The Bear’s Lair: The corporate governance model is broken

John Schnatter, founder of the solidly profitable Papa John’s (Nasdaq:PZZA) was forced out last week for using a naughty word, while Elon Musk remains CEO of the eternally loss-making Tesla (Nasdaq:TSLA) despite tweeting one. The last three decades have supposedly made massive improvements in corporate governance. Well, whatever that is, it doesn’t seem to work in any rational fashion.

The Schnatter and Musk cases, to an outside observer, seem remarkably parallel. Schnatter, who had already been relieved of his status as CEO for criticizing the National Football League, which Papa John’s sponsors, had been forced to undergo pubic relations training with a PR firm Laundry Service. In the course of that training, he gave an example of racism in earlier era, saying that Colonel Harland D. Sanders (1890-1980), the founder of Kentucky Fried Chicken, was prone to use the n-word. Laundry Service reported Schnatter to the Papa John’s Board, who used it as an excuse to fire him altogether, something they had clearly been itching to do. What’s more they then unilaterally put in place a poison pill provision blocking Schnatter from attempting to buy control of the company (he currently owns 30% of the shares).

Schnatter founded Papa John’s in 1984 and had run it ever since, growing it to sales of $1.7 billion, 2017 net income of $107 million and a market capitalization of $1.5 billion. In the other example, Elon Musk CEO of the perpetually loss-making Tesla (admittedly with a market capitalization of a bloated $52 billion) wrote a tweet calling an unconnected rescuer of the young Thai footballers a “pedo,” possibly a less “bad” word than the n-word but an offense surely worsened by being direct rather than merely a quotation and in a public forum. Yet there appears to be no question of career damage for Musk, provided his increasingly implausible management of Tesla succeeds even remotely along the lines of his forecasts.

For a third recent example, this time of a Board working properly, the Board of Directors of Fiat Chrysler Automobiles (NYSE:FCAU) replaced its long-term Chief Executive Sergio Marchionne at the weekend, after he had suffered severe complications from an operation, putting Michael Manley, the head of its Jeep division in his place. Even here though, there was some conflict, since the company’s European head Alfredo Altavilla promptly quit.

You have here three examples of corporate governance in action: one where the founder and major shareholder appears to have no power at all and can be deprived of his livelihood and his property rights at random, one where the founder appears immortal, however poor the results, and one where a mere “hired hand” is replaced quickly and efficiently by a smooth process (albeit possibly bringing disruption down the road).

The modern fad for corporate governance derives from a 1992 report overseen by Sir Adrian Cadbury, the former chairman of Cadbury-Schweppes. After Robert Maxwell fell off his yacht in 1991, having looted his companies’ pension funds, and the Bank for Credit and Commerce International, a bank with almost no British connection, went bust the same year, do-gooders led by Sir Adrian wrongly felt that a tighter system of corporate governance might have prevented those failures, and the immense losses they produced.

In practice, this was naïve. No amount of corporate governance would have stopped Maxwell, known in the City as the Bouncing Czech, or the even more dubious people who had set up BCCI as recently as 1972. Sensible people, including the better merchant banks, saw the warning signs and avoided doing business with such people. (Regrettably, one of my ex-employers was not especially sensible in that respect, at least with regard to the plausible if Socialist Maxwell.) Certainly back then, Maxwell’s politics were a sufficient red flag for sensible people, being in direct contradiction to his economic interests. Alas today tax-evasion is so efficient that billionaires can be Marxists, and only the hyper-scrupulous among us will avoid doing business with them.

As for Cadbury himself, he had already resigned from Cadbury Schweppes in 1989, and his brother Sir Dominic Cadbury retired in 2000, but despite all the corporate governance in the world, the company still managed to get itself taken over by a dodgy over-leveraged foreigner, Irene Rosenfeld of what became Mondelez.

Even Cadbury himself said at the time he propounded the Cadbury Report that “Codes will not catch rogues,” which makes them mere pointless accretions of bureaucracy. The Cadbury report recommended that no one individual should have powers of decision and that a majority of non-executive directors should be fully independent of the Chief Executive. Its general principles were adopted in the United States and by international bodies. In particular “good governance” is now held to require independent Chairmen and Chief Executives, so that every decision is forced to be taken by a committee.

The Cadbury rules have had several highly unpleasant consequences. For one thing, the ubiquitous committee structure, together with the increasing litigiousness of modern life has imposed a deadening political correctness on corporations, which makes it very difficult indeed for mavericks to survive in their senior ranks. The Papa John’s case is only an extreme example of this. Equally, CEOs who are regarded as politically correct can stock the board with like-minded drones, and then have essentially infinite power. Naturally, since the drone worldview is not especially good at running businesses, the companies with the best corporate governance tend to have inferior results.

The “good corporate governance” model works well in emergencies, when the CEO is taken ill, either physically or mentally. That’s because it provides an adequate decision mechanism to operate when the CEO is out of action; in that respect it works better than the old top-down model.

There are two separate situations to consider here: (i) corporations in which the founder or his family are still active and substantial shareholders and (ii) corporations controlled entirely by professional management, even powerful professional management such as GE’s former CEO “Neutron Jack” Welch.

In the latter case, the Cadbury model of corporate governance works fairly well, with one exception. The Cadbury principle that no decision be taken by a single person is directly contrary to the principles of good decision making. By and large, committee decisions will tend towards generally accepted and “politically correct” views. However, in a fast-changing environment a committee structure is most likely to miss changes that have not yet become universally obvious. Worse still, in the case where an individual CEO has through superior ability spotted such a change, they are very likely to talk him out of acting on it, because the evidence for the change will be spotty and inconsequential at first.

Since the ability to react to such changes is the only way in which a business can produce superior returns, the Cadbury model is likely on average to lead to inferior outcomes and should be discarded. The only exception is where a very powerful CEO has made repeated errors. In that case the Board needs to be able to get rid of him; hence a weak Chairman and a Board not entirely subservient to the CEO are appropriate. Howling errors like GE’s 1986 acquisition of Kidder Peabody, the investment bank, a business entirely unrelated to anything else it did and which it made a complete mess of managing, need to result in the dismissal of the CEO concerned, and no amount of PR and headbanging by Neutron Jack should have prevented this.

In the other case, where the founder or his family are still present, more deference is appropriate. Founders like Schnatter have an intrinsic proprietary right in the company they founded, an obvious capability in running it, and an obvious interest in maximizing its value because of their shareholding. Hence a Board composed of politically correct hired hands should not have the ability to dismiss a founder, provided the company’s performance is satisfactory. Of course, eventually the founder will want to retire, and pass the company over to professional management, in which case he should have the right to choose the professional management. The only case where a founder should be replaced is where he is providing erratic management and the company’s finances are so unsatisfactory as to run the risk of failure – precisely the position of Tesla under Elon Musk.

To summarize, company founders are due much more deference from the Board of Directors than conventional ideas of corporate governance permit – after all, without them, the company would not exist at all. “Hired hand” top management are not due especial deference, but even in these cases the Cadbury prohibition against individual powers of decision is a nonsense. “Back me or sack me” is the appropriate relationship between the Board, any Chairman, and the CEO, with second-guessing of the CEO’s initiatives prohibited until they have clearly proved fruitless.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)