The devastating financial crisis of 2008 has claimed another casualty: trust in leaders of America´s most important financial institutions.
Gaining the trust of the people is essential for every leader. Leaders cannot be effective without full confidence of the constituencies that grant their institution its legitimacy, nor can capitalism function without trust. Trust is “the coin of the realm.”
According to the just-released 2008 survey taken by the Center for Public Leadership at Harvard Kennedy School, an astounding 80% of the American people believe we have a leadership crisis in the country today. Unless we get better leaders, 79% feel that the United States will decline as a nation.
Business leaders rank near the bottom of the list, with only 45% reporting confidence in them, down from 59% last year. Only Congress and the President fare worse. In contrast, military leaders have the confidence of 71% of the people surveyed, making it the highest group in the survey.
This decline in confidence in business leaders is extremely worrisome. Not surprisingly, given the current fiscal crisis, the trust issue is most acute among leaders of financial institutions. If we can´t trust in the people who invest our life savings, who can we trust?
For many leaders, the criticisms are well deserved. The heads of failed institutions like Lehman, AIG, Bear Stearns, Countrywide Financial, Fannie Mae, Freddie Mac, Wachovia, and Washington Mutual have done a great disservice to their clients, employees, shareholders, and the nation. It is a disgrace that the U.S. government has had to bail out so many firms to keep the financial system from unraveling.
To their discredit, many of these leaders opposed to mark-to-market accounting rules, regulation of credit default swaps, greater transparency for hedge funds, or insisting that mortgage bankers obtain financial statements before granting mortgages.
These failures were not caused by complex financial instruments. They result from failures in leadership. Heads of the failed firms forgot two basic principles of business: to sustain success, firms must serve their customers well for the long-term and contribute to ensuring healthy markets.
These principles have been central to successful Wall Street leaders for generations. Former CEOs Walter Wriston of Citigroup and John Whitehead of Goldman Sachs always believed clients´ interests and sound capital markets were essential to their firms´ success. So did Treasury Secretary Henry Paulson in his investment banking days. Warren Buffett has consistently spoken out about the problems financial firms were getting into, but few were listening to him, in spite of the enormous success of his firm, Berkshire Hathaway.
In recent years, financial firms engaged in a mad rush to justify high fees for managing clients´ money by producing outsized short-term returns. This caused many leaders to lose sight of the importance of protecting their clients´ long-term investments and their financial security. In the scramble to make money for themselves, the failed firms underpriced risk and relied upon excessive leverage – in excess of thirty-five times as much debt as equity. Gambling with their firms´ futures, these failed leaders created massive short-term gains, followed even greater losses, and wound up putting their firms out of business.
No wonder the public has lost confidence in business leaders.
The wisdom of President-elect Barack Obama applies here when he said about the war in Iraq, “I don´t just want to get our troops out of Iraq. I want to change the mindset that got us there in the first place.” In Wall Street´s case, it´s not sufficient to get out of the mess we´re in. We need to change the mindset that led to these problems, so we don´t repeat them in the future.
Correcting the system´s immediate shortcomings, as hard as that will be, is insufficient. We need leaders who can envision the way 21st century global financial markets must function to maintain stability and serve all participants fairly. Wall Street leaders must work with their government counterparts to put in place institutional rules and oversight to guarantee that markets function smoothly in the future, even under the most extreme circumstances.
We cannot solve problems of this magnitude simply by replacing today´s leaders with people who think and act just like them. We need new leadership and a new mindset for leaders of America´s great financial institutions. Their new leaders should have five characteristics in common:
- They should be authentic leaders, focused on serving their clients and all the institution´s constituents, rather than charismatic leaders seeking money, fame, and power for themselves.
- They should place the interests of their institutions and society as a whole above their own interests.
- They should have the integrity to tell the whole truth, admit their mistakes, and acknowledge their shortcomings. Authentic leadership is not about being perfect. It is having the courage to admit when you´re wrong and to get on with solving problems, rather than covering them up.
- They need to adapt quickly to new realities, changing themselves as well as their institutions, rather than going into denial when things don´t go as intended.
- They need the resilience to bounce back after devastating losses. Resilience enables leaders to restore trust by empowering people to create new solutions that build great institutions for the future.
Some of these leaders have already emerged on Wall Street. The short list includes J. P. Morgan´s Jamie Dimon, Wells Fargo´s Dick Kovacevich, Goldman´s Lloyd Blankfein, and Morgan Stanley´s John Mack. Their firms participated in the same markets as did the failed firms, and used similar financial instruments.
What´s the difference? They kept their clients´ interests paramount, took a more prudent approach to risk and leverage, kept their accounting conservative and transparent, and focused on long-term sustainability.
This short list is insufficient. What´s required is a new generation of authentic leaders to step up to leading America´s financial institutions. These new leaders must be committed to shifting away from short-termism to focus to long-term results for their clients and their firms and to ensure sound, enduring capital markets for our country.
Only then can the financial community regain vitally needed trust and confidence of the American people. And only then can we be assured that we won´t be back in a similar mess in a few years.
