For the first time in my life, I got to teach a law school class last month. I was the guest of Frank Partnoy one of the best business writers I know. What's great about Partnoy is that he's worked on Wall Street, knows the law, understands economics -- he even explained (or tried to explain) derivatives to Senators -- and pulls no punches when it comes to criticizing the lax oversight of our financial institutions by Washington and by corporate boards. Partnoy's a fierce and independent thinker, unconstrained by deference or ignorance.
The first hour of his University of San Diego class was devoted to reviewing the law around corporate governance. What is required of a board director? What are directors indemnified against? What is their responsibility?
The second hour was mine and I spent it discussing how what the law proposes is not what, in fact, occurs. Boards are biased, too like-minded, made up of friends who are typically cronies uncomfortable with conflict. Worse still, in most of our leading corporations today, the positions of Chairman and CEO are held by the same person. This breaks all the basic rules of corporate governance, reduces the power of directors and is the single greatest cause of a lack of debate, challenge and constructive conflict within a board. And yet vast companies -- Exxon, Chevron, Procter & Gamble, GE, General Motors, in fact more than half of the Fortune 24 -- persist in this most obvious abuse. All of these companies whine endlessly and publicly about the onus of Sarbanes-Oxley and now Dodd-Frank but they don't take even the simplest step towards better governance. If you're hoping your investments will fund your old age, you should care mightily that they're so poorly overseen.
Our students seemed to relish this clash of theory and practice but afterwards Partnoy and I worried about how bad governance can be improved. That the law and reality scarcely meet may be entertaining but for investors, large and small, it can be devastating.
Give the Small Shareholder a Seat
"There are two things you could do," Partnoy proposed. "First: reserve one board seat for a small shareholder. This would need to be someone pretty tough, prepared to ask questions, hold their ground and not be easily swayed or impressed." A strong-minded private shareholder should ask hard questions, unconcerned to be part of the club and unwilling to be blindsided by jargon and ideology. Asking blunt common sense questions should generate clear, jargon-free answers. If it doesn't, everyone will know there's a problem. At least, that would be the intention.
Seat the Shorts
His second proposal was even more startling: "Ask a short seller to present to the board." Shorts make their money looking for flaws. They're forensic ferrets, skilled at probing strategies and numbers to find risk and exposure. It was, of course, short sellers who spotted Enron's implausibility and short sellers who saw that the banks were taking on too much risk.
More shocking than Partnoy's suggestions, though, is the response he's had to this one. Nobody will countenance having a short seller present to the board. Why? Because, they say, board members shouldn't be exposed to deep scrutiny and challenge of a kind that shorts do so well (and so profitably). It might scare them too much. Corporate leaders are afraid of the questions they might be asked and lack confidence in their ability to provide competent or satisfactory answers. That's a pretty troubling admission, blindness at its most willful.
My argument in Partnoy's class was that much corporate governance is feeble, ritualistic and can't work because it flies against everything we know about individual neuroscience and group psychology. The only meaningful counterpoise to that has to be a culture of challenge, debate and healthy conflict done well in the interest of shareholders. But if the leaders of organizations can't or won't countenance this, we're in bigger trouble than I thought.
This post has been modified since its original publication.