Train Wreck

The concept of corporate governance implies consistent and effective laws, methods, and metrics for governing our nation's public companies. The sad fact is that there is no such thing. It's a myth. Here's why:

People talk about the fiduciary responsibility of boards of directors. What that means, in plain speak, is that boards are supposed to:

1) Hire and fire the CEO and appoint other corporate officers
2) Compensate the CEO and other corporate officers
3) Oversee corporate strategy
4) Represent shareholders in the transparent and effective governance of the company

As an ex-officer of several public companies and as a consultant, I've been involved with lots of boards, executive staffs, investment banks, VCs, corporate attorneys, and the like. At least in my experience, boards don't operate the way they're supposed to.

Let's take the last point first. Shareholders are offered a slate of directors and a handful of issues to rubberstamp. That means they have two choices: accept or reject.

Now, let me ask you this. If your spouse or doctor says, "Here's my recommendation, take it or leave it," what do you do? That's right, you take it. Is it the best thing for you? Who the heck knows? You had a gun to your head so you nodded up and down. ... Read more

In case you've been in a sensory deprivation tank for the past few days and missed the news, Henry T. Nicholas III, founder and former chief executive officer of chipmaker Broadcom, was indicted on securities fraud, conspiracy, and federal narcotics charges on Thursday.

Henry T. Nicholas III

One of the indictments was related to options backdating, the cause of a $2.2 billion charge Broadcom took last year. But it was the sex and drug-related indictment that captured the media's attention.

If you read the indictment (PDF), you'll understand why one report said, "You can't make this kind of stuff up," .

Rarely does a billionaire and technology industry legend self-destruct in such dramatic and flamboyant style. But there's more to this human tragedy than meets the eye, and it almost surely extends beyond Nicholas. ... Read more

Did you know that the president has a Corporate Fraud Task Force? That's right, he does. It's led by the deputy attorney general, whoever that is.

Anyway, this task force has apparently been very busy. Over a five-year period since its inception, the task force claims 1,236 corporate fraud convictions, including 214 CEOs and presidents, 53 CFOs, 23 corporate counsels, and 129 vice presidents.

That's a lot of fraud. Who knew there were so many dysfunctional executives in this great nation? The dark side of greed and capitalism must be pretty attractive, huh?

I also wonder what these executives' boards of directors were doing while all this fraud was going on? Aren't they supposed to be looking out for shareholders? Isn't that what corporate governance is all about?

Anyway, members of the task force have successfully brought a laundry list of fraud and other charges against executives of Adelphia, Cendant, Comverse, Computer Associates, Dynegy, Enron, Enterasys, Homestore, Imclone, Impath, Monster, Network Associates, Prudential Securities, Qwest, Refco, and WorldCom.

The Justice Department has also recovered $1 billion in ill-gotten gains and distributed the funds to victims of corporate fraud. Want to know how much money shareholders actually lost in all those fraud cases? Me too, but I'm confident the number has two or three more zeros than what was recovered.

According to a Department of Justice fact sheet, President Bush created the task force in July of 2002 "to restore public and investor confidence in America's corporations following a wave of major corporate scandals." Did it work? Has your confidence in America's corporations been restored? Not mine.

You know what I think? I think it's great that the government is cracking down on white-collar crime. Sure, it's sad that so many officers of public companies have such flexible views on ethics and morality. But you know, if that's the way it's got to be, then I say lock 'em up...without the severance package.

While that might be rewarding, I have to admit it doesn't help investors. If, like me, your confidence in America's corporations has not been restored, there's only one thing you can do about it. Don't let your investment and retirement strategy depend on a branch of the government to cover your butt.

The only way to truly mitigate the potential risk of corporate fraud is to diversify your portfolio, plain and simple. If you don't, you're asking for trouble. I hate to say this, but with these kinds of fraud conviction stats, anyone with 5 percent or 10 percent of their assets in one company's stock really doesn't deserve to keep it.

This blog's supposed to be about corporate dysfunctionality, but somehow we've gotten sidetracked. We've never really looked at the big picture. The big picture is this: a reasonably significant percentage of executives and their boards are dysfunctional.

What do I mean by that? I mean they shouldn't be doing some of the things they're doing, and those things can get them in big trouble with a variety of law enforcement agencies. Why do they do it? Who knows.

