The SEC and Negligence Lawsuits

On Thursday this week The Wall Street Journal reported that a couple of Madoff investors are suing the SEC for negligence (Two Investors Sue SEC Over Madoff Probe). This will be an extraordinary case.

The defense the SEC will seek to invoke is "Sovereign Immunity" - a concept based in English law that essentially prevents people from suing the state or king because "the king can do no wrong". It's roll today is to prevent the state from being sued for damages that may result from policy decisions.

The Madoff case will present an interesting challenge here because the SEC was alerted to possible fraud multiple times and they repeatedly failed in their mission to discover what has been made quite obvious - Madoff's fraudulent investment business, not his legitimate market-making business - failed to do any trading at all in his alleged "split-strike conversion" strategy; something anybody who worked in a Wall Street back-office could have discovered. Their repeated incompetence and ineptitude was so egregious that it prompted a Congressman to admonish them in a hearing with the words, "You couldn't find your asses with both hands if you were standing!"

If the SEC made some policy decision that created some sort of market disruption that was unforeseen, "sovereign immunity" could be a good shield from frivolous lawsuits for damages. However, when your dereliction in your duty leads to circumstances that helps to perpetuate and enable a fraud you need to be held accountable and liable for your failures.

SEC Ruling on Proxy Access and BofA’s Lack of Planning

Last Friday, the Wall Street Journal reported that the SEC will wait till early next year, 2010, for any decision regarding making it easier for shareholders to access the proxy.

Naturally the folks at the US Chamber of Commerce are up in arms that shareholder investors would like to exercise their ownership rights and nominate people to corporate boards who may actually make a difference at a company. If they’re concerned about the “activist types” gaining access to the boardroom, why worry? Do they think that these board members will march companies like Merrill Lynch, Bank of America, GM, Chrysler, Lehman Brothers, Bear Stearns, AIG, Fannie Mae and Freddie Mac off of a cliff? THAT’S ALREADY HAPPENED! Did it take “activist” do-gooders and tree-huggers or Greenpeace to destroy some of this country’s best companies? Nope; all it took was no-nothing, do-nothing board-members, megalomaniac executive managers, and spineless professional investment managers. If you’re wondering why I’ve thrown in the investment managers it’s because they’re the largest shareholders of stock in America and all this big, ugly stuff happened while these companies were in “our” retirement portfolios under their supervision and guidance; sorry if this offends some folks, but all of you need to share in the blame.

As for BofA and their lack of succession planning, I’m shocked, but not very surprised. I know they have a lot of new members on that board now, but this just points, again, to the dysfunctional nature of corporate boards. Why, when a country is awash in educated and seemingly intelligent people, does this level of failure in planning occur?

Ken Lewis has been under extraordinary pressure for a year. He’s been scorned and disabused at nearly every turn since this financial calamity was sprung upon the nation and BofA was forced to acquire Merrill Lynch. One would think that succession planning would have been raised as a talking point for no other reason than that the enormous stress put upon Mr. Lewis could have killed him! And the US Chamber of Commerce wants to defend this dysfunction?

Memo to SEC: Put down the fiddle, Rome is burning.

The Proxy, Social Engineering and Corporate America

August 22, 2009

A recent article in Pension and Investments regarding CalSTRS backing of new proxy access requirements by the SEC raised a couple of issues for me. The number one issue I saw was that there was no mention of S&P 500 index company, APOLLO GROUP (APOL). If a state fund like CalSTRS is going to back proxy access reform for director nominations I would think that companies that CalSTRS invests money in would at least have to offer shareholders voting-rights in their publicly traded shares; APOLLO GROUP doesn’t. As such, they don’t give shareholders access to a proxy whatsoever. Is this issue part of proxy reform? If so, I haven’t seen it. In fact, in Googling APOLLO GROUP and CalSTRS I find no news story where CalSTRS flags APOLLO GROUP as a proxy or shareholder Frankenstein. They replaced Worldcom in the S&P 500 in May 2002.

The second issue has to do with CalSTRS calls for greater diversity in corporate boardrooms. I’m very curious as to how CalSTRS equates greater diversity with improved long-term sustainable shareholder-value and how they intend to qualify and quantify how improved corporate performance is directly attributable to social diversity. I’m not saying that a correlation doesn’t exist; I’m asking how do they intend to track this and inform their investors and retirees.

What tools are they going to use in the process? How will they work with their investment managers to ensure their objectives are being met? How will they oversee this goal? From what I have read on the web, tying corporate performance to diversity goals is an imperfect alchemy at best and nailing Jello to a wall at worst.

If they’re calling for it, do they have an obligation to report on it to their constituents on a regular basis? Curious.

Self-Serving Compensation Practices Designed For Gaming

By Robert L. McMahon

NY Times business columnist Gretchen Morgenson has done investing America another great service! Her “Fair Game” column this week, July 26th, uncovers a compensation scheme so sweet, the executives benefiting from it are probably taking daily insulin shots.

Here Gretchen has uncovered, and remember, this is in a post Sarbanes-Oxley America, a company that is adding to its cash-earnings an amortized dollar amount of what it has expensed to acquire additional assets to grow its business. Likewise, they are also adding back to its cash-earnings what it expenses in stock awards to its executives. Would you like to go back and read that again? I thought so.

Alliance Data Systems (ADS) has created an alternate reality that gooses its earnings and makes it easier to hit earnings targets that then make it much more beneficial and lucrative for their C-suite executives to profit from their targeted stock awards via an accounting alchemy that can turn costs into earnings.

This only proves to me the futility of legislating regulatory fixes on American business that dances around aggressive, unseemly, and shareholder unfriendly accounting practices. It also demonstrates to me just how disinterested professional investment managers are by this type of behavior. If the institutional investor community are OK with this, then they’re essentially saying that it’s OK to lie to them as well. They’re the agency shareholders for America and by accepting this type of compensation practice they’re enabling management to undermine the financial health of the company within which they’re investing other people’s money.

According to the Times piece the firm awarded an additional 710,303 stock units the first quarter of 2009. If certain, as yet, unspecified “cash-earnings” growth targets are met for this year, a third of these stock units will vest by early 2010. In addition to that caveat, if the target is met in 2009, the balance of the stock units will vest by February 2012. Well guess what? On July 24th The Wall Street Journal reported a stock buyback by ADS worth $225 million dollars – roughly 4.5 million shares. By reducing shares outstanding they’ll be able to further inflate their “cash-earnings” more easily! So much for how well Sarbanes-Oxley protects the investor from sleazy accounting practices.

For the benefit of you the investor – the American handing your 401(K), kid’s college fund, or company pension plan to an institution – here are the top five institutional investment and mutual fund companies holding ADS on your behalf for your benefit. If you want, let them know that you don’t like being lied to.

Top 5 Institutional Holdings:
Franklin Mutual - 4.5 million shares
Wellington Management - 4.4 million shares
Fidelity Management - 4.2 million shares
Putnam - 3.7 million shares
ValueAct Capital Partners - 3.7 million shares

Top 5 Mutual Funds
Fidelity Small Cap - 2.4 million shares
Mutual Shares Fund - 2.1 million shares
Putnam Voyager - 1.3 million shares
Waddell Reed - 1.1 million shares
Mutual Beacon Trust - 1.1 million shares

Source: Wall Street Journal, Company Research, 26 July 2009

Proxy Access Is After the Fact

Please know that I'm a big believer in easier proxy access. Some people may think that I'm dead-set against it.

