To understand the risks in CEO transitions, the Strategic Communications segment of FTI Consulting recently studied the impact of CEO transitions on enterprise value. FTI Consulting also surveyed members of the financial community to learn how CEO changes affect their investment decisions, expectations and performance guidelines.

CEO transitions are far from rare. Among companies with market capitalizations in excess of $10 billion, nearly a third (31%) announced a CEO transition between July 1, 2007 and June 30, 2010. Among these transitions, 43% were unplanned. In all, the FTI Consulting study evaluated 263 CEO transitions across companies based in 35 countries.

The study also found that the reputation of a CEO is a critical factor in investor decisions to buy or sell a company’s shares. In fact, on average nearly a third of investment decisions are based on perception of the CEO. As a result, leadership transitions put a significant portion of the investment decision at risk as opinions of the new leader are formed.

Knowledge of the industry dynamics and a firm grasp of the company’s challenges and opportunities are crucial for new CEOs, according to investors. However, investors generally grant new CEOs a six-month “honeymoon” to set the vision and strategy for the company while establishing appropriate expectations for key stakeholders. Once this honeymoon period has ended, investors expect CEOs to begin delivering on their strategy.

How investors assess new CEOs

The reputation of a new CEO matters to investors. According to the study, investors indicated that nearly a third (32%) of their investment decision, on average, is based on perception of the CEO (see chart below).

In addition, when asked to name the key factors affecting an organization’s reputation in the investment community, CEO reputation was among the top six factors cited. That was nearly on par with the company’s historical reputation itself and more important than the brand equity of a company’s products and services.

When CEOs change, investors are more than twice as likely to sell shares in a company as they are to buy them. All things being equal, nearly 40% of investors said they would sell a stock solely on the basis of the new CEO, the FTI Consulting survey found, while only 15% said they would buy the stock on the same basis.

Not surprisingly, when a CEO transition occurs, investors will perform due diligence on the new CEO’s qualifications. Their perceptions will be based primarily on the CEO’s track record, which is by far the single most important factor that investors use to evaluate a new CEO (see chart, opposite page).

However, investors are also mindful of the circumstances surrounding a CEO’s departure. Essentially, with greater surprise comes greater value at risk. For this reason, planned successions present the lowest risk (see chart, page 62) and can even have a positive impact on stock prices at the time of the announcement.

While much attention is paid to the market reaction to the announcement of a CEO change, in reality the months that follow present an even greater period of risk — and reward — with a higher potential for both value destruction and value creation. The outcome depends, in part, on how well the new CEO sets the agenda and manages the transition.

As stated above, investors are generally willing to grant new CEOs a six-month honeymoon. This honeymoon, handled well, can buy the CEO time and maintain the company’s value. But handled poorly, this period may lead to serious risk to both the company’s value and the CEO’s reputation.

For example, in late 2010, after Leo Apotheker became CEO of Hewlett-Packard, he failed to establish a clear strategy. Some nine months into his term, HP confused the market by first discontinuing its TouchPad line of mobile tablets, then selling them at a deep discount, and then restarting production. At about the same time, Apotheker said HP might sell its profitable PC division, then said it might not after all. Investors reacted by dropping the price of HP shares some 20% on a single day of trading in August 2011, erasing about $12 billion in market value and leaving the company’s stock near six-year lows. (By
comparison, the S&P 500 that day closed at 1,123.52, down 17.12, or 1.5%.) Including earlier share price declines under Apotheker’s leadership, HP’s stock had lost more than 45% of its value. In September 2011, Apotheker was dismissed from the company.

Once a CEO’s honeymoon ends, he or she must quickly begin to deliver on the new strategy and performance goals. During this period, investors seek evidence of successful execution of the strategy. This should not be confused with financial performance per se, which most investors expect will take at least 12 months to see traction. When a CEO handles this execution period well, the company’s stock value tends to increase; when handled poorly, the company’s value — and the CEO’s career — may suffer.

At Yahoo! Inc., Carol Bartz’s nearly threeyear term as CEO provides an example of the latter. Bartz started with a splash in early 2009, bringing an impressive agenda for a corporate turnaround. Then, during her first six months, she upended Yahoo!’s organizational structure, replaced executives, cut costs and laid off 5% of the workforce. Industry analysts and investors were impressed; the moves, they said, were just what Yahoo! needed. But when the honeymoon ended, Bartz failed to deliver the promised turnaround. In September 2011, less than three years into her reign, Bartz was replaced as CEO; three days later,
she also resigned from the board.

