By Eric Jackson
02/24/09 - 12:01 AM EST
C , BAC , GE (Cramer's Pick) , HD
A couple of weeks ago, I co-authored an op-ed on Forbes.com about the problem of bad corporate boards in America.
In it, Sydney Finkelstein and I laid the primary blame for the wheels coming off our economy in the past year at the feet of our corporate boards. There is no question that others, like politicians, CEOs, banks and consumers all had a hand in this mess.
We don't absolve anyone of their justifiable blame. But ultimately, it was the corporate boards of Citigroup(C Quote - Cramer on C - Stock Picks) , Lehman Brothers, Bank of America(BAC Quote - Cramer on BAC - Stock Picks) and others who gave the green light for excessive risk-taking based on assumptions that housing prices would always rise.
Boards are usually an afterthought for most in the media and public. When asked to explain the problems of the past year, there has been a lot of focus on CEO pay and "Wall Street greed." Most people view boards as nothing more than "window dressing" for a company. They are seen as a group of mostly retired execs, bankers, lawyers and accountants who get together once a quarter and rubber-stamp the desired corporate actions of the CEO.
It's certainly true that these groups have been too friendly over the years in allowing CEOs to run businesses as they saw fit. Quite often, directors feel beholden to the CEOs who appoint them and are well paid for serving as a director, so they do not push back on issues when the CEO is a firm believer. Of course, there's also always a friendly consultant that a CEO can trot out to give some third-party support for whatever the initiative is.
Yet it doesn't have to be this way. Boards are responsible at every company for hiring and firing the CEO. They are also the only interface the shareholders have with the running of a business. Every year (except in the case of staggered boards), shareholders have the ability to vote "for" or "against" each director being re-elected to the job. Sadly, many shareholders don't even bother to vote during these elections. For those who do, they overwhelmingly support the incumbent board, as re-election percentages are usually on the order of 90% to 95%.
If shareholders truly were to become engaged with the voting process, the result would be a much more responsive board of directors on their toes to represent their constituents and not just be in the back pocket of the CEO who appointed them.
Tougher questions would be asked at board meetings, and potential excessive risk-taking would be challenged earlier on. If only boards had been doing their jobs over the last six years instead of cheerleading and rubber-stamping, our economy wouldn't be facing such dire circumstances.
Sarbanes-Oxley Not the Answer
After the last bubble, when formerly billion dollar entities such as Enron, World Com, and Adelphi were shown to be shams, the U.S. government swooped in to improve corporate governance and overall financial and operational fiduciary oversight. The result was the Sarbanes-Oxley law, which required CEOs and CFOs to personally attest to the veracity of financial statements, prevented auditors from also consulting with businesses and supposedly improved the quality of boards of directors.
To have better boards, SarbOx suggested that the roles of chairman and CEO be split, that there be more "independent" directors on every board, and that boards avoid becoming too large so that meetings resembled something more like a United Nations get-together. Of course, none of those changes, even if they were followed (which wasn't required), seemingly did anything to make Lehman's board any better.
Let's consider the Lehman board in detail. About half of the 11-member board had an average age of 77. Seven of the 11 had been on the Lehman board an average of 15 years -- not exactly fresh eyes. Nine of the 11 directors were effectively retired -- many for several years. One director (Roger Berlind) was a former Broadway producer. Another director (Marsha Johnson Evans) was the former head of the American Red Cross and, before that, Girl Scouts of the USA.
There are many types of backgrounds, tenures and ages that make for an effective director. Yet, in looking at this makeup of the Lehman board, you have to ask yourself: Were these people who were going to (or even had the knowledge and experience to) challenge Dick Fuld about the firm's aggressive risk-taking and scenario-planning in the event of a major housing slowdown?
Of course, CEOs, pro-business leaders and their lobbying groups, such as the Business Roundtable and Conference Board, have complained that SarbOx did nothing to stop the breakdown of 2008. Just last week, Ken Langone, supreme capitalist and compensation committee member of the NYSE for Grasso, Home Depot(HD Quote - Cramer on HD - Stock Picks) for Nardelli, and GE(GE Quote - Cramer on GE - Stock Picks) for Welch, made the case on CNBC that the breakdown proved that CEOs should be less fettered by legislation like SarbOx rather than more.
