Wal-Mart, J.P. Morgan, and the perils of ignoring shareholders

May 21, 2012, 5:26 PM UTC

FORTUNE — No working stiff wants bad news about his performance to hit the boss’ desk right before review time. Although the review is supposed to represent a year’s worth of effort, there’s always a chance that the “what have you done for me lately?” question will influence the review and pay outcome.

The same happens with boards and CEOs in the run up to their companies’ respective annual shareholder meetings. This hasn’t been a fortunate year for the largest of firms on that front.

At Citi (C), the inability to pay a promised dividend because of a lack of Fed confidence hit the headlines prior to its annual meeting, where shareholders voted down its executive pay plan. J.P. Morgan’s (JPM) more than $2 billion trading debacle made headlines right before that bank’s annual meeting last week, a story that has led to investigations that will not go away anytime soon. And Wal-Mart (WMT) might have preferred for the New York Times’ bribery investigation to hit the presses sometime other than the run up to its annual meeting on June 1.

For the first time in its history, pension fund CalSTRS has initiated a suit on behalf of Wal-Mart and its shareholders against the retail giant’s executives and directors for their handling of the bribery scandal and investigation. “We take our responsibility to our shareholders very seriously. We are reviewing the lawsuit closely and are thoroughly investigating the issues that have been raised,” a Wal-Mart spokesperson emailed me. In advance of the company’s upcoming board meeting, the New York City Pension fund will be voting no on the re-election of five of Wal-Mart’s directors.

Missed warning signs at Wal-Mart

Wal-Mart’s board received warnings on its compliance oversight seven years ago, newly released documents reveal. In a May 25, 2005 letter to Roland Hernandez, who was then chair of Wal-Mart’s audit committee, New York City Comptroller William Thompson gave fair warning: “Strong internal controls are … essential to ensuring full legal and regulatory compliance.… We urge the Audit Committee to appoint a special committee of independent directors to conduct a thorough review of the company’s controls,” the letter said. Although the impetus for the letter was not the bribery scandal, the signatories to the letter, which included the New York City and Illinois pension funds as well as USS and F&C Investment Management, recognized what the board did not seem to: weak controls in one area can be a symptom of larger problems yet to be unearthed.

Rather than recognize the seriousness of these issues, the board offered a weak response: two months later, Hernandez wrote that the compliance systems for the company were in good shape and that the audit committee was on top of things. But the funds continued to pursue the issue in a meeting in New York City held in September 2005.  Both Hernandez and Wal-Mart’s current audit chair, Chris Williams, attended.

Unbeknownst to the funds, that same month, a “senior Wal-Mart lawyer [had] received an alarming e-mail from a former executive at the company’s largest foreign subsidiary, Wal-Mart de Mexico … [that] described how Wal-Mart de Mexico had orchestrated a campaign of bribery to win market dominance,” a recent New York Times investigation showed. In November, according to the New York Times report, law firm Willkie Farr & Gallagher recommended an independent investigation into the bribery allegations that had surfaced.

A special committee of the board along with independent counsel would be best suited to conduct this kind of investigation. But Wal-Mart’s executives chose to go with an in-house investigation, scaling back the inquiry from four months to two weeks. By December 2005, Wal-Mart’s preliminary bribery inquiry uncovered “a reasonable suspicion to believe that Mexican and USA laws have been violated,” and an internal audit report flagged suspicious payments to government entities in Mexico, the New York Times reported.

Internal audit ought to report to the board’s audit committee. And audit committees have a duty to request the materials they need to oversee their functions properly.

Did the audit committee not specify that they wanted internal audit reports related to suspicious payments — or did Wal-Mart’s management fail to comply? In November, the pension funds again requested the formation of a special board committee that included specific questions related to compliance and whistleblower practices. Yet in February 2006, two full months after the preliminary bribery inquiry and the internal audit report, Hernandez again brushed aside the pension fund’s concerns, writing, “The Audit Committee, the Board and senior management are all committed to developing best practices in the areas of internal controls, legal compliance, corporate responsibility and ethics.”

So where were Hernandez and Williams and the rest of the audit committee all this time?

In May 2006, as Wal-Mart finalized its internal report on the bribery investigation, which Wal-Mart’s director of corporate investigations found to be “truly lacking,” according to the Times, the pension funds reiterated their request for a special committee.

As with the others, the request fell on deaf ears, and despite repeated warnings, Wal-Mart’s audit committee, it appears, never woke up.

On April 24, 2012, Wal-Mart issued a statement that said that in March 2011, CEO Mike Duke authorized a worldwide FCPA (Foreign Corrupt Practices Act) compliance review. “Mike is fully supportive of the independent investigation being conducted in Mexico with oversight by the Audit Committee…. We are confident we are conducting a comprehensive investigation,” the statement said. In an SEC filing last week, the company described the current scope of its investigations and its cooperation with investigations by the Department of Justice and SEC, saying there could be “a variety of negative consequences,” including “criminal convictions” and that the issues may “impinge” on management time.

Wal-Mart is not alone

J.P. Morgan’s board also failed to heed warnings from shareholders about its risk committee last year. In a letter dated March 18, 2011, Bill Patterson, executive director of CtW Investment group, warned the bank’s board of “serious deficiencies” related to its risk oversight, saying the board should not be lulled by “the praise heaped on CEO Jamie Dimon.”

James Crown, who led the board’s risk committee, expressed full confidence in the bank’s handling of the financial crisis in a meeting last April, Michael Pryce-Jones, senior policy analyst at CtW Investement Group, who had attended the meeting told me. Crown also expressed full confidence in J.P. Morgan’s risk officer Barry Zubrow, with whom he effectively co-authored the bank’s risk appetite statement. Crown also questioned the benefits to shareholders of having an outside advisor review its practices according to Pryce-Jones’ notes from the meeting. “When you have the smartest people in the business, why get information from anyone else?” was the general attitude Crown expressed, according to Pryce-Jones. J.P. Morgan declined to offer comment for this story.

Not all boards yet recognize the benefits, but independent directors on effective boards recognize that they will not know everything they need to if they simply look inward for guidance. Shareholders can be board members’ best allies when it comes to alerting to troubles directors may not otherwise see.

Among stronger boards of directors this proxy season, directors are holding discussions on how they can improve companies’ shareholder relationships and how they can get more first-hand experience with investors to gain their insights. The Wal-Mart and J.P. Morgan cases are clear-cut: when shareholders keep knocking, it behooves board members to listen.

Eleanor Bloxham is CEO of The Value Alliance and Corporate Governance Alliance (http://thevaluealliance.com), a board advisory firm.

Editor’s note: A previous version of this story incorrectly referred to the date of a draft report that came from Wal-Mart’s preliminary bribery inquiry team expressing  “a reasonable suspicion to believe that Mexican and USA laws have been violated.” This has been corrected.