Management often does not run corporations for the benefit of their owners, who are the shareholders. Corporate mismanagement is too common.
American public corporations are interesting organizations. Their shareholders own them. The Board of Directors provides strategic direction and oversight. Their executives run them on a day-to-day basis. Some or all of the executives, such as the Chief Executive Officer (CEO) and Chief Financial Officer (CFO), are officers of the corporation. The corporation, using its shareholders’ money, pays the Board and the executives, who are supposed to be working on behalf of the shareholders. Remember, the shareholders own it, lock, stock (pun intended) and barrel. The system is called capitalism. In fact, the Board and officers have a fiduciary (you can also look it up at Mirriam-Webster's site) duty to the shareholders. A fiduciary duty is quite a serious commitment.
Shareholders elect the Directors. They also vote on certain important items of corporate governance, such as approving choice of auditor and stock option plans. Directors choose the officers of the company, or at least they appoint the CEO, who might hire the other officers and executives.
This topic should be especially meaningful to all of us now, in the wake of the Enron, Tyco, Adelphia and Global Crossing scandals. Enron’s management made hundreds of millions of dollars for themselves while destroying their shareholders’ company and leaving many of their employees with worthless retirement plans and no jobs. Tyco’s CEO used the company as his personal piggy bank. The same goes for Adelphia. Global Crossing’s management made hundreds of millions of dollars building a company that turned out to have little value.
Does it actually work this way? Well, sometimes it does. But it often does not. Consider:
Enron -- Management went to about any length it could to drive up reported profits and the share price. Long term, of course, they destroyed the company. Where was the Board during all this? What were Board members, such as Wendy Gramm, wife of Texas Senator Phil Gramm doing, while this fraud went on?
Hewlett-Packard – Management, led by CEO Carly Fiorina, dropped long-time director Walter Hewlett from the Board after he lost the 2002 shareholder vote on merging the company with Compaq. But since when is it their right to do so? Hewlett worked for shareholders, not for management. Management should have nominated Hewlett for another term and let shareholders decide if they wanted him to stay on the Board. If Fiorina did not care for Hewlett, the company could have nominated alternate candidates and let shareholders pick from anong them. Meanwhile, allegations surfaced that Carly Fiorina, the CEO, pressured Deutsche Bank, which owns a bunch of shares, to vote her way by threatening the Bank’s relationship with HP. This is no more acceptable than if a Congressman threatens the Bank with loss of government business if it does not help his re-election campaign. Fiorina should have resigned in disgrace.
Meanwhile, what do the people who run the mutual funds at Deutsche Bank think they are doing? They run those funds for the sake of their shareowners. End of story. They have no right to subject their mutual funds to pressure by the bank. Deutsche Bank has another one of those fiduciary duties to its fund owners. See The New Capitalists for a brief description of Deutsche Bank's unsavory performance. After this escapade, why would anyone ever buy a Deutsche Bank mutual fund again? Where are the class action lawyers? For that matter, why are Deutsche Bank's fund managers not in prison?
In February, 2005, Hewlett-Packard did force Fiorina out. She failed to meet earnings targets and alienated the work force. The company gave her a $42 million severance package. In March, 2006, the Indiana Electrical Workers Pension Trust Fund and three Service Employees International Union funds sued HP. The unions claim the good riddance package exceeded 2.99 times Fiorina's annual base pay plus bonus. That would violate the company's rules. Where are the institutional shareholders? Why are they not filing this suit? Amazingly, unions, supposedly the rivals of shareholders, are looking out for HP's shareholders.
Peter Burrows of BusinessWeek magazine wrote a good book about the Compaq - Hewlett-Packard merger fiasco. The title is Backfire: Carly Fiorina's High-Stakes Battle for the Soul of Hewlett-Packard. This is well worth reading. Click here for a book review.
