The Icahn Report

In The News

• The government and corporate governance – TheDeal.com
• What Red Ink? Wall Street Paid Hefty Bonuses – New York Times
• Clamor for ‘say on pay' gains traction – Charlotte Observer
• Corporations, Tending to a Tattered Image, Clip Wings of Private Jets- Dealbook

In The News

• AIG will still pay swaps team retention bonuses – Raleigh News and Observer
• Cuomo subpoenas Thain in Merrill bonus investigation- FT.com/Alphaville
• Why Good CEOs Make Bad Moves – Seeking Alpha

Improving Transparency, Regaining Investors' Trust

Cindy Fornelli is executive director of the Center for Audit Quality, a Washington-based public policy organization serving investors, public company auditors and the markets.

by Cindy Fornelli

Prodded by the economic crisis, contributed to by events and actions both here and abroad, the new Congress and the new administration are taking a hard look at our financial regulatory framework. They will dramatically increase the odds of getting it right if they can do three things:

Put investors first.

Promote transparency.

Protect independent standard-setting.

Of all parties with a stake in the regulatory framework, no one is more important than the person who puts his or her cash at risk by investing in the capital markets. Investors are the foundation of our financial system, and their confidence in the integrity of the markets is absolutely essential. That confidence has been shaken by recent events, with disastrous consequences for our economy.

At the Center for Audit Quality, we've spent a lot of time listening to investors. As part of a comprehensive effort to improve financial reporting, we solicited suggestions from investors and other market stakeholders during a national Public Dialogue Tour that included stops in 10 cities, from Boston to San Francisco. The overall themes were consistent at every stop.

The market participants we met in our coast-to-coast tour were clear that they don't want more information, they want more relevant information. They would like to see historical information presented with clarity and comparability; they called for forward-looking information; and they called for disclosures that could help inform projections on a company's future operations.

A number of dialogue tour participants proposed adding a "plain English" executive summary to annual reports. Others suggested that "click-down" online technology could let users control how deeply they delve into a particular company’s public reports. We also found considerable support for more complete and understandable disclosures on executive compensation.

In short, investors have made it clear that they want more transparency.

Corruption and malfeasance thrive in the shadows and wither in the sunlight. Bad things can happen when no one is watching, or when those watching — regulators, directors, shareholders and auditors — cannot get accurate and timely information.

We learned that lesson during the corporate scandals earlier in this decade. Now, the excesses and fraudulent activity that contributed to our current economic troubles have given us another reminder that good corporate governance starts with transparency.

Transparency gives investors, regulators and other interested parties the information they need to understand the finances and operations of a company or other business entity.

Some proposals for additional transparency would require significant changes to the current regulatory system — for example, requiring public disclosure from investment entities that now operate outside the regulatory system. Others, however, could easily be implemented within the existing regulatory framework.

Whatever Congress decides to do with the regulatory framework, lawmakers should seek to ensure that the standard-setting process is free from political interference.

We all know that there is no way to fully immunize standard setters from political pressure, just as there is no way to construct a regulatory system that can prevent all fraud. But the difficulty of achieving a goal doesn’t diminish the goal's importance.

The financial markets and financial instruments have become increasingly complex. Setting appropriate regulatory standards requires considerable expertise. Standards should be determined with care, applied with consistency and changed when facts — not political pressure — warrant adjustments.

No one is suggesting that standard-setters and regulators shouldn’t be accountable. They should have a clear mandate to serve investors and suffer consequences if they fall short. And they should not be subjected to political interference on behalf of special interests as they seek to fulfill their mandate.

We are in the midst of challenging times, but challenges are usually a powerful catalyst for change. We are much more likely to get positive change if the Obama administration and the 111th Congress prioritize what is best for investors, promote transparency and try to keep politics out of the standard-setting process.

As the president himself has stated, "I think we have to restore a sense of trust, transparency and openness in our financial system." I couldn’t agree more.

