If you want to improve governance at a corporation, do you need professional directors? Did SOX merely add a layer of legal obligations of board, and do little to improve the quality of those serving as directors?

Robert C. Pozen makes the case in The Case for Professional Boards in the December issue of the Harvard Business Review.

Pozen starts by limiting the size of the board to seven people: the CEO plus six independent directors. He points to research that groups of this size are optimal for decision-making. Bigger groups can result in “social loafing”, relying on others to take the lead and ceding decision-making. Six also gives you enough people to populate the three key committees: nominating, compensation and audit.

The greatest need in a board is expertise. Pozen expects an accounting expert to head the audit committee. He also allows for one generalist to provide a broad perspective on the company’s strategy. But the rest should be experts in the company’s main line of business. That is not easy. Independent experts are most likely working for company’s competitors. He expects that most professional directors would be retired executives in the company’s industry. That would also lead to the elimination of mandatory retirement ages for directors.

Pozen makes a strong case. “To improve corporate oversight we need not more legal procedures but a culture of governance in which directors commit to the role as their primary occupation.” It’s just very radical strategy for companies who have grown and gathered their directors organically.

There have been many stories written about the Goldman Sachs investment in Facebook. On one hand, there is the chatter about the investment placing the valuation at $50 billion. On the other, there hand there is the talk about how this affects a possible IPO by Facebook.

There are two main reasons for an public offering of stock: liquidity and capital.

If you need capital, a public offering of common stock is merely one of many ways to raise capital. The benefit of this option is that the capital does not need to be repaid. A bank loan, a bond offering, venture capital or private capital will generally need to be repaid at some point. Each source of capital has a price and repayment terms that you need to align with the company’s needs and business plan.

It sounds like Facebook has ready access to capital in many forms. So an initial public offering may not be the best or the cheapest source of capital.

The liquidity of public stock is useful for rewarding employees and cashing out earlier sources of capital. Employee stock is great, but in a private company is very illiquid. It does you very little good to be a millionaire on paper if you can’t access the wealth. Early round investors, like venture capital funds, want to be cashed out at some point. They need to return capital to their investors. It sounds like some of the private trading of Facebook stock is being done by employees and early investors.

The third reason for a public offering stock was the reason faced by Google. Once you have more than 499 investors, you need to start making reports public. So you may as well get the benefits of liquidity in the stock.

The cash from a public offering does not need to repaid, but there are costs to the capital. That means complying with Sarbanes-Oxley. The CEO and CFO has potential criminal liability for false reporting. The board of directors will now need to include independent directors. The company will be subject to shareholder lawsuits. There are lots of costs.

To me it sounds like Facebook and Goldman have come up with an ingenious solution to the address the capital needs for Facebook and to avoid a public offering of stock. I assume the Goldman investment and its new fund will be used to provide some capital for expansion and growth. I also suspect that some of it will be used to cash out early investors, purchase employee stock, and repurchase stock that has been privately traded. Gobbling up the stock would be an opportunity to keep the number of investors well below the 499 trigger point. Early investors may take their money and run.

Assuming Goldman can provide $2 billion and charge its investors a 4% fee for investing, they have already made $80 million on their $450 million investment.

Sources:

• No Accountability: Goldman Sachs Wants You To Invest In Facebook by Francine McKenna
• Why Facebook won’t go public by Felix Salmon
• Read Goldman Sachs’ Secret Facebook Pitch Memo in WSJ.com’s Dealbook

Last week, the NYSE Euronext released the final report of the NYSE–sponsored Commission on Corporate Governance. The report identified 10 core governance principles. They cover the scope of the board’s authority, management’s responsibility for governance and the relationship between shareholders’ trading activities, voting decisions and governance.

The Commission on Corporate Governance was established in the fall of 2009 to examine core governance principles that could be widely supported by issuers, investors, directors, experts, and other market participants. These stakeholders have different viewpoints on governance issues, but the NYSE hoped they could find a consensus.

