Power and Governance: Who Really Owns Credit Unions?

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1 GOVERNANCE SERIES Power and Governance: Who Really Owns Credit Unions? Robert F. Hoel, PhD Professor Emeritus, College of Business Colorado State University

2 Power and Governance: Who Really Owns Credit Unions? Robert F. Hoel, PhD Professor Emeritus, College of Business Colorado State University

3 Copyright 2011 by Filene Research Institute. All rights reserved. Printed in U.S.A.

4 Filene Research Institute Deeply embedded in the credit union tradition is an ongoing search for better ways to understand and serve credit union members. Open inquiry, the free flow of ideas, and debate are essential parts of the true democratic process. The Filene Research Institute is a 501(c)(3) not-for-profit research organization dedicated to scientific and thoughtful analysis about issues affecting the future of consumer finance. Through independent research and innovation programs the Institute examines issues vital to the future of credit unions. Ideas grow through thoughtful and scientific analysis of toppriority consumer, public policy, and credit union competitive issues. Researchers are given considerable latitude in their exploration and studies of these high-priority issues. Progress is the constant replacing of the best there is with something still better! Edward A. Filene The Institute is governed by an Administrative Board made up of the credit union industry s top leaders. Research topics and priorities are set by the Research Council, a select group of credit union CEOs, and the Filene Research Fellows, a blue ribbon panel of academic experts. Innovation programs are developed in part by Filene i 3, an assembly of credit union executives screened for entrepreneurial competencies. The name of the Institute honors Edward A. Filene, the father of the U.S. credit union movement. Filene was an innovative leader who relied on insightful research and analysis when encouraging credit union development. Since its founding in 1989, the Institute has worked with over one hundred academic institutions and published hundreds of research studies. The entire research library is available online at iii

5 Acknowledgments I wish to express my appreciation to the hundreds of credit union and corporate CEOs, board members, regulators, and consultants who have helped me better understand and appreciate the complexity of the governance process. Over the past 25 years, they have generously shared their experiences and insights, and a surprisingly large number have candidly discussed their frustrations, disappointments, and failures. Leaders often tell me that they and their organizations substantially improve their governance processes when they honestly and courageously examine their limitations and mistakes. It is in this spirit that I incorporate some of their hard-learned lessons about governance into this report. I thank Research Director Ben Rogers and the entire Filene Research Institute staff for their encouragement and assistance throughout the development of this research report. In addition, my special thanks go to Gary Clark, CEO of Missoula Federal Credit Union and a member of the Filene Research Council, for his very helpful review of this report. Finally, I express my heartfelt appreciation to Colorado State University for championing and supporting applied and theoretical research. iv

6 Table of Contents Executive Summary and Commentary About the Author Introduction vi viii ix Chapter 1 The Search for Good Governance 2 Chapter 2 Credit Unions and Banks: Similar but So Different 10 Chapter 3 Power and Owner Involvement 15 Chapter 4 How to Discourage Owner Participation in Governance 23 Chapter 5 Ownership Realities and Altruism 33 Endnotes 41 References 42 v

7 Executive Summary and Commentary by Ben Rogers, Research Director Governance, of both the credit union and the corporate type, overflows with phrases about responsibility, duty, discernment, and vision. In most cases such phrases are used sincerely; in many cases they are not. For example: A strong, independent, and knowledgeable board can make a significant difference in the performance of any company... [Our] corporate governance guidelines emphasize the qualities of strength of character, an inquiring and independent mind, practical wisdom and mature judgment. So said Enron s Ken Lay in a 1999 speech, and we know what happened next. This governance report, the first in a series of three, encourages directors and leaders of credit unions to lay more than threadbare clichés at the altar of good governance. Through a comprehensive comparison of corporate and credit union governance, it seeks to separate the received wisdom from the effective reality of modern credit union leadership. What Is the Research About? Credit unions rapid modern rise from small, fragmented lenders in the 1970s to increasingly sophisticated full- service institutions today distracts from the fact that governance structures, in statute and in practice, have changed slowly in response. The boards that have responded well have done so because of an inborn desire for improvement and rarely because of external pressures. The report casts a wide net to offer critiques of annual meetings, CEO compensation, antidemocratic board renewal policies, hostile mergers, and board perks, all in the service of separating credit union rhetoric from credit union reality. Power and Governance: Who Really Owns Credit Unions? will be followed by two more reports: Boards and CEOs: Who s Really in Charge? and Boards and Leadership: How Boards Can Add More Value. All three take aim at credit union governance, both the good and the bad, and prescribe real-world responses. The author of this report draws on an exhaustive literature review and decades of firsthand experience to frame each chapter with helpful conclusions, recommendations for credit union boards, and hypotheses that, while not proven, are excellent conversation points for improving governance. vi