I would agree with critics that SarbOx and other laws that seek to improve the quality of boards and board governance are ineffective. If you switch over a board so that it is 100% independent, how is it going to be knowledgeable enough about the business to challenge the CEO? So, if things like SarbOx aren't the answer, what is a solution for better boards?
The Solution for Better Boards
There are two ways to improve the quality of boards in corporate America today. The first is self-improvement: Boards need to fix themselves. The Securities and Exchange Commission or members of Congress can't be a fly on the wall to all boards to tell them whether they are debating issues enough. Therefore, boards must do it themselves. The massive value destruction in real capital and reputational capital that we've witnessed in the last year in firms like Citi, Bank of America and Lehman should send shivers up the spine of every public company director.
We hope that this spurs them to action and to seek out advice from other directors or consultants who have seen these changes successfully put in practice.
It would be nice if boards actually did take it on themselves to improve the quality of their governance. However, I am cynical enough not to expect that Vikram Pandit and Ken Lewis are putting such an effort at the top of their corporate to-do list. This brings us to a second solution, which does have some teeth to it.
The second solution is called "proxy access." The SEC has kicked the can on doing something on this for mor than a decade now. After 2008, there's no excuse for Mary Schapiro not moving ahead on it now.
Today, if any public company shareholder wants to nominate any one or more candidates to be elected by all shareholders to a company's board of directors, that shareholder must foot the bill and jump over an extraordinary number of hurdles to do so. The out-of-pocket costs are at minimum a million dollars (for lawyers, mailing, and proxy solicitors). They must run against an incumbent board's campaign paid for entirely by shareholders.
"Proxy access" would allow shareholders, if they were able to demonstrate that they held shares in a company for a certain period of time, to nominate one or more individuals to be elected to the board on the company's own proxy (so the challengers wouldn't have to pay the freight costs of mailing out the proxies). If the challengers make their case on why they should get a seat at the table as opposed to an incumbent, they should have a seat at the table. May the best directors -- not only the friends of the CEO -- serve.
Shareholder activist Carl Icahn supports this initiative but wants to limit the right to nominate a director to shareholders holding a 5% stake in the company. That's not a problem for him of course, but it defeats the whole notion of "proxy access," which is that if you hold one share in a company, you have a right to air your views and suggest a legitimate candidate to run.
Opponents of proxy access basically make the case that shareholders aren't smart enough as management to nominate people to serve on the board. They say groups such as the AFL-CIO and Teamsters will "hijack" the process and seek to use it to further their "extremist" views. They also like to criticize shareholders calling for change as not having the "long-term interests" of other shareholders in mind.
Citi was criticized for having an obfuscated corporate structure and lack of corporate strategy years ago. The company responded by saying critics were being short-sighted when the stock was in the $50s. "Let our vision for a financial supermarket play out," they said. They repeated the same thing when the stock was in the $40s, $30s, and $20s. Last Friday, the stock dipped below $2. Are shareholders supposed to still shut up and sit on their hands waiting patiently for the all-seeing and all-knowing Citi managers to dig themselves out of this mess? Of course not.
These criticisms have no merit. Any potential director up for re-election to a board of directors -- incumbent or challenger -- should make his or her case on why they deserve the seat. Shareholders can judge for themselves. Large shareholders like Capital Research, Legg Mason(LM Quote - Cramer on LM - Stock Picks) and Vanguard regularly spend a lot of time and effort studying how to vote. Other large shareholders aren't as fastidious, but hopefully that will improve over time. Shareholders can tell if a potential director is a crackpot, an extremist or simply a pawn of the CEO who will do nothing more than rubber-stamp decisions.
When the SEC allows "proxy access," my prediction is that it won't result in a huge number of shareholders rushing to use the power they've been given. Inevitably, some will, and they'll be successful. These few litmus-case examples will do more for improving corporate governance in America than any SarbOx-like legislation could.
There are other changes the SEC could make to improve corporate governance. For example, any director on a board for a company that goes bankrupt or sees its stock price drop by more than 90% in 12 months (like the aforementioned Lehman directors) should have to resign any other corporate boards he/she sits on and not be able to take any future directorships on a public company for the next 10 years.
