Corporate governance stands as a cornerstone of effective management and sustainable growth in modern business landscapes. The case of General Electric (GE) during Jeff Immelt’s tenure as CEO offers valuable insights into the intricate dynamics of governance, oversight, and strategic decision-making within a large and complex organization.
From 2001 to 2017, GE witnessed a significant decline in shareholder value, with its stock price plummeting by over 30%. This decline continued post-Immelt, reflecting ongoing challenges in managing cash flow, strategic acquisitions, and divestitures. These challenges culminated in a notable increase in GE’s debt-to-earnings ratio, signaling deeper financial concerns.
A critical aspect of GE’s governance during this period was the composition and functionality of its board of directors. An oversized board lacking a dedicated finance committee, coupled with oversight lapses in the audit committee, highlighted structural deficiencies that impacted decision-making, risk management, and financial transparency.
However, recent board restructuring efforts, including the establishment of a finance committee, signify a shift towards stronger governance practices. This case study delves into the key governance issues faced by GE, the impact on its performance, and the lessons learned for companies navigating similar challenges in today’s corporate landscape.
Jeff Immelt’s Tenure and GE’s Financial Challenges
During Jeff Immelt’s tenure as CEO of General Electric, which lasted from 2001 to 2017, the company’s stock price dropped by more than 30%, resulting in a loss of around $150 billion in shareholder value. Since Immelt left, GE’s stock has continued to decline by another 30%. The new CEO, John Flannery, has faced challenges managing cash flow due to problematic acquisitions, divestitures, and buybacks over the years.
These issues led to a significant increase in GE’s debt-to-earnings ratio, rising from 1.5 in 2013 to 3.7 by early 2018 according to Moody’s. Despite having an almost entirely independent board of directors comprising accomplished former executives and leaders with relevant expertise, the structure and processes of GE’s board were, in my opinion, inadequately designed to effectively oversee Immelt and his management team. Specifically, three key problems emerged during this period of GE’s prolonged and substantial decline.
Oversized Board: Impact on Governance and Stock Performance
During Jeff Immelt’s leadership at General Electric, the board was notably oversized, comprising 18 directors for most of his tenure. In comparison, the typical size for U.S. public company boards is around 11 members, with the majority falling between eight and 14 members. Research indicates a strong correlation between smaller board sizes and improved stock performance, with a potential increase of 8% to 10%, as highlighted in a GMI study.
This correlation is attributed to studies on meeting dynamics, which suggest that the optimal number of participants for effective discussions is around seven or eight. This size allows for diverse opinions while maintaining a conducive environment for productive conversations. Sociologists have observed that in larger meetings, individuals tend to engage in “social loafing,” where they feel less accountable to contribute actively and instead rely on others to drive discussions forward.
Fortunately, in December 2017, General Electric took steps to address this issue by reducing the board size from 18 members to 12.
The Lack of a Finance Committee at GE’s Board
One notable structural flaw within GE’s board was the absence of a finance committee. Prior to 2018, the board consisted of the standard governance, compensation, and audit committees, alongside a technology and risk committee focused on areas like product risk, cybersecurity, and innovation.
As I’ve detailed elsewhere, a finance committee is crucial for boards in complex public companies like GE. These companies deal with various retirement plans, stock buybacks, and substantial acquisitions. Since the enactment of the Sarbanes–Oxley Act in 2002, audit committees have struggled to manage their extensive duties and address broader capital allocation issues effectively.
Having a finance committee could have improved oversight on critical matters like retirement plan design and funding. When Jack Welch stepped down as CEO in 2001, GE’s defined benefit (DB) plan had a surplus of $14.6 billion. However, by 2017, this surplus had turned into a deficit of nearly $29 billion, the largest among S&P 500 companies.
By 2000, most U.S. public companies had closed their DB plans and made substantial contributions to bolster them. Unfortunately, GE delayed freezing its DB plan and failed to adequately fund it, leading to significant financial challenges. These are precisely the issues a well-functioning finance committee should address and prevent.
Instead, the GE board approved extensive but poorly timed buybacks and acquisitions, which should have been scrutinized by a finance committee. The company’s pension deficit escalated between 2010 and 2016, exacerbated by $40 billion spent on stock buybacks. Additionally, GE made costly acquisitions, such as the $9.5 billion purchase of Alstom’s coal-fired turbine business in 2015.
Moreover, GE’s 401(k) plan allowed employees to hold significant amounts of GE stock without limits, undermining portfolio diversification and exposing participants to undue risk. Many companies had moved away from such practices after the Enron scandal, yet GE’s board did not implement similar constraints on employer stock in its 401(k) plan.
Subsequently, the board underwent changes, including the establishment of a finance committee alongside its other committees, addressing one of the board’s major shortcomings.
Lack of Oversight in GE’s Audit Committee
Jack Welch’s legacy at GE included not just a robust pension plan but also a practice now termed earnings management. From 1992 to 2001, GE consistently met or slightly exceeded Wall Street’s earnings expectations, attributed to last-minute transactions orchestrated at GE Capital by Welch. Despite this history, GE’s audit committee failed to scrutinize the company’s revenue recognition practices.
The games in revenue recognition persisted until 2009 when the SEC took action against GE for misleading financial reporting. GE settled by paying a $50 million fine and rectifying financial statements from 2001 to 2008. One violation involved booking December locomotive sales to undisclosed partners, leaving the risk with GE, inflating revenues by $381 million. Another misstep was misapplying cash flow accounting to interest rate swaps, avoiding a $200 million earnings hit.
An interesting aspect was KPMG’s role, GE’s auditors. The SEC found that local KPMG auditors approved incorrect swap accounting without informing the national office, raising questions about their independence.
This scrutiny extends to recent issues, including a $6.2 billion charge announced in 2018 for remaining liabilities from a health insurance business GE supposedly divested years prior. The SEC is investigating GE’s accounting controls and the process leading to this charge.
GE’s audit committee faces scrutiny for not disclosing these liabilities earlier. With the addition of a finance committee, the audit committee now has more bandwidth to investigate these matters and the company’s revenue recognition practices. It might consider hiring a new auditing firm, enhancing independence and accountability.
While Immelt bore primary responsibility for GE’s operations, the independent directors should have been more proactive in questioning capital allocations and accounting practices. The recent board restructuring positions them better to oversee the decisions of GE’s new CEO.
Conclusion
The case study of General Electric (GE) underlines the critical importance of effective corporate governance and oversight in a large and complex organization. It highlights several key issues that contributed to GE’s challenges, particularly during Jeff Immelt’s tenure as CEO.Conclusion
Firstly, the board’s structure and size were initially inadequate, with an oversized board lacking a dedicated finance committee. This structural deficiency hindered effective oversight of critical financial matters, such as pension planning, capital allocation, and risk management.
Secondly, the audit committee’s oversight lapses regarding revenue recognition practices and accounting irregularities revealed significant shortcomings in internal controls and governance processes. The failure to detect and address these issues in a timely manner led to regulatory scrutiny and financial penalties, impacting shareholder trust and confidence.
However, the recent restructuring of GE’s board, including the establishment of a finance committee and a renewed focus on governance best practices, signals a positive shift towards stronger oversight and accountability. These changes are essential for rebuilding investor confidence, addressing legacy issues, and ensuring sound decision-making under the leadership of GE’s new CEO.
In conclusion, the GE case underscores the vital role of robust corporate governance, active board oversight, and transparent financial practices in sustaining long-term organizational success and stakeholder value.
