Why American Corporate Governance Is a Bust

One of the many problems that defenders of America's free market system fail to address is the severe dysfunction at the top of the nation's big public companies. Cases in point include some of the biggest bankruptcies of the last decade: Lehman Brothers, General Motors, WorldCom, Enron and many more. And at the core of the problems that led to these bankruptcies is a failure of directors to act on behalf of shareholders -- at least in part because they have more of an incentive to work for the CEO than for public shareholders.%%DynaPub-Enhancement class="enhancement contentType-HTML Content fragmentId-1 payloadId-61603 alignment-right size-small"%% I was reminded of this again as I read a report in The New York Times on directors who glide from serving on the boards of failed enterprises to those of surviving ones. One example of such a director is Thomas P. Gerrity, who used to be my boss -- he was president and co-founder of a technology consulting firm I worked for while studying at MIT. After selling that firm, Gerrity became dean of The Wharton School at the University of Pennsylvania, and currently serves as a professor there.

Based on my experiences working for him, I view Gerrity as a brilliant thinker. He was a Rhodes scholar with a doctorate from MIT. He's also a good example of how a bad system might make a good person function at less than optimal effectiveness. How so? According to The New York Times, Gerrity has been a Sunoco (SUN) director since 1990 and was on Fannie Mae's (FNM) board from 1991 to 2006, a period during which Fannie Mae took on big risks -- including in 2004, when accounting problems led to the departure of then-CEO Franklin Raines.

We don't know what Gerrity did or did not do while he served on Fannie Mae's board. But since Fannie Mae is now in government conservatorship and its shareholders have been virtually wiped out, it wouldn't be a stretch to suggest that its leaders made bad decisions in a business that -- as a government-sponsored enterprise which bought, packaged and sold mortgages to investors -- was practically foolproof until it loosened its lending standards.

Don't Rock the Boat -- Unless It's Nearly Sunk

Before getting in to what might have caused Fannie Mae's woes specifically, let's take a broader view. One key point of American corporate governance is that directors are supposed to act in the interests of shareholders, yet they are incented to behave in the interest of management. CEOs pick public company directors, pay them hundreds of thousands of dollars in cash, often grant them stock or options in the company, invite them to meetings in nice locations, and let them pal around with interesting people. Not surprisingly, directors act in line with those incentives by not rocking the boat and upsetting the source of those perks -- the CEO.

To be fair, there are times when directors' legal liabilities for not tossing out the CEO exceed all these nice perks. That liability is probably what caused Gerrity and his fellow directors to show Raines the door in 2004, in the wake of disclosures that Fannie execs had decided not to book non-cash charges so they could meet internal targets that triggered millions of dollars in bonus payments, according to USA Today.

The results of this were painful -- Fannie Mae took a $6.3 billion charge to restate its financial results from 1998 to 2004, according to the The New York Times. And Gerrity was replaced as head of Fannie Mae's audit committee in 2006, according to USA Today.

Time to Align Boards' Interests With Shareholders

In the case of Fannie Mae, its directors clearly failed to stop it from buying far too many sub-prime mortgage-backed securities. The simple reality is that during much of the 2000s, Fannie Mae stock traded in the $80 a share range and now, 15 months after the U.S. took it over, it's worth $1.50 -- this after $45 billion in capital infusions in the year following its September 2008 rescue due to its negative net worth.

For whatever reason, directors like Gerrity were unable to stop Fannie Mae from making what proved to be extremely bad decisions. If they were concerned about Fannie Mae's risks, there is no evidence that they moved to curb them. Even if they had questions, they would have had a hard time getting detailed answers without asking the CEO -- who would have an incentive to provide sugar-coated information.

This is a serious problem for investors in public companies. As I wrote in BusinessWeek in February 2005, one way this problem could be fixed is to boost the power of directors who have large percentages of their personal wealth tied up in the company's stock -- by stacking boards with what I called majority-share directors. What's good about this approach is that it aligns the incentives of a company's directors with those of its public shareholders.

As Gary Becker, winner of the 1992 Nobel Prize in Economics, pointed out, people respond to incentives. Why shouldn't public company shareholders benefit from his insight?

Meet Peter at The World Money Show Orlando, February 3-6, 2010 at The Gaylord Palms Resort.
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