The Need to Reform Boards of Directors

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The Need to Reform Boards of DirectorsRemember Enron? The outrage over the lack of Board oversight of their operational managers sparked a wave of corporate board reforms. But alas, more than a decade later, those reforms have shown unimpressive results. In 2013, the McKinsey group did a survey of 772 board directors. The results are disappointing:

  • 34% of the 772 directors agreed that the board on which they served did not fully understand the companies’ strategy.
  • Only 22% said the boards were completely aware of how their companies created value for customers
  • Just 16% claimed that their boards had a strong understanding of the dynamics of their firms’ industries.
  • From January 2010 to September 2013, the number of interventions by activist shareholders (challenges seeking board representation, share buybacks, CEO removal, and the like) increased an astonishing 88%
  • (One could add that they were stupid enough to expose such ignorance).

The facts demonstrate that too many board directors don’t even have the background to adequately represent their fiduciary duty to shareholders. At the time of the study, the average retainer for a board member was $249,000 and directors spent an average of 25 days per year providing their services of representing shareholder interests.

During the last few years as markets have surged up, US companies have spent over $2.41 trillion on buying back their own stock. Most investors think paybacks are a reward for shareholders but the truth is far from that.

The real reasons why so many companies are spending so much buying back their own stock is to “adjust” top executive pay for performance programs. On average, only about 20% of executive pay is in salary and benefits, the balance paid with company stock. To cover the dilution caused by issuing stock to pay company executives, the company plays games by using buybacks to soak up the excess stock float to make the company’s earnings per share (EPS) look good. Normally, EPS is a measure of how proficient a company is at making money for its shareholders by producing its goods or services. Think about this: $2.41 trillion spent on dressing up the company financial reports rather than investing in innovation, research and development and creating new jobs. But there’s more!

Boards’ decision to use buybacks is a threat to the future of the US economy

The USA used to be the dominant global investor in R&D. Now, Asian countries (ex-China and Japan) spend twice as much in R&D than does the USA. What does that mean for the future economy of the USA?  We will become just sales organizations peddling exotic financial instruments and other intangibles? Of course, that won’t happen because all the unemployed will rise up against such a system. In fact, we are seeing that now in this presidential election. But how have things gotten so far out of control?

The USA used to be the dominant global investor in R&D. Now, Asian countries (ex-China and Japan) spend twice as much in R&D than does the USA.

The USA used to be the dominant global investor in R&D. Now, Asian countries (ex-China and Japan) spend twice as much in R&D than does the USA.

The simple fact is: Too many boards of directors have not done their job as fiduciaries nor are most qualified to even do the job. Too many economists and investors have spoken out against the short term focus of corporations as they see their “success” measured in stock price alone. Yes, Wall Street and investors are partially to blame, but boards are there to represent the interests of shareholders and nowhere is it stated that only short term prices represent the best interests of the shareholders. Many investors make long term investments and depend on regular dividend payments, which make up about 50% of a stock’s total return over time. But it’s not just about the well-being of investors.

Whole communities are dependent on the success of large public companies as are all the employees and their families. Indeed, the future of our childrens’ future employment depends heavily on those corporate bastions of capitalism. But if they are so important, why do companies make such seemingly irresponsible decisions?

According to an article in the Harvard Business Review, corporations need to take on knowledgeable directors who have actually been in business and in positions of responsibility. Moreover, board directors need to become intimately involved in providing input on company strategies and innovation. Also, board directors need to also consider their tangential responsibilities to communities. For example, many of our most prestigious companies (GE and Apple) hold trillions in profits offshore to evade paying US taxes. Company managers make the argument that it is their primary job to optimize shareholder value. But are all shareholders only concerned about stock price and short term gains? Of course, greed is good but so is understanding the whole picture.

How many board members have argued against such short term strategies and the negative impacts such a strategy can have? Do they not care about the flim-flam buybacks that are transforming many companies into slaves of Wall Street and institutional investors and selling our nation’s future need to innovate and stay competitive? Or, is it that they just don’t get it?

Corporations need to make a real effort to hire experienced, knowledgeable directors who will push back on strategies they don’t agree with and put in at least the same as board members of the emerging world’s company directors-54 days per year (as opposed to 25 in the US).

Too many board members hold positions on numerous other boards that not only create potential conflicts of interest but also make no demands for board members to spend time to learn how the company operates and provides value to its customers. How can they help guide as well as represent shareholders? Some companies are starting to see the potential backlash of today’s short-term corporate focus and are requiring board members to have some significant “skin” in the game by owning company stock and locking it in for longer hold times.

Often, we see the CEO of companies actually appointing board members and stacking the deck. After the Enron fiasco, supposedly new regulations were put into place that prohibited such a practice but it appears enforcing it is another matter. Corporate leaders, who supposedly report to the Board, need to set out specific job descriptions for board members and one of the most important is to communicate with investors and should be to explain company strategies as well as help develop long-term growth and goals for innovation.

The number of retail investors is a small proportion of shareholders (with the exception of IRA and 401K accounts, which are usually managed by professional money managers) and more board members need to spend time acting as knowledgeable liaison with the investment industry to facilitate a more cohesive and intelligent long range strategies for corporate America. The risk could be losing the economic dynamism that has made U.S. corporations the dominant players and innovators.

 

Additional Reading

Performance Reviews Are About to Change

Business News Daily’s “CEO Challenges for 2015”: How did you do?

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