Asleep at the Switch?
Corporate Boards’ Culpability in the 2008 Financial Crisis
Politicians and the public at large have been quick to vilify the former chief executive officers of failed financial institutions, including James Cayne of Bear Stearns and Lehman Brothers’ Richard Fuld. Deposed CEOs of companies on government life support have taken flak, too, like Franklin Raines, the former head of Fannie Mae, or Sir Fred Goodwin, erstwhile CEO of the Royal Bank of Scotland. Public ire has not extended to the directors of troubled financial institutions, however, notwithstanding that the legal responsibility for managing a company rests squarely on the directors’ shoulders.
The absence of outrage at directors mystifies David Wescoe, a former corporate lawyer who is now CEO of SDCERS (San Diego City Employees’ Retirement System). “It is a fundamental premise that the affairs of a corporation are managed by the board of directors,” he says. “The boards and individuals that comprise them bear a tremendous responsibility for our current economic predicament.”
Wescoe is not alone in his view. Nell Minow, a long-time champion of shareholder rights and editor of the Corporate Library, an independent research firm dedicated to corporate governance and executive compensation, says the board of directors is responsible for a company’s overall strategy and risk management, and for providing proper executive incentives. “All the failures we are looking at now are the result of failures in those tasks,” says Minow. “The directors are entirely responsible.”
Not everyone is so quick to pin the blame on directors, however. Russel Hansen, managing director of the Board Place, a Boston-headquartered firm that offers director education, consulting, and search services, acknowledges that legally the buck has always stopped with the board. But in practice, he says, directors did not consider management oversight their primary responsibility until after SOX (Sarbanes–Oxley Act) took effect.
“Directors were strategists, advisors to the CEO, more a business advisory cabal than an oversight group,” Hansen explains. And while SOX imposed new responsibilities on directors, it did not alter the business judgment rule. Directors still enjoy protection from personal liability for decisions made in good faith that turn out badly, a point the Delaware Chancery Court reaffirmed in a recent shareholder suit against Citigroup.
WHO’S ON BOARD?
Hansen argues that the composition of public company boards, typically stacked with CEOs or former CEOs of other companies, is in part a holdover from pre-SOX days. “CEOs’ mindset is not to be monitors,” he says. “If that was their career path they would not be leading business enterprises on a quest for growth.” Hansen says that directors who are current and former CEOs have adapted to the post-SOX emphasis on oversight “surprisingly well,” though it goes against their natural inclinations. Nevertheless, he suggests that boards could benefit from the addition of people steeped in monitoring and oversight—lawyers and accountants, for example.
David Baris, executive director of AABD (American Association of Bank Directors), points out that directors of financial institutions are already held to a higher standard than other directors in deference to the critical role banks play in the economy and to the public interest in minimizing deposit insurance claims against the FDIC (Federal Deposit Insurance Corporation). Depending on how regulatory agencies use their authority, directors may in some cases be held accountable even if they were not negligent.
A corporate board is a bit like a Roach Motel: once people are invited in, they seldom choose to check out. That’s why many boards still resemble the collections of cronies that were so common before SOX forced companies to appoint only independent directors to the nominating committee.
“We believe in board members being responsible to the extent of their fiduciary duties,” says Baris, “but we think there ought to be culpability before directors are blamed for something.” He argues that if bank regulators were to move toward a strict liability standard for directors, the best qualified candidates would refuse to serve.
Monday morning quarterbacks will always criticize decisions that turn out badly, but even the best-intentioned directors have to rely on what company management tells them. That crucial point was brought home to Suzanne Hopgood, director of board advisory services of the NACD (National Association of Corporate Directors), when she was hired as an expert witness in a court case to review the performance of a particular director in one of the Enron-era corporate scandals. Hopgood has served on the boards of nine companies herself, including five public companies, and currently chairs the nominating and governance committee of Acadia Realty Trust, a company listed on the New York Stock Exchange.
