Bank of America, Agency Problems and Selective Blindness in Our Judicial System

We wrote a widely read post about Bank of America's $40 billion mistake in acquiring Countrywide Financial back in 2012, which we link here for context.

The government's 2012 complaint in Federal Court (Southern District) makes interesting reading also for context to the current settlement debates.  According the Feds, Countrywide engaged in a scheme to defraud FNMA and FHLMC, and as a consequence the GSEs suffered more than a billion dollars in unreimbursed losses.

The story picks up, for some reason, in 2007 when Countrywide's originations had fallen from $490 billion in 2005, to $450 billion in 2006 to $408 billion in 2007.  A very superficial discussion of the monthly loan performance monitoring program required of the originators by the GSEs begs a very important question. Surely, delinquent or non-performing loans (here referred to as loans with 'defects') would have been evident from the 2005 vintage long before 2007.  There are mechanisms for dealing with these problems from the GSE perspective, including putting the loans back to the originators.  One would also think that reimbursement or compensation provisions would have been part of normal securitization agreements.  None of this is even mentioned in passing.

As we have said before, agency problems for Countrywide shareholders existed writ large because of the behavior of CEO Angelo Mozillo's outlandish behavior, which has been covered widely in the press. His compensation, bonuses and option grants were conditioned on the volume of originations, even if they were subprime 'stated income,' 'liar loans,' or 'NINJA loans.'

Mozillo, in turn, created compensation opportunities for Franklin Raines, who eventually relinquished $24.7 million of ill-gotten stock options gains from a reported six year earnings manipulation scheme, over which his gains would have surely been greater than $24.7 million. Mr. Raines never felt the heat and wrath of Federal prosecutors, rather his slap on the wrist came from another Federal oversight agency. Why wouldn't the full force of our justice system fall on two kingpins of this mess?  Justice for friends is different from justice for those deep pocketed corporations, who are giving up shareholders' money in the end.

In the government's complaint against Bank of America, there are a few selected quotes from the former CEO and from the current CEO which should arose the ire of BAC shareholders.

"We did extensive due diligence...It was the most extensive due diligence we (Bank of America) have ever done.  So we feel comfortable with the valuation.."  Former CEO Ken Lewis.

"....we will pay for all the things that Countrywide did."  Loose language from current CEO Brian Moynihan.
Fast forward to the recent imposition of fines by U.S. District Judge Jed Rakoff.  As one reads through the 19 page opinion, the judge's conception of gross versus net losses and his infantile examples seem to challenge the usual shibboleth that Federal court judges are more capable of understanding complex financial issues. Recent problems arising in the interpretation of potential sovereign defaults by Argentina raise similar issues.

The total value of 17,611 loans issued by the HSSL loan mechanism of Countrywide amounted to $2, 960,737,608.  But, 57% of these loans were, in the opinion of the government's 'expert' not in fact bad apples.  So the final penalty imposed was 43% of the maximum, or $1,267,491,770.  The wisdom of Solomon!

As Harry Truman said, "The buck stops here."  Well, what about the higher ups who sanctioned all ludicrous, uncontrolled financial malfeasance at their institutions?  According to Judge Rakoff, "....the fact that other, higher-level individuals arguably participated in the fraud but were, for whatever reason, not charged by the government..." doesn't rise to the level of this judge's scrutiny.

Instead, he lays liability at the foot of Rebecca Mairone, a Countrywide executive, who took the actions necessary to perpetuate the fraud described in the complaint.  Was she a lone, rogue agent?  Not hardly. Her crime seems to be having given "implausible testimony."  Judge Rakoff is given to pats on the back and slaps in his opinion. Attorneys on both sides are described as "excellent" (from Wayne's World?) and "superb."  Ms. Mairone apparently wasn't well coached by her excellent attorney to not give implausible testimony.  The jury in fact asked Judge Rakoff why the higher ups weren't being brought up on charges. They got the answer quoted above.

