The Corporate Library Blog

Corporate Governance: Not Yet Priced In

Some in the responsible investment community have suggested that the relationship of corporate governance to equity returns is now broadly understood, so that security prices accurately reflect governance risk. Indeed, you’d think that if mainstream investors were ever going to realize that weak boards and bad compensation practices could cost them money, it should have happened in the last year and a half, since the crisis of 2008. However, a study we just commissioned from Quantitative Services Group (QSG), a highly regarded quant shop, suggests that the importance of governance is still an alpha-generating secret. QSG backtested a hypothetical portfolio that used our ratings to screen out companies with high governance risk. They found that our portfolio would have outperformed the Russell 1000 by 275 annualized basis points since 2003—and that  outperformance continued to be strong in  2009, when you’d think the rest of the world would have caught on. (For details, see the report we released today). Broad market understanding of good governance clearly still has a way to go; in the meantime, those of us who are paying attention may have an investment opportunity.

Kimberly Gladman - Director of Research and Risk Analytics

Palm Inc looking for a buyer?

It’s true, Bloomberg says so, Palm Inc is working with Goldman Sachs and Qatalyst Partners to find a buyer, but as with so much M&A activity, is anyone thinking about the corporate governance issues?

They should be.

We already showed that they could have saved $100 billion by thinking about it in the case of AOL Time Warner. Palm – well we’re not talking about losing that much money – but it still needs thinking about, particularly as The Corporate Library recently lowered its rating from low risk to high risk (you can buy the full governance profile here).
What are some of the problems?

Well, takeover defenses, ironically enough, including a classified board and a multiple share class structure. This is what The Corporate Library’s analyst comment says about the latter:

Additionally, the company has a multiple share class structure consisting of common stock, Series B Preferred Stock (Series B), and Series C Preferred Stock (Series C). Common stock is entitled to one vote for each share, Series B shares are entitled to approximately 117.647 votes for each share, and Series C are entitled to approximately 307.692 votes for each share. Together, Series B and Series C are convertible into 53,927,601 shares of common stock. Elevation Partners, L.P. (a private equity firm) are beneficial owners of all the outstanding shares of the Series B and Series C stock. Directors Fred D. Anderson and Roger B. McNamee are co-founders and managing directors of Elevation Partners.

The comment concludes this section with masterful understatement:

Their (Anderson’s and McNamee’s) presence on the board combined with the disparate voting rights raises concerns that the interests of public shareholders may be subordinate to those of Elevation Partners.

No duh!

And executive compensation is not the greatest either, with a recent move to semi-annual cash bonuses, reflecting the company’s faltering performance, perhaps, but also hyperfocusing executives on the ultra short-term which is hardly helpful to shareholders concerned about long-term value. Added to which, recently promoted CEO Jonathan Rubinstein is sitting on some performance-related stock options – a million of them – that at the current stock price have about as much chance of vesting as, well, a stock option that doesn’t have much chance of vesting. You see, they will only vest if the stock price hits targets of $12.75, $17.00 and $25.50, and since it’s currently moldering around the $5.40 mark, there doesn’t look like a hope in hell. Unless, of course…. What’s that clause in his Management Retention Agreement…: “entitles him to full acceleration of the vesting of his outstanding stock options and full vesting of any shares of restricted stock and RSUs (regardless of performance requirements) upon a change of control.”

Hmmm…  a change of control seems a bit easier to achieve than doubling, tripling and quintupling the stock price. Conflict of interest, anyone?

Paul Hodgson - Senior Research Associate

ESG Integration: Massey Energy as Case in Point

In the ongoing debate about the relationship between ESG and investment performance, it is sometimes argued that these variables serve as a proxy for management quality.  In other words, if companies are managing their environmental and social risks well, and if they have governance structures designed to hold executives accountable, they are probably generally well-organized and good at anticipating whatever may affect their business.  Over the long term, the argument goes, such companies will likely be better at protecting shareholders’ interests. This week’s news from Massey Energy may lend support to this thesis. 

