This was a board that took a leisurely approach to overseeing the risk decisions and standards that led to billions in losses and write-downs, was content with a governance structure that concentrated power effectively in the hands of the CEO and sees no need for change at the top. And shareholders actually paid the directors for this performance.
Underperforming assets come in more than just numbers at Lehman Brothers. They are a substantial part of its boardroom, as well. Company chairman and CEO Richard S. Fuld, Jr. and President and Chief Operating Officer Joseph M. Gregory made more than $60 million in compensation between them in 2007 according to the most recently reported figures. And despite announcing in April, at the annual meeting, that “the worst of the impact of the financial markets is behind us,” Mr. Fuld presided over a stunning and unexpected loss of $2.8 billion for the second quarter. So far, Lehman’s write-downs exceed $11 billion.
So what exactly has Lehman been doing? For one thing, it decided -rather inexplicably, given the attendant circumstances involving the Bear Stearns collapse- to buy $2 billion in residential mortgages made to less than top credit borrowers. Lehman CFO Erin Callan called the deal a “great opportunity” on March 18th. (The Wall Street Journal reported on March 17th that JPMorgan Chase had agreed to buy Bear Stearns with Fed backing.) But the move executives prided themselves on in March turned out to be rather sour by June. The company took an additional $2 billion in write-downs involving residential mortgages, mostly in the Alt-A “space,” as Ms. Callan prefers to call it. This is the same Ms. Callan who announced in March that the investment bank was raising $3 billion in fresh capital but that it was “not really needed” to deal with write-downs or losses. It was a spin produced by an aggressive new CFO in the hope of bolstering confidence. Now it looks more like a silly stunt that reveals a company that didn’t know what was happening around it.
You might ask how, during a time of market turmoil in March that required an unprecedented level of intervention by the Fed (which it testified before Congress was necessary to avoid a total meltdown of the financial system) is it possible that Lehman would have taken on more risk in the form of these Alt-A loans? Would not a strong dose of conservative, risk averse medicine have been more appropriate?
For these answers we turn to Lehman’s boardroom, where we find the troubling fingerprints of dubious corporate governance, as we have so often in the worst Wall Street crisis since the Great Depression. It is a board that was pretty much hand-picked by Mr. Fuld, who has been Lehman’s chair since 1994. Only three directors have been appointed in the 21st century.
It is also a board that appears content to leave all the top jobs to -what a surprise- Mr. Fuld, who serves as company CEO, board chair, and chairman of the powerful two-man executive committee. The other member is independent director John D. Macomber, who is 80 years old. The executive committee met 16 times in 2007, more often than the board itself or any other committee. Executive committees, which both defunct Bear Stearns and deceased Hollinger also operated, are considered relics of the past and are not well embraced by most modern corporate governance experts. Best corporate governance practices also call for separation of the positions of CEO and board chair, with an independent director filling the latter post.
You would probably think that in a company where the effective management of risk is such an important determinant of success -or the lack of it- the board’s risk and finance committee would be quite active. That expectation is all the more heightened given that 2007 was a time of increasing worry about the quality of assets and risks in the financial industry. So it is with a sense of bewilderment that we discover Lehman’s finance and risk committee, headed by 80-year-old Henry Kaufman, met on only two occasions during that year. It’s a little reminiscent of Bear Stearns’s board committee of a similar name and mandate, which also met just twice in 2007. We know how that turned out.
Directors at Lehman Brothers were paid well for their services in fees that range from a low of $325,000 to a high of $397,000. Directors also sit on the boards of other publicly traded companies and numerous public institutions on top of their duties to Lehman shareholders. Marsha Johnson Evans serves as a director of Weight Watchers International, Huntsman Corporation and Office Depot, as well as chairman of Lehman’s nominating and governance committee and a member of both the compensation committee and the finance and risk committee. Roland A. Hernandez serves as a director of MGM Mirage, The Ryland Group, Vail Resorts and Wal-Mart Stores, in addition to Lehman. He is also sits on advisory boards for Harvard University’s David Rockefeller Center for Latin American Studies and Harvard Law School, as well as the board of Yale University’s President’s Council on International Activities. He, too, is a member of Lehman’s less than overworked finance and risk committee. Mr. Fuld also has other pressing duties. As we reported before, he is a director of the Federal Reserve of New York, which played a leading role in the great Bear Stearns bailout, a move, as we noted above, that is claimed (by its architects and supporters) to have saved the world’s entire financial system from collapse.
