Blue Wall of Management

During my investment career I have always been perplexed by the make-up of most firm’s Board of Directors, from my coverage of U.S. stocks to global Stocks, from small cap to mega cap companies, from the buy side to the sell side. I have seen it all, and I have almost universally been disappointed. I have seen a medical doctor sit on the board of one the largest railroads in the U.S., management from top customers sitting on compensation committees, and active Fortune 100 CEO’s that also held three board of director positions. But like most investors, I have just noted the poor board make-up, and included it in the mosaic of information I use to make investment decision, because in reality most board memberships are poorly filled and there was little as investor I could do about it. Unfortunately, I did not think about it much, I did not ask why boards were so poorly filled.

So I started to ask, and here is what I found out. When a new board member is needed, either through retirement, term limits (rarer), or performance issues (even rarer), a board of director’s sets up a nomination committee to select qualified candidates. Typically, these candidates are either people they know or recommendations from search firms. This is where we hit the circular issue, if the prior board was poorly constructed and management has huge influence on the board (which is especially troublesome when the board is led by management: CEO/Chairman the ultimate circular issue). The poorly constructed boards seem to fall into the issue of nominating people that look like themselves. Management can clearly have an impact on hiring new director’s that are most beneficial to their own interest. If I could hire my own boss, I would like to think I that would pick someone that would push me to be the best I can be in my role; however, I am pretty sure I would find some way to justify hiring the person that would be easiest on me, never fire me, and give me the best pay raise. I am just human, and that is why we need proper checks and balances.

When I heard about independent director search firms, my first reaction was, that sounds like the perfect solution. But if director search firms have been around for a while and are being widely utilized, why do most board of directors still look so misallocated? I think the problem lies in the same issues we see in poor nominations from the boards. The search firms are hired by the board of directors, I assume their number one priority is to make as much money as possible by getting as many placement as possible. Therefore, they are probably directly or indirectly influenced to make the board of directors and management happy by nominating people they would want on the board. And since the board of directors wants people that look like themselves and management wants bosses that will be easy on them, that seems to be what we get.

The ultimate conclusion of this process seems to be that we hire a lot of management professionals to sit on the board of directors. There is one category of professionals you rarely see on a board of directors, investors. Few people like investors, investors do not like investors, we are necessary evil. We are judgmental, never satisfied, detail oriented, and very results based. This is a group of individuals that have spent their whole career learning how business operate and deciding which business are being run well and which ones are awful. If I was an owner of a company, as all shareholders are, this is the type of person I would want on my board of directors. Not just my employee’s friends. Should the board of director’s be 100% investors, probably not. Should it be 25-50%, seems more reasonable than the current mix of about 0%.

And not to be someone that complains about a problem without some constructive solutions. I think there is no silver bullet, but I think the following recommendations will take us to a place of better board of director placements, and ultimately better corporate governance, investor returns, and dare I say better economic growth.

• Utilization of independent board search firms that focus on investor needs (maybe moonlight in auditor review)

• Limit the board participation of management professionals, and require the Chairman of the Board to be an independent board member

• Reduce or eliminate the participation of limited ownership management (own less than 5% of the company) on a board of directors

• Minimum levels of investor nominations in board of director’s election pool (such as 50%)

• Better investor access to proxies

• Limit or eliminate a CEOs ability to service on other corporation’s boards (CEO is probably a full time job)

I have never seen a good example of self-regulation or self-management, whether it be the police, industry regulators, doctors, employees or investors. I see no reason why we would expect management to be any better, and I see no reason we should expect management to make the changes on their own. In reality, these problems lie squarely on shoulders of investors. We have allowed these questionable policies to go on for years, and for the most part, the only thing we have done is to vote with our feet (sell poor companies). It would be pretty east to make a big difference in corporate government, implement just a few of these policies at the largest firms, and it should create a waterfall effect that impacts the entire market. Like all humans, management and board of directors have a strong self-preservation instinct. If they start to feel that their roles are at risk due to being a bad actor or laggard in corporate government trends, the internal drive to improve governance would be quicker and cleaner than anything we could hope from the government.