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At the opening hearing of the Financial Crisis Inquiry Commission, the bipartisan committee formed by Congress to investigate the causes of the great financial meltdown, there were four chairmen of key Wall Street players in the crisis. There was much anticipation over the proceedings held today in Washington. Since its formation last spring, the Committee has had months to prepare for this day. But there was not a single probing question, as far as we could tell, from chairman Phil Angelides or any other member of the panel, about the role of the board of directors. This is a glaring omission, if you believe that boards matter and what directors did or did not do to avoid the disaster is an important part of the review.
It is one thing for boards to constantly underperform or are not taken as seriously by their executive chairmen as they should be, or as an independent, non-management, chairman might want them to be. It is quite another when an inquiring body appears to forget that, in law and in principles of modern business practice, the buck stops with the board of directors. Where were they?
We will have more on this disappointment soon.
The company, whose management and board have displayed such colossal contempt for common sense and good judgment and have inflicted so much damage on shareholders and employees, deserves to disappear into the winter snows of folly. Its employees do not.
Once again, Nortel – now just the pathetic remnants of a once iconic global brand – has shown its true DNA. It lacks the corporate gene for grasping reality. The latest example came this week when the company, while in bankruptcy protection and after denying severance and benefits to thousands of employees, managed to come up with millions in bonuses for top executives. As we have noted before, from the time Nortel was founded as an offshoot of Bell Canada – with that firm’s monopolistic culture and pampered directors establishing the tone – to the excessive compensation it lavished on previous CEOs (one of whom still faces criminal charges) and the sea of debt it chose to set its course upon, this company has never adapted to reality very well – or accounting rules, for that matter. It has had, as a defining hallmark of its culture, the tendency to reward and mollycoddle those in the executive suite and in the boardroom, while viewing employees as expendable bodies.
The outcome, though perhaps predictable, is of course sad on many levels, and especially in its human dimension. But a company whose management and board have displayed such colossal contempt for common sense and good judgment and have inflicted so much damage on shareholders and employees, deserves to disappear into the winter snows of folly. Its employees do not. If enough public outrage can be mounted – and it is surely deserved – perhaps management can be forced to share the pain in the same way Nortel’s employees have, by sharing the dollars that go with their obscene bonuses. It is unfortunate that little indignation is being voiced by the judge who is overseeing the process. Canada has few jurists like U.S. District Judge Jed Rakoff, who, it will be recalled, refused to go along with the cozy settlement concocted by the SEC and Bank of America last summer. He thought it was offensive to the public conscience. So is the compensation arrangement approved in court proceedings for Nortel’s executives.
Ultimately, after having been the most valued company on the TSX, all that there is to show for the shattered remains of this once promising enterprise is a lesson in hubris and, more particularly, the consequences of taking future success for granted, of assuming trophy directors actually are plugged into the company and know what is going on, and of buying into the myth of excessive compensation where riches for a few at the top are taken as a guarantee for all the other investors and employees who have a stake. Perhaps Nortel can do a better job in that role than it did when, in the mid-1990s, it used to give keynotes at corporate governance seminars holding itself up as a model of sound governance and enlightened leadership.
As Winston might have said: Some governance. Some leadership.
Even a former Premier of Ontario claimed he was duped as he presided over this fraudster’s scheme.
The odd name YBM Magnex suddenly emerged from its shadowy past last week when the FBI placed Semion Mogilevich, its Russian mobster mastermind, on its “Ten Most Wanted” list. He is accused of swindling Canadian and U.S. investors out of $150 million in a complex international financial scheme. Authorities say the fraud involved preparing bogus financial books and records, lying to Securities and Exchange Commission officials, offering bribes to accountants and inflating the share values of YBM, which was headquartered in Newtown, Pennsylvania but whose stock was traded on Canada’s top exchange, the TSE (now TSX). The policing of potential fraud was a low priority for the TSE in those days, and the reputation of Canada’s capital markets suffered significantly during this period. So did confidence in its corporate governance.
There continues to be an active debate as to whether Canada is tough enough on white collar crime, and whether, without a single national securities commission, as I and others have long advocated, there can be any hope for a more robust enforcement regime.