Lehman is a company that took on added risk when everyone else was fleeing from it, raised capital which it claimed it did not need, and lost more money than it, or others, ever expected. On such occasions it is traditional to ask why the CEO, and perhaps other top managers who were responsible for these decisions, are still at their desks. Many at other companies have been booted out. CEOs at Merrill Lynch, Citigroup and UBS come to mind. Accountability at Lehman seems to have no real consequence or manifestation.
This was a board where most of the directors have been around since the firm’s initial public offering in 1994, which took a leisurely approach to overseeing the risk decisions and standards that led to its recent blunder, and was content with a governance structure that concentrated power effectively in the hands of the CEO. It apparently sees no need for a change in its own governance, or that of top management either. It took a bet that its approach would work and it lost big time in the form of billions in losses and write-downs, diluted share value (because of added capital offerings) and a plunge in the price of its stock.
So the real question is: Why are these underperforming assets, also known as Lehman’s directors, still in the boardroom?
We have cast a skeptical eye in recent months on the Fed’s response to the subprime meltdown, and its handling of the Bear Stearns bailout. In The Wall Street Journal today, Greg Ip writes: (subscription required)
Since the credit crisis began last August, the Fed has expanded the volume and types of loans it is willing to make to banks and securities dealers — loans that are backed by a wide variety of collateral from subprime mortgages to student loans. It has so far not directly purchased such debt. It did, however, make an unprecedented loan of $29 billion to facilitate the sale of Bear Stearns Cos. to J.P. Morgan Chase & Co.
Actually, the Fed did not make a traditional $29 billion loan to JPMorgan Chase, as its official statements would have us believe. It was more of a wink-and-a-nudge deal to take on the poorer assets without going through the formality (and the barrage of questions that would follow) of actually purchasing them. How do we arrive at that conclusion?
When you take out a loan and provide collateral, the lender does not usually get to sell your collateral with the hope of making a profit. But that is precisely what Fed chairman Ben S. Bernanke plans to do, if you believe his testimony before the Senate Banking Committee last month.
If we sell these assets over time -and we have allowed ourselves up to 10 years- although we can sell these anytime we like and therefore avoid the need to sell into a distressed market- that we will recover the full amount and that, in addition, if we are fortunate, we may turn a profit…
He repeated versions of the same statement, reiterating the plan to dispose of these assets, throughout his testimony. We have previously noted the cozy relationship that many of Wall Street’s top players have with the Federal Reserve System.
This is part of what former Fed chairman Paul Volcker has described as pushing the legal limits of the central bank’s mandate. The Fed also refuses to disclose details about the Bear Stearns collateral it holds, prompting many to conclude that these assets are not entirely marketable in the first place and that only the Fed could afford to sell them off at fire sale prices over ten years. The whole process behind the bailout lacked even rudimentary transparency.
There are more details disclosed on the label of a jar of Jif peanut butter about the contents of that $2.90 product than the Fed has revealed about the contents of the Bear Stearns collateral it “bought” for $29 billion and the circumstances surrounding that transaction.
For a Fed that is likely to play a much larger role in the regulation of financial institutions, its standards of openness and candor require added scrutiny. If its own conduct in the Bear Stearns bailout is any clue to the approach it will take in the regulation of others, there is little that inspires confidence.
A UBS commercial asks if the company could be “the most powerful two-person financial firm in the world.” With a total of $38 billion in subprime related write-downs, and a Q1 loss of $11 billion reported today, it seems to be headed in that direction. It also plans to cut some 5,500 jobs.
The sheer magnitude of the bad decisions that would have put so much money at risk almost defies comprehension, especially for an institution like UBS that prides itself as a money manager for the very wealthy.
