When John Bogle Speaks, People Should Listen!

By Robert L. McMahon

Yesterday The Corporate Library sent out a great Tweet regarding John Bogle, the founder of The Vanguard family of mutual funds, titled JACK BOGLE ON THE SILENCE OF THE FUNDS. The man who created index fund investing was speaking at the CFA Institute in Boston and ardently implored institutional fund managers, at all levels, to get off their collective duffs and pay closer attention to corporate governance.

One would imagine that if you're investing trillions of dollars for the future benefit of millions of Americans a duty of care would be exercised whereby you would know as much as possible, not only about a company's balance-sheet and income-statement, but that the company has an educated, experienced and effective board; that this board is not a rubber-stamp for management, that their are competent compensation, governance, and accounting committees; that the firm doesn't have pending legal issues that would compromise earnings, and is generally compliant with state and federal regulations. How about that the company offers shareholders "voting-rights"? But Mr. Bogle addressed the issue that mutual and pension fund managers have no interest, incentive or motivation to follow any of these governance issues.

In Mr. Bogle's address to the CFA he admonished mutual and pension fund managers for moving away from their "own-a-stock" outlook to a more "rent-a-stock" perspective. The Corporate Library reminded readers of the fact that average portfolio turnover now is 100%. Mr. Bogle urged professional investment managers to return to a long-term point of view and even supports the reinstatement of Glass-Steagall - the seperation of investment & commercial banking.

Mr. Bogle's final swings at these large money management firms was in calling for them to take corporate governance into consideration in the securities analysis process and would support legislation that would establish a "fiduciary responsibility" for the industry. Now there's some change I can believe in!

Improving Corporate Governance: A Memo to Investment Managers

By Robert L. McMahon

On May 10th John Brennan, Chairman Emeritus of the Vanguard Mutual Fund Company, penned an Op-Ed for The Wall Street Journal titled, “Improving Corporate Governance: A Memo to the Board”. In his piece Mr. Brennan makes eight (8) suggestions that Board Members can undertake to enhance company performance and improve overall governance; all of his advice should be well taken and understood to be well meaning for board members and shareholders alike.

However, when I saw that it was Mr. Brennan writing this piece about corporate governance I held out hope that he would also take the time to address issues of corporate governance from the perspective of an investment manager. I was looking for Mr. Brennan to weigh-in much like John Bogle has by saying that investment managers, like board members, need to be engaged in looking at the “governance characteristics” of the firms within which they are investing other peoples’ money.

Ironically, as Mr. Brennan was writing his piece, congress has found itself considering financial reform legislation that deliberately omits the two firms – now in conservatorship – at the heart of the financial crisis: Fannie Mae (FNM) & Freddie Mac (FRE), the two huge mortgage giants that nearly destroyed our economy. Even more ironic these two GSE’s (Government Sponsored Enterprise) were publicly traded firms, in the S&P 500 index, and were widely held by nearly every index, pension, and mutual fund in America. But as far back as 2002 any equity analyst or portfolio manager could have learned that these two firms were abject corporate governance disasters rivaling Enron. In fairness to FNM & FRE, they did work to improve their governance profiles since 2002, but there wasn’t a great deal of consistency to the effort. By 2007/2008 they had slid all the way back to rock-bottom per GovernanceMetrics (http://www.gmiratings.com/) governance reports. In 2008 we saw FNM and FRE fall to price levels that would not have bought you a copy of The Wall Street Journal as we saw the prices dip below $2.00 a share.

Incredibly though, between 2002 and 2008, we saw no major fund or portfolio manager call out the risks these two firms presented to the financial community and their investors in general. We didn’t see S&P look to remove them from their most widely tracked index (S&P 500), and we repeatedly saw congress look to minimize and mitigate the risks to the mortgage and credit markets these two presented even as everyone knew they were exempt from regular SEC filing standards and their executives were compensating themselves via accounting games designed to make their earnings look better than they actually were.

It simply isn’t the sole responsibility of the Board to keep an eye on corporations. I would additionally say that investment professionals should be a force in readiness to assess the risks when investing the hard earned money of working Americans. There needs to be a fiduciary standard of care for investment managers that requires them to assess the corporate governance risks of companies they buy and sell for our long-term benefit.