In The News

• Shareholders Deserve Good Leaders – Wall Street Journal
• Why We (Continue to) Pay Lavishly- Psychology Today Blogs
• CEOs Boosting Their Pensions While Workers Pensions go Poof- Huffington Post
• CEO pay consultants raising eyebrows- IndyStar.com

The Economy Needs Corporate Governance Reform

As seen in the Wall Street Journal.

In his inaugural address this week, President Barack Obama said "our economy is badly weakened, a consequence of greed and irresponsibility on the part of some," and due in part to "our collective failure to make hard choices."

He's offered few policy specifics other than saying we need to undertake massive new infrastructure and education programs. But he is right, there are a lot of hard choices we need to make. And one of them is the decision to fix the way public companies are managed.

Private enterprise forms the basis for our economy. It provides most of the jobs we enjoy and creates the wealth that raises living standards. New government spending can only do so much to repair the economy. Reshaping corporate management can do much more.

The problem with doing nothing is obvious. Faltering companies are now soaking up hundreds of billions of tax dollars and they are not substantially changing their management structures as a price for taking this money.

How does it serve the economy when we subsidize managements that got their companies into trouble? Where is the accountability? More importantly, where are the results?

The economy continues to sink, jobs are being lost, the markets continue on a downward course. Changes are needed and can come if Congress insists on reforms that make corporate boards and managers more accountable to stakeholders.

First, Congress needs to pass legislation giving shareholders enhanced rights to elect new boards, submit resolutions for stockholder votes, and have far more input on executive compensation and other issues. As companion to these reforms, Congress needs to pass legislation that prevents managers from making it more difficult for shareholders to exercise their ownership rights.

Managers often come up with creative ways to perpetuate their reigns of error. These include myriad takeover obstacles like poison pills, bylaw provisions and others devices that thwart shareholder efforts to hold managers accountable.

If Congress is reluctant to make wholesale changes at the federal level, it can enact one simple provision that would allow many of the needed changes to take place on the state level: It can give shareholders the right to vote to move a company’s legal jurisdiction to a more shareholder-friendly state such as North Dakota. Currently that decision is in the hands of company boards.

It is not reasonable to expect managers with failing track records to improve their performance on their own. They will only improve if they are placed under greater pressure by shareholders empowered to exert more influence on management decisions. Nothing will do more to improve our economy than corporate governance changes.

What we need are measures that let the capitalist system produce jobs and economic activity, with minimal but effective government oversight. Government spending is an important catalyst to economic gains, but we need to focus on improving the way private companies are managed so private capital can flow into them.

Our private sector is the greatest wealth creation machine ever devised, far outperforming any other economic model. Still, major improvements could do a lot to mitigate what Mr. Obama calls "the sapping of confidence across our land."

Lax and ineffective boards, self-serving managements and failed short-term strategies all contributed to the entirely preventable financial meltdown. It is time for battered shareholders to fight back.

Mr. Obama was right when he said that "it has been the risk-takers, the doers, the makers of things . . . who have carried us up the long, rugged path towards prosperity and freedom."

I hope that this means that the day of reckoning has come for those executives who simply feed at public and private troughs, putting little or no capital of their own at risk, and who produce little of value for the national economy.

It is time for change and the place to start is in the corporate boardrooms of America.

Shareholder Voting Rights

Jonathan Macey is Deputy Dean and Sam Harris Professor of Corporate Law, Corporate Finance, and Securities Law at Yale Law School. He is the author most recently of Corporate Governance: Promises Made, Promises Broken (Princeton University Press, 2008) available at http://www.amazon.com.

My second post is on the general problem with shareholder democracy caused by defects in the shareholder voting process.

Shareholder Voting

In "Corporate Governance: Promises Made: Promises Broken," I discuss the need for additional shareholder voting rights. With an improved process, corporate performance and accountability would have the capacity to advance even further. Some dissenters claim that shareholders probably vote too much, and others take the position that voting rules are efficient as they are.

