Checks and balances…they’re a feature not a bug

It’s been an exciting few days for checks and balances.

Adam Neumann got ousted as CEO of WeWork after their IPO disappeared in a flash of unicorn dust.

The Democrats started an impeachment case against President Trump in Congress.

California Governor Gavin Newsom signed a new law forcing Uber, Lyft and similar companies to reclassify their contractors as employees…a potential knockout blow to the business models of those firms.

In the UK, Prime Minister Boris Johnson came off second best in the Supreme Court earlier this week.

And late on Friday evening, news broke that Boris Johnson’s behaviour while Mayor of London, by allegedly favouring a female entrepreneur he was close friends with, has been referred to the Independent Office for Police Conduct. (An oversight route made possible because, as Mayor of London, he was also London’s Police and Crime Commissioner.)

Much as I’m scathing about WeWork’s Adam Neumann on Twitter from time to time, in fairness he’s largely accepted the game’s up for him (albeit he has 700 million reasons not to feel too bad about the way things turned out).

In every other case, the response of those who’ve had their behaviour questioned is to say that the case against them is a political move by their opponents.

But is it?

A feature, not a bug

Having your political opponents take a case against you isn’t a bug in the system, it’s a feature of it. And one we should treasure.

After all, who’s going to keep you honest? Your cronies, your friends, the people who drink deeply from the same well of dodgy cash as you do?

Of course not.

It’s the people who have completely different views to yours, opponents who don’t bathe in the same water as you do, who keep you honest. That’s exactly how checks and balances are supposed to work.

The US Constitution, for all its faults, is still one of the finest structures for the separation of powers the world has ever seen.

The three elements of government – the Executive, the Legislature and the Supreme Court – have been set up in such a way that one element alone cannot act without the consent, tacit or otherwise, of the other two.

While that’s occasionally frustrating, we have to remember the drafters of the Constitution wrote it that way on purpose. They were the original “small government” pioneers who resented the Kings and Queens of England interfering in the affairs of the North American colonies.

That’s why the Declaration of Independence didn’t replace a King in London with one in New York or Boston. The colonialists wanted an entirely different model. One where no absolute ruler could tell them what to do.

So the US Constitution was designed to make it all-but-impossible for any one person to hold all the cards when it came to the business of government.

But the drafters of the US Constitution were also public spirited enough to recognise that they had a responsibility to, as the preamble to the Constitution says, “promote the general welfare”.

So if all three elements – Executive, Legislature and Supreme Court – agreed on a course of action, that was probably a sensible way forward which the country could unite behind.

The drafters of the US Constitution never quite put it in these terms, but they’d suffered under the yoke of far-off kings and noblemen for long enough to know that, in the famous words Lord Acton would utter a century or so later…

Power tends to corrupt, and absolute power corrupts absolutely. Great men are almost always bad men…

Lord Acton – letter to Bishop Creighton, quoted by econlib.org

From the Boston Tea Party to chocolate’s sugar rush

In the UK, we famously don’t have a written constitution. Most of the time it somehow all works anyway, but there are times when that unwritten constitution is strained to its limits.

The same is true in company law. For a long time company bosses could do pretty much what they liked. Most were decent people trying their best, but a few disreputable individuals with their eyes on the big money prize pushed things too far.

The late 1980s and early 1990s saw financial scandals like Polly Peck, Robert Maxwell’s plundering of his companies’ pension funds, the Barings Bank collapse and BCCI.

Even for a country with an unwritten constitution we Brits collectively decided there had been one corporate scandal too many, so decided we’s write a “constitution” for our businesses to follow.

The basic structure for this new system of corporate governance was laid out in the Cadbury Report, named after Sir Adrian Cadbury, of the Cadbury chocolate empire, who chaired the less than snappily-titled Committee on the Financial Aspects of Corporate Governance.

I did a law degree before being seduced by the bright lights of an accounting career, and had a particular interest in constitutional law, so I was probably less surprised than many to find the Cadbury Report highlighting the importance of the separation of powers in an organisation to help keep people honest.

This included the principle, familiar to drafters of national constitutions around the world for the last 250 years or so, that no one individual should have final decision-making powers in a business. This would be ensured by having independent non-executive directors in the majority on company boards.

In the most recent iteration of corporate governance standards in the UK, the UK Corporate Governance Code, there is an explicit requirement for the Chair of the board to be independent of the business and separate from the Chief Executive (Provision 9).

All UK-listed companies are required to comply with the UK Corporate Governance Code as a condition of retaining their stock market listing. Similar provisions apply in most major financial markets around the world.

