Yet, too often, boards have become enabling lapdogs rather than trust-worthy watchdogs and guides.
There are, unfortunately, dozens of cases to choose from to illustrate the seriousness of the situation. Merrill, GM, and Lehman are instructive because they were companies no one could imagine failing, although, in truth, they fostered such dysfunctional and conflicted corporate leadership that their collapses should have been foretold. As you read their obituaries, viewer discretion is advised. You should think of the money paid to the executives and directors, as well as the losses in stock value, not as the company’s money, as it is so often portrayed in news accounts, but as your money—because it is, in fact, coming from your mutual funds, your 401(k)s, your insurance premiums, your savings account interest, your mortgage rates, your paychecks, and your costs for goods and services. Also, think of the impact on ordinary people losing their retirement savings, their jobs, their homes, or even just the bank or factory or car dealership in their towns. Then add the trillions of taxpayers’ dollars spent to prop up some of the companies’ remains and, finally, consider the legacy of debt we’re leaving for the next generation.
DURING MOST OF HIS nearly six years at the top of Merrill Lynch, Stanley O’Neal simultaneously held the titles of chairman, CEO, and president. He required such a high degree of loyalty that insiders referred to his senior staff as the Taliban. O’Neal had hand-picked eight of the firm’s ten outside board members. One of them, John Finnegan, had been a friend of O’Neal’s for more than twenty years and had worked with him in the General Motors treasury department; he headed Merrill’s compensation committee, which set O’Neal’s pay. Another director on the committee was Alberto Cribiore, a private equity executive who had once tried to hire O’Neal.
Executives who worked closely with O’Neal say that he was ruthless in silencing opposition within Merrill and singleminded in seeking to beat Goldman Sachs in its profitability and Lehman Brothers in the risky business of packaging and selling mortgage-backed securities. “The board had absolutely no idea how much of this risky stuff was actually on the books; it multiplied so fast,” one O’Neal colleague said. The colleague also noted that the directors, despite having impressive résumés, were chosen in part because they had little financial services experience and were kept under tight control. O’Neal “clearly didn’t want anybody asking questions.”
For a while, the arrangement seemed to work. In a triumphal letter to shareholders in the annual report issued in February 2007, titled “The Real Measure of Success.” O’Neal proclaimed 2006 “the most successful year in [the company’s] history—financially, operationally and strategically,” while pointing out that “a lot of this comes down to leadership.” The cocky message ended on a note of pure hubris: “[W]e can and will continue to grow our business, lead this incredible force of global capitalism and validate the tremendous confidence that you, our shareholders, have placed in this organization and each of us.”
The board paid O’Neal $48 million in salary and bonuses for 2006—one of the highest compensation packages in corporate America. But only ten months later, after suffering a third-quarter loss of $2.3 billion and an $8.4 billion writedown on failed investments—the largest loss in the company’s ninety-three-year history, exceeding the net earnings for all of 2006—the board began to understand the real measure of failure. The directors discovered, seemingly for the first time, just how much risk Merrill had undertaken in becoming the industry leader in subprime mortgage bonds and how overleveraged it had become to achieve its targets. They also caught O’Neal initiating merger talks without their knowledge with Wachovia Bank, a deal that would have resulted in a personal payout of as much as $274 million for O’Neal if he had left after its completion—part of his board-approved employment agreement. During August and September 2007, as Merrill was losing more than $100 million a day, O’Neal managed to play at least twenty rounds of golf and lowered his handicap from 10.2 to 9.1.
Apparently due to sheer embarrassment as the company’s failures made headlines, the board finally ousted O’Neal in October but allowed him to “retire” with an exit package worth $161.5 million on top of the $70 million he’d received during his time as CEO and chairman. The board then began a frantic search for a new CEO, because, as one insider confirmed to us, it “had done absolutely no succession planning” and O’Neal had gotten rid of anyone among the 64,000 employees who might have been a credible candidate. For the first time since the company’s founding, the board had to look outside for a CEO. In spite of having shown a disregard for shareholders and a distaste for balanced governance, O’Neal was back in a boardroom within three months, this time as a director of Alcoa, serving on the audit committee and charged with overseeing the aluminum company’s risk management and financial disclosure.
At the Merrill Lynch annual meeting in April 2008, Ann Reese, the head of the board’s audit committee, fielded a question from a shareholder about how the board could have missed the massive risks Merrill was undertaking in the subprime mortgage-backed securities and collateralized debt obligations (CDOs) that had ballooned from $1 billion to $40 billion in exposure for the firm in just eighteen months. Amazingly, since it is almost unheard of for a director of a company to answer questions in public, Reese was willing to talk. This was refreshing and might have provided some insight for shareholders, except that what she said was curiously detached and unabashed. “The CDO position did not come to the board’s attention until late in the process,” she said, adding that initially the board hadn’t been aware that the most troublesome securities were, in fact, backed by mortgages.
Merrill’s new CEO and chairman, John Thain, jumped in after Reese, saying that the board shouldn’t be criticized based on “20/20 hindsight” even though he had earlier admitted in an interview with the Wall Street Journal that “Merrill had a risk committee. It just didn’t function.” As it happens, Reese, over a cup of English tea, had helped recruit Thain, who lived near her in Rye, New York. Thain had received a $15 million signing bonus upon joining Merrill and by the time of the shareholders’ meeting was just completing the $1.2 million refurnishing of his office suite that was revealed after the company was sold.