However, "proxy access" is not a silver bullet solution; it's a solution after you, the shareholder owner and investor, have been shot by a poorly governed company. Proxy access is "reactive" and is not "pro-active".

The wording of the Schumer bill does not put teeth where it needs to be and that is on the side of the professional investment and pension fund managers to be better engaged in researching, assessing, monitoring, and analyzing the corporate governance profiles of the companies they are buying and selling for OUR benefit - i.e. retirement, college-funds, trust fund, etc... And disclosing how they are incorporating these assessments in their compliance program(s).

Investors look upon professional investment and pension managers as folks who should be completely informed about a company's risks and if you're not looking at governance as a risk, well, what good are you? Where's the value in launching a proxy fight after the $60 or $80 stock that was one of your "Top 10 Holdings" craters to $3 a share?

As I have previously said, if you're not managing the risk, the risk is going to certainly manage you.

“Proxy Access” – Holy Grail or Trojan Horse

By Robert L. McMahon

Is “proxy access” really the Holy Grail solution to better corporate governance or simply a well masked Trojan Horse to advance social and environmental policies without accountability? Small wonder the discussion centers on the proxy, huh? If there has ever been a topic that makes citizen-investors’ eyes glaze-over and roll-back in their heads it’s having a corporate governance discussion about “proxy-access”. Yes, I know I’m hitting this subject extremely hard, but if anybody wants to know why John Q. Public, and those in the media, cannot seem to follow the ball when having a discussion about why “Corporate Governance” is so important, it’s because all discussions revert to heated and conflated perspectives about the proxy.

Would proxy access have prevented Merrill Lynch from turning itself into a mortgage bank these last six or seven years? Prevented AIG from issuing uncollateralized credit default swaps? Improved our automotive industry; or stopped Citibank from becoming a “financial supermarket”? The answer is no. Discussions about the proxy access, at this point, are equivalent to discussing place-settings as the Titanic is sinking; it’s all form without substance. And although I know and appreciate that having access to the proxy is extraordinarily important, agenda driven special interests are blowing so much smoke we’re unable to see the 800 pound gorilla playing with Grandma’s crystal – the pension and investment managers who actually invest OUR money in the companies that turn into governance disasters.

The bottom-line is that John Q. Public would much rather our professional investment and pension fund managers get more aggressive in seeing the next Enron or AIG on the horizon and not after it has already been slipped into their retirement fund, mutual fund or 401(k); proxy, schmoxie at that point, right? But is that how new legislation being discussed in Washington, and touted by the Council for Institutional Investors (http://www.cii.org/), is framing the discussion? No, of course it isn't.

Senator Charles Schumer is leading a charge in congress to introduce new legislation on May 19th called the “Shareholder Bill of Rights Act of 2009”. The three (3) major sections of this legislation are the following:

· Section 2: Shareholder Vote on Executive Compensation

· Section 3: Shareholder Input in Board Elections

· Section 4: Corporate Governance Standards

Just who, may I ask, are the vast majority of shareholders in America today? They are the large institutional pension and investment management firms of all stripes – public pensions, union pensions, brokerage firms, mutual funds, insurance companies, asset managers, trusts, banks, hedge funds, you name it. Just where to do these “agency” owners fit in the discussion of corporate governance? John Bogle, the founder of The Vanguard Group of mutual funds, has laid much of the blame for what has transpired in corporate governance failures at the feet of these “agency” shareholders that invest vast amounts of OUR money in the companies – “issuers” in governance parlance – that have failed. Let’s ask three (3) questions:

· Did the failures in corporate governance occur because the “issuers” were stiffing access to a proxy and the agency owners couldn’t effect change?

· Were the agency-owners more focused on their own parochial agendas for change and regarded other governance issues as unworthy of their consideration?

· Or were the agency owners not even considering “corporate governance” as a metric to be examined in the investment selection process?

If you’re thinking that delivering a solution for just one of these questions will be a silver bullet, you’re wrong. As I have previously written on my Blog, what we really need are investment and pension managers who act like genuine owners; not just advocates for change or traders.

Actually John Q. Public knows that the problems facing us are more driven by the failures of our pension and investment managers than by simple “proxy access” or beating up on the issuers themselves. If one company is poorly governed and implodes it should come as no great shock to anybody and shouldn’t create systemic risk to the global economy. But since 2000 we have witnessed a near systemic breakdown in all sorts of industries and companies, investors aren’t just chagrined by the corporate disasters, but their confidence has been radically shaken in their investment professionals. The pension and investment management industries are flooded with degreed, chartered and certified investment “experts” who have managed to measure every aspect of a company’s finances and managed to miss how to qualify and quantify corporate governance quality.

Where, in Senator Schumer’s “Shareholder Act”, are the accountabilities and responsibilities imposed on these agency-owners to be more engaged in researching, assessing, monitoring, managing, limiting and disclosing governance risk in the investment selection and oversight process? Why are we going to make this a one way street where large institutional and “political” investment managers and pension funds get to succeed in imposing an agenda on a company, but then exempt themselves from having any responsibility that may cause this company to fail; meaning if you pressured for change to improve overall financial performance due to poor corporate governance, you’re going to need to assess how your changes are improving both performance and governance; otherwise what’s the point? How does the legislation address that Senator?

Likewise, I didn’t see anything in the bill that addresses companies who are either public now or wish to go public later, where they have to offer voting-rights, that dual class stock structures, special class stock, stock with superior voting rights and so forth will be prohibited. There is no mention of imposing new or remediated rules on index companies when they place a company in an index - that will wind up being widely held – that they have to adhere to a particular governance profile. The company that replaced Worldcom in the S&P 500 index in 2002 is Apollo Group, a company that doesn’t offer voting-rights on the Class A, publicly traded shares, doesn’t offer access to a proxy at all, and is controlled by insiders and founders.

Nothing in Senator Schumer’s bill addresses the lack of focus on long-term sustainable investment performance on behalf of the investors. In fact, and I’m going to be pretty bold here, I see it as nothing more than a means for politically favored state and union pension funds to press agendas in social and environmental policies on corporations without any accountability as to whether or not their advocated changes bring about long-term sustainable investment performance and value.

Is it Stranger than Fiction? You be the Judge

By Robert L. McMahon

The last year has been, if nothing else, a watershed moment in our country’s financial history as the US government has stepped forward to prevent a worldwide financial calamity where bank accounts, investment accounts, and homes and livelihoods are all lost forever. But what does the systemic failures of the banking, mortgage, derivatives and housing markets have to do with “rescuing” the American auto-industry?

Since the early 1980’s this industry has been walking on thin ice and has been sustained through witless and craven congressional interference, witless and spineless corporate management, and witless and ignorant union demands that have bled the goose dry. And now the US tax-payer is supposed to come in and save what the foolish, cowardly and ignorant couldn't? This is business?