A road map for CEO transition

Given the impact of CEO transitions on enterprise value, companies should take concrete steps to prepare for and carefully manage leadership change.

CEO succession planning helps reduce the surprise of a transition and should be an integral part of any company’s preparation for leadership change. However, it must be accompanied with and informed by a robust due diligence on all CEO candidates. In addition, having a deep knowledge of stakeholder opinions on the company, its strategy and competitive position can help to align board decisions with stakeholder expectations, permissions and needs. This can be particularly helpful in addressing the ongoing risk inherent in transitions involving fraud, regulatory investigations, strategic transformations, bankruptcies and restructuring.

Equally important, new CEOs must align their organizations to respond to change by setting the vision and strategy, establishing the appropriate expectations across stakeholder groups, and then engaging with stakeholders through new and diverse communications channels. The study found that six months after the start of the new CEO, stock performance often reversed from the knee-jerk euphoria or disenchantment at the time is critical, 80% of new CEOs have no prior CEO experience. Therefore, there is often minimal publicly accessible independent information of past performance available. For internal candidates, the board and management team can address this paradox by showcasing the depth and breadth of the management bench (and one or more potential successors). This increased level of exposure and positioning can be instrumental in managing unplanned transitions.

Apple Inc. provides a case in point. CEO Steve Jobs’s surprising resignation for health reasons, in August 2011, could have been perilous for the company’s stock. Never before, it seemed, had any company been so closely associated with its top executive. Yet on the day of Jobs’s resignation, Apple’s stock price dropped by only 5% in afterhours trading. This relatively small change resulted from several factors: Apple had announced a succession plan more than two years earlier; Jobs had previously revealed his illness to the general public; and Jobs’s heir apparent, Timothy Cook, was well known and well liked by key stakeholders.

As a result, even the shock of Jobs’s death mere weeks later was quickly absorbed by investors.

Of course, it is not enough for a board to simply name a CEO candidate. The board must also perform due diligence, ensuring that the candidate possesses the qualities investors and other stakeholders seek. In this way, the board helps protect share value.

How do investors assess a CEO? Mainly, they expect a positive track record of past execution, as well as some industry experience. In the FTI Consulting survey, industry experience was identified by nearly 20% of investors as a key factor shaping their initial opinion of a CEO.

Apple again provides a good example. Cook, successor to Jobs and now the company’s CEO, had earned a solid reputation for both execution and industry experience during his 14 years of working for Apple. As the company’s COO, Cook had outsourced much of Apple’s manufacturing, improving the company’s margins. Also, because Cook is an Apple insider, he knows the company’s business and industry, and this smoothed the transition after Jobs’s surprising resignation.

Yet industry outsiders can succeed too, as long as they can demonstrate an understanding of the company’s situation and a relevant track record of execution. For example, Alan Mulally has successfully led Ford Motor Co. despite his lack of prior experience in the auto industry. Mulally became Ford’s president and CEO in late 2006; he had previously served as CEO of Boeing Commercial Airplanes. Under Mulally’s leadership, Ford — which had lost tens of billions of dollars during the recent recession — has posted eight consecutive quarters of net profits. Ford is also the only one of the Big 3 U.S. car companies to have avoided a government-sponsored bankruptcy.Investors, as part of their due diligence on a new CEO, will seek insights from a broad range of information sources, including internal and external stakeholders, both past and present. In particular, the FTI Consulting study found that customers, partners and the candidate’s former colleagues were the sources that most influenced investors’ opinions of new CEOs. In addition, investors will look to the board for reassurance that the candidate’s management approach is likely to be in harmony with the company’s situation and overall approach. Accordingly, companies should leverage perception studies and anecdotal evidence to better understand the stakeholders’ views on a CEO candidate. For the new CEO. During the first six months in office, a new CEO should be dedicated to articulating a new vision and strategy, establishing appropriate expectations and managing internal talent. Investors, in their initial interactions with a new CEO, will be watching to see how well the CEO takes command. It is no longer sufficient to serve as a command and control executive. Instead, investors are looking more for “hard” attributes — including a grasp of the company’s situation and plans for the future — than for “soft” ones, such as leadership style, charisma and personality.