After the tragic accident that killed at least 25 miners at one of the company’s operations this week, there has been widespread press coverage of Massey’s record of safety and environmental violations.  A look at the company’s governance also reveals a pattern of serious issues.  The Corporate Library has registered high concern about CEO compensation at the company for some time, due to repeated cash retention bonuses (with no performance triggers), extensive stock and option awards, and the downward adjustment of performance targets for the annual incentive program in 2008 after 2007’s proved hard to meet.   The board has additional problems:  three members received over 10% withhold votes at their last election, which is unusually high.  One of them, James B. Crawford, received over a quarter of votes withheld, and another, Lady Barbara Thomas Judge, received a majority of votes withheld.  (Because of the company’s plurality voting standard, she was not required to resign.)  The board’s committee structure is also unusual, with several very large committees of six or seven members each (including the Environmental, Health and Safety Committee, whose members might expect to see some more withhold votes this year, given recent events).  Given these large committees, a number of directors serve on several committees at once.  Typically, boards limit committees to three or four seats so that a few directors can focus their attention on a given area, and develop some expertise that can help guide the board as a whole. Massey’s directors are likely to be too scattered to adequately oversee the specific issues they are charged with. Massey's complete corporate governance report is available for purchase on The Corporate Library's website.

In sum, by multiple ESG measures, this seems to be a company that does not have its affairs in order.  The consequences for some employees have already been devastating; investors may also be at serious risk.

For more information on the link between ESG factors and investment performance, download our free report, "The Corporate Library's Governance Ratings and Equity Returns."

Kimberly Gladman - Director of Research and Risk Analytics

Here's Your Chance to Question Wall Street CEOs

The Financial Crisis Inquiry Commission headed by Phil Angelides will hold its first substantive hearing next week and Commissioner Keith Hennessey has asked for suggestions on what questions to put to the four Wall Street CEOswho are scheduled to appear:

• Lloyd Blankfein of Goldman Sachs;
• Jamie Dimon of JPMorgan Chase;
• John Mack of Morgan Stanley; and
• Brian Moynihan of Bank of America.

Hennessey, former senior White House economic adviser to President George W. Bush, encourages anyone to send suggested questions via email or comment on his blog.  It is a great opportunity to crowd-source the hearing and allow Main Street to present their concerns directly to the Wall Street.  This selection from the invitation letter sets the framework of the hearing:

The FCIC is interested in learning what caused financial problems experienced by your company, including losses incurred, and what changes have been implemented as a result. Therefore, your testimony should address the following topics:

• What were the primary errors and business practices that caused the financial problems at your company and what actions have been taken to address them;
• What were your company’s business models and major sources of income (or loss), what changes have been made, what were the reasons for the changes, and what are your company’s current business models and sources of profit;
• What types of lending activities did your company pursue that caused the financial problems, including the amount, Iypes and terms of loans being made, what changes have been made, what were the reasons for the changes, and what are your company’s current lending practices;
• What were the risk management policies and practices at your company, including the types of investments being made, underwriting and approval of investments including reliance on third parties for due diligence, monitoring of investments by management, the board of directors, committees of the board of directors, and any other persons or entities, and the accounting and public reporting of the company’s investments. What changes have been made to your company’s risk management policies and practices, what were the reasons for the changes, and what are your company’s current risk management policies and practices. In addition, what were your company’s risk exposure, what changes have been made to your company’s risk exposure, what were the reasons for the changes and what are your company’s current risk exposure;
• What were the executive compensation plans and practices at your company and how did they contribute to the problems. What changes have been made to your company’s executive compensation plans and practices, what are the current executive compensation plans and practices, and what were the reasons for the changes.

Nell Minow - Editor

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Another 137 pages from the SEC on risk, executive compensation etc.

Back on July 1, the SEC released 137 pages of reforms for comment. One hundred and thirty-seven. These covered, among other things:

• Compensation policies and risk
• Changes to the Summary Compensation Table
• Additional requirements for director nominations and qualifications
• Additional disclosures surrounding leadership structure
• Board’s role in risk management
• Compensation consultant disclosures

o All additional services
o Aggregate fees
o Involvement of management in hiring for exec comp advice
o Has board approved additional services

• Voting results filed on 8-K within 4 days of meeting

First, in the area of executive compensation and risk: specifically, it is looking for better disclosure about the relationship between a company's overall compensation policies and its risk profile.

