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Identifying Black Swans: The Many Facets of Risk Oversight

January 28th, 2015 | By

The Metropolitan Corporate Counsel recently interviewed NACD President Peter R. Gleason on how boards are recalibrating their approach to risk oversight and strategy development.  The original interview can be found here

MCC: Risk oversight is a key responsibility for corporate boards. What are the major areas of risk?

Gleason: It’s interesting. When you think about it, everything falls into the risk category. Where we used to have discussions around financial reporting or compensation, the conversation has evolved to financial reporting risk or compensation risk (or the risks in these areas). And traditional categories are still on the agenda, such as competitive, economic and reputational risk.

We see geopolitical risk, which is closely linked to cyber risk, at the forefront. Take, for instance, the falling price of oil, which benefits U.S. consumers but has complex global implications for companies or countries that are suppliers of oil. How do falling prices affect the countries’ economies? How does it affect the companies’ financial situations relative to competitors or their geographic environment?

MCC: Given this complexity, how does the board identify and prioritize the potential risks facing a company?

Gleason: While the board will use a variety of approaches to identify risk, these all rely on board engagement with the management team around strategy. Last October, NACD released a Blue Ribbon Commission report on strategy development that discussed how board members have to move away from the traditional review-and-approve approach to management’s strategy and, instead, engage in earlier-stage dialogue about the various options management is considering during the process.

For example, traditionally, the management team may discuss three or four options and then choose “strategy A” for presentation to the board. As part of this deeper engagement, directors should ask “but what other strategies were on the table? Why did they choose A over B? What were the assumptions underlying that strategy that we should discuss as a board?”

This level of dialogue allows boards to identify risks to the business and to the execution of a particular strategy. The engaged dialogue within the process helps identify risks within the strategy itself, within the industry, and then within the economic purview of the company as it relates to the global economy. With this level of knowledge, directors can quickly change course, as needed, if the company’s strategy is later disrupted by a previously unidentified risk or by a geopolitical event.

MCC: These are dynamic issues. What is the right approach to this world of emerging or unidentified risks?

Gleason: This topic is under constant discussion in our Advisory Councils: how do we know what we don’t know? Or as our CEO Ken Daly phrases it, “how do we make the completely unknown merely uncertain?” There is no way of knowing; by definition you can’t predict the proverbial black swan. There is, however, the idea of gathering different perspectives and more information, engaging in more dialogue, and establishing ongoing discussion with management that helps identify issues, or even realms of issues, that are not yet on the radar screen.

This idea of “constructive dialogue” is tied directly into the Blue Ribbon Commission’s focus on continuously reviewing and testing the assumptions that underlie management’s strategic plan. For example, in the context of geopolitical events, let’s say, as a company, that we get all of our “chemical AAB” from a country in Eastern Europe, but that chemical is no longer available because of terrorism activity. Where can we get the chemical now, and how does that change affect our supply chain, costs and pricing?

While this individual situation may seem minimal in the big scheme of the company’s strategy, those discussions are essential because they identify risks that the company may face more broadly.

Frankly, board engagement provides focus. Take the financial crisis, as another example, which arose from strategies that created incentives in the mortgage industry to drive volume, but not necessarily quality. This generated huge portfolios of poor-quality loans and major economic disruption. In hindsight, better oversight was needed to ask, fundamentally, about the risk within this strategy, and to identify and discuss the possible consequences before adopting it.

MCC: Which groups within the board should be responsible for risk oversight?

Gleason: The board’s job is to oversee the enterprise risk management process, to make sure measures are in place to identify risks, to get the right reporting, to bring insight from the directors’ own experiences, and to participate in dialogue with management about strategies to address the issues.

In terms of who should have the primary responsibility, we look at risk oversight as a full-board function. Risk is too big for any one committee. Traditionally it has been the purview of the audit committee; however, adding oversight for the entire organization’s risk profile would overwhelm the committee’s already heavy agenda. Although we still see a number of companies placing risk oversight squarely on the audit committee, interestingly enough, NACD’s annual public company governance survey reflects that a significant portion of respondents from those companies believe that risk oversight really ought to be a full-board activity.