During the CEO’s second six months, investors expect to see evidence that the strategy is being executed successfully (see chart below). To stay ahead of investor expectations, a CEO should carefully set the expectations against which he or she wants to be measured. Then the CEO can begin to meet stated financial objectives, improve the company’s financial performance, and boost market performance and valuation over the ensuing 12 months, which is in line with investor expectations. Also, in evaluating performance success, the study reinforced the principle that the investment community values metrics associated with stewardship of capital and cash flow, such as return on invested capital and free cash flow, far more than bottom-line metrics such as earnings per share and net income.

The high value of good communication

For a new CEO, communicating effectively with all stakeholders is critical to managing risk and its impact on a company’s enterprise value. While communications are important at any time of major change, they are especially vital during a CEO transition.

How to communicate effectively? New CEOs should begin by listening to the market. For example, CEOs can conduct research to gauge perceptions and test company messaging. This can help them identify any gaps between what the company says and what its stakeholders actually hear. New CEOs also need to have a well-honed corporate narrative to tell the company’s new story. To achieve this, a CEO should develop a comprehensive communications strategy that is linked closely to his or her vision and strategy. This may involve the development of appropriate messages and channels for different groups, according to what will best reach and persuade them. For example, at The Coca-Cola Co., CEO Muhtar Kent has made a point of communicating his strategy and other changes through new channels to better engage with the company’s workforce, especially those based outside its headquarters. Kent does so, in part, by conducting town halls at bottling facilities and sending text messages to workers’ mobile phones, as many employees of Coca-Cola cannot readily access e-mail, video or other means of communication during the workday.

Also, while many companies focus their communications efforts on the media, the FTI Consulting survey indicates that it is not a terribly influential constituency for investors. When investors were asked for the key external source shaping their opinion of a company, only 27% named the media, far less important than those much better placed to judge the capabilities of an executive, such as customers, business partners and former colleagues (see chart, opposite page).

Call to Action

Because CEO transitions create a potential risk for enterprise value, all companies should make CEO succession planning an integral part of their riskmitigation strategy. At the same time, companies should be aware that CEO succession planning cannot take into account all factors that affect stock value.

When announcing a CEO succession plan, the board should also emphasize the CEO candidate’s track record of execution. Again, this track record is by far the most important factor for investors. Industry experience and personal reputation are a distant second and third.

Once the new CEO is in place, he or she should align the organization by communicating with stakeholders, establishing credibility and setting reasonable expectations among stakeholders.

To protect share value, all companies should remember that surprises increase risk. Therefore, boards should strive to create CEO transitions that are both smooth and well thought out. A CEO’s planned retirement, for example, involves far less risk than a forced resignation. But even when a CEO transition hurts the stock price in the short term, the right management initiatives later can often restore value over the long term.

The shift in power from management to shareholders is inexorable and, most recently, has been furthered by the 2010 Dodd-Frank Act. The era of the proxy process as an annual rubber-stamping ritual of a company’s policies and actions has passed. Investor actions on a myriad of issues such as Say on Pay (SOP) and Say on Frequency (SOF) are growing.

Investor concerns aren’t seasonal. Trying to influence or change investor votes during proxy season is risky at best. It is too late in the game to capture investors’ attention and change their minds. Companies need to engage shareholders systematically throughout the year to understand and address their concerns.

Companies May Have Gotten a Break in 2011

By many broad measures, it might seem as though the 2011 proxy season passed without the storms that SOP and SOF votes threatened. Most executive pay plans were approved, even the majority of plans that received negative recommendations from proxy advisers. According to the global law firm Latham & Watkins, only 2% of the companies that filed proxy statements by June 23, 2011, failed SOP votes — 71% of the Russell 3000 secured more than 90% approval.

However, the 2011 proxy season may not have fully reflected the depth of investor sentiment and the pressure that investors will continue to apply. Research conducted by FTI Consulting (“What Are Investors Saying About Say-On-Pay?” February 2011) found that investors viewed SOP votes as more than an issue of pay. Many saw SOP as a referendum on company and executive performance and a forum to air their displeasure. This past year, investors had to digest thousands of compensation packages. We suspect that they didn’t have sufficient time to fully digest the implications of SOP and SOF. Nevertheless, their strong preference for annual SOP votes clearly indicates a desire to keep management on a tight leash. We expect investors to keep leveraging their newly acquired rights — and for them to be better prepared to do so in the future.