Fiduciary Standards and Financial Reform

In recent weeks the words "fiduciary standards" has been elevated in the discussions surrounding financial reform and this is good. Largely these discussions have centered around Financial Advisers and Brokers though and not around where the largest pools of capital are invested - mutual funds and asset managers.

With respect to the discussions involving FA's and Brokers, largely the discussions come around to the "appropriateness" of certain investment asset classes for their clients, disclosures of fees and compensation, and whether or not the FA/Broker is putting the interests of their clients first and foremost. One would think that 70 years after the Investment Adviseries Act of 1940, 76 years after the Securities Exchange Act of 1934, and 9 years after Enron, Tyco, Worldcom, Global Crossing etc... looking out for the investors' interests would have been settled. And naturally what adds to the complexity for these two differing investment managers is that one is regulated directly by the SEC and state regulators - FA's, and the other falls into the category of SRO - a self-regulated organization under the Financial Industry Regulatory Authority, or FINRA - Brokers. And FINRA and the SEC both played large parts, for 20 plus years, in doing very little regarding the Madoff affair. So good luck with those fiduciary standards.

My concern with fiduciary standards has more to do with ideas expressed by Vanguard founder and "Grand-Old-Man" of low-cost mutual fund investing, John Bogle. Institutional fund managers and fund firms - the single largest owner-shareholders of stock in America, and worldwide, need to get more involved in corporate governance than they have been previously. When John Bogle looked back at the investment crisis earlier in this decade that gave rise to the costly and dubious legislation known as Sarbanes-Oxley, he saw a crisis not only in the idiocy that transpired in corporate America, but in the army of professional investment managers in this country who should have known better when assessing a potential company for investment selection.

In Mr. Bogle's view, these investment professionals should have been a first line of defense in uncovering some of this corporate foolishness and accounting lies, but because of inherent internal conflicts of interest, a lack of fiduciary duty, and near industry-wide view that corporate governance is for bow-tied, loafer-wearing academics in law schools a blind-eye was turned to red-flag issues that could have raised questions about Enron's accounting, Tyco's rubber-stamp board, out-sized options dilution, etc...

The subject of Corporate Governance is not just a topic for social activists and public-policy wonks to discuss at cocktail parties. Investment professionals have to take Corporate Governance into consideration as an investment risk. The same people who wouldn't buy a $500K or $1,000,000 home without it being inspected professionally are the very same people who are perfectly willing to take $500 million of other peoples money and invest it in the next Enron. This has to stop and bringing a fiduciary standard to the mutual fund and asset management industry would be an excellent way of starting.

Bank of America and the SEC Part II

The other aspect I would like to address here is the SEC’s relentless push to have BofA grant proxy access to shareholders – essentially the right to nominate directors – even if those parties hold as little as 2% of the company. Why are they targeting BofA like this? Is it because the SEC wants to have some good PR and BofA is an easy target? Bank of America didn’t have a dual-class stock structure, didn’t withhold voting rights from shareholders, and possessed a largely independent board back in 2007 and 2008. The problem with the old BofA board was that they were largely uneducated in banking and genuinely didn’t have the right mix of knowledge to be an effective board.

If the SEC were serious about shareholder rights, shareholder proxy access and investor reform, they would be targeting firms that don’t provide shareholders with a vote in director elections, or better yet, gives shareholders rights through one class of stock, but then mitigates the voting through a “dual-class” stock structure. What’s worse Ms. Shapiro, no voting-rights or watered-down voting-rights? How about companies with large block holders of 50% or more? How about controlled companies SEC? Where do you come down on the advocacy train for companies that are largely run by insiders, for the benefit of insiders?

Hey, I’ll make it easy for you; here are a few names you can win some headlines with if you’re serious about shareholder-rights and proxy access:

Apollo Group (APOL), Kelly Services (KELYB), Bio-Rad (BIOB), Expedia (EXPE), IAC/Interactive Corp.(IACI), Federated Investors (FII), Google (GOOG), Mead Johnson Nutrition (MJN), and New York Times Company (NYT)

And much like Fannie Mae and Freddie Mac, several of these names are in the S&P 500 index and are therefore widely held by every mutual fund company and pension fund around the world.

