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When governance goes wrong

Worries about corporate governance in the US - or lack of it - are nothing new. They have been a cause for concern, going right to the very top of the system. A statement from the president of the US, no less, illustrates this point:

"I see in the near future a crisis approaching. Corporations have been enthroned and an era of corruption in high places will follow until all wealth is aggregated in a few hands."

The president was Abraham Lincoln, and the year was 1864, but you do not have to go that far back to see just how bad corporate governance in the US has become.

Take the annual shareholders meeting for Home Depot, in 2006. Robert Nardelli, then CEO, presided alone. He appeared with no other directors. Shareholders - the owners of the company - could ask only one question and could only speak for one minute. When one shareholder used his precious minute to enquire about board independence and conflicts of interest, Nardelli replied: "This is not the forum in which to address these comments."

Nardelli was sent packing earlier this year, but with a $210m (€155m) severance package to ease him into retirement.

Another example is Caremark RX. Caremark's CEO agreed to merge the company with CVS and this was rubber stamped by the directors. CVS was not required to pay any premium to existing Caremark shareholders. The offer was for $48.50 per share when Caremark's shares traded above $50. Caremark's CEO and directors all kept their jobs and were allowed to claim a change of control provision which showered them with money, as if they had been sacked. CVS was given a $675m break up fee if the deal did not go through and Caremark's directors agreed to a ‘no shop' clause with CVS, which prohibited the Caremark directors from soliciting higher bids. If this were not bad enough, an unsolicited bid from Express Scripts was tendered at $26bn after the CVS bid of about $21bn, and Caremark's directors rejected it.

TheStreet.com, with great prescience, labelled this deal "No. 1 of the Five Dumbest Things on Wall Street". This deal did eventually close, but not until CVS agreed to increase their bid to $27bn.

Consider also Hank McKinnel, the former CEO of Pfizer. He presided over the decline of $137bn of
shareholder value. Yet, he received a breathtaking pension of $82m. And his total retirement package, including stock options, retirement benefits, deferred compensation and other prerequisites totalled $200m. But the ‘kicker' that really annoyed me was that shareholders even had to pay $305,644 to McKinnel for unused vacation days.

Another, more topical corporate governance problem in the US is back-dated stock options, which are options that are granted to a corporate executive today but with a prior grant date, with a lower stock price, so as to give the option holder an immediate boost in value.

This is certainly a problem. Backdated stock options are a freebie - the executive is awarded for no effort because the backdated grant date already reflects an increase in value.

To date, the US Securities and Exchange Commission (SEC) has investigated over 193 cases of backdated stock options, including at IBM, Pfizer and Home Depot.

Apple, for example, has acknowledged 6,428 cases of improper stock option backdating. To date, accounting re-statements and revised charges total $10bn.

Another example of back-dated stock options involves William McGuire, founder and former CEO of United Health Group. He came under fire for back-dating options and in defending this gift said: "This isn't a giveaway of money that occurs out of the premiums of healthcare recipients. These are shareholder dollars."

 

It gets worse. Yet another example is from an actual filing by CableVision, a US public company listed on the NYSE, with the SEC regarding backated stock options.

It said: "One of these two awards was to the company's former compensation consultant (which was subsequently cancelled in 2003) and the other award related to an executive officer whose death occurred after the stated grant date of the award and before the actual grant date." Translation: CableVision awarded backdated stock options to a deceased person.

This is truly astonishing. These various examples of egregious behaviour all highlight a key difference between the UK and the US. In the UK, shareholders can sack directors. But in the US, home of democratic values, shareholders cannot sack the directors of a public company. Shareholders in the US can only withhold their vote for a director but there is no right to vote against a director of a US public company.

Therefore, if all votes are withheld for a director save a single vote in favour of that director - likely the director's own vote in favour of him or herself - the director will still be elected. There have been a few attempts in the US to change this rule, most recently a rule proposed by the SEC, known as Open Access to the Company's Proxy Statement. But this proposed rule was soundly defeated by powerful lobbying forces, most notably, the Business Roundtable.

However, a court case in the US in September 2006 allowed shareholders access to the proxy of the AIG Corporation and so the debate continues. Hermes, which is 100% owned by the BT Pension Schemes in the UK, has long been recognised as a leader in corporate governance and we press for improvements all across the world, including trying to improve the position in the US.

 

ow, much of this article has been taken up with pointing the finger of blame at particularly egregious examples of poor behaviour by businesses.

But not all of the blame can be placed at the feet of corrupt corporations. Unfortunately, short-term investing remains the primary investment paradigm in both the US and Europe. Short-term investors rent stocks, they do not own them. For example, the average annual turnover for a US mutual fund is 100%. With such a high turnover rate, ownership does not apply.

Asset owners put pressure on asset managers to produce quarterly and annual outperformance versus their benchmarks. Asset managers, in turn, demand short-term outperformance of the companies in which they invest.

This puts pressure on public companies to focus on short-term earnings rather than long-term growth and a vicious circle results.

Hermes' approach to corporate governance is based on a fundamental belief that companies with interested and involved shareholders are more likely to achieve superior long-term financial performance than those companies without.

Our objective is to add value to the investments that we have in over 3,000 public companies worldwide. Our goal is to work in a constructive and collaborative fashion with the boards of directors, not seek to micro manage company affairs.

Our engagement programmes are intended to assist boards in taking the tough decisions sometimes required of them and to support them in implementing those decisions once taken.

This approach delivers superior results and we will continue to pursue it. We will also continue to press for improvements to the system of corporate governance in the US, to improve the quality of businesses there and improve returns to the owners of those businesses.

There may still be time to prevent the Abraham Lincoln's prediction from coming true.

Mark Anson is chief executive officer at Hermes Pensions Management

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