Companies were not sufficiently prepared for SOP and SOF votes either. Many were surprised by shareholder pushback and negative recommendations from the proxy advisory firms. A key factor in the negative recommendations was a disconnect between compensation and performance as measured by total shareholder return. A prominent financial services company, for example, received a recommendation against the chief executive’s pay. Although it finally passed, it did so with less than 60% of the vote. And three other management recommendations (of eight) were thwarted.

Other companies with negative recommendations passed the vote. But average support was only 72% vs. 92% for those with a favorable recommendation. Companies with pay/performance disconnects and subpar shareholder support (70% is generally regarded as the inflection point) are essentially “on notice.” Support for their SOP votes could erode next year if management doesn’t discover and remedy the issues.

It is important to note that although SOP and SOF votes are “advisory,” they have teeth. Their influence extends into boardrooms and legal domains. Negative investor sentiment on SOP can be directed at compensation committee directors. To wit, at companies where SOP votes failed, these members garnered an average of 13.5% fewer votes than other directors on the ballot. Furthermore, losing a vote on pay can expose a company to damaging litigation. Four companies that failed to secure SOP approval had shareholder derivative lawsuits filed against them, alleging breach of fiduciary duty and corporate waste.

More Investor Concerns Are Brewing

Historically, strong recoveries following recessions have generally produced a calming of the public mood and dissipation of the rancor previously targeted at those institutions perceived to be poor corporate citizens. Given the muted economic recovery, corporate performance may not sustain its current pace, fracturing business confidence and undermining shareholder returns. Public angst, represented by the Occupy Wall Street protests, along with regulatory agency actions and government legislation, may continue to influence investors and drive demands for more influence over corporate affairs.

Some areas to watch

Oversight of Political Spending. Support for disclosure and oversight of corporate political spending is surging on the heels of the 2010 U.S. Supreme Court Citizens United decision. While a high-profile proposal at Home Depot was soundly defeated, a corporate political disclosure and accountability resolution captured a majority vote — at Sprint Nextel the resolution passed with 53% of votes cast. Close on these heels, resolutions from the U.S.-based Center for Political Accountability, which requires companies to divulge details of their political contributions, gained more than 40% of the vote at the annual meetings of four more companies.

Proposals concerning the oversight of political spending are multiplying, and support for them is rising:

• In the first half of 2011, according to Institutional Shareholder Services, shareholders filed 78 proposals seeking disclosure and oversight of corporate political spending, up from 48 during the first half of 2010.
• According to the Council of Institutional Investors, the average support for the 39 proposals that came to vote as of June 2, 2011, was 31%. Six years ago it was 9%.

Proxy Access
While not enacted as planned by the Securities and Exchange Commission, proxy access is back. Companies will have to allow shareholders to submit proposals requesting that the board implement proxy access or that the company’s bylaws be amended to implement proxy access.

The consequences are difficult to anticipate. It is likely that some companies will be targeted by investors in 2012, particularly poorly performing ones with long-standing governance issues or those with weak or shareholder-unfriendly boards. The chairman of the SEC supports broad-based proxy access, so there might be further developments.

For most companies the window for shareholder proposals opens in November. The next few months should provide some visibility into whether activists will avail themselves of this opportunity. Given the time lines for distributing proxy materials, managements will not have much time to evaluate and craft responses to these proposals. Companies that might be vulnerable should preempt the situation — they should start the process early and be prepared to respond if necessary.

Environmental Sustainability Measures
Investor concerns over corporate responsibility and the environment have been nascent for some time. It is difficult to know when an idea reaches an inflection point and becomes front and center, but these topics may have already done so:

• A record 109 proposals were filed with 81 companies in the United States and Canada during the 2011 proxy season.
• Ernst & Young reported that corporate social responsibility proposals grew to 40% of all shareholder proposals in 2011, vs. 30% in 2010.

Other issues on our watch list include:

• Shareholder actions by written consent
• Shareholder power to call special meetings
• Forthcoming SEC regulations on the ratio of CEO pay to median employee wages (which are strongly supported by the public sector, unions and socially responsible investors)

Although shareholder proposals on these topics are generally rejected, a few have passed and may be indicative of growing support. We expect that more will pass.