Sybase – CEO John Chen did raise revenue in 2000, to $468 million, from $422 million in 1999. After that, revenue shrunk -- from $389 million in 2001 to $326 million in 2002 to $275 million in 2003 -- despite a series of acquisitions. Beginning in 2004, revenue began increasing. In 2008, revenue was up to $1.1 billion, a siignificant improvement He has been there 12 years and now somehow owns 3.1% of the stock (he used to own even more, but presumably has dumped some), along with vested options that would let him almost double that stake, due to the company's largesse, while the stock price has been mediocre. The company's stock traded over $20 for much of the 1990's, then went below $20 for the first half of the 2000's. Since mid-2005, the stock price has been in the $20's and $30's. This is not much of an accomplishment for 10 years of, ahem, leadership. Chen has barely grown the company. The company is basically a conglomerate of what was once a leading database product, a GUI programming tool (PowerSoft), some mobile computing tools, assorted financial services industry software, and other stuff. The various products do not complement each other and are sold by unintegrated sales forces, preventing synergies. Chen empowers assorted internal overhead groups, such as accounting and Human Resources, at the expense of sales and services. Meanwhile, Chen has chanege in control provisions to protect him if Sybase is taken over, and the Board is classified. Shareholders should fire him.
PeopleSoft - In June 2003, Oracle offered to buy PeopleSoft, in an apparent attempt to snatch PeopleSoft's application software business for itself. This was probably a bad idea for PeopleSoft's customers, and maybe even PeopleSoft's employees. On the other hand, it would really be good for PeopleSoft's shareholders. Did Craig Conway, PeopleSoft's CEO, whose duty was to maximize the value of his company's shares for the sake of his shareholders, embrace the buyout? No, he fought it as hard as he could. He asked the federal government to declare the purchase to be an anti-trust violation. See this article by Donald Luskin at SmartMoney. Conway signed contracts with customers promising them huge payments if PeopleSoft were taken over and support cut for products. Why would Conway take these steps to hurt his own company and shareholders? Could it be that he cared more abut his own job than his shareholders? Fortunately, in October 2004, PeopleSoft's Board finally did their job. They fired Conway. PeopleSoft and Oracle then agreed on a deal. As for Conway, he received a multi-million dollar settlement.
An interesting side note to this affair is the $807 million liability that Conway has created for PeopleSoft with his customer refund program. PeopleSoft's 10-Q from November 2003 not only provides the $807 million figure. It states that "The customer assurance program has no financial statement impact on PeopleSoft" because this would only affect a buyer of the company. Are they crazy? Assume, for the sake of argument, that a 50% chance exists that someone would buy PeopleSoft and trigger the payments to customers, despite Conway's selfish poison pill. That makes the projected cost to PeopleSoft's shareholders one half of $807 million, or about $400 million, an amount by which a buyer would presumably reduce its offer. PeopleSoft needs to show such a reduction in the value of the company in its financial statements. And that is a significant sum. For the four quarters ending in November 2003, PeopleSoft made $111 million, so that would wipe out four years' worth of profits. KPMG audits PeopleSoft. Given that KPMG has not stopped this from happening, why would anyone ever trust a KPMG audit?
DoubleClick - the company serves ads to users of Internet sites, on behalf of Web site publishers or on behalf of advertisers or advertising agencies. Under CEO Kvin Ryan, DoubleClick's ad volume, in addition to revenue, barely grew. The company's revenue dropped from $506 million in 2000 to $271 million in 2003. Some of the decrease was due to divesting the Media business, though it was already in decline by the time DoubleClick got rid of it. Revenue for the company's core TechSolutions business segment, which includes ad serving and email, decreased from $203 million in 2000 to $175 million in 2003, despite acquisitions of email businesses. Ryan fixed nothing. Instead, he spent time chasing new businesses that did not work, like e-mail and Web site ratings. Meanwhile, DoubleClick sat on hundreds of millions in cash and other liquid assets. Finally, in July 2005, DoubleClick sold out to a private equity group, after which Ryan left to pursue the proverbial other interests. Hopefully, American business will never have to put up with that hack again.