As the financial crisis continues to whipsaw the markets, the question we need to ask is: “Where were the boards of directors of Lehman, AIG, Bear Stearns, Countrywide Financial, Wachovia, Washington Mutual, Fannie Mae and Freddie Mac?”
Were they lulled into complacency by their CEOs? Or did they lack the insight to see that their firms had placed themselves in great peril if there were major disruptions in financial markets? Or were they looking at computer models rather than applying the judgments they were selected to make?
Regardless of the reasons, the boards of directors of these firms are directly responsible to their shareholders for the firm’s viability and survivability, and they should be held accountable for their failures. Yet no one is focusing on how these boards failed to exercise the fiduciary duties they assumed when elected by the shareholders.
If history teaches us anything, it is that financial markets can and will gyrate wildly from time to time. Of all corporations, financial institutions must keep their balance sheets and cash balances in line to weather the kind of storms we are currently experiencing. The bursting of the housing bubble was predicted back in 2006 and the excessive debt consumers were holding was also evident. Yet, the directors of these firms kept approving higher and higher levels of leverage as the storm clouds grew ever darker on the horizon.
Even the early signs that the housing bubble had burst in early 2007 were ignored. Didn’t anyone notice the filing for bankruptcy protection of mortgage lender New Century Financial? By taking on the same kind of mortgages, wasn’t it obvious that Countrywide Financial would be next – forced to sell itself to Bank of America after its stock declined 85% — and would drag down the banks that were repackaging these mortgages as AAA securities?
My Harvard colleague Ben Heineman, former general counsel of General Electric, writes, “It is clear that the boards of our major financial institutions did not understand the risks the entities were taking.” He further asserts, “The boards of financial institutions did not choose CEOs wisely in recent years. The institutions pursued profits with overleveraged and ill-understood strategies and banished tough risk assessment from the center of decision-making.” Sad, but true.
Confirming Heineman’s thesis, a year ago a former colleague of mine joined the board of one of the world’s largest banks. At his first audit committee meeting he asked to see management’s assessment of the firm’s cumulative risks. He was told bluntly by the audit chair, “This bank is far too large to look at cumulative risks, as risk management is delegated to all our units.” In the following six months, the bank was forced to write off over $20 billion in losses, and the CEO had to resign.
In response to the Enron and WorldCom crises, the Sarbanes-Oxley legislation of 2002 , with its intended improvements in board governance, was rushed through Congress in just thirty-one days. Since then, we have witnessed the growing power of shareholder advisory firms like ISS that aim to improve board governance. Apparently, neither these firms nor Sarbanes-Oxley caused the boards of these failed institutions to step up their oversight of management and the risks it was taking.
Where were the board audit committees when management was rationalizing that their computer models gave the best indication of the value of their holdings, instead of marking them to market as required by “fair value accounting”? Some financial firms and politicians are now arguing that mark-to-market accounting caused the problem and should be abandoned. To the contrary, marking to market is the only way to force managers and boards to face reality and provide shareholders and debt holders with an accurate valuation of the firm’s assets.
If the government accepts this flawed line of reasoning and abandons mark-to-market accounting, we will not have learned anything from this debacle. As a consequence, we will have yet another crisis in a few years. The innovative financial instruments will be new, but the root cause will be the same: a focus on short-term gains enabled by the under-pricing of risk and inaccurate accounting. Doesn’t anyone recall the Nobel Prize-winning economists who brought us the Long-Term Capital Management fiasco in 1998?
In their failure, these boards of directors forced the Federal Reserve and the Treasury Department to step in and take over their responsibilities. As a result, it seems almost certain that the U.S. government will have to impose greater regulations on all financial institutions, and thereby assume some of the fiduciary responsibilities previously held by their boards of directors.
As capitalists, this is certainly not the outcome that any of us would have intended. But it is the logical consequence of what happens when boards fail in their responsibilities. The solution is not to diminish the responsibilities of directors, but rather to hold them accountable to fulfill their fiduciary duties and to enforce negative consequences when they fail to do so.
The current crisis on Wall Street is being characterized in technical terms that few Americans understand: subprime mortgages, credit default swaps, mortgage-backed securities, and CDOs.
But this is not a crisis caused by the failure of complex financial instruments. This is a crisis caused by the failure of leaders on Wall Street.
The heads of firms like Bear Stearns, Lehman Brothers, AIG, Countrywide Financial, and Washington Mutual all too often sacrificed their firms´ futures in order to maximize short-term gains. This meant under-pricing of risk in exchange for immediate fees and taking on inordinate levels of debt to invest in complex, highly uncertain instruments.
Compounding their errors, these leaders were unwilling to face reality when the value of their holdings tanked, as many declined to mark these instruments to market. Instead, they argued that their complex financial models yielded a superior valuation for their holdings. In some cases, this “mark-to-model” approach, or what Berkshire Hathaway (BRK.A) Chairman Warren Buffet calls “mark to myth,” led to their undoing as people inside or outside the firms had difficulty figuring out what their assets were really worth. Had they followed the long-term investing philosophies of Buffet, these firms would be still be around.