8 What Are the Credit Union Implications? As the responsibilities and expectations of boards change to match an ever-more- complex marketplace, individual directors have to keep up. Seventy- five years ago even 40 years ago it was the credit union or nothing for many consumers. But today, it is the credit union or a national bank or a regional bank or a community bank or another credit union. Democratic credit union participation is rarely required, and therefore rarely practiced in a world where consumers vote with their feet. And as that participation continues to dissipate, and ownership slips into the theoretical, credit union directors have to remake themselves for the needs of the day. That means boards must: Measure members sense of credit union ownership and assess the relative governance power of the actors in their credit union to determine whether that power hierarchy is in the best interests of members. Take steps to overcome governance biases. For example, the bias toward lack of board professionalism can be addressed through targeted board recruitment efforts. The bias toward excessive risk aversion can be addressed through in-depth analysis and discussion of risk-reward tradeoffs. Expect regulators to overreact and try to dominate credit union decision making in difficult economic environments. Operate the credit union with transparency. Withholding information from members is unnecessary if the board is doing its job well. Not fret about low turnout at credit union annual meetings. Most owners of large institutions do not wish to be directly involved in the governance process. Instead, create an extravaganza and use the event primarily as a marketing opportunity. Realize that they share the responsibility to prioritize goals and demand high levels of organizational performance. Credit union members won t demand anything. They will just take all or part of their business elsewhere if you don t deliver good economic value. The failure of Enron and its board is noteworthy because it was so spectacular. But slow, silent slides into failure are much more common. Use this report as a working document to guarantee your governance protects from, rather than pushes toward, that fate. vii

9 About the Author Robert F. Hoel, PhD Bob Hoel is professor emeritus of business at Colorado State University. His primary research interests are in the areas of financial institutions, governance, marketing strategy, and consumer analysis. He frequently speaks about research findings and their implications to executives, board members, and professional groups across the United States and internationally. During his career at Colorado State University, Bob has been a professor of business and chairman of the department of marketing. He received the university s Outstanding Business Professor Award on three separate occasions. His research has been reported extensively in academic and industry journals. His most recent Filene Research Institute publications are Thriving Midsize and Small Credit Unions; Alternative Capital for U.S. Credit Unions? A Review and Extension of Evidence Regarding Public Policy Reform; Thriving Large Credit Unions; and Delivering Financial Education to Graduating College Students (with W. Ronald Smith). Bob is on the board of directors of the Credit Union Foundation of Colorado and Wyoming. He serves on committees of the Credit Union National Association and the Federation of Community of Development Credit Unions. He has been on the board of directors of two credit unions. For 15 years, he was CEO of the Filene Research Institute. The National Credit Union Foundation presented Bob its 2008 Herb Wegner Lifetime Achievement Award for his many contributions to the success of credit unions, including his advocacy of objective, rigorous research about credit unions, consumer needs and preferences, and financial innovation. He has also been inducted into the Hall of Fame of the Credit Union Executives Society. Bob received his PhD from the University of Minnesota, an MBA from Indiana University, a BA from Hamline University, and additional management education at Stanford University. viii

10 Introduction Insights for Better Credit Union Governance from Corporations? Power and Governance: Who Really Owns Credit Unions? is the first report in a three-part Filene Research Institute series on boards of directors and governance. The purpose of the research is to see if a wide range of studies about the governance of corporations can help credit unions enhance the effectiveness of their boards of directors and governance processes. All three research reports in this series find that credit union leaders can learn much about good and bad governance by examining the experiences of corporations and their boards of directors. Similarities in corporate and credit union governance issues are more numerous than generally understood. Furthermore, governance issues have been more thoroughly researched in private- sector, for-profit corporations. In these reports, boards of directors and other credit union leaders will find recommendations that will likely improve governance and performance of their institutions. They will also find intriguing hypotheses deserving additional research and analysis in individual credit unions and the industry. All recommendations and hypotheses flow from research about the experiences of corporations and credit unions and occasionally of nonprofit, non-credit- union organizations. ix

11 CHAPTER 1 The Search for Good Governance Theory and reality are uncomfortable bedfellows. In principle, it s easy to identify how governance should work at credit unions, but the reality is much more complicated. This chapter questions the effectiveness of governance in general, with a discussion about improving the weak links.

