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!