Controlling Public Corporations

This decade will undoubtedly go down in history as the worst time for public corporations. This has been a time of radical change, far more than we have ever seen in business, and it is not over yet.

When you see the recent changes in the United States and Canada, with governments becoming involved in the automobile industry, you can see this is just the beginning. Both countries have become shareholders in General Motors and the United States is a large shareholder of Chrysler. We also see the U. S. government taking a strong stance towards financial organizations, even dictating salary caps for different management positions (particularly CEOs).

PERILS OF ‘MARK-TO-MARKET’

The financial problems we experienced in 2008- 09 had historical roots. Most of the problems were a result of poor regulations and/or the lack of safeguards in the United States. Compensating for this, governments suddenly overreacted, attempting to exert greater control over corporations and creating many unreasonable accounting regulations. The housing crisis, for example, started back in the ’90s, when speculators, builders, banks and financial institutions took far greater risks than they should have. The situation at American International Group (AIG) is a good example of an insurer taking on risks that it did not fully understand. It provided guarantees, not recognizing the risk involved in an out-of-control housing market. Low down payments and inadequate credit checks resulted in many speculators and homeowners investing in properties they could not afford.

Then the antiquated, “mark-to-market” accounting rule was applied to banks and financial institutions that held mortgages on properties that were considered to be valued less than the mortgage. Governments immediately reacted, particularly in the United States, and considered many of the banks and other financial organizations to be insolvent. It would have been better had governments simply relaxed the “mark-to-market” rule and subsequently reviewed the financial position of the banks and financial institutions.

The fact is that governments typically overreact to situations, trying to deal with them on a short-term basis.

REGULATORY RESPONSE

Many problems we face in Canada stem from the United States, but we have also had situations in Canada in which governments have acted without just reason. A good example of this was Confederation Life several years ago. It was deemed to be insolvent partly because of the “mark-to-market” rule. Many of their investments were temporarily valued much lower than their carrying costs, but, after they were taken over by a receiver, it was ultimately found that the assets were greater than the liabilities. It was obvious they were not insolvent, and yet they were deemed to be so simply because of accounting rules.

The situation was very different in the United States, where companies like Enron and WorldCom featured executive management and directors that were found to be responsible for many accounting irregularities and improper actions by U. S. regulators. To make matters worse, the U. S. Securities and Exchange Commission (SEC) found in January 2008 that a practice leader working at the time for Enron’s auditor, Arthur Andersen, Michael Odom, had not picked up on Enron’s financial misrepresentations.

Arthur Andersen has had several problems in the past, going back many years. They settled shareholder litigation involving Sunbeam for US$110 million in 1997. One year previous to that, they were fined over problems involving the audit of Waste Management. In 2000, they received US$52 million in fees from Enron, including consultant fees totalling US$27 million. Since that time, most public companies have discontinued the practice of allowing their auditors to perform consulting or actuarial services.

Due to these major problems involving management, directors and auditors, the United States introduced the Sarbanes-Oxley Act (SOX) on July 30, 2002. This act called for new disclosures by management and accountants and placed the financial responsibility for companies directly on the CEO, the CFO and accounting firms. SOX created a great deal of additional expense for reporting corporations due to its detailed requirements and, particularly, the certification by their auditors that the corporation had complied with the act. This meant all companies listed on U. S. stock exchanges had to comply with the act, including Canadian and other foreign companies listed on the New York Stock Exchange.

A few years ago, at a conference in Chicago, Illinois, I asked U. S. Senator Michael Oxley if he felt that the cost of complying with SOX was justified. I also asked him for his opinion about what value corporations received from this act. His response was that people had lost confidence in the stock market and he felt that SOX had brought back a great deal of comfort to shareholders. However, what he failed to recognize was this: after the attack on the World Trade Centre of Sept. 11, 2001, there had been a collapse in the market. The economic recovery from this event was a normal, anticipated proces. It was not the result of SOX.

INDEPENDENT DIRECTORS

Following the introduction of SOX, the SEC and the Ontario Securities Commission (OSC) started to make several changes in the control of public corporations. One important change was to require that independent directors control boards of public corporations. Unfortunately, there was no requirement that the independent directors have any knowledge pertaining to the business of the corporation. In many cases, directors felt they were responsible for the operation of the corporation — i. e. as opposed to being responsible for its management — and started to micromanage the company.

For a period of time, a number of companies, especially in the United States, had boards that would suddenly decide to replace the CEO of the corporation when there was a reduction in the stock price. The thinking was that they would eliminate any liability on their part by making a change, even if there was nothing wrong with the operations or the results. In some situations, it was just a matter of earnings or sales being off because of market conditions and the board had overreacted. Even today, we find a number of corporations that have boards trying to micromanage the company rather than relying on the ability of the management team that has more knowledge and experience than the board members.

A good example of this is what happened at AIG, which was the world’s largest insurance corporation. It was built up to that size and controlled by Hank Greenberg, a well-known CEO. Greenberg was forced out of AIG in 2005, when an accounting fraud investigation by Eliot Spitzer, then New York attorney general at the time, cast a cloud over his leadership. All criminal charges and some civil charges laid against Greenberg during Spitzer’s investigation have since been dropped, although some civil charges remain unresolved. However, rather than AIG board members backing Greenberg during the Spitzer investigation — and thus risking that they might possibly be forced out themselves — they decided to replace Greenberg instead.

Considering what happened next at AIG, which subsequently required about US$170 billion of federal funds to avoid bankruptcy, you have to seriously wonder whether it would have been different if Hank had still been in charge. After all, he had the knowledge and ability to build the company into the largest — and most profitable — insurance organization in the world over the years. When a company has problems, you need an experienced person in charge to deal with difficult situations.

As I said earlier, we can expect many changes in the way public companies are controlled in the future, particularly in the United States. This has been a very interesting decade of change and before it is over, we will see mo re.