Lynn Turner, who served as the SEC’s chief accountant from 1998 to 2001 and later as a board member for several large public companies, recalled that he spoke about this period to a friend who was a director at Merrill Lynch in August 2008. “This is a very well-known, intelligent person,” Turner said, “and they tell me, ‘You know, Lynn, I’ve gone back through all this stuff and I can’t think of one thing I’d have done differently.’ My God, I can guarantee you that person wasn’t qualified to be a director! They don’t press on the issues. They get into the boardroom—and I’ve been in these boardrooms—and they’re all too chummy and no one likes to create confrontation. So they get together five times a year or so, break bread, all have a good conversation for a day and a half, and then go home. How in the hell could you be a director at Merrill Lynch and not know that you had a gargantuan portfolio of toxic assets? If people on the outside could see the problem, then why couldn’t the directors?”
The board was so disconnected from the company that when Merrill shareholders met in December 2008 to approve the company’s sale to Bank of America after five straight quarterly losses totaling $24 billion and a near-brush with bankruptcy, not a single one of the nine nonexecutive directors even attended the meeting. Finance committee chair and former IRS commissioner Charles Rossotti, reached at home in Virginia by a reporter, wouldn’t say why he wasn’t there: “I’m just a director, and I think any questions you want to have, you should direct to the company.” The board missed an emotional statement by Winthrop Smith, Jr., a former Merrill banker and the son of a company founder. In a speech that used the word shame some fourteen times, he said, “Today is not the result of the subprime mess or synthetic CDOs. They are the symptoms. This is the story of failed leadership and the failure of a board of directors to understand what was happening to this great company, and its failure to take action soon enough . . . Shame on them for not resigning.”
When Merrill Lynch first opened its doors in 1914, Charles E. Merrill announced its credo: “I have no fear of failure, provided I use my heart and head, hands and feet—and work like hell.” The firm died as an independent company five days short of its ninety-fifth birthday. The Merrill Lynch shareholders, represented by the board, lost more than $60 billion.
AT A JUNE 6, 2000, stockholders annual meeting, General Motors wheeled out its newly appointed CEO, Richard Wagoner, who kicked off the proceedings with an upbeat speech. “I’m pleased to report that the state of the business at General Motors Corporation is strong,” he proclaimed. “And as suggested by the baby on the cover of our 1999 annual report, we believe our company’s future opportunities are virtually unlimited.” Nine years later, the GM baby wasn’t feeling so well, as the disastrous labor and health care costs and SUV-heavy product strategy caught up with the company in the midst of skyrocketing gasoline prices and a recession. GM’s stock price fell some 95 percent during Wagoner’s tenure; the company last earned a profit in 2004 and lost more than $85 billion while he was CEO. Nevertheless, the GM board consistently praised and rewarded Wagoner’s performance. In 2003, it elected him to also chair the board, and in 2007—a year the company had lost $38.7 billion—it increased his compensation by 64 percent to $15.7 million.
GM’s lead independent director was George M. C. Fisher, who himself presided over major strategic miscues as CEO and chairman at Motorola, where the Iridium satellite phone project he initiated was subsequently written off with a $2.6 billion loss, and later at Kodak, where he was blamed for botching the shift to digital photography. Fisher clearly had little use for shareholders. He once told an interviewer regarding criticism of his tenure at Kodak that “I wish I could get investors to sit down and ask good questions, but some people are just too stupid.” More than half the GM board was composed of current or retired CEOs, including Stan O’Neal, who left in 2006, citing time constraints and concerns over potential conflicts with his role at Merrill that had somehow not been an issue during the previous five years.
Upon GM’s announcement in August 2008 of another staggering quarterly loss—this time of $15.5 billion—Fisher told a reporter that “Rick has the unified support of the entire board to a person. We are absolutely convinced we have the right team under Rick Wagoner’s leadership to get us through these difficult times and to a brighter future.” Earlier that year, Fisher had repeatedly endorsed Wagoner’s strategy and said that GM’s stock price was not a major concern of the board. Given that all thirteen of GM’s outside directors together owned less than six one-hundredths of one percent of the company’s stock, that perhaps shouldn’t have been much of a surprise.
Wagoner relished his carte blanche relationship with GM’s directors: “I get good support from the board,” he told a reporter. “We say, ‘Here’s what we’re going to do and here’s the time frame,’ and they say, ‘Let us know how it comes out.’ They’re not making the calls about what to do next. If they do that, they don’t need me.” What GM’s leaders were doing with the shareholders’ dwindling money was doubling their bet on gas-guzzling SUVs because they provided GM’s highest profit margins at the time. As GM vice chairman Robert Lutz told the New York Times in 2005: “Everybody thinks high gas prices hurt sport utility sales. In fact they don’t . . . Rich people don’t care.”
But what seemed good for GM no longer was good for the country—or for GM’s shareholders.
Ironically, GM had been widely praised in the early 1990s for creating a model set of corporate governance reforms in the wake of major strategic blunders and failed leadership that had resulted in unprecedented earnings losses. In 1992, the board fired the CEO, appointed a nonexecutive chairman, and issued twenty-eight structural guidelines for insuring board independence from management and increasing oversight of long-term strategy. BusinessWeek hailed the GM document as a “Magna Carta for Directors” and the company’s financial performance improved for a time. The reform initiatives, however, lasted about as long as the tailfin designs on a Cadillac. Within a few years, despite checking most of the good governance structural boxes, the CEO was once again also the board chairman, the directors had backslid fully to a subservient “let us know how it comes out” role, and the executives were back behind the wheel.
