Archive for the ‘Risk Management’ Category

Environmental and Innovative Disruption: What Directors Need to Know

August 31st, 2015 | By

On July 17, NACD hosted a Directorship 2020® forum in Seattle that focused on how disruptive forces are changing the way companies do business. Through keynote addresses, expert panels, and small group discussions, the program provided an in-depth look at environmental and innovative disruptive forces and how boards can oversee management of the risks and opportunities such forces create. This event was held in partnership with Broadridge Financial Solutions, KPMG’s Audit Committee Institute (ACI), Marsh & McClennan Cos., and PwC.

In his keynote address, Hewlett-Packard Co. (HP) Global Director of Sustainability and Social Innovation Nathan Hurst examined the nexus of environmental issues and innovative technology. Motivated in part by concerns about the anticipated effects of climate change, consumers are more alert than ever to the impacts that businesses and their products are having on the environment. As our increasingly data-driven society shifts to digital media, the new technologies being used to store, manage, and process this data are producing a larger environmental footprint than one might expect. Hurst estimates that if cloud computing were a country, it would rank as the fifth largest country in the world in terms of energy use.

According to Hurst, companies must understand their environmental footprint in order to leverage the opportunities provided by “big data” and other technological tools for managing corporate sustainability. HP, for example, examined its operations, supply chain, and product portfolio to gauge its end-to-end carbon footprint. This assessment involved an organization-wide effort that required expertise and feedback from senior management, information technology departments, and operations departments, which was then used to determine the company’s baseline performance, set sustainability goals, and collaborate with organizational units on initiatives to reach those goals. For Hewlett-Packard, the relationship with supply chain managers was especially important, as the company sought to develop products whose production consumes fewer resources—such as power or water—and generates less waste—such as greenhouse gas emissions. In addition, Hewlett-Packard signed a power purchase agreement with SunEdison, the world’s largest renewable development company, to provide wind-generated electricity to its 1.5 million square-foot data center in Texas. Hewlett-Packard originally set a deadline of 2020 for reducing its greenhouse gas emissions by 20 percent of 2010 levels; however, the SunEdison agreement will enable HP to realize that goal by the end of the 2015 fiscal year.

Hurst succinctly summarized HP’s rationale for its sustainability and social innovation initiatives:  the benefits of these initiatives for the company’s reputation and employee engagement, combined with new opportunities for profitable growth, collectively have the potential to produce major gains for HP.

In the second keynote address of the afternoon, Mark Silva, founder and CEO of KITE, spoke on innovation partnerships and described them as a gateway to investments, mergers, and acquisitions. Many companies at the forefront of innovation begin as small start-ups. While these businesses may initially be viewed as competitors with larger corporations, pursuing partnerships can be a mutually beneficial arrangement that allows established companies to embrace the latest wave of innovative ideas, provides start-ups with quick access to infrastructure and resources, and empowers both organizations to unlock growth opportunities. For example, the management team behind Sphero, a  toy robot that can be controlled via smartphone or tablet devices, participated in a mentorship program offered by The Walt Disney Co., which subsequently used Sphero’s technology to create a robot featured in its Star Wars franchise. Through this partnership, the Sphero team has realized growth and greater exposure; and by providing a forum in which entrepreneurs can test their ideas, Disney continues to stay abreast of the latest innovations and trends. Other established companies, including Nike and Unilever, have similar brand accelerator programs to rally resources, invest in learning, and develop new capabilities.

Subsequent presentations and panel discussions generated the following key takeaways for board members:

Keep disruptive forces on the agenda. Trends and events that could potentially overturn the company’s business model should be routinely discussed at board meetings so that directors are always aware of and up to date on how management is approaching risks and realizing opportunities. Being proactive and thinking ahead about how to manage disruptors also promotes resiliency when a company faces a crisis. Boardroom discussions should address how the organization can diversify its supply chain so that the success of the business is not dependent on a single link in the chain in order to maintain production. For example, the board might ask management to consider how environmental changes—such as prolonged droughts or severe weather patterns—might lead to new business norms, and to plan how the company will adapt and stay competitive. Panelists agreed that boards need to “ask for the data”: What questions are customers and suppliers posing? What factors are driving their business decisions? What are, or could be, the game-changers in the company’s industry?

