The most interesting thing about Andrew Ross Sorkin's new book Too Big To Fail: The Inside Story Of How Wall Street And Washington Fought To Save The Financial System -- And Themselves is not his narrative of the behind-the-scenes gamesmanship that supposedly averted a total financial meltdown. That is interesting, yes, but the most interesting thing about the book is what it tells us about American corporate culture at the end of the last decade.
You see, by day, Sorkin is a business journalist at the New York Times. By night, Sorkin is the toast of Wall Street. Sorkin's closeness with Wall Street is well documented, and Sorkin does not deny it. Wall Street's luminaries, including many of the subjects of Too Big to Fail, feted Sorkin at New York's Monkey Bar last October. New York Magazine wrote a long profile of Sorkin that revealed, among other things, that titans of the financial world keep him on speed dial and that he, more often than not, eschews overt criticism of their activities.
Sorkin is close to Wall Street, so what? Well, it turns out that forms of Sorkin's comprised "reporting" are part and parcel of an American corporate culture that rewards insiders and excludes everyone else -- most glaringly, the shareholders (that's you and me). Like Sorkin's closeness with his subjects, our corporations are governed through a conflict-ridden system where impartial oversight is the exception, not the rule. If we want to clean up this system and restore shareholders -- who, after all, are a corporations' owners -- to their proper place, we need to get serious about solving the following three glaring conflicts.
Directors Are Often Controlled By Management
The problem starts at the most fundamental level: the entrenchment of corporate management. When managers get entrenched, they start to run a corporation like their own little (or big) fiefdom. The counterweight to management entrenchment is supposed to be vigilant "directors" (the people who sit on the corporation's governing body). Corporate boards are supposed to do things like establish performance guidelines, set management's compensation, and hire good, competent managers (and, conversely, get rid of bad, self-serving, managers).
However, the ability for corporate directors to effectively and impartially police management's activities has been eroded by the control that management exercises over directors. There are three principal ways that management's control is exercised. First, in many corporations, the Chair of the Board of Directors is also the Chief Executive Officer of the corporation. In other words, the corporate board is headed by a manager. In addition to the CEO, other managers, or friends of managers, often serve as directors as well. Most state's law require a certain number of "independent" directions, usually meaning directors that are not associated with management (you'd be surprised who is technically independent -- a subject for another post) but the CEO, as Chair, wields considerable procedural power and often exercises that power in favor of his management team. Second, board members nominate themselves (even the independant ones). More often than not, management (the CEO, for example) has an inordinate say in who the board nominates to be a director. Directors are usually paid tens of thousands of dollars for their service, so there is a natural tendency to go along with management lest a director ends up not re-nominated. Third, in most states, corporations are not required to give shareholders access to management's proxy. Management spends tens of thousands of dollars sending out proxies featuring the directors its used its influence to help nominate and shareholders are only allowed to accept or reject management's selection of directors and cannot suggest their own. To illustrate how this system works against shareholders, Gretchen Morgenson, a New York Times business columnist, recently wrote a great piece demonstrating that management-friendly directors seem to swiftly move from one imploding corporation to another. Wall Street won't be feting Ms. Morgenson anytime soon.
Shareholders Can't Remove Bad Directors
When it comes to the actual election of directors, a series of conflicts and structural problems erodes the ability of shareholders to vote out bad directors. Most states do not require a majority vote for uncontested directors, meaning that if all directors are uncontested (which they usually are, since shareholders cannot nominate their own directors), directors do not have to be approved by a majority of shareholders, only a plurality. Likewise, in most states, shareholders cannot vote against a director but can only withhold their vote. The effect of not being able to vote against a director combined with the plurality voting standard is that so long as one shareholder votes "yes" the director is elected: essentially, withheld votes don't count. Some large corporations have recently voluntarily adopted majority voting standards which essentially count withheld votes as being against a director but there is no requirement that corporations require majority voting. Finally, in some corporations, the shareholders' vote is only advisory, and the board is permitted to reject it and simply reappoint ousted directors.
Several other factors conspire to make the election of directors a forgone conclusion. First, most shareholders don't vote (you know you're guilty of tossing proxies, unopened, into the trash). If a non-voting shareholder holds their shares through a broker, as many retail investors do, brokers have been permitted to vote the shareholder's proxy in uncontested director elections without asking the shareholder how they wish to vote. A serious conflict arises here because brokers tend to work for financial institutions that are retained by corporate management for numerous other services. Thus, the "broker non-vote" inevitably votes with management. In many cases, the "broker non-vote" was enough to elect a director even assuming that some shareholders contentiously withheld their votes from a director or voted no, where permitted. A new New York Stock Exchange rule bans broker non-votes in uncontested director elections by NYSE registered brokers. The elimination of the "broker-no vote" combined with a requirement that directors receive an actual majority (and a few companies already require directors to receive a majority, not a plurality, of the votes cast) means that directors now have to solicit shareholders for support. It's a good start.
Can't determined shareholders just spend the money to run their own proxy campaign with their own slate of dissident directors? Well, for all practical purposes, no. First, it's extremely expensive to run a proxy campaign. In addition to the costs of printing and mailing proxies and soliciting votes, dissident shareholders need to hire lawyers to advise them on the corporation's by-laws governing director elections, and those costs are rarely reimbursed (and are certainly not reimbursed if you lose). Second, even if dissident shareholders overcome the procedural hurdles, most large institutional investors (hedge funds, pension funds, etc) use what are known as "proxy advisors" who, more often than not, advise their clients to vote with management. Proxy fights are notoriously difficult to win.
There is No Independent Review of Executive Compensation
Executive compensation got out of hand due to similar conflicts that prevented directors from hemming in management's outlandish demands. First, in most states, shareholders do not vote on compensation (despite the catchy name, shareholders have no "say-on-pay") so management's friendly directors do what friends do - give their friends exorbitant pay packages. For good measure and because the board has a fiduciary duty to act in the best interest of shareholders, most companies retain "compensation consultants" who advise the board how much to pay management. But those compensation consultants are themselves conflicted because, often, the consultants are doing lucrative work for the very managers whose compensation they are supposedly setting. Under most states' law, there is absolutely nothing wrong with that dual role (although sometimes the conflict needs to be disclosed to shareholders).
It's important that the public, whether investors or otherwise, realize how the current conflict-plagued system of corporate governance prevents shareholder democracy. I know there are conflicts out there other than the four I identified, and I'd love any suggestions (in the comments section). For example, some of the nefarious ways managers maintain control of a board, like through creating a "staggered board" requirement in a corporation's by-laws, can be considered a conflict. (On a side note, it's the inability of shareholders to suggest by-law changes that tend to be the cause of many similar problems, but that's a complex subject that I'll save for a future post.)
So can we reform the way our corporations are governed? That brings me back to Sorkin. Americans know there is something untoward about a business journalist being so close with the people he covers. Americans will (hopefully) learn, if they don't already know, that the current conflict-ridden system of corporate governance is ill serving shareholders by entrenching corporate management. Once Americans realize this, will they be content to look the other way and believe that, somehow, corporate governance just magically works? Or will they agitate for reform? I don't know. However, I know that although Wall Street maybe too big to fail, corporate governance reform is just too important to fail.