The changes to the Summary Compensation Table – ignoring my impassioned letter about the subject – indicate that the commission wants to include the grant date value of stock and stock option awards in the table rather than the “expensed value." As I said, this continues to mix real and imaginary pay, apples and oranges, it’s just a different kind of orange, mandarin, rather than Seville. I’m saying it again, let’s just have apples!

Additional requirements surrounding director nominations and qualifications go well beyond the new requirements put out by the Treasury on increased independence for compensation committee members by requiring the company to provide a great deal of evidence to persuade a shareholder to vote for the director, including risk assessment skills, past experience and what use it might be, the nominee’s area of expertise, and what benefit he or she would bring to the board.

With all the discussion about the split between chairman and CEO, the commission is also seeking for companies to explain why they combine or do not combine the roles, or why they have a lead independent director and what benefits this decision might bring for shareholders. As part of this, a much more comprehensive description of the board’s role in the risk management process is likely to be required.

In response to much shareholder activism, a raft of additional disclosures surrounding the hire of compensation consultants by the board are also being proposed, including the disclosure of other work they do for the company, what each of these services cost, the involvement of management in the hiring decision and the board’s involvement in approving other work.

As well as a huge range of complex changes to the proxy solicitation process, the commission is also transferring the disclosure of voting results from the 10-Q that follows the meeting to an 8-K filing that must be with the SEC within four days of the annual meeting.

Paul Hodgson — Senior Research Associate

Major CEO Pay Concerns at Chesapeake Energy

Below is an excerpt from The Corporate Library’s governance risk profile for Chesapeake Energy (CHK). The company’s annual meeting is tomorrow. To have access to The Corporate Library’s governance risk ratings of over 3,200 U.S. and Canadian public companies to help assess investment risk, request a free product trial.

Excerpt:

The Corporate Library has major concerns with the CEO compensation for Chesapeake Energy’s co-founder Aubrey K. McClendon. For fiscal 2008, total realized compensation for Mr. McClendon was $114,286,867, or about 2,500 times the nominal U.S. GDP per capita in 2007 ($45,725 according to IMF). Put another way, this would be enough to buy more than 1,098,912 barrels of oil at the historic price of $104 per barrel in 2008 or more than 28,571,716 gallons of gasoline at a price of $4 per gallon. If he were driving an SUV that got 15 mpg, that would be enough gas to drive from the earth to the sun and back to earth, twice! Imagine how far he could drive if the price of gas were lower.

In spite of a 40% decline in stock price in 2008, Mr. McClendon received a bonus of nearly $77 million, $75 million of which was awarded under the Founder Well Participation Program (FWPP).  This plan, approved by shareholders in June 2005, permits the company’s two founders, Mr. McClendon and Tom L. Ward, to continue to participate as working interest owners in new natural gas and oil wells drilled by the company. Through this program, Mr. McClendon continues to be a significant co-investor in the company, and as such, should not need an extensive CEO compensation package to incentivize him.  Despite this fact, the board awarded Mr. McClendon the very high sum of $1,800,817 in “all other compensation” in 2008.  The total included an extraordinary $577,113 for accounting support (the need for accounting services at this level may itself be a sign of excessive compensation), as well as $648,096 for personal use of fractionally-owned company aircraft,  $131,226 for engineering support, $438,750 for company matching contribution to retirement plans, and $5,632 for other benefits such as financial advisory services, supplemental life insurance premiums, country club dues, and tax reimbursements for spouse/family travel.

Another concern is Mr. McClendon’s $34.5 million of value realized from vested restricted stock awards. This is the cost of the company’s tradition of granting restricted stock awards. In 2008, the CEO received two separate grants with an overall total grant date value of more than $32.7 million. The disadvantage of restricted stock is that it provides rewards whether the stock price is rising or falling, and unless retention clauses are attached to awards (stock must be retained for a period after vesting), executives can cash out immediately once awards have vested. Restricted stock awards would be more effective and credible if they were tied to performance goals and if executives were required to retain shares until or past retirement.