This situation got me thinking – “I’ve heard this before.” It was a long time ago, but not in a galaxy far away. It was a book I read the summer of 1979 and I have read it six times since; maybe I’ll read it again this year. Let’s see who’s first to send me the name of the book and the author. Here’s the passage that today’s financial crisis and the US auto-industry prompted:

“We voted for that plan at a big meeting, with all of us present, six thousand of us, everybody that worked in the factory. The Starnes heirs made long speeches about it, and it wasn’t too clear, but nobody asked any questions. None of us knew just how the plan would work, but every one of us thought that the next fellow knew it. And if anybody had doubts, he felt guilty and kept his mouth shut – because they made it sound like anyone who’d oppose the plan was a child-killer at heart and less than a human being. They told us that this plan would achieve a noble ideal. Well, how were we to know otherwise? Hadn’t we heard it all our lives – from out parents and schoolmasters and our ministers, and in every newspaper we ever read and every movie and every public speech? Hadn’t we always been told that this was righteous and just? Well, maybe there’s some excuse for what we did at that meeting. Still, we voted for the plan – and what we got, we had it coming to us. You know, ma’am, we are marked men, in a way, those of us who lived through the four years of that plan in the Twentieth Century (Motor) factory. What is it that hell is supposed to be? Evil – plain, naked, smirking evil, isn’t it? Well, that’s what we saw and helped to make – and I think we’re damned, every one of us, and maybe we’ll never be forgiven….Do you know how it worked, that plan, and what it did to people?

Try pouring water into a tank where there’s a pipe at the bottom draining it out faster than you pour it, and each bucket you pour makes that pipe an inch wider, and the harder you work, the more is demanded of you, and you stand slinging buckets forty hours a week, then forty-eight, then fifty-six – for your neighbor’s supper – for his wife’s operation – for his kid’s measles – for his mother’s wheelchair – for his uncle’s shirt – for his nephew’s schooling – for the baby next door – for the baby to be born – for anyone anywhere around you -- it’s theirs to receive, from diapers to dentures – and yours to work, from sunup to sundown, month after month, year after year, with nothing in sight for you but their pleasure, for the whole of your life, without rest, without hope, without end …From each according to his ability, to each according to his need…..”

Okay, be the first to go on record with the author's name and book title!

When laws are brushed aside by governments and investor rights get trampled people need to hear it and understand it. Companies, corporations that are publicly traded and borrow money from investors (i.e. the public) are the first line beneficiaries in a bankruptcy; that’s corporate and investment law. If the government begins trashing investor rights in a bankruptcy to benefit union workers at the expense of bond-holders our financial system, and government, is no better than Venezuela’s. Adios amigos.

In Memorium: William Seidman, God bless....

Prayers and condolences to the family and friends of one our country's great financial minds, William Seidman.

Bernie Madoff and Me

It's been almost a year and half since Bernard L. Madoff Investment Securities, LLC (BMIS) and I parted company. It was no great loss for me except that I was unemployed, but the tragedy and irony of what has transpired since really caught me by surprise; and for the long-time employees of BMIS I left behind it must've been downright traumatic. Why has Eleanor Squillari, Bernie's secretary of 25 years, come forward now? I believe she's doing it as a form of "post-traumatic stress " therapy. Yes, she probably is writing a book, but that only helps her make sense of what her life has been caught up in by this crime.

For my part I've been trying to reconcile my role at the firm, Business Analyst and Project Manager, with the technology I saw there and, what I call, the dysfunction of managing it. From the outset few people were told what my role was to be and why the head of technology, the late Liz Weintraub, hired me. And although she passed away shortly after I joined the firm, the two people she recommended to replace her, never had a full picture as to my role. They viewed me as an outsider to their "unique" world. And unique it was.

Although the trading technology I saw was sophisticated, it was also somewhat dated by 2007 standards. BMIS used Stratus Technology - super computers - for their trading engine and had the software developed and supported for this in-house; a quintessential Rolls-Royce when a Smart Car is required. Yes, this was the model for robust and sophisticated trading 20 or more years ago, but with today's off-the-shelf, plug-n-play technology you simply don't require the added expense of "owning" the IT to the extent Madoff did. Expanding into additional asset-classes for example required "reprogramming", table structure expansion, directory changes, and other issues I had not contended with since the 1980's.

And this is not an indictment of the people managing the Stratus Systems. These people were doing Homeric work, but seemed more and more pushed to the wall to hold the systems together as newer requirements were pushed down to them from Madoff Trading. I was always wondering and trying to inquire as to "Why". How come these legacy systems weren't "sunset" and newer technologies implemented so Madoff could grow his business faster? Not only was Madoff competing with other B/D institutions, but in a real way they were also competing with technology providers. If you're ABC broker-dealer "employing technology" and not "building technology", you're better positioned to begin trading a new asset class or instrument a whole lot quicker; you're just buying what you need off the shelf and implementing it.

In hindsight it becomes very apparent. Madoff couldn't upgrade to other technology platforms because he would have to invite other IT technologists in to assist with the upgrade. This would entail an assessment of not only the Stratus Trading Engine, but a system Madoff kept on the 17th floor - an IBM A/S 400. In today's world, trading engines and reporting systems can reside together - makes things easier given today's data-base and data-modeling technologies. But in Bernie's World, these were separated; and to Bernie, for good reason. The A/S 400 was Bernie's printing press for statement generation and he couldn't risk the information being stored on that system being seen by other, more knowledgeable, technologists. If the A/S 400 had "statement records" on it, but no individual trading data, questions would have been raised and the charade found out.

In retrospect I met some very, very smart people at Madoff. Several IT developers there deserve to be product, program and division managers within the financial services and trading industries; these people were wonderful to work with and should not be held to some foolish myopia about "having worked at Madoff" - Bulls--t!

Most recently though I was reminded, in very stark terms, of just how insidious and evil this whole affair actually is. I was interviewed for a BBC production regarding my experiences with Madoff and only just realized yesterday, 5/11, that my British interviewer was the son of a man who killed himself as a result of losing his retirement funds to Madoff. His father was a professional British Soldier, an Officer, a Gentleman. Words cannot express what needs to be.

Cheap Shots at John Bogle and Michael Jacobs

By Robert L. McMahon

In the mix of letters published this week in the WSJ as responses to last week's Op-Ed’s of John Bogle and Michael Jacobs, “A Crisis of Ethic Proportions” and “How Business Schools Have Failed Business” respectively, I noticed a few rather cheap shots at the ideas put forth by the authors.

One letter writer appears to accuse Mr. Bogle’s leadership in creating index funds as the lead culprit in giving rise to a lack of concern regarding governance issues. To a certain extent indexing has provided an awful lot of cover to investment managers, but it should never excuse them from acting like an owner. And this is Mr. Bogle’s point.; just because a poorly governed firm makes it into an index the fund manager is tracking to, does not, and should not, release them from there duties and obligations as a capitalist shareholder. But this leads to another letter writer’s misconception about ERISA as having some enforceable fiduciary framework for investment managers to follow; it simply isn’t true, the statute doesn’t say that.

Under ERISA the only fiduciary framework provided is for the “Plan Sponsor” and even this fiduciary framework has a big missing link – it doesn’t impose any fiduciary accountability standard on the “sponsor” or the “investment manager” to put the long-term interests of the plan investors to the fore. In other words, the sponsor and the manager are free to invest in the next Enron and get a good night’s sleep.

With regard to a letter writer being dismissive of Mr. Jacobs’ Op-Ed as “overwrought navel gazing”, I ask where were the fund managers of America in alerting investors to the risks of Fannie Mae and Freddie Mac to our financial system? I worked at GovernanceMetrics in 2002 and when their first round of reports was released that November, both firms were rated at the bottom of the barrel yet both were S&P 500 names. They were the walking dead seven years ago.

