Question

Case Analysis

Answer the assignment questions for this exercise after reading Chapter 2 and Concepts & Connections 2.4. The mini case is also provided below. The exercise should help you become aware of the role and responsibility of a company's board of directors in overseeing the strategic management process.

Executive compensation in the financial services industry during the mid-2000s ranks high among examples of failed corporate governance. Corporate governance at the government-sponsored mortgage giants Fannie Mae and Freddie Mac was particularly weak. The politically appointed boards at both enterprises failed to understand the risks of the subprime loan strategies being employed, did not adequately monitor the decisions of the CEO, did not exercise effective oversight of the accounting principles being employed (which led to inflated earnings), and approved executive compensation systems that allowed management to manipulate earnings to receive lucrative performance bonuses. The audit and compensation committees at Fannie Mae were particularly ineffective in protecting shareholder interests, with the audit committee allowing the government-sponsored enterprise's financial officers to audit reports prepared under their direction and used to determine performance bonuses. Fannie Mae's audit committee also was aware of management's use of questionable accounting practices that reduced losses and recorded onetime gains to achieve EPS targets linked to bonuses. In addition, the audit committee failed to investigate formal charges of accounting improprieties filed by a manager in the Office of the Controller.

Fannie Mae's compensation committee was equally ineffective. The committee allowed the company's CEO, Franklin Raines, to select the consultant employed to design the mortgage firm's executive compensation plan and agreed to a tiered bonus plan that would permit Raines and other senior managers to receive maximum bonuses without great difficulty. The compensation plan allowed Raines to earn performance-based bonuses of $52 million and total compensation of $90 million between 1999 and 2004. Raines was forced to resign in December 2004 when the Office of Federal Housing Enterprise Oversight found that Fannie Mae executives had fraudulently inflated earnings to receive bonuses linked to financial performance. Securities and Exchange Commission investigators also found evidence of improper accounting at Fannie Mae and required it to restate its earnings between 2002 and 2004 by $6.3 billion.

Poor governance at Freddie Mac allowed its CEO and senior management to manipulate financial data to receive performance-based compensation as well. Freddie Mac CEO Richard Syron received 2007 compensation of $19.8 million while the mortgage company's share price declined from a high of $70 in 2005 to $25 at year-end 2007. During Syron's tenure as CEO the company became embroiled in a multibillion-dollar accounting scandal, and Syron personally disregarded internal reports dating to 2004 that warned of an impending financial crisis at the company. Forewarnings within Freddie Mac and by federal regulators and outside industry observers proved to be correct, with loan underwriting policies at Freddie Mac and Fannie Mae leading to combined losses at the two firms in 2008 of more than $100 billion. The price of Freddie Mac's shares had fallen to below $1 by Syron's resignation in September 2008.

Both organizations were placed into a conservatorship under the direction of the U.S. government in September 2008 and were provided bailout funds nearly $200 billion by 2013.

Sources: Chris Isidore, “Fannie, Freddie Bailout: $153 Billion . . . and Counting,” CNNMoney, February 11, 2011; “Adding Up the Government’s Total Bailout Tab,” The New York Times Online, February 4, 2009; Eric Dash, “Fannie Mae to Restate Results by $6.3 Billion Because of Accounting,” The New York Times Online, www.nytimes.com , December 7, 2006; Annys Shin, “Fannie Mae Sets Executive Salaries,” The Washington Post, February 9, 2006, p. D4; and Scott DeCarlo, Eric Weiss, Mark Jickling, and James R. Cristie, Fannie Mae and Freddie Mac: Scandal in U.S. Housing. (Hauppauge, NY: Nova Publishers, 2006), pp. 266–286.

Questions

1.Corporate governance at Freddie Mac failed the enterprise’s shareholders and other stakeholders such as taxpayers and homeowners by _________________________.

a. allowing agent managers to exploit managerial control to receive excessive compensation

b. making the company's CEO and CFO primarily responsible for financial reporting

c. failing to establish audit or compensation committees

d. overstepping the board of directors' fiduciary duty to provide managerial oversight

e. allowing the board of directors to impede the implementation of management's key strategic initiatives

2.Fannie Mae’s board of directors fulfilled which of the following of its four important obligations to shareholders?

a. Critically appraised the company's direction, strategy, and business approaches.

b. Evaluated the caliber of senior executives' strategic leadership skills.

c. Fannie Mae's board of directors did not fulfill any of its primary obligations to shareholders.

d. Properly oversaw the company's financial accounting and financial reporting practices.

e. Instituted a compensation plan that rewarded actions aimed at increasing stakeholder value.

3.Fannie Mae’s compensation committee __________________________.

a. adequately ensured that financial performance was reported fairly and accurately

b. fulfilled their duty to protect shareholder's interests

c. improperly evaluated the leadership skills of senior management and tried to correct misconduct and fraudulent behavior at the enterprise

d. failed to protect shareholders by approving compensation packages that encouraged fraud

4. Governance failures at Freddie Mac and Fannie Mae __________________________.

a. led to a massive government bailout and had a negative impact on the stability of the U.S. economy

b. resulted because of the large number of inside directors on the boards of both enterprises

c. allowed agent managers to adopt strategies that were overly focused on long-term performance

d. All of these.

e. led to the passage of the Sarbanes-Oxley Act

5.Fannie Mae’s audit committee ______________________________.

a. disregarded information provided by financial control mechanisms. Fannie Mae's audit committee did not exercise effective oversight

b. was hindered in exercising oversight by opportunistic management

c. adequately ensured that financial performance was reported fairly and accurately

d. All of these.

e. failed to certify to shareholders that the CEO was doing what the board expected

Answer 1

ANSWER-1

option (a) Allowing agent managers to exploit managerial control to receive excessive compensation.

ANSWER -2

option(c)-Fannie Mae's board of directors did not fulfill any of its primary obligations to shareholders.

ANSWER-3

option(d)-Failed to protect shareholders by approving compensation packages that encouraged fraud.

ANSWER-4

option(a)-Led to a massive government bailout and had a negative impact on the stability of the U.S. economy.

ANSWER-5

option(a)-Disregarded information provided by financial control mechanisms. Fannie Mae's audit committee did not exercise effective oversight.