As for you good folks--investors and employees--well, I don't want to be an alarmist, but if you knew what really goes on out there, the countless ways you can get screwed, well, let's just say you'd need a good dose of Ambien to get any sleep.

The good news is you can protect yourself; we'll get to that in a minute.

Until then, here are the most common ways that dysfunctional executives and directors can mess up. I've included a few well-known examples, but the scary part is that, for every big-name scandal, hundreds fly under the radar screen.

The seven deadly sins of corporate dysfunctionality

Creative accounting
Most of the biggest scandals of our time have included some form of creative accounting: shell companies, offshore accounts, creative expensing, or just your run of the mill accounting fraud. That's what did in Enron, WorldCom, Adelphia and a host of others.

Conflicts of interest
One of the biggest scams in history was the conflict of interest between investment banks and their research analysts leading up to the dot.com bust. The top ten investment banks coughed up $1.4 billion to get the SEC, the N.Y. attorney general and a host of others off their back. A few analysts were banned, but amazingly, nobody went to jail.

Insider trading
If you really think this is just the domain of Martha Stewart and ImClone ex-CEO Sam Waksal, then I've got some nice used cars from New Orleans to sell you. I'd be willing to bet that at least half the executives who say they've never traded on inside information would be lying. The other half have so much money they don't need to.

Dysfunctional families
I don't care if it's IBM in the old days, Motorola all too recently, Adelphia, Wang Laboratories, or Atmel. If you're considering a company with any family relations on the executive management team or the board, forget it. And if a family actually controls the stock's voting rights, as was the case with Adelphia, soon enough you'll read about it in the newspaper.

Rubber-stamping boards
Behind every dysfunctional executive and company is a board that fits nicely into the CEO's back pocket and rubber-stamps everything put in front of them. Tyco was a great example, but there are probably hundreds, if not thousands of boards that are blindly loyal to their company's CEO.

Generic SEC filings
10Ks have to be the biggest waste of paper since An Inconvenient Truth was published. The risk factors are generic and watered down while the business sections do more to hide than highlight competitive challenges. The lawyers and Sarbanes-Oxley consultants are in charge. That's really scary.

Ludicrous compensation
How many CEOs and other officers have been sacked as a result of stock option backdating scandals? Must be 30 or more in the technology space alone. Besides the sometimes ludicrous equity and monetary compensation, CEOs can sometimes make even more money by quitting or getting fired. Sure, some deserve their pay, but many don't, and there's everything in between.

Well, that's the seven, and I'm not even talking about the rare psychopath that can take down an entire sector. Take Bernie Ebbers of WorldCom. How smart do you have to be to ask a simple question: in what universe does it make sense for a guy who was a motel owner, a milkman, and a gym teacher to somehow be competent at running one of the world's largest telecom companies? Just thinking about it makes me feel delusional.

With all these ways to get hosed, what's an investor to do? Simple, diversify. If you have more than five or ten percent of your net worth in any one stock, you're asking for trouble. As for employees, you need to manage your own career. Don't expect anybody or any company to do it for you. Trust and protect yourself and you'll do fine.

The only person you can be sure isn't dysfunctional is yourself. If you're not sure if you're dysfunctional, take this quiz and find out.

Mergers and acquisitions, M&A, business development, strategic development, corporate development, there are lots of names for the business of acquiring companies. They all sound important, even exciting. But whoever said, "may you live in exciting times," didn't necessarily mean that to be a prophecy of good things to come.

On the contrary, if you're like most investors, employees or executives, it's more of a curse. You see, in the corporate world, exciting usually means risky. And there's probably nothing riskier or more prone to failure than merging with another company.

I can cite lots of studies, but anyone in the business knows that most big mergers fail. Moreover, companies that have demonstrated a competency for acquiring companies--like Cisco and Broadcom, for example--are few and far between.

Just to be clear, for purposes of this post, we'll use the terms merger and acquisition interchangeably. The difference is primarily related to accounting, and nobody gives two beans about that...except the accountants.

So, what exactly is a failed merger? I define it two ways. Qualitatively, whatever the companies had in mind that caused them to merge in the first place doesn't work out that way in the end. Quantitatively, shareholders suffer because operating results deteriorate instead of improve.