In November 2005, when GM’s stock price was still in the mid-20s, Ric Marshall, the chief analyst of the Corporate Library, a governance rating service that focuses on board culture and CEO-board dynamics, wrote: “Despite its compliance with most of the best practices believed to comprise ‘good governance,’ the current General Motors board epitomizes the sad truth that compliance alone has very little to do with actual board effectiveness. The GM board has failed repeatedly to address the key strategic questions facing this onetime industrial giant, exposing the firm not only to a number of legal and regulatory worries but the very real threat of outright business failure. Is GM, like Chrysler some years ago, simply too big to fail? We’re not sure, but it seems increasingly likely that GM shareholders will soon find out.”
By the time Wagoner was fired in March 2009, at the instigation of the federal officials overseeing the massive bailout of the company, the stock had dropped to the $2 range and GM had already run through $13.4 billion in taxpayers’ money. In spite of this, some directors still couldn’t wean themselves from Wagoner, and were reportedly furious that his dismissal occurred without their consent. Others were mortified by what had happened to the company. One prominent director, who had diligently tried to help the company change course before it was too late, had eventually quit the board out of frustration with the “ridiculous bureaucracy and a thumb-sucking board that led to GM making cars that no one wanted to buy.” Another director who left the board recalled asking Wagoner and his executive team in 2006 for a five-year plan and projections. “They said they didn’t have that. And most of the guys in the room didn’t seem to care.”
The GM shareholders, represented by the board, lost more than $52 billion.
IN A COMPANY as large and complex as Lehman Brothers, you would expect the board to be seasoned, astute, dynamic, and up-to-date on risks it was undertaking with the shareholders’ money. Yet the only nonexecutive director, out of ten, with any recent banking experience was Jerry Grundhofer, the retired head of U.S. Bancorp, who had joined the board exactly five months before Lehman’s spectacular collapse into bankruptcy. Nine of the independent directors were retired, including five who were in their seventies and eighties. Their backgrounds hardly seemed suited to overseeing a sophisticated and complicated financial entity: the members included a theatrical producer, the former CEO of a Spanish-language television company, a retired art-auction company executive, a retired CEO of Halliburton, a former rear admiral who had headed the Girl Scouts and served on the board of Weight Watchers International, and, until two years before Lehman’s downfall, the eighty-three-year-old actress and socialite Dina Merrill, who sat on the board for eighteen years and served on the compensation committee, which approved CEO Richard Fuld’s $484 million in salary, stock, options, and bonuses from 2000 to 2007. Whatever their qualifications, the directors were well compensated, too. In 2007, each was paid between $325,038 and $397,538 for attending a total of eight full board meetings.
The average age of the Lehman board’s risk committee was just under seventy. The committee was chaired by the eighty-one-year-old economist Henry Kaufman, who had last worked at a Wall Street investment bank some twenty years in the past and then started a consulting firm. He is exactly the type of director found on many boards—a person whose prestigious credentials are meant to reassure shareholders and regulators that the company is being well monitored and advised. Then they are ignored.
Kaufman had been on the Lehman board for thirteen years. Even in 2006 and 2007, as Lehman’s borrowing skyrocketed and the firm was vastly increasing its holdings of very risky securities and commercial real estate, the risk committee met only twice each year. Kaufman was known as “Dr. Doom” back in the 1980s because of his consistently pessimistic forecasts as Salomon Brothers’ chief economist, but he seems not to have been very persuasive with Lehman’s executives in getting them to limit the massive borrowing and risks they were taking on as the mortgage bubble continued to over-inflate.
In an April 2008 interview, Kaufman offered an insight that might have been more timely and helpful a few years earlier in both the Lehman boardroom and Washington, D.C.: “If we don’t improve the supervision and oversight over financial institutions, in another seven, eight, nine, or ten years, we may have a crisis that’s bigger than the one we have today. . . . Usually what’s happened is that financial markets move to the competitive edge of risk-taking unless there is some constraint.” With little to no internal supervision, oversight, or constraint having been provided by its board, the bigger crisis for Lehman came sooner rather than later, and it collapsed just four and a half months later.
After Lehman’s demise, Kaufman has continued to offer advice to others. Without a trace of irony or guilt, he said to another interviewer in July 2009, “If you want to take risks, you’ve got to have the capital to do it. But, you can’t do it with other people’s money where the other people are not well informed about the risk taking of that institution.” In his recent book on financial system reform (which largely blames the Federal Reserve for the financial meltdown and has an entire section listing his own “prophetic” warnings about the economy), Kaufman neglects to mention either his role at Lehman or his missing the warning signs when he personally invested and lost millions in Bernie Madoff’s Ponzi scheme. He does, however, note that “The shabby events of the recent past demonstrate that people in finance cannot and should not escape public scrutiny.”
Dr. Doom did heed his own economic advice, while providing an instructive case of exquisite timing—as well as of having your cake, eating it too, and then patting yourself on the back for warning others of the caloric dangers of cake. Lehman securities filings show that about ten months before Lehman stock went to zero, Kaufman cashed in more than half of the remaining stock options that had been given to him for protecting shareholders’ interests. He made nearly $2 million in profits.
“The Lehman board was a joke and a disgrace,” said a former senior investment banker who now serves as a director for several S&P 500 companies. “Asleep at the switch doesn’t begin to describe it.” The autocratic Richard Fuld, whose nickname at the firm was “the Gorilla,” had joined Lehman in 1969 when his air force career ended after he had a fistfight with a commanding officer. He served since 1994 as both CEO and chairman of the board, an inherent conflict in roles that still occurs at 61 percent of the largest U.S. companies.