Yes, it’s not simply the fault of greedy MBA’s solely that has created this economic and financial disaster. Quite obviously it’s a dysfunctional set of corporate laws and regulations that have obfuscated accountability. But when you’re managing other peoples’ money you should be doing everything you can to ensure that that your funds $500 million investment in a company simply won’t evaporate due to issues you’re blithely ignoring. John Bogle’s point is that we are an industry awash in financial talent that has effectively been silent on the sidelines as our financial economy has burned to the ground.

Be a Capitalist and Act Like an Owner

April 26, 2009

By Robert L. McMahon

Within a week we have seen two extraordinary Op-Ed’s in The Wall Street Journal. On April 20th we had John Bogle, founder and former chief executive of the Vanguard Group of Mutual Funds, writing a brilliant piece titled A Crisis of Ethic Proportions and on April 24th we had Michael Jacobs, a professor at the University of North Carolina’s Kenan-Flagler Business School, writing the incisive How Business Schools Have Failed Business. Both pieces are exceptional in their timeliness and subject matters, and both point the way forward in how we need to improve our professional investment management communities.

John Bogle’s perspective is that our financial and business communities have drifted further and further away from an “ownership society” and more toward an “agency society”. He lays out the usual suspect causes, those the financial media discuss, as the proximate cause of our current financial debacle: credit, financial risk, the over reliance on securitization to mitigate risk (which actually compounded the problem), the extraordinary leverage which encouraged outsized risk for outsized rewards, the overreliance on complex, esoteric derivatives, and, naturally, the failures of our regulatory bodies in performing their duties. In reality though, these are merely symptoms of the disease in our financial markets, “agencyitis”.

The greater cause he see’s is much more painful for us to think about, yet much more menacing if we continue to ignore it; and that’s how the further away from an ownership society we move, the further away from a capitalist society we also drift. He goes on to say, “But the larger cause was our failure to recognize the sea change in the nature of capitalism that was occurring right before our eyes. That change was the growth of giant business corporations and giant financial institutions controlled not by their owners in the “ownership society” of yore, but by agents of the owners, which created an “agency society”.”

In this world the “managers” of the corporations could more readily put their own interests ahead of the owners, i.e. “the shareholders”. And just who are these shareholders today? They’re the professional investment managers of America who control, through agency, some 75% of all shares of publicly traded companies and who, by the way, vote in near lock-step with management on proxy issues and directors at these same publicly traded companies. If you want to blame somebody for the idiocy you see before your eyes daily on CNBC talk to your investment managers! In John Bogle’s words, “They fostered the crisis with superficial security analysis and research and by ignoring corporate governance”.

And this is where we divert our conversation to Professor Michael Jacobs' Op-Ed on how business schools have failed American business. He posits that our American business schools have undereducated our graduate students in three keys areas: compensation schemes, corporate board accountability, and the rights and obligations of shareholders (emphasis added here by R. McMahon). Let’s stay with item three here, for John Bogle’s sake, because it has the most to do with capitalist ownership.

As Prof. Jacobs writes, “About 70% of the shares of American corporations are held by institutional investors such as pension and mutual funds. These organizations are brimming with MBA’s. But how many of these MBA’s took a class devoted to how shareholders should exercise their rights and obligations as the owners of America’s corporations? .... When shareholders are uneducated about their obligations, how can a corporate accountability system function properly?” Or as I like to rhetorically say, “When everybody owns General Motors, nobody owns General Motors.” Yes. You can safely blame every investment firm in America for GM’s demise. They stood by, quietly, head in the sand, fingers in their ears as the corporation that won World War II killed itself, very publicly, on CNBC. God, how I loved the lines and sound of that 1967 GTO and my Mom’s 1967 Impala…

In the end capitalism requires owners, individuals engaged in enterprise for profit, for gain, for growth. Nothing I’ve read could beat the quote that John Bogle includes in his Op-Ed when he cites capitalisms “grand old man”, Adam Smith:

“Managers’ of other people’s money rarely watch over it with the same anxious vigilance with which they watch their own….they….very easily give themselves a dispensation. Negligence and profusion must always prevail.”

Obfuscate, Regulate and Bloviate: Welcome to Investing for Retirement

12 April 2009
by Robert L. McMahon

To the uninitiated civilians out there who don’t know what to make of my “Corporate Governance” scribblings and why I believe corporate governance to be vitally important in understanding “how we got here” in this financial crisis, I’m going to offer two (2) important quotes. The first is by noted corporate governance author and pioneer, Robert A. G. Monks and is the title of a monograph he co-authored with Allen Sykes from November 2002, “Capitalism without owners will fail”, and the other is by noted governance expert, author, and Senior Fellow at The Millstein Center of The Yale School of Management, Stephen Davis, who wrote this week, “Owners that fail to exercise stewardship responsibilities must be understood as a systemic risk….” Both men’s quotes can be addressed at our investment and pension management industries. Why? For their repeated failures to act as owners of the companies they invest our hard earned dollars in – at both the investment management company and issuer levels. Misters Monks and Davis are precisely correct to admonish our investment managers for their delinquent attitudes of ownership, but it’s also our house of mirrors regulatory framework that has helped to create the current state of affairs.

The regulatory framework within which we invest our money seems to have been crafted by the “gang that couldn’t shoot straight”, or so it would seem to me, because the framework itself seems to stand in the way and obfuscates the roles and responsibilities of ownership and fiduciary accountability. The first area I will focus on is ownership rights where laws are established to actually inhibit shareholders from exercising those very rights. Within days of Mr. Davis writing the above words we were treated to having Carl Icahn pen an Op-Ed for the New York Times titled, “We’re Not the Boss of A.I.G.”. Mr. Icahn quickly get’s to his point with the words, “…under American corporate law share ownership does not count for much.” And Mr. Icahn is writing, believe it or not, about how little power the US government has over A.I.G. even though it is a “majority” shareholder – the biggest by far (40% interest I believe). To Mr. Icahn governance reforms need to address “proxy access” which has been deliberately crafted by corporate law to be an extraordinarily expensive process for shareholders to gain access to. He concludes his piece as follows, “The ownership rights that the government, as a shareholder, is now talking about are the same ones that activist shareholders have been demanding for years”; notice how the calls for greater exercise of ownership rights, can be directly mitigated by laws that are enacted to protect and shield management and the boards; the boards who are supposed to represent the shareholders.

The second area of this regulatory framework that has been setup to obfuscate is fiduciary accountability. Previously we saw the layer of corporate babble that inhibits the exercise of fiduciary ownership, and then we get to the layers where the Department of Labor and ERISA (Act of 1974) diffuse fiduciary accountability of pension and investment management by deliberately omitting language that enforces, as Stephen Davis writes, “…oversight powers to ensure that retirement fund behavior was aligned with long-term member interests.” Essentially this means that the pension plan manager is acting as a fiduciary only insofar as selecting the investment company to receive the plan assets, in seeing that fees are kept to a minimum, that the plan is diversified, and that it is following all the codes established by ERISA. But here there is no fiduciary accountability standard established to oversee the quality of the investment selection(s) that the fund manager would be doing; that is, the pension plan sponsor is exempted by practice, rule, and law from ensuring pension assets are invested for the “long-term member interests”. That pension plan could be investing in Bernard L. Madoff for all they know, but as long as Bernie passed the smell test, shows he’s diversified, and has his paperwork in order, well, you get the picture.