Willamette Industries - management fought for years to avoid a takeover by Weyerhaeuser. Chief Executive Officer Duane C. McDougall and Chairman William Swindells Jr. seem to have had some personal enmity towards Weyerhaeuser. This may have been because Weyerhaeuser chief executive Steve Rogel was the former head of Willamette, which he left late in 1997. While refusing the takeover, Willamette also did not put the matter to a vote of its shareholders. In late 2001, Willamette looked into some sort of purchase of part of Georgia-Pacific to stay away from Weyerhaeuser. Willamette even agreed to pay Georgia-Pacific's expenses of researching such a transaction. Apparently, Willamette would do most anything to avoid Weyerhaeuser. It sure looked like the Willamette Board and management was more concerned with perpetutating their own jobs than in trying to help their shareholders. See this letter from CalPERS. Finally, in early 2002, after three Board members had lost their re-election bids to Weyerhaeuser sponsored candidates, Willamette gave in and agreed to sell out. This escapade is another example of the problem with staggered Boards. Someone wanting to take over a company cannot replace the Board in one year, even with the support of a majority of shareholders. See Commentary: It's Time for Willamette to Give in to Weyerhaeuser for Business Weeks's commentary, including their opinion on the personalities involved. A couple simlar articles are at Pulp Friction at Weyerhaeuser and Why Weyerhaeuser Pines for Willamette, though you may have to be a subscriber to Business Week Online to read these two. Note that corporate officers have no right to allow their personal issues to intrude on decisions they are making for their shareholders. These people have a fiduciary responsibility to their shareholders. When they allow personal feelings to interfere, they are liable for damages to their shareholders.
Merck – For several years, the Board failed to implement shareholder resolutions requesting that it drop staggered Boards, even though shareholders passed the resolutions. Disgustingly, no Directors resigned in public disgrace. Eentually, in early 2004, the Board put forward a resolution asking shareholders to approve declassifying the Board. Of course, they did so in a manner that left Directors who had been "elected" to multi-year terms in office beyond a single year. Why have Merck's Directors not resigned to give shareholders a chance to vote on them? Then, in September 2005, Merck withdrew its arthritis painkiller drug Vioxx after discovering it causes heart problems. The company is now subject to huge potential legal liabilities amid allegations it knew about the problems years earlier. Merck's stock price actually went down over the five years prior to the Vioxx mess and is down a lot more since the Vioxx withdrawl. Amazingly, Merck shareholders continue to re-elect these Directors.
Bristol-Myers Squibb – Bristol had a similar situation to Merck's, where the Board ignored the resolution for six straight years, until finally giving in and agreeing to eliminate the staggered Board in early 2003. See the above-mentioned link Commentary: How Shareholder Votes Are Legally Rigged.
Gillette – Similarly, Gillette shareholders passed resolutions requesting one-year terms for Directors in 2002, 2003 and 2004. The Board ignored them all. Apparently, these people do not know who they work for. Please vote against all Directors of Gillette. And vote against them if they are nominated for other Boards, too.
Xerox - The SEC sued several former executives for misleading investors by inflating profits from 1997 - 2000. The false profits led to bigger bonuses and profits on Xerox shares for the executives. In June 2003, the SEC and the executives settled, with the executives agreeing to pay $22 million. But Xerox agreed to reimburse the executives for all but $3 million. Just whose side is the Board on? Why would the Board protect its executives, who cheated the company and its owners, at the expense of shareholders?
American Airlines - The Board had to force CEO Donald Carty to resign. In spring 2003, American was negotiating with its unions to avert bankruptcy, by trying to obtain concessions from those unions. AMR, the holding company that actually owns the airline and is listed on the New York Stock Exchange, disclosed that Carty had arranged in late 2002 to place corporate funds in a trust for high executives' pensions. He thus protected his personal interests, and those of his elite peers, at the expense of unions -- and shareholders. The unions threatened to walk out of the talks. So, the Board pushed Carty out. This was disgraceful action by Carty, He deserved to lose his job. But, it is even worse than that. First of all, the Board should have taken some responsibility, too. Second, why did American's investors, who were in the process of being cheated by Carty, have to rely on the unions for protection against their own officer(s)? It really is amazing how little power and how little recourse shareholders have. It is fascinating how unions, theoretically opponents of shareholders, are protecting those investors, while the Board watches. This is what American capitalism has come to. Investors have to rely on labor unions to protect their interests.