Clarify the payoff. Directors should ask management to demonstrate how responses to disruptive trends will impact the company’s bottom line. Nathan Hurst illustrated this point with an example from Wal-Mart, which has worked with several of its suppliers to reduce waste and costs. Noting the high water content of its liquid laundry detergents, the retailer joined forces with Procter & Gamble, Unilever, and Church & Dwight to create “doubleconcentrated” detergent, a product that delivered the same washing power as the old formula in just half the volume. Because of doubleconcentrated’s reduced water content, manufacturers could pack the product in smaller plastic bottles. The new product size allowed more bottles of detergent to be packed onto trucks and store shelves, while its lighter weight resulted in lower transportation costs.

Companies can also consider incorporating sustainability metrics into executive compensation plans. Some companies will not embrace sustainability unless it entails demonstrable cost savings or a failure to address environmental impact will cause the company to lose ground to competitors. But, as the Hewlett-Packard and Wal-Mart initiatives illustrate, focusing on sustainability offers a way to drive more efficient business practices, which in turn allows management to make better-informed and more effective decisions.

Furthermore, sustainability reporting can foster positive relationships with both shareholders and the general public. According to an analysis by Gibson Dunn, shareholder proposals on environmental issues—specifically those concerning climate change and greenhouse gas emissions—are among the most frequently submitted types of proposals. NACD’s Oversight of Corporate Sustainability Activities handbook advises that directors should understand how the company has chosen to define sustainability in the context of its strategy, and the board should be comfortable with management’s decisions about how the company communicates sustainability information within the organization and to shareholders. Reporting not only demonstrates the company’s culture and character; it can also give it a competitive edge.

Examine board composition. Another example raised in the panel discussions was that of Encyclopædia Britannica Inc., which had a board composed of bookbinders who, by virtue of their profession, were disinclined to embrace digital innovation. The advent of Internet-based rivals, such as Wikipedia, quickly made the company’s business model and flagship product obsolete.

The board should analyze the company’s current and future business models to see how well the criteria for director selection correspond to those models. Maintaining a balance between tenured directors, who have invaluable insights into the company, and newer directors can present challenges when that new talent pushes against the status quo, which in turn can lead to culture clash within the board. Since culture, by definition, functions to preserve the status quo, it can make or break innovation. By bringing in outside perspectives and people who will question it, the board can keep the company moving forward.

For information on future events and recaps of past events, including video highlights of keynote speakers, visit the NACD Directorship 2020 microsite. To hear more from keynote speakers at past 2015 NACD Directorship 2020 events, join us at the NACD Global Board Leaders’ Summit, where Mark Silva, founder and CEO of KITE; Paul Taylor, former executive vice president of the Pew Research Center; and Scott Steinberg, CEO of TechSavvy Global, will be speaking on disruptive forces.

Additional Resources on Environmental and Innovative Disruption

Oversight of Corporate Sustainability Activities

Tools for Integrated Reporting

Sustainability Reporting: Demonstrating Commitment and Adding Value

FAQs on the Role of the Board in M&A

August 14th, 2015 | By
  1. What is the current trend in M&A?

Right now, M&A deal value is at its highest since the global financial crisis began, according to Dealogic. In the first half of 2015, deal value rose to $2.28 trillion—approaching the record-setting first half of 2007, when $2.59 trillion changed hands just before the onset of the financial crisis. Global healthcare deal value reached a record $346.7 billion in early 2015, which includes the highest-ever U.S. health M&A activity. And total global deal value for July 2015 alone was $549.7 billion worldwide, entering record books as the second highest monthly total for value since April 2007. The United States played an important part in this developing story: M&A deal value in the first half of 2015 exceeded the $1 trillion mark for announced U.S. targets, with a total of $1.2 trillion.