Finally we get to number three on the list where the regulatory framework fails to impose any fiduciary accountability standard on the investment manager itself to consider the “long-term member interests” of the members invested dollars. This goes to the heart of the matter when money is being plowed into the next Enron, publicly traded insurance company with an uncollateralized CDS portfolio, or brokerage firm turned mortgage bank. If there were requirements for investment managers to screen for what has been heretofore called “unforeseeable” pretty soon it will become “foreseeable” when it’s required. If building, engineering and construction codes were setup like this we would have codes laid out in terms of simple measurements with no requirements as to the “quality” of the materials used. We would have engineering and construction firms escaping liability because there was no “quality” metrics, no “build to code” guidelines imposed upon them.

Today we have an opportunity to correct this dysfunctional regulatory framework that prevents shareholders from acting like owners and disqualifies investment managers from any fiduciary standard of accountability. With this opportunity we can begin the process of rebuilding trust into our investment management and financial market systems. But this can only be accomplished if the parties involved can accept responsibility for their previous failures and work toward correcting the mistakes. What we don’t need is finger-pointing, bluster, and bloviation for the cameras; and especially when questions are asked by citizens of their congressional leadership and what is returned is arrogance, posturing and denigration; especially when that congressional leadership can be quoted as saying, with regard to the situation that Fannie Mae and Freddie Mac helped to exacerbate, “I do think I do not want the same kind of focus on safety and soundness that we have in OCC [Office of the Comptroller of the Currency] and OTS [Office of Thrift Supervision]. I want to roll the dice a little bit more in this situation towards subsidized housing.”

Personally I don’t want anyone with any sense of responsibility (even if they were just “the ranking minority member”) for oversight EVER to say that they are going to “role the dice” with other peoples money congressman. It makes me think that you treat tax-payer money as if it’s nothing more than casino chips and serves as a great example of why most Americans hold your collective body in such contempt.

Investment Managers Act as Enablers

5 April 2009

By Robert L. McMahon

It’s the quintessential parental bromide when we were teenagers; the analogy our parents gave to us to explain the roles that responsibility and accountability will play in our lives and I’ll use it here to illustrate my point; it’s the story of “Everybody”, “Somebody”, “Anybody”, and “Nobody” as applied to our investment management industry and their demonstrated willful enabling of lax corporate governance standards in corporate America and it goes like this:

· Everybody should have done something about it
· Somebody would have done something about it
· Anybody could have done something about it
· But nobody did anything about it

And so the jawboning for corporate governance continues with everyone flailing their arms, beating their breast, putting pen to the umpteenth white-paper, but few investment managers behaving proactively to watch-out for your money and mine in the long-run. There are some out there who understand the importance of solid governance, but they’re an eye-dropper in the ocean considering the industry.

The reasons for this consistent state of “Catch-22” in our professional investment culture are complicated and rife with conflicts and patent self-interest. The most obvious ones are that these investment firms and mutual funds are competing for the “retirement funds” of the companies they also invest in; their bid for that business could be quietly ignored if they agitated for change. Another is that if they were to appear as an “activist” to a company, the investment firm could lose key executive access to the issuer and effectively wind up blacklisted. This can be especially true if the asset management firm is a subsidiary of an investment bank, except that investment banks don’t exist anymore.

The most insidious reason though, is that the fund manager’s compensation is tied to the performance of their stock selection. So if a poorly governed company is returning that manager all sorts of “alpha” with your money, he’ll ride that risky company till he sells it or it blows up in a series of governance failures like Enron. The additional alpha earned by that fund manager, which directly goosed his income, he get’s to keep, but the portion of your retirement that he was investing on your behalf simply evaporates. At the end of the day that manager can claim plausible deniability and still keep his money with a clear conscious.

My point here is to push forward a notion expressed by John Bogle, the founder of Vanguard Mutual Funds, that our professional investment managers, whether they are asset managers, mutual fund managers, or brokers don’t necessarily put the interests of the investors first; our money is somewhat expendable to them. As such they act as enablers for poor governance practices in our corporate economy. Yes, they aid and abet the proliferation of dysfunctional governance with their silence. However, Mr. Bogle says that these managers should be the first line of defense in helping to mitigate these governance catastrophes and the subsequent investor losses.

Consider it this way; if a fund manager buys a company that is poorly governed it’s akin to becoming a homeowner without an insurance policy, or insuring their house for less than its market-value. Investment managers who continue to diminish the importance of solid corporate governance structures in their investment selection process are taking our money, buying a house, and not insuring it. This is not investing; last time I looked this was called gambling.

Rebuilding Trust: Wall Street to Main Street

30 March 2009
by Robert L. McMahon

One of the first things that needs to happen in rebuilding trust from Wall Street to Main Street is to get the brokerage and investment banking industry out from under the political dysfunction of our Federal government; not because of any real or imagined notions of supporting “Wall Street greed”, but because our congress has publicly demonstrated itself to be more aligned with Cuba, Venezuela, and North Korea than with our own free-enterprise economy. The House of Representatives recent confiscatory ex post facto tax proposals regarding retention bonus payments to employees of AIG was not only craven political bloviating in the extreme, but ran directly counter to our Constitutional principles; enter Ayn Rand and John Galt stage right.

Another avenue for rebuilding trust is the complete separation between the traditional “Broker-Dealer/Investment Banking” (BD/IB) and “Investment/Asset Management” functions within some of these firms; you do one or the other, period. Buy-side fund managers do not need the self-evident conflict(s) of their IB unit doing business with an issuer the fund manager is selling or BD research that’s touting an issuer in a report, while the fund manager has publicly issued a contrary opinion.

However, perhaps the most effective way for Wall Street investment managers to regain Main Street’s trust is to act as genuine fiduciaries when investing their money; act more like professional skeptics and owners rather than opportunists and traders when it comes to researching companies and disclose potential areas of “governance risk”.

Governance risk can be assessed by examining six key areas of an issuer:

· Board Accountability
· Compensation Schemes
· Financial Transparency & Controls
· Shareholders Rights
· Ownership & the Market for Control
· Corporate Citizenship (CSR issues)

And today, within the governance and compliance field, there is growing consensus that “Enterprise Risk Management” (ERM) practices will become a seventh point for examination. By then quantifying and qualifying these specific areas for risk factors, an investment professional can gain a more accurate and comprehensive perspective of an issuer than merely what is presented by the commonly examined "magic-show" of financial metrics: free-cash flow, EBITDA, debt to equity ratio, and all that stuff they restate months later in financial foot-notes. Only by assessing these underlying governance metrics will an investment professional get a clear picture into the “character” of the issuer; previously unseen and under-quantified risks will be fleshed out in this process.

If being forewarned is being forearmed, investment managers will have more information with which to question corporate managements and their boards. And by getting the investment managers of America – the overwhelming majority of equity shareholders today – engaged in remediating governance weaknesses, we’ll have the “intended consequence” of strengthening our financial services and wealth management industries; thereby leading from the front in rebuilding trust with Main Street, but without all the overbearing, over-regulated, over-bloviated Congressional oversight.

