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Friday, April 5, 2013

Should Germany Prop Up the E.U.'s Southern States?

In April 2013, Deutsche Welle reported that the German central bank had “analyzed possible effect a domestic growth package could have on southern European economies. ‘By and large, it would have no impact,’ claimed Clemens Fuest, president of the Mannheim-based Center for European Economic Research. ‘We won't be able to fight recession in southern Europe with domestic growth incentives.’ He added that southern European states do not just have a demand problem. ‘Prices there have got out of hand,’ he said. ‘Wages and labor costs have spiraled out of control, and must be brought down again. If you were to implement a growth scheme, you'd only slow down the necessary adjustments.’”
Additional spending by the Bundestag to increase German demand probably would not foster economic growth in Greece, Italy and Spain. It follows that Angela Merkel could not use this rationale as a way to legitimate a pre-election increase in spending to improve the prospects of her re-election. Hemmed in by their own public debt loads, Greece, Italy and Spain could not provide their own stimulus spending. Nor could those states control monetary policy. According to Guntram Wolff of the Bruegel think tank in Brussels, the southern states were in an intractible position. “We in Germany aren’t really aware how desperate the situation is in southern Europe,” he said. In his view, the widespread disenchantment in the south could lead to more political instability there.
Fuest and Wolff miss a third alternative, however. Namely, the E.U. itself could provide the stimulus spending, effectively redistributing economic growth from the north to the south, other things equal. Two obstacles would doubtless raise their heads in protest were such a proposal to be made.
First, the power of the state governments in the European Council would permit net-paying states like Germany to veto the stimulus based on the rich states’ own immediate interests. Indeed, Angela Merkel had been criticized in the southern states for having too much power at the E.U. level in pushing for austerity without stimulus spending.

As a possible solution, increasing the competencies subject to qualified majority voting in the Council would lessen the power of a big state such as Germany to unilaterally dictate federal policy. Additionally, the E.U. Commission could send its proposals first to the European Parliament instead of the European Council.

If the German government had indeed exploited the opening for the direct involvement of state governments at the E.U. level, even other wealthy states may find it in their interests to weaken the veto in the European Council and strengthen the European Parliament such that it could be a check on the state governments acting through the Council.

For example, after German Finance Minister Wolfgang Schaeuble openly wondered whether a state economy based on banks could still be viable after the crisis in Cyprus, Luxembourg's Foreign Minister Jean Asselborn snapped back, "Germany does not have the right to define the business models for other" E.U. states. If Luxembourg's state officials perceived Germany as having too much power in the European Council, those officials would have a motive to further restrict the usage of the veto in the Council and the Council itself relative to the European Parliament in legislating. Put another way, it is possible that enough states have an incentive to reduce the power of the state governments at the E.U. level.
The second obstacle to targeted stimulus spending at the E.U. level is known as the "democracy deficit."  The weakness of the European Parliament relative to the European Commission suggests that bureacrats rather than elected representatives run the E.U. That the state officials in the European Council are themselves elected representatives may mean, however, that the charge of a deficit is over-stated. A person living in Germany, for example, has an elected representative in the European Parliament and an elected representative—the German Chancellor—in the European Council. This translates into a substantial democratic presence at the federal level. Whereas the excess power of the states at the federal level is a problem, the dearth of democracy at that level is overblown. Even so, strengthening the authority of the European Parliament would "kill two birds with one stone," meaning that the influence of the state governments would be lessened while democracy is strengthened.

In conclusion, while skipping the E.U. as a source of stimulus spending for troubled states is understandable the governmental weaknesses at the federal level, the option should not be dismissed entirely, especially if governmental reform at the E.U. level is continued. Such reform should continue to hem in the states' involvement while invigorating the European Parliament.



 Zhang Danhung, “Eurozone: Putting a Halt to Spending Cuts?Deutsche Welle, May 4, 2013.


Thursday, April 4, 2013

States Move Beyond Congress on Gun Control

On April 4, 2013, the government of Connecticut passed “a sweeping new set of gun control reforms.” Colorado and New York had already passed their respective versions of “sweeping gun legislation,” all in the wake of the Sandy Hook school shooting in Connecticut the previous December. 

The complete essay is at "Is the E.U. a Federal System?"

