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.