A financial failure? No, this is a leadership failure.
The first job of any leader is to preserve the viability of the enterprise. These leaders focused on short-term gains and large bonuses for themselves, instead of ensuring the survivability of their companies and building them for the long-term. In this sense, their behavior mimicked failed leaders from earlier in the decade like Jeff Skilling of Enron and Bernie Ebbers of WorldCom, except there is no indication here of any illegal actions.
In contrast, five leaders of financial firms stand out for their prudent leadership as they prepared for this crisis by anticipating the impact of systemic risks and emphasizing the long-term health of their firms: Dick Kovacevich of Wells Fargo (WFC), Jamie Dimon of JP Morgan Chase (JPM), Ken Lewis of Bank of America (BAC), Lloyd Blankfein of Goldman Sachs(GS), and John Mack of Morgan Stanley(MS).
- Wells Fargo´s Kovacevich built the nation´s leading mortgage banking portfolio by emphasizing sound lending practices and avoiding the unqualified mortgages that led to the demise of mortgage bankers like Countrywide Financial.
- JP Morgan´s Dimon and Bank of America´s Lewis kept their balance sheets clean and healthy so that they were prepared to purchase distressed firms like Bear Stearns, Washington Mutual, Countrywide, and Merrill Lynch (MER) at bargain basement prices.
- Goldman´s Blankfein and Morgan Stanley´s Mack built liquidity and carefully managed risks as their firms shifted to the bank holding company model.
When it comes to authentic leadership in this crisis, no one stands out more than Treasury Secretary Henry Paulson. As a member of the Goldman Sachs board since 2002, I had the opportunity to observe him at close range. Were it not for Paulson – and his adaptability, tenacity, and ability to get other leaders to face reality – the U.S. financial condition would be in far worse shape than it is.
When he took the Treasury post, Paulson never dreamed of bailing out Wall Street financial firms, because his primary focus was on restoring relationships between the U.S. and finance ministers around the world. As the crisis unfolded, he immediately stepped up to leading the country through it. Using skills honed for decades as an investment banker, Paulson was able to bring the administration and warring political parties to agreement on the $700 billion bailout package approved by the House on Friday.
Paulson is a fervent believer in the free market system, but he recognized that without U.S. government intervention, this crisis could topple our entire financial system. We can only hope these latest moves, coupled with government takeovers of failed institutions, are sufficiently strong to restore confidence in the market and rid the economy of excessive bad debt.
This is just the latest–and largest–in the once-a-decade crises that Wall Street goes through. We shouldn´t forget the savings and loan debacle of the 1980s, the collapse of Long-Term Capital Management in the 1990s, and the bursting of the technology bubble in 2002. Yet creative financial people continue to invent new models and new instruments that create short-term gains, often without understanding the pitfalls they represent.
Many pundits blame these problems on greed, but greed is nothing new. The underlying characteristic of all these fiascos is the same: brilliant managers who thought they could out-smart the market, instead of leaders with the wisdom to build sound firms for the long-term.
The boards of directors of the failed firms bear a heavy responsibility for their failure to select the right leaders and to monitor their actions. All too often they permitted high-profile, ego-driven leaders put their image and drive for power ahead of their responsibilities as leaders.
We will never avoid these problems until boards of directors start selecting authentic leaders to run their firms known for character, substance, and integrity. These attributes are essential if we want to restore the strength and primacy of the U.S. financial system and build our economy for the long-term.
The likely nominations of Republican John McCain and Democrat Barack Obama all but ensure major changes in Washington in the next four years. With the 2008 election intensifying, business leaders need to engage more vigorously in the national debate. It is time to be proactive in shaping the debate, not just in lobbying for our self-interests.
The consequences of the 2000 and 2004 elections suggest business leaders should be careful about what we wish for. All too often, seemingly obvious choices have long-term outcomes that have not been adequately considered:
- In 2000 we wished for tax cuts and got large deficits and widening income disparities.
- We wished for fewer regulations and got the subprime crisis and mammoth losses on Wall Street that forced firms to raise capital from sovereign wealth funds.
- We wished for a weaker U.S. dollar so we could export more and got rapidly escalating oil and corn prices as foreign governments preferred holding commodities over dollars.
- We supported invading Iraq and found our country trapped in a war we don´t know how to end and a $2-3 trillion price tag.
- We wished for a free enterprise health care system and wound up with health care costs that make our companies non-competitive and 45 million uninsured citizens.
- We abandoned the Kyoto treaty instead of renegotiating it and lost vital time as the global environment worsened.
As a result, trust in the president and the Congress, as well as business leaders, has fallen to the lowest levels of our lifetime. That should be a source of grave concern.
In every election, candidates promise great things to many constituencies in order to get elected. The danger in this election is that voters may get so upset with the current mess that the political pendulum swings too far the other way, causing politicians to devise hasty solutions that result in unintended consequences. (Does anyone recall the thirty-day legislation that produced Section 404 of Sarbanes-Oxley?)
