What shall we do about the board of directors?

The banking upheaval, still in progress, is creating a wave of hindsight scapegoating. Yesterday's Wall Street Journal (9/22/08) was chock full of fingerpointing. But the most concise statement I've heard as to the root cause of the whole mess came from Robert Shiller, when he was interviewed last week by Russ Roberts (listen to it at this page). Shiller's summary: It crossed almost nobody's mind that housing prices might stop climbing. Not buyers, not sellers, not intermediaries, not those who securitized the paper, not those who insured against defaults, not Congress, not the president, not the foreign banks, not you, not me. Almost nobody in the loop thought to include that possibility in their risk/return equations. (One exception: Warren Buffet, who called the risky debt instruments a "time bomb" a few years ago, just before he distanced Berkshire Hathaway from the threat.)

In any case, while I was thinking of all the shareholders (owners) who suffered the Black Swan events of the last few weeks—namely, the sudden surprise of an Enron-style fall in the value of their ownership stakes—I wondered how differently things might have turned out for them if their representatives inside the companies had asked, and obtained acceptable answers to, the above what-if question Shiller says everyone ignored.

So I dusted off a book I read a quarter century ago (see the end note below). Then I read Chapter 12 for the umpteenth time since 1984. The book was written by the retired CEO of ITT Corp; the chapter was about how poorly the owners of the top 500 corporations were being served by their elected representatives (the board of directors); and the recommended solution was still dramatic and thought-provoking, after all these years.

A few excerpts:

Above the exalted chief executive, if you look closely, is a large, amorphous mass, representing the owners of the corporation, the stockholders, who more often than not far outnumber all the employees. And if you look even more closely, you will see that the mass of owners is connected to the corporate pyramid by an archaic, creaking contraption at the top call the board of directors.
       . . .
The board was elected to act in the place of the owners. The board’s responsibility is to sit in judgment on the management, especially on the performance of the chief executive, and to reward, punish, or replace the management as the board, in its wisdom, sees fit. That is what is supposed to happen. That is what may appear to happen. But it doesn’t.
       . . .
Under present conditions, shareholders, whether individuals or institutions, have virtually no way of knowing whether or not they are getting their money’s worth from the [people] hired to manage their company... Over the years [boards] have grown so soft and so ineffectual that most often they are a captive of management, rather than effective representatives of the company owners.

The dramatic solution: Ban corporate employees, including the CEO, from membership on their company's board of directors. In the author's words:

...we would have to make boards of directors genuinely independent of the managements they are there to judge ... The board should represent the owners and only the owners, even as they support valid positions of the management to the stockholders.

The author concludes the chapter as follows:

The impact of a free and independent board of directors upon a company’s management would be profound. Its ultimate effect upon the productivity of this country would be enormous.

Open question:
Republicans and others are fond of saying that America is being transformed into an "ownership" society. Well then, is it time to give all those owners a little more power over the companies they own and the CEOs they've hired?

Feel free to comment; I don't have the answer yet—just the quarter-century-old question. [But after watching this segment of CNBC's Fast Money, I decided that Carl Icahn would smile favorably on the above proposal.]

===============

The book: Managing, by Harold Geneen. You can buy the book for one penny (plus shipping) from Amazon's used book market, at this link. Chapter 12 all by itself is a good whack on the side of the head.

Comments

[JIMB]

The main theme (no one asked what would happen if housing stopped climbing) is counterfactual, Steve.

There were many people that saw this coming, many prominant figures in finance ... even major websites: Itulip, ml-implode, prominant individuals like Jim Rogers (short all the financials...), Robert Shiller (he is incorrect if that is an accurate replication of his quote).

Bob Hoye over at institutionaladvisors said precisely that the problems would occur right after housing stopped going up.

The guys that seemed to get it totally wrong were Kudlow, Luskin, etc. the supply siders who are right about a lot but get monetary policy badly wrong (asset inflation and price discoordination is a much bigger cost than "price deflation").

I think the relevant question now is (would love to see a post on this) is can the government finance a 1.5 Trillion bailout if it is structured correctly?

I'd assume 10% interest rates to account for success (where interest rates climb) or failure (where tax revenues plunge and increase the debt)

My feeling is the government can finance the bailout can. So the second question is, how will it be financed and what are the groups most likely to be hurt? And what does this lead to for the next cycle?

[millhead]

I work for a 91 year old, 4th generation owned, media company. We are not publicly traded...but, the theory is the same. The CEO that took over for his father 4.5 years ago abandoned the "board of directors" model that consistently rubber stamped what his father wanted. Additionally, he bought out his siblings stock therefore taking sole ownership. He then chose to enact a small "advisory board" made up of a couple publishing peers, a banker, a CEO of an unrelated industry, and a CFO of an unrelated industry. This group of individuals provides the advice a "board of directors" never did...from financial, to technology, to human resources, to content creation, etc.

Bottom line - it has worked well and we have survived and even thrived through the biggest transformation in the media/publishing business since TV originated. Why has it worked? He has solicited an unbiased, common sense approach to improving top line revenue and reducing costs.

Publicly traded companies could learn from this model.

[PseudoNoise]

I'm imagining the board room of a company whose competitors were leveraging 30:1 and making money hand-over-fist for the last several quarters. Two choices are presented:
A) Let's have some sanity, keep to our usual leveraging, not chase the quarter's biggest profit, perhaps hedge a bit too because this looks wacky ..
B) Damn the torpedoes, full speed ahead, 40:1 leverage here we come!
What choice would an independent board completely beholden to shareholders make?

[Bob]

I'm not sure if your post is meant to address the current mess or is more general.

If the former, then you might want to take a look at what "mark to market" (part of the SARBOX fiasco) has done to asset valuation and why in heavens name the uptick rule was eliminated. Other than that sheer stupidity in MBS alchemy is a big contributor.

If the latter, then here's some bullets:

1. Expense stock options. As Buffet questioned: "If it's not an operating expense, what is it?"

2. I like the idea of a non-employee board and would take it a step further. Any potential board member who has made a settlement with the SEC, regardless of admission of guilt, shall be barred from serving on any board for 10 years...of something like that.

3. Take a close look at what mutual funds are up to. Really, my view is that many, very many, of them care less about what is going on at the C level as long as the stock goes up and the fund manager makes his metrics.

[inf4mia]

I'll start by saying that I'm not sure what the solution is. The problem in my opinion is essentially the "good ole' boy network".

Company's will frequently stack the board with people who have never worked for the company, but buddy-buddy with executives. These friends while giving the appearance of independence will essentially rubber stamp anything the company throws in front of it.