To increase its lure to investors, the company attracted some prominent independent directors, including David Peterson, a former premier of Ontario. In testimony some years later before the Ontario Securities Commission on the matter, Mr. Peterson admitted that he did not make notes at company board meetings and did not retain any records. He was, for a scheme like YBM and Mogilevich, the ideal slumbering director.
I was one of the first to write about the scam and the failures that led to it, in 1998. Below is one of those articles, published in the Financial Post more than a decade ago.
Wednesday, July 15, 1998
Guest Column
YBM simply the latest example
Top securities regulators asleep at the switch again
By J. RICHARD FINLAY
The Financial Post
History sometimes repeats itself. In Canada’s premier securities market the failure of regulators to respond to danger signals is becoming an alarming habit: Cartaway, Timbuktu, Bre-X, Delgratia.
The latest case involves YBM Magnex International Inc., whose trading was halted on the Toronto Stock Exchange in May amid questions over the company’s 1997 audit and in the wake of police raids on its corporate headquarters in Pennsylvania. The scandal bears such eerie similarities to the Bre-X Minerals Ltd. scam of just a year earlier one is tempted to conclude it is the fickle hand of fate that is writing this drama. But it is not fate. It is the recurring folly of this country’s top securities regulators.
Both Bre-X and YBM began their journey on the Alberta Stock Exchange. Listings on the TSE and inclusion on its prestigious 300 composite index followed for both companies. In April 1997, the exchange’s president, Rowland Fleming, assured investors the Bre-X debacle had “heightened the state of alert in our market surveillance department.” But, later that same month, YBM was added to the TSE 300 index.
TSE officials have since admitted they knew then of criminal investigations on two continents into an alleged Russian crime figure with a stake in YBM. However, neither the exchange nor the Ontario Securities Commission, which was also aware of the investigations, thought it advisable to disclose these facts to investors at the time of YBM’s listing and later stock offering. It is an omission that makes Canada’s top securities regulators potentially more culpable in the YBM fiasco than they were in Bre-X.
Another Bre-X-type danger signal was the extensive insider trading occurring before the accounting firm of Deloitte & Touche Ltd. announced in May it was unable to certify YBM’s 1997 financial statements. The company’s president, Jacob Bogatin, and several officers sold more than $2 million worth of stock between late February and April.
Troubling too is the trading activity of Kenneth Davies, one of YBM’s independent directors and a member of its audit committee. He reportedly made a profit of nearly $250,000 selling YBM shares after the board learned Deloitte & Touche was suspending its audit of the 1997 figures but before that information was disclosed to the public.
Clearly, regulators need to be more alert to insider trading in companies with questionable track records. In addition to the police investigations they knew about, regulators had forced YBM to have its 1996 books re-audited, resulting in a restatement of material facts.
Directors of Bre-X also engaged in heavy insider trading before negative revelations that saw share values evaporate. For more than a year, the OSC has been investigating the Bre-X trades for possible securities law violations. Yet the regulator still hasn’t released any information, this despite its increased resources thanks to a changed funding formula — including a new chairman with an annual salary of more than $450,000 — and enormous public interest.
Also, the corporate governance practices of these two companies were well known to both the TSE and OSC, and to YBM’s legion of mutual fund and institutional investors. Bre-X had an insider-dominated board that violated exchange guidelines on good governance. YBM’s list of outside directors includes Owen Mitchell, who is also a director of First Marathon Securities Ltd., the company’s lead underwriter. Former Ontario premier David Peterson is also a director, while his law firm acts as Canadian solicitor of record for YBM. Peterson, like other directors, has also participated in the company’s generous stock option plan. TSE guidelines on corporate governance advise directors should keep themselves “free of relationships and other interests which could, or could reasonably be perceived to, materially interfere with the exercise of judgment in the best interests of the corporation.”
The parallels between Bre-X and YBM show how little the TSE and the OSC have learned — and how vulnerable the public is to regulators’ omissions that put their investments at risk. Since these issues involve the integrity of Ontario’s capital markets — a key Canadian asset in the global economy — it is time for Ontario Finance Minister Ernie Eves to order a review of what needs to be done to make the TSE and the OSC more vigilant. Neither Canada nor the investing public can afford to have such regulatory folly repeat itself another time.