Kroger – same as Merck. See Call for Kroger Co. elections brushed off by the Cincinnati Enquirer.
Lucent – Has had the same issue as Merck. Finally, in 2004, Lucent's Board has put forth a proposal to eliminate the staggered Board.
The interests of shareholders, who own corporations, and executives, who manage corporations, are not aligned. This is not a new problem. For example, in ancient days, if a king died when his heir was still a minor, someone typically acted as regent until the kid grew up. The regent was supposed to act in the interests of the young king (and maybe the kingdom, too). Some regents did, and some did not. Some regents were more interested in getting rich or perpetuating their own power. Another example is an attorney who takes over the affairs of an incapacitated (often elderly) person. The attorney’s interests may lie in making money from the estate. If said attorney is unethical, he or she may find a way to take money that should go to take care of the client.
This situation is an agency problem. Management is the agent, acting on behalf of the owners. Much of business law covers rules for what agents may do. Much of our problems with corporate governance come from imperfect alignment of interests between agent (management) and owner (shareholders). We need to synchronize these interests and recreate our public corporate system, so that management runs a corporation for the sake of its owners, who are the shareholders. The shareholders should have the power. Isn't that the idea of capitalism? Quoting from the Wikipedia article that the last sentence links to, "Under Capitalist systems, ... authority over the units of productive capacity resides with the owners". In other words, shareholders have the right to control their corporations.
Always vote against Directors on staggered Boards
Always vote against all incumbent Directors of a company that will vest stock options or other bonuses upon a “change of control” or other takeover. It is shareholders’ rights to replace Directors and management at their whim. Management should be striving to do such a good job that owners will not want to get rid of them, not to ensure they get paid if they get tossed.
Default is to vote No on re-electing Directors. Make them explain why you should re-elect them.
Companies must announce results of Board decisions, including individual Directors’ votes. They could use their Web sites. Let shareholders know if Directors are taking positions that they agree with. Boards no more have to speak with one voice than Congress does.
Analysts – Just ignore them if they work for investment bankers. Of course their opinions are biased. This also means we have no need to bother regulating them.
Asset managers should publicly announce their votes on all shareholder matters. Then owners and prospective purchasers of mutual funds could decide if they agree with those votes and whether or not to continue owning the fund. The SEC adopted a rule in January, 2003 that says pretty much the same thing. See Disclosure of Proxy Voting Policies and Proxy Voting Records by Registered Management Investment Companies . Web technology makes this possible. However, we should go further. See the next suggestion.
On some votes, asset managers should invite their fund holders to vote. Let the end owners decide. Web technology can make this possible.
Open nominations for Directors. Perhaps the rule could be that owner(s)
of ½% or more of a corporation’s shares get one nomination. Adjust the amount based on
the size of the Board. Then require that shareholder meeting material that is
distributed to shareholders include material on all candidates for Directors,
with no prejudice for incumbents or those nominated by management. Require companies
to spend equal amounts on behalf of all Board candidates. Company mamagement
should not be allowed to spend its shareholders’ money to give current
Board members an advantage at getting re-elected.
Similarly, allow any group that can claim, say, 5% of the voting shares of a corporation to send its proxy to shareholders at the company’s expense. Give shareholders a choice of whom they want to give their proxy to. Of course, these proxies would have to include all the nominees for Directors mentioned in the last paragraph.
Separate the jobs of Chairman of the Board and Chief Executive. The CEO works for the Board. Therefore, the CEO cannot also run the Board. No one should get to be their own boss.
Encourage management to be neutral on more shareholder resolutions. Example – divestment from South Africa, a major moral matter from the 1980's. The shareholders own the company. They should get to decide if they want to sacrifice profits in the interest of morals or, for that matter, other ideals.
