Corporate Governance: What a Joke

   If it seems to you that it is just too easy for corporate executives to openly loot a corporation without suffering any repercussions, you are not alone. It is. Corporate executives within the Fortune 500 have free reign to steal as much money as they want through egregious pay packages, corporate perks, and dilutive stock options. It seems that the deck is stacked against the individual investor as corporate executives put their own financial well being ahead of shareholders.  Sarbanes-Oxley was supposed to stop corporate fraud, but, unfortunately, the most nefarious corporate activities are considered legal. That's right: It is perfectly legal to loot a corporation for a few hundred million dollars as long as you get the BOD's approval (just make sure to disclose it in the 10k). The problem is that while there is great emphasis put on the concept of corporate governance, it is only a myth and does not really exist in practice.

    It never used to be as bad as it today when it comes to executive theft and corruption. In a time not long ago corporate executives used to be accountable to the stockholders. They were always paid well (but no more than 20 times the average wage of a worker) for their services and respected by society.  The difference back then was that the board of directors were completely independent of management and usually represented the company's largest stockholders and creditors. These people did not simply rubber stamp what management put in front of them. They looked out mainly for their own interests, which, in turn, resulted in what was best for the corporation. Why? Because it was their money at stake. Today the board of directors are nothing more than a bunch of paid fraudsters who work for management.  They care nothing for the company or its shareholders and have absolutely no financial interest in the company.  The only thing they are concerned about is appeasing management so that they get their $80-100,000 salary and stock options. They owe their position to management, which is allowed to nominate a slate of directors who will never disagree or challenge management in any way. It is great deal for management--install your best friends as board members and get them to pay you hundreds of millions + stock options.  Whether the company does well or not, you make out like a king and retire in five years.

    What led to this corrupt system of corporate governance that we currently have? I know some may disagree. but I believe the culprits are mutual funds and fragmented ownership of company stock.  Before  the 1960's, the majority of stock was held by private individuals as opposed to mutual funds. The ownership structure was usually concentrated among a few major players including the founder's family, rich private investors, and retail.  Management's obligation was to increase earnings and the value of the company (stock price). If management failed or was corrupt, there were enough large investors to force them out.  However, by the 1960's, mutual funds came to dominate corporate ownership, which allowed management to assume full control of the company, thanks to a fragmented ownership. Mutual funds generally diversify their investments so that they do not have very large investments in any one individual stock.  If you look at a list of top owners of a stock, it will always be 20-30 mutual funds that own 1-5% of the stock.  Another aspect of mutual funds is that they will never challenge or vote against management, ever. They will always either approve management's slate of directors or simply withhold their vote. This is true for 98% of mutual funds. Why? To be honest, I don't really know why.  It could simply be that they do not have the inclination to push management to look out for shareholder interests. I have also read that they do not want to be seen as pressuring management or appearing to exercise undue control which could lead to problems with the SEC. Whatever the reason, mutual funds have let corporate executives exercise total freedom when it comes to running a corporation, corporate governance, and executive compensation. Naturally, events have run their course.

   Corporate executives have taken advantage of this lack of real oversight and enriched themselves at the expense of shareholders.  Executive compensation has soared from around 20 times the average workers' salary (in 1920) to over 300 times, and I really doubt if execs are doing a better job than they did 90 years ago.  The main reason is that CEO's are in a position to create their own pay packages; the board considers the request for about 18 minutes while the CEO waits outside and then approves the pay package, claiming that they are only paying a competitive wage. But then the CEO asks for stock options, because after all, he can't just live off his salary. No, he has to own a part of the company. Note, of course, that the CEO never puts his egregious salary into company stock. Instead, the CEO expects to be GIVEN stock options to feel that he has his incentives aligned with shareholders. The board for PR reasons wants to be able to claim that management's interests are aligned with shareholders so they approve 6 million shares of stock options (annually). Shareholders get screwed once again as management literally steals ownership of the company away from them. By granting stock options, each shareholder owns less of the company-- all to give management an incentive to do their job (create shareholder value).

    This is criminal theft, and because it is approved by the board, it is considered legal and fair. I have found that when it comes to corporate America the most evil and crooked actions are deemed legal such as stock options. It is all done under the guise of creating shareholder value, but it is a completely fallacious statement. Giving corporate executives stock options does not align their interest with stockholders. It would be better if executives were required to put a certain percentage of their salary into company stock every year (like 50%). Then they might have an incentive to do what is best for the company.

    Is there any solution to the current atmosphere of looting and corruption with in corporate America? It depends.  Will shareholders, mutual funds, etc., ever take back control of their own companies? As Ben Graham noted, shareholders have absolute power over corporations but never seem to exercise their power. Theoretically, they are the owners who simply hire managment to make them money, not enrich themselves. If shareholders demanded change, they would get change rather quickly.  All they have to do is vote against managment's board of directors and install directors who represent the largest owners of the company who have a real incentive to do what is best for all shareholders. These directors would have absolute power over management, not the other way around. Executive compensation would be reasonable at around $1 million per year. No bonus or stock options. If management balks at this new agreement, the board terminates their employment and outsources their job to India or China. I bet you could find quite a few highly educated, talented, and motivated executives out there who would work for the measly sum of $500,000. This arrangement would be great for sharholders because it would save money that would be wasted on high priced management.

Black Swan Insights  


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