They started with the 10 core principles:

1. The Board’s fundamental objective should be to build long-term sustainable growth in shareholder value for the corporation;
2. Successful corporate governance depends upon successful management of the company, as management has the primary responsibility for creating a culture of performance with integrity and ethical behavior;
3. Good corporate governance should be integrated with the company’s business strategy and not viewed as simply a compliance obligation;
4. Shareholders have a responsibility and long-term economic interest to vote their shares in a reasoned and responsible manner, and should engage in a dialogue with companies thoughtful manner;
5. While legislation and agency rule-making are important to establish the basic tenets of corporate governance, corporate governance issues are generally best solved through collaboration and market-based reforms;
6. A critical component of good governance is transparency, as well governed companies should ensure that they have appropriate disclosure policies and practices and investors should also be held to appropriate levels of transparency, including disclosure of derivative or other security ownership on a timely basis;
7. The Commission supports the NYSE’s listing requirements generally providing for a majority of independent directors, but also believes that companies can have additional non-independent directors so that there is an appropriate range and mix of expertise, diversity and knowledge on the board;
8. The Commission recognizes the influence that proxy advisory firms have on the markets, and believes that it is important that such firms be held to appropriate standards of transparency and accountability;
9. The SEC should work with exchanges to ease the burden of proxy voting while encouraging greater participation by individual investors in the proxy voting process;
10. The SEC and/or the NYSE should periodically assess the impact of major governance reforms to determine if these reforms are achieving their goals, and in light of the many reforms adopted over the last decade the SEC should consider the expanded use of “pilot” programs, including the use of “sunset provisions” to help identify any implementation problems before a program is fully rolled out.

In Section IV of the report, they dive deeper into the roles of the board of directors, company management, and shareholders, recognizing the interdependence and inter-relatedness of the three groups. I found this to be the most interesting section. They lay out rights, responsibilities and expectations.

In the end, they do not end up advocating for change:

“Finally, it is important to note that as the Commission reviewed these issues, it did so in the context of the reality that, notwithstanding certain governance failures over the last decade, the current governance system generally works well. The Commission believes that failures of corporate governance were not the sole reason for the financial crisis of 2008, and more broadly believes that most of the thousands of public companies in this country are well governed, with hard-working and ethical boards and shareholders who are involved in the companies. This does not mean that the system is perfect, but it does mean that before further fundamental change is sought, all parties considering such change should recognize the strengths of the current system and the benefits it provides to investors and the economy.”

Sources:

• Report of the New York Stock Exchange Commission on Corporate Governance September 23, 2010
• Press Release:NYSE-Sponsored “Commission on Corporate Governance” Outlines Key Governance Principles
  - Committee Representing Broad Group of Investors, Issuers, Broker-Dealers, Governance and Proxy Experts Defines 10 Core Principles of Corporate Governance
• NYSE Commission on Corporate Governance Issues Final Report from TheCorporateCounsel.net
• Web Notes and Updates by Kevin M. LaCroix in the D&O Diary

The National Association of Corporate Directors (NACD) publishes the Directorship 100. They surveyed 15,000 public company directors and executives to form the final 100 honorees.

I was interested to see how they broke them into groups:

1. Regulators and Rule Makers
2. Directors
3. CEOs
4. Governance Policy Makers
5. Attorneys
6. Investors
7. Auditors
8. Recruiters
9. Compensators
10. D&O Insurers, Governance Advisors
11. Corporate Governance Officers, Corporate Secretaries & General Counsel
12. Professors
13. Strategists
14. Media

I found it interesting that “attorneys” list was as big as the list of “directors.” It’s clear from the list that there are lots of stakeholders affecting the boardroom’s activity.

All members of the Directorship 100, regardless of how they arrived here, have power and influence. Some of it is new, some of it is long-standing. Our modest job is to reveal those who exert the kind of influence that will permit the continued, if sometimes shaky, path that our system of capitalism is on, and the importance of corporate governance as a critical guidepost along the route

They also included the 2010 Corporate Governance Hall of Fame.

I also wanted to say congratulations to Douglas K. Chia of Johnson & Johnson for making the list. He even managed to get his picture into the pdf version of the publication (page 44).

Sources:

• The Directorship 100 by Jeffrey M. Cunningham
• The Directorship 100
• The Most Influential People in Corporate Governance by Emily Holbrook in Risk Management Monitor
• Influential Voices in U.S. Board Rooms in Business Ethics

President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act at the Ronald Reagan Building today. The clock starts ticking on the compliance and rule-making deadlines.