We are told, as we have been in every year since the Enron scandals, that director compensation has risen across the board. It is up by 12 percent over last year. The reason, so they say, is the increased work load in the wake of Sarbanes-Oxley. There have been regular stories since the passage of the first U.S. securities laws in 1933 and 1934 that boards are working harder than ever. One scholarly commentator remarked in the 1930s that “the weight of the New Deal” appears to have fallen on the board of directors. There has never been a time when boards have admitted that they could be doing more for investors. But they always claim they are working so much harder than they did before. And they demand more money. Yet for all that extra work, the world is facing its worst credit crisis since the Great Depression and a scale of losses unimagined even in that bleak period. The financial sector has posted more than $300 billion in mortgage-related losses and write-downs since the beginning of the subprime crisis.
Firms in the financial sector, like UBS, claim to have superior listening powers and ways of understanding the market that give added value to investors and customers. With the costly underperformance of so many of these institutions, much of which we have attributed to a failure of corporate governance, a more credible demonstration that boards truly value their investors would be to start giving back some of their fees, not adding insult to injury by demanding more money for the privilege of presiding over more losses.
Investigations by Congress in 1912, 1932 and 2002 revealed weaknesses and abuses in both the regulatory regime and in the governance of corporations that yielded major reforms. A comparable effort is needed now in the face of the worst credit crisis since the Great Depression.
A trio of former SEC chairmen and a solo performance on the part of a former high-ranking Fed official are making for some interesting music and a much-needed counterpoint to the current chorus of conventional thinking. In a recent Op-Ed piece in The New York Times, William Donaldson, Arthur Levitt, Jr. and David Ruder write: “In 1987, a presidential task force was established to investigate the Black Monday crash. Today, we need a similar exhaustive, bipartisan and impartial examination to explore a series of possible business and regulatory failures”. The former securities regulators invite an examination of:
…apparent conflicts of interest on the part of the credit ratings agencies; the failure of banks and other lenders to adopt sound lending practices; the failure of investment banks to disclose that they had significant portfolios of securities backed by subprime mortgages; the sale of high-risk securities to investors for whom they were unsuited; the breakdown (or absence) of adequate risk management systems among the top financial services firms; and the failure of regulators to recognize and take early action to deal with the problems that have grown to today’s magnitude.
We would add to that list for investigation the alarming failure of too many boards to effectively oversee risk and the role that excessive compensation played in rewarding CEOs for taking on levels of risk that would run up the price of shares and boost their pay in the short term but which ultimately proved to be unmanageable over the longer run. As we predicted some years ago, Titanic-sized CEO compensation has proven to be the most corrosive force in the modern American boardroom. It will continue to be associated with mishaps, scandals and failures in the future, as it has been in the past, unless it is checked by a healthy injection of common sense and sound judgment around the director’s table.
Valuable as a review of the SEC’s role would be, we have expressed the view that a more comprehensive inquiry regarding the actions of all the players in the subprime ordeal, and what changes are necessary both in the regulatory system and in corporate governance practices, is more appropriate. Back in January, in Time for Tough Questions About Subprime Solutions -and Their Potential Dangers, we suggested that Congress needed to get to the bottom of what was happening and why. We concluded by noting:
The issues of subprime bailouts, foreign investment and the failures that brought American capitalism to this troubling state are far too important to be permitted to escape scrutiny or unfold by stealth or default, which is the current mode of operation. Those actors have too often entered the room when no one was paying attention and waltzed out with most of the silverware in their pockets.
Vincent Reinhart, who was director of monetary affairs at the Fed until last year, has called the Bear Stearns bailout “the worst policy mistake in a generation.” We, too, have had our reservations about that rescue and the lack of transparency associated with it. As we said shortly after the deal was announced:
Americans cannot permit free enterprise to reign just when CEOs and companies are making piles of money only to have it replaced by socialism when they are teetering on disaster.
In a later posting we noted:
More and more, the picture is emerging that this was a bailout of Wall Street, prompted by Wall Street, over problems caused by Wall Street, with terms dictated by Wall Street. The Fed’s agreement constitutes the single most significant market intervention in generations. Such a decision…places substantial taxpayer dollars on the line and the concept of moral hazard in jeopardy.