There has been a trend in recent years of establishing mandated risk committees ­– for example on the boards of financial institutions – and we may see similar changes in other industries going forward. At NACD, we don’t necessarily see a risk committee as the panacea. The bigger question is how does it execute? Every board takes a different approach to identifying and overseeing risk, and that’s okay because boards have to adapt their structure, style and processes to the company.

MCC: Expand a bit on how boards work effectively with the executive team to ensure that directors are asking the right questions and management is providing the right information.

Gleason: A prevalent challenge for every board is asymmetric information risk. This risk is inherent in directorship, given that management will – and should – have vastly more knowledge about the company’s business than the board ever will. A balancing act exists in that management needs to provide the board with the right information – not all the information – to enable a productive discussion of risk. Further, today’s directors own at least one device that provides access to any and all information about the company. So the question becomes, to what extent should board members rely, so to speak, on their own detective work to get information beyond what management reports? That balance is so critical because, in turn, directors can overwhelm management with one-off requests for information.

In sum, boards have to ask constructive questions about whether they are getting the relevant information, such as outside opinions from financial experts or reports from whistleblower hotlines, so they can make decisions about the company’s ongoing performance and sustainability.

MCC: Do outside perspectives vary as to assigning accountability for effective risk management? NACD’s Advisory Council on Risk Oversight has noted that “the general pattern is that investors are more tuned in, while regulators will blame the board.”

Gleason: Right now, we are looking at how shareholders themselves can present a risk to the organization. Look at what’s happening at DuPont with Trian Partners. Here’s a company that has outperformed the market and its peers for the last five years but is still facing an activist investor. Companies are wondering which of them will be the next to face challenges to management or board structures and corporate strategies; the number of activist engagements has doubled in the last couple of years, and the funding behind new activist initiatives is growing.

I think companies are facing unparalleled levels of pressure not only from investors but also from regulators. Large shareholders generally understand what boards face, but they have a responsibility to deliver a return on their portfolios. The regulators are proving to be a wildcard, of sorts. With the unfolding of Dodd-Frank they are putting pressure on boards to perform at a certain level in response to situations.

MCC: What is the general counsel’s role in optimizing the interaction between board and management?

Gleason: The GC or the corporate secretary is the gatekeeper, with information generally flowing through them from the management team to the board. Their job is to see that specific information is produced at the appropriate time and as aligned with the agendas of the standing committees. GCs and their teams also keep the board apprised of the company’s legal risks. So the legal team is in the middle of the dialogue between directors and shareholders, especially for large public corporations. For instance, in response to activist issues, GCs will play a central role in assessing the risks and addressing the legal requirements related to the production of disclosure documents.

MCC: Tell us about NACD’s Advisory Councils more generally. On what issues do they focus, and who participates?

Gleason: Our Advisory Councils are made up of committee chairs on Fortune 500 boards, as well as regulators and shareholders, and they all engage in a multi-stakeholder dialogue. We originally created three councils for the key committees – audit, compensation and nominating/governance – and then we added a fourth on risk. This Advisory Council on Risk Oversight is a bit of a hybrid because not many companies have a standing risk committee.

At council meetings, we invite speakers to talk about issues that the council has identified as top-of-mind priorities. We bring in large institutional shareholders like Vanguard and T. Rowe Price as well as regulators like the Financial Accounting Standards Board (FASB) or the SEC. Representatives from Institutional Shareholder Services (ISS) have joined us to talk about their perspective. So the councils are designed to get different perspectives around issues and, as you mentioned earlier, start to identify the unknown issues.

All of our councils function on a similar basis, and we keep it fresh, relevant and topical. For example, council meetings aren’t always standard roundtable discussions. Recently, the Advisory Council on Risk Oversight staged a mock cyber crisis in which everyone had an assigned role to play, including the role of the CFO, the GC, the risk committee and the advisory council itself. The idea was to play out the scene, identify the issues and decide how to approach the crisis. Interestingly, during this scenario disclosures became a primary concern. In a cyber breach, while you know you have regulators to satisfy, law enforcement may be telling you to wait, essentially to allow them time to catch the perpetrator in the act. So the question debated in the meeting was: what do you do when the SEC says you need to disclose to your investors right now, but the FBI is saying you can’t?