She completed her performance review—and could find no fault with the director’s actions. “That was an awakening to me, one of the most unsettling things at the time. All the right questions had been asked, but the people who answered were not straightforward and in some instances gave answers that were not appropriate or totally honest,” Hopgood says. “It is so easy to say the board wasn’t doing its job, but we sometimes forget that as directors we are totally dependent on the information we are given.”
The boards of financial institutions tend to be larger than those of other public companies—banks often have 15 or even 20 directors rather than the 8–12 that are typical of nonfinancial companies. Hopgood, whose father once founded a national bank, says that’s a legacy from the days when all banks were local. A CEO would invite neighborhood business dignitaries to serve as directors in the expectation that they would help generate new business and provide an informal check on underwriting standards. If anyone asked for a business loan, chances were that one or more directors either knew or had done business with the prospective borrower.
While that model may still work well for community banks, it doesn’t serve the needs of huge financial conglomerates with tentacles that reach to every corner of the globe. A clutch of public company CEOs—even if they run multinationals—cannot pretend to know all the institution’s major clients. In fact, CEOs of nonfinancial firms may not even understand today’s complex financial products.
“Most of these boards were utterly ill equipped to deal with the crises that have arisen over the last 12–18 months,” says Patrick McGurn, special counsel at the RiskMetrics Group’s governance unit. “The wrong people were serving, by and large. You need people who understand the businesses these financial firms are in.”
That doesn’t mean bank boards have to be stacked with other bankers, which would violate the antitrust laws anyway. Nor do all directors have to be financial whizzes, although they should have enough financial literacy to understand the various businesses the banks conduct. McGurn says qualified candidates might include people familiar with risk management, accounting, and other specific disciplines that are useful to the board as a whole.
He would not preclude CEOs of nonfinancial companies from serving, but the days of star-studded bank boards laden with current or former CEOs are numbered. “Investors, taxpayers, and everybody else can no longer afford bank boards that look like a trophy case of CEOs,” says McGurn.
CRONYISM
A corporate board is a bit like a Roach Motel: once people are invited in, they seldom choose to check out. That’s why many boards still resemble the collections of cronies that were so common before SOX forced companies to appoint only independent directors to the nominating committee. The clubby atmosphere discourages management and other directors from ousting those who no longer carry their weight; companies prefer to duck the difficult conversation and wait until age limits force deadwood directors out. In the aftermath of the financial crisis, though, McGurn expects to see more directors decline to seek reelection, making room for new blood.
An independent nominating committee sounds good in theory, but in practice the board composition may not change much. Even when a committee hires a search firm to find qualified candidates, Wescoe says the CEO still retains considerable influence over which potential nominees are chosen and whether directors continue to serve.
In contrast, although he is CEO of SDCERS, Wescoe does not sit on its board of administration and has no control over who is nominated; members are either appointed by the mayor or elected by plan members. Public pension plans answer to different constituencies than corporations, of course, but Wescoe believes the time is ripe for a debate about whether corporate CEOs should sit on the board at all.
He suggests that financial institutions would benefit from directors who know the company’s products from a customer’s perspective: the treasurers and chief financial officers of industrial companies that buy financial instruments. Prior to the financial crisis, says Wescoe, “none of the independent directors of these financial services organizations truly understood the products the firms were selling.” The objective, he believes, is not to find well-rounded directors to fill every available slot—an impossible task—but to create a well-rounded board from candidates who understand finance and bring relevant disciplines to the table.
Lehman Brothers has been widely criticized for a board that, at the time the venerable securities firm collapsed, had 10 independent directors, of whom nine were retirees, four were aged over 75 (including a theatrical producer who sat on both the audit committee and the finance and risk committee), and one was a former admiral who spent her navy career in human resources and education. Only two had ever worked in financial services. Skeptics question whether a group so ill versed in finance could have grasped the risks involved in mortgage-backed securities, let alone collateralized debt obligations, credit default swaps, and other exotic derivatives.