The good news is that both parties are poised to nominate authentic leaders for president. These two candidates seem prepared to engage in an intense debate about what´s best for America for the next decade, instead of focusing on minor issues, false charges, and gimmicks.
The next president needs to face the realities of our current situation and level with the American people by describing the problems as they really are. Then we need presidential leadership to engage all of us in concerted actions to get America back on track. Business leaders should participate vigorously in this debate, going beyond our self-interests to focus on what is best for the country. We cannot sustain business success unless America is strong and our economy is healthy.
Business leaders should offer the new administration and Congress a thoughtful platform of implement policies and programs that will restore America´s economic strength and our standing in the global community. This requires us to address the broader issues that will ensure competitive companies, healthy markets, and equitable rules of engagement.
Specifically, we should advocate for:
- A fiscally responsible federal budget that strengthens our long-term competitive position in the world economy.
- Free trade agreements that enable U.S. companies to compete around the world while insuring our employees are fully competitive and have secure futures.
- A focus on innovative products and services to strengthen exports and provide domestic jobs.
- An education and training system that enables all citizens to have productive jobs providing livable incomes.
- An energy policy that reduces consumption, improves efficiency, and increases the proportion of supply from North American while creating breakthroughs in renewable sources.
- An efficient and competitive health care system that covers all citizens.
- A foreign policy in which the U.S. collaborates with other countries to restore world peace and strengthens our military without repeated military incursions.
A tall order? It is indeed. This agenda must be challenging because the problems are so great. We may not get there in the next four years but, to quote author Stephen Covey, we need to “begin with the end in mind,” so that we know we are heading in the right direction and making progress in getting there.
That´s the only way we can restore the confidence of the American people in business and political leaders. And it is best way to insure America and its business community is strong and vibrant.
In returning as Starbucks´ CEO, Howard Schultz follows in the footsteps of Steve Jobs, Michael Dell, and a long line of founders who turn the reins of their companies over to a hand-picked successor and wind up being dissatisfied with the results.
Conventional psychology tells us that founders like Schultz cannot let go of their babies, get frustrated being away from the action, and believe that only they can run the company. If the explanation were that simple, these returning founders would fall flat on their respective faces. Yet surprisingly, they do extremely well in their encores. To understand why, we have to look a lot deeper at what´s going on in these “redux” performances.
First of all, founders like Schultz, Dell, Jobs and others have a far better grasp than their successors on the essentials of the business and the internal people who make it go. Their initial success was based on brilliant intuitive skills that enabled them to create unique value for their customers and to inspire their employees. They combine that intuition with an unstoppable drive to see their business succeed and the ability to motivate their teams to peak performance. They are gifted leaders, even without formal management training.
On the other hand, successors like Jim Donald at Starbucks, John Scully at Apple, and Kevin Rollins at Dell were professional managers that specialize in the processes of management, but lack the creativity and passion of the founders. In attempting to install the type of discipline and systematic approaches that mark a company like General Electric, they fail to grasp what made the business successful in the first place and demotivate the key people who make the company go. Often, they spend more time in meetings than they do in the marketplace, and more time working the numbers than learning from their employees.
Let´s delve into these three cases in point to see what´s really going on:
- Howard Schultz built Starbucks around the principle that “satisfied employees create satisfied customers.” Even as chairman, he visited two dozen stores a week, just to observe the interplay between Starbucks employees and their customers. What he saw in the past year was deeply disturbing to him: in an effort to speed up service, Starbucks management put large, automated machines between the barista and the customer, thus taking away the charm and smell of the coffee-making process. All of a sudden, Starbucks felt more like a McDonald´s store. When Schultz wrote a confidential memo to his successor expressing this concern, he could not have been happy to see it leaked to the media.
- Steve Jobs got brutally forced out of the company he founded by Scully and the Apple board, not even being given the dignity accorded Schultz and Dell to stay as board chair. So founded Pixar and became highly successful in creating animated film. Meanwhile, the only thing sinking faster than Apple´s market share was its morale. The “cult” of Apple´s famed software geniuses was dying, as a succession of failed CEOs nearly put the company out of business. Upon his return, a wiser but no less creative Steve Jobs brought the magic back to Apple and transformed the company with the Ipod and Iphone. These days Apple investors are smiling all the way to the bank.
- Mike Dell built his franchise on low cost computers, distributed directly to customers. The company was wildly successful until his successor failed to master the need to provide service, especially to corporate clients. Over at Hewlett-Packard, Mark Hurd, Carly Fiorina´s successor, saw an opening and took advantage of Dell´s weakness. Without Mike Dell´s daily inspiration, morale at the company sunk rapidly and is only now beginning to recover under Dell´s second act.
These three examples, and many more like them, give us valuable insights into what makes companies successful. Simply stated, it is leadership. There is a plethora of skilled managers around who know how to manage budgets, analyze computer models, and run businesses with systems and procedures. Business schools are turning out more and more of them every year. All too often these analytically-oriented managers drive out the very leaders who make companies successful in the first place.