Finally, we are left with Bank of America, which recently reported results. Earnings were a bit better than expected, analysts claim because of expense controls, better than expected trading revenues, and lower provisioning, offset by much higher than expected legal expenses.  Revenues from the core banking businesses were, however, disappointing.  I wonder what will drive 2014 incentive compensation for the executive team?  Based on current expectations, BAC looks fully valued, but longer term its future growth, if it can ever put Countrywide issues behind it, still remains in question.

H-P's Approach to Executive Comp Is a Lot Better Than JP Morgan's Handwaving

We posted recently about the formulaic and uninformative discussion of JP Morgan Chase's executive compensation philosophy and metrics that might justify a $20 million compensation award to CEO Jamie Dimon. 

Today, in HP's proxy we see the kind of approach that is both mandated by SEC guidelines and which gives a shareholder an insight into how the board looks at the task of setting executive compensation.  Their approach stands in stark contrast to that of JP Morgan Chase's board. 

Having sat on both sides of the board table for public company executive compensation discussions, I can tell you that cannot be solely a highly quantitative, black box process, no matter what the consultants say. There is quite a bit of luck in how equity-based compensation can work out. (see Rakesh Khurana's writings on this issue) It is not the magic bullet, but it is an important part of the compensation tool kit. 

There is no perfect structure that can apply to all companies.  That is why the issue of setting out the philosophy and choice of metrics is important.  Shareholders deserve to know, and management needs to understand, how targets are being set and how they are designed to align with shareholder interests.

HP states that their Human Resources Committee, which met eight times during the past fiscal year, reviews their process and structure annually.  Like management, boards can always get better. 

Their institutional audience of 5% owners has remained unchanged from the prior year: Dodge & Cox own 8.1% of the equity, BlackRock own 6.1%, and on behalf of mutual fund owners State Street holds 5.5%. 

Whereas JPM's board uses the boiler plate term "alignment," the HP board shows how they interpret and implement the concept both in executive compensation and in corporate governance.  I think a diligent analyst or shareholder familiar the company's history can glean a lot from this presentation. 

ALIGNMENT WITH STOCKHOLDERS
Pay-for-Performance		Corporate Governance
• The majority of target total direct compensation for executives is performance-based as well as equity-based		• We generally do not enter into individual executive compensation agreements
• Total direct compensation is targeted at the median of our market		• We devote significant time to management succession planning and leadership development efforts
• Actual total direct compensation and pay positioning is designed to fluctuate with and be commensurate with actual performance		• We maintain a market-aligned severance policy for executives that does not have automatic single-trigger equity vesting upon a change in control
• Incentive awards are heavily dependent upon our performance against objective financial metrics which we believe link either directly or indirectly to the creation of value for our stockholders. In addition, 25% of our target annual bonus is contingent upon the achievement of qualitative objectives that we believe will contribute to our long-term success		• The HRC Committee utilizes an independent compensation consultant
• We balance growth and return objectives, top and bottom line objectives, and short- and long-term objectives to reward for overall performance that does not over-emphasize a singular focus		• Our compensation programs do not encourage imprudent risk-taking
• A significant portion of our long-term incentives are delivered in the form of performance-contingent stock options ("PCSOs"), which vest only if sustained stock price appreciation is achieved		• We disclose our performance goals and achievements relative to these goals
• We provide no special or supplemental pension benefits		• We conduct a robust stockholder outreach program throughout the year

Instead of talking about reasonable compensation, HP's board talks about targeting direct compensation at the median of its market, or peer group.  The interesting thing is the choice of peer group, which is effectively very close to the top ten or twenty stocks owned by institutional investors who might look to own HP. At least, this is how I interpret the table.  In addition to Microsoft, Cisco, Google and other technology bellwethers, the peer group also includes Pepsi and Johnson & Johnson two high quality growth stocks which often appear in their 5% owners' portfolios.  As a whole, the peer group companies are subject to economic forces, market forces and technology cycles which should make the median comp metric an appropriate measure. 

