"Ranting and Raving"
By Dan Haugh

All of the discussions from Washington have concentrated on legislating morality and getting the posse together to go after the few bad apples.  There has been no talk at all of fixing the system that has degenerated to such an extent that allowed these events to happen.  And how are we sure that there are only a “few” bad apples, since the extent of this behavior is by no means known.  Our current acceptable methods of corporate governance fosters an atmosphere that both provides the motive for this type of behavior and concentrates enough power in a small enough group to allow it to occur.

The motive for this behavior is money.  The motive becomes larger with each gross pay raise, option package after option package, golden parachutes given after mediocre performances, excessive loans followed by debt forgiveness package, etc. Top management in many corporations have much to lose.  Are top managers really worth that much more than the average worker, multiples greater than they were ten or fifteen years ago, in spite of the fact that we constantly hear about ever increasing levels of productivity of the same average worker.  Even if you disregard the fairness issue, it just does not add up to be a proper allocation of resources.  So, who is allocating those resources and are there controls in place to assure it is done in the best interest of shareholders?

The opportunity for this type of behavior is that CEOs of many corporations have total control of the reins of power.  Just imagine the US Government where the President has (a) no term limit, (b) the ability to cast votes for many, if not most, of the citizens, (c) effectively has total control over the legislature because he or she appoints them, effectively controls them with very large compensation packages and the ability to remove them, (d) effectively controls the judiciary that rules on the presidents report to the citizens by controlling the purse strings for their only high margin business.  How many of us would like to live under this arrangement?  The saying that “power corrupts and absolute power corrupts absolutely” comes to mind.  This is exactly the system that now passes for our corporate governance!

The system of proper checks and balances has been slowly eroding over the past two or three decades.  The checks and balances that investors could depend upon in the past were: (a) a shareholder base that took an active role in voting their interests, (b) an active and independent board of directors to which management actually reported, and (c) a truly independent auditor that is responsible to the best interests of the shareholders.  Were these checks and balances in force, the problems we are now facing would certainly have been less likely to have occurred, and arguably, could not have occurred.  Lets look at these individually:  

  An active shareholder base – I personally do not know of one individual investor who takes the time to vote their shares, myself included.  With companies having so many shares outstanding many of which are controlled and voted by management, the attitude becomes “why bother?”.     

An active and independent board – On a nominal basis, board members are elected by the shareholders, but in practice many are appointed by the CEO controlling the votes.  Even if a board member sits on other boards or is otherwise gainfully employed, the surest way to never be appointed to another board is to be removed for “being uncooperative” with management.  If nothing else, this is a significant disincentive to ask the tough questions needed to protect shareholder interests.   

A truly independent auditor – Things have really changed in this area.  When I graduated from college approximately a quarter of a century ago I interviewed with the “Big Eight” Accounting Firms.  One of the firms refused to make me an offer in the Chicago office because my father was a controller of a small client in that office.  The fact that I would not be a decision maker on that audit or the fact that I would never work in any capacity on that audit was not good enough, for the all important “even the perception of independence”.  Fast forward a few years, to my securities firm’s audit, and the auditor doing the balance sheet work was impressed with our execution skills and wanted to open an account.  But the thought was, one to two discount commissions per month could harm the perception of independence.  I am having a real hard time reconciling my personal experiences of auditor independence with the currently accepted practice of consulting contracts the size of some third world economies.

I do not say that every auditor and board member is not independent.  What I do say is that the current system does allow a very aggressive CEO to select auditors and board members with significant conflicts and use these conflicts to his or her advantage to consolidate control.  I will also go so far as to say that for the corporations that have had corporate governance lapses, we will probably see most, if not all, of the above controls were abused.   

So let’s make the leap of faith that we have a very strong, ambitious and conflict free SEC Chairperson that has the resources and the mandate to fix these issues.  What can be done? 

·         How can we make shareholders once again desire to take an active role in the companies they own?  The answer is that we cannot, but we can remove some of the impediments.  

1.       One idea that would definitively make me more motivated would be removing the ability for management to vote proxy shares for certain issues, such as mergers or acquisitions, items affecting share dilution and most importantly the election of corporate directors.  I personally would take a much more active interest if I believed the vote was not won or lost before it was held.   

2.       Another avenue open to the SEC, since it also controls many institutional investors, such as mutual funds as they themselves are securities, the SEC could require them to vote some number or percentage of shareholder issues.   

·         How do you encourage an active and independent board?  I do believe this is the area that may need the least drastic changes, but as we saw from the Enron Board’s testimony it still needs work.  

1.       Term limitations or rotation of board members, this coupled with the election of board members solely by shareholders as noted above could significantly make directors more responsive to shareholders.  Directors need to owe their jobs and loyalties to the shareholders.  

2.       Require minimum qualifications for some audit committee members with regard to financial reporting.   

3.       Limit management’s board responsibilities, either in the number of employee members, presence on key committees or even not allowing the CEO access to the dual responsibility of chairperson.   

4.       Require certain issues to be brought to shareholder vote.

5.       If the problem becomes more widespread than we currently anticipate, the SEC could take a very drastic but effective step of creating a pool of SEC compensated board people and require one to be rotated on each board.

·         How do you regulate the independent audit function?  As mentioned earlier, this is something that was self-policed in a very drastic and effective manner not that long ago, so it can be done.

1.       The SEC could very easily extend its reach by requiring audits from SEC regulated companies that have met certain criteria that could very well include a very strict minimum level of independence.  This would obviously put to rest the issue of audit and consulting for the same client.

2.       The SEC could also require rotation of auditors.

3.       The SEC could also require auditors to review the last two years data, basically forcing a peer review when auditors are rotated. 

The above analysis presents some ideas that if implemented in whole or in part could restore the faith of investors for years to come, not just in the immediate aftermath of the upcoming jail sentences.  With the systems in place to once again distribute the powers of corporate governance among the rightful parties, real confidence can return to investors.  I personally do not wish to rely totally on the morals of future generations of CEO, but rather on a system that significantly discourages if not prevents a moral lapse of one or two individuals from becoming a frightening collapse of a major corporation with the inevitable personal and economic cost.

Go Back to Archives

What are YOUR thoughts on this hot topic?  We would love to hear if you agree with Dan Haugh or if you have some ideas of your own on how to tackle this problem.  Send your feedback to: Sarah@PTISecurities.com