12 Governance Drives the Organization In Theory, Governance Isn t Difficult Corporations and credit unions perform similar basic economic tasks. Through their governance structures and processes, they bring together resources, manage risk, create value in our economic system, and deliver benefits to their owners. In simple models of governance, the owners of a corporation or credit union select a board of directors to represent the owners and to direct the organization s general affairs. The board hires a manager (called a CEO in this report) to oversee the daily and intermediateterm operations of the organization. Also, a watchdog committee is chosen (usually by the board) to ensure that managers, employees, and the board operate honestly and candidly report the financial performance of the organization. In corporations, this watchdog is usually called the audit committee, and in credit unions it is the supervisory committee. The board may also create other committees to assist in creating value for the owners. Irrational Leaders, Slackers, Crooks, and Grumpy Regulators They All Complicate Governance High levels of marketplace and financial success and high returns to owners are not ensured for either corporations or credit unions. Good governance is not easy, given changing market environments and naturally conflicting interests of participants in the governance process. Frequently, organization leaders manage the enterprise badly, and it stagnates and withers. In worst cases, courts and regulators must intervene and order liquidation or disposal of assets in other ways. The biggest problem underlying poor organizational performance is that board members and senior managers are not perfectly rational, all- seeing people as often assumed in classical economic- man models of behavior. Instead, they are disgustingly human. They often act in 3

13 their own best interests at the expense of the organization s owners and the general public. Some become slackers and even fraudsters. Because actions by boards and CEOs can harm the general public, government involvement in corporate and credit union governance is hardly surprising. For example, leaders of bank corporations and credit unions, unfettered by government laws and regulators (and often when fettered by them), can cause their organizations to recklessly lend money, engage in fraud and other abusive practices, and injure individuals, communities, and the nation. As demonstrated in the recent global economic crisis, behaviors of financial organization leaders can even threaten to destabilize international payments systems. Government regulators, who among other things may administer deposit insurance programs, have become important actors in the overall governance process of bank corporations and credit unions. They may be perceived as pushy, grumpy, and little more than professional pessimists dedicated to making business of the organization difficult and expensive. Boards and management routinely First-class governance cannot be achieved through the use of complain about regulators while simple checklists or raw reliance on the good intentions of grudgingly acknowledging their board members and the CEO. legally mandated functions and powers. Regulators have the power to remove all other actors individually and collectively from the governance process and to shut down the organization. Boards and management should listen to regulators and at least humor them even if they don t believe the regulators when they say, We are here to help you. Because operating and legal environments are increasingly complex, additional participants play vital roles in the governance processes of modern corporations and credit unions. Auditors, attorneys, credit rating organizations, risk management companies, and bonding companies are examples. What Is Good Governance? After reviewing a broad range of studies of corporations and credit unions, it became clear that good governance involves much more than the intrafirm organization chart. It includes internal and external actors and complex processes. First-class governance cannot be achieved through the use of simple checklists or raw reliance on the good intentions of board members and the CEO. Good governance in both corporations and credit unions is, in essence, the leadership structure and the complex system of incentives, checks, and balances that makes sure that the organization creates long-term, sustainable value. 4

14 Boards of Directors and Governance Breakdowns Are Boards of Directors Weak Links in Governance? Many experts think so: Business management expert Peter Drucker (1974, 628) believes, There is one thing all boards have in common, regardless of their legal position. They do not function. In a provocatively titled book, The Fish Rots from the Head, international governance authority Bob Garratt (2003) asserts that the root cause of most corporate failures, scandals, frauds, and other major misdeeds is the loss of board power to the firm s executives. Executives, in his view, operate without appropriate checks and balances rightfully imposed by informed, active boards. He calls for reestablishing the supremacy of the corporate board. Early in his career, William O. Douglas, former US Supreme Court associate justice and one-time SEC chairman, concluded that directors are largely figureheads who don t direct. He never changed his mind (Kim, Nofsinger, and Mohr 2010, 46). A seasoned director of several corporations once boasted, If you have five directorships, it is total heaven... No effort of any kind is called for. You go to a meeting once a month, you look grave and sage, and on two occasions say, I agree (Brooker 2002). John Carver (1997), a well-known authority on governance of nonprofit organizations, finds that most boards aren t very effective and many are completely ineffective. Boards, he says, spend too much time focusing on the past, on short-term issues, and on trivial matters. Half of credit union CEOs feel that they deal with moderately to largely incompetent and inept boards, according to off-the- record CEO interviews and discussions at national and regional conferences. Even more CEOs believe that two or more of their board members do not add measurable positive value to the governance process at their credit union. Board Members Are Often Conned Unscrupulous CEOs often dupe board members, and flattery is part of the con. At a 1999 conference on ethics and corporate boards, one of America s most highly regarded CEOs delivered a compelling speech, in which he stated: A strong, i ndependent, and knowledgeable board can make a significant difference in the performance of any company... [Our] corporate governance guidelines emphasize the qualities of strength of character, an inquiring and independent mind, practical wisdom 5