Benign Neglect Rules in Investment Management

by Robert L. McMahon

21 March 2009

Here’s a question for you; do you believe investment firms, including mutual funds, have adopted any kind of active screening or research tools that would alert them to potential failures in corporate governance? At this point are you asking, why is assessing “corporate governance” important? Unfortunately you aren’t alone in asking that question. Incredibly, many professional investment managers are asking the very same thing.

Who would think that seven years after the Enron, Tyco, and Worldcom debacles corporate governance risk would still be something that is treated with benign neglect by professional investment managers? For those of you who have been marooned on a desert island the past year, corporate governance failures have been part and parcel of today’s headlines regarding the meltdown of our financial system – albeit aided and abetted by congress, government sponsored enterprises (GSE’s), and regulatory oversight that would make for a wonderful Joseph Heller novel, “Bernie Madoff was the best at avoiding the SEC’s radar, because Bernie knew they didn’t hire qualified people…”

Corporate governance failures were rampant in this financial meltdown in one of the most regulated parts of our economy – Banking. The board of Citigroup is only now undergoing a makeover, but for the last fifteen years it was nothing more than a rubber-stamp for management and their “supermarket model” for marketing financial services to the masses. Merrill Lynch, Bear Stearns, Lehman Brothers, and Bank of America had much the same board issues – unqualified, unquestioning, go-along to get-along, friends of corporate management. The board’s job is to oversee management and be accountable to the shareholders; not be a lap-dog to over-egoed managers.

Although everyone is in agreement that the root cause of this meltdown was driven by a “housing bubble” the sheer lack of understanding and questioning of “risk” in the securitization and derivatives portfolios of these banking behemoths I find overwhelmingly stunning. And this is why corporate governance quality is so vitally important to assess when investment managers make investment selections on our behalf. These assessments will lead the investment manager to have a much more complete picture of a company beyond the usual financial information, key ratios and PR spin. A governance assessment will offer direct insight into, not only the quality of management, but also the accountability, knowledgability, and independence of the board.

Investors have been brutalized by failures at nearly every turn in this meltdown, but one area where their investment managers should be turning for help is to research that can arm them in uncovering potential governance weaknesses. So as investors we should all start questioning our investment managers about the assessments they actively perform with regard to governance quality; starting right now.

Managing to Fail at Leadership

by Robert L. McMahon
22 February 2009

During my career in financial services I’ve adopted a unique way of assessing the quality and caliber of the managers I have worked for, and with, by drawing upon my time in the United States Marine Corps. At the end of the day I don’t look for quality management, but quality leadership; things get managed, people require leadership and if leadership is lacking, you’re going to manage to fail.

The entire crisis the economy is facing currently can be directly attributed to two interconnected points of failure: corporate governance and leadership. By far, however, the failures in governance rest upon this other, much more insidious, failure – ineffective, incompetent, and ignoble leadership. And the failures are not just in the private sector, but are also prevalent at the regulatory and congressional levels as well. Based upon what we have had demonstrated to us these last several months, all of these bodies are equally culpable in managing to fail in upholding their responsibilities. This failure in leadership is simply without comparison.

Since the 1970’s this country has made a gargantuan investment in graduate business education that has brought the United States to the pinnacle of world economic power and the precipice of an economic abyss. Call me cynical, but all this investment in business education seems to have advanced a culture that rewards cleverness and guile more than intelligence and character; salesmanship trumps leadership. We need only look at the craven, self-centered manner in which the SEC managed to fail in the Bernard Madoff affair as confirmation. The NY office was more concerned about “how they would look” in accepting leads given to them by the Boston office than the fraud itself.

The SEC then compounded this failure in pursuing Harry Markopolos’s repeated leads by managing to fail in demonstrating the required competence in reviewing Madoff’s securities operation, audit trail, and client financial statements. We found out only late last week that for more than thirteen years, Madoff had not placed one trade for a client account. It would seem the entire SEC managed to fail at every turn in its duty to protect investors. Quality leadership is not demonstrated simply by possessing a degree from an accredited institution, wearing a suit, or giving lip-service to motivational poster slogans.

Another clear example is John Thain, former CEO of Merrill Lynch. He’s learned leadership requires much more “substance over form” than the other way around. It means practicing what you preach and not putting your personal ego ahead of those you are leading. In the military officers who manage to fail at leadership can be charged with criminal offenses: dereliction and conduct unbecoming are two that come to mind in the case of John Thain. Ultimately though, the real dereliction charge can be leveled at the Board who managed to fail in its duty to oversee Merrill Lynch management.

Board level leadership is a centerpiece of our financial market system. It requires people who have demonstrated industry experience, demonstrated operational and subject matter expertise, and demonstrated independence from management. If Boards continue to slip and slide in these three basic leadership qualities then America’s companies will continue down the path of managing to fail.

Governance Risk: A Fiduciary Duty

by Robert L. McMahon
12 February 2009

The financial crisis of the past year has rekindled debate and discussions about Corporate Governance and its place in financial investing. The fact that so many banks, brokerages, and investment firms were all equally impacted by the mortgage market melt-down demonstrates, to me at least, that having greater financial business knowledge in the board room and better financial disclosures to those boards could have helped mitigate this catastrophe. The fact that many of the people we entrust our financial futures to either don’t fully grasp the complexities of the instruments and assets they’re buying and selling “for our benefit”, or that their internal risk and reporting systems do not work as advertised I find appalling. And for all the investments these firms have made in creating computer generated financial models, my guess would be that if their models were designed, say, to build an aircraft, the resulting aircraft would be capable of just two (2) things: taking off and flying at a 45 degree angle on a sunny day.

The key failure in this entire financial debacle is rooted in poor corporate governance quality. Weak governance structure is the gorilla in our darkened financial living-room and because the room is dark no one knows if the gorilla is 100, 200, 400, or 800 pounds; and nobody wants to put the lights on to see just how big the problem is because nearly everyone wants to remain ignorant of the risk; hear no evil, see no evil, speak no evil. But if you’re not measuring and managing “governance risk”, then your portfolio, mutual fund or brokerage account will always be measured and managed by something you’re willfully keeping yourself in the dark about. How smart is that?

The measuring and assessing of corporate governance quality is something I would equate to a fiduciary duty. How can any investment or mutual fund manager, plan-sponsor trustee, or securities analyst look anybody in the eye and say with a straight face, “corporate governance quality is not my concern, it doesn’t matter in the final analysis with regard to investment selection”? And likewise I would also say to the firms like Dow Jones, S&P, Russell, Nasdaq, etc…, who have created truly great products with regard to their index services, to please refrain from adding firms to an index that do not pass the smell-test of sound governance quality. And a classic example of this is S&P’s replacing Worldcom, in May 2002, with Apollo Group (APOL). Regardless of Apollo’s potential for success, this company continues to be an affront to shareholders; Apollo has a dual-class stock structure, they do not offer shareholders of the publicly traded Class A shares voting-rights, there is no access to a proxy, they do not hold regular annual meetings, there is no meaningful separation of management and the board, and the firm can be classified as a “controlled company”. If Apollo Group were to go the way of Enron, Worldcom, or Lehman Brothers would anybody be able to hold S&P accountable for imbedding a corporate governance Frankenstein in every index fund in America? What would their excuse possibly be? Yeah, I like that line from “Animal House” too.