The risk of being fired by shareholders through proxy access will always be in the back of the minds of corporate directors. This will indirectly lead to incumbent directors asking tougher questions and better corporate governance. And that will benefit all shareholders in the long-term.
At the time of publication, Jackson had no positions in stocks mentioned.
Eric Jackson is founder and president of Ironfire Capital and the general partner and investment manager of Ironfire Capital US Fund LP and Ironfire Capital International Fund, Ltd.
Tuesday, February 24, 2009
Thursday, February 19, 2009
Thu Feb 19, 2009 3:24pm EST
By Alexei Oreskovic - Analysis
SAN FRANCISCO (Reuters) - Google Inc is famous for pampering its employees, but some shareholders feel like they're getting a raw deal.
The sore spot became evident after the Web search leader decided last month to reset the price of underwater employee stock options, in light of a more than 50 percent drop in Google's share price from its November 2007 peak of $747.24.
The move, which will result in a $400 million charge, provoked grumbling among some investors who are not being similarly compensated.
While investors have griped about Google's unconventional actions in the past, such as its refusal to provide earnings forecasts, its appreciating stock price had muted most of the discord. But with shares well off highs, some analysts say Wall Street may be less willing to give Google a pass this time.
"I don't have as good a feeling as I did before about the company," said Jerry Dodson, chief executive of Parnassus Investments, which bought Google shares when they were priced in the low $400s. The stock was trading at $343 on Thursday.
For now, Dodson said he is prepared to live with Google's offer to reset the price of employee options with a strike price below Google's closing price on March 6. "But it puts all of us that have invested in the company en garde," he added.
Patrick McGurn, special counsel of RiskMetrics Group, which advises institutional investors on governance and proxy issues, said Google has some fence-mending to do, as there may be an outpouring of discontent at the company's annual shareholder meeting, which is usually held in May.
McGurn said the option repricing plan is clearly not shareholder friendly, but it is too soon to say whether his firm might recommend shareholders to take any action.
Stock options provide incentives for employees to work hard and share in profits. But the option becomes worthless when the market price falls below the exercise price. Google has said about 85 percent of employees have underwater options.
"Because motivating and retaining employees is a good thing both for those employees and our shareholders, we believe this exchange works for all involved," said Google spokeswoman Jane Penner.
Many investors feel Google's plan, which lets employees exchange underwater options at a one-to-one value, is overly generous and not necessary given the difficult job market.
But analysts say the issue would quickly be forgotten if Google resumed its track record of impressive growth and innovative products once the economy began to recover.
"As long as the company continues to execute, I think shareholders will give them a lot of leeway," said UBS analyst Ben Schachter.
Indeed, Google shares have risen about 12 percent since it delivered better-than-expected quarterly results in January, when it detailed the option exchange plan. That compares with a flat Nasdaq composite index over the same period.
That said, it's still unclear whether Google can buck the recession, or whether it's simply a matter of time before it feels the effects of wide corporate cuts on advertising spending.
In the fourth quarter, Google's revenue grew 18 percent to $5.7 billion, much better than rivals including Yahoo Inc, Time Warner Inc's AOL and IAC/InterActiveCorp. But growth was below the 30 percent-plus rates Google had delivered in previous quarters.
The company is already taking a harder look at costs, pulling the plug on various projects and slowing its hiring.
DUAL CLASS SHAREHOLDER STRUCTURE
Still, Google provides various employee perks, such as free all-you-can-eat meals at several on-campus restaurants, which might strike some as extravagant in the tough economy.
And some say Google is inherently unreceptive to investor input. Its dual-class share structure gave three individuals -- co-founders Sergey Brin and Larry Page, and Chief Executive Eric Schmidt -- 67 percent of voting rights as of 2008.
"Having that unequal voting right in and of itself tends to indicate that shareholders definitely take a back seat," said McGurn of RiskMetrics.
Critics of Google fault it for not holding a shareholder vote on the options exchange plan, as most companies are required to do under Nasdaq and New York Stock Exchange rules.
It is possible for a company to avoid a shareholder vote when its stock option plan explicitly allows repricings, as is the case with Google's 2004 stock option plan.
"The (institutional shareholders) really, really don't like repricings, particularly those that don't get shareholder approval," said Michael Frank, a partner in the employee benefits and executive compensation group at the Morrison Foerster law firm.
