Investment Initiatives » Fiddling While Rome Burns

02.25.09

Fiddling While Rome Burns

Posted in Blog at 10:47 pm

I have participated in several conferences and numerous other discussions regarding corporate governance since the spreading calamity enveloped us all last autumn, and one distressing fact keeps leaping out at me: the corporate governance debates have not adjusted at all to the fact that there has been a catastrophic failure of the economic system. People are still discussing the same sorts of palliatives, with the same lack of urgency, that they were doing when GDP growth was forecast at 3% per annum for the next several years, and the Dow was approaching 15,000.

Governance specialists are still focusing their attention to discussions of “Say on Pay” campaigns and majority voting for directors, rather than examining the strange new world in which we now must try to make our way. The financial and corporate landscape, having been bombarded by colossal losses and spectacular failures, will have to be re-erected, perhaps in radically different form, yet from those who were some of the corporate sector’s most trenchant critics, we hear almost nothing as to how it should be re-built.

Some of the fault is no doubt due to the reflex response of most institutional investors and pension funds, which was to cut back radically on corporate governance budgets—along with every other easily accessible form of ‘overhead’—in the face of a sudden economic decline. Governance people are in fear of losing their jobs, and staff reductions have further cut into the resources which might have been available to examine what fundamental reforms are needed.

The fear of one’s own demise may “focus the mind wonderfully,” but usually along only the most practical lines, and in such circumstances it may be unfair to expect that governance professionals can usefully reconsider the assumptions that got the economy into the mess in which we now find ourselves. If so, the fault is with short-sighted senior managers and trustees who are ignoring the benefits that governance programs could have conferred in avoiding some of the most calamitous mistakes which got investors into this trouble.

Governance could have been used as a prophylactic screening mechanism to protect portfolios from involvement with many of the companies which led the way into the crash. These leaders of the downward spiral were typically governance swamps, with poor risk management, lopsided compensation structures that encouraged high levels of short-term gambling, and weak or complacent boards. Large investors could have engaged the companies, and led efforts encouraging them to change. Such efforts might have also focused much-needed regulatory attention upon risky practices. If nothing else, investors would have begun to lighten their positions long before disaster struck, minimizing the impact upon themselves and perhaps precipitating a reconsideration by the broader markets.

Now that the disaster is upon us, institutional investors should be attempting to re-examine what they could have foreseen, and how they could use this information to protect themselves in future. They should be looking for what tell-tale signs there were, what tools could be sharpened and perfected, so that they might escape other such disasters.

Given that the political powers-that-be are likely to insist upon radical re-vamping of whatever structures emerge from the carnage, institutional investors also have a strongly vested interest in attempting to ensure that such new structures do not contain the hidden flaws of the previous ones, and that the future financial and corporate legal structures are more likely to resist the cycles of euphoria and collapse than those we have had. Corporate governance should be at the forefront of such efforts, to make the system function better next time.

Nothing like this is happening. Instead of looking back at the correlations which predicted that certain companies were likely to fail, instead of attempting to refine the diagnostics which are the real justification for monitoring corporate governance in the first place, most practitioners are discussing how they should adjust their criteria for complaining about re-pricing of options in light of the stock market decline, and whether TARP recapitalizations should be construed as poison pills. Curbs on executive compensation are still being considered more from the point of view of limiting payments for mediocre performance, or punishing those who have presided over a period of decline, rather than for their use in attempting to get rid of a gambling culture at many companies, and preventing senior executives from managing companies to further their own short-term goals.

There are many—mostly outside the field of governance, one hopes—who believe corporate governance is merely a highly technical set of requirements governing how a board is elected, and what one can and cannot vote upon at a shareholders’ meeting. This compliance-oriented view has ensured that governance remains largely irrelevant to the investment process, and to risk management.

Especially after the current run of corporate disasters, I would hope that corporate governance is defined instead as a systematic review of how corporations are run, how much power can be amassed by one or a small group of individuals, and what checks can and should be put upon this power to extract enormous rents from the shareholders, to damage other stakeholder interests, and to run risks which may endanger the whole enterprise and even the broader society. Corporate governance is uniquely positioned to evaluate the potential for risk: risk to the shareholders’ investment, risk to stakeholders’ interests, risk to the company, its industry, and to the whole economy. If corporate governance is not this broader and more important endeavor, something else should and must be.

But why re-invent the wheel? Corporate governance already exists as a field, and it focuses upon the principal means by which those who should have the company’s success most at heart can have a positive influence upon its behavior: the relationship between the investors in a company and its board of directors. Rather than invent a whole new field—say, “External Portfolio Risk Management”—and have to staff it from scratch, establish its credibility, and promote it in the face of the many competitors for corporate attention and corporate budgets, does it not make more sense to beef up the field which already exists, and possesses many talented individuals who have been studying the subject and applying its lessons for years? It is up to senior managements—officers and trustees—to seize the opportunity. But it is also up to corporate governance professionals to begin the dialogue.

1 Comment

  1. Sarah Wilson said,

    02.28.09 at 9:42 am

    Andrew you highlight very clearly the problem with ‘The Market’. There is no market for corporate governance in traditional investment; the culture of investment does not have governance embedded in its DNA. Why are we not seeing layoffs on dealing desks to ensure that the governance teams can strengthen their work? It is after all the culture of buy and sell rather than buy and hold and buy some more which has encouraged some of the most perverse behaviours.

    Risk management cannot and must not, IMHO, just come out of a software model. It needs a multi-disciplinary, hands on approach drawing on all the skills and talents of knowledgeable, fully informed and responsible individuals. Black Box models got us where we are today.

    We must also move away from the notion that centralised rules and regulations are a substitute for informed oversight and basic business honesty.

    Corporate governance, corporate responsibility are, investment consultants please note, not an investment style but a core philosophy. We have paid a very high price for the attitude of governance being someone else’s problem.