Many corporate governance protocols being implemented in the United States, such as SOP, were adopted in Europe years ago. Companies should be attuned to developments in the European Union. The United Kingdom is instituting the Stewardship Code, requiring institutional investors to attest to their responsibility for the companies in which they invest. A key provision of the Corporate Governance Code requires annual re-election of all directors. Gender balance on boards is being debated, and the European Commission is examining how corporate governance overall can be improved.

Keeping Shareholders onBoard

It’s essential that companies engage shareholders throughout the year to address concerns. Ongoing engagement can yield dramatic improvements to a company’s credibility with investors, as the Dow Chemical Co. experienced between 2008 and 2011.

Dow was hit by a near “perfect storm” of events that shook investor confidence and drove its stock price down 60% from late 2008 to the market bottom in early 2009. Immediately upon Dow’s commitment to the large and transformational acquisition of Rohm & Haas, the global economy plunged, causing uncertainty in the credit markets, unprecedented low demand for chemical products and ultimately the collapse of a $17.4 billion joint venture in Kuwait just 48 hours before its expected close.

To rebuild investor confidence and build support for the transformation story, Dow launched an investor engagement program. Milestones for execution were laid out, and as each one was met, Dow communicated to investors that it was following through on its near-term strategic objectives and executing ahead of schedule. As performance strengthened, the company expanded its dialogue with investors and the media to include the more innovative aspects of the company’s transformation and to highlight the growing investment and value of its R&D portfolio, which long-term would play a major role in the company’s transformation. To ensure that Dow’s message was resonating with investors, the investor relations team regularly measured the impact of its communications on different stakeholder groups and refined the message when needed. The team also provided greater transparency through more detailed operating information, access to more of the company’s leadership and use of more pervasive, digital communications methods. Dow ultimately succeeded in restoring investor confidence — its stock price recouped the losses of late 2008, and 87% of Dow’s shareholders approved of the company’s executive compensation, a strong endorsement.

Few companies manage investor sentiment as well as this, and yet many could easily do much better. In our experience, companies that build investor confidence and manage their concerns follow these practices and recommendations:

Understand the Company’s Points of Vulnerability

The 2011 proxy season provided a number of indicators of what investors view as good practices regarding compensation. Highly desired: transparent disclosure of how compensation is determined, performance-based compensation and longer vesting periods. Large severance payments and “golden parachutes” are objectionable (McCahery and Suatner, Tilberg University research paper). Ahead of the next proxy season, companies should analyze their compensation plans to identify disconnects between pay and performance and identify best practices.

Understand the Composition and Sentiment of the Shareholder Base
It is critical to know which shareholders are influenced by proxy advisers. Companies should target new shareholders who have a history of filing proposals or who take social issues into account when investing; in particular investor classes most likely to take their governance grievances public, such as socially responsible investors; activists; foundations; faith-based organizations; special interest groups; and state, municipal and union pension funds. Companies can also revisit the 2011 votes to identify the active shareholders and determine where the company’s responses were weak.

Work with the proxy advisers
If a company received a negative recommendation on SOP from the proxy advisers, it should consider engaging with them during the off-season to make its case. Companies subjected to inappropriate peer group comparisons, incorrect compensation calculations or any other inaccuracy should attempt to resolve the issues. An early resolution or correction is less stressful than tackling the issue during proxy season.

Engage Shareholders
Companies should engage shareholders and stimulate a dialogue on policy changes and the reasons driving them. Management should put mechanisms in place to hear investor concerns and respond with communications that explain decisions and demonstrate that it listens to investors. If shareholder sentiment on an issue is strong and broad-based, management should consider changing policy.

It is important to know how shareholders evaluate performance. In our research we have found that investors prefer measures related to value creation and executive stewardship, such as return on invested capital and free cash flow generation. They are less interested in earnings per share or overall growth statistics. This may not apply to all shareholder bases, but it pays to ask the question.

Shareholders have spoken. They want to vote on SOP every year. As proxy season approaches, companies need to articulate their compensation strategy and how pay is determined. The proxy is the selling document. It should present the case completely to avoid additional filings. Supplementary filings can be perceived as evidence of shareholder resistance.

Be Prepared

Proxy season is not the beginning and end of a company’s engagement with its shareholders. It is a point in time that reflects the effectiveness of management’s relationship with its investors.