A lawsuit filed in early 2009 by the New Jersey Department of Investment alleges that $118 million in losses to the state pension fund resulted from fraud and misrepresentation by Lehman’s executives and the board. The role of the board is described in scathing terms:
The supine Board that defendant Fuld handpicked provided no backstop to Lehman’s executives’ zealous approach to the Company’s risk profile, real estate portfolio, and their own compensation. The Director Defendants were considered inattentive, elderly, and woefully short on relevant structured finance background. The composition of the Board according to a recent filing in the Lehman bankruptcy allowed defendant “Fuld to marginalize the Directors, who tolerated an absence of checks and balances at Lehman.” Due to his long tenure and ubiquity at Lehman, defendant Fuld has been able to consolidate his power to a remarkable degree. Defendant Fuld was both the Chairman of the Board and the CEO . . . The Director Defendants acted as a rubber stamp for the actions of Lehman’s senior management. There was little turnover on the Board. By the date of Lehman’s collapse, more than half of the Director Defendants had served for twelve or more years.”
John Helyar is one of the authors of Barbarians at the Gate, which documents the fall of RJR Nabisco in the 1980s. He also cowrote a five-part series for Bloomberg.com on Lehman Brothers’ collapse. Helyar was a keen observer of those companies’ boards when they folded. “The few people on the Lehman board who actually had relevant experience were kind of like an all-star team from the 1980s back for an old-timers’ game in which they weren’t even up on the new rules and equipment,” Helyar told us. “Fuld selected them because he didn’t want to be challenged by anyone. Most of the top executives didn’t understand the risks they were taking, so can you imagine a septuagenarian sitting in the boardroom getting a PowerPoint presentation on synthetic CDOs and credit default swaps?”
In a conference call announcing the firm’s 2008 third-quarter loss of $3.9 billion, Fuld told analysts, “I must say the board’s been wonderfully supportive.” Four days later the 159-year-old company declared the largest bankruptcy in U.S. history. The Lehman shareholders, represented by the board, lost more than $45 billion.
THE DISASTERS at Merrill Lynch, GM, and Lehman were not isolated instances of hubris, incompetence, and negligence. Similar stories of boards and CEOs failing to do their jobs on behalf of the companies’ owners can be told about Countrywide, Citigroup, AIG, Fannie Mae, Bank of America, Washington Mutual, Wachovia, Sovereign Bank, Bear Stearns, and most of the other companies directly involved in the recent financial meltdown, as well as many nonfinancial businesses whose governance-related troubles came to light in the resulting recession. In the short term, the result has been the loss of hundreds of billions of dollars for shareholders, and economic devastation for employees and others caught in the wake. In the long term, a growing crisis of confidence among investors could cripple our economy, as capital is diverted away from American corporate debt and equity markets and companies suffocate from lack of funding.
Investor mistrust takes hold fast and punishes instantly in the modern economy. Enron, once America’s seventh-largest corporation, crashed in a mere three weeks once the scope of its failures and corruption was exposed and its investors and creditors began to withdraw their funds. Today’s collapses can happen even faster. Because the companies are larger, their operations more interconnected, and their financing so complex and subject to hair-trigger reactions from institutional investors with enormous trading positions, the impacts are greatly magnified and reverberate globally. Bear Stearns went from its CEO claiming on CNBC that “our liquidity position has not changed at all” to being insolvent two days later.
Of the world’s two hundred largest economies, more than half are corporations. They have more influence on our lives than any other institution—not just profound economic clout, but also enormous political, environmental, and civic power. As they have grown in influence, they have also become more concentrated: In 1950, the 100 largest industrial companies owned approximately 40 percent of total U.S. industrial assets; by the 1990s, they controlled 75 percent. Global corporations have assumed the authority and impact that formerly belonged to governments and churches. Boards of directors are supposed to be the most important element of corporate leadership—the ultimate power in this economic universe—and while some companies have made progress during the past decade in improving corporate governance, the recurring waves of scandals and the blatant victimization of shareholders that appear in the wake of economic crashes prove that our approach to leading corporations is badly in need of fundamental reform.
Ideally, a board of directors is informed, active, and advisory, and maintains an open but challenging relationship with the company’s CEO. In reality, this rarely happens. In most cases, board members are beholden to CEOs for their very presence on the board, for their renominations, their compensation, their perquisites, their committee assignments, their agendas, and virtually all their information. Even well-intentioned directors find themselves hopelessly compromised, badly conflicted, and essentially powerless. Not that all blame can be put on bullying, manipulative CEOs; many boards simply fail to do their jobs. They allow themselves to be fooled by fraudulent accounting; they look away during the squandering of company resources; they miss obvious strategic shifts in the marketplace; they are blind to massive risks their firms assume; they approve excessive executive pay; they neglect to prepare for crises; they ignore blatant conflicts of interest; they condone a lax ethical tone. The head of one of the world’s largest and most successful private equity firms told us that he considers the current model of corporate boards “fundamentally broken.”