The causes of the worst crisis in America’s capital markets since the Great Depression, and the unprecedented decisions of the Fed in dealing with it, along with the role other public and corporate actors have played in this saga, call out for serious analysis and national discussion. Congress has acted before in the face of momentous challenges to the stability of the market and public confidence in its functioning. A special subcommittee of the United States House of Representatives was formed in 1912 under the legendary chairmanship of Louisiana Congressman Arsène Pujo to examine the influence of the “money trust” and the growing power of Wall Street titans like J.P. Morgan.
In 1932, in the wake of the Crash of 1929 and the ensuing economic depression, the United States Senate Committee on Banking and Currency (as it was called then) began to consider the need for reforms. Its landmark work, spearheaded by committee counsel Ferdinand Pecora, produced the first securities laws of 1933 and 1934 and created the SEC.
More recently, as a result of a series of accounting scandals and widespread failures in corporate governance, efforts by Congress under Senator Paul Sarbanes and Representative Mike Oxley led to the creation of omnibus boardroom reforms known as the Sarbanes-Oxley Act of 2002.
A wide-ranging inquiry into the causes and lessons of the subprime credit implosion, similar in scope and heft to the Pujo, Pecora and Sarbanes-Oxley hearings, needs to be conducted, and soon. We also think it is important to include in that review the governance of the Federal Reserve System and the reforms that are needed to bring it into line with 21st century levels of public confidence, independence and accountability. We pointed out earlier, for instance, that at the New York Federal Reserve, which played the leading role in the Bear Stearns bailout, Jamie Dimon of JPMorgan Chase, the Fed-assisted purchaser of Bear Stearns, was a director. Richard Fuld and Jeffrey Immelt, CEOs of Lehman Brothers and GE, both big players in the capital markets, were elected by the New York Fed directors to represent “the public.” That, we find to be a bit of a stretch. It’s a throw back to the cronyism of the New York Stock Exchange before it was faced with a wave of demands for reform after the pay scandal involving former CEO Richard Grasso. It is simply not possible for any player in the Fed system to maintain credibility regarding its important public mandate while at the same time maintaining what is an essentially privately structured, club-like governance system. It is time for a serious rethinking about to whom and for what the Federal Reserve System is accountable, and how its governance practices need to be more aligned with its public mission.
Comprehensive investigations by Congress in 1912, 1932 and 2002 (and these were not one- or two-day affairs, as recent hearings on some aspects of the subprime debacle have been) revealed weaknesses and abuses in both the regulatory regime and in the governance of corporations that yielded major reforms. Their enactment paved the way for a restoration of public confidence and enabled significant periods of growth and expansion.
It is important that the opportunity to understand more completely the causes of the subprime crisis, and the vulnerabilities that led to it, not be lost. Only then will the full spectrum of necessary reforms both in the boardroom and in the regulatory arena become clear. In that respect, basic logic if not sound public policy principles counsel that the package of regulatory changes proposed recently by the Bush Administration was premature. More needs to be known about the specifics of the failures at all levels that created the current problem before the correct solution can be adopted. Uppermost in any such legislative review is the question: How exactly was one company, Bear Stearns, allowed to become so critical to the functioning of the market that only by preventing its failure through a massive intervention of the federal government could the collapse of the entire financial system be narrowly averted, as U.S. officials have asserted in testimony before Congress.
Not even in the unfettered era of J.P. Morgan’s trusts, or at the height of the rail-riding Great Depression, was the American public presented with the frightfulness of that prospect.
Care about risk was not permitted to intrude upon the holiday from reality many boards chose to take in the years leading up to their subprime cataclysm, which is why the credit crisis of 2008 can be traced to a complete failure of corporate governance.
There is a common theme emerging from the subprime debacle as it relates to the banking industry: risk was not respected. A recent internal UBS report found that the bank’s approach to risk was “insufficiently robust” and that the oversight of investment banking “lacked effectiveness.” UBS has written off over $37 billion in connection with subprime shortcomings, more than any other bank. We noted earlier that the board of Bear Stearns, whose mishandling of risk nearly brought down the whole financial system, according to U.S. government officials, did not establish a risk committee until early 2007. It met only twice in all of that year. John Thain, who succeeded Stanley O’Neal as CEO after Merrill Lynch posted the largest losses in its history, said the risk committee there did not function. A failure to treat risk with the care it deserves was also central to Société Générale, where the bank lost more than $7 billion as a result of unauthorized trades by a mid-level employee.
