Bear Stearns & revamping the board room

Having met a number of company board members and chairmen, it seems clear to me that there are a number of very competent people doing a task over which they are confused.

Around 6 years ago Bear Stearns completed a survey on board performance globally which involved a questionnaire of individual directors in respect of their own, their compatriots and their collective performance. New Zealand did not feature in this study as we are globally insignificant. We were bunched in with Australia and there may be only one or two Kiwis who actually contributed to this survey. But suffice to say there were thousands of responses. We have less than 1200 professional directors in the whole country.

As a result of this study a book was produced with the full survey results, some conclusions, and recommendations, it was entitled... "Back to the Drawing Board". The theme of the book was that our entire governance structure around business is flawed and as a consequence we needed to go back to the drawing board.

This said, the book failed to fundamentally do the latter and instead tweaked around the edges of the problem, focusing on board performance review processes, selection processes and succession issues. It did not talk extensively about the role of the board and role confusion and it did not even begin to think about the structural deficiencies of corporate structures.

The book arrived in the mail under a covering letter. I normally have a quick scan and throw such books away, especially when they come from interest groups. In this case however I read it. I then had a call from the author of the book while he was in NZ. Once I had admitted to reading it, he said he would like to visit me for feedback which he did and he got. So this blog is in part a book review and in part a summary of my feedback to him.

I imagine that you won't be able to find this book in any library, as it was published privately by a US bank - swallowed by JP Morgan Chase in 2008 as it tottered on the brink of collapse - and I suspect there were very limited copies produced. I gave my copy to a journalist as I felt it deserved wider publication, I never got it back nor did the journalist ever write anything up on the issues canvassed.

The survey was extremely comprehensive, and as far as it went balanced, i.e. not leading. The most compelling part of the book was the 70% plus of it which was the survey data.

As I think I have said before I am not a huge fan of research as invariably research can be designed to support whatever hypothesis you want to promote. But this research appeared to produce some alarmingly contradictory results that left the reader with the view that boards as a structure are completely dysfunctional, delusional and confused.

The research in essence said that an individual when questioned on his own competence for the job as a director of a major corporate enterprise, felt entirely out of his or her depth. The shear scale and complexity of business structures was the main cause of this, not the relatively straight forward business issues that small or large business has to confront.  As a result of the individuals own feelings of inadequacy they also felt disempowered.

When asked about the performance of their peers on the board, most felt that they were the pick of the bunch and the rest were even worse than them. Surprising then that when boards do 360 peer reviews on themselves the results are usually positive. So in addition to the sin of arrogance, board members also gloss over how they truly feel when confronted by the pack mentality of boards and the chummy cohesion arguments around selection.

This was not lost on Bear Stearns, which is why it focused on peer review and selection processes. It recommended independent parties to complete peer reviews on a confidential basis and robust selection processes that are transparent. These are now accepted as part of a good governance environment.

And the final questioning sequence was on collective board performance. The answer was that collectively board members thought the process worked and the outcomes were Ok. Go figure, individually they feel out of their depth, individually they think they are the smartest of the bunch , i.e. the rest are worse and in some magic way collective individual inadequacy results in a collective acceptable outcome? Perhaps this is the dynamics of all committees, - collective idiocy becomes wisdom.

Perhaps the problem is the scale of corporate endeavour; perhaps the size that we have allowed business structures to grow into has effectively disempowered the people in those structures including those who are supposed to lead it.

You may recall some time ago I did a blog on ethics and discussed a debate I had with others for the Institute of Directors. A senior Waikato University lecturer in business and economics outlined the theory of personal utility and said there was no research or theory that supported the hypothesis that ethics pay. I sort of catch up with him when I go to Waikato each year to do a guest lecture.

Last year he was a changed man. Firstly he does accept that ethics pay in the long term, and that values in business are a significant driver of performance, but his next throw away line, yes he too has become an extremist, is that all big business should be made illegal and broken up into smaller groups. Perhaps this is the answer that needed to be on Bear Stearns' drawing board. But of course a merchant bank that makes money from large scale business would never propose such a radical thought and when the author came to me for feedback neither did I.

Now to the feedback and clarifications that were obtained when you have the opportunity to talk to an author. I said to him human nature will not allow review processes to be honest even if third parties are involved without the complete anonymity of the masses (i.e. your global survey) personal honesty will not come to the fore, humans hate to offend. I guess I am not human...

Further, human nature will always result in people selecting people who look like and sound like them to serve with them on boards. Like will always beget like no matter what process you put around it. So your solutions are just process crap that will change very little in the real world.

I then said if you want your book to be true to its title you should really consider something more fundamental. I said to him the best way to improve board performance is to abolish boards. That floored him; he must have come to the view that I was a complete nut but decided to humour me.

So the discussion with him went like this......

Do you accept that a company is just a legal structure that brings together in partnership labour and capital and that, big or small, all business is a partnership between labour and capital to exploit an opportunity?...... Yes.

As a result of scale do you accept that at an individual level, owners have been emasculated in that partnership and that they can no longer exert ownership rights? .... Silence; remember he is a merchant banker whose stock in trade is takeovers etc.