In fiscal 2013, 75% of the incentive comp targets were made up of quantitative metrics: revenue (25%), corporate net earnings (non-GAAP) also 25%, and corporate FCF as a percent of revenue at 25%. The other 25% were composed of qualitative factors. 

Management delivered revenue of $112.3 billion, short of the target $117.9 billion, attaining a 19.6% incentive payout versus the target 25% available. The actual payout on corporate net earnings fell 5 percentage points short of target, whereas FCF as a percent of revenue was 8.1% versus a target of 6.3%, and the outperfomance on the latter metric, along with some consideration of the total stockholder return of 81 percent put the overall achievement for the quantitative metrics at 2 percentage points above target.

Our objective is not to provide a complete review of this document, but to show that there is plenty of meat for an interested party to consider in their decision whether to own, hold, or sell HP shares.The document gives a clear picture of management's performance and a window into how the board looks at that performance and pays for it. 

By contrast, JPM's discussion of executive compensation reflects poorly on their board and on their governance.  

Jamie Dimon's Pay Raise: It's About Principles Not Personalities

When a company like JP Morgan Chase raises their CEO's 2013 pay to $20 million, a 74% increase, the public markets should try to process this information to see what it really means. Unfortunately, with Jamie Dimon the discussion is always about personalities and not about fundamentals.

Back when there was talk about splitting the roles of CEO and board Chair, his buddies from Greenwich weighed in.  Why should their opinions matter in a public forum, rather than over a beer? With the latest news, Warren Buffett opined that $20 million was a "bargain."  It might be, but again, with all due respect, shareholders and the capital markets need and deserve more.

When the SEC greatly expanded the required disclosures about Executive Compensation in corporate proxies, it was done to at least provide some insight from the board on how they, as stewards of stakeholder interests, approached issues of compensation.  This is where an analyst or shareholder should look for answers about the $20 million and not to the interesting, but off point opinions of pals and pundits.

Ben Heineman, Jr. of the Harvard Law School's corporate governance project has written the most reasoned introduction to this issue.  After reading his piece, we went back to the original document, namely the proxy: it doesn't give a shareholder any comfort.

Here's what a reader finds about principles for governance and compensation:

• Maintaining strong governance: Independent Board oversight of the Firm’s compensation principles and practices and their implementation
• Attracting and retaining top talent: a recognition that competitive and reasonable compensation helps attract and retain the high quality people necessary to grow and sustain our businesses
• Tying compensation to performance: A focus on the qualitative as well as the quantitative performance of the individual employee, the relevant line of business or function and the Firm as a whole.
• A focus on multi-year, long-term, risk-adjusted performance and rewarding behavior that generates sustained value for the Firm through business cycles.
• Performance assessments that are broad-based and balanced, including an emphasis on teamwork and a “shared success” culture
• Aligning with shareholder interests: a significant stock component (with deferred vesting) for shareholder alignment and retention of top talent
• Very strict limits or prohibitions on executive perquisites, special executive retirement severance plans, and no golden parachutes
• Integrating risk and compensation input into compensation determination.

It's hard to disagree, because much of this is the same boilerplate that was produced by most companies before the change in requited disclosure.  What is "competitive and reasonable" compensation? Is $20 million such a number?  "Competitive" is still beset with the same peer group, compensation consultant problems which have always existed.

"A significant stock component with deferred vesting" certainly works on the upside, especially when the big grant is given post-trough with $20 billion in various case settlements having already been agreed.  

To one of Heineman's key points: there is one reference to corporate culture, that of "shared success." What does that mean?  Is that a sufficient description of what kind of corporate culture is required to assure meaningful, risk-adjusted success apart from cycles in the financial sector? 