Finally, the CEO’s new employment agreement reduced the ownership requirement for Mr. McClendon from 500% of annual salary to 200%. This adjustment was made after the CEO sold down his stockholdings to meet margin calls; the fact that this step was necessary raises serious concerns about the CEO's commitment to an adequate level of continuing ownership in the company.

Seen as a whole, all of these compensation practices and related party transactions raise concerns about the board's ability to align executive interests with those of shareholders.

Hoang Nguyen — Ratings Analyst

FCX Investment Risk Assessment

Below is an excerpt from The Corporate Library’s governance risk profile for Freeport-McMoRan Copper & Gold Inc. (FCX). The company’s annual meeting is Thursday. To have access to The Corporate Library’s governance risk ratings of over 3,200 U.S. and Canadian public companies to help assess investment risk, request a free product trial.

Excerpt:

…Our other area of concern relates to CEO Compensation for Richard C. Adkerson. Total realized compensation for Mr. Adkerson was more than $53.6 million in 2008. This is more than 157,317 times the standard monthly salary for mine workers ($341) at the company’s mine in Timika, Indonesia, even after it had agreed to raises the workers’ pay after a four-day strike in April of 2007. This total includes $2.5 million of base salary, $5 million in change in pension value, $3 million in “all other compensation,” $16.8 million of value realized on exercised option awards, and $26.2 million of value realized on vested stock awards. Several elements of the pay package raise serious concerns.

To begin with, the CEO’s base salary is 2.5 times the limit for deductibility imposed by Internal Revenue Code Section 162(m). When base salaries for those executives subject to 162(m) exceed the limit by so much, it raises concerns about the decision-making of the board when it comes to protecting shareholders interests. The base salary is contractually set through January 1, 2012 and therefore this fixed compensation component will not be dependent on the CEO’s performance. Secondly, the more than $5 million increase in pension value is double the CEO’s already-high base salary and is an unnecessary use of company resources. Much of this is related to the $4.8 million increase in the CEO’s supplemental retirement plan, or SERP. Currently, Mr. Adkerson has a present value of accumulated benefit of more than $14 million under his SERP and an aggregate balance of more than $14.7 million in non-qualified deferred compensation plans.

Likewise, the large amount and the components of the CEO’s “all other compensation” raises red flags, as they are typically difficult to justify in terms of shareholder benefit since these payments are not linked to company or individual performance. This category included $40,000 in matching gifts, $20,000 in financial and tax advice, $412,475 of aircraft usage, $106,156 for the personal use of company facilities and personnel, $24,586 for club memberships, $182,975 in security and car, $122,391 in taxes paid, $2,584,049 for company contributions to defined plans, $126,238 for insurance premiums, $10,500 for director fees, and $4,349 in interest credited on dividend equivalents. Overall, more than $10.5 million paid to the CEO (base salary, increase in pension value, and perquisites) is not based on any type of financial performance…

Hoang Nguyen — Ratings Analyst

Letter to SEC on Compensation from The Corporate Library

Below is a letter to SEC Chairman Mary Schapiro from Senior Research Associate  Paul Hodgson sent last week.

Dear Chairman Schapiro,

Lessons from past experience: Not squaring the circle – apples and oranges in the
Summary Compensation Table

The Commission has indicated it will soon hold hearings regarding modifications to the rules for mandatory disclosure of compensation information. I am writing to share some thoughts that may be helpful to you during these deliberations. For eight years, I have served as the lead researcher on executive compensation at The Corporate Library, an independent corporate governance firm. Our work is based primarily on data derived from SEC filings, so the matter you are considering is of particular importance to us.

As you are aware, the SEC introduced new compensation disclosure requirements in 2006. During the SEC’s open meeting on 17 January 2006 which premiered the new compensation disclosure proposals, one of the commissioners questioned why retirement benefits would not be included in the Summary Compensation Table. In response, Alan Beller, the chief architect of the proposals, said he did not want “to try and square the circle and include future compensation in the Summary Compensation Table.”