Corporate governance isn’t just about believing everything one former Vice President says about climate change or getting tobacco companies not to sell cigarettes to our children. The dominant factor in getting our heads wrapped around corporate governance quality is to better understand “risk” and increase “shareholder value”.

Due Diligence and Fiduciary Duty

by Robert L. McMahon

7 February 2008

This past week we watched Harry Markopolos sit before Congress and speak truth to power like never before; effectively dismissing the Securities and Exchange Commission as being an ineffective cabal of idiot lawyers who, as Congressman Ackerman so eloquently put it, couldn’t find their ass with both hands if they were standing up.

Mr. Markopolos’s pointed testimony in the Madoff Scandal can also be aligned with what I see on a similar, but much more pervasive scale with regard to ordinary investors and that is the roles of “due diligence” and “fiduciary duty” when other people manage our money.

Much attention has been focused on the lack of due diligence undertaken by the so-called “feeder funds” who were shoveling piles of money into Madoff’s wonderful, but utterly impossible, “split -strike” strategy. In my own world of mutual fund investing a thought came to me then, what sort of due diligence is undertaken by my fund(s) with regard to the suitability of a company (a stock) and its risk profile for being a potential Madoff, Fannie Mae, Lehman Brothers, or Enron? What we all need to recognize with regard to these and other recent corporate failures, is that they were, first and foremost, the result of weak and ineffective corporate governance structures. If that is the root cause, then what is being done by our asset and mutual fund managers, brokers and investment advisers, to assess that risk and make it transparent to us; the folks giving them our retirement futures?

Due diligence is defined as “the process of investigation, performed by investors, into the details of a potential investment, such as an examination of operations and management and the verification of material facts”. This sounds like very serious stuff, but just how much investigating and examining is performed by the firms we give our money to? I tried investigating this via my mutual fund’s website and prospectus materials and found not a word about corporate governance suitability or governance screening. You can read a lot about proxy voting guidelines, that investments can vary in value and that past performance is not to be trusted, but if you want to see the governance profile of the fund’s top ten holdings you’re going to be looking a long time. Simply stated, there’s no readily apparent evidence that my fund actually performs this level of due diligence and if they do, well they’re keeping it a well guarded secret.

The term “fiduciary duty” can be defined as “acting with true faith and confidence in protecting the assets of another person and where there is an obligation to act for another’s benefit and interests”. Well that sounds all very serious and proper as well. It also sounds like the entity with the fiduciary duty must put the interests of him/herself behind that of the person they have the obligation to. In other words, they cannot and should not put their own monetary self-interests before yours in managing your money.

As an illustration of where this can potentially lead, let’s imagine that ABC Small-Cap Growth Fund has been on a stellar run gaining 15% and 20% for several years. Investors in the fund have done amazingly well and the fund manager has been beating his “bogey” by 10% routinely. By all appearances everything is going well and then disaster strikes out of the blue seemingly. Two of the fund’s largest holdings suffer extraordinary setbacks for different reasons; one firm is the spin-off of a well-known and much larger company that was the subject of litigation and a settlement. As part of the settlement the smaller company is obligated to commit up to 15% of the settlement total, effectively erasing 55% of its net income. The other company is in an accounting scandal when the Chairman/CEO dies suddenly and senior executives abruptly resign. It seems the firm was a “controlled company” whereby the founder and CEO (and his family) controlled the company through separate, non-trading Class B shares that had all the voting rights. As things unfolded material accounting irregularities came to light and executives resigned to evade responsibility and culpability.

The question I would have at this point is, “If these risks were known by the fund manager, why weren’t they made available to the investors in the fund?” Certainly if one is a securities analyst and fund manager the risk of contingent litigation against a company would be something very knowable from filings. Likewise, so would the risks of investing in a “controlled company”; just how much transparency would there be for a company that may not offer owners voting-rights, access to a proxy, or even hold regular annual meetings?

And here’s where the rubber meets the perennial road, just like Harry Markopolos uncovered the weaknesses in Madoff’s $50 billion Ponzi-scheme in five minutes, fund managers and securities analysts can deduce whether a company might be party to litigation or that it is a controlled company in about the same timeframe? Now if Madoff’s “feeder funds” can be accused of a lack of due diligence and owing a fiduciary duty to high-net worth investors in a hedge fund, shouldn’t the asset managers of America who oversee some $4 Trillion of equity funds alone exercise an equal amount of due diligence and fiduciary accountability for their much smaller and lower net-worth investors? The continued governance failings we have seen this past year seem to prove otherwise and they should really know better.

The Investment Disconnect

by Robert L. McMahon
02 February 2009

Investing America is clamoring for solutions to today’s financial calamities. Ordinary citizens who have been regularly investing in their college savings plans, retirement accounts and pension funds have taken a 50%, or more, haircut in their investment assets and both corporations and government are pointing fingers at one another assigning blame. There’s blame enough to go around for everyone involved, but how can investors ever trust again the firms they gave their money to only to watch that capital go off to money heaven? There’s a disconnect in investing America that needs some attention.

In his 2005 book The Battle for the Soul of Capitalism, Vanguard Fund founder John Bogle tagged this disconnect the way Joe DiMaggio would tag a low and outside fast-ball when, in writing about the corporate and investment scandals of 2000 to 2003 he revealed a stark truth about nearly all the investment firms we give our money to on a regular basis:

“…there is little, if any, evidence that (these) professional investors took with any seriousness the ownership responsibility of the institutions that employed them or understood the due diligence required of security analysts. These institutions were part of no scandal, except the scandal that they failed to do their homework on the stocks they were buying and selling each day, and the scandal that they failed to speak up for the interests of the last-line shareholders – the mutual fund owners and the pension beneficiaries – they were duty-bound to serve. The participation of our private financial institutions in corporate governance was close to nonexistent.”(emphasis added in bold by this author)

The key word in the indictment above, to my way of thinking, is “ownership”. These investment firms, in all their forms, represent the largest pools of investment capital ever amassed anywhere, yet they demonstrate no interest in acting as owners for the benefit of our invested dollars; again it’s this disingenuous disconnect that bothers me.

As an illustration of this disconnect consider that there is a company in the S&P 500 index today that has been the subject of regulatory investigations, senior executive resignations (including two CEO’s), an options back-dating investigation, has been categorized as a delinquent filer, doesn’t hold regular annual meetings, offers no voting rights to Class A shareholders, doesn’t offer proxy access to Class A shareholders, and is essentially a controlled company – a company where there is no meaningful separation between the board and management, and is controlled through the voting power of the non-trading Class B shares held by the owners and senior management. This company, according to the records at The Wall Street Journal Online, lists the top ten largest institutional shareholders with a combined investment of nearly $4.5 billion of the Class A shares.

If this company were to implode tomorrow due to these documented governance failings and that $4.5 billion went up in smoke – your money and my money – what possible excuse would these institutional titans of investment acumen provide to you and I for selecting this Frankenstein stock as an investment opportunity? None would be the correct answer, because that is essentially the non-response they gave when Enron, Tyco, Worldcom, Adelphia, Global Crossing, Fannie Mae, Freddie Mac, Parmalat, Satyam, Merrill Lynch, and Lehman Brothers imploded. And they keep telling us that there’s an SEC out there!