“The fact is, the financial industry is central to our nation’s ability to grow, prosper, compete, and innovate. There are a lot of banks that understand and fulfill this vital role, and a lot of bankers who want to do right by their customers. Well, this reform will help foster innovation, not hamper it. It is designed to make sure that everyone follows the same set of rules, so that firms compete on price and quality, not tricks and traps. It demands accountability and responsibility from everyone. It provides certainty to everybody from bankers to farmers to business owners. And unless your business model depends on cutting corners or bilking your customers, you have nothing to fear from this reform.” – excerpt from the president’s speech

The President was joined on the stage by two non-politicians:

Andrew Giordano is a retired Vietnam veteran from Locust Point, Maryland who the President met last year when he participated in a roundtable to discuss the outdated rules regulating the financial sector. Mr. Giordano was saddled with hundreds of dollars in overdraft fees on his veteran’s account because his bank had automatically enrolled him in “overdraft” protection that he never asked for. The new Consumer Protection Bureau will enforce new rules on overdraft programs to make sure that consumers like Mr. Giordano get a real choice and are not unknowingly charged unnecessary fees.

Robin Fox is a 7th grade science teacher from Rome, Georgia who sent an letter to the President in early August because her credit card company retroactively increased the rate on her existing credit card balance from 10.90% to 17.90%, even though she paid her account on time. The increase has been a burden on her family at an already difficult time, after her husband’s landscaping business dried up due to the financial crisis. The new Consumer Protection Bureau will enforce the Credit CARD Act of 2009, which bans arbitrary rate hikes on existing balances and other unfair practices by credit card companies.

The politicians on the stage:

• Vice President Biden
• Secretary Timothy Geithner
• Chairman Chris Dodd, D-CT
• Chairman Barney Frank, D-MA
• Speaker Nancy Pelosi, D-CA
• Senator Harry Reid, D-NV
• Senator Blanche Lincoln, D-AR
• Representative Collin Peterson, D-MN
• Representative Steny Hoyer, D-MD
• Representative Paul Kanjorski, D-PA
• Representative Maxine Waters, D-CA
• Representative Mel Watt, D-NC
• Representative Luis Gutierrez, D-IL
• Representative Gregory Meeks, D-NY
• Representative Dennis Moore, D-KS
• Senator Tim Johnson, D-SD
• Senator Jack Reed, D-RI

I assume everyone got pens.

Sources:

• President Obama’s prepared remarks a the bill signing
• Background on the signing ceremony
• Image is from AFP

House Financial Services Committee Chairman Barney Frank (D-MA) issued the following statement on the passage of the Financial Stability Bill:

“I congratulate Senator Dodd on an impressive act of legislative leadership, and I also congratulate Majority Leader Reid for pushing this through. The two bills are very similar, and the House is ready to go to conference to work out the remaining issues. I am confident that we can have a bill ready for President Obama’s signature very soon.”

It’s going to take a while to get through all of amendments to the bill to figure out what changed. (Over 400 were proposed.) Senator Dodd still can add a “manager’s amendment” which is supposed to only make technical changes, but often has substantive changes.

As my Congressman Frank states, the House and the Senate need to hash out a compromise bill that both can pass.

The New York Times has a great chart highlighting some of the differences on the big items.

Are you’re looking for some basic understanding of corporate organizations, sprinkled with some pro-business propaganda? I have a video for you.

The Business Roundtable is an association of chief executive officers of leading U.S. companies.

Tucked into the Tax Extenders Act of 2009 (H.R. 4213) was a provision targeted at partnership interests held by partners providing services. H.R. 4213 flew through the legislative process of the House of Representatives. It was introduced on December 7, 2009 and passed by the House on December 9, mostly along party lines. The Carried Interest Tax is one of several dozen changes to the tax code included in that bill.

But will the bill pass in the Senate? Let’s hear from Sen. Debbie Stabenow (D-Michigan):

• “I don’t think it’s going to be part of the Senate bill.”
• “While members of the committee have brought it up, it won’t be part of any bill we pass.”
• “You never know, but I seriously doubt it.”

The US Senate has not introduced anything similar to the Tax Extenders Act. With a Democratic controlled Senate I assumed that passage was inevitable.