In my view, as currently practiced, shareholder voting probably does not do shareholders much harm, but it doesn’t do them much good either. And the annual votes that shareholders make for boards of directors certainly do not legitimize all of the decisions of boards of directors to routinely support and highly compensate incumbent management.

Voting could serve shareholders well in takeover contests and in expressions of shareholder disapproval in high-profile instances of corporate governance breakdown, such as when poison pills have been proposed by management or outside lawyers. It is, however, irrational to think that expanding shareholder voting can improve the daily governance and operation of a large public corporation. Shareholders simply do not have the requisite information, or the inclination, to become sufficiently knowledgeable about what is going on within a public company to be useful to management in this way. Nearly all shareholders, even large institutions like pension funds, mutual funds, and insurance companies, hold highly diversified portfolios. It is not only illogical for such shareholders to immerse themselves in the business operations and strategies of the companies in which they invest, it is impossible. With modern funds holding shares in thousands of companies, the costs to their clients of emerging in corporate governance would make their funds noncompetitive.

Since mutual funds and pension funds own shares in such a vast number of companies, it makes sense for them only to become well informed about very major issues, such as takeovers or other fundamental corporate changes. In order for large, sophisticated investors to take the time to become sufficiently informed about their portfolio companies, they must reduce the number of companies in their portfolios. Most hedge funds and private equity funds pursue exactly this strategy. But even with hedge funds and private equity funds, formal voting is not useful. Instead, it is far more sensible and efficacious for such funds to immerse themselves in real-time decision-making. When the time comes to vote to ratify a major decision such as an acquisition or a divestiture, it's too late for investor input to add value. As the available evidence shows, when sophisticated outside investors do become involved in corporate governance, they do not express themselves by voting; rather, they inject themselves into the corporation's quotidian decision-making on an ongoing basis.

The argument here is that the basic infrastructure of the law of corporate voting is in need of repair. For example, the ability of management to control the timing of elections and the federal rules governing proxy solicitations do not serve the interests of shareholders and should be reformed.

Shareholders do not face the same conflict of interest problems that plague decision-making by management and their captured boards of directors. On issues where the choice is between the shareholder’s lack of information and management’s self-interest, corporate law should choose the shareholders by giving them the deciding voice in corporate governance. Takeovers are perhaps the paradigmatic example of a corporate governance issue that forces us to "decide who should decide" as between shareholders and management.

It is also important to distinguish between "generic" and "firm specific" corporate governance issues. The argument that diversified shareholders are unlikely to inform themselves sufficiently to assist in the corporate governance applies only to "firm specific" corporate governance issues. For example, issues such as whether a particular CFO or CEO should be retained, or whether a company should buy or sell a particular asset such as a subsidiary or a division, are specific to particular firms. As a general matter, voting by shareholders is not likely to be an effective corporate governance mechanism for making decisions about these sorts of issues.

In contrast, a generic corporate governance issue is an issue concerning broad policy that is likely to affect the value of all of the companies in a particular portfolio. One example is whether a particular anti-takeover device such as a poison pill should be adopted by a company. For such generic or market-wide corporate governance issues, it will likely be efficient for diversified shareholders to become well-informed because the resources spent in learning about the relative merits of various anti-takeover devices can be distributed across all of the public companies in an investor's portfolio.

Stephen Bainbridge of UCLA has succinctly summarized the law of shareholder voting as "so weak that they scarcely qualify as part of corporate governance." Consistent with this analysis, the list of items about which shareholders have voting rights is remarkably short. Shareholders vote annually on director elections, amendments to the corporate charter, and fundamental corporate changes, such as mergers, dissolution of the corporation, and the sale of all or substantially all of the assets of a corporation. Confusingly, shareholders and directors both hold the power to vote on changes to corporate bylaws. This, in turn, raises difficult legal questions about whether a shareholder vote on bylaws can trump a decision on bylaws made by the company’s board of directors.