The author writes,

"The case against the raise begins and ends with JPM’s corporate culture, for which Dimon also bears ultimate responsibility. The broad array of issues for which JPM has paid settlements totaling billions all took place on Dimon’s watch. Except for the inherited Washington Mutual and Bear Stearns bad practices, they all involved JPM employees. They involved core bad behavior: collusion, inadequate disclosure, money laundering, abusive behavior towards debtors, indifference to red flags of massive fraud. They arose in different parts of the bank, not just one dysfunctional unit. They substantially impacted profitability. They have seriously corroded the bank’s reputation with regulators, a number of investors, and the public. JP Morgan’s own report on the matters surrounding the London Whale indicates broad failings. Dimon himself, after virtually all the problems had surfaced, admitted that under his leadership the bank had failed to pay enough attention to controllership issues, and had failed to create an appropriate culture of integrity, compliance and risk management."

We wrote in a prior quarter about the strength of the JPM's last quarter and the platform it provides for future growth.  We also have to admire the CEO's rough hewn New Yorker's approach to evergreen questions like share buybacks. But, the board of JP Morgan Chase--which is not of the quality that a global financial powerhouse deserves--failed to give shareholders a window into their thinking about the $20 million which was based on their fundamental views about economic, management, and ethical principles which underpin the corporate culture that governs the firm they oversee on behalf of stakeholders.

Choking on Disclosure

The newsletter Compliance Week reported on a symposium of general counsels, risk and compliance officers from a variety of public companies, mainly mid to large cap companies. These officers generally felt overwhelmed with the current and evolving structure of disclosures and filing regulations. Having gone through SOX as a first generation, accelerated filer, I can speak personally about the pressures this Act put on a small, efficient finance and accounting function. The people in the CW Symposium have very large staffs and access to sizable outside resources, and they feel overwhelmed!

They also felt that their boards had been forced into a checklist mentality, which has taken them away from their most important function which is to formulate, implement and monitor the company's strategic growth initiatives.

The example of the new SEC disclosures on climate risk is cited as an egregious example of regulation without purpose or value. Responsible scientists globally have a difficult time quantifying what climate change is, let alone "climate risk." Take this down to the level of an individual corporation: the concept of a corporation being able to describe or measure the effects of its actions on its incremental climate risk is laughable. Nevertheless, trees will be felled, paper wasted, and expensive lawyers will draft opaque prose that meets the standard, but which also will be glossed over by institutional investors for whom this provides no guidance on whether or not to buy or sell shares.

Ken Jones, the Chief Compliance Officer of Huron Consulting said, "We spend three times as much money...on executive compensation reporting than we did two years ago." This is a CAGR of 73%! The Dodd-Frank bill will add considerable complexity to the already foggy bog of executive compensation reporting.

To be fair, there's another side to the executive compensation issue. The previous disclosure was woeful, and in light of egregious practices that came out during the financial meltdown, it was clear that this was, and is, a serious issue of misappropriation of shareholder funds as well as an issue of economic rent capture. Since nothing substantive was achieved to address the fundamental issues that Rakesh Khurana has so clearly identified for so long, it was inevitable that a crushing set of regulations, yet to be implemented through rules, would emerge from the vacuum.

What about smaller public companies, which is where I have served as a CFO and a board member? Kevin Fry, the general counsel of PACCAR, said "You can't be a little public company anymore." That is not good for economic vitality.

Reform Runs Out of Gas

Last week I attended a presentation by Bob Pozen, author of "Too Big to Save." Bob is Chair of MFS Investment Management, former Chair of Fidelity Management & Research, and lecturer at the Harvard Business School. Bob is an attorney by profession and Robert Shiller, the Yale economist, is his co-author of the book. I came with a lot of optimism, but left with a sense, at least from the slides, that reform of the financial markets has now been, as the Brits say, "crocked." That is to say, the plate has been thrown down on the floor and broken into shards of crockery. Reform now means a lot of incremental procedural changes that altogether don't add up to much.