From Sir Adrian Cadbury onward, those in charge of corporate governance in the UK have understood that “power corrupts and absolute power corrupts absolutely”. They have done their best to make sure nobody holds absolute power in an organisation.

Well, that’s the theory…

Of course, even a system with separation of powers built into it relies on people behaving honestly and sensibly.

And this isn’t an expectation for company bosses alone. It’s how the UK’s parliamentary oversight process is supposed to work, as is the governance process in trade unions.

However, as we’ve seen recently in politics, if you make sure…by fair means or foul…the people exercising oversight all share precisely the same position as you do on this issues of the day, or that they have some vested interest in the outcome you’re seeking for yourself, even if that’s for a different reason than the reason you have, then oversight can quickly become a sham.

Tiny numbers of people control the UK’s main political parties by taking positions which have alienated substantial numbers of their own supporters. Far from being political suicide, as you might initially think, this means those spouting the most extreme nonsense, on both left and right, hide under the language of “implementing a democratic mandate from my party”.

When “your party” means the 20 or so most vocal activists in each constituency cobbling together to ensure a vote which serves a party leader’s best interests, that’s not a democratic mandate at all. It’s closer to mob rule.

And the same is true of corporate governance.

Governance of any sort is a sham when the people doing the oversight are just as interested in reaping the rewards as the person heading the organisation.

Their precise objectives might be slightly different, but the key is that now, in effect, we have a single individual able to make all the decisions in direct contravention of every fundamental precept of corporate governance.

In theory, the governance structure has been set up to prevent that. In practice nobody wants to stop an out-of-control Chief Executive because they get a share of the spoils if the Chief Executive gets away with it.

Take the unfortunate WeWork saga.

There was absolutely nothing Adam Neumann did at that company which wasn’t public knowledge and which the chair and board of directors were unaware of. There was full disclosure in the S-1 form filed with the SEC prior to WeWork’s abortive IPO. There is no suggestion that any information has been withheld from either the board of directors or the SEC.

In fact, it was the disclosure of what WeWork had been up to in their S-1 which sank their IPO without trace.

The only question is – how on earth did the corporate governance abomination that was WeWork ever think their behaviour as a business, and their Chief Executive’s…shall we politely say…narcissistic idiosyncrasies were in any way acceptable for a public company with a supposed value of $47 billion?

The answer – any rational notion of corporate governance in that business had completely failed.

The consequence of that failure of corporate governance – WeWork went from a valuation of $47 billion to, effectively, zero in the space of a few weeks. That’s an expensive lesson, so let’s look at how such a spectacular failure happened on the eve of a major IPO.

Where was the board while all this was going on?

You might think the board of WeWork would have stepped in when Adam Neumann started going off the rails a little.

In fairness to Neumann, he clearly had energy, vision and a way of presenting his ideas persuasively which would have made him an asset to any business. But he was like the 3 year-old whose parents don’t stop them eating as many cookies as they want and instead end up dealing with their child’s poor behaviour as they ride the roller coaster of successive massive sugar rushes followed an hour or two later by deep crashes.

In the business world, as for toddlers, poor behaviour left unchecked tends to have severely negative consequences down the line. Not usually $47 billion-worth, admittedly, but still consequences.

Yet the board of WeWork displayed very little inclination to keep Adam Neumann’s hands out the narcissistic cookie jar, even though it is the role of the board to preserve the long-term health of the business. Whatever the people who lost $47 billion thought they were doing, they certainly weren’t preserving the long-term health of the business, as subsequent events have proved.

And that’s largely because the board of WeWork had their hands in a cookie jar too, albeit a financial cookie jar rather than a narcissistic one.

They didn’t get their “hits” from another narcissistic episode, like their Chief Executive basking in admiring articles in business magazines and speaking at top-line conferences around the world.

In the words of Vanity Fair…

It’s hard to overstate the degree to which WeWork’s business is built on the egomaniacal glamour and millennial mysticism of Neumann and his wife. Neumann sold WeWork not merely as a real estate play. It wasn’t even a tech company (though he said it should be valued as such). It was a movement, complete with its own catechisms (“What is your superpower?” was one). Many major players found this special sauce irresistible.

Vanity Fair, 23 September 2019

No, the board got their “hits” from selling shares in WeWork at successively higher valuations, which in turn made their personal shareholdings, and those of the investors they represented, more valuable.

WeWork was founded in 2010 and by 2012 had raised $17 million in a Series A funding round. A $40 million Series B followed and their $157 million Series C in November 2013 valued the company at $1.6 billion.

From there, it was up and up, all the way to $47 billion by summer 2019.

