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?”
How this 85-year-old icon of Wall Street was governed was also a clue as to how it might fail.
When rumors were circling the company and threatening its survival, it responded by issuing a strong statement denying liquidity problems. The board agreed. But astonishingly, the company disintegrated less than 48 hours later and was quickly valued at only $2 per share in a fire sale to JPMorgan. The board agreed with that number. Then, in yet another stunning twist, just a few days later the company was suddenly valued five times higher by the same suitor and a new price of $10 per share was set. The board agreed with that number, too. In the dust and rubble that cover the collapse of Bear Stearns, much is still unknown and unexplained. But one thing is clear: the fifth largest investment bank in America has been governed by one of the most incurious and acquiescent boards in history. On the other hand, perhaps it has had no real board at all.
On paper it appears that Bear’s board complies with NYSE rules and Sarbanes-Oxley legislation. Dig deeper though and you will find a dysfunctional board, overstretched independent directors and an executive chairman whose approach to his duties is novel, to say the least.The first thing that hits you about this Wall Street icon is that it is governed by men. Only men. It was like that at its inception in 1923; it remains a men’s club in 2008. Three of its 12-member board are insiders, as is the executive chairman, James Cayne. (There were actually four insiders until Warren J. Spector, the firm’s president and co-chief operating officer, resigned last fall over the collapse of Bear’s hedge funds.) Best corporate governance practices generally prefer management limited to one or two seats at most. The insider problem in Bear’s boardroom is even more pronounced where all the heavy lifting is done: the company’s executive committee. Composed entirely of the top insiders of the investment bank, company filings confirm that in 2006 (the most recent figures available) the executive committee met on 115 occasions. By contrast, the full board met only six times.
When the board of a sizeable and complex institution such as Bear Stearns believes it has so little need to meet, it is generally a sign that the company’s corporate governance culture has not evolved to the level that shareholders and the global capital markets require in the 21st century. Another red flag is the existence of a committee of insiders that performs much of the board’s work to the exclusion of any independent director involvement.One of the hallmarks of boards today is the role of independent directors and the extent to which they are actually informed and empowered. When they are left out of the equation, accountability and sound decision-making can be severely compromised. There was an executive committee composed solely of insiders at Hollinger International, for instance. It was headed by Conrad M. Black, who also held a jaded view of modern corporate governance practices. Lord Black of Crossharbour, as he prefers to be called, is now presiding over a small cubicle cell at the Coleman U.S. prison complex in Florida.
It’s not that Bear’s independent directors are underworked, however. They are busy –serving on the boards of other publicly traded corporations. On the all-important seven-member audit committee, three directors hold among them 18 board seats on listed companies. Vincent Tese, the audit committee chairman, serves on the boards of five listed companies in addition to Bear Stearns. Two members of the audit committee, Michael Goldstein and Frederick Salerno, serve on the audit committees of 11 public companies between them. In the Sarbanes-Oxley era which tightened up the role and duties of audit committees, it is rare, and more than a little troubling, to see boards tolerating that level of concurrent responsibility on the part of audit committee members.
Bear Stearns was among the most aggressive risk takers of the top investment banks. Its demise today reflects how poorly that risk was managed. Yet the firm never took a formal approach to its risk oversight responsibilities until a year ago when, on March 22, 2007, the board approved the charter for a finance and risk committee. Prudent directors would have known, given the nature of Bear’s business lines and how intricate its products had become, that a risk committee was called for much earlier. The choice of how Bearn Stearns was governed and how its board was structured to discharge its duties were clearly a decision of its directors and, especially, of James Cayne, who became CEO of the firm in 1993 and has been chairman of the board since 2001.
In my 30 years or so of following, working with and commenting on boards, I have come to learn that the chair of the board sets the tone for how it performs. In searching for clues as to where the board was when the seeds of Bear’s destruction were being sewn, one need look no further than Mr. Cayne. It has often been asserted, in the aftermath of boardroom debacles, that directors were asleep at the wheel. In Mr. Cayne’s case, there is compelling evidence that he was not even on the ship.
