Note: Pat Dorsey is the former director of equity research at Morningstar. He is now the president of Sanibel Captiva Investment Advisers.
Jason Stipp: I'm Jason Stipp for Morningstar. Questionable behavior in the executive suite and the boardroom is nothing new, but some recent high-profile cases might have investors wondering when they really need to sit up and take notice. Joining me here to offer some insights is president of Sanibel Captiva Investment Advisors, Pat Dorsey.
Pat, thanks for joining me.
Pat Dorsey: Always happy to be here, Jason.
Stipp: There have been a few high-profile cases from a number of companies that make you wonder is this something I really, really need to be worried about. The first one we'll talk about is really a poster child for bad corporate governance, Chesapeake Energy. The firm was in the news again recently. What was the story behind that, and why is this really important to raise some eyebrows?
Dorsey: So, it appears that CEO Aubrey McClendon had borrowed some money, about $1.5 billion from some private equity firms that Chesapeake had had other dealings with. He has a very unusual arrangement where he gets about 2.5% of revenue from every well the company drills, but he has to foot some of the costs. So, the supposition is that that's where some of the borrowing needs came from, but it appears that the board didn't know a whole lot about this.
Chesapeake, of course, has a little bit of a history of unpleasantness in terms of corporate stewardship. There was a map collection that the company bought back from McClendon during the depths of the natural gas crisis in 2008 or so, when he got a margin call on his entire Chesapeake holdings. Board members get paid about $450,000 per year, plus 40 hours in the personal jet. So, how independent are they? I report, Jason. You decide.
Stipp: So, the board potentially even if they had known about this most recent dealing, given that they're pretty captive at this point, wouldn't have necessarily made a lot of difference.
Dorsey: That will be my considered opinion, yes.
Stipp: There are a couple things there. There is certainly a compensation component there and also the related-party transactions. Would you say those are two pretty big red flags?
Dorsey: I think so. When you see companies where board members are paid way out of line with companies of similar size, $450,000 a year for directors at a business of Chesapeake's size is just out of the ballpark. And then there's the use of the personal jet. CEOs using the company jet for personal time is an issue. But board members [getting] 40 hours? It really raises questions as to how likely are those individuals to raise that tough question at the board meeting when they're just getting such lavish perks from the business.
Stipp: Another company, a household name that's been in the news recently, is Avon. It had a takeover offer from Coty that it rejected. This is a company that's kind of been in the woods a little bit recently. What would you say about the governance there?
Dorsey: The average tenure of board members is I think about 10 years there. One could argue that CEO Andrea Jung stuck around a little bit too long. The board was very reluctant to get rid of her, even though the company really has not been performing well for several years. It has undergone numerous restructurings, and now the board has rejected a takeover offer without much of a credible plan of their own frankly. So again, it's just an issue at the board level here, whereas is the board truly independent? Is the board going make difficult decisions when the rubber hits the road?
Stipp: And really as a shareholder, you're depending on the board, especially for a company that's somewhat of having a crisis moment here, to make some of those tough decisions and maximize the value of what they've got there.
Dorsey: They are your representatives.
Stipp: Pat, another one that was in the news, it's not a public company yet, but soon will be, Facebook. Mark Zuckerberg went out and made a deal for Instagram, and it seems like maybe the board wasn't completely in on this from the get-go.
Dorsey: Here's one where you can say that, well, Zuckerberg is an entrepreneur. He has run this company very well. Obviously, he created an enormous amount of wealth for a lot of people, notably Facebook employees, when the company goes public. But at the end of the day, if you want to behave like a public company, which Facebook soon will be, it's considered polite, I think, if not legal, to let the board know and get them involved in $1 billion transaction. The issue with this phase is going forward is, you've seen over time, many entrepreneurs have trouble kind of staying with their companies as they get larger and larger. They are wonderful at creating things, but they have a harder time running a large business as it matures. Here, this is an example; this is "Can Zuckerberg make that transition?" This is an indication, that maybe [he can't] because Zuckerberg appears to report to Zuckerberg, and is that what you want in a company that's becoming as large as Facebook is, and which will face different challenges as it grows?
Stipp: Certainly there is a lot of hype around this one, but a lot of question marks, too. Those are some important reasons for investors to take pause there as they are maybe considering that IPO.
Another one that was in the news, Pat, and this is kind of an interesting case, is Google which reported that it is going to have a separate share class now. And that can raise some issues for investors in some cases generally. What's your read on this?
Dorsey: This is an interesting one. This is one where they've generally run this company fairly well. One can argue with some of the 'science' projects that Google has that have not really paid off terribly well. But generally speaking, I think, Google has been run fairly well as a business, and what they are simply saying is, they want to maintain some independence. Now, it's one you would want to watch closely, but again there is a track record there, longer than, say, Zuckerberg's. Then you can say, "OK, they've run this business fairly well." And I think, the issue of separate share classes often gets blown out of proportion frankly. You look at family-controlled businesses, like Brown-Forman or Comcast even. Well, the Roberts have made people a lot of money with Comcast over the years, and the families that own Brown-Forman have generally been very good stewards of that business. And you can kind of think why. With family-owned businesses, they answer to the family. If they really run that businesses into the ground, Thanksgiving dinner gets a little unpleasant. Family-run companies can often take longer-run decisions, and not be answerable to quarterly earnings quite as much.
In my view, if I have sort of the choice between the lesser of two evils, as a business with egregious compensation at the board level and a board stuffed with cronies, and then a business that just has a second class of shares but is run by a family who has generally maximized shareholder wealth over time, I'll take the second one any day of the week.
Stipp: So, there are certainly a lot of things we'd like to see as shareholders, but you really have to kind of dig in and see what's really affecting the operations of the business here, such as whether the company is really held back by some of the stewardship issues that can come about?
Dorsey: Yes. A lot of times, it's the spirit of things rather than the letter of things. Again, it's what actually happens as opposed to what checkboxes do they check on some corporate governance sheet.
Stipp: All right, Pat. Well, some great insights on corporate governance. Thanks for joining me today.
Dorsey: Always happy to here.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.