Category: Governance

And how was your week?

July 22, 2024 /

After a hiatus on the blog and social media, we are back. And boy howdy what a moment. There was an attempted assassination of a Presidential candidate/former President, the sitting President stepped away from his re-election campaign, and an update to an omnipresent piece of cybersecurity software took down airlines, healthcare providers, and financial institutions. The damage is still being tallied and the “2024 CrowdStrike incident” already has its own Wikipedia page (https://en.wikipedia.org/wiki/2024_CrowdStrike_incident). And how was your week?

Meanwhile, markets continue to rip with seemingly not a care. In our prior global capital markets risk assessment we had flagged geopolitical conditions that would be destabilizing to markets like the battlefront shifting toward Europe in the Russia-Ukraine conflict, China moving against Taiwan, or a regional conflict erupting in the Middle East. Sure enough, Israel is embroiled in a multi-front proxy war with Iran and markets hum and rates stay benignly elevated. The price of oil is hovering barely above pre-Pandemic levels. One of the few traditional signs that the kids are not all right is gold holding an all-time high since April.

For any of our readers who have followed us for a while in our blogs and newsletters, we are always poking at one of two questions – when times are good we are asking what will take the market out, and when they are bad, we are asking what will put a bottom in the market. Right now we have to ask if markets are punch drunk and can’t react any more or truly are that resilient.

If we were playing disaster bingo we would not have guessed much less expected this kind of sequence of extraordinary events in the span of less than two weeks with barely a wince.

That the market was able to withstand that much adverse news suggests fundamentals still matter even from the top down. Presidential elections of late have not been a strong market factor, and the misfortunes of a single $90B public company do not dictate the overall direction of share prices. In the case of CrowdStrike, the market, as reflected in that company’s share price, seems to see the need for clients to diversify away from a single provider in their space, and for governments to seriously question the monotonic strategic technology infrastructure exposure to a single company where a fat-fingered software update can wreak global havoc. CrowdStrike is being taken to the proverbial shed around back, but the rest of the market continues apace.

We are still left with the question of what could take this market out, but our concerns are ameliorated to a certain degree by market participants not burning the house down to light a single candle. We don’t think that means there is no risk, but we believe that the kind of risk that broadly hits capital markets will be systemic.

This is Not That

March 12, 2023 /

One of the (very few) benefits of being in the business of capital markets and investing across more than three decades is the ability to quickly recognize the similarity of an event to something in the past. Or, in the case of this past week, the lack of similarity. The rapid unraveling of Silicon Valley Bank and the apparent encore of Signature Bank has people talking of 2008 and the Financial Crisis. It is actually hard for us to believe it has been around 15 years since the Crisis. It seems much more recently that we were standing with our colleagues watching Bloomberg screens of credit default swaps wondering who would fall next and what the likelihood was it would be our own employer. The whole system was unraveling. This is not that.

Superficially, there is enough in common to suggest history may not be repeating itself but at least it is rhyming. High-flying bank gets too far over its skis, customers and markets lose confidence, run on the bank, regulators step in and shut it down and look for a buyer. Looking another layer deep there is still some commonality – the bank failed at its most basic function, providing safekeeping of and access to customer money.

So, reasonably, people are concerned about contagion and a more widespread run on banks. But, unless some startling levels of as-yet unknown malfeasance or malpractice emerge to change the narrative, there is an important difference between what took down SVB and what took down Lehman Brothers, Bear Stearns, WaMu and others. In the depths of the Financial Crisis, the main problem was that nobody knew what bank balance sheets were actually worth. Complex securitized loan pools were valued based on assumptions and risk models that proved to be fragile or entirely wrong all at once. It wasn’t possible to look at these holdings and get even the slightest idea of what they were worth, which meant there was no way to understand how much capital the banks actually held against their depository and other obligations. The banks’ use of leverage also multiplied these unknowns making the consequences even more far reaching.

SVB on the other hand appears to be a good old fashioned case of staggering incompetence. Don’t get us wrong – that is no excuse. But in this case, it does not appear that the balance sheet of SVB cannot be valued. It is simply that they entirely blew the most basic and central internal role they needed to perform, which was to properly match assets and liabilities. They ended up with too many long-dated assets and short-dated liabilities and simply did not have the liquidity to satisfy customer demands that then blossomed into a run on the bank. By all accounts everybody knows what is on the balance sheet and what it is worth – and the answer is… not enough in the current market environment. Not zero, but not enough.

It also doesn’t appear that there is a quality issue like what plagued banks in 2008 where the securities on the books turned out to be far junkier than their ratings would suggest. They simply held too much high quality but long-dated Treasury and other obligations that got hit hard with the spike up in rates this past year. After the Crisis, the rules did change on what types of holdings counted and to what degree when assessing an institution’s capital adequacy. Treasuries are right at the top of the chart of holdings that satisfy those ratios. The bonds are still there, and there is no reason to think they wouldn’t pay out 100 cents on the dollar if held to maturity. But, SVB couldn’t sell them today to satisfy withdrawals for what they will be worth a decade from now. Again, basic asset-liability management seems to have eluded them.