Boards are prone to give away the shareholders’ store. A 2004 study of CEO employment agreements in large companies showed that 96 percent of the CEOs with such contracts could not be fired “for cause” for incompetence, and 49 percent even if they breached their fiduciary duties. Michael Jensen, a former Harvard Business School professor and corporate governance expert, says, “Understand that if I fire you for something other than ‘for cause’ as specified in your contract, I have to pay you the total compensation associated with your contract for its entire life, including bonuses, etc. CEO Bob Nardelli received more than $200 million in severance pay when he was dismissed from Home Depot ‘without cause,’ and Michael Ovitz received $130 million after being fired in 1996 for incompetence but ‘without cause’ after 14 months on the job as president of the Walt Disney Company. He received more pay for being fired than he would have received had he remained employed for his entire contract.”
IS BAD CORPORATE GOVERNANCE a recent phenomenon? Definitely not. Disastrous cycles of crises and failed reforms of business leadership date back to the dawn of corporate history. Two of the all-time worst fiascos involved large-scale companies in the eighteenth century—the South Sea Company in England and the Society for Establishing Useful Manufactures in the United States.
As businesses reached a certain size, it became impractical for the owners to control all aspects of the operations themselves. So they borrowed the concept of representative governance from the organizational structures found in town councils, craft guilds, and the church hierarchy. Things were somewhat simpler and more cost-effective back then. The term board comes from the use of a wooden plank across two sawhorses to create a table where the directors held their meetings. The board members sat on stools and their leader had a chair. He was thus the “chairman.”
Boards of directors were chosen to oversee joint stock companies such as the British and the Dutch East India companies, which had been granted authority under royal charters to trade in specific goods, services, or geographic regions. But trouble developed almost immediately in the form of conflicts of interest, negligence, incompetence, and cronyism. The South Sea Bubble of 1720, sometimes now referred to as the Enron of England, so harmed the reputation of corporate governance that new companies were largely banned for much of the next century. Formed in 1711 to assume a portion of England’s national debt, the South Sea Company was secured by future government interest payments and a monopoly on trade with South America. Nine years later, amid rumors of endless riches flowing from gold mines—and fueled by massive accounting fraud, stock manipulation, and the bribery of public officials by the company’s directors—the company’s stock price skyrocketed, appreciating by nearly 1,000 percent during an eight-month period.
As recounted in Charles Mackay’s Extraordinary Popular Delusions & the Madness of Crowds, investors went wild bidding up stocks with little regard for risks. At the height of the bubble, hundreds of new companies were being formed overnight to soak up speculative demand, including one titled “A company for carrying on an undertaking of great advantage, but nobody to know what it is,” which promised a 100 percent annual return. (The founding chairman, after raising a substantial sum of deposits in a single afternoon, disappeared.) Although one South Sea Company director was widely quoted as being able to feed his horses on gold, the company made almost no profits from the South American trade, other than modest returns from transporting African slaves. Punctured by news that the chairman and many of the other thirty-two directors were dumping their stock, the bubble suddenly burst and the company’s stock plunged 87 percent, causing economic ruin throughout the country.
A subsequent parliamentary inquiry exposed widespread corruption by the directors and resulted in fines for most of them amounting to seven-eighths of their wealth. As one historian noted, “Sadly, the plea of ignorance asserted by many of the company’s directors during the investigation and prosecution following the company’s collapse in 1720 is eerily reminiscent of the response of directors to scandals ever since.”
New “bubble laws” that prohibited the issuance of stock and restricted the formation of new companies were enacted in reaction to the crash, but also because the remains of the South Sea Company wanted to stifle competition. The laws, which kept companies and their boards under very strict control, were not repealed until 1825.
In 1776, Adam Smith had already identified one of the key problems of corporations. Writing about the governance of joint-stock companies in his classic study The Wealth of Nations, he observed: “The directors of such companies . . . being the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own . . . Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company.”
A separate problem resulting from the nature of corporate governance was identified almost 180 years ago by Alexis de Tocqueville, the perceptive French visitor to the United States who, in a chapter titled “How Aristocracy May Emerge from Industry” in the second volume of Democracy in America, explored the tendency of industrialists to become a narrow, self-sustaining, and isolated group within American society. He warned that “the manufacturing aristocracy that we see rising before our eyes is one of the hardest that have appeared on earth”—and declared it a situation which threatened to create a “permanent inequality of conditions and aristocracy.”
This dim view of the corporate leadership class was apparently held by many in America, and businesses were constrained through state charters that granted them only limited functions. The largest such enterprise by far was the Society for Establishing Useful Manufactures, or SUM—a project founded by Alexander Hamilton. In 1791, SUM received the first manufacturing charter granted by the New Jersey legislature and planned to produce cloth, shoes, and other goods in a sort of early-day industrial park. Hamilton envisioned it growing rapidly into a huge manufacturing hub that would establish America as a global trading power.
It is remarkable how closely board and CEO malfeasance at SUM and the company’s resulting financial collapse parallel those of modern-day, scandal-ridden corporations. SUM’s board of thirteen directors was supposedly elected by the shareholders but actually was chosen by Hamilton, who also named New York financier William Duer as governor (chairman) and the French city planner, Major Pierre Charles L’Enfant, who had just laid out the city of Washington, D.C., as superintendent (CEO).
Even considering the less stringent standards of that era, some of the conflicts of interest are breathtaking. Hamilton, while serving as the U.S. treasury secretary, used his political influence to obtain tax exemptions, monopolies on specified products, and a direct state investment of $10,000 for SUM. He promoted the company using his Treasury stationery, personally helped sell the initial stock offering, and later arranged a below-market-rate bailout loan for the failing company from the head of a bank that held federal funds, while making confidential assurances that he would see that the bank did not suffer a loss. Hamilton proved to be a micromanager. He wrote detailed rules for the directors on what workers were to do with broken tools and, as the company ran into trouble, spent days at a time at board meetings dictating strategy. He personally recruited industrial spies who had stolen secrets from British companies on their latest textile machinery. He hired one such spy as SUM’s foreman, while subsidizing his living expenses from the U.S. Treasury.