  1. What is the board’s role in M&A?

This question can be answered in two words: readiness and oversight. At any given time, directors may need to consider either the sale of their own company or the purchase of another company. The key word here is may: nothing obliges a board to buy or sell if a transaction is not in the best interests of the company and its owners. After all, internal growth and independence usually remain options for a company under ordinary circumstances. Nonetheless, the board must still carefully weigh all opportunities to buy or sell as part of its routine corporate oversight.

Director responsibilities will vary by industry and company, but in general, corporate directors have duties of care and loyalty under state law which also apply in the M&A context.

  • Duty of care. The duty of care requires that directors be informed and exercise appropriate diligence and good faith as they make business decisions and otherwise fulfill their general oversight responsibilities. When reviewing plans to sell a company unit or to buy or merge with another company, the board must exercise proper oversight of management, especially with respect to issues of strategy and compliance with legal obligations such as mandatory disclosures. Pricing is another important consideration, and boards should be wary of claims of synergy. Academic studies offer mixed opinions on the track record for merger returns. Some find positive returns compared to non-acquiring peers (Petrova and Shafer, 2010), especially for frequent acquirers (Cass Business School and Intralinks, 2014). Other studies, for example a recent Fiduciary Group study citing McKinsey, claim a 70% failure rate.
  • Duty of loyalty. The duty of loyalty requires that a director act in the best interests of the corporation, including in the M&A context. Boards can maintain independence from an M&A transaction by appointing a standing committee of the board composed entirely of independent, non-conflicted directors to review the terms of a particular deal with the help of an independent third party, who can render a fairness opinion. (NACD submitted an amicus curiae letter on this issue in May 2015.) For a substantive legal discussion of the board’s role in M&A transactions, see this article by Holly J. Gregory of Sidley Austin, which appeared in Practical Law (May 2014).
  1. Should the board be proactive in M&A, and if so, what are the most important questions directors should ask management about the opportunities and risks that M&A entails?

Even if your board is not currently considering an M&A transaction, it is important to remain aware of M&A as a strategic potential for the company, whether as buyer or seller. Here are some questions to ask, as noted in a recent article by Protiviti:

  • What potential opportunities and risks are involved in growing through acquisition?
  • Does M&A activity align with our current strategy and in what ways?
  • Looking at our portfolio of products and company units, are there any we might consider selling at this time? Why or why not?
  • Do we know the current market value of our company and its various units (if these are separable)?
  1. What impact will a merger have on the boards of the combining companies, and how can boards weather the change?

M&A typically leads to a change in board composition, with the board of the acquired company (often referred to as the target board) usually being absorbed into the acquiring board. According to a study by Kevin W. McLaughlin and Chinmoy Ghosh of the University of Connecticut, among the mergers of Fortune 500 companies, most directors on the acquiring board (83%) stay on, while only about one-third of directors from the target board (34% of the inside directors and 29% of the outside directors) continue to serve after the merger. The study also shows that for acquiring company boards, outside directors who sit on more than one other outside board have a higher chance of remaining members. For both acquirers and targets, outside directors with CEO experience are more likely to keep their seats.

In the September–October 2014 issue of NACD Directorship, Johanne Bouchard and Ken Smith consider these findings and offer “Advice for Effective Board Mergers.” Their article outlines what boards can do to prepare for their own mergers. “Whether the board composition changes as a result of the merger or acquisition,” they note, “the board will benefit from holding a special session (or sometimes multiple sessions) to regroup and align before going into the first official board meeting.” At that first meeting they can get to know each other and the leadership team, check strategy, transfer knowledge, establish the role of the board chair, and “begin to function as an effective board.”

  1. If the board is approached by management or a third party with a proposal to buy another company, what issues and questions should directors raise?

The extent of the board’s involvement in a proposed transaction will vary depending on the size of the acquisition and the risks it may pose. If a very large company regularly buys smaller companies in its industry and has already developed a process for finding, acquiring, and integrating these firms, boards need not focus on the details of any particular transaction. They can and should, however, periodically review the entire merger process, from strategy to integration, in the context of strategic opportunities, attendant risks, and operational implications, to make sure that the process is sound and functional.