After Enron and other scandals, legislators in the United States concluded that boards needed to take the “surprise factor” out of financial reporting and assume greater responsibility for the prudent supervision of their companies. Section 404 of the Sarbanes-Oxley Act of 2002 sets out the expectations of cautious boards and top management in their handling of risk and the safeguarding of financial controls. It was not long ago that officials in the Bush Administration and in the business community were seeking to ease Section 404 requirements. SOX went too far, they suggested, and it was hobbling the ability of American business to compete. The irony is that at the very same time these players were claiming SOX was too onerous, they were failing to monitor risk to such an extent that it would lead to the worst credit meltdown and largest write-downs and losses in modern corporate history. Millions of ordinary Americans, as well as stakeholders elsewhere, would be dramatically impacted by the recession-causing missteps that were taken by some of the most revered names in banking.
What is becoming more apparent is that directors and top management, all very well paid, were living in a fantasy land where they acted as though the era of soaring fees and uninterrupted success would continue indefinitely. They chose to see only what they wanted and never contemplated the prospect that reality might hold a more dismal scenario. It was a time of deafening party making where the voices of reason and prudence, if they were invited to the occasion at all, were completely drowned out in the giddy bonus-popping euphoria of the modern Gilded Age’s newest members. Care about risk was not permitted to intrude upon the holiday from reality many boards chose to take on Wall Street and elsewhere in the years leading up to the subprime cataclysm. Like the Enron-type upheavals and accounting frauds that produced the most comprehensive reforms in securities law since the 1930s, the subprime debacle reveals serious shortcomings in boardroom culture and in the way directors are supposed to work.
Simply put, the credit crisis of 2008 can be traced to a complete failure of corporate governance. Others contributed speaking (or non-speaking, as the case may be) parts to the calamity, including sleeping regulators and conflicted rating agencies. But it was the boardroom that played the leading role in this unsettling drama, where the consequences when directors fail to direct were reprised in high definition, even while the scandals of the past were fresh in their minds.
It was a time of excess at every level of the corporate enterprise -except in sound thinking and common sense in the oversight of risk, in vision for looming hazards, and in CEO compensation tied to reason instead of the unsustainable illusion of growing subprime fees. Once again, the safeguards and governance tools that could have protected these companies -and, ultimately, the health of the financial system- from what is fast becoming the worst economic crisis since the Great Depression were the Rodney Dangerfield of the modern banking boardroom.
They just didn’t get any respect.
Bear Stearns’s collapse confirms that excessive CEO pay, along with the feeble corporate governance that permits it, continues to be one of the most corrosive forces in modern business. It offers further evidence that, far from aligning pay with performance, oversized compensation induces risks that lead to disaster. It comes at a price that is too costly to society.
One of the striking features of corporate governance scholarship is that it reveals the same shortcomings and the same calamitous results occurring time and again throughout history.
“The sad case of Penn Central,” Dun’s magazine wrote about the giant corporate collapse in 1970, “is worth mentioning, not because it is unique, but because it is not. Many another US corporation has gotten into trouble because its directors did not do what they were supposed to do, that is, keep a warily inquiring eye on management and ask the right questions at the right time.”
A similar refrain was expressed about the boardroom before and after the Penn Central debacle. As we detailed in Part 1 of this series, Bear Stearns’s weak, distracted and ineptly led board was a contributor to its collapse as well.
Bear was not alone in displaying obvious signs of corporate governance weaknesses, however. Boardroom-wide, directors have permitted the complete discrediting -some would argue hijacking- of the executive compensation system. They have legitimized the creation of payment schemes that have induced CEOs to take on excessive risk in the hope of bringing in fees and deals that push up share values in the short-term and trigger unprecedented awards of stock and bonuses, while at the same time insulating them from the consequences of their actions by guaranteeing golden separation packages in the event of failure.
Excessive CEO pay, as I suggested in a submission to the Senate Banking committee during its Enron-related hearings in 2002, is the most corrosive force in modern business. It is fast eroding respect for the leadership of American capitalism among both shareholders and society. It was a contributing factor in the demise of Enron and Hollinger and in the scandals involving WorldCom, Tyco and many others. Its cancer is also evident in the current economic crisis. Over the past five years, when the foundation for the subprime disaster was being laid, the CEOs of Citigroup, Merrill Lynch, Countrywide Financial and Bear Stearns were paid more than half a billion dollars -$556 million- among them.
