The Bear’s Lair: The G in ESG is as bad as the E and the S

The ESG movement, whereby companies follow centrally approved directives in the areas of environmental activity, social activity and governance, has seen some setbacks recently. Environmental and social goals have been criticized as reflecting leftist political wish-lists not compatible with fiduciary duties to shareholders and others. Yet the “G” – governance – which had been seen as an anodyne mildly benign set of requirements — may be even more damaging to general prosperity than the other two goals. This was demonstrated this week by OpenAI’s firing of its founder Sam Altman, which if upheld would have destroyed tens of billions of dollars in value and endangered the nascent Artificial Intelligence industry.

The “governance” factor in the ESG acronym was inserted to give the whole structure more intellectual respectability among those concerned with shareholder rights, particularly among the legal profession, and to soften the highly political cast of the E and S factors. Governance was thought to be a universal good – who could object to a company being well governed, particularly among its shareholders, who might otherwise risk loss of their investment through embezzlement or management foolishness?

The model of corporate governance in shareholder-financed companies arose in the 16th and 17th centuries, when a group of investors – merchants and the occasional landowner – combined to finance a company too large to be funded by a single investor — the classic example was the 1601 East India Company. In the traditional model, Directors were appointed who each had invested substantially, to keep an eye on the entrepreneur and his employees, ensuring that the money they had invested was not misapplied. When investors died, new Directors were appointed to take care of the interests of their heirs.

Even in the East India Company (EIC), that sensible arrangement did not last forever. EIC’s shares were publicly traded and new capital was added several times, both voluntarily and through compulsory conversion of defaulted debt. By 1776, when Adam Smith wrote, he described the EIC as “a nuisance in every respect.” Few Directors owned substantial numbers of shares; a Directorship was either a sinecure for someone who had grown wealthy in other business or, worse still, a piece of political patronage for the government of the day. The blockage of Fox’s East India Company Bill in 1783 was not due to substantive differences on policy, but because the King and the Tories did not want Fox to benefit from the gigantic patronage available through controlling the EIC’s operations.

More and more, the Board of Directors served to draw the EIC — and its responsibility for governing much of India – under Crown control, with no care for the interests of the EIC’s shareholders. The EIC lost its independence of the government completely through Liverpool’s 1813 Act and was abolished in 1858, after decades of rent-seeking and ineptitude.

The incompetence of Boards of Directors with no significant stake in the company was well demonstrated in the fraudulent private equity-backed drug company Theranos. If you remember, Theranos was built on the claim by Elizabeth Holmes that she had invented a method of performing accurate diagnostic blood tests using very small amounts of blood. In the process of raising $900 million and reaching a theoretical value of $10 billion, Holmes and her venture capitalists attracted as Directors two former Secretaries of State (George Schultz and Henry Kissinger) one former and one future Defense Secretaries (William Perry and Jim Mattis) two former senior Senators (Sam Nunn and Bill Frist) and the former chairman of Wells Fargo (Richard Kovacevich), among others.

Of those, only Frist, a former heart surgeon and son of the founder of Hospital Corporation of America, could be expected to have had any expertise whatsoever in Theranos’ business. Not surprisingly, despite their being well paid with both retainers and stock options, the collapse of Theranos came as a complete surprise to its Directors, and they did nothing either to detect or to prevent the fraud involved – Ms. Holmes was subsequently sentenced to 11¼ years in prison.

In the case of FTX, likewise, the Board of Directors added nothing to its governance. The parent exchange appears to have had no Board, being domiciled in the Bahamas. Its U.S operation, FTX U.S. Derivatives, regulated by the Commodity Futures Trading Commission, had a chairman, Larry E. Thompson, former Vice Chairman of the Depository Trust clearing house with legal and regulatory expertise and other Directors who were quasi-public sector, like Thompson, internal, or traders who presumably did business with FTX. Like Theranos’ Board but without its members’ true distinction in other fields, it proved incapable of stemming massive embezzlement and collapse.

Theranos is an example of an exceptionally eminent Board being useless, indeed mere window-dressing; OpenAI, the owner of the immensely important AI software ChatGPT, appears to have run into the opposite problem: a Board that meddled excessively in the management of the company for which it had responsibility. This is a problem that comes up frequently in companies funded by private equity; the private equity suppliers appoint a Board that is responsible to them only and then, when differences of opinion arise, the Board, distressed by the problems, exerts its power by firing the founder of the company. Since the founder is the person whose vision created the company and is generally driving its growth, that situation almost never ends well. The “professional” manager appointed by the Board to replace the founder is a mere drone, also subject to arbitrary dismissal after a bad quarter, so any long-term-oriented actions to fulfil the founder’s vision, even if the professional manager had any understanding of what that vision was, become impossible.

In Open AI’s case, the situation is complicated by OpenAI’s ownership by a non-profit association, surely the most damaging ownership possible for any entrepreneurial, supposedly fast-moving operation. Non-profits exist to promote some generally leftist social idea and to aggrandize themselves, both thoroughly detrimental to the mission of an entrepreneur with a long-term vision for his business. In OpenAI’s case, there was a business-destroying rift between several Board members, who feared that AI could end up destroying humanity, and Altman and the 800 OpenAI employees who were trying to build a business in the real world.

This came to a head last weekend, when the Board dismissed Altman. Initially it appeared that they had destroyed the company by doing so, since Microsoft, OpenAI’s leading sponsor, offered Altman a job, and the great majority of OpenAI employees objected to his firing and would presumably have joined him. Had that gone through, Microsoft would have gained both OpenAI’s people and effective control of its intellectual property, and the OpenAI Board would have been left as a non-profit Board controlling a company without any profits, or indeed any prospect of making any.

Altman has now been reinstated and the Board restructured, minus the members who thought AI would destroy humanity and with the addition of Larry Summers. Summers, a former Treasury Secretary of a Schultz/Kissinger level of career distinction, has the disadvantage of being almost 69 and without a clear grasp of the technology. Summers is also very strong-willed, which means he may not be prepared to draw his fat monthly check and sit quietly. (Disclosure: he once described this column to my then boss as “unacceptably Austrian.”) Time will tell, but at least the most important company in the AI space, worth some $60 billion, has not disappeared in a puff of governance-induced smoke.

The Theranos, FTX and OpenAI examples must surely discredit the concept of governance as currently practiced. To prevent fraud, more important than a Board of Directors full of ex-Cabinet members is an auditor that does its job properly and protects shareholders’ interests, as it is supposed to. This generation’s stunning collapse of audit quality from the Big Four accounting firms, a result of their stifling oligopoly, is a blight on capitalism that must be swiftly reversed.

However, Boards of Directors as such serve little purpose, except to the extent that individual Directors represent the interests of major shareholders in the Company. That was the original intention when the corporate form was set up, and to that we must return. “Governance” is a menace to capitalism that must be rejected.


(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.)