The professional investors we entrust our assets to continue to demonstrate that the corporate governance quality and character of their investment selections is unworthy of their consideration. And here lies the proverbial disconnect you can drive a bus through; for as governance failings continue to blow our retirement dollars away, investment firms are reluctant to educate themselves in assessing governance risk and it certainly seems willful on their part.

Measuring the Intangible of Corporate Character

by Robert L. McMahon

January 22, 2009

If we ever needed more evidence that the subject of corporate governance really does matter, the past month provided multiple exhibits in the form of office furnishings. In January we learned that John Thain, the former Chairman and CEO of Merrill Lynch, had shareholders foot the bill for his office renovation to the tune of $1.22 million. As egos go, John Thain makes Dennis Kozlowski –of Tyco infamy – look like a rank piker for having his shareholders pay $6,000 for a shower-curtain; John had shareholders cough up nearly $180,000 for a rug and two chairs.

Listening to Charlie Gasparino on CNBC enumerate the lavishness of John’s executive cubicle we collectively giggled to ourselves at the juxtaposition of it all – a 53 year-old executive, a recognized financial leader, a hired reformer and cost-cutter – being outed as someone with an immense sense of his own personal grandeur; here’s a guy who takes himself very, very seriously. So serious in fact, that he requires a $1,400 “parchment” waste basket.

While watching this train-wreck though, the question that immediately came to my mind was, “where was the board during all this decorating?” Wouldn’t they have to approve this lavish embellishment of corporate ego? And then I remembered that John was both Chairman and CEO. Having held both positions gave him a very high-hand in matters of what actually gets revealed to the board for review and consideration, as well as what he could do without their consultation. What do corporate governance experts recommend? That the two functions, in fact, be separated for precisely these reasons.

In then reviewing the composition of Merrill’s old board, I was struck by the sheer lack of pertinent Wall Street know-how: there were two academic leaders, a college president and a former Cambridge provost, an “adviser” to a brewing company, a real estate development executive, a retired admiral and former diplomat, an insurance executive, a retired law partner (she did work for the SEC in the 80’s, but we know just how ineffective that place is), a private equity executive, and the co-founder and co-executive director for “The Center for Adoption Policy”.

Boards are extraordinarily important to our financial system. They are supposed to be working for the shareholders and investors in overseeing management and protecting shareholder wealth. Just how accountable and effective is a board that allows its CEO to decorate his or her office in a manner more accustomed to that of a monarch? And just how is this viewed by the investment professionals we trust our hard-earned retirement dollars to? Do they even care about the corporate governance quality of the companies they invest our money in? And just how is that demonstrated to us?

As an investor in mutual funds for my retirement I’m disgusted with what I have seen these last 10 years or so regarding Wall Street, corporate corruption and an impotent regulatory system. If our financial industry is to ever regain the trust of its citizen investors it had better start demonstrating that corporate governance quality genuinely matters. We have seen how figures lie and liars figure when assessing the usual suspects of financial analysis, but what is never quite expounded upon is the corporate character of the company being analyzed.

We were fooled by John Thain’s business persona and his resume when looking at him. It took the revelation of his office decorating to reveal the real man behind the suit. But what was also revealed were the intangible corporate character flaws of Merrill Lynch: an ineffective board, joined roles of chairman and CEO, lax disclosure, and limited transparency. The intangibles of corporate character form the foundation of our financial system and if we aren’t examining them, measuring them, and questioning them we will continue to be entertained by the John Thain’s of the world. And John, please write a check to Bank of America.

Howard Beale Meets Wall Street and He’s Mad as Hell

by Robert L. McMahon

17 January 2009

Much like Peter Finch’s last role in the 1976 film “Network”, the mad television news anchor Howard Beale, I’m mad as hell and I’m not going to take it anymore!

Recent months have delivered a horror show for the U.S. economy. Corporations, investment firms, and banks have all been dragged before the klieg-lights of inquiring minds asking the same litany of questions, but all boiling down to “How could this have happened?” It’s all very apparent and simple really; boards have stopped functioning as guardians of shareholders and have become the enablers of over-egoed management. I could say something about our governmental and regulatory leadership too, but that might really frighten people; board members are supposed to be the adults in the room who are there to prevent government and regulatory authorities from getting anywhere close to being involved in the business of America.

We can all point to that moment in 2001 when Enron flew into the pages of financial news and corporate governance became part of the regular news-cycle, but does anybody outside of a parochial circle of governance professionals genuinely have an appreciation for just how important this subject really is? One would think that investment firms that manage the wealth for millions of Americans would be at the forefront of assessing corporate governance; John Bogle, the founder of Vanguard, has said that these firms should be the first line of defense due to their unique status as fiduciaries, but clearly they are just as equal to the title of enabler as “board member” has become.

This year we saw Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers, Merrill Lynch, Bank of America, Citigroup and the entire American auto-industry fall off the edge of a cliff due to failures in corporate governance and heard nary a peep from securities analysts, portfolio managers, mutual fund managers, asset managers, or anyone else from the investment management community about these failures sitting in all our funds and portfolios.

Now, I’m not a portfolio manager or a securities analyst in the industry. I do not hold an MBA degree or a CFA charter. I’m just a guy who’s curious. I like looking at things like board composition and the “demonstrated competence” thereof. Let’s take a walk down the composition of Citigroup’s board. I won’t use any names as it’s not my intent to embarrass people, but to point out just how under-equipped they are for the task at hand.

Citigroup’s board is jammed with people who do not possess any direct, hard, real, operational commercial banking experience. We have a finance and investment banker, a portfolio and hedge fund manager, a hospital manager, an aluminum executive, an oil executive, an MIT professor and former CIA director, an international bank executive, a chemical executive, an electronics executive, a media executive and lawyer, a lawyer for IBM, a non-profit president, another investment banker advisor, a medical device executive, and a consultant/lawyer for a non-profit. These are the folks who must meet and oversee the management of one of the most complex financial conglomerates in the known galaxy, but I can almost bet none of them worked as a bank-teller, much less a commercial lending officer. Can we see why Citi is a $3.00 stock now? Sadly, if I were do the same for Merrill Lynch, Bank of America, Fannie and Freddie and the auto industry the list would be very similar

However, when I look at a board like General Dynamics’, I see a much tighter alignment of qualifications. The board here has people that directly understand what the company produces, how the products are used, how they’re financed, and how the company must work closely with the U.S. government to manage product development. Here one can appreciate having a retired Air Force General and Admiral on the board, but I do not see the value add of having a retired Army General on the board of Bank of America. The mission of BofA’s board is not to fight our enemies, develop weapons systems or stroke the ego of its chairman who simply likes to have popular people around him.

As I said earlier, I’m not an investment professional overseeing other peoples money; I’m just a guy asking questions whose fed up with the “supposed” professionals who are treating lapses in governance with benign neglect. Why aren’t we seeing or reading about investment pros railing at the leadership of these companies? Where’s the outrage? I don’t see any anger expressed by these pros at the leadership of the companies they continue to shovel our hard earned dollars into.

Here’s what I want: I want to see bank boards have people on the board with banking skills, not diploma pedigrees. I want to see heavy industry boards with people who are not perfume executives, or leaders of the center for “pick-a-cause”. I’m mad as hell and I’m going to be watching all of you!