While shareholder voting is limited to just a few issues, this is not the only or perhaps even the most significant restriction on the impact of shareholder voting. An important additional constraint on shareholder voting is the problem of screening by boards of directors. Before an issue even gets to the shareholders for their approval, it must almost always first pass through the board of directors for its approval. The only exceptions to this rule are the provisions for electing directors and for amending the bylaws, which do not require board approval prior to action by the shareholders. Some avaricious managers have even tried to impose greater constraints on the election process by attempting to screen nominees of outside groups. While this practice is probably illegal, it is accomplished by requiring that all candidates proposed as nominees for directorships must first be approved by the nominating committee of the incumbent board. Given their questionable legality, these provisions illustrate the extent to which some companies are willing to go to deter outside efforts to gain control.

The current law and regulation of the shareholder voting is too restrictive. Shareholders are only be permitted to vote on issues of large magnitude because it is thought that these are the only instances in which shareholders will be able to overcome the rational ignorance and voter apathy problems that plague the decision-making process and make voting uninformed and irrational. Shareholders also should be allowed to vote on generic issues, that is, on issues that come up again and again in the course of share ownership (or, in the political context, in the case of citizenship.). The costs of becoming informed on such generic issues can be amortized over every investment in the investor’s portfolio in which these issues arise.

In The News

• By Switching Their Charters, Banks Skirt Supervision – Washington Post
• HP’s Hurd brings in $42.5 million; 4 other top execs top $20 million – ZD Net
• Obama, the Courts, and Governance – Race to the Bottom

In The News

• Financial Regulatory Reform Is Coming- Dealbook
• Obama Should Have Overpaid CEOs Shaking – TheStreet.com
• Bailed-Out French Bankers to Forgo Bonuses – WSJ
• Group asks IBM to slash exec pay, stop offshoring U.S. jobs – Times Herald- Record
• Questions for Mr. Geithner – New York Times

Director Capture

Jonathan Macey is Deputy Dean and Sam Harris Professor of Corporate Law, Corporate Finance, and Securities Law at Yale Law School. He is the author most recently of Corporate Governance: Promises Made, Promises Broken (Princeton University Press, 2008) available at http://www.amazon.com.

The Icahn Report has exposed: (1) abuses in the use of golden parachute agreements; (2) many of the false premises behind the faulty assumption that corporate elections are "democratic" event that legitimize corporate boards; (3) the entrenchment effects of staggered boards of directors and, most importantly perhaps; (4) the sheer corruption of law and morality that is represented by the continued legality and adoption of poison pill defensive devices.

In my next two blog postings I would like to bring my own, admittedly academic perspective to two topics that are, I believe, highly relevant to the agenda of this blog. The first topic is the problem of "board capture" among boards of directors of public companies. The second is the general problem with shareholder democracy caused by defects in the shareholder voting process.

Director Capture

In the academic world, particularly among political scientists and economists, "capture" occurs when decision-makers such as corporate directors favor certain vested interests such as incumbent management, despite the fact that they purport to be acting in the best interests of some other group, i.e. the shareholders. The problem of capture and the theories associated with the idea of capture are most closely associated with George Stigler, and the free-market Chicago School of Economic thought. Among the more interesting and important theories of Stigler and other proponents of capture theory is the idea that capture is not only possible, in many contexts it is inevitable.

In my recent Princeton University Press book "Corporate Governance: Promises Made: Promises Broken" I apply capture theory, which is usually used to describe and model the behavior of bureaucrats in the public sector, to the directors of publicly traded companies who come to their positions through the board nominating committee.

In my view, such directors are highly susceptible to capture… even more susceptible than bureaucrats and politicians. Capture is inevitable because management controls the machinery of the corporate election process. Management's narrow interest in having passive and supportive boards manifests itself in the appointment of docile directors who are likely to support management's initiatives and unlikely to challenge management or to demand that managers earn their compensation by maximizing value for shareholders.