Getting More For Doing Less: Bank Board Directors

Executive compensation is an art rather than a science. It is not as if certain numbers are fed into a computer and the correct compensation amounts pop out. There is more discretion involved than meets the eye. “Since the financial crisis,” the New York Times reported in 2013, “compensation for the directors of [America’s] biggest banks has continued to rise even as the banks themselves, facing difficult markets and regulatory pressures, are reining in bonuses and pay.” Board and upper management pay seem to be going in different directions is spite of both being presumably tied to the same firm performance. There is much maneuver, in other words, even given a performance-incentive approach.
At $488,709 in 2011, Goldman Sachs had the highest director-pay of any American bank. Some of the bank’s 13 directors make more than $500,000 because they have extra board responsibilities. As the directors are paid in stock, 2012 promised to be an even better year for the thirteen. Compensation experts say banks must pay premium dollar to pay such figures for what is essentially part-time work in order to get the best advice. However, JPMorgan, the largest American bank, gave its directors “only” an average of $278,194 in 2011. Bank of America paid its directors $275,000 each. Equilar reports that the average compensation for a director at one of the six largest American banks in 2011 was $328,655. This compares with $232,142 at almost 500 publicly-traded companies, according to Spencer Stuart, in spite of the fact that regulations have narrowed the responsibilities of bank boards. One would think that compensation would reflect changes in the number of tasks even more than macro indicators of bank performance.  
“I get you have to pay up for sophisticated board, but what is that complexity worth?” said Timothy M. Ghriskey, co-founder of the Solaris Group, a financial services shareholder that voted in 2011 to reject a pay plan for top executives at Citigroup. “Does it take $200,000 or $500,000? The discrepancy between a board like JPMorgan and Goldman is confusing.” For one thing, the differential indicates that the matter is far more subjective than meets the eye. This in turn suggests that when a compensation expert claims that a certain level is necessary, the claim can be critiqued rather than taken at face value.
In fact, when it is claimed that a certain director-level compensation is necessary (e.g., X amount of stock at Y exercise price), the fact that this claim is not true may suggest that insider collusion between board members or the board and upper management is involved. Put another way, the false-necessity may be a subterfuge used by insiders seeking to enrich each other. You scratch my back, and I’ll scratch yours. The dispersed stockholders a left with less.
In short, it can be doubted whether the director compensation level is necessary or even in the stockholders’ interest. The excess probably reflects the difficulty facing stockholders in holding the insiders accountable. Accordingly, one consequence of corporate governance reform may be a reining in of pay for what is really a part-time job (i.e., gravy) with fewer and fewer responsibilities.


Susanne Craig, “At Banks, Board Pay Soars Amid Cutbacks,” The New York Times, April 1, 2013.




The Banks’ Consultants: Guarding the Hen House

Leaving it to consultants hired by mortgage servicers to right the wrongs that the services inflicted on foreclosed homeowners was the unhappy consequence of bank regulators giving ambiguous guidance and failing to install viable oversight mechanisms. According to the Government Accounting Office, “regulators risked not achieving the intended goals of identifying as many harmed borrowers as possible.” Even if the reviews had been completed, there was on guarantee that wronged mortgage borrowers would have received any compensation. On the other side of the ledger, the banks had received billions from the U.S. Treasury with no strings attached. Whether intentional or not, the banking regulators put too much stock in the consultants, who, after all, had been hired by the mortgage servicers.
"The report confirms that the Independent Foreclosure Review process was poorly designed and executed," Rep. Maxine Waters (D-Calif.) said. The "report confirms what I had long suspected -– that the OCC’s oversight of the supposedly independent consultants hired by the servicers was severely deficient. The report should serve as a wake-up call.” By referring to the consultants as supposedly independent, Rep. Waters implies in her statement that the flawed review process put the consultants in the position of being able to exploit a conflict of interest.
On the one hand, the flawed oversight means that the consultants were the ones to protect the public interest. The public had to rely on them to correct the wrongs in the interest of the foreclosed. We can label this the consultants’ “public interest” role. The consultants’ other role  was in working for the servicers. As Benjamin Lawsky, the superintendent of New York's Financial Services Department, pointed out, "The monitors are hired by the banks, they're embedded physically at the banks, they are paid by the banks and they depend on the banks for future business." This is the consultants' other role, which can compromise the first role.