"So they may tend to vote against a future proposal with respect to the plan; for example if a company wants to add shares to the plan," Frank said, speaking generally and not about the Google situation in particular.
Given the dual-class share structure, investors may have little recourse other than a symbolic protest vote.
Those who invest in Google signed away a lot of their rights to complain about decisions, said Ironfire Capital's Eric Jackson, who was involved in an activist campaign directed at Yahoo in 2007, but who does not have a position in Google.
"Many investors have chosen to do that because they assumed growth is going to be fantastic and they wanted to be along for the ride," he said. "It's instances like this that cause shareholders to take a step back and think about it."
(Reporting by Alexei Oreskovic, editing by Tiffany Wu and Gerald E. McCormick)
Wednesday, February 18, 2009
By Eric Jackson and Sydney Finkelstein
02.18.09, 11:25 AM EST
A simple two-step program for greatly improved governance.
Who's responsible for the swift and severe downturn in the economy over the last 18 months? Many groups deserve blame, but the most culpable group of all is boards of directors. They let their organizations leverage up enormously without fully understanding the risks or seriously considering the possibility that housing prices could level off or decline.
The last six years have proved beyond a shadow of a doubt that a tick-the-box legislated attempt to improve corporate governance, like the Sarbanes-Oxley Act of 2002, is just not sufficient; secondly, business leaders don't deserve a free pass to police themselves. We propose a two-part carrot-and-stick process, for both fixing boards and reducing the odds that such a calamitous breakdown in capital markets would happen again.
Politicians have a way of showing up at a crime after the fact (as long as it's serious enough to register with public opinion, that is) to produce legislation they hope will make people think they've done something to prevent the same problem from occurring in the future. Before September 2008, when Washington was forced to come to grips with the vastness of the downturn, politicians hadn't been so interested in business since the dot-com bubble burst eight years ago.
Back then, the drop in stock prices that savaged Americans' 401(k) portfolios was accompanied by revelations of egregious corporate wrongdoing at companies including Enron, WorldCom and Adelphia. Sarbanes-Oxley was the politicians' answer to that bad corporate behavior. It was supposed to make boards more vigilant and accountable for their companies' results. But it was utterly ineffective in preventing this biggest market breakdown since the Great Depression.
We know, from years of research and empirical evidence, that good governance does improve corporate performance and prevent corporate breakdowns. We also know that what makes governance "good" vs. "bad" has nothing to do with most of the "best practice" that finds its way into legislation. A board can be made up mostly of "independent" directors (however you define that); it can have some less tenured members and a chairman who is not also the chief executive officer, but all that has little to do with actual financial results.
The factors that most correlate with better governance and performance, it turns out, are things such as the quality of debate in board meetings, the open-mindedness of the CEO and the directors, whether the board does extensive scenario planning and whether it engages in playing devil's advocate when discussing possible courses of action. None of that is easily measured, so it can't easily be introduced into legislation. Yet it is absolutely critical to good governance.
Business leaders and their apologists at the Business Roundtable and Conference Board criticized Sarbanes-Oxley for years after it passed. They said it was too expensive, bureaucratic and good only for auditors, who got to raise their fees astronomically. They argued that Washington should take a much more hands-off approach. Businesses could police themselves, thank you very much. That point of view has been thoroughly discredited by the econolypse of the last year and a half.
In the two-part carrot-and-stick strategy we propose for improving the functioning of our country's boards, the carrot is better self-governance. Boards need to regulate themselves more effectively. The Securities and Exchange Commission can't be a fly on the wall to every board to tell it whether it's debating issues enough; boards must do that themselves.
The past year's massive destruction of both real capital and reputational capital at firms like Citigroup (nyse: C - news - people ) and Lehman should send shivers up the spine of every public company director. They should be seeking advice from other directors or consultants who have been successful at improving governance.
We have been involved since 2004 in implementing corporate early-warning systems at the board level to help directors address potential problems in a much more rigorous and systematic way. One basic measure of how a board is doing is whether it has an early-warning system in place. Boards must do everything they can to insulate themselves against failure.