Unfortunately, the regulations eventually ended up doing precisely this by including in that table the “expensed cost” of equity awards, rather than any actual amounts that have been realized, or profits that were made, during the fiscal year in question. These latter figures, the true present compensation from equity awards, are disclosed in a different table.

Simply put, the SEC’s Summary Compensation Table currently includes a mix of both current, actual compensation and future, unrealized compensation.

It has been reported that that the Commission is now considering including the “grant date present value” of equity awards rather than the expensed cost in this table.  If this is true, then we will still have a mix of apples and oranges – it will just be a different variety of orange. The Commission will still be trying to square the circle with future compensation continuing to be included in the Summary Compensation Table alongside earned compensation. This is at best a sideways step and not a forward move.

Such a proposal is all the more difficult to understand because the Commission clearly understood from the beginning that the Summary Compensation Table was largely intended to present compensation paid currently, current earnings from other compensation plans, and “the dollar value of all other amounts earned during the fiscal year pursuant to incentive plans.” Why, then, should it also include amounts “expensed” in the year but not earned, or the estimated value of grants made in the year?

Summary Compensation Table should include only realized compensation
As far as the Summary Compensation Table is concerned, it would seem that the best way forward would be to have two such tables: one that indicates monies received in the year – Realized Compensation; and another that discloses the target, future level of compensation aimed at by present grants and awards – Realizable Compensation.

The two tables would therefore include the following items for each named executive officer. All amounts are dollar amounts:

“Realized Compensation”: Compensation received in fiscal year	“Realizable Compensation”: Target compensation
Base salary	Base salary rate (the rate set during the year, not the amount paid)
All other compensation (itemized in supplemental table, but see below)	Expected cost of all other compensation (itemized in supplemental table, but see below)
Annual cash bonus	Target annual bonus
Value of any vested time-restricted stock	Grant date value of any time-restricted stock award
Value of any exercised stock options	Grant date value of stock options
Value of any other LTIP payout – Cash amount in one column/equity amount in another	Target payout of any other LTIP – Cash amount in one column/equity amount in another
Actual increase in pension value and non-qualified deferred compensation earnings	Expected cost of increase in pension value and non-qualified deferred compensation earnings
Total realized compensation	Total realizable compensation

“In this way, all the “apples” will be in one table, and all the “oranges” (whether they be Navel or Seville) will be in another. Such an arrangement would also negate the need for the Grants of Plan-based Awards Table.

You will note that I have suggested that the Bonus and Non-equity Incentive Compensation amounts are conflated into a single Annual Cash Bonus column. The distinction between Bonus and Non-equity Incentive Compensation is often not clear and has caused immense confusion among shareholders and some commentators. In addition, it is not sufficient distinction that some companies have bonus plans that set targets at the beginning of the year and others assess performance at the end of the year. Truly discretionary bonuses such as signing payments and guaranteed bonuses should be recorded under All Other Compensation, not the bonus column.

I have also suggested that long-term cash compensation be disclosed separately. This is another area that has caused immense confusion for shareholders when the Non-equity Incentive Compensation amount includes two or even more types of compensation that can represent payouts from multiple plans each measuring different kinds of performance over different time periods. This combination is again not helpful to shareholders trying to understand where compensation has originated

While these two suggested tables would negate the need for the Grants of Plan-based Awards Table, I would suggest retaining the Options Exercised and Stock Vested Table for a number of reasons. Firstly, this will allow shareholders to see how many options were exercised and how many shares vested, as they do now. I would like to make some suggestions for changes and additional disclosure to this table, however. Like the separation of short and long-term cash bonuses, I would also suggest that time-restricted and performance-restricted stock be separated – as they are in the current Grants of Plan-based Awards Table. This will allow shareholders more clearly to see how much compensation has been earned based on performance and how much on merely remaining in post – a valuable distinction. Finally, additional disclosure should be required in this table that details the grant dates of these awards and the original exercise price in the case of options. In almost every case I have examined companies have very carefully explained how and when future compensation might be earned, but in most cases there is no information as to where the long-term awards that are described in this table originated. You would have thought companies would volunteer such information as it would go a long way to justifying what are often very substantial amounts of compensation, yet I have found none do. On the other hand, those companies to whom I have suggested this voluntary disclosure have reacted very positively, understanding that it might improve their shareholder relations substantially.