Even now shareholder advocates are working to exploit the shifting balance of power and taking on more corporate governance issues. They are using the off-season to shape the discussions and air their side of the debate. If companies wait until the 2012 proxy season to air their positions, they could very well find themselves scrambling to respond to concerns that have been festering for months.

Amid the hubbub, it is important to remember a central fact about the banking crisis: it was caused by the failure of the sector to deliver in its fundamental societal role – i.e. to provide the economy with its money cabling and pipework, efficiently assess and spread risk, transform maturities and allocate resources where they are needed. The big question is why? Clearly banks are not the only ones to blame, but if we are to avoid an early repetition of the events of the past three years, it makes sense to work out some of the reasons for those events and to address them.

A Higher Purpose

Banks are different than other companies. If a Walmart or a General Motors goes bust, the consequences will be painful for thousands of workers and investors, perhaps even taxpayers. But there are alternative suppliers. The failure of a bank, however, creates serious practical problems for its customers, triggers panic and has repercussions that can be difficult to contain.

Our banks are essential to our way of life to a degree greater than their mere commercial role would indicate. But that lesson was not learned from the costly savings-and-loan problems at the end of the 1980s or the LTCM hedge fund crisis at the end of the 1990s, or the many other incidents that might have been taken as warnings that all was not well with the financial system.

This obliviousness had a parallel in the culture. Oliver Stone had intended Gordon Gekko – with his “greed is good” ultra-laissez faire credo – to be a cautionary tale. What happened? Thousands of young bankers emulated Gekko’s look, with greased-back hair, two-tone shirts and colorful suspenders.

Similarly, in a widely cited article in the November 2008 issue of Portfolio, author Michael Lewis recounted that when he wrote his 1989 book Liar’s Poker, which told of the reckless culture he found as a young banker working for Salomon Brothers, he too expected it to serve as a warning to readers. As Lewis writes: “I expected them to gape in horror when I reported that one of our traders lost $250 million, but six months after Liar’s Poker was published, I was knee-deep in letters from students who wanted to know if I’d any other secrets to share about Wall Street. They’d read my book as a how-to manual.”
These stories characterize a view of capitalism as being most effective when untrammeled. But the lesson of the past three years – at least from this European’s point of view – is that it ain’t necessarily so.

Feeding the Beast

Lewis’s Portfolio article goes on to chronicle, mainly through the more recent experiences of hedge fund manager Steve Eisman, how the culture fomented in the 1980s culminated in the subprime feeding frenzy of the past decade.

Subprime can be taken as the near-fatal symptom of the collision between Main Street and Wall Street, brought about by the reversal in their traditional relationship. Whereas the banks’ primary role should be to lend to businesses and individuals to facilitate their commercial activities, they encouraged people to borrow, sometimes recklessly, in order to feed the “originate-and-distribute” model that relieved them of any responsibility for loans that defaulted.

In a reality-based market, subprime lending should have been a small, specialized corner of banking, lending at appropriate terms to those with bad credit risk. Instead, it grew to account for 14% of all first-lien U.S. mortgages, with a nominal value approaching $2 trillion. Other variations of mortgage-backed securities and collateralized-debt obligations grew and proliferated, with credit-default swaps supposedly mitigating the risks.

The terms of the loans – eight or 10 times loan-to-value against mobile homes and low-cost urban dwellings – were virtually guaranteed to lead to default. It was a transaction-driven market that gave little attention to traditional models of risk management.

Because banks are essentially “virtual” businesses – their products are almost all variations of accounting entries wrapped up in legal contracts – they can scale up to the extent their regulatory capital ratios and processing systems allow. They also have a nearly limitless appetite for complexity.

So not only did banks balloon in size but too many managers didn’t fully understand their products or appreciate how these products impacted each other. When the financial system began to implode, another inherent weakness of banks was exposed: the fragility of liquidity. Funding short term in order to lend long makes banks susceptible to issues of confidence in both retail and wholesale money markets (as Bear Stearns learned after losing access to the overnight repo market). To paraphrase Warren Buffett, when asset prices fell and the liquidity tide went out, some banks were caught naked.

Regulatory Renaissance

What allowed this to happen was a combination of several factors:

• the blurring of the lines that had separated commercial banks and investment banks since the passage of the Glass-Steagall Act in 1933;
• high liquidity and low interest rates;
• neffective regulation in areas such as capital standards and the use of ratings;
• a focus on “fair value” as an accounting driver.