When Bear’s mortgage-based hedge funds were collapsing last summer –and there were strong adumbrations of a gathering storm of subprime credit before this– Mr. Cayne was off enjoying a golf and bridge vacation. As we noted previously:
Of course, it is harder to excuse a CEO who is making stupid mistakes or issuing comments that are so at odds with reality that it becomes impossible to have confidence in his sense of vision and judgment. This was the case with Mr. O’Neal’s previous pronouncements that things were looking OK with the subprime situation at Merrill Lynch. And we expect it will also be the case with Bear Stearns’s Jimmy Cayne, who rode out that company’s summer hedge fund storm in the calm of a golfing and bridge tournament vacation and who may yet learn that, in the department of CEO appearance, a corporate crisis always trumps a card game. Others will surely fall before the latest turmoil is quelled and the surprise-o-meter is likely to get quite a workout when all is said and done.
The first losses in Bear’s history soon followed Mr. Cayne’s summer shenanigans. A few months later he gave up the CEO slot while remaining executive chairman of the board. They were not the only hits the above noted surprise-o-meter took, as predicted.
But in an astonishing encore of his now infamous disappearing act, Mr. Cayne was at a bridge tournament in Detroit while the investment bank was facing its deepest crisis ever. This he chose to do even while rumors about the company’s liquidity problems were so rampant that it had to put out a press release denying them. So bizarre were Mr. Cayne’s actions that the only equivalent that comes to mind is Nero’s reported fiddling while Rome burned. It is no doubt an approach to a director’s duty of care that has not escaped notice by the shareholders’ bar. There is no record of any independent director having been troubled by Mr. Cayne’s frolics during the past six-month fall of the company. There is no evidence available that the corporate governance committee, whose charter includes “the evaluation of the Board and management,” or the lead director, took any action to replace Mr. Cayne when it was first apparent that he had other priorities besides leading the board during this decisive period.
With a board that seldom meets and has a habit of giving over so much of its authority to an insider-dominated executive committee, and an absentee leader at the helm like James Cayne, one wonders precisely how much due diligence directors did before they signed off on the sale. They sizably undersold the company’s assets, as the recent $10 per share price –five times what the board accepted last week- confirms. Such a dramatic shift over a period of just a few days in what the directors think the company is worth suggests a board that is either being poorly advised or is not entirely focused on its duties. It was an approach to corporate governance in Bear’s boardroom that was consistent with the pattern of shortcomings that brought the firm to the point of crisis and collapse in the first place.
Much of what happened and how it could have been permitted remains a mystery. There were, after all, many lessons from the past that showed the painful consequences of disengaged boards which the chairman and directors of Bear should have committed to memory. But this much is certain: When such an important financial institution begins to crumble so quickly, leaving the capital markets in turmoil and requiring the intervention of the highest echelons of the federal government, Congress needs to ask some pointed questions.
It should start with the Bear Stearns board.
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If Bear Stearns had no chairman and no board at all, would the results have been any worse?
Read part 2 of this series.
With absentee leaders like Jimmy Cayne at the top and a corporate governance culture straight out of the 1920s, the surprise is not that Bear Stearns fell into a confidence chasm. The surprise is that calamity did not strike earlier.
When the subprime meltdown was already giving a chilling preview of coming attractions last summer and his company’s mortgage-based hedge funds were collapsing around him, the CEO of this Wall Street icon was off on a bridge and golf vacation. Last week, during a liquidity crisis that saw the near death of the company and the resulting intervention of the Fed that carried with it echoes of the Great Depression, he was at a bridge tournament in Detroit, according to the Wall Street Journal. It is not certain where this long-time investment banking figure is right now, but odds are soon Jimmy Cayne may not have an office or a company to return to.