A shareholder who can see clearly that a CEO has waited nine and a half years to exercise an option and who has overseen a considerable increase in the stock price rise can readily understand where such option profits have originated, and that if they had bought stock at the same time as the option was granted would have benefited from the same appreciation in value.

Perquisite disclosure
To turn to the disclosure of perquisites, there are also problems associated with this area of the regulations; it is relatively easy to see, for example, how companies can circumvent the law to avoid proper disclosure. The rules require “that each item of compensation included in the All Other Compensation column that exceeds $10,000 be separately identified and quantified in a footnote.” The original “Request for Comment” that was sent out in 2005 asked:

• Should all compensation no matter how de minimis be required to be disclosed?

• Will companies be able to track this information without undue burden?

• Is $10,000 the appropriate threshold for separate identification and quantification?

The answers to these questions were and still are: yes, yes and no, respectively.

There is no real justification for any threshold, companies already track these expenses, and there is very little likelihood that the information is not readily available. Therefore there should be no additional burden involved in disclosing even de minimis amounts. Furthermore, the $10,000 threshold for separate identification is clearly open to abuse. Given that the threshold was reduced because investors were interested in the “what,” not necessarily the “how much,” this lack of a requirement to identify separate perks is not even logical.

Furthermore, it takes no time at all to discover how to get around the rule. The only thing companies would need to do is break perks down into tiny, smaller than $10,000 increments in order to evade disclosure. In this way, an executive could receive 10 separate, equally valued perks worth a total of $90,000 and not have to disclose any of them. Or, instead of disclosing a car allowance, the company breaks this down into a car leasing allowance, and a petrol allowance, and a car insurance allowance, and a chauffeur’s uniform allowance, and a chauffeur’s uniform cleaning allowance, and a car valet allowance, and a travel allowance per trip…. Pretty soon, you have all other compensation of $800,000, comprised of 880 separate items, none of which needs to be disclosed individually. Furthermore, with the threshold in place, the absurd situation is still in place where a tax reimbursement on a perk has to be disclosed, but not the perk on which the tax is reimbursed. This clearly does not make sense.

Disclosing golden parachutes
SEC rules currently state that severance benefits be disclosed in a narrative, requiring that companies give the estimated payments and benefits that would be provided in each termination circumstance. It is very important that disclosure covers each termination circumstance; even before the implementation of the new proposals we had an example of a company – Morgan Stanley – volunteering such information, but selectively. So, when a termination actually occurred, its cost bore no relation to anything that had been disclosed.

Morgan Stanley’s 2005 compensation committee report indicated that then CEO Philip Purcell did not have any agreements entitling him to base salary, cash bonus, perquisites, or new equity grants following a termination. In the company’s narrative disclosure of “termination scenarios” in the report, termination was discussed as a result of a voluntary termination, a change in control termination, or a “for cause” termination. The eventual outcome, the board’s termination of his employment, was neither discussed nor disclosed; therefore what looked like great disclosure was actually selective and obstructive disclosure.

Mr. Purcell’s eventual termination led to severance payments of two times salary and annual bonus along with the immediate vesting of all equity awards. Mr. Purcell also received a cash payment of $250,000 per year in lieu of benefits, full retiree medical benefits, administrative assistance, and $250,000 per year in charitable contributions. All of these benefits were to be provided for the rest of Mr. Purcell’s life.

In other words, there was no agreement entitling Mr. Purcell to severance payments, but when it came time to terminate him, one was drawn up, instituting the very things the compensation committee report said were not entitlements. In addition, the eventual amount paid out to Mr. Purcell did not resemble any of the amounts disclosed either in aggregate or in detail as part of the narrative disclosure. As you can see, this is obfuscation not disclosure

The SEC’s “alternative narrative disclosure” did not improve matters to the fullest extent possible, and it would have been far more effective to mandate these disclosures in tabular form. Where figures are involved, it is an invariable rule that a tabular format is both easier to understand and easier to present, and should be adopted for every such disclosure. That many companies adopted tabular disclosure is proof of this maxim.