Brilliant leaders understand what it takes for their companies to succeed: inspired employees who can create great value for their customers. Instead of churning out numbers experts, our business schools ought to figure how to create more entrepreneurs who can follow in the footsteps of authentic leaders like Schultz, Jobs, and Dell.
The main cause of the messes at Citigroup and Merrill Lynch is their boards’ failures to develop authentic leaders and succession plans.
What were the boards of Citigroup and Merrill Lynch doing all this time? How often did they take a hard look at the leadership below Chuck Prince and Stan O’Neal to develop successors? Did they monitor the CEOs’ performances closely enough to know what was going on and understand the risks of not having succession plans?
It is astounding that a huge multinational such as Citigroup (C), which has 350,000 employees, has not been able to find a leader to succeed Prince. While fortunate to have former Treasury Secretary Robert Rubin as temporary chairman, the board still seems to be searching for that new superhero. (Insider Sir Win Bischoff is interim CEO while the search continues for a permanent successor to Prince.)
The board of Merrill Lynch (MER), meanwhile, moved rapidly to snag John Thain. With his deep understanding of markets and risk gained at Goldman Sachs (GS), Thain is the right leader to bring Merrill’s organization under control.
But why weren’t these boards grooming internal candidates for the jobs? Many observers have this odd notion that no one can lead these mammoth enterprises. Nonsense. They don’t need a Beowulf to slay the dragons but authentic leaders to unify the team at the top and rebuild trust throughout the organization. If the boards of Citigroup and Merrill Lynch insisted on this in the first place, they wouldn’t be facing their damaged state.
Unfortunately, these are just the latest examples of boards that failed to build solid leadership succession plans. Look at past problems at Morgan Stanley (MS), Coca-Cola (KO), Home Depot (HD), Hewlett-Packard (HPQ), and Procter & Gamble (PG):
- Morgan Stanley’s board let former CEO Phil Purcell force out agreed-upon successor John Mack and then purge most of Morgan’s top leaders. Only protests from former executives pressured the board to bring Mack back to put its house in order.
- When Coca-Cola’s Roberto Goizeuta passed away, the board promoted Douglas Ivester, who failed in less than two years. Then it compounded its errors by appointing Douglas Daft. After years of market-share losses, new CEO Neville Isidell is attempting to rebuild the company.
- Home Depot’s board passed over its executive team to recruit GE (GE) superstar Bob Nardelli, whose lack of understanding of the retail business led to market share losses. Outside pressure resulted in Nardelli’s replacement by Home Depot insider Frank Blake.
- Boeing’s (BA) board tolerated the ethical deviations of former CEO Phil Condit, turned to Harry Stonecipher, who had his own ethical problems, and finally woke up to recruit Jim McNerney from 3M (MMM). McNerney moved quickly to restore Boeing to world leadership.
- Hewlett-Packard went outside for Carly Fiorina, who failed to grasp the company’s culture. With HP’s stock price declining, the dysfunctional board mishandled Fiorina’s departure but recovered its wits to attract Mark Hurd. He rapidly restored HP’s egalitarian culture and its sales.
- Procter & Gamble’s board passed over A.G. Lafley to promote Dirk Jager to the top job and “shake things up.” After Jager caused a management revolt, the board turned to Lafley, who has emerged as a great leader and superb team builder.
These recurring examples raise the obvious question: Why do so many boards wind up looking outside the company for new leadership? My view is that they spend far too little time building sound succession systems. Lacking well-tested candidates, they presume an outsider can quickly transform the company and its culture.
The evidence clearly disproves their assumptions. In his new book, The CEO Within, my Harvard colleague Joseph Bower makes an irrefutable case that the best CEOs come from within the organization. Outsiders have clear disadvantages: They don’t know the company’s culture, the key players, and the subtleties of the business. Beyond that, they have to spend valuable time building trust. Or, like Nardelli, they bring in an entirely new team, which causes morale problems.
Contrast these fiascoes with the smooth internal leadership successions at General Electric, ExxonMobil (XOM), Goldman Sachs, Johnson & Johnson (JNJ), General Mills (GIS), and Pepsico (PEP). These companies have benefited enormously from building strong teams of authentic leaders, which resulted in seamless transitions to new leadership.
If you are working in an organization that doesn’t do sound succession planning and reward leaders, you might want to jump ship to one that appreciates authentic leadership-and provides you with the opportunity to make it to the top.
Boards are irresponsible if they guarantee pay regardless of performance and such boards put themselves and employees at risk.
The public is outraged these days over CEO compensation, with good reason. Far too many chief executive officers get paid large sums even when they don’t perform. I believe that CEOs should be well-paid when they do perform, but there is no justification for paying for nonperformance.
As a result, shareholders are demanding the right to approve CEO pay packages. Following the tradition of British companies, “say on pay” proposals on proxy statements are gaining momentum in the U.S. But under U.S. corporate law, determining the compensation of CEOs is a fundamental responsibility of the board of directors. Directors are charged with the fiduciary duty to use their “business judgment” in these matters, and the courts have consistently backed them up.