Options should only be exercisable after a longer period of time. For senior executives, this could be ten or so years into the future. The options could vest over a few years, but just be exercisable more years in the future. After all, these people are being paid to make the company succeed in the long term. So, base their compensation thusly. One argument against this could be that the executive’s compensation will depend on what happens even after they have left the company. However, that is part of the point here. Shareholders are paying executives to establish directions and procedures and to hire people for the long run. It is indeed the job of these executives to lay the groundwork for corporate success even after they have left.
Index exercise prices for options to a stock market index. Do not let executives profit from share price increases that merely reflect what the rest of the market does. Variable compensation should be based on above-normal accomplishments. On the other hand, do not index exercise prices to a falling market. When the price falls, shareholders do not make money, and neither should management.
Limit the value of options. It seems that executives can get rich from cashing in just a portion of their options now. This is too easy and encourages them to push for short-term stock price increases. If they need most of their options to be valuable in order to be wealthy, they will be more likely to work for long-term and sustainable stock price increases.
Obviously, ban golden parachutes.
Place (after-tax) proceeds from variable compensation for Directors and executives in escrow. Wait for a few years to release the money to its recipient. In the meantime, if the company has to materially restate earnings (downward) from a year for which the executive or Director earned the money, return a proportional amount to the company. This approach will require some strict and well thought-out rules, but it will eliminate abuses whereby management exercises options, cashes in, then the company restates earnings a couple years later, and the stock then falls. The rules would need to be a little strict, but this should have a beneficial impact. Rules of this sort would make executives very careful to account conservatively, because restatements would cost them dearly.
Treat shareholder resolutions as mandatory. Under some state laws, at least the way courts interpret the laws, this is currently illegal, which is a reason why so many shareholder resolutions are structured as recommendations or requests. See Shareholder Proposals in the SEC's Website. Find Substantive issues near the bottom of the page and note item 1. Or look at Securities and Exchange Commission Shareholder Regulations (Rule 14a-8) on the Northwest Corporate Accountability Project's Website. Another good summary is at How to Draft & Defend Shareholder Resolutions. The obvious implication is that we need to change the state laws or supersede them with federal law. The Delaware provision that bars mandatory shareholder resolutions is Section 141. This is a little strange, because, as you can see, the Section does not obviously bar anything. It seems that the language "business and affairs... shall be managed by ... a board of directors" has somehow been taken to mean that shareholders do not get to interfere with the Board by telling it what to do, even though the Board works for the shareholders. This ought to be enough to persuade people that a new law is needed. Another example of awful state law in Delaware is that it specifically does not allow a majority of shareholders to remove Directors without cause if the Board is "classified" (which means staggered). See General Corporation Law Title 8 and scroll down to paragraph (k).
Auditors need to compete more. They need to change their business model so that they are not selling a commodity product. It is ridiculous that the accounting profession feels it needs to remain in the consulting business in order to attract bright employees. They seem to think so little of their own profession. And indeed, they sell a rigid commodity product. Make auditing better, and make it more important. Rates and profits will improve. And bright people will want to participate. If we can change auditing in this matter, we will not need so many regulations on what auditors are allowed to sell. Still, we probably should not allow auditors to sell too many non-audit services to audit clients.
More controversially, either eliminate the corporate income tax, or do not tax corporations on dividends they pay. This is a long-standing concept that economists pursue, because the corporate income tax is inefficient. It causes profits to be taxed twice: once when earned by the corporation and once again when paid out to shareholders. Among other things, this has the perverse effect of incenting companies to borrow money instead of raising equity, even to over-leverage the company. The reason is interest payments are tax-deductible, while profits and dividends are not. This topic may not seem relevant to a Web page about corporate governance, but it is. Eliminating or reducing the corporate income tax would raise after-tax profits for companies. It would mean that management would have to pay more attention to making money for shareholders. Right now, a corporation with a marginal tax rate of 33% only costs shareholders 67¢ for each dollar it spends. Of the two approaches, eliminating the tax or just not taxing that portion of profits paid out in dividends, deducting dividends may be superior. That way, government authorities will still need to monitor and audit the corporation, to be sure it is not cheating. Such inspection is good for shareholders, as it also protects their interests against theft and manipulation by managers.