J. Richard Finlay heads the Centre for Corporate & Public Governance.
The long-running Livent legal drama shows that what passes for Canadian justice among white-collar offenders remains something of a mystery, like a glacier that moves imperceptibly.
You have to wonder what Livent’s former investors are thinking, or what others might be learning, about Canadian justice. First of all, there were four convicted criminals on Livent’s board, which we were the first to note here. That would be a record if it were not for Hollinger’s boardroom, which boasted a grand total of six felons.
Next, they have had to contend with the iceberg that is Canadian justice. Garth Drabinksy and Myron Gottlieb were both charged with fraud in U.S. federal court in 1999. It wasn’t until 2002 that they were charged in Canada. Six years later the trial began, and last March a conviction was handed down. In a much shorter span of time, Martha Stewart, Jeffrey Skilling, Sanjay Kumar, Dennis Kozlowski and Conrad Black, to name a few, were all charged, convicted and put behind bars. Some are still there. Livent’s duo were convicted in March of this year. They will not be sentenced until mid-August, seven years after the Canadian charges were filed. There will be appeals that will keep the crafty pair out of jail for many years. Along with an appointed senate and a system where the prime minister selects judges for the supreme court and all other top courts without any constitutional checks or balances whatever, what passes for Canadian justice as it pertains to the errant white- collar community remains something of a mystery. Nortel’s former CEO has yet to see the inside of a courtroom. The Ontario Securities Commission seems to have forgotten about Hollinger and dropped an appeal in a high profile case it lost. No one was ever convicted in the Bre-X fraud, the largest crime of its kind in mining history. None of this, including the lethargic handling of the current Livent case, is likely to change the image that Canada is soft on white-collar crime.
If that playbook is followed, Livent’s founders will spend a relatively short time in prison. A sentence of between two-and-a-half and three-and-a-half years would not be surprising given the leniency Canadian judges have shown toward miscreants in the boardroom. These courts have little trouble expressing outrage over a single mother who passes bad cheques. When it comes to rich tycoons or theater impresarios, their disdain appears more muted, almost apologetic, for having to find someone guilty. Livent’s founders will regain some measure of freedom within months of beginning their sentences. Some of Judge Mary Lou Benotto’s decision reads in places like a publicity brochure for one of Livent’s productions and in others could pass for the citation during the awarding of an Order of Canada medal (which Mr. Drabinsky holds).
As to the proposal put forward by Mr. Drabinsky’s lawyer that his sentence include no prison time but rather a speaking tour on the topic of ethics in business: In this fictional portrayal worthy of the stage, Mr. Drabinsky would find himself in the company of an interesting cast. Ken Lay used to give such speeches before his conviction in the Enron case. Bernard Madoff, when he chaired NASDAQ’s board, was seen as a strong advocate of robust industry regulation on Wall Street. Michael Edwards, a former chairman of the Toronto Stock Exchange, was also considered a proponent of ethical and governance reforms, until he was penalized by the Ontario Securities Commission for his failures in the RT Capital (then a division of the Royal Bank of Canada) scandal some years ago. He was also a member of the committee that brought forward the Exchange’s 1994 landmark corporate governance guidelines. It was later discovered that he chaired a board at RT Capital that never actually met. Ethics, it seems, is the last available refuge for the corporate scoundrel.
Having looked at the subject over several decades and given more than my share of speeches and media interviews on it, as well as advice to several governments and major corporations, I have found that it is a good idea for one to know something about the subject of ethics before claiming to extol it. It requires a commitment to ethics as a core value, not as a convenient tool to avoid prison or promote good public relations. Ethics might also entail some knowledge of right and wrong. As far as Mr. Drabinsky is concerned, there has been no demonstration of remorse or appreciation for the wrong he committed and the injury he caused.
Canadian justice has moved at its customary glacial pace since the fraud at Livent was alleged in the Manhattan Office of the U.S. Attorney. Perhaps all investors and advocates of a higher standard of justice in the boardroom and enforcement by Canadian regulators and the courts have left is the hope that by the time the sentence is handed down next month, it will not have melted into a puddle of meaningless platitudes where the offenders pay with empty words instead of a significant measure of their freedom.