QUALIFICATIONS
Much depends on a board’s willingness to demand an explanation when faced with presentations that are troubling or simply unclear, according to Steve Shappell, managing director of the legal and claims practice of Aon Corporation’s financial services group. The Chicago-based insurance broker’s many lines of business include a major presence in the market for D&O (directors and officers) liability coverage. While directors who know the industry do add value, Shappell’s clients repeatedly say that their top priority is finding candidates who are good at spotting issues and crafting plans to ensure those issues are addressed. On paper, a retired banker may look like a better candidate for director of a financial institution than an elementary school teacher, but the opposite may be true if the banker is coasting along in his dotage while the teacher is young, inquisitive, and willing to reach out for help.
“How seriously they take their jobs as directors is the key,” Shappell says. “Companies spend more and more time looking at the quality of people when they vet potential board members.”
Directors need to know how to interpret the information they receive, a skill in which bank boards are deficient.The meltdown revealed that directors often were not aware of the financial complexities of derivatives or sometimes even of the fact that the companies on whose boards they served had delved into these instruments.
The appropriate qualifications vary from one institution to another, based on the nature of an institution’s businesses and the skills existing directors bring to the table. AABD’s Baris notes that community banks continue to call on local figures while regional banks typically add directors of national standing as well. The largest institutions care little about geographical ties, often tapping prominent business leaders, educators, and people connected to the political establishment—former bank examiners, for example.
It’s important for a board to function as a cohesive unit, too. While the old-school “friends of the CEO” board has fallen into disrepute, it did at least promote a degree of mutual trust and respect among directors. “You have to maintain a certain decorum in a group,” says Baris. “On the other hand, you want people to say what they are thinking and speak out if there is a problem.”
The Corporate Library rates boards of directors on a scale from A through F, a service popular with D&O liability insurers who find the ratings useful for evaluating litigation risk. Before the financial crisis hit, none of the major financial institutions had scored better than a C rating, and all but one of the companies that were eventually bailed out by the government scored either D or F.
“It’s not rocket science,” says Minow. “We try to avoid giving automatic credit for positive structural indicators.” A director may meet the legal definition of independence but still be an insider for all practical purposes, for example. Or a company may have split the roles of chairman and CEO. Minow actually favors that policy, but if the chairman is the institution’s former CEO, it counts for less on the grading scale than if the chairman were truly independent.
Minow agrees that personal courage and integrity matter more than paper qualifications, but no matter how capable directors are, they still owe allegiance to the CEO. “As long as the CEO invites them on the board and is responsible for the quantity, quality, and timing of the information they receive, you can’t be surprised they operate as though they are inside a bubble,” she says.
Minow favors greater shareholder influence over the election process as a check on the CEO’s sway. She suggests that the increasingly common practice of requiring a director to attract a majority of votes at the annual meeting should be enshrined in listing standards. She also supports permitting shareholders to nominate directors in the company proxy statement, an idea that went nowhere during the Bush administration but that Mary Schapiro, the current chairman of the Securities and Exchange Commission, has indicated she intends to pursue.
Companies can and often do help directors hone their skills through programs of continuing education. Aon’s Shappell says the number and value of director training programs has increased exponentially in the years since Enron failed. Colleges, business schools, and other organizations now offer conferences that drill down into the minutiae of board procedures. “It’s not the 30,000-foot view. It’s the 100-foot perspective on audit committees and best practices for risk management and compensation committees,” says Shappell. “It’s night and day compared to when I started speaking at these conferences a dozen years ago.”
RISK MANAGEMENT
For directors of financial institutions, understanding risk management is a critical skill because it touches on everything the companies do. The reporting line often flows from the operating-level risk management committee through the chief financial officer to the board, a structure Shappell says has proved effective and offers good accountability. The model isn’t cast in stone, however. “I don’t think there is a right way as long as people in the boardroom look for and get information directly from risk management,” he says.