Unfortunately, however, as there was a general free-for-all as to what should and should not be included in any voluntarily-provided table, we have completely inconsistent results from company to company. Therefore, any changes to the disclosure rules should mandate a specific table, with mandated column headings as in every other instance of compensation disclosure. It is difficult to see why severance should have been treated any differently from other forms of future compensation (such as pensions and deferred compensation). A survey of the very best examples of disclosure, including those that disclose the cost of excise and other tax gross-up payments as well as any retirement and other benefits that vest on termination, should be taken so that the SEC can adopt corporation-defined best practices and impose these on all corporations.

We would be most grateful if you could take these comments into consideration if any changes to executive compensation disclosures are contemplated in the coming months. If you would like to receive any further detail regarding these suggestions or would like to discuss these issues further, we would be happy to arrange a meeting.

Yours sincerely,

Paul Hodgson
Senior Research Associate
The Corporate Library

Mozilo & the Countrywide Board of Directors: The Devil Wears Gucci

As reported this afternoon on the Dealbreaker blog, the SEC has officially charged  Angelo Mozilo, the former Countrywide Financial CEO, with insider trading.

It was on October 8, 2005, at the Waldorf-Astoria Hotel’s Grand Ballroom in New York City, that one Angelo Mozilo, of California, holder of raffle ticket number 271 in the Columbus Citizens Foundation’s Gala Dinner, for which he paid $1,000, was awarded the top prize of the evening: a $170,000 yellow Lamborghini Gallardo sports car.

Though the Gallardo is easily Lamborghini’s most popular model, fewer than 2,000 Gallardos are made each year. It was, in short, the perfect prize for a man who already had everything, including, it is said, a gold Rolls Royce.

Angelo Mozillo is a man with the Midas touch. He built Countrywide Financial Corporation into the nation’s largest and most successful mortgage company, and himself into one of the nation’s most successful and widely-respected CEO/Chairmen. His story, and the story of the company he founded, is the American Dream writ large. It is also an American Tragedy, with tragic flaws to spare and with Countrywide’s former directors acting more like stage sets than a mindful chorus.

Now reduced mainly to a significant liability on the Bank of America balance sheet, the last traces of the Countrywide trademark are being steadily wiped clean, and Mozilo himself appears likely to face charges of fraud and other civil violations by the US Securities and Exchange Commission.

The irony of this tale is that it might never have gone sour for Mozilo personally had he only retired as planned, back in December, 2006, when Countrywide was still the very essence of success and vitality. According to testimony by the then-chair of the Countrywide Compensation Committee and the company’s most recent Lead Director, Harley Snyder, "It turned out that during that year, the individual we thought would succeed Mr. Mozilo as CEO had left the company,” which then led the board to retain Mr. Mozilo "as CEO for an additional three-year term."

In negotiating a new contract with Mozilo, however, the Committee appears to have ignored the advice of two prior Countrywide comp consultants, Pearl Meyer and Ross Zimmerman of Exequity, in favor of the recommendations of John England of Towers Perrin, tapped originally by Mozilo himself. In England’s own words, from an email directed at Mozilo, the final terms of the new contract represented a “significant enhancement from what Zimmerman had the first time around.”

Mozilo’s response, almost certainly reflective of the attitude of many other top American CEOs of that period, made clear his belief that boards were unwisely limiting CEO compensation due to political pressures. As he rather vividly put it, “Boards have been placed under enormous pressure by the left-wing anti-business press and the envious leaders of unions and other so-called CEO Comp Watchers, and therefore Boards are being forced to protect themselves irrespective of the potential negative long-term impact on public companies.”

The Corporate Library downgraded its rating on Countrywide from an overall C to an overall D on January 2, 2005, in direct reaction to the Countrywide board’s capitulation to Mozilo’s new contractual demands. We further downgraded Countrywide to an overall F on August 19, 2005, based on the board’s inability to bring the company’s internal controls into compliance with Section 404 of Sarbanes Oxley.