But it appear that the divide between the House and the Senate on private equity and private funds appears to be growing. Both bodies keep talking about clamping down on hedge funds, but neither seems to know what one is and is not bothering to define it in the legislation.

Sources:

• Stabenow: Senate won’t hike taxes on VC, equity-firm profits By Tom Henderson in Crain’s Detroit Business
• US Senator: carry tax hike won’t pass by Jennifer Harris in PERE news
• Carried interest is done? Pretty please? in The Dirt Lawyer’s Blog
• Carried Interest Taxed as Ordinary Income? Not So Fast says Senator Debbie Stabenow in Private Equity Professional Digest
• Carried Interest Tax Legislation Suddenly Appears and Moves Forward – Previous Post

November 1, 1974 - "We're Moving Right Along," Herblock, Copyright by The Herb Block Foundation

The Securities and Exchange Commission Historical Society has launched a new gallery exploring the SEC during the mid to late 1970s: In the Midst of Revolution: The SEC, 1973-1981.

“From 1973 to 1981, the securities industry and the SEC experienced revolutionary change that created enormous upheaval, provided new economic opportunity and made the task of the SEC to respond to the new demands wrought by the rapid changes in the market increasingly more difficult.”

I was surprised to discover that the SEC’s Historical Society existed. I was even more surprised to see the wealth of information in its archives and virtual museum.

There is also a great history of the SEC’s regulation of insider trading.

It seems like executive compensation consultants come from Lake Wobegon, where “all the women are strong, all the men are good looking, and all the children are above average.”

I think executives should be compensated for out-performing their peers. They shouldn’t be punished for a negative performance due to external forces if they still out-performed their peers. Further, they shouldn’t be rewarded for a positive performance, if they under-performed their peers.

The magic is in picking the peer group to compare. Ideally, a peer group should include companies that are similar along several characteristics (e.g., industry, size, diversification, and financial constraints). Of course matching all of those characteristics would lead to a very small group for comparison.

In an article in the Wall Street Journal, Cari Tuna points out that Tootsie Roll Industries used Kraft Foods as a peer for deciding how much to pay its executives. Tootsie had $496 million in sales and Kraft had $42.2 billion in sales.

A study by Ana Albuquerque of Boston University examined what needs to go into selecting the peer groups. She found that having the the same industry and size quartile shows the best evidence for creating a relative peer group for executive compensation. In a second study, she found that companies tend to choose peers that pay their CEOs more, which in turn translates into firms paying their CEOs more.

In their study, Michael Faulkender of the University of Maryland and Jun Yang of Indiana University came to the conclusion that “compensation committees seem to be endorsing compensation peer groups that include companies with higher CEO compensation, everything else equal, possibly because such peer companies enable justification of the high level of their CEO pay.”

You can also add into the mix that the company may not want to seen as having a CEO who is below average. If your CEO is below average, then your company may be below average.

If you’re a CEO of a public company, it’s getting harder and harder to be below average.

References:

• Picking Big ‘Peers’ to Set Pay by Cari Tuna for The Wall Street Journal
• Compensation Peer Groups by Michael Faulkender of the University of Maryland and Jun Yang of Indiana University in HLS Forum on Corporate Governance and Financial Regulation
• Faulkender, Michael W. and Yang, Jun,Inside the Black Box: The Role and Composition of Compensation Peer Groups(March 15, 2007). AFA 2008 New Orleans Meetings Paper. Available at SSRN: http://ssrn.com/abstract=972197
• Peer Firms in Relative Performance Evaluation by Ana Albuquerque of Boston University in HLS Forum on Corporate Governance and Financial Regulation
• Albuquerque, Ana M.,Peer Firms in Relative Performance Evaluation(March 26, 2009). Journal of Accounting & Economics (JAE), Forthcoming. Available at SSRN: http://ssrn.com/abstract=1368893
• Albuquerque, Ana M., De Franco, Gus and Verdi, Rodrigo S.,Peer Choice in CEO Compensation(July 21, 2009). Available at SSRN: http://ssrn.com/abstract=1362047
• Ethics in CEO Compensation by Chris MacDonald on The Business Ethics Blog
• CEO Pay and the Lake Wobegon Effect – previous post
• CEO Pay and the Lake Wobegon Effect by Rachel Hayes and Scott Schaefer of the University of Utah in the Journal of Financial Economics.