Of course, directors also need to know how to interpret the information they receive, a skill in which bank boards are deficient, according to Frank Partnoy, a professor at the University of San Diego School of Law and a leading authority on corporate governance. The meltdown revealed that directors often were not aware of the financial complexities of derivatives or sometimes even of the fact that the companies on whose boards they served had delved into these instruments. Partnoy expects banks to look for candidates fluent in derivatives to plug the gaps in board expertise exposed by the financial crisis. Experts in the field are already in high demand.
Risk management technology has become far more sophisticated in recent years, but companies that came to rely on quantitative measures alone have discovered to their cost that statistical estimates disguise the effect of worst-case scenarios because they assign such a low probability to tail events. Partnoy argues that directors need to demand regular stress tests that show how bad things could get and where the biggest potential exposures lie. “Quantification of risk is useful in many contexts,” he says. “But it’s important for boards to keep in mind that risk management at its core involves a commonsense assessment about what can go wrong.”
Directors of a financial institution must assess operational risks, not just risks associated with the institution’s assets and liabilities. NACD’s Hopgood asserts that directors must identify those risks, then make sure a board committee takes full responsibility for each one. For example, the board needs to assess the risks associated with compensation programs, an obvious culprit in the recent financial crisis. If a company has both a risk management committee and a compensation committee, one of them has to take ownership.
“The danger with a risk committee is that you are not pointing to the compensation committee and saying, ‘Unintended consequences from compensation packages is your job,’” says Hopgood. If the board does have a separate risk management committee, it should have overlapping membership with the other key committees in order to resolve potential conflicts and ensure that nothing slips through the cracks.
COMPENSATION
Lynn Stout, a professor of corporate and securities law at UCLA, says pay for performance was second in importance only to deregulation of the financial markets as a root cause of the financial crisis. When Congress passed the Commodity Futures Modernization Act in 2000, it specifically excluded over-the-counter derivative contracts from regulation by the Commodity Futures Trading Commission—thereby unleashing, in Stout’s view, the potential for speculative excess that culminated in the market meltdown.
Against that backdrop, she argues that directors’ qualifications have no bearing on whether another crisis could occur in the future. “Since the Great Depression it has been understood that corporate governance alone could not prevent speculative bubbles and crashes,” says Stout. “It is not sensible to focus on boards of directors as the way to prevent these kinds of problems. The problems are inherent in the system.”
With the benefit of hindsight, financial institutions are scrambling to redesign compensation programs to eliminate one-way options that pay out big cash rewards up front without recourse if transactions later go sour. To Stout, those programs are symptomatic of a broader preoccupation with short-term results that afflicts investors as well as executives, to the detriment of companies’ future prosperity. Although retail investors often have a long time horizon because they are saving for retirement, they put their money in mutual funds, which turn over their portfolios about once a year on average. “Managers who figure on getting out within a year take more risk,” says Stout. “They hope to get a positive return and sell before the chickens come home to roost.”
Corporate executives, who keep the bonuses they earn in good years even if the company later runs into trouble, have a similar incentive to roll the dice. In addition, Stout says stock options encourage senior executives to pump up the stock price in the short term and perhaps even sell the company. “The only people left to fight the short-term perspective are the directors, most of whom at least want the firm to survive for several years,” she says. “We need a much longer-term focus in executive compensation.”
And not just at the senior management level. RiskMetrics’ McGurn says compensation committees review pay packages for the top officers and usually insist they acquire and retain shares in the company for the long term. He points out that while Richard Fuld earned hundreds of millions of dollars in cash bonuses while he ran Lehman Brothers, he also lost hundreds of millions of dollars in paper wealth when the company failed and the stock he owned became worthless.
McGurn says the bigger risk lies in some proprietary traders’ and bankers’ pay packages, which provide unlimited upside and virtually no downside. Wall Street firms, including UBS and Morgan Stanley, have already adopted plans that place a portion of cash bonuses into escrow subject to clawback against losses in future years.
“People were clearly encouraged to take excessive risks,” says McGurn. “We need to get rid of pay-for-failure packages. Risk committees need to work with compensation committees to ensure they don’t set up a pay structure that ends up betting the future of the firm.”