However, by not paying CEOs based on company performance boards are failing to execute their responsibilities. Unless they step up to this issue they risk ceding their responsibilities if unhappy shareholders push through say on pay resolutions.
Home Depot, Hewlett-Packard Handouts
If this were to happen, who would determine these complex compensation packages? The courts? The Securities & Exchange Commission? External governance gurus, who have no responsibility for the corporation’s performance? None of these alternatives makes sense. In fact, they threaten the very foundation of our system of governance.
I must emphasize that the real problem here is not that CEOs are paid too much money. You don’t hear criticism of the compensation of top performers like A.G. Lafley of Procter & Gamble (PG) and Bob Ulrich of Target (TGT). The real problem is paying enormous sums to CEOs who fail to perform. Our system of capitalism is based on taking risks and being rewarded for success, not on guaranteeing huge payouts to CEOs who destroy shareholder value.
How can anyone justify Home Depot’s (HD) former CEO Bob Nardelli receiving a $200 million termination settlement after declines in market share and shareholder value? Or the former CEOs of Morgan Stanley (MS) and Hewlett-Packard (HPQ) losing their jobs and walking away with tens of millions? Shareholders ought to be outraged by these inequities.
Taking a Toll on Employee Motivation
It is ironic that by guaranteeing CEO compensation, boards put their CEOs at minimal risk while putting employees at far greater risk. When CEOs in these firms fail, it is the employees who lose their jobs and their income, while CEOs pocket their guaranteed pay.
Is it surprising that outsized CEO pay packages destroy employees’ trust? With loss of trust, employee motivation gives way to to cynicism and superior performance becomes mediocre.
The underlying cause of this problem is the failure of boards to develop their future CEOs internally. The board’s most important job is to ensure long-term succession plans for the top leadership. But many boards don’t take the time and expend the effort to develop seamless internal succession, and consequently they are forced to search outside the company, often yielding to investor pressures to hire a corporate savior.
No CEO Contracts at General Electric
In turn, these high-profile CEOs from outside the company who know little about the business, the company’s culture, or its people, hire high-powered attorneys to negotiate multiyear contracts that guarantee their compensation, regardless of performance.
Why do CEOs need contracts in the first place? The CEOs of General Electric (GE), Goldman Sachs (GS), and Exxon (XOM) don’t have them. They get paid to perform.
Executive compensation should be tied directly to the company’s long-term objectives and based on building the firm’s economic value, not its stock price. The best compensation programs tie up half of the executives’ compensation for the duration of their tenure, so they cannot cash out when the company’s stock peaks. These programs are based on a mix of short-term and long-term incentives so that no one objective can be pursued to the detriment of the firm’s interests.
To ensure the CEOs’ separation from the compensation process, boards should hire their own compensation consultants who do no work for management.
Finally, CEO compensation should not be based solely on a comparator group, which can be easily manipulated. Rather, internal equity should be given equal weighting so that gaps between CEOs and their subordinates are narrowed, and it is the team that is rewarded for the company’s success.
To rebuild the confidence of shareholders and the public and to retain control over CEO compensation, boards of directors should put their CEOs wholly at risk, with no contracts, and pay them only for long-term performance.
That’s the only way to restore trust in corporate leaders and in our system of corporate governance.
The never-ending barrage of proxy proposals from governance experts raises an uneasy question: Who is governing corporations these days – elected boards of directors or self-appointed governance firms?
The 2002 enactment of Sarbanes-Oxley and NYSE listing requirements has led to significant improvements in corporate governance. Boards operate more independently and the relative power of CEOs and their boards has been rebalanced. Even relationships between corporations and the SEC – the official federal regulator of corporate governance – have settled into appropriate equilibrium.
Just as corporate governance gets on track, self-anointed governance gurus – for-profit firms like Institutional Shareholder Services (ISS), the Corporate Library, GovernanceMetrics International (GMI), and Glass, Lewis – are challenging these legally elected bodies for control of corporations. Not satisfied with the improvements, these firms – which are not shareholders at all – agitate to wrest control for themselves and for shareholder activists. They purport to represent shareholders by rating company governance, submitting proxy proposals for consideration at shareholder meetings, and consulting with companies desirous of improving their governance ratings.
The governance gurus wrap themselves in the banner of “shareholder democracy,” although governance of American corporations was never intended to be democratic. The legislators who created governance laws recognized most corporate governance decisions are too complex to be made independently by thousands of shareholders. Only the most important decisions, such as the election of directors and major mergers and acquisitions, require a special shareholder vote.
Like elected representatives in the federal government, corporate directors are elected by shareholders and legally charged with the fiduciary responsibility to govern the corporation. The courts have consistently backed the responsibility of directors to use their “business judgment” in making decisions regarding the corporation´s best interests.
What these governance firms are proposing is not democracy at all, but rather taking control of corporate governance in order to promote an active market of takeovers and force changes in management and boards of directors. Their power is growing because institutional shareholders are unwilling to do the analysis and invest time into voting proxies for their vast array of shares. So they follow these firms´ recommendations – all for a fee.