Like many an imperial CEO, L’Enfant quickly spun out of control and had to be replaced after a year spent wasting much of the company’s capital not on building a factory, but on an extravagant scheme to replicate his plan for Washington, D.C., on the New Jersey SUM site. Two-hundred-foot-wide avenues at right angles were envisioned, despite the near-wilderness setting of hills and streams. When L’Enfant left, he stole the plans.
Hamilton’s choices for directors turned out to be an even bigger disaster than his selection of L’Enfant. Composed almost entirely of local financiers instead of people with manufacturing experience, the board proved practically useless. Its deputy governor, Archibald Mercer, wrote Hamilton about the firm’s dire financial straits and admitted “For my part, I confess myself perfectly ignorant of every duty relating to the Manufactoring business.”
The board governor, William Duer, who was also the largest shareholder, was a compulsive gambler and speculator who, in a conspiracy with several other SUM directors and investors, led an attempt to corner the market for certain bank stocks and government bonds. Duer’s market manipulation triggered a massive speculative bubble and the resulting Panic of 1792, the young nation’s first market crash. Securities dropped 25 percent in value within a two-week period, forcing Hamilton to stabilize markets much as the modern-day Federal Reserve and Treasury did in the 2008 financial meltdown. Duer, who had borrowed massive amounts to fund his scheme, was wiped out, taking thousands of investors with him. In the aftermath, the board discovered that Duer had embezzled much of the company’s accounts. Duer refused to resign as the SUM governor and spent the rest of his life in debtors’ prison, where he was protected from an angry mob of hundreds of investors who gathered one night, shouting for his head and throwing rocks at the prison walls.
A committee of investigation found that another SUM director, John Dewhurst, had stolen $50,000 he was supposed to use for buying materials in England. Disgusted investors withdrew their pledged funds, and SUM, mortally wounded, struggled in vain to recover. By early 1796, the company had shut down its operations, leaving only a bunch of abandoned buildings amid the weeds. The lesson Hamilton drew from the embarrassing experience is summed up in a letter he wrote to a friend when Duer’s duplicity was revealed—and it is a key point for those seeking to reform corporate governance today: “Public infamy must restrain what the laws cannot.”
Despite this rough start, the Industrial Revolution and the need for growth capital caused many restrictions to lapse, and publicly held corporations governed by boards quickly became the norm. So, too, did successive waves of speculative booms and busts—and scandals involving boards—with canals, railroads, oil, steel, the Robber Baron–era monopolistic trusts, the gold and silver price manipulations, the 1929 stock market crash, the conglomerate mania, the defense contractor bribery scandals, the junk bond buyout movement, the savings and loan crisis, the Long-Term Capital Management collapse, and so on through to the Enron and WorldCom–era scandals, the dot-com and real estate financial bubbles and massive neo-Ponzi schemes of our time. Two consistent themes have emerged. First, as companies have grown larger, more interconnected, and more powerful, the crashes are occurring more frequently and are increasingly destructive, with repercussions on a global scale. Second, the governance reforms that have been attempted in their wake focus narrowly on the perceived cause of the most recent crash. Nothing really changes because these reforms impose ineffective, costly, or counterproductive legal and structural requirements rather than deal with the cultural problems of CEO-board collusive relationships and the lack of shareholder power. With the assistance of lawyers, accountants, and bankers, the boards and executives quickly find creative ways around the new rules. Even worse, people are lulled into a false sense of security that the problem has been addressed, investors return to the markets, and the cycle continues.
Post-Enron reforms such as the Sarbanes-Oxley Act and new stock exchange requirements calling for more independent directors and periodic board sessions without the CEO have not done enough to prevent recurring governance disasters. In fact, some changes have had unintended negative consequences; others have high costs that outweigh the benefits for shareholders and society. As a result, too many boards are now focused on cover-your-ass legal processes and box-checking exercises rather than on formulating company strategy, identifying risks, and evaluating executive performance. Real reforms will come only from improvements in the composition and culture of boards, and not just from additional regulatory controls or structural requirements.
Even the companies that have avoided major governance scandals are suffering from new burdens. A recent survey showed that directors now spend nearly twice the time on board work than they did twenty years ago. Fifty-nine percent of directors have declined a board seat due to the risks associated with the role, and 55 percent believe it is more difficult to recruit high-quality directors. The increasing time commitment required of board members, the complexity of contemporary business problems, the threat of reputational liability, the inherent conflicts between monitoring and advisory responsibilities, and the frustration of serving in a role under intense scrutiny in a brutal economic environment have made the job of a director unattractive to many capable people and difficult for anyone to discharge effectively. That means fewer strong, informed, committed board members, and as a result, too many boards stocked with weak, acquiescent, uninvolved directors.