The dismantling of the Glass-Steagall Act was done bit by bit under various governments over more than two decades, with legislation usually following practice; but the biggest symbolic piece in the U.S. came with the Gramm-Leach-Bliley Act – also known as the Financial Services Modernization Act – in 1999, which essentially reversed the last vestiges of Depression-era rules.

U.S. President Barack Obama now appears likely to rebuild some of this regulatory architecture, with proposals tabled to separate federally insured bank business from proprietary and speculative activities. There are also proposals to overhaul the oversight structure, with some calling for a lesser role for the Federal Reserve, giving senior authority in an oversight council to the Treasury. Whatever structure is adopted in the U.S., it is likely to set the tone for the rest of the world.

The UK is on course to rebuild some of its regulatory defense walls that had been dismantled, and strengthen its key regulators, such as the Financial Services Authority. But specific proposals to shore up the capital bases of UK financial institutions – including “contingent capital,” a kind of quasi-equity, and a levy-based resolution fund – are controversial and still under discussion. As countries steer a course between the need for a better-regulated system and maintaining competitive advantage, it remains to be seen what oversight gaps might be left unfilled.

However, change must go beyond legislative reform, for it wasn’t simply deregulation on its own that can be blamed. Regulators on both sides of the Atlantic went into this crisis with the powers to approve or disapprove key management, the powers to vary capital to their own requirements and the power to stop individual institutions from doing business they didn’t like the look of. But most regulators didn’t exercise those powers.

Macro-Prudential Supervision

There was also egregious failure in terms of macro-prudential supervision – i.e. supervision at a level that takes into account the broader economy – with no one looking at the whole market and saying, “we have high asset prices, too much liquidity – we need to prick the bubble.” Or, to borrow the phrase attributed to William McChesney Martin, the Federal Reserve’s longest-serving chairman, central bankers failed in their primary role, which is “to take away the punch bowl just as the party gets going.”

In the UK, there was no role for macro-prudential supervision in Prime Minister Gordon Brown’s regulatory construct, where it fell between the stools of the Treasury, the Financial Services Authority, and the Bank of England. One of the starkest illustrations of this was the way Icelandic institutions were able to collect £10 billion from UK depositors. That couldn’t have happened in France, where bank regulation has historically been more intrusive.

The New Normal

What should a new regulatory system look like? There are three main elements required for effective regulation, two of which are relatively simple conceptually and one that requires a fundamental shift in thinking about bank governance.

The first element is macro-prudential supervision. This will help to keep banks safe from policies that may facilitate asset price bubbles that draw in borrowers and lenders alike, often at the wrong point in the economic cycle. Oversight requires less bureaucracy and more bright people (with lots of data) who are savvy enough to spot out-of-control liquidity and asset prices, and consequent bad borrowing and lending practices, and are empowered to stand up and say “Okay, we are approaching dangerous territory.”

The second element is customer protection. While fairly straightforward to design, implementation is another matter, as highlighted by the opposition to the proposed U.S. Consumer Financial Protection Agency. Opponents have argued that such an agency could stifle competition and raise the cost of finance for consumers. Its supporters argue that buyers of financial products are inevitably at a knowledge disadvantage compared with the providers, and need protection. It’s a battle about getting the right balance of red tape and market freedom.

The final element is also the trickiest: prudential oversight at the institutional level. Any well-run financial institution is comprised of management; the business; the platform – i.e. technology, processes and information systems; liquidity; and capital. Supervisors need to ensure that all of these functions are present and fit for purpose. In particular, regulators must ensure that management is equal to the challenge of running the business and is adequately challenged – by internal firm functions (finance, risk, internal audit, compliance, and legal) as well as by external functions (non-executive directors, auditors and regulators).

The real issue with supervision at the level of an individual firm is the competence of management and how they’ve organized the business. Oversight challenges have been brought to light by the financial crisis. To cite just one example, the head of group regulatory risk at HBOS, the fifth largest UK bank, claims he was forced out by management in 2004 when he raised concerns over excessive risk-taking, particularly in large commercial and real estate lending. Fast forward to September 2008, and HBOS is taken over by Lloyds in the days after the collapse of Lehman Brothers. The credit losses which have emerged at HBOS are far larger than anyone could have anticipated.