Bank of America and The SEC

Why is Bank of America first and foremost in the SEC’s mind? Here’s a company that helped prevent a potential calamity in our financial economy with its acquisition of Merrill Lynch, but has morphed into being a whipping post for capitalism in America it seems. How come the SEC isn’t focused like a laser-beam on Fannie Mae and Freddie Mac, the two government sponsored entities that really pushed the financial markets to the brink of disaster. Oh, right; they’re both effectively delisted now and placed in government “conservatorship”. Having gone from a high of $86.75 in December of 2000 to a low of $0.33 in November 2008, the SEC (and congress) wouldn’t want to remind us that Fannie Mae (and Freddie Mac) were exempt from SEC filing standards for years while they both sat in the S&P 500 index and wound up being large holdings in everyone’s 401(k) and mutual fund.

To put some numbers around a comparison of BAC and FNM let’s consider the gains and losses of each. Being a shareholder of BAC your shares would have gone from a high in Dec. 2006 of $53.87 to a low in Feb. 2009 of $3.95, a percentage loss in value of over 1,360%. With FNM you would have gone from a high of $86.75 in 2000 to a low of $0.33 in Nov. 2008, a percentage loss of over 26,000%. On the upside with BAC, your $3.95 stock has now increased in value by some 402% to close recently at $15.88 a share. With FNM your stock would have gone from $0.33 to $1.02, a gain of 309%. And the SEC is asking for $150 million from Bank of America?

By two other measures BAC is on the road to profitability – it has repaid its TARP funds with interest to the tax-payer and it’s acquisition of Merrill Lynch has turned a profit for shareholders. On the governance front, BAC has settled one of the most politically driven SEC suits in memory for $150 million and has seen its CEO, Ken Lewis, forced into retirement for essentially agreeing to acquire Merrill Lynch and swallow all its mounting losses at the behest of the federal government; who then had the gall to turn around and sue the firm for doing its bidding, thereby providing political cover for congressional crony capitalism. In fact, FNM and FRE had their loss ceilings raised just before Christmas weekend by some $400 billion. Which means that the tax-payer is being made more liable for more congressional folly. So tell me again why Bank of America is the bad guy here to be persecuted?

One has to marvel at the argument that what BAC did put shareholders at risk when congress has been placing shareholders AND tax-payers at risk for years vis-à-vis the lies that were Fannie Mae and Freddie Mac. Again, it’s all about the “misdirection” – keep the klieg-lights shining on all those bad old capitalists and off the dolts in congress who have foisted this economic calamity upon America.

Letter to Elizabeth Warren Regarding Her WSJ Op-Ed

In today's WSJ Elizabeth Warren, Harvard Law Professor and Chair of the TARP Congressional Oversight panel, penned an Op-Ed I thought a tad too one-sided (it is addressed to her Assistant at Harvard University):

Dear Ms. Bateson:

In reading Prof. Warren's piece today she went after Wall Street bankers and such very well, but she left out Fannie Mae, Freddie Mac, HUD, and congressional policies of the last 25 years that have essentially weakened lending standards. Banks, as we all very well know, are in the business of making money and not squandering capital. For years they resisted the pressure brought to bear by congress and special interest groups to extend credit and other installment based financing vehicles to the masses who could least afford them. All of this was done with the best of intentions, but the unintended consequences have come home to roost.

I certainly don't want to sound like I'm defending Wall Street - the lack of leadership I saw (or didn't see) was stunning, but they are only one of the spokes in this wheel of a financial disaster. When the government encourages banks and financial services providers via legislation or lawsuit to facilitate risky business practices the shareholders and the tax-payers pay the price - and the shareholders pay twice! The policy-makers and law-makers never seem to accept any responsibility for their ill-conceived ideas that they foist on the citizenry.

The derivatives expansion grew as a result of trying to better manage the outsized risks that bad policies and bad loans infused into the financial system - again, a symptom of the process and not the infection itself - by pooling the risks and spreading it out around the whole market. But these instruments get created by a select few and are understood by even fewer. Many of them do not trade on exchanges, have no quote system, aren't settled electronically, and are sometimes one-off counter-party agreements. Couple this with conflicting regulatory policies like FAS 157, potentially marking thinly traded OTC derivatives to "zero", Basel II capitalization requirements, Sarbanes-Oxley, the disparate understandings of "risk", readily accepted data standards to manage risk, a lack of reporting tools that automate risk reporting, and you have yourself the perfect storm of a financial calamity.