Unfortunately, President Bush's reduction of taxes on dividends is different than this idea. He cut taxes on dividends on people's personal income tax returns. This will only indirectly affect corporate behavior. And that effect will be minimized because so many shares are held in accounts that are already tax-free, like 401Ks, pension funds and IRAs. Shares owned by mutual funds and held in taxable accounts will yield a tax benefit to taxpayers, but the benefit will go to the individual, not to the mutual fund's management, which means the level of indirection goes up even more. In short, Bush's tax change will have a trivial effect on improving corporate governance. We should have rejected it. We should instead just stop taxing all dividends paid by corporations, perhaps phasing this in as we can afford it.
Here is an interesting way to sum all these up. The quote is from James B. Stewart in SmartMoney magazine's January, 2003 issue, in his article entitled, "The SmartMoney Manifesto". "All shareholders are created equal". (Note to SmartMoney Magazine -- if you would place this story online, we would link to it, and the publicity would be good for the magazine and help you sell subscriptions.) Stewart uses this principle to say that certain shareholders, like officers and directors, should not get special treatment. They should not receive perks from suppliers, such as investment banks peddling cheap IPO shares, due to their position at the company. They should not have access to better information about the company's prospects. An extension of Stewart's principle is that corporate insiders are not entitled to more voting power. They should not be enitled to exclusive access to corporate proxies to nominate themselves to the Board of Directors and exclude competing candidates.
For some interesting opinions on corporate governance, see POCLAD - Program on Corporations, Law and Democracy. We do not agree with much of what they propose. They want to diminish the power of corporations and make it harder for them to conduct business. They want to let “people” control corporations. We do not think that corporations have too much power or that we need to set up more bureaucracies to encumber them. Rather, we believe that management of corporations has too much power. We think that the owners of corporations will control them if we give them the capability. Still, they are at least trying to improve what is a bad situation. Some somewhat related muckraking populism is at Jim Hightower's Web Site.
eRaider is a site with opinions similar to this site's. This link is to a page with their suggestion to open up Director elections.
Paul Sturm is a columnist who writes for SmartMoney magazine. His column from the September, 2003 issue entitled Memo To Management discusses the agency problem and its effect on profits and investment returns.
On May 6, 2002, BusinessWeek published a special report called How to Fix Corporate Governance. You have to be a subscriber to see this useful article. It covers some corporate management misdeeds and suggests some improvements. The ideas do not go far enough, but they are good nonetheless.
Another BusinessWeek column, by Jeffrey E. Garten, from its Jaunary 27, 2003 issue calls for more acitvism by institutional shareholders. Again, if you are a subscriber to BusinessWeek’s site, see Put Your Mouth Where Your Money Is.
A BusinessWeek guest column, by John C. Bogle, former CEO of Vanguard, ran in the magazine's March 29, 2010 issue. The column points out a big problem with the Supreme Court's Citizens United vs. Federal Election Commission decision that allowed corporations to make political contributions. Corporations will spend shareholders' money without regard to shareholders' own opinions and positions. Bogle calls for requiring corporate management to obtain shareholder approval, by a lot more than majoriyy vote, for political contributions. That would be shareholder democracy. See It's Time to Stand Up to the Supreme Court.
The Duke Energy Employee Advocate has a good summary page on problems with corporations. See Corporations and click on the various pages listed on the left.
The Council of Institutional Investors has a set of policies they recommend for institutional investors. These are good policies, though they do not go far enough.
The Corporate Governance site has a nice summary of issues relating to corporate governance.
Saving Capitalism From the Capitalists, by Raghuram G Rajan and Luigi Zingales, is a reasonably useful book on the capitalist system, its history, and some of the problems facing the system, with emphasis on financial markets. Its final paragraph has a number of suggestions to improve capitalism. Some of the good ideas are improving the safeguards that investors have against corporate managers and strengthening antitrust law.
Last Update:14 March 2010
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