MCC: And of course this is all done for the benefit of NACD’s members.

Gleason: Yes it is. At Advisory Council meetings, it is NACD’s job to capture and distribute the key discussion points so our members can learn from them. Our membership ranges by ownership structure – from public and private, to nonprofits – and by size, from the smallest to the biggest global players. They all appreciate our ability to convene different perspectives around critical issues, facilitate group discussion and then deliver insights in exceptional reporting and educational programs.

The largest companies out there are participating in our Advisory Councils and education programs, and our in-boardroom programs also help us surface the important issues. We have peer exchanges on a regular basis where we put a topic on a table, let a group of seven to ten directors discuss it and then report out.

That is a goal of NACD’s 2020 initiative, now in its third year, which ties together the key components of effective board leadership with emerging risk oversight in programs we offer nationwide. Through this initiative, directors can learn about how various boards have approached disruptive forces and then look forward to how boards will operate in 2020. Our goal is to keep the directors informed and help them do their jobs better.

It is important to remember that all boards are struggling with risk to some degree, and managing it is a balancing act. One commissioner from our Blue Ribbon Commission on Risk Governance said it well: “A car in neutral goes nowhere.” If you’re not driving the business, you’re not going to face any risks, and you’re not going to enjoy any rewards.

Please email the interviewee at resources@NACDonline.org with questions about this interview.

In Conversation with James Jones

October 14th, 2014 | By

As the business world is continuously reshaped through advances in technology, growth of new markets, and changing political landscapes, the issues that arise in both the public and private sectors have become increasingly complex. The international crises that dominate news headlines today–the emergence of the Islamic State, the ongoing war in Syria, and the crisis in Ukraine–will play a part in redefining global markets and impact how companies operate in the future. In a conversation with NACD Senior Advisor Jeffrey M. Cunningham, Gen. James L. Jones, USMC (Ret.), former national security advisor to President Barack Obama, Supreme Allied Commander Europe and Commander of the U.S. European Command, and 32nd Commandant of the Marine Corps, shared his perspectives on international policy and global competitiveness.

Gen. James Jones (Ret.) NACD Conference

We are living in dangerous times. Terrorist groups are the common enemy, but unlike the uniformed antagonists this country faced in the conflicts of the 20th century, these insurgents are asymmetric, omnipresent, and far from an easily contained problem. “We need leadership,” Jones said. “And leadership has got to have moral courage and the dedication to do the right thing at the right time. If you wait too long it’s hard to put things back together.” The new challenge of American leadership is, however, forming coalitions to effectively address these problems on the battlefield, as well as in the boardroom.

Looking at the trajectory of the United States in the 21st century, Jones looked to the past. By 1950, the United States had evolved into a global power with considerable presence on the international stage. That standing, however, is currently in flux, namely because this is a century of competition. “We have economic challenges coming from China, the European Union, Brazil, India, a whole host of areas. And how we compete with those areas is going to dictate where we will be in 2050.”

To enjoy the level of success in 2050 that we enjoyed in 1950, Jones said that the public and private sectors need to work more closely together. “All of our competitors are joined at the hip between public and private interests, and we don’t do that very well,” he said. “The pillars of governance and rule of law need to play a large role in that.” To that end, he added: “I think we talk too much. Before you talk about tactics, you need to make sure you have a strategy.”

Jones also emphasized the need for leaders to foster constructive relationships. Reflecting on his time as national security advisor, he remarked on President Obama’s inclusiveness during cabinet meetings. Jones shared that regardless of politics, President Obama sought out the perspectives of everyone at the table and ensured that anyone who had equity in the issue at hand was heard. And on a global scale, Jones observed that personal relations between heads of state drive the relations between nations.