Perhaps we should all take a page from Congressman Barney Frank's book and believe that the federal government will back-stop everybody and let's roll the dice another time. I doubt J. P. Morgan himself was cavalier at all with his client's money.

Sincerely,
Bob McMahon

Andrew Cuomo - A Leading Enabler of the Financial Crisis

An oft quoted line I've been using these days is from the 2001 film, "Swordfish", which stars John Travolta and Hugh Jackman and goes like this: Gabriel Shear - "Have you ever heard of Harry Houdini? Well he wasn't like today's magicians who are only interested in television ratings. He was an artist. He could make an elephant disappear in the middle of a theater filled with people, and do you know how he did that? Misdirection." Stanley Jobson - "What the f--k are you talking about?" Gabriel Shear - "Misdirection. What the eyes see and the ears hear, the mind believes."

No better example of "misdirection", as defined by John Travolta's super-secret-agent Gabriel Shear, is what NY State Attorney General Andrew Cuomo is doing now in pursuing civil charges against two Bank of America executives, Ken Lewis and Joe Price. Once again The Wall Street Journal, in today's paper, has done America a great service in highlighting what AG Cuomo would like everyone to be misdirected from - his tenure as Secretary of Housing and Urban Development (HUD) during the Clinton administration.

It was during his tenure as HUD Secretary that he established new "Affordable Housing Goals" between 1997 and 1999 that required Fannie Mae and Freddie Mac - the two GSE's involved in housing and mortgage finance - to expand their mortgage portfolio by some $2.8 TRILLION over the next 10 years. These new goals required a loosening of lending standards and directly led to Freddie and Fannie's massive purchases of sub-prime mortgages. Today the US taxpayer is on the hook for the failure of these two GSE's to the tune of $111 BILLION and possibly hundreds of billions more down the road.

The WSJ reminds us that back in August of 2008 Wayne Barrett, writing in the Village Voice, raised some serious issues with Andrew Cuomo's tenure at HUD and can be summed up with his words, "the country will be living with his HUD mistakes, ill- or well-intended, for a long time to come." And so, again I ask, what damage(s) have Ken Lewis and Joe Price inflicted upon their shareholders when Merrill Lynch has turned a profit for the bank, repaid their TARP funds with interest to the tax-payers, the share price of BAC has risen by more than $6.00 a share, and Ken Lewis has resigned as CEO? What are these "sins" compared to Andrew Cuomo's failed policies at HUD that have ruined two publicly traded GSE's, crippled the mortgage market, and put the US tax-payer on the hook for hundreds of BILLIONS in liabilities? And he wants to bring this sense of sound judgement to Albany as governor?

New York State AG Cuomo and Bank of America

Although I am not a fan of the former CEO of Bank of America, Ken Lewis, the civil suit Andrew Cuomo is looking to bring against he and BofA's CFO, Joe Price, is about as blatant a political move as one could possibly imagine; think Eliot Spitzer all over again. Forgive me if I don't believe Mr. Cuomo's motives are solely directed by the plight of the shareholders of BofA; in the long-run they're fine.

The Wall Street Journal has a wonderful Op-Ed in the Saturday, February 6th paper titled BLAMING BANK OF AMERICA, which essentially lays out the political self-interest Mr. Cuomo is exhibiting in bringing this civil case against these two executives. I guess that Mr. Cuomo misses the irony in the fact that if Misters Lewis and Price were intent on defrauding shareholders by withholding pertinent facts about Merrill's losses in December 2008, they would also be defraudung themselves and throwing their own financial self-interest under the bus; not to mention their careers and whatever could be left to say about their good names.

Needless to say this doesn't cognitively register with a lawyer whose political ambitions are squarely centered on his own future within the Democratic party and the requiste requirements of making his bones on the backs of bankers in 2010; a very convenient target that deflects any blame from the GSE congressionally enabled idiocy called Fannie Mae and Freddie Mac - two recipients of TARP who will never pay any of the funds back in my life-time.

So let us count the ways Ken Lewis and Joe Price have harmed BofA investors: the acquisition of Merrill has turned profitable, BofA's TARP funds have been repaid, the price per share of BAC has increased over $6.00 a share since December 2008, and Mr. Lewis has subsequently resigned as CEO. I rest my case your honor....