We reviewed these downgrades and the compensation factors we found to be most problematic in a previous Analyst Alert issued in September, 2007: Download Analyst Alert.  But in general our reasons were exactly the opposite of those cited by Mr. Mozilo: we felt that the Countrywide board had failed to provide proper oversight for Mr. Mozilo’s compensation and other terms of employment, demonstrating a short-term focus at the expense of the company’s long-term prospects.  We saw these actions as clear indicator of governance risk.

The story of Countrywide’s subsequent decline and ultimate demise is well known, but what of the individual directors who served on the Countrywide board in those last two or three critical years? How have they fared since the company’s acquisition by Bank of America?

One place you won’t find them is on the board of Bank of America, unlike several of the directors of other past BofA acquisitions such as MBNA and FleetBoston.

But four remain in active service on the boards of one or more public corporations, and two now serve together on the same board.  These four individuals are:

• Michael E. Dougherty, who joined the Countrywide board in 1998. In 2006-07 he served as Lead Director, Chairman of the Corporate Governance & Nominating Committee, and as a member of the Compensation Committee. Mr. Dougherty is the founder and Chairman of Dougherty Financial Group LLC, which was formed in 1977. Mr. Dougherty currently sits on the board of directors at the Forestar Group, a real estate and other asset management company, where he is a member of the Corporate Governance and Nominating Committee.

• Kathleen Brown, who joined the Countrywide board in 2005, and departed in 2007. In 2006-07 she served as a member of the Credit and Finance Committees. Ms. Brown currently sits on the board of directors at the Forestar Group, a real estate and other asset management company, where she is a member of the Audit and Management Development & Executive Compensation Committees.

• Robert T. Parry, who joined the Countrywide board in 2004. In 2006-07 he served as Chairman of the Operations & Public Policy Committee and as a member of the Audit & Ethics and Credit Committees. Mr. Parry is the retired President and Chief Executive Officer, effective May 2004, of the Federal Reserve Bank of San Francisco. He had served in such capacity since February 1986. Mr. Parry is a director and member of the Executive Committee of the San Francisco Bay Area Council of the Boy Scouts of America. He has also served on the board of directors of the National Bureau of Economic Research and Countrywide Bank, FSB. Mr. Parry is currently serving on the boards of directors of Janus Capital Group, Inc., where he is Chairman of the Corporate Governance & Nominating Committee and a member and designated financial expert of the Audit Committee, and also the board of directors of PACCAR, Inc., where he is a member of the Compensation Committee.

• Keith P. Russell, who joined the Countrywide board in 2003. In 2006-07 he served as Chairman of the Credit Committee and as a member of the Audit & Ethics and Finance Committees. Mr. Russell currently serves on the board of directors of Nationwide Health Properties, where he is the Chairman and designated financial expert of the Audit Committee and a member of the Corporate Governance & Nominating Committee, and Sunstone Hotel Investors, Inc., where he is a member and designated financial expert of the Audit Committee and a member of the Compensation Committee.

The remaining former members of the Countrywide board have all retired from active service on the boards of public corporations, though most continue to serve on various private and non-profit boards.

The circumstances of Countrywide’s precipitous decline are also by now well documented, but a few key questions will always remain for those who try to understand the role of boards and corporate governance in such situations. How could such a talented and experienced board have failed so badly? Would things have turned out differently had the board either decided not to re-hire Mozilo in the first place, or at the very least refused to meet his new contractual demands? The forced departure of Hank Greenberg at AIG doesn’t appear to have made any difference with regard to the ultimate outcome for AIG – would things have been different at Countrywide absent Mr. Mozilo?

We may never know the answers to all these questions, but we can say with certainty that key signs of significantly increased governance risk were clearly visible at Countrywide as early as 2005, when we first downgraded the company, and that investors and D&O insurers who followed The Corporate Library’s governance risk ratings would have avoided altogether the tremendous losses that were to come.

Ric Marshall — Chief Analyst