More than two years ago, we asked the question “How long can Nortel go on being Nortel?” The final answer came this weekend, when it was announced that the remains of the company would be broken up and sold off, leaving not much except a once- respected, but long since discredited, name.
You might wonder what happened to Canada’s most valued corporate prize–this bastion of innovation that put Canadian technology on the map around the world. The answer is a failure of corporate governance, pure and simple.
Nortel had a series of boards that drew their cultural inspiration from the old Bell Canada monopoly model which gave the company its life many years ago. Many of Nortel’s directors in the 80s and 90s, and even in the 21st century, were also directors of Bell Canada. The former CEO of BCE (or Bell Canada now), Jean Monty, took two turns at being Nortel’s CEO and then going back to head BCE.
That model was about a never-ending deference to management and the assumption that large size would always translate into continued success. Nortel’s boards missed red flag after red flag and took the wrong turn in the market, like General Motors, on almost every occasion. They continued to put their fate in the hands of managers who were not up to it, and pay them absurd levels of compensation. They thought they could give lessons to the world on corporate governance. Several of Nortel’s directors, including one-time CEO John Roth, were on a committee appointed to reform Canada’s corporate governance practices. They fell embarrassingly short of that mark but did manage in one respect to provide an unexpected lesson: how to take a giant company with an astonishing pool of innovative workers and enormous shareholder support and turn it into a basket case of accounting scandals, self-serving management and stunningly complacent directors.
Rest in peace, Nortel. You deserved better.
Had there been no board at all at AIG, Bear Stearns, Merrill Lynch, Lehman Brothers, General Motors and so many others, it is hard to imagine how the outcome could have been any worse for those institutions and their investors. This is a stunning indictment of a vital and much relied upon function of modern business that creates real systemic risk. It should not have been overlooked as major focus for reform.
Take any defunct company or failed enterprise of major note in recent years -Enron, Hollinger, Nortel, Bear Stearns and Lehman Brothers jump to mind- and you will see the faint outline of the ghosts of its board desperately seeking to attain meaning in death which it failed to achieve in life. In many cases, the difference between the productivity of a sleeping board and one no longer breathing at all is barely perceptible in any event. These boardroom apparitions have likely tried to make contact with the administration of U.S. President Barack Obama as it prepared its sweeping agenda for reform of the financial system. They have apparently been without success in that endeavor as well.
Whenever there has been a collapse or serious threat to the survival of a company, a first slumbering-and then startled-board of directors has been discovered cowering close by. The inability of directors to properly direct and exercise the informed, independent judgment that is required of their positions was a defining feature of the 20th century’s two great financial upheavals. It is a distinguishing factor in the worst economic crisis of the 21st century, where board after board claimed to be unaware of the true depths to which their companies had fallen and most professed surprise at the extent to which management had run amok with risk and debt.
As we have observed many times in public forums and before legislative committees, no other institution in modern business has so persistently failed to perform its intended mission or brought discredit to otherwise illustrious names of accomplishment and virtue as the board of directors of the publicly traded company. At a time when their size and power have expanded to the point where companies have become too big to fail or require billions in taxpayer support to prevent their total collapse, it is unacceptable-indeed, it is an affront to any concept of sound risk management-that the board of directors is the weakest and most unreliable link in the corporate governance chain.
In the run-up to the subprime debacle that brought the world to the brink of financial collapse, boards at some of America’s oldest and most respected financial institutions were seemingly oblivious to the risks that their companies were incurring or the mortal threats that were gathering on the horizon. Many, like Bear Stearns and Lehman Brothers, seemed to have no effective oversight at all. Citigroup’s directors appeared to be in a constant state of suspended animation, acting always too slow and too late on the few occasions when they actually did anything. When AIG’s directors received warnings about the Financial Products division, whose out-of-control derivatives business eventually brought the company to the edge of ruin, they remained in denial. At Hollinger, big name directors seemed to have all the requisite skills, except the ability to read and ask discerning questions of a constantly scheming management. Even in non-financial companies, like General Motors, the board seemed indifferent to management’s repeated failure and disconnected from the changes that were reshaping the consumer market. (See these companies under categories section for more analysis).
