Board of directors system broken

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As most investors are aware, these are not the best of times for the board of directors system. And in the quarters and years ahead, we'll likely hear a great deal about how a board of directors should function and what reforms to the system are needed.

Briefly, the board system is under stress. This is definitely not the first period in American history in which board of director prudence and accountability was questioned: the Enron and WorldCom scandals also shook shareholder confidence. Meanwhile, the alarming rise in U.S. senior executive salaries and compensation packages -- packages that exceed compensation increases for previous economic expansions -- further lower shareholder confidence in the system.

The system's metastasization under the Bush 43 presidency, during which scores of executives were granted large compensation packages despite unprofitable (or dysfunctional) business models, created perhaps the biggest scandal for the system since the Robber Baron era.

Further, no doubt many Americans will recommend that the United States return to an era when boards of directors represented that "other" player that's critical for a market economy -- you know, shareholders?

Astoundingly, in the Bush 43 era, boards of directors managed to outdo even their previous shortcomings; in the past decade they managed to avoid representing the interest of shareholders almost entirely. One can just hear the late, great business journalist Louis Rukeyser giving the needle to critics of the board reformers:

Imagine that? Requiring boards of directors to represent the interests of shareholders! Why it's a reform that requires performance for a role, and accountability. Perish the thought of such heavy-handed radicalism in these United States!

Board of directors: Painstaking oversight?

Further, in failing at this most basic and intrinsic function, the board system has opened itself up to a major review -- a review that most likely will include questions on the issue of levels of compensation throughout the economy, not just in the investment banking sector, plagued as it is with its perverse incentives for executives and other senior professionals that led to a host of corporate, economic, and financial system troubles. Moreover, the view from here argues that this reform momentum is not likely to subside any time soon.

As a result of the dereliction of their most basic responsibility to shareholders, the economy and the financial system, legal and ethical issues are becoming more important not only to shareholders, but to the broader American public, and it may very well result in a new board system. The populist firestorms that we've seen recently represent the flashpoint of shareholder and general public disapproval of the current board system. Hence, as a result of some truly monumentally arrogant, irresponsible, and/or incompetent decisions, boards are likely to have to surrender even more ground, kind of like the way a less than fit marathon runner has to give ground to fit runners, out of hope of being able to just finish the long race.

Further, one wonders where the board of directors was when AIG (AIG) was rapidly transforming itself from insurer to stealth hedge fund with enough risk to, if conditions deteriorated, plunge whole markets -- even nations -- into financial turmoil? Forget the AIG bonus travesty (if that's possible) for a moment; where was AIG's board of directors when the company was transforming itself into an financial weapon of mass destruction?

Did the AIG board fulfill its obligations to shareholders? Protect the markets against reckless acts? Put the interests of the financial system of the United States first, when common sense said that should have occurred?

Put another way: it's quite possible that AIG came within 72 hours of triggering an unprecedented financial catastrophe in the United States -- one that would have sent financial and economic shockwaves around the world. The inability of AIG's board of directors to rein in the company's reckless, rogue, and deeply problematic activity compelled an emergency intervention by the U.S. Federal Reserve. Vital federal money authorized by Congress would also inch the nation's banking system toward stabilization. Even so, there are still market observers who say, "Oh, no, the Fed and the Congress can't intervene. This is a matter for the board of directors."

Well, the Fed intervened, thank goodness, and answered the fire alarm. The Fed is stabilizing the financial system, the U.S. Treasury has announced a plan for toxic asset removal, and Congress will shortly evaluate a likely request for additional seed bailout money to both remove these assets and further loosen credit markets. Further, while the above are not likely to be the only measures needed to stabilize the financial system, board of directors reform is intrinsic to this process, due to the generally poor oversight provided by boards at each step in the toxic asset fiasco.

What's ahead? Reform

To be sure, there are those who will oppose all of the above, arguing that the matters are best left to the market and to decisions by private boards of directors. Well, the board of directors system proved to be woefully deficient, and it's in need of reform. A few economic conservatives will even question the authority of Congress to reform the board of directors system.

Sorry, but it doesn't work that way: Congress, as the legislature, can approve reforms because it is closest to the general will (in Rousseau's sense of the term), or the will of the people, and is therefore sovereign.

So when reforms come to the board of directors system, we should welcome these as acceptable, normal, and justified -- and above all constitutional. The only question remaining is how extensively will Congress reform it.

Financial Editor Joseph Lazzaro is based in New York.

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