Pozen says that there is too much focus on bank lending to business as being the key to economic expansion. He notes that bank lending was about 26% of total credit creation in 2006. Much more important, he says, is the task of reinvigorating the securitization market. He says that current volume, if I heard it correctly, is about $20 billion annually versus $1.2 trillion in 2006.
One reason that the market imploded, among many, was the fact that issuers were not required to hold a retained interest in the securitizations, and I would presume that establishing this as a norm would be one of the enhancements discussed in the book.

I felt that he glossed over the role of S&P, Moody's and Fitch in the whole debacle. The capabilities, business models, and governance of these institutions have not changed. Pozen's answer is to have these and other credit rating agencies, submit bids to an SEC master who would pick the best one for each issue. This seems like a procedural step that leaves all the significant issues behind the failure of the agencies untouched. It's another "check the box" procedure, a la Sarbanes-Oxley.

He rightly points out the popularly misunderstood nature of the extent of financial institutional bailouts. Out of about 650 financial companies that have been recapitalized, there are 290 small banks. Many of the companies don't hold deposits, but received TARP money anyway. The program was rolled out without any limits or rationale. That was, and is, reflective of management incompetence on the part of the Government. Remarkably, he notes that the Government got 15% warrant coverage on its deals whereas Warren Buffett demanded and received 100% warrant coverage for his Goldman deal! Don't want to ruffle any CEO feathers, especially with the taxpayers' money.

Repealing Glass-Steagall was clearly a humongous mistake. Pozen says reinstating a separation of commercial and investment banking is not desirable. It may not be, but his argument escaped me. He says that underwriting securities is not the problem. That may be true, but principal trading of all manner of convoluted instruments surely is the problem, and it takes place on the same trading desks. There was an obligatory comment about financial innovation, but who needs the kind of "innovation" that got us here? Finally, he rightly points out that if other nations don't follow, then US banks would be at a disadvantage. But, wouldn't the UK and the other G's want to coordinate this kind of policy?

On the subject of executive compensation, he noted the failure of the whole system for regulating the banks that took TARP money. We've always pointed out that this was a blunt instrument, and that focusing on the back-end compensation without getting at the philosophical issues about economic rents and short-termism in corporate objectives would be a futile exercise. He noted that Wells Fargo responded to the guidelines by stripping down the options-related compensation of its terrific CEO, whom I have always admired for his focus and consistency. Unfortunately, his base salary went from $900,000 to $5.6 million, and his restricted stock grants more than made up for any "loss" of option-related potential gains. Pozen said that this is not the kind of "reform" that was intended, but that it was a rational and predictable response to the foolish rules-based structure.

Pozen mentions that there is no data to support the notion that procedural-based SOX led to better stock price performance or less malfeasance or bad governance. Again, our systems are based on rules and bright lines, and Europeans tend to favor principle-based systems. Ultimately, it's the people in charge of Governments and the corporations, along with an informed citizenry that make a system fair and reasonably efficient.

I'm sure that there's lots of good ideas in the book and some good analysis of the historical origins of the crisis from Robert Shiller. After all this time, though, I would have expected more penetrating ideas for reform.

What Sunk the Ship?

Andy Kessler in today's Wall Street Journal makes the same basic point that we made in our last post about the futility of focusing on executive pay at banks. There is one philosophical difference that probably originates in the fact that Kessler is a former hedge fund manager. He says it wasn't excessive compensation schemes or excessive risk-taking that almost sunk the global financial system. Rather, he says it was the excessive use of leverage. He claims that Wall Street is good at managing their day-to-day risks. I have a hard time following this one.

Leverage is a decision variable that magnifies risk and returns, and so it is part and parcel of risk taking. So when Bear, Stearns or Lehman Brothers leveraged their portfolios at 35x, these were the accumulation of conscious decisions taken on their trading desks. It is the produce and distribute model for products that are as economically useful as carnival elixirs that needs to be changed and regulated. Unfortunately, there is no appetite to do this any more, as everyone is worn out by the minute-by-minute crisis watch over the past three quarters.