The board’s primary role is to perform a reality check on management’s plans. A common claim in proposed mergers is that the whole will be greater than the sum of its parts—what Mark Sirower of Deloitte calls “the synergy trap” in his classic book of that name. But the challenges of integration can often result in a loss of value, an issue that is explored in noteworthy articles from McKinsey and Protiviti. Drawing on these articles as well as the thoughtful questions raised in the Report of the NACD Blue Ribbon Commission on Strategy Development, we have compiled a few queries the board may wish to put to managers and advisors.

  • Strategic considerations: Why are we considering this deal? If there are synergies, what hard evidence indicates that they will materialize?
  • Tactical considerations: What processes are now in place to create a pipeline of potential acquisitions, close deals, and execute the post-M&A integration?
  • Risk: What is the company’s current risk profile, and how does it correspond to the company’s risk appetite?
  • Capital and cost implications: Does our company have the cash on hand, projected cash flow, and/or available credit to commit to this transaction?
  • Operations: What changes will need to be made to the current operating structure and logistics following the merger? Will the supply chain be affected?
  • Talent: As we blend the human resources from the two companies, will we have the right talent to make this merger a success?
  • Technology: Is the company’s technology infrastructure capable of supporting the planned merger? How will the acquired company’s technology be treated post-merger?
  • Culture: Will the merger involve a blending of two different cultures? Do we foresee conflicts? If so, what are our plans for resolving them? Will there be a new postmerger culture? How can we ensure that all retained employees thrive in the new environment?
  • Monitoring Progress: What are the dashboard components for this deal? What elements will management monitor and how frequently? What dashboard metrics will the board use to measure the transaction’s overall success?
  1. If the board is approached by management or a third party to sell the company or a company unit, what issues and questions should directors raise?

While many constituencies will have a stake in any proposed company sale (including notably employees), shareholders’ main focus will be price. The two critical legal considerations in this regard are the Revlon doctrine (for public companies) and fraudulent conveyance (for asset-based transactions, usually relating to private companies).

  • Revlon doctrine. In the landmark case of Revlon Inc. vs. MacAndrews & Forbes Holdings (1986), the court described the role of the board of directors as that of a price-oriented “neutral auctioneer” once a decision has been made to sell the company. This Revlon “doctrine” or “standard” is alive and well even today. It was cited in the In re: Family Dollar Stores decision of December 2014, in which the court denied a stockholder action claiming that the Family Dollar Stores board had violated its Revlon duty by merging with Dollar Tree Inc. and by failing to consider a bid from Dollar General Corp. According to recent commentary by Francis G.X. Pileggi, a regular columnist for NACD Directorship, this case showed an “enhanced scrutiny standard of review for breach of fiduciary duty claims under the Revlon standard.”
  • Fraudulent conveyance. All company directors, whether of public or private companies, have a duty to make sure that the company being sold is represented accurately to the buyer. Otherwise they can be sued for approving a “fraudulent conveyance,” especially in an asset sale. Fraudulent conveyance lawsuits became very common during the leveraged buyout era of the 1980s, when acquirers that overpaid for assets using borrowed funds failed to generate returns and tried to recoup losses. This longstanding legal concept, like the Revlon doctrine, is still in current use and was recently cited in relation to the LyondellBasell merger, according to the law firm of Kurtzman Carson Consultants LLC.

In light of these concerns, questions to ask before approving the sale of a company or a division might include the following:

  • Are we certain that the sale is our best option? Have we assessed alternatives?
  • Under state law and/or our bylaws, do shareholders need to approve this sale?
  • Have we received a valid fairness opinion on the price?
  • Does this sale conform with the Revlon doctrine?
  • If this is an asset sale, are we sure that the assets have been properly appraised?

By asking the kinds of questions discussed in this brief commentary, boards can improve the chances that any M&A transaction, if pursued, will create optimal value for all participants.

