Last week's meeting of the Council of Institutional Investors (CII) in Chicago was punctuated by keynote addresses from two corporate leaders and panel discussions on how to preserve pension values in the face of the global credit crisis.
Brenda Barnes, CEO of Sara Lee, recounted her determination to focus on long-term value creation, based on a strategy that includes strong research and development investment, even as the stock price of the food products company has declined by 30 percent since she took the helm in 2005. In his turn at the podium, real estate tycoon Sam Zell predicted that "as long as Congress keeps hands off," the controversial $700 billion bailout will work, and the government will make money by providing a market for mortgage-related assets that will then attract other capital.
Anchoring a panel on "Rethinking the U.S. Regulatory Model," former chairmen of the Securities and Exchange Commission Richard Breeden and Harvey Pitt addressed the growing demand for more transparency around financial instrument transactions.
Much discussion focused on key causes of the crisis, which Pitt traced back to passage of the 1999 Gramm-Leach-Bliley Act. That allowed banks to offer investment, commercial banking, and insurance to foster competition in financial services, but Congress failed to update the regulatory framework, leaving "a 1900s regulatory system for a 21st century financial system," Pitt said.
Breeden noted that an important part of the market was not regulated at all, in that lenders were able to package and sell mortgage-backed securities to any party willing to buy -- "a small town in Norway," for example.
Breeden also underscored leverage as a major culprit. The Federal Reserve misjudged the "hyperleverage" being built into the system, he said, even though some firms were leveraged as much as 50- to 100-to-1. That can only be explained by avarice, he added. Lack of both internal and external transparency exacerbated the problem. Some firms didn't even know how much they were leveraged, and the government failed to require transparency that would inform the market.
Neither panelist offered a specific regulatory solution. At another session, "Examining the Futures & Options Markets," however, Craig Donohue, CEO of CME Group (the Chicago Mercantile Exchange) offered his firm, which each day clears millions of transactions involving highly sophisticated commodities-related instruments, as a good model for the financial sector. He further implied that the CME would be involved in securities auctions related to the recently approved bailout.
The former SEC chairmen agreed that a lack of alignment between executive pay and long-term performance also contributed to the financial crisis. Pitt cited John Thain at Merrill Lynch as a highly compensated chief executive who demonstrated that he had "no clue" about a key facet of the company's business, as he continually revised public statements about the extent of Merrill's mortgage-related write-downs--"$5 billion one day, to $7 billion, then to $11 billion." Boards must correlate and measure performance, and pay accordingly, Pitt urged.
Breeden mentioned bonus "claw backs" as one solution. H&R Block, where he ran an overwhelmingly successful proxy contest in 2007 and currently chairs the board, now has a policy that requires executives to return incentive pay if a restatement provides that the awards were not actually earned--regardless of whether the restatement involves misconduct. "In the financial world, you have bonuses paid today based on accrual earnings, whereas shareholders bear risk for a long time," Breeden observed. Pay systems should incentivize risk-taking, but they cannot just reward it without linking pay to performance, he emphasized.
Pitt's recommendation is more radical: Divide [senior executives'] compensation into two portions. One annual amount that is "enough to live on" and an additional sum that is put into an interest-bearing account and paid [at the end of the executive's career] based on the board's judgment of long-term performance. If the long-term portion is deemed not to have been earned, it "would be returned to shareholders."
While cautioning that it's "too easy to just blame boards," Breeden admonished the directors who did not protect shareholders. Pointing again to H&R Block, he said the goal of his proxy contest was to accelerate the company's exit from the subprime mortgage business, something "the [existing] board could have done but didn't."
Modern corporate culture remains "very insulated," Pitt noted, with boards still getting their information from managers who are proposing or defending their own agendas, or from outside advisors brought in by those same managers. Boards must hear from independent, unaffiliated outsiders, he said, lamenting that "too many directors don't actually understand the company's business."
Breeden and Pitt stopped short of calling the financial sector meltdown "another Enron," which was rooted in fraud. "What we have now is more like stupidity," Breeden suggested, but he agreed that the current crisis "cries out for proxy access." If there had been proxy access, "[H&R Block] might have exited subprime sooner and saved shareholders billions of dollars," he said.
Pitt, who stepped down as SEC chairman around the time that the American Federation of State, County, and Municipal Employees launched a campaign in early 2003 asking companies to give shareholders access to the proxy for director nominations, said that the issue has become "bogged down in irrelevant details." Although on record as opposing proxy access as recently as June, Pitt opined at the CII meeting that the federal government should not be involved in what is a state law issue. "Any shareholder should be able to amend the bylaws [to establish proxy access] if they get enough votes," he said. The system is now problematic since state law may allow access (through bylaw changes), "but the SEC won't allow it."
Problematic Regulatory Fixes
Both former chairmen agreed that the SEC's suspension of mark-to-market accounting for thinly traded securities is dangerous if companies are allowed to report "values that they wish," as Breeden put it, rather than what the market will support. Fair-value accounting is "unassailable," Pitt added, but he acknowledged that current rules create difficulties "when someone who has an asset to sell must value it based on a price from a buyer who doesn't want to buy." If the market freezes up and values must be marked to a model, a key requirement in establishing asset values is to have "truly independent" outside experts assessing the validity of the models and the assumptions underlying them. Although the SEC started to require companies to disclose the assumptions underlying their valuation models after the Enron debacle, "this was not being done by financial companies," Pitt noted.
Both Pitt and Breeden also agreed that short-selling "done properly" is helpful (and perhaps essential) for the market to understand pricing and provide liquidity, but so-called naked short-selling is "an abuse of the marketplace," Pitt said. Once the market has settled, Breeden added, the mechanics should get further review, given that billions of dollars have been invested in short funds in the last few decades. "But [regulators] need to work with knives and bullets," he said, rather than nuclear weapons, to maintain market balance.
What should investors do now, in the absence of market stability? Rely on "the old fashioned virtues of financial analysis," Breeden suggested, noting that strong free cash flow gives companies the time to cope with whatever difficulties come along. Pitt's firm, Kalorama Partners, spends "a lot of time" talking to individual directors. "The truth is, every company is just a step or two away from the next crisis," he said. "Boards must be prepared to deal with it by having their own agenda not just managements' agenda. Breeden agreed that board members are often confused about their roles and their primary duty to protect shareholders' interests. It is "amazing," he said, how many independent directors never talk to shareholders.