2013 was a year of continuing challenges and opportunities for U.S. banks. The low-interest rate environment continued to challenge the ability of banks to lend profitably. Already burdensome regulatory demands grew weightier with expanded Dodd-Frank stress testing and the finalization of the Volcker Rule, among other things. More than ever before, the responsibility of directors of financial institutions for regulatory compliance and bank safety and soundness is broadening, highlighted most recently by the OCC’s steps to formalize its program of supervisory “heightened expectations” for larger banks and their directors. Against this backdrop, the banking industry saw steady and creative deal activity, with a pronounced concentration among community banks.
Posts Tagged ‘Board monitoring’
On October 30, 2013, the Office of the Comptroller of the Currency (the “OCC”) issued updated guidance to national banks and federal savings associations on assessing and managing risks associated with third-party relationships, which include all business arrangements between a bank and another entity (by contract or otherwise).  The new guidance introduces a “life cycle” approach to third-party risk management, requiring comprehensive oversight throughout each phase of a bank’s business arrangement with consultants, joint ventures, affiliates, subsidiaries, payment processors, computer network and security providers, and other third parties. Rather than mandating a uniform set of rules, however, the guidance instructs banks to adopt risk management processes commensurate with the level of risk and complexity of its third-party relationships. Accordingly, the OCC expects especially rigorous oversight of third-party relationships that involve certain “critical activities.”
The revamped guidance reflects the OCC’s concern that the increasing risk and complexity of third-party relationships is outpacing the quality of banks’ risk management over these outsourcing arrangements. The guidance cautions that a bank’s failure to implement appropriate third-party risk management processes may constitute an unsafe and unsound banking practice, and could prompt formal enforcement actions or a downgrade in a bank’s CAMELS management rating to less than satisfactory. The severity of these consequences suggests that third-party risk management practices are becoming an increasingly important focus of OCC supervisory efforts.
In many respects, the relentless drive to adopt corporate governance mandates seems to have reached a plateau: essentially all of the prescribed “best practices”—including say-on-pay, the dismantling of takeover defenses, majority voting in the election of directors and the declassification of board structures—have been codified in rules and regulations or voluntarily adopted by a majority of S&P 500 companies. Only 11 percent of S&P 500 companies have a classified board, 8 percent have a poison pill and 6 percent have not adopted a majority vote or plurality-vote-plus-resignation standard to elect directors. The activists’ “best practices” of yesterday have become the standard practices of today. While proxy advisors and other stakeholders in the corporate governance industry will undoubtedly continue to propose new mandates, we are currently in a period of relative stasis as compared to the sea change that began with the Sarbanes-Oxley Act and unfolded over the last decade.
In other respects, however, the corporate governance landscape continues to evolve in meaningful ways. We may be entering an era of more nuanced corporate governance debates, where the focus has shifted from check-the-box policies to more complex questions such as how to strike the right balance in recruiting directors with complementary skill sets and diverse perspectives, and how to tailor the board’s role in overseeing risk management to the specific needs of the company. Shareholder engagement has been an area of particular focus, as both companies and institutional investors have sought to engage in more regular dialogue on corporate governance matters. The evolving trend here is not only the frequency and depth of engagement, but also a more fundamental re-thinking of the nature of relationships with shareholders and the role that these relationships play in facilitating long-term value creation. Importantly, this trend is about more than just expanding shareholder influence in corporate governance matters; instead, there is an emphasis on the roles and responsibilities of both companies and shareholders in facilitating thoughtful conversations instead of reflexive, off-the-shelf mandates on corporate governance issues, and cultivating long-term relationships that have the potential to curb short-termist pressures in the market.
Shareholder activists are meeting now to consider what proposals they will file for the 2014 proxy season and the results are largely in from the 2013 proxy season, with analysis coming from all the different proponent groups, the proxy advisory firms and others interested in what happened this year. Si2’s own report in August showed that the upward climb of investor support for social and environmental policy proposals continued this year, with average support hitting a record level of 21.3 percent and requests for more board and workplace diversity, sustainability reporting and corporate political activity disclosure got the highest levels of support. (More information on these overall findings and overall trends, illustrated with charts, appears here.)
One group that reports on proxy season findings is Proxy Monitor, a project of the Manhattan Institute’s Center for Legal Studies. It focuses on resolutions that go to votes at the 250 largest U.S. firms, reporting on the vote results and presenting analysis of the trends on its website. The group’s analyses of proxy season results trends have some significant blind spots that are not always apparent to the novice proxy analyst, but its reports nonetheless are widely quoted in the press. As such, they deserve some scrutiny, which this post offers. Si2 took a look at all the shareholder resolutions filed since 2010 and compared the results to the Proxy Monitor database to see precisely how PM reaches its conclusions.
The current public controversy notwithstanding, valuable governance lessons arise from JPMorgan Chase’s internal analysis of the highly public 2012 losses in its synthetic credit portfolio; the saga of the so-called “London Whale”. The internal JPMorgan analysis should not be confused with the March 15 report on the “Whale Trades” issued by the Senate Permanent Subcommittee on Investigations.  Neither should its credibility be undermined by the Subcommittee’s critical report.
