Throw the Bums Out — of the Boardroom

March 18th, 2010 by Phil Mattera

The financial reform bill just released by Senate Banking Committee Chairman Chris Dodd is facing a great deal of criticism for being too weak. Let me pile on by focusing on one of the less noticed parts of the bill: the provision dealing with the composition of financial institution boards of directors.

Among the many reasons for the financial debacle of the past few years was the failure of board members at the big commercial and investment banks to exercise any kind of meaningful oversight while the executives of those companies were applying the business principles of Charles Ponzi. This was a replay of what happened during the Enron and other corporate scandals of the early 2000s.

One of the key causes of feckless boards is the phenomenon of interlocking directorates — the tendency of large and powerful corporations to share directors. This happens when the chief executive of a big company or bank sits on the board of another corporate leviathan, or when retired business executives join multiple boards. In these cases the outside director can usually be counted on to endorse the strategies put forth by top management and to be generous when it comes to setting executive compensation policies. And perhaps be willfully ignorant when management is cooking the books.

According to the recent report from its bankruptcy examiner, that was the case when Lehman Brothers was engaged in its Repo 105 scam to hide the fact that its balance sheet was becoming overwhelmed by toxic assets. Prior to its collapse in 2008, the chair of the audit committee of Lehman’s board was the retired chief executive of Halliburton.

Tucked in Dodd’s 1,336-page bill is a short section (no. 164) that addresses the board issue by proposing a modification in what is known as the Depository Institutions Management Interlocks Act (DIMIA), an obscure law from 1978 that prohibits someone from sitting on the boards of more than one bank, depending on the size and location of the institutions. Dodd wants to apply DIMIA to the large nonbank financial companies that would be subject to additional regulation under his bill. In doing so he would bar the Federal Reserve from allowing any interlocks between those nonbank financial companies and large bank holding companies.

There’s nothing wrong with that, but it does not begin to address the corporate governance lapses that helped bring about the Wall Street meltdown. Those lapses showed that existing rules on corporate boards, such as those contained in the 2002 Sarbanes-Oxley Act, are not up to the task.

And we certainly can’t count on big financial institutions themselves to choose the best board members or even to exclude those whose track record should disqualify them. Citigroup made a big show last year of revamping its board, but the person it chose to chair that body was Jerry Grundhofer, who, in addition to being the former CEO of U.S. Bancorp, had served as a director of Lehman Brothers during its last ignominious year.

Another bailed out institution, Bank of America, also chose some new directors last year. Its choices included two former regulatory officials – Susan Bies of the Federal Reserve and Donald Powell of the Federal Deposit Insurance Corporation – whose agencies did little to detect or prevent the crisis. B of A also brought on Robert Scully, a former executive of Wall Street giant Morgan Stanley.

In the wake of the Enron scandal, groups such as the AFL-CIO called on companies on whose boards Enron’s outside directors also served to ease them out when they came up for reelection. In 2005 board members at Enron and at WorldCom had to pay millions of dollars of their own money to settle lawsuits brought by investors in the two companies brought down by fraud.

So far, those who served on the boards of the large banks have avoided a similar fate. It would be good to see them face litigation and public disapprobation, but at least they should be barred from continuing to serve on the boards of institutions where future financial crises may occur. Strengthening the rules against interlocks in a meaningful way would also help diminish cronyism in the boardroom.

Big Money requires the kind of strong external regulation that financial reform could conceivably bring about. That regulation should also make sure that institutions also have a decent first line of internal regulation in the form of truly independent and diligent board members.

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