As a result of this expansion of business so that owners no longer sit at the table in partnership would you accept part of the role of the board is to be the proxy or agent of the owners?   Long pause .... Yes.

Your research accepts that board members individually are confused so do you think some of that might be role confusion? Let me clarify, board members I have met are confused as to whether they are there to represent owners. And if so in what capacity or whether they are there to run the business. Some shareholders think that if they hold enough shares they are entitled to be on the board, i.e. a representation view, while boards think membership is about skill set and performance.

Some even think it is about diversity, which is another representation argument, i.e. that boards should be representative of society, more women more Maori (in NZ). Heaven forbid eventually even someone who is intellectually handicapped could be a requirement if this representation of society argument takes hold. Stakeholder mumbo jumbo. Long pause....Ummm maybe we should have asked them about the perception they have of the role.

It then became clear that the survey subset was mostly independent directors, not the management and major shareholder representatives, so that sort of explained the results. Collectively they got to the right answer (maybe) due to the input of those exceedingly undesirable directors, management and shareholder representatives. More on independent directors in the next blog.

In my experience boards collectively break into two groups with a few that tinker on the fringes of each, those who desire to pull the levers of business and lead the business and those who wish to guide those who pull the levers. Over the last 10 years the lever pullers as a group have been in decline thankfully. There is no point having a dog (a CEO) and barking as well. Common sense really but quite uncommon until recently.

So I said let's get back to basics. Business is about a partnership of capital and labour, and with widely diverse ownership the governance issue is about owners finding an appropriate representation model in that partnership without that module compromising the effectiveness of whoever represents the ownership side of the equation in that partnership, or worse, the business itself  ... Would you agree?  Yes he said that is why we have focused on selection and review processes. Competence and performance is about continual replenishment and skill mix. I chip in and say ... and about commitment?  Pause.... Well yes.

So  I say, how do you get commitment from a committee where each can pass the buck to another, each can blame the other, all are part time, mostly poorly paid relative to the risk and in the case of independent directors, there's no other real commitment to the business to focus them on its successes? Yes, agreed he says, pay is an issue. Structure or quantum?... Pause.... Both.

So what we know is directors feel disempowered and incompetent, the independent ones that is, yet the board performs ok. So why do we not just save the money we spend on independent directors and just sack the lot of them?  

But who would then keep those that are conflicted honest? Spare me I say you don't really think that independent labelled directors do that do you? Silence. Hence why I say we need to abolish boards and find a new structure that rebuilds the partnership between ownership and management operationally, and at the same time deals with the pay and risk issues while still accommodating direct representation of ownership. Your book is a failure in that it did not consider fundamental change to deal with fundamental failure.

By now I had gone from nutter to revolutionary, so he asked what would you do?

Simple say I, business is a partnership so it should be run by its partners, being management and the owner. Management is simple that is the CEO. The owners are more troublesome, but it needs to be one fulltime, well paid individual. So let us abolish the board, set aside the pay approved by shareholders as directors' fees and pay it all to one person who becomes a fulltime executive chairman that works alongside the CEO in partnership to run the business. This person must be a shareholder in his own right and must behave as a proprietor owner on behalf of all owners.

His job is to fulfil the role of a full time engaged proprietor. The CEO will have pre eminence over the Revenue and operational activities of the business, and the chairman will have a veto over the appropriation of capital or the raising of debt. What happens if these two guys get too chummy this structure could be a disaster, he says,  true... But wait there is more.

Every company should have a shareholder council, that is free from liability issues, called to meet when required whether by the council itself or by the chairman. Its role is to act as a sounding board for the chairman on issues that affect owners, and as a loyal mentor. Their job is also to question results and act as an audit committee and to receive audit reports including internal audit reports directly from the auditors, they should be paid for these services.

For significant enterprises, a company secretary or corporate counsel should be appointed by this committee as an additional bridge between management and owners, to attend to all statutory matters. This committee's sole power is to remove and/or replace and reward the chairman, and it is the chairman's role to appoint, reward and remove the CEO.

This committee should be representation based, so that anyone who holds 10% gets one seat, for each 10% they hold.  All shareholders with below 10% go into a pool and vote for the free seats, with the represented shareholders not getting to vote on these appointments. Any member of this committee must also be a shareholder, and if the committee lacks the skills to discharge its duties, eg the audit role, they are free to buy these skills in if they need them at the company's expense.

This shareholder council should report annually to all shareholders on its activities in such manner as it sees fit without input or interference from the CEO or the chairman.

Now none of these thoughts are new or original but in the context of NZ and other jurisdictions revolutionary none the less.  For this to come to pass it requires legislative intervention as boards are an entrenched role in all companies.

Fat chance of any help there. I and the Shareholders Association have been petitioning for 7 years for relatively minor changes to the Companies Act, around the definition of company which will fix a number of anomalies, to no avail. This said Commerce Minister Simon Power does seem to be made from a different cloth and does seem to have more influence in cabinet than his predecessor.

I understand that National and Power have a major reform program in mind and separating out small companies and big companies would be a good start. Have a Companies Act for all companies and an overriding Act, a Corporations Act to deal with the big companies, whose issues are quite different.

Next blog:  Independent directors and another book review.