But hoping public companies' boards will self-regulate is hardly sufficient. In our opinion, there needs to be a stick in place, too. To create it, SEC chairman Mary Schapiro and her commissioners need to swiftly enact something called proxy access. Today, when any shareholder in a public company wants to nominate a candidate for the company's board of directors, that shareholder must foot the bill and jump over an extraordinary number of hurdles.
The cost is, at minimum, $1 million for lawyers, mailings and proxy solicitors. The candidate must run against the incumbent board member, whose campaign is paid for entirely by shareholders. Imagine the same kind of stacked deck in favor of a one-party system in a political context--we'd call it Venezuela.
Well, U.S. shareholders have been trying to run against Hugo Chavez for years here, with Chavez protected by Delaware court decisions and SEC rules that seek to maintain the status quo (and that also keep the state coffers of Delaware filled, by the way). Proxy access would allow a shareholder who had held shares in the company for some time to nominate one or more board candidates on the company's own proxy. The challengers wouldn't have to pay the costs of mailing out proxies. If a challenger can make the case that he or she should be on the board in place of an incumbent, it should happen. May the best directors--not only the friends of the CEO--serve.
Critics of proxy access argue that shareholders who seek to be elected this way will either have extremist views (i.e., groups such as the AFL-CIO or Teamsters may gain more influence than a true majority of shareholders would want, and hijack the process), or "short-termist" views (i.e., shareholders will demand quick fixes for company problems instead of trusting management to do what's best for the long term).
In our view, these criticisms have no merit. Any potential director up for election to a board of directors, incumbent or challenger, needs to make a case for deserving the seat. We trust shareholders to judge for themselves. We believe Capital Research, Legg Mason (nyse: LM - news - people ), Vanguard, and other big investors can tell if a potential director is a crackpot or an extremist--or, on the other hand, a pawn of the CEO who will do nothing more than rubber-stamp his decisions.
We don't believe proxy access, if passed, will cause a major increase in board challenges, but there will be a few, and those could result in a sea change in board effectiveness. If board members are more closely tied to the people they are supposed to represent--the shareholders--they are bound to ask tougher questions. And that will be in everyone's best interests.
Eric Jackson is founder and managing member of Ironfire Capital LLC and general partner and investment manager of Ironfire Capital US Fund LP and Ironfire Capital International Fund, Ltd. Sydney Finkelstein is professor of strategy and leadership at the Tuck School of Business at Dartmouth and is author of Think Again: Why Good Leaders Make Bad Decisions and How to Keep It From Happening to You (Harvard Business Press, 2009).
Monday, February 16, 2009
By Eric Jackson
02/16/09 - 10:20 AM EST
C , GS (Cramer's Pick) , GOOG , YHOO
Through this terrible stock market unraveling, we've seen denials of a housing bubble and over-charged credit environment give way to acceptance. We've seen the idea -- once laughed at -- of the investment banking model going the way of the dodo bird become reality.
With each new step down in the cycle, notions once perceived as sacred cows get skewered.
Much analysis and thought have gone into the future of financials. To a lesser extent, we've read about the implications of this downturn on hedge funds, retailers and consumer behavior in general. But, as time goes on, and the downturn continues to extend its pain in further job losses and stock market declines, there are second- and third-order effects occurring.
Even if the economy were to turn on a dime tomorrow and begin improving, there is psychological damage that has been done which will have ramifications for years to come. Although many investors have been scared away from the stock market with what's gone on, among sophisticated large investors, this downturn will cause them to be much more fearful of illiquid investments -- rather than the liquid equities market -- and it will lead to a sharp shrinking of venture capital, private equity and hedge fund firms who specialize in illiquid assets.
I'm not the first person to point out that private equity is going to go through some wrenching changes in the next few years. My RealMoney.com colleague Doug Kass was the first to say this several weeks ago. Barron's also did a cover story on this at the beginning of February. In both cases, they pointed out how the credit markets freezing up took away the lifeblood of private equity firms. They can't do new deals as a result and they're also stuck with the deals done in 2006 and 2007 at the top of the market.
The Harrah's deal was done by TPG and Apollo at $27 billion in late 2006. Its debt recently traded at 25 cents on the dollar.