15 In most cases when corporate boards underperform, the firm continues operations, and stock prices and dividends do not achieve their potential. and mature judgment... It is no accident that we put strength of character first. Like any successful company, we must have directors who start with what is right, who do not have hidden agendas, and who strive to make judgments about what is best for the company, and not what is best for themselves or some other constituency. (Monks and Minnow 2008, 4 5) That speech was delivered by Kenneth Lay, then CEO of Enron Corporation and now widely considered one of the great corporate scoundrels of the modern era. Because of illegal activities by Lay and other executives, Enron collapsed, stockholders lost most of their invested capital, and thousands of conscientious employees lost their jobs. As the Lay speech illustrates, great words about governance and boards of directors do not always match the facts. Enron s board of directors did not show outstanding character, inquiring and independent minds, or mature judgment. At the time of failure, Enron had an impressive code of ethics and had received high marks from just about everyone for best governance practices. Also, the credentials of the board members were outstanding on paper the chairman of the audit committee was the former dean of the Stanford Business School (Monks and Minnow 2008, 4 5). Not All Corporate Failures Are Caused by Fraud General Motors Corporation is a stunning example of corporate and governance failure not involving fraud. A few decades ago GM held nearly a 50% share of the US automobile market. Its market share subsequently fell below 20%, and the US and Canadian governments felt compelled to infuse capital into the failing firm. Management and labor deserve part of the blame. Certainly the board of directors deserves blame too. Why didn t the board take strong remedial actions during GM s extended period of decline? Surely these highly compensated, well-known, highly respected captains of industry and nonprofits should have known what was happening. The literature about governance is filled with additional examples of well- credentialed boards of large and small corporations failing to identify and respond to serious and seemingly obvious problems that would later destroy their organizations. While most authorities believe that no single element of corporate governance deserves full blame for corporate catastrophes, boards of collapsed corporations rarely deserve top marks. 6

16 Poor board performance does not always result in failure of the firm. In most cases when corporate boards underperform, the firm continues operations, and stock prices and dividends do not achieve their potential. Governance Systems Malfunction in Credit Unions Too While the US credit union system generally fared very well during the recent economic downturn, it experienced some spectacular failures. More specifically, several corporate credit unions, which provide liquidity, investments, payment systems, and other services to other credit unions, became insolvent and were seized and placed into conservatorship by the National Credit Union Administration (NCUA). 1 Prior to the corporate credit union debacle, most natural person credit unions (the owners of corporate credit unions) believed that corporate credit unions were safe and sound. 2 Participants in the governance process of corporate credit unions were respected and trusted. Corporate boards were composed of industry all-stars who were successful executives in other organizations. Watchdog regulators maintained permanent offices inside the facilities of some corporate credit unions. Rating agencies overoptimistically declared the risky investments in corporate portfolios as very safe. The NCUA placed the largest corporate credit union, U.S. Central Federal Credit Union, into conservatorship in March 2009 and liquidated it in October The once- mighty U.S. Central, which had $45 billion in assets at the end of 2007, had been, in essence, the credit union for corporate credit unions. Its owners lost their entire capital investment due to the failure, and the National Credit Union Share Insurance Fund (the primary credit union insurer) reported a $1.45 billion additional loss as of June 30, 2010 (Office of Inspector General, National Credit Union Administration 2010a). The Office of Inspector General s postmortem investigation found that most of the actors in U.S. Central s governance system, including management, the board, rating agencies, and the NCUA, had performed poorly. It concluded that the board of directors and management failed to adequately diversify the investment portfolio, pursued an unwise growth strategy, and did not recognize the substantial risk that U.S. Central undertook in complex mortgagebacked securities collateralized by subprime assets (Office of Inspector General, National Credit Union Administration 2010a). Another example is NCUA s placement of Western Corporate Federal Credit Union (Wescorp) under federal conservatorship in Here, too, governance had broken down in several areas, according to the Office of Inspector General. Its report said that the board of 7