Bank management may have assumed since cash was coming in hard and fast over the last couple years that liquidity was never going to be an issue, so they could step further out on duration to squeeze extra basis points of yield out of the balance sheet. A little stress testing would have shown that a meaningful rise in rates would hit the value of those long bonds, which meant everything rested on either the cash continuing to come in or at the very minimum their customers not looking for withdrawals in size. SVB, because of their business strategy, is unusually concentrated in its client exposure to the Tech and tech-adjacent sectors. It wasn’t a mystery that the whole Tech space was undergoing market stress, investors were tightening purse strings, and companies and their funders would be looking to tap their cash reserves to keep things going. They got caught in a simple squeeze – their principal clients needed to access liquidity at a time the bank couldn’t satisfy it without taking a hit on those assets.

As of late this weekend the regulators have stepped in and assured liquidity for all depositors, insured and uninsured. They do have a facility paid into by the banks that was set up precisely for this kind of situation. SVB (and Signature) is essentially defunct, and likely will be bought whole or in parts by one or more big, solvent institutions at a very attractive price and without having to assume the kind of risks banks faced buying the failed banks in 2008. In a bank run psychology does become reality, and even though the problems are not systemic in the way they were in the Financial Crisis, it is right and reasonable to be concerned about contagion. Customers could manufacture a crisis where one didn’t exist just out of fear. Regulators are doing the politically unpalatable and interceding in a way that will benefit a lot of unsympathetic parties in order to keep a very specific problem with a very specific group of institutions from blossoming into something much more damaging.

Dodd-Frank has never been popular, seen as too odious and heavy-handed and in the way of free enterprise in the view of industry stakeholders, and with the benefit of more than a decade in use it could definitely be improved. However, this past week serves as a graphic example of why it is necessary, and why regulation and supervision are essential to the orderly functioning of our financial systems. In the all-too-apropos words of the comedian Ron White, there’s no cure for stupid.

WCM Chart(s) for April 29, 2022

April 29, 2022 /

The subject of DE&I – diversity, equity, and inclusion – is having its moment in discussions about companies and workforces. Numerous studies have been conducted attempting to quantify the degree to which all manner of performance metrics improve when access and representation look more like the population at large. We are entirely supportive of a focus on DEI, but not necessarily the focus as it currently stands in the investment world. There is a strong impulse to count and score things to reduce the uncertainty of qualitative observations to quantitative data points, which is not unique to DEI or ESG. DEI happens to lend itself well to that approach because people can be counted. How many women? How many indigenous peoples? How many veterans? What we find is that counting or checking boxes can illuminate deficiencies, but does little to uncover how or why, and fails to understand the interdependencies between different categorizations, such as veterans and health and disability, or race/ethnicity and economic status and education. For instance, a company hiring STEM workers may come up short in its hiring of women or people of color, which could be a failure of policy and practice, or it could be that the supply of qualified candidates is insufficient because universities are not producing a diverse pool of graduates from which to draw. For us, it is a systems-level question. We start with the reasoned assumption that diverse, equitable and inclusive workplaces are more productive and more profitable as well as being more fundamentally just, but our focus is on the systems that perpetuate unproductive biases. That could be and often is rooted in discriminatory practices and systemic biases, but those biases do not exclusively live with the hiring manager or company nor are they fixable in the immediate term no matter how radical a policy shift is implemented. It takes time to establish systems of good governance, cultivate and develop talent, and equalize compensation and promotion opportunities, and those systems extend well beyond the four walls of a given company into our communities and our education, nutrition, health care and other civic services. High performance through an ESG lens where DEI is concerned is establishing and fostering systems and processes that naturally produce a more representative workforce by developing and improving the capability and capacity of candidate workers and opening access to opportunities. [charts courtesy US Bureau of Labor Statistics, Current Population Survey]

A new definition for “systemically important” businesses

March 19, 2020 /

At the peak of the Financial Crisis in the stretch from 2007 to 2009, we became familiar with the notion of systemically important institutions. With the failure of major banks and investment banks like Bear Stearns, Lehman Brothers, Countrywide and Washington Mutual, the private and public sectors had to come to grips with the idea that for-profit businesses could be so essential to the orderly functioning of the overall capitalist system that they could not be allowed to fail, even if that required the rescue of a public company with taxpayer money. This notion gave rise in part to a series of laws and regulations including the Dodd-Frank Wall Street Reform and Consumer Protection Act. Certain financial institutions were too important either by virtue of function or size or both to be allowed to fail, undermining confidence and the orderly conduct of our economy and markets. These institutions would be protected, but they would also be more critically regulated to mitigate the risk of failure.

Whether standing in long lines of anxious neighbors to stock up on staples or watching a public address from the White House rose garden, we have been presented with a new and really more fundamental notion of what a systemically important business is. In fact, the shelter-in-place approach to mitigating the spread of COVID-19 has created a new class of systemically important businesses as we redefine, on the fly, what used to be luxuries like working from home or having household staples delivered as now being existential.