Additional NACD Resources

NACD BoardVision – Mergers and Acquisitions

Litmus Test for M&A: Part 5

NACD BoardVision – M&A Information Security

In-Boardroom Development Program: Role of the Board in Mergers & Acquisitions

Forum Covers Managing Risk ‘Before It Manages You’

August 12th, 2015 | By

While the Internet initially was a communication tool between the U.S. Department of Defense and multiple academic organizations, it has become the backbone of a global economy and government operations, the Hon. Tom Ridge told a rapt audience of more than 200 directors at the NACD Strategy & Risk Forum in San Diego. The first secretary of the U.S. Department of Homeland Security, Ridge currently serves as president and CEO of the strategic consulting firm Ridge Global and is a director for the Hershey Co. Ridge delivered the opening keynote to directors convened for the two-day forum co-hosted by the National Association of Corporate Directors (NACD) and its sponsors.

“We’ve come a long way from a simple communication tool,” Ridge said. “What’s really remarkable is the tool is designed to be an open platform.… It wasn’t designed to be secure. It wasn’t designed to be global. The ubiquity of the Internet is its strength, and the ubiquity of the Internet is its weakness. For every promise of connectivity, there’s a potential vulnerability.”

A report released last year by McKinsey & Co. and the World Economic Forum found that more than half of all respondents surveyed—and 70 percent of executives from financial institutions—view cybersecurity as a strategic risk to their companies. The report was based on interviews with more than 200 chief information officers, chief information security officers, law enforcement officials, and other practitioners in the United States and around the world.

“In this world, you’ve got to manage the risk before it manages you,” Ridge advised the audience.

Support for the forum was provided by BDO USA, the Center for Audit Quality, Dechert, Dentons, ­Diligent, Heidrick & Struggles, KPMG’s Audit Committee Institute, Latham & Watkins, Pearl Meyer & Partners, Rapid7, and Vinson & Elkins.

The Chattering Class

Risks to reputation are nuanced and numerous. Jonathan Blum, senior vice president and chief public affairs and global nutrition officer for Yum! Brands Inc., which operates 41,000 KFC, Pizza Hut, and Taco Bell restaurants worldwide, has seen firsthand the damage that can be done to a company’s reputation. He recounted an incident that hit the brand’s reputation and bottom line, and ultimately spurred substantial changes in the company’s supply chain.

In December 2012, a state-owned television network in China reported that some local poultry suppliers were putting unlawful amounts of antibiotics in chicken. One of the many suppliers investigated happened to be one of KFC’s suppliers, albeit one of the restaurant chain’s smallest. “But, because we’re the largest brand in China, not just the largest restaurant, we obviously bore the brunt of the publicity,” Blum said.

The most damaging aspect of the negative attention, according to Blum, was not the investigative report that aired on television, but rather the chatter on social media in the wake of the report. The fallout was a tarnished reputation, a sharp downturn in sales, and some decisive action.

“Consumer trust plummeted. Belief in our brand plummeted. Our sales plummeted. We saw a huge drop in our stock,” Blum said. “Now, this was at the end of 2012, so the impact on our financial results that year was negligible. Up until 2013, we had had a 10-year run of at least 10 percent [earnings per share] growth year over year, which is pretty unusual. In 2013, given the ditch we were in in China, our earnings per share dropped 9 percent. We lost $270 million in profit as a result of this incident, and it took about a year to rebound.” In the aftermath of the negative publicity, Yum! Brands learned that its stakeholders wanted answers to three questions:

  1. What happened?
  2. What was being done about it?
  3. How would the company would prevent it from happening again?

Yum! Brands apologized to the public, fired about 1,000 small poultry suppliers, and worked with the Chinese government to upgrade the quality of the poultry supply.

“Over time, that rebuilt consumer trust,” Blum said.

The company also took a significant step toward managing its reputation on social media.  “As a result of this incident, around the globe, 24/7, we monitor what consumers are saying about us and we immediately respond,” Blum said.

More information on managing reputation risk is available in the publication Board Oversight of Reputation Risk, part of the Director Dialogue series by NACD and global consulting firm Protiviti.

Additional coverage of the forum is available in the July/August 2015 issue of NACD Directorship magazine.