 In a conflict of interest, one role can circumvent another, more legitimate role. Even if the conflict is not exploited with the more legitimate role taking the hit, a person or institution in such a position can be reckoned as unethical, according to some scholars. Other scholars argue that only the actual exploitation of the more legitimate role by the other is unethical.

In my view, if exploitation can be seen as a possibility in the relation between two roles, the relation itself is unethical. Put another way, it is unethical to put a person or organization in such a position, even if actual exploitation does not occur. In my view, to create or perpetuate the condition wherein a person or organization can exploit a conflict of interest is unethical.

It follows that the government has a moral responsibility to eliminate the conflicting roles even if they are not being exploited. Furthermore, the person or organization having two such conflicting roles  as can be counted as a conflict of interest is also ethically obliged to pick one role or the other. Often this is not convenient from a short-term financial standpoint, so business practitioners tend to look the other way, rationalized that since no actual exploitation of the conflict of interest has occurred, there are no ethical issues. They are wrong. The mortgage servicers should never have hired consultants to monitor the servicers. This circle itself is problematic, ethically speaking.
The regulators rather than the consultants should have been the key enforcers, and thus protectors of the public interest. The regulators can be faulted not only for their lack of competence, but also ethically in having allowed the conflict of interest to exist.  A business should not be allowed by the regulators to guard the hen house. To permit this to happen is unethical even if no hens are eaten.  


Ben Hallman and Eleazar Melendez, “GAO Foreclosure Report Finds Bank Regulators Failed to Provide ‘Key Oversight’,” The Huffington Post, April 3, 2013.

 Dan Fitzpatrick, "'A Dose of Healthy Competition' For Banking Regulators," The Wall Street Journal, April 18, 2013.

Sunday, March 31, 2013

Bad Directors at HP: Like Guests Who Overstay?