The extension of capture theory to corporate boards of directors is supported not only by foundational work in political science and economics but also by important work in social psychology. Directors participate in corporate decision-making. In doing so, these directors, as a psychological matter, come to view themselves in a very real way as the owners of the strategies and plans that the corporation pursues. And of course, these plans and strategies inevitably are proposed by incumbent management. Thus, directors inevitably risk simply becoming part of the management "team" instead of the vigorous outside monitors and evaluators that they are supposed to be. Management’s persistent support of and acquiescence in the proposals of management consistently renders directors incapable of objectively evaluating these strategies and plans later on. Of course this is not the case when the directors represent hedge funds or other large investors who have a large financial stake in making sure that the company prospers.

Another factor leading to board capture is the fact that boards of directors have conflicting jobs. They are supposed not only to monitor management, but also to select and evaluate the performance of top management. After top managers have been selected, the boards of directors making the selection decisions are highly likely to become committed to these managers. For this reason, as board tenure lengthens, it becomes increasingly less likely that boards will remain independent.

The theory of "escalating commitments" predicts that decision-makers such as corporate directors will come to identify strongly with management once they have endorsed the strategies and decisions made by management. Earlier board decisions supporting management, once made and defended, will affect future board decisions such that later decisions comport with earlier decisions. As the well-respected Cornell psychologist Thomas Gilovich has shown, "beliefs are like possessions" and "[w]hen someone challenges our beliefs, (for example the belief of directors that management is highly competent) it is as if someone [has] criticized our possessions."

The cognitive bias that threatens boards of directors and other proximate monitors is a manifestation of what Daniel Kahneman and Dan Lovallo have described as the "inside view." Like parents unable to view their children objectively or in a detached manner, directors tend to reject statistical reality (such as earnings performance or stock prices) and view their firms as above average even when they are not. The first step in dealing with the problem of board capture is to recognize that the problem exists.

Boards should be free to choose whether they wish to be trusted advisors of management or whether they want to be credible monitors of management. They can’t be both. We should stop pretending that they can.

One policy proposal would be for companies to have two boards of directors (as they do in Germany and the Netherlands), one for monitoring and one for assisting in the management of the company. Firms that decide to retain the single board format should be required to choose whether their board should devote itself to "monitoring" (or supervising) management or to advising (or managing along with) the company’s CEO and the rest of the management team. The farce that board can do both should end.

Boards that purport to monitor or supervise management should be held to an extremely high standard of independence. Management should not be involved in any way in the recruitment or retention of these board members. Socializing and gift-giving should be prohibited. And, of course, managers themselves should not be allowed to sit on monitoring boards. Managers should not be allowed to serve as the chairmen of monitoring boards.

Independence standards should be relaxed for the boards of companies that elect to participate in management. Decisions that involve a conflict between the interests of shareholders and the interests of management should be subjected to close scrutiny. Such decisions include decisions about executive compensation of all kinds, particularly bonus and severance payments, as well as decisions about such things as the adoption of staggered terms for the board or the adoption of a poison pill rights plan.

Shareholders of companies with management boards should have substantially more rights than shareholders of companies with independent boards. Shareholders of companies with management boards should be strictly prohibited from engaging in defensive tactics such as adopting poison pill anti-takeover devices. In addition, shareholders of management board-run companies should have enhanced voting rights. A majority vote of the shareholders should be required to approve executive compensation agreements in companies with non-independent, managerial boards, and directors of companies with managerial boards should be subject to ouster every year in the form of an annual no-confidence vote by the shareholders.

Finally, shareholders of companies that are run by managerial boards should be able to vote annually to require their companies to switch to an independent board. Well-run companies that prefer to operate with an insular managerial board can stay that way, but shareholders are entitled to a truly independent board if they want one.

Bankruptcy Rules Thwart the Recovery

As seen in the Wall Street Journal

The epic financial crisis afflicting the banking industry in the last 18 months is largely the result of cratering values of loans and other assets stuck on bank balance sheets. When the market for such loans stalled, banks couldn’t sell them and were forced to take billions of dollars in writedowns.