When speaking among themselves, some directors voice increasing concerns about how some of their colleagues have discharged their duties. For each of the past seven years, a large annual survey of directors has shown that almost a third of board members answer yes when asked if they believe a fellow director should be replaced, usually because he or she lacks sufficient skills, is unengaged, has served too long, or is unprepared for meetings. William George, the highly regarded former CEO and chairman of Medtronic, Harvard Business School professor, and board member at several S&P 500 companies, told a forum of directors in 2008 that “Serving on a board is about one thing: it’s about responsibility for the preservation and growth of the enterprise. If you can’t pass that test, you can’t blame it on the CEO, you can’t blame it on your fellow directors. You have to look at yourself in the mirror. We are in a major crisis of corporate leadership.” For better or worse, leadership is the hinge on which our current economy swings. In the last round of scandals from earlier this decade—Enron, Tyco, Adelphia, WorldCom, and others—most of the governance failures revolved around improper accounting and financial malfeasance. This time they have centered on excessive borrowing and risk taking in an overheated market, and on boards approving executive compensation systems that not only encouraged such risks but virtually guaranteed they would lead to disaster.
The depth of the problems stemming from such failures by CEOs and directors often comes to light only after an economic bubble has burst. In the meantime, as Citigroup’s CEO and chairman Charles Prince told the Financial Times in mid-2007 just before the bank’s risky portfolio began to implode, “As long as the music is playing, you’ve got to get up and dance. We’re still dancing.” When the music stopped abruptly, as it did just a few months later, some of the dancers such as Prince were fired, but most were not. Those who had been in charge blamed others, claimed to be victims, or suggested that it was all out of their control despite their having suggested otherwise when justifying their compensation packages. The CEOs and directors of failed financial services firms continually referred to the “financial tsunami” and other outside forces during their media appearances and congressional testimony. AIG’s former CEOs Martin Sullivan and Robert Willumstad, for example, both told Congressman Henry Waxman’s oversight committee that financial disclosure laws requiring the firm’s securities to be valued at current market levels were to blame for AIG’s troubles. Lynn Turner, the former chief accountant at the SEC, responded: “That’s like blaming the thermometer, folks, for a fever.”
H. Rodgin Cohen, a banking lawyer who heads Sullivan & Cromwell and was in the boardrooms advising shell-shocked directors and CEOs at Lehman Brothers, Bear Stearns, AIG, Wachovia, Fannie Mae, and twelve other major financial companies during their 2008 crises, recalled what it was like in the trenches: “Think about it. You’re sitting around on a Friday night and you’re being told the bank probably cannot open for business on Monday—or, if it does, it’s going to be shut down very quickly.” He observed that “any modern financial system is built on confidence and when that confidence evaporates in individual institutions, the lifespan of that institution is measured in days. When it declines in the system as a whole, you have credit gridlock.” Cohen partly blames poor regulatory supervision, especially in the Federal Reserve’s failure to oversee nonbank mortgage lenders like Countrywide who were issuing Option Adjustable Rate Mortgages that allowed subprime borrowers to get in over their heads by deferring principal and interest payments. Cohen also told us that too many bank leaders were driven by competitive psychology in trying to beat Goldman Sachs’s profitability and “failed to recognize risks,” in part because of the mistaken assumption that having an accounting expert on the board’s audit committee—a Sarbanes-Oxley reform measure enacted in 2002—already addressed such concerns. “Boards should have a risk committee and a risk expert,” he says.
AN ESTIMATED 57 million American households own stock in public companies, sometimes directly, but more often through mutual funds, pension plans, and 401(k) accounts. Boards have legal duties to represent the best interests of the shareholders. Directors are typically required by state law to avoid self-dealing and conflicts of interest, and to exercise care, loyalty, and good faith in protecting shareholders. In modern economic thinking, boards should also monitor the interests of employees, customers, suppliers, creditors, and the communities and the environment in which a firm operates, because these interests can be critical to increasing the long-term value of the shareholders’ investment.
On behalf of shareholders, boards’ specific duties are to choose and when necessary replace the chief executive officer of the business; evaluate the performance of senior managers; set executive compensation; approve key strategic and financial decisions; nominate candidates for shareholders to elect as directors; and insure the company’s integrity, sustainability, and compliance with laws and regulations as it tries to grow. Directors are expected to contribute wisdom and long-term vision to a company, steering it away from peril and toward success. In effect, boards are the executive, legislative, and judicial branches of business government, as well as the bankers, the police, and the tribal elders. They are the final check and balance on behalf of the owners, standing in for them by overseeing management.
In reality, many boards fail miserably in these duties. Under the corporate laws of most states, board members avoid liability even if their actions or, more likely, their inaction lead to catastrophic losses for shareholders. This is especially true in Delaware, where the vast majority of large companies choose to incorporate precisely because of that state’s management-friendly laws and courts. Shareholders have little to no influence over which state is selected for incorporation, thus setting off the notorious “race to the bottom” by corporate leaders to those jurisdictions where there is little deterrence for mis, mal, and non-feasance by boards.
Delaware’s “business judgment rule” excuses almost any bad board behavior under the assumption that directors have acted in good faith, even if they didn’t act, and even if they have shown devastating negligence. To be held liable, they must have “knowingly and completely failed to undertake their responsibilities” or had “an actual intent to do harm”—a standard that has let thousands of failed boards off the hook over the years. If shareholders are foolish enough to engage in a lawsuit, they run into process and cost nightmares like that with the AIG civil case which took from 2004 until 2009 just to get to the stage of not having the case summarily dismissed. The first five pages of the judge’s opinion is a list of just some of the lawyers involved: 114 attorneys from 43 different firms, including 22 based in Wilmington, Delaware. The tens of millions in legal fees for the parties on all sides are largely being paid by AIG’s shareholders—80 percent of whom are now, of course, us—the U.S. taxpayer. As one director remarked to us, “As long as you can show you’ve conducted a minimal amount of process and haven’t committed an outright crime, you just can’t be sued successfully.” Consequently, boards fear reputational damage more than legal or financial liability. The one effective constraint is the threat of embarrassment in the rare instances when the consequences of their failures come to public attention.
