How Boards Are Destroying Corporations
The foundering Kraft buyout of Cadbury is the latest example of how corporate boards are costing us trillions. David Zweig and John Gillespie on how shareholders need to get tough.
When companies award billions of shareholder dollars to bailed-out Wall Street bankers, it's like taking candy from a baby—and the babies are all the rest of us as shareholders and taxpayers. Oblivious corporate governance and candy are linked as well to the now-foundering Kraft buyout of Cadbury
As much as it is loved, chocolate has also been associated with unappetizing things: child labor, tooth decay, acne, love handles. In one recent business situation, it at least has a palatable center, an example of how shareholders—or at least the world’s most respected one—can help to steer a company in the right direction, despite a board that repeatedly approves expensive and questionable things.
By almost every study, 60 to 80 percent of mergers and buyouts fail to increase shareholder value. (They always increase CEO pay.) So why do they continue?
Kraft, the world’s second-largest food company and purveyors of other arguably non-food items like Velveeta, Cheez Whiz, and CoolWhip, has been stalking the venerable British confectionary company Cadbury with a $16 billion hostile takeover bid, but Warren Buffett doesn’t want them to overpay.
The deal deserves note because of its irony, if nothing else. Back in the early ‘90s, media mogul Robert Maxwell stepped off his yacht and took his frauds and thousands of workers’ pensions to the bottom of the ocean with him. Around the same time, the massive financial fraud at BCCI was exposed and the British were moved to study how to prevent further cases of such dramatic corporate malfeasance. They sought the most modest, clever, and smart businessman they could find to run a commission. Sir George Adrian Hayhurst Cadbury, CEO and chairman of the chocolatier, agreed to chair it.
The Cadbury Commission made its recommendations in 1992. These quickly became the Magna Carta for corporate governance, the set of principles companies should follow to assure that shareholders and the rest of society are protected. The commission's recommendations led to reforms in the U.K. that we still don’t have over here, despite the multiple shellackings our investments have suffered over the years.
In fact, many of the commission’s recommendations have been implemented in 50 countries around the world. Britons, by far, have more direct investment in the U.S. than does any other nation, but here in the U.S. it has taken numerous governance-related blips like Enron, Healthsouth, WorldCom, Tenet, Tyco, and WorldCom, as well as the recent unpleasantness which led to over $7 trillion in shareholder losses, to finally focus attention on some of the Cadbury Code reforms. The recent drama with Kraft demonstrates how far we still have to go to bring American companies into line with these best practices.
Kraft is chasing Cadbury, the exemplar of good governance. Cadbury says no, your offer is too low, too short on cash and too long on cheap dollar-denominated stock, and ultimately “derisory.”
Kraft’s offer is a little short of cash because the company has frittered away a lot of its money: In 2008 the company used stockholders’ money to buy back 150 million shares at $33 a share. That stock is now worth $27. (Dr. Irene Rosenfeld, the Kraft CEO, is worth a lot more, however, because her board gave her a 40 percent pay raise in 2008 to $17 million.)
So, Kraft just sold its highly profitable frozen pizza brands to Nestlé for $3.7 billion cash to toss onto the Cadbury pile. Now Kraft wants to issue up to 370 million new shares, costing existing shareholders up to 25 percent of their stake, to pursue Cadbury for its profits and its access to billions living at the Bottom of the Pyramid.
Enter the world’s savviest investor and richest man, Warren Buffett, whose Berkshire Hathaway is the largest shareholder of Kraft Foods with 9.4 percent of the outstanding stock. This week he sent a public letter to Kraft telling them they should not have a “blank check” based on selling stock at depressed prices, and with no shareholder control over the deal.
Before the release of Buffett’s letter, Kraft’s CEO presumably requested Buffett’s blessing and was rebuffed. You might imagine that Buffett would then talk sense to Rosenfeld's boss, the company's chairman, but he couldn't: Rosenfeld is the chairman. (The roles are combined in 63 percent of S&P 500 companies, contrary to the Cadbury Code. An additional 18 percent are former CEOs from the same company.)
If you are among the 57 million American households that own stocks outright or have shares in a mutual or pension fund that owns stocks, you should know that these acquisition schemes, exemplified by Kraft's wooing of Cadbury, wring more out of your life’s savings than perhaps any other thing that CEOs do—even including paying excessive executive compensation. By almost every study, 60 to 80 percent of mergers and buyouts fail to increase shareholder value. (They always increase CEO pay.) So why do they continue?
The answer is simple: Boards routinely approve them without asking tough questions. At Kraft, for example, the board clearly has drunk the Kool-Aid—another Kraft product. In writing our new book, Money for Nothing: How Corporate Boards Are Ruining American Business and Costing Us Trillions, we talked to many directors who complained of being the sole dissenter on boards that approved disastrous—even fatally catastrophic—mergers and acquisitions.
One director opposed a bet-the-company acquisition and the snide investment banker who stood to profit from the deal gave him the board game Risk as a gift. The company tanked.
Another director opposed a merger that later brought down a 150-year-old New York financial institution. The CEO asked him why he was “hurting the morale” of the staff that had worked so hard on the deal. Within three years the company sold for pennies on the dollar, the shareholders were wiped out, and most employees lost their jobs.
Psychologists have a name for the urge to merge: hubris. Academics have correlated mergers with all manners of CEO phenomena, from excessive pay to poor subsequent individual performance to oversize egos as measured by the CEOs’ prominence in annual report pictures, the purchase of stadium naming rights, and other dubious behavior. Lionized “superstar CEOs” tend to get much higher pay, yet begin to underperform their peers.
If the CEO is also the chairman, who will hold the CEO in check on behalf of the shareholders? Perhaps Warren Buffett, if you are lucky enough have him. If you don’t, then you have to rely on the board, whom you supposedly elected in the first place to grow and guard your investment.
The board has a fiduciary duty to shareholders. The reality is that most boards, despite being composed of decent, intelligent, experienced people who are tough in other aspects of their professional lives, become meek, collegial cheerleaders when they enter the boardroom. Too often, directors have become an elite, self-perpetuating clique that fails to represent shareholders’ interests because they are beholden to the CEOs for their very presence on the board, their renominations, their compensation, their agendas, and virtually all their information. This system badly needs fundamental reform. And shareholders have to do their part by becoming better informed about the fatal flaws in the structure and culture of boards—and demand that they be fixed.
Boards often act as they do because they’re using other people’s money. The best prevention is a good board, with directors who act like shareholders, and shareholders who act like owners. Like Warren Buffett.