And in virtually every case where the existence of a company has been imperiled, or it has disappeared altogether, the specter of wildly excessive CEO compensation loomed large. Rather than acting as watchful guardians of shareholders’ assets, directors too often seemed to be little more than obliging ushers, happy to facilitate the greatest transfer of wealth of its kind in history to the CEO class of management. It is the failure of boards to properly bring discipline to the compensation file that permitted a situation whereby CEOs were encouraged by oversized bonuses to take the unjustified risks that later led to a cascade of unprecedented failure and stock market calamity.
It is not a matter that accountability and director engagement have had an insufficient presence in the American boardroom. In many cases, they didn’t even make it into the company’s main floor elevator. Had there been no board at all at Enron, AIG, Bear Stearns, Merrill Lynch, Lehman Brothers, Hollinger, Nortel, Livent, General Motors and so many others, it is hard to imagine how the outcome could have been any worse for those institutions and their investors. This is a stunning indictment of a vital and much relied upon function of modern business.
So it is with astonishment that we find the issue of corporate governance and the need to make boards work as intended are nowhere to be found in the Obama administration’s comprehensive agenda for financial regulatory reform. Nor does it appear that the Securities and Exchange Commission is undertaking any significant overview of what has gone wrong at so many boards, as we recommended on these pages some months ago. Indeed, in the executive branch’s proposals for reform, the term “board of directors” as it applies to the publicly traded company appears only once-in passing-in all the report’s 88 pages.
The issue is hardly insignificant. As we said last April:
Here’s something else the SEC is missing: What exactly was the role of boards of directors in the credit and financial meltdowns of the past 18 months, and to what extent did a failure of structure or culture among directors contribute to a global crisis affecting hundreds of millions of individuals, costing trillions of dollars and eventually leading to the collapse of banks around the world?
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What boards did and did not do, and how they were organized, in recent years and months when calamity has been such a frequent guest are lessons that are too important to ignore. We suspect that what will be found is a weak and compliant boardroom culture where the most taxing job for most directors was lifting the rubber stamp marked “yes.” That, in our view, is the real definition of systemic risk.
Boards exist as stewards of other people’s money. The wise use of that trust is central to the principle of capitalism. Without it, capitalism would cease to exist. Either the board of directors occupies an important place in the functioning of the modern, publicly traded, corporation, or it does not. Either there is the need to ensure that management is held accountable and that directors answer for their stewardship to investors, or that charade should come to an end. Either the system of corporate governance that has evolved over the past 100 years and which views the board as the lynchpin of that regime should be accorded its rightful prominence, or an entirely new system needs to be created.
One thing is clear: Oversight of the operation of a company, including its management of risk, the supervision of its ethical standards, the quality of supplier, employee and customer relations and the accuracy of its financial reporting, cannot be left to outside regulators alone. Capitalism and its stakeholders cannot rely on government for every aspect of their survival. That is for other systems of economics and government, not for one that values freedom, individual choice and personal initiative. What capitalism must do is to first look within its own system to ensure that the tenets of fairness and integrity that are essential to its existence are being upheld. Companies need to self -regulate if they are to fulfill the promise of a system that is said to thrive in a climate of least involvement by government. It is the job of the board of directors to perform this self-regulating task, though, sadly, many boards betray discomfort when called upon to protect their own shareholders’ interests, much less serve as guardians of capitalism. Free market advocates and champions of limited government someday need to address this glaring gap in leadership.
Public policy periodically, and generally after some scandal or disaster, has tended to recognize the vital role that boards hold and has attempted to raise their standards of performance and accountability. This happened notably in the 1930s and again after the Enron-era accounting scandals. There is no reason to think that, in the aftermath of the most costly abuses and betrayals on the part of Wall Street and the financial sector since the 1930s, the importance of the board has suddenly been diminished or its need for reform has been averted.
If restoration of confidence in the system of capital markets is the goal of the Obama reforms-if there is a genuine desire to minimize the chances of disaster in the future-the role of the board of directors, and what needs to be done to make it more effective, cannot be overlooked. It was disappointing that the administration, which is otherwise rather astute in its comprehension of economic forces, chose to do so. We look at some ideas to bridge the gap between what boards are supposed to do, and what they have actually done, in Part 2.