Through the present market turmoil, it is difficult to see this new order clearly, but in the months and years to come we will collectively be forced to reflect on what we are learning through experience now. There are fundamentals to the orderly functioning of communities and societies that we all know intuitively, and yet we continually fail to prioritize until we are tested. Right now we are sitting at the bottom of Maslow’s hierarchy of needs, focusing on physiological and safety needs. That’s health, food, water, shelter, personal security, financial security, and so on. Our current situation is depriving us of the ability to climb further and focus even on social belonging because of the paramount importance of the first two.

We can make light of the run on toilet paper, canned goods and hand sanitizer, but that is as explicit a manifestation as there is of what matters right now – health and hygiene and nutrition. The systemically important are food producers and grocery stores, pharmaceutical companies and pharmacies, hospitals and laboratories. They are also the providers of basic infrastructure, public and private, that keep the lights on, the water flowing, and goods and services moving from point A to point B so we can be home and be socially distant. We are also going to get a graphic look at how fragile the bottom of the economic ladder is where access to basic physiological and safety needs is not assured on a good day much less in the midst of a crisis.

From an investor’s perspective, this will cause a re-rating of securities according to what really matters when we are against the wall. From municipal finance to support hospitals and emergency workers to ownership of companies that are essential to the food supply chain, we will have a renewed and clarified sense of where our investment capital is the most needed and where it should be treated with the highest levels of stewardship and oversight, whether or not it is backstopped by government, because these companies and services are simply too systemically important to fail. And with that, there is an opportunity for companies and for governments to rethink stakeholder rights and responsibilities, and to provide best-in-class transparency and good governance and prioritize quality and longevity over short term rewards.

The Purpose of a Corporation

August 19, 2019 /

It will take some time to unpack both the intent and the implications of the Business Roundtable’s redefinition of the purpose of a corporation, but a quick meditation on their announcement on August 19th leads to a very confusing place for a sustainability-minded stakeholder.

On the surface, the “Statement on the Purpose of a Corporation”, co-signed by 181 CEOs, seems like a tectonic shift in the alignment of stakeholder values. At long last, corporations are committing to prioritize something beyond unadulterated capitalism. The points they made and the rhetoric they used could have been taken right off the vision boards of a thousand responsible and sustainable investors. The five central principles they outlined are (direct quote from the Business Roundtable, August 19, 2019):

  • Delivering value to our customers. We will further the tradition of American companies leading the way in meeting or exceeding customer expectations. 
  • Investing in our employees. This starts with compensating them fairly and providing important benefits. It also includes supporting them through training and education that help develop new skills for a rapidly changing world. We foster diversity and inclusion, dignity and respect.
  • Dealing fairly and ethically with our suppliers. We are dedicated to serving as good partners to the other companies, large and small, that help us meet our missions. 
  • Supporting the communities in which we work. We respect the people in our communities and protect the environment by embracing sustainable practices across our businesses.
  • Generating long-term value for shareholders, who provide the capital that allows companies to invest, grow and innovate. We are committed to transparency and effective engagement with shareholders.

These principles actually vibrate on the same wavelength as the Certified B Corporation “Declaration of Interdependence”:

  • That we must be the change we seek in the world.
  • That all business ought to be conducted as if people and place mattered.
  • That, through their products, practices, and profits, businesses should aspire to do no harm and benefit all.
  • To do so requires that we act with the understanding that we are each dependent upon another and thus responsible for each other and future generations.

So where’s the fly swimming in the punchbowl? The sub-heading for the Roundtable’s press release said the following – “Updated Statement Moves Away from Shareholder Primacy, Includes Commitment to All Stakeholders”. Again, at face value this is a good thing putting aside profit and shareholder value as the priority above all others. But, this announcement lands almost contemporaneously with an announcement that the SEC would be holding meetings to discuss a plan on the table to reign in proxy advisory firms (a prior discussion of this move from Cydney Posner, Cooley LLP on the Harvard Law School Forum on Corporate Governance and Financial Regulation can be found here), and during a period where the SEC has been increasingly lining up with companies to brush back shareholder resolutions and keep them off the proxy ballots. This move to limit the shareholder franchise has taken the form of questioning the materiality of the resolution to the overall business, as well as inching toward requiring a minimum percentage of ownership in order to sponsor a resolution. 

The danger here is that the confluence of disenfranchising shareholders with this new announcement from the Business Roundtable could actually mean a net setback if sustainable business behavior is defined almost exclusively by what management says it is without the input from and the natural corrective of the shareholder. That fifth principle is the linchpin to whether this will work or not – being “…committed to transparency and effective engagement with shareholders.” If the SEC defangs the shareholder, what does that actually mean in practice? We have seen repeated examples from aerospace to pharmaceuticals where self-supervision and fast-track regulation lead to bad outcomes for all stakeholders.

The Roundtable is on the right track if these principles are pursued in a regulatory environment that preserves an appropriate level of governance and accountability for shareholders, who are ultimately the only ones that have the ability to hold managements fully responsible in a free market. Employees can quit, customers can boycott and suppliers can freeze their pipelines, but boards and C-suite executives work for the shareholders.

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