Lest it be thought that Congress ignoring the business lobby would result in laws capable of reforming corporate governance in the U.S. in the interest of stockholders, even putting the “objectionable” stuff back into legislation may not be sufficient. In this essay, I look at the proposed elimination of plurality voting in the original Dodd-Frank bill from the perspective of the case of HP. Put simply, the question is whether it would have made any difference had the proposal been retained in the bill.
Under the plurality voting system, which as of the end of 2012 was still prevalent at many companies, the nominees to board seats who receive the highest number of votes are elected no matter how few they get. Managements have noticed that by supplying only enough nominees to fill the open seats, all of those nominees can be elected even with one vote each (which may be their own!). A provision to eliminate plurality voting and replace it with majority voting was eliminated from the Dodd-Frank financial reform bill while it was still in committee. To be sure, it is not clear that the elimination of plurality voting would have made any difference. At the very least, shareholders would have to be able to submit their own nominees for even majority voting to work. If there is only one nominee for a given seat, reaching a majority is still pretty easy.
Mary Schapiro, a former chair of the SEC, pushed for a proxy access rule that would have allowed shareholders to nominate their own candidates and required companies to put them on the ballot. The SEC passed the rule in 2010, but in 2012 a federal appeals court blocked the rule because the SEC had not done an adequate cost-benefit analysis.
Had the plurality voting system been retained in Dodd-Frank and the SEC’s proxy access rule not been challenged in court by the Business Roundtable and the US Chamber of Commerce, would stockholders have any greater sway over management in deciding whether directors should be retained? Even under extraordinary bad financial performance wherein much stockholder wealth is lost, a management subject to the majority voting system for directors and a proxy access rule similar to that of the SEC can still have directors retained at the expense of shareholder interests. I have in mind the case of HP.
In 2011, HP’s directors unanimously approved the acquisition of the software maker Autonomy for $11.1 billion. Even at the time, that company was considered to be “wildly overpriced,” according to the New York Times. Less than a year later, HP wrote off $8.8 billion of the acquisition cost. Moreover, HP wrote off a total of $18 billion in 2012 related to failed acquisitions and other failures.
Lest it be thought that the Autonomy decision was an isolated error of the HP board, the hiring of Leo Apotheker points to a pattern. Apotheker had been fired as chief of the E.U. software company SAP after just seven turbulent months. Yet HP’s board merely rubber-stamped the four-person search committee, at least one of whom would be nominated by Apotheker to be a director at HP and voted in. The pattern is that of a lack of due diligence. Additionally, a conflict of interest exists in Apotheker’s nomination (via Raymond Lane) of John Hammergren, who had been on the search committee.
                                                      Leo Apotheker during his disaterous tenure at HP.  siliconangle.com
The HP stock price went from more than $45 a share to a little more than $22 during Apotheker’s eleven-month tenure. In spite of this horrible performance, the board paid him more than $11 million in termination benefits. Such a decision reflects very negatively on the board directors themselves. “You really couldn’t have a stronger case for removing directors,” Michael Garland, executive director for corporate governance in the New York City comptroller’s office said in March 2013. Moreover, he added, “There’s been a long series of boardroom failures that have harmed the reputation of the company and repeatedly destroyed shareholder value over an extended period of time.” In the case of HP, all 11 directors were re-elected on March 20, 2013. The majority voting and access proxy rules in place at HP were not sufficient to give shareholders enough power to protect their collective wealth in the company.
Put another way, even if stockholder activists had gotten what they wanted in the Dodd-Frank Act and at the SEC, it would not have been enough. The problem thus goes beyond the resistance of the business lobby. As one indication of the shortcomings in the two rules that were proposed, there is a conflict of interest in that major stockholders tend to be asset management firms and managers of index firms. Mutual fund and asset management companies may be managing company retirement plans. The major stockholders may thus have a financial interest in kissing up to the managements in order to win contracts on the retirement funds. Lest it be presumed that a firewall in the firm adequately separates these two interests (i.e., stockholder and fund manager), there is always an office of sufficient reach in an organization that can reach both functions in spite of the wall. Additionally, it is all too easy for employees to ignore the wall as supervisors look on. The cases of the rating agencies and CPA firms provide sufficient evidence of the ineffectiveness of internal firewalls in companies operating by the profit motive. At the very least, the inherent conflict of interest would need to be prevented rather than managed for stockholders to be able to protect their interests adequately in corporate governance.
The overriding conflict of interest getting in the way of effective corporate governance is that of the CEO having influence over the board whose function includes holding the management accountable. Management should not be allowed to even nominate directors, let alone be on the board. Yet in many cases, CEOs chair the board tasked with holding them accountable! It is truly astounding how much the conflict of interest is willfully ignored or dismissed by legislators and the public. Business is of course all to willing to ignore it, but why do stockholders put up with it? I suspect  that part of the problem is that human nature is typically held to be stronger than it actually is in withstanding the temptation to exploit structural or institutional conflicts of interest.
For example, managers at companies tend to assume that their internal firewalls are sufficient. I spoke with the director at Deloitte whose responsibilities included constructing such walls. He presumed that partners would not gear an audit opinion to being renewed as the client’s auditor for the next year. He also presumed that the wall between the firm’s consulting and auditing functions would prevent the consultants from influencing the auditors and the auditors from auditing the consultants’ work. The latter has occurred in regulatory compliance hires (i.e., Deloitte was hired at a bank to shore up the money-laundering checks that Deloitte consultants had designed and installed). Periodic internal “spankings” cannot suffice in countering the financial incentive in one back scratching the other at a CPA firm. The director’s faith in his own firewalls struck me as highly naïve, and yet he presumed that he could not be wrong.
In terms of corporate governance, stockholders are vulnerable because we as a society tend to permit institutional conflicts of interest that should not be tolerated. For example, a CEO should not be allowed to chair the board of directors or nominate directors. Past and present managers should not even be allowed to vote for directors, let alone serve on the board. This does not mean that a board could not avail itself of their expertise when needed. Simply increasing the number of outside directors would not be sufficient, given the depth of the conflict of interest that benefits managements at the expense of shareholders (and thus property rights). In 2012, there were elections for 17,081 director nominees at U.S. corporations. Only 61 of them, or 0.36 percent, failed to get a majority. Of those 61, only six actually stepped down or were asked to resign, according to Institutional Shareholder Services.
It can be concluded, therefore, that managements have achieved control of the corporate governance machinery that is supposed to serve as a check on those managements. Put another way, the system has broken down and yet we as a society are acting as if it is still operative. Only in outward appearance are stockholders protected, though exceptions can be listed. Boards put together by management have indeed fired CEOs. However, even then, what happens to the directors who installed the flawed CEO in the first place? 



James Stewart, “Bad Directors and Why They Aren’t Thrown Out,” The New York Times, March 30, 2013.