Board members are selected from the same gene pool. They are a relatively narrow, elite group with homogeneous backgrounds, values, and worldviews. The joke among diversity advocates is that boards are overwhelmingly “male, pale, and stale”—and, indeed, women and minorities are still shockingly underrepresented in American boardrooms. Despite substantial progress during the last half of the twentieth century (until 1964, there had not been a single African American director of a Fortune 500 company), the growth in diversity has stagnated in recent years and actually declined in a number of categories. Boards lack diversity not just in terms of gender, ethnic origin, and age, but, more important, in their members’ range of relevant experiences, in their personalities, and in how they perceive and deal with business issues.
Very few board members have a significant percentage of their own personal wealth invested in the company. Of course, they often get lots of stock from grants or options, which are supposed to align their interests with those of the investors. But it is feared that too much alignment will lead them to manipulate stock prices. Too little and they have no particular reason to care about them. As corporate governance expert Nell Minow said, “At the end of the day, 99 percent of board decisions are based on the fact that it’s not their money.”
Being on a board is a part-time job. Frequently, board members lack the time to be sufficiently committed to their duties, especially if their own company or the one on whose board they sit develops a crisis. Members who are retired and do have the time may lack the energy or current business experience required to be active, effective, and assertive contributors in the boardroom. The very role of the board is increasingly contradictory. Directors are asked to provide a long-term strategic view while they are caught up in details and processes that leave insufficient time for vision. They are supposed to independently monitor executives while also providing them with knowledgeable advice, counsel, and connections.
The go along-to-get-along culture of boards is usually very ingrained, and all the check-the-box reform efforts do little to change it. Collegiality and passivity are the norm; directors who ask tough questions or vote against management proposals are often ignored, passed over, and cut out. And, of course, as human beings, directors are no less prone than the rest of us to the biases, emotions, and behavioral psychology that affect people under stress making decisions in groups.
Representative democracy for a company’s actual owners is still largely a myth. Despite recent improvements that have somewhat increased shareholders’ voices in governance, levelheaded observers such as former SEC commissioner William Donaldson have compared our system to “the old Soviet-style elections” in which shareholders basically have no choice other than to vote for those nominated, abstain from voting, or sell their stock. Except in a tiny handful of cases, board elections are a closed and self-perpetuating exercise without a real choice. Well over 99 percent of the nominees put forward by boards win election. Mounting a proxy fight to elect alternative directors is prohibitively expensive and intentionally blocked by bureaucratic processes that make even getting a list of shareholders nearly impossible. Ballots are secret to the voters, but not to management. Thus, the CEO knows in advance how the vote is going and who has voted for or against the company’s recommendations. In close elections, companies can use this information to arm-twist institutional investors to ensure the outcome.
The bylaws of most corporations allow boards to ignore shareholder proposals, even if they receive an overwhelming majority, because such votes are merely advisory. Since their votes seem meaningless and the process itself is so cumbersome and confusing, most individual shareholders practice rational apathy. Only a third of them bother to vote in corporate elections. However, these shareholders still hold strong opinions about boards and were angry about a number of issues even before the recent financial meltdown. In mid-2007, a national survey of investors holding $100,000 or more of stocks or mutual funds showed 78 percent think boards are giving CEOs too much in compensation; 89 percent think jail time should be mandatory for corporate officers or board members convicted of practices harmful to employees, investors, and the public; and 79 percent say prosecutors should try very aggressively to recover company losses from that executive or board member’s personal assets.
Large institutional investors have a fiduciary duty to vote on behalf of those who actually provide the money for the stock they control, but some of these institutions have conflicts with their constituents’ interests. Mutual funds, pension funds, endowments, insurance companies, and other large institutional investors now collectively control more than 70 percent of the shares of U.S. public companies. In most cases, with the exception of some activist public and union pension funds and hedge funds, they simply vote their shares according to a company’s recommendations, or they farm out the decisions and paperwork to a proxy advisory service. Mutual funds, in particular, have an inherent conflict in such votes because many of them want to manage the 401(k) and other investment funds for companies. There’s not much upside, but a great deal of downside to voting against the management of their current or potential customers.
Companies spend enormous sums of shareholders’ own money to fight proposed reforms directly or through organizations such as the Business Roundtable and the U.S. Chamber of Commerce. The SEC’s proposal in the post-Enron era to allow shareholders to nominate a limited number of directors was dropped after a massive lobbying campaign led by the Roundtable, an association of CEOs whose companies account for a third of the total value of the U.S. stock markets. In mid-2009, in the wake of renewed efforts to reform the director nomination process, the U.S. Chamber of Commerce announced a $100 million “sweeping national advocacy campaign encom
How CEOs and Boards Are Bankrupting America
Money for Nothing
How CEOs and Boards Are Bankrupting America
Based on extensive original reporting and interviews with high-level insiders at a host of leading companies, John Gillespie and David Zweig—both Harvard MBAs with thirtyplus years of Fortune 100 experience—reveal the inner workings of this dysfunctional culture and the many methods CEOs and boards use to shut shareholders out, entrench themselves, and fight reforms with shareholders' own money. Money for Nothing is a vital exposé of how the game is played and a powerful call for change, laying out the specific reforms that are needed to fix the glaring dysfunctions that are imperiling the health of American business.