But I want to approach the problem facing private equity and venture firms from a different angle than the credit side. From the institutional investor side, there is tremendous fear at the moment. Just as consumers have pulled in their horns since Lehman Brothers went under in September, investors -- retail and institutional -- have liquidated many holdings to seek out the comfort of cash or T-bills.
Hedge funds have felt the brunt of this fear over the last five months, as many investors have run for the exits. Even the funds with positive performance last year were heavily redeemed in December.
Some hedge funds have slammed gates on their investors, preventing them from redeeming their investments until a later date. Although the funds were well within their rights to do this according to their offering documents, it's created a further level of mistrust and desire for liquidity among some institutional investors. There will be further ramifications of this in the months ahead.
For the hedge funds who have used their gates, while still collecting fees (Citadel is one but there are many other examples), they will face a skeptical audience with a long memory when raising funds down the road. But the funds that will face the toughest audience from potential investors will be the VCs, PE firms and illiquid funds. There are three main reasons for this.
- Many of these investors are pension funds, foundations and endowments. Even five years ago, most of these funds knew that a 5% annual return was not going to be enough to face their foreseeable capital needs and distribution needs for retiring baby boomers. Most have known they needed 7% or more annually. Of course, they looked around for models of what they should do and found them in Yale, CalPERS, and Harvard.
For those three groups, alternative investments (meaning hedge funds, venture capital, infrastructure and private equity) have been an important contributor to their overall portfolio returns for years. And, much like Merrill Lynch and Citigroup (C Quote - Cramer on C - Stock Picks) tried to emulate Goldman Sachs (GS Quote - Cramer on GS - Stock Picks) in terms of taking on more risk when times were good, smaller pensions and endowments increasingly upped their allocation to this asset class over the past four years.
After last year's losses, the need to deliver high-single digit returns has never been greater for these investors, so they have become very demanding and very impatient. This has a direct impact on the next two reasons.
- Seven years of waiting is too long. All VCs, PE firms and illiquid funds promise strong returns, but state that it must be measured over the lifetime of the investment, which is typically five to seven years. Given what happened in 2008, these pension fund and endowment investment committees will be under great pressure to demonstrate that any dollar invested today will truly return a 10% internal rate of return over the next seven years.
It will be difficult for many investment committees to agree to tie up their capital for so long, when they can allocate to other managers who allow them much easier access to their capital if needed.
- Capital call structure is too uncertain. Typically, VC and PE firms get capital commitments from their limited partners, but only call on the capital when needed. Although this has been standard operating procedure in these industries for years, in this environment, it's become an annoyance for many investors. Because of a greater desire for more transparency and liquidity, investors will prefer to move their investments as much as possible to the ones with the best liquidity terms without a capital call structure.
There will always be an interest in venture and private equity because of a perception that this group is delivering uncorrelated returns with other aspects of a diversified portfolio -- and the world will always have brand name firms like KKR and Kleiner Perkins. But after the shock of 2008, many investors have come to see that principle of uncorrelated returns across the portfolio as less important compared with greater certainty around returns and liquidity.
With less capital allocated to the venture and private equity space, there will be fewer of these firms tripping over themselves to get deals done. The deals that do get done will be at lower valuations, as investors anticipate lower valuations for exits. With the drop in capital and deals, there will also be a great reduction in these firms -- by as much as 50% in the next five years.
Will there still be innovation? Of course. Angel investors like Ron Conway, Marc Andreesen, Roger Ehrenberg and Howard Lindzon and early-stage investors like Josh Kopelman's First Round Capital will still make early investments in the venture space. In fact, it's cheaper than ever for small investments to take companies like Twitter very far. (This bit of good news, sadly, doesn't apply to the PE industry.)
Many Silicon Valley cheerleaders like to point out that Google (GOOG Quote - Cramer on GOOG - Stock Picks) was started in the last downturn. The Valley came back from the 2000 bubble, so it will come back again, they say. The gray-haired men of the private equity megafunds also like to say that their industry has lived through downturns before and will get through this time. I don't think so. We are living in a moment where something's been broken in our midst and it will not soon be repaired.
Companies will still get taken private and tech companies will still get bought by Yahoo! (YHOO Quote - Cramer on YHOO - Stock Picks) and other big names, sure as night will follow day. There just won't be as many deals, and they won't be for as much.Sphere: Related Content