When you’ve got a charismatic founder with, ahem, those little idiosyncrasies generating significant personal wealth for you…or a substantial return on investment for your employers…or both…very few people are strong enough to want to knock that particular gravy train off its tracks.

And yet that’s precisely what should have happened long ago.

When fantasy meets reality

Sooner or later even gravy trains hit the buffers.

There’s even an expression for it in financial markets – the “greater fool” theory.

It states, roughly, that no matter how delusional you are, as long as you can find someone more delusional than you are to buy your shares from you at a fancy price then everything is OK.

Indeed, they’re buying those shares in the expectation that they’ll be able to find a “greater fool” a little way down the line to sell those shares on to and make a profit for themselves.

But if you’re the last “fool” in line before the market shifts south at a rate of knots, then you’re the one whose wealth is destroyed.

At lower levels of valuation, WeWork might have made some financial sense. London-listed IWG plc, which has been in the shared office business for 30 years and operates the Regus brand of shared offices, is worth a little under $5 billion.

But there was a point for WeWork when the valuation jumped across a line from “a very optimistic view of future prospects” to “delusional and not justified under any sensible economic model”.

And at that point, WeWork’s corporate governance failed.

Not because they didn’t tick any boxes they should have ticked. As I’ve said already, there is no suggestion that WeWork withheld any information from the SEC, the NYSE or the legions of public investors they hoped to attract.

But, had the WeWork IPO got away, there wouldn’t be a single person on their board upset with Adam Neumann. He’d still be their CEO, in all his idiosyncratic glory.

The early investors would have banked their cash and gone off into the sunset before the ordinary man and woman in the street realised they’d been completely stiffed by people who sold them a business model which made no economic sense.

And the board was egged on by the investment bankers at JP Morgan and Goldman Sachs who stood to make millions in fees from a successful IPO. In the memorable words of NYU Stern Business School Professor Scott Galloway

The bankers (JPM and Goldman) stand to register $122 million in fees flinging feces at retail investors visiting the unicorn zoo.

Scott Galloway August 16, 2019

Corporate governance failed at WeWork because nobody was prepared to take the other side of the deal.

While the investment bankers, board members and investors were licking their lips and planning to buy themselves oceangoing yachts and Gulfstream jets with their profits, nobody was saying “are we all sure this is a good idea?”.

Nobody was looking out for the retail investors, the ordinary people who invest their hard-earned savings in public companies, either directly or through their pension funds and mutual funds…except perhaps Professor Galloway.

And it’s not that nobody knew the truth.

People who work at JP Morgan and Goldman Sachs might not have moral compasses which work terribly well, but they’re smart people. They know how to run an Excel spreadsheet. And there’s no way on earth an objectively-constructed Excel spreadsheet loaded with WeWork’s business plan would have made any economic sense at any point in the next several centuries.

They must have known WeWork’s plans made no sense, but pressed on anyway with their eyes on $122 million in fees.

By the same token, the board of WeWork, which had plenty of smart people sitting on it, must have known the business plan made no economic sense, but pressed on anyway with their share of $47 billion as the prize for getting the IPO away.

WeWork, in a sense, did nothing wrong. Every box which should have been ticked was ticked.

And yet WeWork did everything wrong when it came to the fundamental principles of corporate governance.

Every business needs someone taking the other side of the deal

In the modern corporate world, pledging allegiance to some corporate messiah is what fancy business schools’ leadership programmes say should happen.

This is hokum.

The most valuable person in any business is the one who isn’t drinking the same Kool-Aid as everyone else. The person who can take an independent view, someone who can put themselves in the position of an outsider looking in on the business and ask the CEO and investors “are we quite sure we want to do things like this?”.

Like the little boy in the story about the emperor’s new clothes, someone has got to be given authority to speak out and challenge the prevailing orthodoxy without fear or favour.

Despite what people with fancy MBAs will tell you, that sort of dissent isn’t a sign of organisational weakness, it’s a sign of organisational strength.

And it’s the foundation of good corporate governance – not the tick-box type where your high-priced lawyers make sure you don’t get sued, but the type that matters. The type of governance that stops you making a $47 billion fool of yourself, destined to go down in business history as either a crook or a moron.

Checks and balances matter. They’re a feature not a bug, but when everyone’s drinking from the same ego-fuelled money trough, all the tick-box corporate governance in the world won’t save an out-of-control business from the consequences of its investors’ greed and its Chief Executive’s narcissism.

It cost WeWork $47 billion to learn this lesson.

Hopefully you’re a lot smarter than they were.

(Picture credit: Bekir Dönmez on Unsplash )

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