Just like SOX was a victory for accountants, consultants and lawyers with little impact on long-term shareholder value, so too will be the pursuit of executive compensation in banking. It's become so ridiculous that a local paper featured a story about a school board that rescinded performance pay bonuses for senior district administrators. Their performance measures, which included increasing enrollment in special programs, increases in minority performance and the like, were set a year ago; they seem clear, reasonable and measurable. The bonus amounts were a reasonable percentage of the base compensation. Now the administrators were told to give back their bonuses as contributions into special programs, "for the kids." It's not the fault of school administrators that Wall Street got the entire country into the crisis of the century!

Misguided populism is raising its head because the Administration and its Congressional lackeys don't have the guts or understanding to attack the problem at its roots because they are all running for their next campaigns. What a shame.

Executive Pay in Banking Is A Symptom

The Fed and other politicians are now grabbing headlines by vetoing pay packages for banking executives. Look, there is no doubt at all that pay packages for public company CEO's in US public companies was, and is, out of hand. However, it wasn't the level of the payouts that got us into the financial meltdown.

The financial system, and especially the shadow financial system, originated and distributed products such as MBS, CDO's, and CLO's that shifted risks off the balance sheets of the originators and offered investors high returns with what they thought were AAA credits. The creation of credit default swaps, where a buyer or seller need not have any actual interest in the underlying interest caused this market to explode. Proprietary trading in these same toxic instruments was and will always be a very profitable business, because it is dominated by a few large traders and it is not transparent.

Regulation needs to address (1) bringing the shadow system into the regulatory light; (2) forcing originators to retain a substantial portion of the securitization on balance sheet; (3) reforming the rating agencies that gave the AAA tranches their unjustified ratings; (4) perhaps requiring that traders in credit default swaps have some demonstrable interest in the underlying instrument; (5) meaningful SEC regulatory review of financial product creation process-- a firm can't just decide to package pay day loans into a new class of securities without going through some meaningful examination.

Corporate boards of large financial services company were ill equipped to deal with these issues. Jay Lorsch et al. quote a director of a giant financial services company, "[Two banks]--I think they crashed and burned. Neither one of them had anybody that I could detect on the board that's had any serious financial skills. And doesn't look to me like these boards demanded to know what was going on off balance sheet." Another director at the same company questioned management's financial acumen as well. "The bank boards and the bank CEOs and leadership, obviously, with the exception of maybe one or two, did not understand the risks they were managing." Again, it's not a problem of risk management process, it is a lack of care and competence.

Executive pay in these sectors was a symptom of the overreaching, overly coddled CEOs controlling passive boards, which the board members themselves admit, as above. Focusing on pay without focusing on regulating the creation, distribution, marketing, trading and accounting for toxic ("innovative") financial products is a futile exercise.

Say (What) On Pay?

Directors of Chesapeake Energy have managed to thumb their noses at investor dissatisfaction over outrageous executive pay packages by ponying up $112 million to its CEO, which included a bonus equal to more than 75 times the CEO's base pay and $33 million in stock awards. Please note that the stock price declined during the measurement period; imagine the bonus if the stock price had risen!

Just to make sure that investors got a finger in both eyes, the board also did business with some CEO-affiliated companies and bought the CEO's collection of maps and artwork for $12 million.

So for all the talk about proxy access and "say on pay," some boards manage to remain tone deaf to their fiduciary duties and to any kind of business common sense.

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.

The Executive Pay Distraction

Executive pay is a fundamental, long-term issue for public companies, as well as for mutual fund managers who often lead the chorus for "reforming the other guy's pay." These issues can't be dealt with as part of the banking and credit crisis. Unfortunately, hand wringing about bonuses at AIG comes after the horse has left the barn, and it is a diversion from the main issue.