17 Progress is the constant replacing of the best there is with something still better. directors and management did not implement appropriate risk management practices to adequately limit or control significant risks in its investment strategy (Office of Inspector General, National Credit Union Administration 2010b). Investors and the NCUA initiated legal proceedings against Wescorp s management and directors for a variety of alleged misdeeds and omissions. As of January 2011, most of those suits remained unresolved. Some natural person credit unions also failed during the difficult economy. It is unfair to fault the leadership of all these failed credit unions, particularly in those serving areas where the value of real estate used as collateral on loan portfolios dropped by 40% or more. However, some of these credit unions had engaged in poorly conceived schemes to make out-of-state construction loans to short-term house flippers. Others made large numbers of loans without appropriate review, expertise, and documentation. Many acted as though real estate prices would soar forever. The checks and balances of good governance were clearly deficient. Edward A. Filene Credit union failures can be instructive. One lesson is that good intentions and impressive credentials of individual board members are insufficient to protect owners. Credit unions need to develop and deploy good governance systems. Beware of Success: It Is the Biggest Challenge to Future Success Business history reveals that one of the biggest threats to organizations is success. Success breeds complacency and overconfidence. It causes leaders to believe that their organization has discovered a recipe for perpetual growth and prosperity, and it contributes to deterioration of effective governance. Monks and Minnow (2008, 303) observe: 8 Unquestionably, the biggest challenge a company faces is not failure, but success. If we look at the most spectacular swan dives and meltdowns of the last thirty years, most were at one time almost spectacular successes... A company that is successful generally does not know where the roots of that success lie. There is consequently a tendency to fall into a pattern of not changing anything. If success is a big threat, credit unions have reason to worry. At the end of 2010, membership in 7,486 US credit unions exceeded 91 million. Despite recently passing through the worst economic downturn since the Great Depression, their aggregate net worth to asset ratio is 10.0% (Credit Union National Association 2011). This

18 is far above statutory capital requirements, where adequate net worth is defined as 6.0% and well- capitalized net worth is 7.0%. Edward A. Filene department store magnate, revered business genius, and father of the US credit union system frequently warned corporate and credit union leaders not to look backward and dwell on their past successes. He urged them to continually strive for improvements in governance and organizational performance. Progress, he said, is the constant replacing of the best there is with something still better. Conclusions and a Hypothesis Conclusions Boards of directors are usually the weak link in the governance process and are often easily manipulated by other governance participants. Good governance requires more than good intentions and simple checklists. Credit unions can learn much from the governance experiences of corporations. Reading journals and attending meetings where corporate governance issues are discussed can be very helpful for improving credit union board performance. Good governance creates long-term value for owners. All actors in the governance process are disgustingly human, that is, imperfect, sometimes irrational, and occasionally deceitful. High levels of corporate and credit union success often create overconfidence and complacency. Hypothesis for Further Testing There s at least a 50% chance that the board of directors is the weak link in your credit union s governance process, regardless of how well the board feels it is performing. 9

19 CHAPTER 2 Credit Unions and Banks: Similar but So Different Credit unions and banks appear similar but behave differently. Credit unions are generally more conservative, but banks remain better positioned to grow. A mix of culture, market, and regulatory pressures affects the structure and the habits of directors at banks and credit unions.

20 Looks Can Be Deceiving Credit Unions and Banks Appear Similar on the Surface To casual observers, banks and credit unions may appear nearly identical. Both provide financial services, and their customers often say they go to their bank or credit union to do their banking even if their bank is a credit union. The governance systems of banks and credit unions include owners, boards of directors, CEOs, and watchdog groups called audit committees or supervisory committees. The government In a 2010 report, over 65% of credit unions had four- and defines the scope of their operations and monitors the safety five-star ratings and were recommended, compared to 59% of banks receiving similar ratings and recommendations. and soundness of both types of financial institutions. In both the credit union system and the banking industry, there are some differences between federally chartered institutions and state- chartered institutions. But these similarities are only part of the story. Dissimilar Behaviors of Credit Unions and Bank Corporations Despite their many product and governance similarities, banks and credit unions conduct themselves differently in the marketplace: Credit unions behave more conservatively than banks. Credit unions tend to avoid excessive risk taking, and they favor high levels of capital. Evidence of this conservative behavior can be found in ratings of the financial health of banks and credit unions. At the end of the third quarter of 2010, BauerFinancial s five-star rating update showed that just 5.6% of federally insured credit unions received two stars or below (troubled and problematic institutions), while 12.7% of banks received those low ratings. Over 65% of credit unions had four- and five-star ratings and were recommended, compared to 59% of banks recei ving similar 11

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