ISS is the most powerful – and most conflicted – of the firms. It derives its power from its proxy advisory service for institutional shareholders, who currently hold over sixty percent of the shares of U.S.-based companies. Through its recommendations, ISS can influence – if not control – thirty percent or more of the shares voted. The “Corporate Governance Quotient,” ISS´ ratings model, attempts to quantify the quality of firms´ governance. ISS also sells its advisory services to companies anxious to improve their governance ratings, creating conflicts of interest for ISS´ supposedly independent advice. Nevertheless, many companies cater to ISS to improve their ratings and ensure favorable votes on proxy items.
In recent years governance firms have focused on the annual election of all directors, eliminating multi-year terms and staggered boards in order to enable hostile raiders to replace the entire board at a single meeting. They have also insisted on majority votes for directors. Recognizing the importance of director elections, many boards have agreed to reconsider directors´ standing in the absence of majority votes.
But these changes have not satisfied the governance specialists, who are now asking for “cumulative voting” for directors. Cumulative voting means that a shareholder representing one million shares in an election of twelve directors could cast twelve million votes for a single director, perhaps a write-in candidate. Shareholder democracy?
In actions like these governance firms have shown their hand, which is not democracy at all but support for takeovers and management changes. This enhances their relationships with the hedge funds, which usually care more about events that create volatility than they do about shareholder value.
Another focus is “say on pay” resolutions, following the British tradition of giving shareholders an up or down vote on the CEO´s compensation. At first glance, letting shareholders opine on compensation sounds logical, but the problems it creates are enormous. Legally, determining executive compensation is the responsibility of the board of directors, which in turn is delegated to its compensation committee. Determining CEO compensation is an extremely complex task, one that must be closely linked to the firm´s objectives and to employee compensation plans.
Granting shareholders such a privilege raises serious questions about the board´s responsibilities. What´s the remedy if the shareholders turn down the CEO´s compensation? Propose another plan and let the shareholders vote again? The governance firms would likely offer their own alternative to the CEO´s compensation. At this point, the power transfer from the board to the unelected governance firms would be complete and would lead to their next proposal to increase power. Boards that naively attempt to curry favor with ISS and others to win their approval will learn the hard way that these outside firms will never be fully satisfied until they have wrested control from the boards.
I am not suggesting that boards should stonewall these initiatives by dissident shareholders and governance firms. Rather, these unrelenting pressures suggest that board members must step up to their legally-elected leadership responsibilities and become more active in corporate governance. This requires more time and greater leadership. No longer can boards delegate their responsibilities to company management – but neither can they abdicate their duties to governance gurus.
The alternatives are clear: either boards step up to leadership, or our entire system of corporate governance is at risk. The time for leadership is now!
Controversies over the rising power of private equity firms continue to rage.
Time Magazine labels their leaders, “Private-Equity Pigs.” To hear critics describe private equity, they are the new robber barons, ready to plunder our great corporations and leave them in a shambles.
Nothing could be further from the truth. The dynamic leadership of private equity firms and the executives they hire to run client firms is providing great benefits to the corporate world, the American economy, and society as a whole.
Five years ago private equity firms had trouble coming up with more than $1 billion for a single deal. Today, they can top $50 billion, and there seems to be no limit to the size of deals that can be put together. Why? It´s simple: investors are attracted by the returns of these deals and willing to tie up their money for three to five years.
Let´s take a closer look at the myths about private equity:
Myth #1: The growing power of private equity firms is a threat to public corporations.
Unlike the raiders of the 1980s – remember Mike Milken, Irwin Jacobs, and Carl Icahn? – private equity is doing its deals on a friendly basis. They show up when no public buyers are interested. That´s what happened when Daimler put up Chrysler for sale, no automobile companies showed up, so PE leader Cerberus stepped up to Chrysler´s challenges.
Myth #2: Under private-equity, acquired firms get torn apart and value destroyed.
PE does the vitally needed restructuring that the previous public owners did not have the will or ability to undertake. Ten years of changes are compressed into three years or less. PE firms can achieve those high returns by creating value that public managers apparently did not see, and monetizing their gains in the public market.
That´s what happened in 2001when Blum Capital Partners purchased by CB Richard Ellis, the nation´s leading commercial real estate firm. The firm was drastically restructured, and brought public three years later. In three years its market capitalization grew from $1.3 billion to $9.1 billion, a 600% increase.
Myth #3: CEOs flee public companies to avoid scrutiny from demanding investors.
Wrong! Private equity investors are far more demanding than public investors and much more engaged in the business. Leading PE firms generate returns that far exceed the public market.
Just look at what Eddie Lampert has done with the venerable Sears Roebuck, whose public market valuation declined steadily for thirty years as its retail sales slumped. Lampert consolidated Sears into his bankrupt Kmart operation, monetized the value of its real estate portfolio, and brought it back to the public market. Just four years later, its stock has risen ten times.
Myth #4: The greed of private equity owners is harming the economy.