When asked for his perspective on Edward Snowden, a figure who is as revered as he is reviled, Jones commented: “I don’t have a lot of respect for people who take the coward’s way out. There’s a way to work within the system and taking a lesser traveled road [to say what you need to say] is, in my way of thinking, not honorable and not good for the country. I completely stand behind the leadership aspect of moral responsibility. Leaders are responsible for everything their units do or don’t do. And I think that’s true of the private sector, as well as the public sector. It’s a matter of standing up for the right thing.” He also emphasized the need for leaders to understand the meaning and the impact that their privileged positions carry. “It’s easy to stand up and take a bow, but there are times when you need to stand up and take a hit and you need to be willing to do that.”

Rethinking IR: Investor Insights

October 13th, 2014 | By

Shareholder activism is on the rise. Between January 2010 and September 2013, shareholder actions carried out all over the world surged by 88 percent. Going back to the past 10 years, the number of shareholders with specific activist strategies has doubled. These statistics drive home the need for boards to have healthy investor dialogues year-round—not just when in the throes of proxy season. Looking ahead to 2015, a slate of top influencers in the investor community offered their insights on what the top priorities for boards are going to be. Panelists included: Donna F. Anderson, vice president and corporate governance specialist, T. Rowe Price; Glenn Booraem, principal fund controller, Vanguard; and Stu Dalheim, vice president, shareholder advocacy, Calvert. Peter Gleason, director, Nura Health and managing director and CFO, NACD, moderated the panel.

Using NACD’s Investor Perspectives: Critical Issues Board Focus in 2014 as a framework, Gleason noted that first and foremost: “It’s important for the board to know their investors. It’s too easy to lump them all together—but each investor has their own objectives. Engagement strategies are similarly different from one institution to the next. For example, Dalheim explained that at Calvert, their approach is always to engage with constructive outcomes in mind. Furthermore, there are three principles that guide their approach:

  1. Long-term value creation.
  2. Accountability, where management is accountable to the board and the board is accountable to shareholders.
  3. Sustainability, where companies that are sustainable from a financial, environmental, and societal perspectives will be more successful.

In addition, Dalheim explained that the approach to engagement strategy varies depending on the industry. Calvert has analysts that focus on specific sectors and know the governance practices in each sector. In that review process, they see which companies have room to improve. Furthermore, Calvert makes a point of fostering and developing relationships with portfolio companies over time, ensuring that there are open lines of communication. These open lines of communication are fortified by disclosures, which are critical to investor relations.

Anderson emphasized the responsibility of the shareholder on their side of the relationship. From her perspective, shareholders should respond to engagement requests in well-prepared ways, with the proper resources and with a team that is committed to creating a productive engagement experience. On the other side of the table, directors should engage if there has been a request to do so, or that there is a need for those exchanges to take place. With that in mind, she said that there are three key questions an institutional investor should ask before engaging with directors:

  1. Do we have standing to talk to these directors?
  2. Do we have something constructive to offer?
  3. Will this be constructive? And by extension, does the institutional investor think that the board will constructively work with them?

The panel closed by looking ahead at the pressing issues that will present themselves in the coming year. Anderson singled out the issue of bylaws: principles that institutional investors generally believe they can count on, but may not actually be in place for whatever reason. (For example, a company may have revoked its bylaws.) Boards may avoid putting certain bylaws into effect out of fear of activism; however, there needs to be a dialogue about what bylaws boards can change unilaterally.

Booream said that engagement is likely to be triggered by observable components that cause a board to be an outlier—for example, boards whose directors have above-average tenure or boards that lack minority directors. On this score he advised directors to observe the ways in which their boards are outliers, and either own it and explain why their governance practices are in shareholders’ best interests or fix the problems. Shifts in boardroom mindsets will not happen overnight, so it’s important to initiate those conversations as soon as possible.

Dalheim pointed to the issue of director qualifications. He said that boards should have a list of areas of expertise that are needed to effectively oversee the company and then explain how the current board slate illustrates those attributes. In his opinion, this list helps boards identify what’s needed to create growth. Nevertheless, there is currently little disclosure with regard to board evaluations, in terms of either the process or the outcomes. Some companies have an annual statement about board performance–and resulting action steps–which may be a pay that draws increased scrutiny in the coming year.