I was going to make my introductory post earlier this week but what with the Obama inauguration and everything I decided to wait a couple of news cycles so as not to steal his thunder. Actually, that’s not true. The real reason is that I’ve been bouncing back and forth about whether to write about the failure of governance in the recent corporate meltdowns or about a survey just published that found that women have better orgasms with rich men. After all, Brett said I could blog about anything as long as it had to do with money.
Speaking of Brett, I’d like to thank him for the opportunity to contribute to The Long Run along side Jon and Karl. I will do my best to continue their tradition of applying critical thinking to financial topics. I’ll also keep politics out as much as possible although I will confess upfront that I’m an unabashed capitalist who is socially liberal but fiscally conservative. Rather than turning my first post into an autobiography, I’ll just tell you enough about me to set up the topic.
What in the world qualifies me to talk about women’s orgasms and corporate governance? Well, in the mid-90’s I was part owner of a dating franchise (all legit) in the Northwest. At around the same I became president and coo of a tech company that was traded on the NASDAQ exchange. The company was later acquired by a large German conglomerate and I was named CEO of the company as well as another of the acquirer’s portfolio companies in Germany which was merged-in at the same time. I’ve sat on several boards and have attended countless public and private company board meetings. In retrospect, I guess I’m better qualified to write about corporate governance, so here we go.
Corporate Governance is the term that is applied to the processes, principles, regulations, and practices that define the relationship among the primary stakeholders in a firm. Stakeholders are broadly defined to include customers, the community, even the environment in some cases. My definition is not that broad. For me, the shareholders take precedence over all other stakeholders. It is the board’s responsibility and duty to look out for the shareholders’ interests within the corporate governance framework. That’s it. And first on that list of shareholder interests is turning a profit.
All public companies devote a fair amount of time explaining their corporate governance framework on their web site and in SEC filings. They are all similar largely due to Sarbanes-Oxley. There are committees, policies, procedures, disclosures, audits and more audits. But these are all about doing things right – not doing the right thing. Even worse, when it comes time to do the right thing, it is also probably the hard thing, and boards generally don’t do well with hard problems.
Since GM has been in the news lately, let’s take a look at how their shareholders have been served by their board. GM is has thirteen directors who are paid big bucks (~$150,000 per year) for their governance. That’s almost $2 million per year in director stipends! These guys must be good, no? Let’s take a look at GM’s performance since the current management team took over in 2000. Most of the current directors were already on board in 2000.
In 2000, GM held 15.1% share of total world wide car and truck auto sales. In North America, GM held a 27.8% share overall with 28.6% and 27.0% in cars and trucks, respectively. By 2007, GM’s worldwide share slipped to 13.3% In North America, GM followed suit slipping to 20.8% share overall with 19.4% and 27.0% in cars and trucks, respectively. In 2008, Toyota overtook GM as the largest producer of vehicles in the world. The loss of market share story is not new – this has been going on since the first foreign car took to our highways. As an aside, the first foreign automaker to manufacture in the United States was Volkswagen in 1978, not the Japanese. Unfortunately VW closed that operation in 1988 due to labor unrest. The real loss in share began in the early 1980s, when Japanese producers were taking a steadily growing share of the U.S. car market. Bob Lutz was hired in 2002 to fix that problem but the loss of share has continued.
Their gross margins aren’t that great either. GM was the largest and one of the oldest manufacturers of vehicles in the world. They have textbook economy of scale and they ought to be pretty good at it. If nothing else, they should have learned in from Toyota in their NUMMI joint venture that manufactures the Toyota Corolla, Toyota Tacoma and Pontiac Vibe. But GM’s automotive gross margin has been eroding steadily since 2000 from 13.9% to 6.7% in 2007 and 8.0% in the most recent quarter. By comparison, Toyota’s gross margin was 17.6% in 2007, more than twice GM’s. Interestingly, in 2007 the average GM vehicle sold for $19,018 and cost $17,744 to make. Toyota’s average vehicle sold for $28,984 and cost $23,883 to make. Meanwhile, GM has added $6 billion in inventory on flat to declining sales from 2000 to its most recent quarter. That’s about half of the $13.4 billion lifeline they received in the way of federal bailout funds in December 2008 when they sheepishly returned with a plan on how they were going to fix their company. Shouldn’t they have had one already?
GM turned a profit of $4.5 billion in 2000 but lost $38.7 billion in 2007 and $2.5 billion in its most recent quarter. In 2000, they had more cash, $9.1 billion, than debt, $7.4 billion. In their last reported quarter they had $15.8 billion in cash and $36.1 billion in debt (prior to taking on the bailout loan). The outlook for 2009 is down and GM is already calling for more government loans to keep the company afloat during the recession. This amount of debt places GM closer to a “loan-to-own” takeover. Such a takeover would leave existing common shareholders either squeezed out or significantly diluted.
GM just announced that they settled with the SEC on charges that there were errors in financial statements filed in 2002. In the civil lawsuit, the SEC alleged that GM made significant misstatements or omissions in the 2002 filing concerning two critical pension accounting estimates of discount rates and its expected return on pension assets. GM has restated its financial results several in recent years. They acknowledged accounting errors and said they would hire new executives and consultants to tighten their accounting processes. That should make everything kushty.
GM’s share price had dropped by a third, from $36.55 at the end of 2000 to $24.35 by the end of 2007. It closed 2008 at $3.20. The S&P 500 has lost about 25% of its value in the last 5 years, GM has lost 90%.
Little has been written about role of the board of directors in the recent meltdowns. Yet the boards of these companies should be getting as much attention, or more, than their management. In the case of GM, they’ve had the same management and board in place enough time to earn the credit or blame for the company’s performance. My conclusion is they earn the latter, but you may disagree. But pinning well deserved blame on GM’s board and management is not the point of this post. What I’d like to discuss with you is the notion that there are some basic flaws in the system of governance that lead to a misalignment between the interest of shareholders and those of their boards and management. Chief among these is the lack of skin in the game by those making the most critical decisions.
One way this misalignment could be mitigated is by changing the way in which directors are elected to boards. The first change that I would implement is to create two types of directors, voting and non-voting. The number of voting seats would be allocated based on ownership. Enough seats would be allocated to accommodate 51% of the voting shareholders. For example, GM’s top-10 institutional shareholders of GM own 51.9%. The current combined board of GM owns 1.3% of the company, mostly composed of shares, share units, and options granted to them for their service along with cash compensation and a GM car.
The board would be able to add non-voting directors chosen for any reason the board deems fit. For example, GM might want to add their CEO, CFO, a UAW representative, or supply chain expert to their board. They may even add a politician or lobbyist that can help them out with the Washington and regulatory crowd. These guys can advise and wax poetically as much as they want, but they don’t get a vote. Lastly, the CEO (or any other executive officer) can not be the chairman under any circumstances. The position of chairman and CEO is eliminated.
With these changes, boards would be better aligned with the interests of their shareholders.
What changes would you make?
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