Like any capitalist who starts his own business, private equity firms invest their own money, putting it all at risk. When they gain, they deserve every penny. That´s the essence of capitalism. If their wealth makes us angry, then we should take it out on poor old Warren Buffett, the greatest capitalist of all, who made $40 billion through his investments in select companies and is giving it all away to philanthropy, to be managed by the Gates Foundation.
Rather than harming the economy, PE firms are giving it new vitality by taking moribund corporations – or pieces of them – restructuring them to uncover real value, and making them healthy, competitive, and viable once again. This benefits the entire economy by reducing the “drag” from poorly managed firms and replacing them with revitalized competitors.
This sounds so easy. Why don´t publicly held companies do the same thing? Is Wall Street restraining them from facing problems? Not exactly. Wall Street generally cheers when public firms face the music and restructure, as the stock tends to go up. The answers lie deeper. Here are the reasons why firms under the PE model are doing so well:
- Take on high leverage and spread the risk. PE firms take on much greater amount of debt. In recent years the low cost of debt and high liquidity have made this model very attractive. Why don´t publicly held companies do the same? No doubt they could handle more debt, but the PE firms can spread their debt across many companies, thereby mitigating the risk. If a public company cannot meet its debt obligations, it is bankrupt, a la Delphi or Delta Airlines. If a PE-held company goes down, the PE holder can cover its losses from its broadly-based balance sheet of multiple holdings.
- Compress the time frame of making changes. PE firms don´t waste any time making changes. They aren´t concerned with internal objections, reluctant boards, and unfavorable publicity. They determine what needs to be done, and move swiftly with surgical precision to implement changes. Can´t public companies do the same? Of course they can, but often they fall into the trap of worrying about quarterly earnings, internal morale, power struggles on their boards, and external criticism, and vital time is lost. Worse yet, they rationalize the real problems and make “quick fixes” but never get the business healthy.
- Leadership. Aren´t private equity managers just a bunch of financial manipulators, not leaders?
Au contraire. Private equity has attracted some of the most talented leaders in business, both to run the PE firms themselves and to run the companies they acquire. Their leadership is characterized by extreme intensity and clear focus on the business and its results. PE leaders have the courage to make the changes immediately, and restore the business to on-going health. They are clear in their purpose and decisive in their actions. Sounds like leadership to me. . .
So what´s the risk with private equity? First, if short-term interest rates rise sharply, the high levels of leverage could become infeasible. Second, with more PE money chasing fewer deals, there is always the risk of overpaying for a major deal. Or not having access to the public market to monetize their gains. This is a real risk in the case of Cerberus´ acquisition of Chrysler.
Finally, private equity has had the benefit of paying capital gains taxes on profits rather than ordinary income tax, as publicly held corporations do. These loopholes in our tax system accruing to the benefit of private equity owners are simply wrong: all firms, public and private alike, ought to play by the same tax rules. Congress is right in attempting to correct this inequity.
There are reasonable questions about whether the private equity model works for well-run, long payout businesses like high tech, biotech and pharmaceuticals, and aerospace. Personally, I am very skeptical. Thus far, the PE firms have steered clear of these industries. We´ll see where they go in the future.
What does all this mean for publicly held companies and their boards? There is a great deal they can learn from private equity if they don´t buy into the myths or bury their heads in the sand. First of all, they should take an objective look at their business as if it had just been acquired by PE. What would a PE firm do differently? Where would they find value? What would they jettison? If they can make these changes without damaging the long-term value of their company, then they should act immediately.
In the regard, private equity is serving as a positive impetus to publicly-held companies to get their act together.
Bill´s bottom line: The private-equity movement is good for the U.S. economy and good for business. It will be around for a long time.
For the past decade we´ve had a big problem in the corporate world, but no one will name it. The problem is that many leaders believe they are more responsible to Wall Street than they are to Main Street. But it’s Main Street where the customers live and where the money is made.
The only way to create long-term value for shareholders is to create superior value for your customers. That comes from motivating your employees to create great products and superior customer service. That´s why companies like Target, Johnson & Johnson, and PepsiCo have been so successful in sustaining their growth.
But companies whose primary focus is on Wall Street, and meeting its short-term goals, are never going to create long-term value. Wall Street may focus on quarterly earnings, but it still takes five years or more to discover a drug, design a semiconductor, or create a breakthrough like the i-pod.
You simply can´t do it overnight. If you don´t stay focused on your True North, you´ll get buffeted by the winds of change, and wind up capitulating to playing the short-term game. At Medtronic, it took a decade to create breakthrough products that restore millions of people to health, but that´s how we created $60 billion in shareholder value- not by responding to Wall Street.
Unfortunately, many corporate leaders don´t have the patience or the vision to do that. They bow to Wall Street, keep shifting strategies, and wind up destroying their value.
Authentic leaders stay focused on creating great value for Main Street customers. And that´s how they create long-term shareholder value. Authentic leaders who focus on Main Street will out-compete every time those who only worship Wall Street.
I’m Bill George.