Like the toxic effects of the credit catastrophe that spread into the housing market, then to the balance sheets of major financial institutions, and finally into the wider economy, the debilitating repercussions of excessive CEO pay and the subprime misjudgments they spawned have long since moved past the shareholder annual meeting and into the recession dampened lives of ordinary people. In the last year of reported filings, James Cayne (then chairman and CEO of the company) and Alan Schwartz (then president and co-chief operating officer) were paid more than $73 million between them. Did the prospect of such huge compensation distort their judgment and tempt them to accept unwise risks and ignore red flags? It is a line of inquiry policy makers ought to pursue with Bear Stearns and throughout the financial industry.
For every year of the past five, while management misjudgments and miscalculations were laying the course for the credit crisis that eventually claimed the investment bank, the compensation committee of Bear’s board declared that it was happy with the performance of the company and that management fully deserved the compensation it was awarded. So blind was the committee to any notion of excessive risk that was being taken, it simply copied and pasted many of its statements of praise and satisfaction from one proxy statement to the next. “Therefore, the compensation paid to the Company’s executive officers reflects the Company’s strong absolute and relative performance” was how the compensation committee was fond of putting it -so fond, in fact, that it used exactly the same phrase year after year.
Close ties and over familiarity may also have been a problem with Bear’s compensation committee. The board’s pay panel was headed by 81-year-old Carl D. Glickman. While securities filings by the company claim that he has been a Bear director since 1985, biographical information provided by Cleveland State University, where Mr. Glickman is also a trustee, claims he has served on Bear’s board since 1978.
At the very least, the compensation committee’s culture, structure and decisions raise unsettling questions about whether its products are more the reflection of a cozy club mentality of close connections than the result of vigorous market forces and heavy negotiation.
As we noted earlier, long-time chairman and former Bear CEO James Cayne recently sold all his holdings in the firm to net $61 million, according to formal declarations. By some standards, that sum is far below what his holdings were worth a few months ago. On the other hand, he has long been chief officer of the Bear Stearns ship. Having set its ill-fated course, it is remarkable that he came out with anything at all. The ship is going down, but Captain Cayne managed to jump into the Fed-sponsored lifeboat before anyone else. It is not often that any single person, much less one who has been such an outspoken advocate for free market capitalism as Mr. Cayne, can trace his added wealth to the entire apparatus of the federal government coming to his rescue, and to the Federal Reserve taking actions not seen since the depths of the Great Depression.
The subprime scandal also exposed holes in the governance of other investment banks. Merrill Lynch, as incoming CEO John Thain observed, had a risk committee that didn’t function. And Countrywide Financial, which likes to think of itself as a bank, has another all-male boardroom that seldom formally meets and where the compensation committee writes with a hyperactive pen that seems unable to stop putting zeros at the end the CEO’s paycheck. How it permitted a situation where the CEO was allowed to sell a substantial chunk of his own shares at a time when the company was engaged in a share repurchase plan which pushed the price up constitutes an unbecoming stretch for even the most compliant board.
But Bear Stearns is the first institution of its kind to collapse so dramatically with the fingerprints of questionable corporate governance practices found throughout the ruins. There was a disconnect between what the board was supposed to be doing and what it actually did. In that respect, it is reminiscent of the approach taken by another board: Enron’s. It did not end well for that company, either.
The directors of Bear Stearns were paid well for their duties -at least $200,000 each. Management directors were paid in the tens of millions every year. For that sum, and under the board’s unhurried watch, shareholders and employees were treated to the privilege of witnessing the unthinkable: an 85-year-old institution that survived the Great Depression and two world wars only to slide under the turbulent sea of subprime folly, leaving a token reminder in its decimated share price that it once existed at all.
“Where was the board?” is a question governance scholars and others have increasingly come to inquire during times of corporate calamity. It has been asked of many large failures over much of the past 100 years. But for this most recent boardroom mishap an even more probing question needs to be posed: “If Bear Stearns had no chairman and no board at all, would the results have been any worse?”