Last January, when the company posted the first loss in its 84-year history, Mr. Cayne turned over CEO duties to Alan Schwartz. When he’s not away escaping a corporate crisis as executive chairman -a post he has held for seven years- Mr. Cayne presides over the Bear Stearns board. And what a board it is -another one of these all male clubs that acts like a throwback to black and white movies.
The board meets only six times a year, according to company documents. The real work seems to be done by Bear’s executive committee, which in 2006 met a whopping 115 times. All of the directors on the executive committee are management insiders, including Mr. Cayne, making management effectively accountable to itself. Maybe this helps to explain why, despite the lessons of Enron and the risky nature of much of the company’s business, Bear Stearns’s board did not get around to creating a finance and risk committee until January of 2007 and why there has been so much patience with Mr. Cayne’s card-playing antics.
Just a year ago, the firm was boasting that it was well insulated from the subprime fallout. Then the stock was trading around $160. On Friday the stock closed at $30. It lost nearly half its value in just one day. When Rome burned, it is said that Nero fiddled. When Bear Stearns melted down, its one-time emperor played bridge. We will leave it to others to determine whether any smoke was present at the occasion this time.
It is widely asserted, especially on these pages, that what boards do matters. Yet it seems clear that if Bear Stearns had had no board whatever, the results could not have been any worse. One can understand how utterly lacking in effectiveness Bear’s board is when it is being led by an absentee chairman.
Mr. Cayne, who is 74, would have known the crisis his company faced given the extraordinary nature of the press release it issued on March 10th which denied any liquidity problems. Still, even when Wall Street’s fifth largest investment bank was sitting on a precipice later in the week, a bridge game trumped the fight for corporate survival for the firm’s well paid chairman.
As we have said on more than a few occasions, the stratospheric compensation that many boards award CEOs increasingly shows that both directors and top management are living on another planet. Excessive CEO pay has been a leading indicator of disaster in companies that run the gamut from Enron and Computer Associates to Countrywide and Hollinger. Bear Stearns can now be added to this list. Just last year, many commentators were celebrating the genius of Jimmy Cayne and how he deserved every penny of the $34 million he received for 2006 and the $23 million for 2005. You might think that would entitle shareholders to a little more than the calamity that has been unfolding for the past several months. You might also think it would entitle shareholders to a CEO or a board chairman who clocks in during the hours when disaster has decided to pay a visit.
Bear Stearns also makes the case that if investment banks are now able to enjoy the benefit of the Fed’s intervention -and these firms have already shown that their misjudgments are capable of causing enormous turmoil in the capital markets and ultimately in the wider economy, members of the public have a huge stake in what companies do and how well they govern themselves. They also have a major investment in whether board compensation programs reflect a rational level of thinking or whether they reflect a mentality that says the CEO is king and temps them to pursue high paying subprime-like schemes that cannot be sustained.
With absentee leaders like Jimmy Cayne at the top and a corporate governance culture straight out of the 1920s, the surprise is not that Bear Stearns fell on Friday into a confidence chasm from which it may not recover. The surprise is that calamity did not strike earlier. Which makes the failures of the Bear Stearns board and its chairman our choice for the Outrage of the Week.
Never in modern business has so much been given to so few for such colossally failed results.
In just five years, these three CEOs made more than $460 million while leading their companies into the greatest losses in their history. One of them, Charles O. Prince of Citigroup, even got a bonus of $10 million, despite presiding over more than $20 billion in losses and write-downs. Stanley O’Neal left with $161 million after Merrill Lynch chalked up its largest losses ever. And Countrywide Financial‘s Angelo Mozilo, one of the highest compensated CEOs in America, has pocketed more than $400 million since 1999. The company has lost four times that amount over the past six months. Never in modern business has so much been given to so few for such colossally failed results.
To the average working person, who rarely receives a bonus even for doing an exemplary job, much less a bad one, this performance must have seemed like something of an out-of-body experience. Pay and accomplishment seldom have seemed more disconnected.