JPMorgan’s primary findings were contained in an exhaustive report of the trading strategies and management activities that led to these losses, prepared by a management task force.  Additional findings and recommendations were included within a much shorter companion report prepared by the board’s Review Committee. This companion report concentrated on the board’s risk oversight practices.  To a certain extent, the “sizzle” was contained in the lengthier management task force report, with its focus on what happened, why it happened, and who was to blame for it happening. But from a governance perspective, the lessons for corporate America are in the companion report, with its focus on improving the process by which risk information is reported to the board. These governance recommendations are highly relevant today, because the broader fiduciary landscape has been dominated of late by concerns about the quality of board oversight of risk.
An important task for boards is to oversee executive compensation. The effectiveness of boards in carrying out this monitoring responsibility, however, is widely debated. In the paper, The Effect of Disclosure on the Pay-Performance Relation, forthcoming in the Journal of Accounting and Public Policy, we argue that disclosure improves board effectiveness. First and as a general point, disclosure can improve transparency, which facilitates the monitoring of management and hence causes managers to act more in the interests of shareholders. Such monitoring is potentially valuable since managers will not always act in the best interest of shareholders.
In the paper, Governance in Executive Suites, which was recently made publicly available on SSRN, my co-author (Yao Lu) and I analyze the interplay between governance in executive suites and board monitoring. We find an exogenous shock increasing board independence weakens governance in executive suites. The empirical proxy for the strength of governance in executive suites is based on the governance mechanism identified by Landier et al. (2009), wherein dissenting executives steer CEOs towards more shareholder friendly decisions through “an efficient implementation constraint that disciplines the decision-making process.”
The two most authoritative positions in a boardroom are the CEO and the chairman. However, when these roles are combined, all the authority is vested in one individual; there are no checks and balances, and no balance of power. The CEO is charged with monitoring him or herself, presenting an obvious conflict of interest. Indeed, if the CEO is responsible for running the company, and the board is tasked with overseeing the CEO’s decisions in the interests of shareholders, how can the board properly monitor the CEO’s conduct if he or she is also serving as board chair?
While the theory behind separating the two roles has been the subject of much shareholder and governance activist protest and commentary, an analysis of GMI Ratings’ data suggests that other, more practical considerations would support the separation of the two roles. In addition to the inherent conflict of interest already discussed, CEOs who also command the title of chairman are more expensive than their counterparts serving solely as CEO. In fact, executives with a joint role of chairman and CEO are paid more than even the combined cost of a CEO and a separate chairman. Also, companies with a combined CEO and chairman appear to present a greater risk of ESG (environmental, social and governance) and accounting risk than companies that separate the roles. Furthermore, companies with combined CEOs and chairmen also appear to present a greater risk for investors and provide lower stock returns over the longer term than companies that have separated the roles. Thus having a separate chairman and CEO costs less, is less risky and is a better investment. This report focuses on 180 North American mega-caps, those with a market capitalization of $20 billion or more. This group was chosen because, given the relative complexity of running the companies, it might be expected that the resulting differentials between leadership structures in cost structure, performance and risk exposure would be more marked. Here are some of the main findings of the report:
In the paper, Learning Mores and Board Evaluations – Soft Controls in Corporate Governance, which was recently made publicly available on SSRN, I argue that the prevailing boardroom mores, the unwritten rules, are at one end of having an impact on board effectiveness. Legislation, the more tangibly written rules, is at the other end. In between are voluntary codes of conduct, or legally embedded corporate governance codes.
How, without switching to increasing degrees of legislation with hard controls, do we provide direction to desirable conduct in the boardroom and thus to more effective corporate governance? International corporate governance codes were developed in the 1990s in response to declining trust in the financial system and exchange-listed companies. In recent decades, research into corporate governance focused mainly on the design of governance. Corporate governance codes were drawn up with guidelines for executive directors, non-executive directors and shareholders. The requirements in the corporate governance codes were aimed principally at establishing the conditions under which monitoring could be conducted, and less on the actual way in which this monitoring was conducted.
So much of the architecture of corporate governance has been the subject of recent federal reforms (SOX, Dodd-Frank, FCPA expansion, etc.) that it is easy to forget that those enactments leave a lot of the governance landscape unaddressed. Clearly, federal requirements for compulsory CEO and CFO financial statement certifications, automatic clawback of senior executive stock option grants following restatement of financials, expanded MD&A and CD&A disclosures, say-on-pay voting requirements, board committee charter mandates, federal one-size-fits-all proxy access rules (that have been blocked in court from implementation), new federal whistleblowing protection schemes, and other federal reforms have reshaped many of the peaks and valleys of corporate governance and are covered at length in this handbook.
However, directors’ robust exercise of their oversight responsibilities depends on much more than taking into account those federal promontories and gullies. Arguably, some of the most important director oversight functions, such as CEO succession, conflict of interest avoidance, strategic risk assessment, capital allocation and employee retention occupy large spaces in the governance landscape that are only indirectly touched by headline-fetching federal reforms. Yet those other key oversight responsibilities might easily become neglected lacunae in the landscape if they are overshadowed by the burden and time devoted to regulators’ mandates.
Consequently, well apart from regulatory guidelines and headline pressures that structure many board tasks, directors also need to devote the self-disciplined effort requisite to fulfilling those fundamental oversight duties.