Independent boards not all they’re cracked up to be
NEW YORK
In another surprise, the study also found
that, contrary to what is widely believed, the
amount of financial expertise of board members had little or nothing to do with firms’
financial performance during the crisis. Neither did it matter whether or not the CEO also
served as board chairman, or whether the
board had a risk committee.
What did make a significant difference,
though, was the amount of company stock
owned by institutional investors, with greater
institutional ownership translating into poorer stock performance.
The percentage of independent directors
averaged 82 percent for the sample as a whole,
ranging on a countrywide basis from 64 percent in the U.K. to 93 percent in Switzerland.
Institutional ownership averaged 67 percent
in the U.S. and 27 percent in Europe, and
stocks of the companies studied declined on
average by about one third in both places.
“Firms with higher institutional owner-
ship took more risk prior to the crisis, which
resulted in larger shareholder losses during
the crisis period, and firms with more inde-
pendent board members raised more equity
capital during the crisis, which led to a wealth
transfer from existing shareholders to debt
holders,” wrote the study’s authors, David
Erkens, Mingyi Hung and Pedro Matos of
the University of Southern California. They
concluded that, “While the optimal level of
risk-taking and equity capital for financial in-
stitutions is unknown, our findings cast doubt
on whether regulatory changes that increase
shareholder activism and monitoring by out-
side directors will be effective in reducing the
consequences of future economic crises.”
What accounts for the propensity of in-
dependent directors to raise equity capital
when companies’ share prices are sinking?
“In contrast to corporate insiders, who are
primarily concerned about their job security
at the firm, and therefore have an incentive
to hide bad news to avoid being replaced by
shareholders, independent board members
are primarily concerned about their reputa-
tion in the market for directorships,” the pro-
fessors explained. “Prior research finds that
outside directors hold fewer board seats after
serving in companies that file for bankruptcy
or privately restructure their debt. Thus, inde-
pendent directors have an incentive to avoid
the reputational cost of a bankruptcy.”
Further, the professors noted, “Indepen-
dent directors build their reputation as
monitors ... by requiring firms to have more
transparent financial reporting. During the
crisis period, transparent reporting implied
the timely recognition of losses related to sub-
prime mortgages. Because the recognition of
losses led to lower capital adequacy ratios,
firms had to resort to raising equity capital
to avoid regulatory intervention when they
recognized losses related to subprime mort-
gage-related assets.” AT
“service obligation.” As the lessor
collects cash, it reduces the receiv-
able, reports interest income, and
converts the obligation to lease
revenue. The property’s full origi-
nal cost is depreciated (a nearly
two-centuries-old traditional but
anachronistic practice consistent
with no sound principle whatsoev-
er) with the expense netted against
the revenues. Thus, entering a lease
(a good thing) forces lessors to fal-
laciously report a larger base for the
return on assets and a larger nu-
merator for debt/equity ratios (two
bad things). The outcome looks a
lot like the lessor signed an operat-
ing lease and does not parallel the
lessee’s presentation.
draft would have the lessor merely
deduct an allocated fraction of the
original cost, based on the relative fair values of the transferred
and retained rights to the physical
property. It is absurd that fair values
are sufficiently reliable to use in the
allocation but are somehow not reliable enough to be reported on the
financial statements.
After identifying these two alternative treatments, the boards had
to specify how to tell them apart.
The answer was another broad
agreement that the choice depends
on “whether the lessor retains exposure to significant risks or benefits associated with the underlying
asset.” This loophole-prone test is
essentially figuring out whether
the lease is a rental or a sale of the
physical asset, the same test that
was unsuccessfully pursued in APB
Opinion 7 in 1966 and SFAS 13 in
1976! This strikes us as an agreement without a principle.
Usefully resolving the lessor is-
sue demands recognizing a sale in
every case, because doing so is the
only way to reveal the truth. When
both sides report the truth, it inevi-
tably follows that their statements
will be symmetrical. The proposed
standard will not achieve that out-
come and utterly wastes the golden
opportunity to bring progress to
lease accounting after 34 years.
A BIGGER POINT
These ineffectual agreements in
principle have clearly weakened the
proposed standard. Its lack of specifics allows managers to continue
indulging the fantasy that they will
be rewarded by the capital markets for publishing misleading and
incomplete financial statements.
Instead, both common sense and
rigorous research shout that they
will be penalized with higher capital costs that in turn lead to lower
stock prices.
But apart from this negative im-
pact, we see a bigger point that the
Securities and Exchange Commis-
sion definitely needs to compre-
hend. Specifically, this draft is likely
to characterize the outcome of all
the convergence projects, especial-
ly if the current deadline pressure
is allowed to continue. More omi-
nously, it epitomizes what would
happen if FASB were to be replaced
by the IASB. Without the teeth that
come from having the SEC as a
strong source of power backing up
its decisions with scrupulous and
otherwise rigorous enforcement ef-
forts, the IASB cannot and will not
produce definitive standards that
impose tough new requirements.
GAAP with IFRS to produce rigorous standards, this exposure draft
surely provides it.
No amount of lipstick can cover
up that fact. AT