But to the past and current CEOs who testified before the House Committee on Oversight and Government Reform this week, there is no disconnect at all. The universe, for them, unfolded exactly as it should. It was about as we expected.
They, and the heads of the board compensation committees which approved these deals, all offered the usual bromides: The amounts were fully approved; the money was earned; the market is king; high pay is needed to attract and keep the best talent. How it is that CEOs who preside over record losses represent the best talent was never quite explained. One claimed only to want to help homeowners live out the American dream. Another cited his grandfather being born a slave. A third trumpeted his company’s ethics and corporate governance reforms. Mr. Mozilo ventured that the subprime meltdown had a notable culprit: “There was a lot of fraud there.” he told lawmakers. Many will agree, but they might not be thinking about the garden variety mortgage applicants to which Mr. Mozilo was referring. What role more lofty figures had in pushing out subprime loans, and who benefited from the resulting torrent of fees and record bonuses, will be something regulators and legislators should be looking at more closely.
The group of CEOs and directors who appeared before the comittee managed to slice and dice their compensaton decisions so much that they looked like they came out of a boardroom Veg-O-Matic: the pay wasn’t for this year, it was for last; it wasn’t severance, it was deferred compensation; it wasn’t a bonus for this year, it was payment for previous excellent performance. They said they actually lost a lot of money when the stock went down, just like all the other shareholders. Except most other shareholders did not head the company and make the wrong decisions. Most did not run up record losses and most did not receive tens or hundreds of millions in stock options and bonuses and salaries bigger than the state of Texas. One more thing: the process, they testified, is all fully in accord with the Business Roundtable guidelines on CEO compensation. Now that’s a really high bar. The Roundtable is made up of America’s top and best-paid CEOs. The ranking Republican on the Committee, Rep. Tom Davis (R-Va.), called the Business Roundtable guidelines the “gold standard” for corporate compensation. Is that because it makes sure the CEOs get all the gold?
Astonishing even for this group, when asked by Rep. Paul Kanjorski (D-Pa.) if there was any amount they would consider to be too much, there was silence, punctuated by self-serving proclamations of satisfaction with the way things are. All reassured the committee that they were not underpaid, however, and thus a sigh of relief was heard across the country.
America is experiencing one of the worst economic downturns since the Great Depression. The brokerage and mortgage lending industries played the central role in creating this contagion. But if high CEO pay is truly linked to performance and is good for the economy, people will want to know why it is, during a period that has seen the largest transfer of wealth from investors to the boardroom in history, the result is now one of falling stock values, shrinking economic growth, galloping home foreclosures and mounting job losses.
The hearing this week gave a rare opportunity for business leaders to admit that CEO compensation has gotten out of control and that it’s time for a new reality show in the boardroom. What began with the attendance of prominent CEOs and boardroom luminaries ended with the spectacle of men twisted like pretzels, having engaged in every type of contortion to show that these compensation arrangements were reasonable and had nothing to do with decisions to pump out more fee-generating subprime loans and structured investment vehicles. They also sent a veiled warning: any change to or reduction in the way CEOs are compensated, and capitalism as we know it may not survive. Here’s a bulletin for the boardroom: capitalism may not survive the kind of leadership that permits an ever increasing gap between CEO pay and everyone else’s, rewards failure with multi-million dollar bonuses and severance, and sees CEOs spinning off with a king’s ransom while leaving everybody else in the dust.
This was an opportunity for real leaders to admit that there are serious problems between the leadership class of capitalism and those who depend upon it for their well-being. To stand up and acknowledge the trend toward excess, to take the lead in stepping back and not being the first in the lifeboat when disaster strikes, to show some meaningful sacrifice at a time when so many are hurting instead of flashing five figure watches, five thousand dollar suits and a tan direct from the winter mansion at Palm Beach (or Palm Springs) -this would have been the kind of leadership that CEOs showed during two great wars and other times that tested America. This group showed none of that. One suspects they are, regrettably, an accurate reflection of the pool of CEOs and directors of which they are a part.
