SEC Drills a Peephole into Boardrooms


Over half the world's biggest economies are corporations. In America, business arguably exerts more influence over government than does government over business. Nominally, the 52 million American households that hold stocks own these firms vote for the boards of directors who are supposed to represent their interests. And now that boardroom negligence is being exposed as a major contributor to the recent economic meltdown--leading to taxpayers owning 80 percent of the shares of such bailed out companies as AIG--these directors should be more answerable both to shareholders and We the People.

If you think political democracy has its problems, wait until you see what goes on in our other elections. Imagine the Senate with no C-SPAN, no journalists, no public sessions, no transcripts, no voting records, no open nominating process, and no accountability. And all of them work for the President, who also happens to be a one-person Supreme Court. That's about what we have in the American corporate boardroom.

This is not to argue that greater transparency and shareholder power would insure that all companies succeed. But the current broken system creates a hermetic seal where bad things can and too often do happen. Like Enron, Worldcom, Tyco, Adelphia and others in the previous wave of corporate scandals from a decade ago. Or Lehman, Merrill, Bear Stearns, Fannie Mae, General Motors, Citigroup and scores more in the latest debacle that resulted in a a multi-trillion-dollar meltdown, whose root causes in failed corporate leadership have yet to be addressed.

Some baby steps in the right direction are beginning to occur. The SEC, for example, approved new disclosure regulations that took effect February 28. They shine a dim light, at least, on what goes on in the corporate sanctum sanctorum. Companies are now required to explain their boards' leadership structure, director qualifications, whether directors have served at companies with prior legal imbroglios, as well as how they approach risk oversight (to avert another meltdown), and diversity (however they definite it--which should be interesting).

The SEC is asking in public some of the questions that directors should have asked in private--and for which shareholders should have demanded answers . They're being asked now because the prior failure of our national leaders, including directors, has sunk this nation into a very deep hole.

Corporate and financial regulation moves in cycles. History clearly tells us that a period of laxity precedes billions (now trillions) of losses, followed by righteous indignation by those who should have or did indeed know better, culminating in a ratcheting up of some parts the regulatory regime. Unfortunately, the focus is typically restricted to the perceived causes of the past crisis and little is done to address the broader problems that then fester into the next disaster.

For every action, there's a reaction. After the rules are cinched up, some business leaders seek ways to avoid the intent of the regulation, find new ways to make money through loopholes, or try to vitiate enforcement or repeal the regulations altogether through lobbyists, campaign contributions, and the revolving door into the public sector.

So here we sit, with one in 10 American mortgages at or near default, the FDIC staring at a record number of dying banks and its own reserves trending toward total "empty." Other omens abound. How could America have contributed so much to this global economic calamity even after the Sarbanes-Oxley Act, the congressional response to the Enron era, had been in full force?

Sarbanes-Oxley was a legalistic response to an ethical and behavioral problem in key sectors of American business and political leadership. The problem's epicenter lay in the executive suites of corporations and in the accounting industry, whose main product ought to be the trustworthiness of their monitoring of financial statements. Because executives and auditors had proven untrustworthy, the logic ran, SOX's principal thrusts were to elevate the responsibilities of "independent" directors and to require CEOs and CFOs to certify the accuracy of the company's accounts. Independent directors were to have have no formal business connection to the company, but despite companies putting on a straight face about compliance, the word "independent" is a sham. The CEO's college roommate who now plays golf with him every Sunday morning qualifies as independent under the rules. In addition, directors can watch executives certify all the financial statements they want, while below decks, the crew is shoveling tons of debt and risk--on the books or off them--into the boilers in a race to catastrophe.

In a prior burst of regulatory zeal, Congress and the stock exchanges thought that by increasing the workload and nominal authority of such directors, the benefits of independence would shower down upon the latest herd of freshly shorn investors. "We won't be fooled again," as The Who recently sang at the Bridgestone Super Bowl Halftime Show.

It was not to be. For example, Dina Merrill, the octogenarian brokerage heiress, socialite and former movie starlet, remained on Lehman's board as it made the mistakes that later drove it into the largest bankruptcy in history, cost shareholders some $45 billion and nearly pushed the entire world economy into the abyss. If, as a member of the compensation committee, after 18 years' service on the board she failed to appreciate the linkage between risk and compensation, she deserves understanding. No one said she was bond genius Bill Gross. In fact, that's presumably what got her the job, as well as the supporting cast of financially illiterate directors with whom she served. As CEO Dick Fuld pocketed over $400 million from 2000 to 2007, he didn't want any tough questions asked about how precarious Lehman's enormous pile of dubious real estate investments and mortgage-backed securities had become.

In a conference call announcing the firm's 2008 third-quarter loss of $3.9 billion, Fuld told securities analysts, "I must say the board's been wonderfully supportive." Four days later the firm collapsed, costing shareholders some $45 billion and nearly pushing the entire world economy over the cliff. In a blatant conflict of interest, CEO's still also serve as the chairman of the board at 61 percent of our 500 largest companies (and the former CEO is the chairman at another 18 percent). In most companies, when shareholders vote on proposals, the board can simply ignore shareholder's votes even if a majority approves a change.

In the dark days before the abyss opened wide, in one week Citigroup abruptly reclassified downward the fair value of billions in heretofore "healthy assets" toward the non-performing range. Who knew? Not the board. Major institutions like Citigroup, Lehman, Merrill Lynch, General Motors, and Bank of America were shown to have no succession plans in place after CEOs abruptly, albeit belatedly, walked the plank. Who knew? Not the board. Washington Mutual celebrated a single employee who underwrote two billion in mortgages in a year. What a busy guy! Who knew? None of the directors thought to ask if something might be amiss.

Winthrop Smith, the son of a founding partner, blamed Merrill's collapse on "the failure of a Board of Directors to understand what was happening to this great company, and its failure to take action soon enough."

All these were clear failures by boards in deference to imperious CEOs--those who brung 'em to the dance in the first place.

How could this happen? How could it continue? And how can it be prevented before it happens again?

Even if it had wanted to be a greater force for reform, the SEC is handcuffed because many corporate legal issues are left to state jurisdiction--and the cash-strapped states fight for corporate fees in a race to the regulatory bottom in which investors and consumers lose. But at least the Commission is now forcing companies to go on the record. CEOs and boards will have to leave footprints in the snow. Their lawyers must now craft language that speaks to aspects of the tacit wink-wink-nod-nod "gentlemen's understandings" around board structure, qualifications, diversity, and risk. Weasel-words will be somewhat more obvious. Persistently all-white, all-male boards may have some explaining to do at the annual meeting.

This ounce of embarrassment can be worth tons of regulation. Directors fear reputational damage more than anything else and these disclosures can put them on the spot. Shareholders must pay attention and demand changes within their companies if they're warranted. And If directors themselves would simply remember the investors whose interests they are supposed to serve, and not just the CEOs who so often have invited them to the board table, we all might sleep more soundly when the next downturn comes.

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