By Paul Hodgson – Chief Research Analyst
Global LeaderBoard (GLB) is an online research and data-visualization tool designed to deepen the analysis of corporate governance practices that can materially affect issuer risk. GLB maps complex relationship patterns at the individual, organizational, industry and regional levels. Among many other insights, GLB allows subscribers to identify corporate interlocks, such as directors serving on multiple boards together.
Why should investors, insurers and others affected by issuer risk care about interlocks? Here’s why.
No corporation or corporate board functions in isolation. Corporate entities and their leaders are enmeshed in intricate intersecting relationships that can exert a powerful influence. The study of governance-related issuer risk is simply incomplete without a thorough look at the broader context of influences on corporate decision-making.
Social networks represent a powerful force. In the corporate world, many directors will tell you that, in most board posts, “it’s not what you know but who you know.” Getting things done depends largely on knowing the right people.
But what are those things that we want to get done? Some of them are undoubtedly good things, but some are also bad. Very bad. And social networks can spread the bad just as quickly as they can the good.
Previous research from GMI Ratings has uncovered the negative effects of interlocks in three separate areas:
- The spread of egregious retirement/consultancy agreements for CEOs
- The spread of excessive pay for failure
- The spread of option backdating
Interlocks Enable Golden Perks
Let’s start with those contracts. Those of us with long memories will remember the Sunday night in 2002 when a journalist from the New York Times, quietly reading through the court papers for Jack Welch’s divorce, suddenly came across the fact that, among many, many other things, GE was going to continue to subsidize Mr. Welch’s fresh flowers and courtside Knicks tickets for the rest of his natural life.
With current disclosure requirements, we might already have known about this but, back in the dark ages of 2002, no one had any idea that this was going on. This is how the proxy disclosures had it:
In addition, the contract specified that the company would provide him continued lifetime access to company facilities and services comparable to those which were made available to him just prior to his retirement, including access to company aircraft, cars, office, apartments, and financial planning services, as well as reimbursement of living expenses.
The divorce disclosures indicated that the employment contract considerably understated the full range of these benefits. But even the face value of disclosed benefits was extremely costly. For example, financial counseling alone cost over $140,000 in 2001. All of the other benefits that would be provided to Mr. Welch in retirement were valued at over $2.5 million a year. The furor surrounding this caused Mr. Welch to volunteer to pay for the benefits himself which, given his $417 million retirement package, it might not have been unreasonable to require him to have done so in the first place.
Of course, when the journalists started calling Nell Minow and myself, they all wanted to know who else had these Golden Perks. Since few other CEOs were getting divorced at the time, it was difficult to tell.
Difficult but not impossible.
A search for the phrases “continue to have access” or “at substantially the same level” turned up a little treasure trove of such contracts. Check this one out for Charles Knight, former CEO of Emerson Electric.
C.F. Knight, Chairman of the Board, is an employee of the Company. Under the terms of his employment agreement, after his retirement as an officer and employee of the Company Mr. Knight will be available at management’s request to consult with the Company up to 30 days per year, for a period of not less than 15 years and will be compensated with a daily consulting fee based on his daily salary rate at the time of his retirement. He will also continue to have access to Company facilities and services, including the Company’s aircraft, car, driver, financial planning and club memberships if he meets certain conditions including not competing with the Company.
That’s a “Welch Contract” if I ever saw one.
Subsequent searches turned up similar contracts at Honeywell, IBM, and SBC Communications. Oddly enough, Edward Whitacre, CEO of SBC Communications, was on Emerson Electric’s compensation committee, and Charles Knight was on SBC’s board. Similar interlocks were found at all the other companies with such contracts.
Interlocks Enable Rewards for Failure
Later research by former Senior Research Associate Jackie Cook in Corporate and Director Interlocks in the USA: 2003 identified such links as “cross over interlocks” between insiders and outsiders. Whitacre and Knight, for example, turned out to be among the directors with the 10 highest “connectivity values.” The report defined connectivity value as:
A computed measure intended to reflect the degree of connectedness of a company or director to others in their ego-network via both direct and indirect links.
Don’t even ask about ego-networks.
It also turned out that the CEOs with these overly generous retirement contracts were among the most highly paid CEOs in the economy, and not often because of stellar performance. Indeed, most often it was because of long service. And several appeared in our list of 21 CEOs with golden parachutes in excess of $100 million.
Interlocks Help Spread Option Backdating
Then, back in 2006, the option backdating scandal blew up. We published two groundbreaking reports about this at the time, the second – The Spread of Option Backdating: A closer look at the boards and directors involved – in October. This tells the story:
One of the most significant conclusions of The Corporate Library’s first examination of backdating stock options – Backdating Stock Options: Are There Common Characteristics Among the Companies Implicated? – was that the level of interconnectedness between directors sitting on the boards of companies implicated in the scandal was much higher than could be expected from a similar, randomly selected sample. This conclusion led us to believe that the practice of backdating stock options may have been spread by word of mouth, through the conduit of directors sitting on the boards of more than one company.
A new study of the wider group of companies now implicated in the backdating scandal, based on data taken from The Corporate Library’s governance database Board Analyst, has supplied further evidence for this conclusion. Indeed, director interlocking relationships are fast becoming what appear to be the most important characteristic and indicator of backdating problems.
Below are the graphs associated with first, the interconnected companies, and second, the interconnected directors.
Graph 1: 51 Connected ‘Scandal’ Companies
Significantly, all of the companies involved have some association with at least one other company involved, and the nexus that spins out of Novellus Systems and Sanmina SCI looks like a galaxy rather than a constellation.
Graph 2: Network of All Boards with Shared Directors on ‘Scandal’ Boards
Representing directors interlocks as it does, this chart is littered with second-degree links – those lines that cross the lines spinning out from none other than Home Depot. These are the kinds of spider webs that you can generate with ease from companies and/or directors that have complex networks using Global LeaderBoard.
So do we want to limit social networks? Do we want to limit interlocks between corporations and directors simply to prevent the spread of illegal and other types of value-destroying behavior? Limit them and lose all the benefits that networking brings? Do we want to throw the baby out with the bathwater?
Not necessarily, though appointing directors without extensive corporate social networks, thus bringing diversity to the board, will lead to superior long-term performance. What is needed here is awareness, transparency, knowing about the interlocks. Because without knowledge there is no oversight. And the only way to find out about those interlocks and monitor them effectively is… Global LeaderBoard.