Excessive CEO pay has become synonymous with what is worst about American business: crony boards where one back scratches the other; compliant compensation committees made up of past and current CEOs; and an ethical value system enabling displays of greed and over indulgence that is not something parents generally want to impart to their children. It has been associated with every scandal from Enron and WorldCom to Nortel and Hollinger and countless failures in between. It is now a contributing factor to the recession that is unraveling the world’s credit markets and crippling economic well-being for millions.
What was obvious, too, from the testimony is that none of these CEOs and business leaders is possessed of superhuman ability. All seemed rather ordinary in the insights they offered and in the information they imparted, despite being recipients of extraordinary compensation and a corporate publicity machine that makes superman look like a slacker.
Despite the number of experienced CEOs and directors who appeared before Congress this week, one voice was distinguished by its absence: that was the voice of genuine leadership. America is entitled at a time of crisis to more than the spectacle of hugely paid, decidedly self-satisfied CEOs who feel that the system is working as it should. It needs leaders who recognize there is a need to restore public confidence in capitalism and the ethics of those who steer it. And that requires shared sacrifice and an understanding that, even in the great American boardroom, there are limits to what rational people both need and deserve.
Capitalism, like any household, should be governed by values, and not just who can get the most as quickly as they can. And so the actions of the CEOs and directors who appeared before Congress this week, and the failures of their boards that produced these results, is our choice for the Outrage of the Week.
In four of the past six years, from 2001 to and including 2006, Nortel has posted a loss. Over that time, the losses have soared past $30 billion. The years that made a profit accounted for less than $200 million. Out of the four quarters for 2007, Nortel posted losses in three, including a whopping $844 million for Q4, announced today. All told, the Toronto-based maker of telecom equipment lost more than a billion dollars for 2007 on a quarterly basis.
In each year since disaster struck the company to reveal management scandals, accounting irregularities and a woefully myopic board, Nortel, when not announcing restatements in its financial figures (it’s had four) announced more job cuts. Worldwide at Nortel, close to 60,000 people have been laid off, fired or have taken retirement since 2000, according to Information Week. Each time, job losses and layoffs were trumpeted as part of the great strategy for what CEO Mike Zafirovski now calls “our transformation.”
But you have to wonder what’s going to happen when Nortel runs out of jobs to cut. Will they try to lay off workers at other companies in order to look good? Stranger things have happened at Nortel, not the least of which is the infinite patience investors have shown for a company that always promises paradise in the abstract but generally delivers disappointment in the quarter.
The special board committee which is investigating the $7 billion trading fraud at Société Générale issued its interim report today. What stands out is the conclusion found at point 9 of the English summary.
9. The author of the fraud began taking these unauthorised directional positions, in 2005 and 2006 for small amounts, and from March 2007 for large amounts. These positions were uncovered between January 18th and 20th 2008. The total loss resulting from these fraudulent positions has been identified and amounts to 4.9 billion euros, after their unwinding between January 21st and 23rd 2008.
What the board is admitting is that a lone trader, and a fairly junior one at that, was able to hoodwink the entire internal control and security apparatus of one of the largest and most respected banks in Europe from 2005 until January of 2008. Do they really think these findings will arrest the fears of the investing public and restore faith in the bank? Far from getting management and the board off the hook, the report serves as a stinging self-indictment of a financial institution that was so inept in its security it might as well have left the keys to the vault on the cafeteria table.
But there is more.
10. The General Inspection department believes that, on the whole, the controls provided by the support and control functions were carried out in accordance with the procedures, but did not make it possible to identify the fraud before January 18th 2008.
Controls were carried out in accordance with zee procedures? Allo? Eez anybody hat zee home? Surely Inspector Clouseau had some part in this investigation. The controls worked –except for the fact that $7 billion was lost. Does somebody fall down the stairs next or have their false nose go up in flames? This is a Blake Edwards production if ever there was one.
Nice to have you back, Monsieur. We look forward to zee next hact.