So, we now know that Federal largesse has gone to make a limited number of contract counter parties whole, one of which is Goldman, Sachs, whose former official Henry Paulson pressed for this aid package in the first place. To use the poker term, the Fed and the Treasury are now "all in" on AIG, with diminishing hope of taxpayer recoveries and increasing risk. We as taxpayers cannot and should not shoulder all the counterparty risk in the AIG portfolio. I don't understand what we are trying to do at this point, and the market doesn't either.

The Federal government has become a significant "owner" of AIG, yet it has chosen not to act like an owner, but like a silent partner. Owners take ownership, participate in business and oversight decisions, and demand accountability. Since the Feds has to do none of these, it's not at all surprising that management were untrammelled in paying themselves for being irresponsible. It's probably too late to go back and place a Federal director on the board who reports directly to Congress or the executive branch. It is a shame.

The bonus issues are hard to understand, because bonuses are typically paid on mixture of corporate and personal objectives. What kind of objectives could have led to some the reported payouts? A corporate objective of maintaining a non-zero share price? A corporate objective of taking more Federal money? Unfortunately too, the proxies will come out long after our Twitter attention spans have forgotten about these issues. Perhaps the companies receiving the handouts should have to 8-K their real time, current compensation plans on their websites. Now, that would be transparent. When someone like Dick Kovacevich refers publicly to Fed and Treasury stress tests as "asinine," you know that there is trouble in Dodge.

Black Swans and Black Suits

Nouriel Rabini, writing in the Wall Street Journal today, comes out on our side for nationalizing the banks. Here's a short, cogent excerpt from the interview, "Mr. Roubini tells me that bank nationalization "is something the partisans would have regarded as anathema a few weeks ago. But when I and others put it in the context of the Swedish approach [of the 1990s] -- i.e. you take banks over, you clean them up, and you sell them in rapid order to the private sector -- it's clear that it's temporary. No one's in favor of a permanent government takeover of the financial system." (The Wall Street Journal, Online Edition, January 21st, 2009)

He talks about Greenspan's intellectually slavish adoption of Ayn Rand's economic view, and the Bush administration's disastrous idea of turning the Fed into the "lender of only resort." What's needed now is not a discussion about the merits of a free market system--an academic concept--but rather decisive action.

Fail--Nationalize--Renew

After waiting with bated breath for the Treasury's latest rescue plan, it's clear that we're out of ideas and have lost clarity and focus about issues and effective solutions. Today, there is much being written about Japan's "Lost Decade," and the need to learn from it.

Heizo Takenaka, who headed up the Japanese financial reform effort is quoted in the New York Times as telling Japanese banks, "Don't cover up. Don't distort principles. Follow the rules." So, let's learn from this.

Whether by enhanced Comptroller of the Currency audits or not, let's acknowledge that banks holding a large percentage of national deposits are insolvent. Wipe out the shareholders, which unfortunately are the rules of the game for owners of the residual interest. Nationalize the banks, and workout the assets. Let new banks emerge and bid for the assets. Let a new banking industry emerge, and incidentally it should be much smaller. If private equity types want to play in this field and operate banks under much tighter oversight and scrutiny, then that's preferable to the alternative.

A really bad idea that won't go away is to have government buy the distressed and toxic assets in partnership with private equity investors. A basic principle: that partnership's benefits will accrue to one and only one side, namely the private equity players. If really smart bond market investors can't value the assets properly, then certainly the government can't. The pressure to build in a rental, or subsidy, element into the prices will be irresistible on the Hill. A truly bad, bad idea.

In a related area, the legislation to require private equity vehicles to register and be subject to SEC oversight and regulation should be passed. Arthur Levitt, former Chairman of the SEC, correctly identified the 'levelling of the information playing field" to be critical for the efficient functioning of the capital markets and so it is. I wonder if we have the gumption for this, but now with the ineffective former leadership of the SEC out, perhaps we can find the fortitude.

If we believe in capitalism, then don't only focus on capital creation, because capital destruction is an integral part of the cleansing and renewal process. Take the medicine now and be done with it.