Fearing the worst, the government pumped hundreds of billions of taxpayer dollars into these institutions, with questionable long-term results. Though it is early days in the rescue, the economy has shown few signs of improvement, which was one intended result. And the bank losses continue.

Why should taxpayers foot the bill when there are trillions of dollars in private money on the sidelines in the world financial markets? Private investment is a far more appropriate agent to revive these institutions, yet little is coming in.

One reason for this is that the distressed assets on bank balance sheets are being priced at artificially low levels as a direct result of federal bankruptcy laws. With a few changes, the banking system could face a financial revival backed by private investment, not public funds.

Convoluted bankruptcy laws keep loan prices artificially depressed because in this bear market, the prospect of a bankruptcy puts a huge damper on investor appetite for debt securities in overleveraged companies. This includes hundreds of billions of dollars in bank and bond debt issued for scores of leveraged buyouts in recent years.

This sorry state of affairs could be improved by the elimination of one key bankruptcy rule: the “exclusivity” period. This rule unfairly gives managements, with court approval, a monopoly to formulate a reorganization plan for a minimum of 18 months and sometimes more. Such a plan generally includes proposals to restructure debt, sell assets and void onerous contracts.

But during this period non-trade creditors like bank debt and bond holders languish in significant uncertainty as to what will happen to their investment.

The exclusivity rule mainly benefits equity holders and managements, not creditors. But why should the same managements that got the company into trouble be given the right to lock-up its assets for an extended period of time?

Without an exclusivity period, different classes of creditors and equity holders could immediately propose different restructuring solutions, including the sale of assets overseen by a bankruptcy court.

The biggest impact of such a rule change is that the assets in a company operating in Chapter 11 would be priced as though they could be sold, in effect giving them a ‘mergers & acquisitions premium’ unshackled by what amounts to federal intervention into company affairs.

This small change would cause distressed loan prices to rise in many cases – having the effect of bolstering balance sheets of banks and other companies that hold them – without public money.

Furthermore, it would slash the need for expensive bankruptcy lawyers, restructuring firms, consultants and others advisors, which can reap tens of millions of dollars in fees – often at the expense of creditors and company treasuries. These operatives would likely be the biggest opponents to such a change, besides entrenched company managements who benefit from the exclusivity monopoly.

It is one thing to apply the exclusivity rule to small businesses in the hopes that an individual who has spent his life building a business has a chance to keep it. But it makes no sense that huge private equity players can use these same rules to crush billions of dollars of debt that banks lent to finance once-healthy companies.

If equity holders bet and lost, then debtholders should be able to come in quickly and salvage the company and their investment. In the long run, this would be good for the company, the credit markets, employees and the communities in which companies are located.

Few are helped by the exclusivity rule, other than the desperate equity holders and top managers clinging to the helm of the companies that faltered under their watch. And eliminating exclusivity would not necessarily lead to more company liquidations, but would take away the monopoly management has on formulating restructuring proposals. It would also force managements to redouble their efforts to find ways to stay out of Chapter 11 – which can only be a good thing. Chapter 11 is often a crutch to lackluster and unimaginative managements. Changing the rules would put them under more pressure to keep their companies healthy to avoid it.

I have long argued for increased shareholder rights and last year initiated United Shareholders of America to advocate strengthening those rights. In this case I argue for increased creditor rights.

But the economic philosophy behind both initiatives is identical. In both cases it allows market forces to work better, both in pricing securities and also eliminating management monopolies in the affairs of companies.

We must allow market forces to do their job, which includes promoting the ability of the rightful owners of assets – not just managements - to control their fate to the maximum extent practical. The idea is to efficiently maximize the value of the assets through operational changes, restructuring or sale to third parties.

Today, troubled assets are often frozen in a quagmire and will be for years to come unless bankruptcy laws are changed.

The capitalist system is the most efficient wealth-producing machine in existence. We must strive to remove barriers that thwart this efficiency.