The idea of matching risk and reward is hardly new to financial institutions, which wrestle with a mismatch in duration between their assets and liabilities every day. Dylan Roberts, a partner in the finance and risk practice at management consultants Oliver Wyman, says companies are reviewing compensation programs with an eye toward modifying any that provide current-period rewards to people who take on risks that could come back to haunt the institution several years later. It’s a delicate balance when people are free to move from one job to the next.
“I am quite sure no one will get it perfectly right,” says Roberts. “The solutions will improve, but people will still be addressing the challenges fifty years from now.”
The new structure won’t gain easy acceptance on Wall Street. In the wake of compensation restrictions imposed under the government’s Troubled Asset Relief Program, McGurn says some boards have already approved proposals that would effectively fund supplemental executive retirement plans and other previously unfunded obligations to senior executives, eliminating the risk that beneficiaries won’t collect the money if the company fails.
The “me first” attitude is rife in society at large, too. In presentations at business schools, McGurn often asks students what their compensation should be if they have a good year but the firm as a whole does not. Invariably, the students want to be paid based on how much money they personally make for the company. “When people have that attitude it is not a culture, it’s the absence of a culture,” says McGurn.
SHAREHOLDER EMPOWERMENT
Frustration at directors who favor the interests of senior management over shareholders has long driven corporate governance activists to demand greater shareholder influence through majority vote requirements for directors, shareholder approval of executive compensation plans, and proxy access. The first two are fast becoming established practice, and shareholders may soon gain the ability to nominate directors in the company proxy, too.
It will not be an unalloyed benefit, however. Hansen of the Board Place argues that boards may need to rethink other aspects of governance if proxy access becomes a reality. For example, he says age or term limits may no longer be appropriate. “Why would you try to get rid of directors that the stockholders not only voted for but had the right to nominate?” Hansen asks.
Shareholder nominations also undermine the case against staggered boards. If shareholders replace the entire board in a single year, the company loses the institutional memory and experience continuing directors provide. “You do want companies to be sensitive to shareholders,” he says, “but responding to pressure for quarterly performance created some of the problems leading up to the financial crisis.”
Hansen’s views are anathema to those who see shareholder empowerment as the key to good corporate governance. “Corporate interests have been very successful at neutralizing the oversight by shareholders that is the essence of the exercise of legitimate corporate power,” says the Corporate Library’s Minow. Proxy access is a step in the right direction, but she would go further and reimburse expenses to shareholders who lead successful proxy contests. Shareholders should be able to change the state of incorporation to their venue of choice, too, which would give them the power to escape jurisdictions that curb their influence.
To UCLA’s Stout, shareholder primacy is a flawed concept that has been tried and found wanting. “In the last 10 years, we have had the best corporate governance—as the reformers define it—that we have ever had,” she says. “We have also had the worst shareholder returns since the Great Depression.”
Stout espouses a “team production” model in which corporations answer not only to shareholders but also to employees, the communities in which they operate, and other interests—closer to the way corporations behaved in practice before governance activists picked up the cudgels and pushed shareholders to the fore.
“At some point you have to look at the last 10 years and say whatever caused the crisis had to be something new,” says Stout. “If we changed anything in corporate governance it was to give shareholders more power and to pay executives by performance. We have to focus more on the long term.”
In that respect, at least, all sides of the corporate governance debate agree—and the responsibility for that long-term perspective lies squarely with the directors. The right board composition depends on the business model, to some extent, but today’s complex financial institutions need directors who understand finance and are willing to speak their minds. Far too many boards fail to fit that description. As RiskMetrics’ McGurn says, “I would be surprised if financial institution boards in five years look anything close to what they have looked like in the past.”
Neil A. O’Hara brings 29 years of experience in the financial services industry in London and New York to his second career as a freelance writer. His work has appeared in Institutional Investor, Alpha, FTSE Global Markets, and the New York Times, among other publications.