In the year ahead, a number of regulators are set to introduce requirements for better governance. The new norm will be a separate risk committee with wide-ranging powers and a chief risk officer (CRO) who can only be fired by the board. A further step to strengthen CROs’ independence would be to establish a statutory direct line to the external regulator. This change will be reinforced by new requirements around non-executive directors and the engagement of institutional shareholders. And, of course, the supervisors themselves are reinforcing their processes and their people. However, these changes will not amount to much unless there is a clear benchmark of what constitutes robust internal governance.

Accounting philosophy also needs fundamental reform. Accounting has not served banking as well as it might, with the failure to harmonize between different jurisdictions and the aggressive adoption of “fair value.” Fair value can be the wrong type of transparency – it cements a disconnect between real investment horizons and what the numbers show. It tends to accelerate profit recognition (and therefore bonus and dividend payouts), operating in ignorance of the business cycle to which banks are prone. Bank accounting should be more about evaluating cash flows – a “maturity ladder” approach.

It is somewhat bizarre that regulators determine banks’ capital requirements and accountants determine the quantity of capital in place, yet the two have no formal coordination. Having those two sets of people talking would send the right signal to bankers about the kind of regulatory regime they can expect. It is starting to happen, but there are obstacles in the way – not least a difference of opinion between the U.S. and everyone else.

Sorting out regulation is partly about returning to banking’s first principles. As economist John Kenneth Galbraith said, “The process by which banks create money is so simple that the mind is repelled.” Over the past two decades, the accuracy of that observation seemed to diminish. The banking crisis creates the chance to simplify and clarify, and it’s an opportunity that governments should grasp.

The essence of the proxy reform proposal is to allow shareholders who own at least 1% of a company’s shares to have their board nominees included in corporate proxy materials. This would apply to companies with a market capitalization exceeding $700 million. A 3% stake would be required for shareholders of midsize companies and a 5% stake for shareholders of smaller companies.

After releasing a detailed proposal in early June, the SEC received more than 500 sets of comments.  The intensity of the response is not a surprise. As one attorney told The Wall Street Journal, ‘It’s the biggest change relating to corporate governance ever proposed by the SEC. Period. It gives activists the ultimate vehicle to express dissatisfaction with a board, the ability to replace board members at the company’s expense.’

The all-out lobbying battle in Washington has pitted the Business Roundtable, U.S. Chamber of Commerce and National Investor Relations Institute against investor groups such as the Council of Institutional Investors and institutional-investing giant Capital Research & Management Co., as well as some large unions. All agree the present proxy system is too complex, but some argue the SEC isn’t attacking the root of the problem, and instead is approaching reform in a piecemeal fashion that doesn’t take into account how the interrelated parts need to work together.

Critics of the SEC proposal argue more time is needed to ensure the technology is in place to support this new style of proxy voting, and to ensure that corporate issuers aren’t hampered with excessive costs of materials printing, mailing and proxy solicitation firm engagement to get out the retail vote.

The real issue behind the proxy access rules is that it has the potential to simplify shareholder activism and reduce the costs associated with it. Lower turnout and support for board members this proxy season paves the way for bad press, hostile shareholders and heightened activism levels at target companies. The SEC’s proposed rules put few limits on shareholder activists who will find it easier to advance their narrow interests at the expense of the broader shareholder goals.

The New York Stock Exchange’s Rule 452, approved in July, provides a preview of how the proxy reform would work in practice, were it to be enacted. It is likely to cause short-term problems since it eliminates ‘Broker Discretionary Voting’ without providing an easy way for retail shareholders to vote. While the intention of removing brokers’ ability to cast votes for shareholders who don’t return voting material unless instructed to do so may be fine, the consequences could have major adverse impacts in practice. Without new technology to lower the cost for retail shareholders to vote, the rule will likely translate into lower voter participation rates. Board members may appear to get much less support than in the past, making them appear to have lost shareholder confidence when, in reality, there were simply fewer voters. This may have the unforeseen consequence of exacerbating the voting impact of the better coordinated activist or opposition group.

It remains an open question as to whether the SEC will approve changes to the proxy process. If it does, it could lead to a shake-up in corporate boardrooms. What’s not clear is whether the shake-up will be for better, or for worse.