Wednesday, April 1, 2009

Medtronic Business and Law Roundtable (Pt. II)

Continuing from a previous post covering Professor John Coffee's presentation, the next presenter was Lizanne Thomas,Chair of the Global Corporate Governance Team for Jones Day, the largest law firm in the world. Lizanne is an outside director for Krispy Kreme doughnuts. Krispy Kreme launched its IPO, I recall, at a price of about $10 per share, reached well above $45 per share, and settled down below $2. It is a classic case for how not to run a business, and how not to deal with public disclosure.

She talked about the business judgment rule, which requires directors to show loyalty and care in all their deliberations and decisions regarding the company for which the shareholders elect them as fiduciaries. Lizanne noted that some boards take this rule and force themselves into a process-oriented oversight, rather than digging into the substance of business decisions and the risks that they entail. No matter how smart regulators think they are, they cannot, in her opinion, "legislate trustworthiness into general corporate behavior."

She advised all corporate directors to "remember, relish, and assert their independent roles." Lizanne always advises her board clients to never succumb to management pressures and approve what they don't fully understand. This seems like a simple point, but the interpersonal dynamics governing this situation go unnoticed. If the board of a financial services company is listening to a long, PowerPoint presentation, full of charts, graphs, and mathematical model outputs covering risks in a derivative portfolio, I can assure you that most directors remain silent. The ones who have already bought into management's strategy are nodding their heads and going "Uh huh." It is very difficult for a peer who is a director to say something like, "Look, I've been a CEO of an S&P 500 company, but I confess that I don't intuitively understand this strategy and its risks. Can you make it simple for me?" Everyone drinks the Kool Aid; it's much more collegial and face-saving that way.

She thinks that a lot of board decisions that seem overtly foolish came about not from a motive of pure greed, but from a lack of understanding. Incidentally, that doesn't make it any less shameful or regrettable, but I thought that was an interesting comment from someone who is a leader in the legal practice of advising boards of large, public companies. No proposal should go forward through a board approval, she suggested, without every one agreeing on the three biggest risks to the project and deeming these risks acceptable.

On executive compensation, Lizanne Thomas said this had to be reformed and that pay should be for "sustainable performance." She cited the work of Frederic W. Cook in this regard.

She also noted that corporations are devoid of an internal moral code. Lizanne also chided her colleagues in the legal profession for punting when they need to confront a board or management that are paying them hefty fees by taking the pass, "Ultimately, it's a business decision."

William Chandler III is Chancellor of the Delaware Court of Chancery. Delaware is looked to as the bellwether for corporate matters, trust and estates,and other fiduciary matters. Their goal, the Chancellor said, was not to instill public trust in corporations or business, but rather to earn the trust of the public in the integrity of the Chancery Court's process.

In general, he said, corporations are expected to behave in a way that is equitable and fair. Delaware corporations are expected to obey the statutes, and this means that they should hold a duly called annual shareholder meeting, and they should approve all significant transactions after reviewing them with due care and with loyalty to both the corporation and to the interests of stakeholders.

Boards also exert fiduciary duties that should also be based on equitable principles. Chancellor Chandler used words like "duty," "obligation," "fidelity, "faithfulness," and "loyalty." For someone like myself, steeped in quantitative and financial rubrics, it was very interesting to hear these kinds of words being cited as being the bedrock supporting corporate governance.

The opinions of the Chancery Court were referred to as "moral stories," and I have to say that they make interesting reading just as do Warren Buffet's letters. The opinions are offered as road maps and a way forward for directors and officers of public companies.

Rakesh Khurana is Professor of Leadership Development at the Harvard Business School, and he gave a very long presentation that was time compressed; my summary doesn't do it justice. In 1950 he noted that business schools turned out about 3,000 MBA's per year, whereas today the industry produces about 120,000 per year. He cites the work Maureen Tkacik . Maureen's work is full of dark humor and the satirist's truth. Rakesh mentioned that MBA students today run their lives like "little corporations," and he rues their failure to view the modern corporate organization in a high minded or holistic way. This tied back in my mind to the spirit of William Chandler's remarks.

Whereas in 1955, there were 138 accredited institutions issuing the MBA degree, in 2000 there were 995 institutions,many of which are not accredited. Early theories of the firm, which I learned about in Milton Friedman's book on price theory, talked about the firm's objective function being to maximize profit. Michael Jensen of the Harvard Business School eventually changed that into the notion of maximizing shareholder value in a seminal 1997 paper.

Now, a confluence of events conspired to set the stage for decades of debacles. The large stock of MBA's fanned out into the S & P 500, where about two-thirds of the CEO's have MBA's, with Harvard holding the number one ranking among this group. Warrent Buffet describes the transformation as one from "owner capitalism" to "managerial capitalism." The MBA mindset taught these executives that they were nothing but agents of the shareholders. Their self-styled technical and quantitative expertise put them beyond their boards and led them to drive strategy, tactics, and financial management towards short-term earnings goals and quick hits in their share prices. These managers also put into place outsized variable compensation schemes that guaranteed huge rewards for themselves with no regard for sustainability and long-term value creation.

As institutional ownership became the dominant model for large, public companies, "earnings visibility" became a code word for "just deliver the quarter and talk up your stock's P/E." This exclusive focus on shareholder value was enshrined in a 1997 Business Roundtable proclamation. Today, we have the Aspen Principles--quite a difference.

He also noted the irony that directors, faced with technical doublespeak from both management and institutions, chose to outsource a lot of their basic oversight functions to corporate governance consultants, investment bankers, valuation consultants, and executive comp consultants. Directors, he said, fell prey to a "culture of politeness and power asymmetries."

Professor Lyman Johnson in his concluding remarks emphasized that there is no law that says directors are to maximize shareholder value as a primary or exclusive governing principle. Chancellor Chandler noted that regulatory law had completely failed in the current crisis. Professor Coffee noted that securitizations started becoming more toxic when the issuers were no longer required to retain the lowest tranches on their books.

Again, I hope that this summary stimulates thoughts and questions for the readers of this blog.

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