Here's a list of 10 notorious failed mergers that I've evaluated in one way or another: AOL/Time Warner, HP/Compaq, Alcatel/Lucent, Daimler Benz/Chrysler, Excite/@Home, JDS Uniphase/SDL, Mattel/The Learning Company, Borland/Ashton Tate, Novell/WordPerfect, and National Semiconductor/Fairchild Semiconductor.

Some failed so spectacularly that the combined company went down the tubes, others resulted in the demise of the executive(s) that masterminded them, some later reversed themselves, and others were just plain dumb ideas that were doomed from the start.

In my mind, the two big questions are: Why merge to begin with? Why do mergers fail?

Companies merge when, for one reason or another, their strategic plans indicate they should. I know that sounds trite, but there are too many permutations to go any deeper.

That being the case, there must also be operating synergies between the two companies. In a nutshell, that means the whole will be financially healthier than the sum of the parts. Said differently, at some point after the merger is complete and the companies are integrated with redundant functions eliminated, shareholder value should increase. It's as simple as that...theoretically.

I experienced one merger firsthand: National Semiconductor's acquisition of Cyrix. On the surface, the deal seemed to make sense. National needed Cyrix's microprocessor technology to realize its strategic vision of becoming a system-on-a-chip company. Cyrix needed National's manufacturing technology to effectively compete with Intel.

However, once you got down beneath the surface, well, let's just say there were holes in the strategy so big you could drive a truckload of MBAs through them. This is in hindsight, mind you. Some of it I saw coming, some of it I didn't.

First, National's own strategy was flawed, merger or not. The market for its Cyrix-based system-on-a-chip products never really materialized.

Second, National didn't anticipate what competing head-on with Intel would do to its own operating results.

Third, when Cyrix's designs were produced in National's fabs, the chips didn't perform as hoped. That's about the most even-handed way I can put it.

As if that wasn't enough, National was probably too heavy-handed with its integration strategy. The two companies were culturally incompatible, and most of Cyrix's top engineers quit when their retention agreements expired.

The result was ugly. National's operating results went from black to red immediately following the merger, and the combined company continued to hemorrhage red ink until National sold most of Cyrix. A year and a half and more than $1 billion in cumulative losses and write-offs later, National was back to normal.

It's important to note that the usual three-month due diligence process didn't uncover any of the potential flaws in the deal. That's because merger due diligence processes typically have only one goal--to shield executives and directors from shareholder litigation. That, the companies did successfully. Shareholders lost their class action suit.

In summary, the planets have to align for a merger to be successful. In other words, for every way to do a merger right, there are probably 10 ways to do it wrong.

Here are my top 10 most common, preventable merger failure modes. One is enough to spell doom, but the more the merrier the train wreck:

1. Flawed corporate strategy for either or both companies
2. One company sugarcoats the truth, the other buys a PowerPoint pitch
3. Sub-optimum integration strategy for the situation
4. Cultural misfit, loss of key employees after retention agreements are up
5. Acquiring company's management team inexperienced at M&A
6. Flawed assumptions in synergies calculation
7. Ineffective corporate governance, plain and simple
8. Two desperate companies merge to form one big desperate company
9. CEO of one or both companies sells board and shareholders a bill of goods
10. An impulse buy or panic sell gets shoved down the board's throat

Last word
From a corporate governance standpoint, all significant mergers should be scrutinized by some really smart, experienced and disinterested (and therefore objective--this is key) people. Why boards don't do that as a matter of course I have no idea.

The burden of proof for mergers to make sense should be as high as their risk, their failure rate and the pain they inevitably cost shareholders.

When most of us quit a job, we give two weeks notice, collect our final check and we're out the door. Maybe we have some stock options to exercise within 30 days, but that's about it. When we get fired it's even simpler - same thing except no notice.

In a prior post, we discussed strategies for negotiating an exit package - a sort of self-inflicted layoff. If you're lucky and a great negotiator, that might get you a few months of salary, stock option vesting, and extension of benefits, depending on your management level and longevity with the company.

So, when we exit a company through whichever door, we're talking a few thousand bucks if you're a regular Joe, maybe up to six figures if you're a VP who's been with the company a while.

CEO exit packages are similar in concept to those mere mortals might hope to negotiate, but that's where the similarity ends. The end result is more like hitting the lottery. ... Read more