Posts Tagged ‘financial crisis’

Keep a Steady Focus on Strategy, but Incorporate Flexibility

January 17th, 2013 | By

For nearly three years, the boardroom maintained a consistent response to a tumultuous marketplace. Whether it was following the 2008-2009 financial crisis, navigating an economic recovery unlike any other, or facing a debt crisis with global implications, reaction from directors seemed to stay the same. Year over year, NACD’s Annual Governance Surveys did not register significant upheavals in methods or structures used. Areas of high priority continue to be strategic planning and oversight, corporate performance and valuation, and risk oversight.

NACD’s Board Confidence Index (BCI), a measure of the boardroom’s attitude toward the state of the economy, told a similar story. Although the index would fluctuate by a few points from quarter to quarter, confidence remained in the slightly optimistic side of uncertain.

This changed last fall when the nation was forced to address the pending fiscal cliff. At November’s NACD Directorship 100 event, DuPont Chairman and CEO Ellen Kullman remarked that uncertainty over future regulatory activity and the general economy had led her company to reevaluate major investments for 2013. Uncertainty in the future of the economy and consumer demand also significantly impacted Coca-Cola’s decisions to make capital investments, according to presiding director James D. Robinson III.

Just a few weeks later, results from the fourth quarter BCI further demonstrated how the economy affected the boardroom. Although the overall index score remained on the positive side of uncertain (51.8), for the first time responding directors indicated outright pessimism in the state of the economy in the next three months. Directors also echoed the statements made at NACD Directorship 100: In preparation for 2013 nearly half (47%) had reassessed corporate strategy.

The need to focus on strategy was also confirmed at NACD’s recently held Master Class in Naples, Florida. Although sessions were designed to address the new and emerging risks entering the boardroom, discussions often returned to the importance of strategic planning in uncertain times. Both panelists and attendees agreed that directors need to keep a steady eye on the established strategic plans at hand.

This recommendation is not without caveat. With a maintained focus, directors should not relegate a discussion on strategy to an annual event. Instead, the established strategic plans should be woven into every board meeting and discussion. Furthermore, plans should be adjusted to incorporate flexibility from the boardroom. This includes shorter response times that are now necessary to address situations that could be presented by emerging methods of communication and rapidly changing technologies.

Lehman Doubles Down: Learning Opportunities for Directors

February 17th, 2011 | By

Shock and awe were on every director’s face as they listened to Tony Valukas, the court-appointed examiner in the Lehman bankruptcy (and chairman of the law firm Jenner & Block LLP) relate his findings at an NACD program recently. Lehman was the largest bankruptcy in American history—greater than Enron, WorldCom, Wachovia, Washington Mutual, and CIT combined.

Tony answered the questions all directors want to know: what happened, how could it have happened, and where was the board? In an upcoming issue of NACD Directorship you will have a chance to read his comments verbatim, but this news is too important not to share at this time for all of our director members and readers who are proponents of strong corporate governance.

He prefaced his remarks by saying that management’s miscalculation led to a ”doubling down” into risky investments just as the credit market was about to head into Armageddon. Management, forged in the “masters-of-the-universe” mold, believed their hunches—that a countercyclical strategy would be profitable despite the market signals that suggested caution. The mantra was “pedal to the metal.” The board ratified management’s strategy without questioning it in the detail that in retrospect they might have.

Despite the out standing business and financial acumen on the board, the board did not seek and did not have any third-party or independent sources to confirm the risk models presented to them by management, and the board did not probe as management burdened  the balance sheet with a toxic brew of questionable assets.

In the end, Tony did not find that the board should be held liable. The board exercised judgment which, in retrospect, was wrong, but within the Delaware courts’ business judgment rule.
Tony did, however, offer a sobering forecast for future boards. After this episode, boards are likely to be expected to have learned some lessons and to be held to a higher standard. The same set of facts will likely be judged differently and more critically by future courts.

During Tony’s methodical and articulate speeches, one hears him say, “Lehman failed because of its own decisions to increase risk.” While there were regulatory failures within the SEC and the Federal Reserve and structural failures within Lehman itself, the core issue, according to Tony, stems from management’s failure to understand and accurately measure the extent of risk at this once superior financial institution, and the board’s failure to more aggressively question management.

According to Tony, Lehman didn’t fail due to a lack of risk processes; Lehman utilized, and shared with the board very detailed, quantitative risk management systems and scorecards. The problem was that Lehman didn’t adhere to its processes. The risk procedures were designed to set limits on the amount of risk Lehman should take on. But when the limits were exceeded, Lehman didn’t reduce or stop taking on risk; rather, it increased the limits. Hard questions were not raised regarding why. It was simply accepted that increased risk was tolerable.  Compounding the problem, as Tony points out, is that “stress tests [that were supposed to predict Lehman’s ability to survive if the risks materialized] were not conducted on all asset classes, just in aggregate, and the failure to understand the financial risks associated with their commercial real estate portfolio was not fully understood.”

While many books have been written, and many movies are likely to result from this unfortunate situation, there are many key lessons for boards of directors—regardless of industry and company type. Tony Valukas suggests that all directors and members of all board committees—

i.e., audit, compensation and nominating and governance—need to have healthy skepticism when listening to, considering and making decisions.

In a recent Financial Times article, Robert C. Pozen, senior lecturer of business administration at the Harvard Business School, suggested several questions for directors to consider asking executives in a post-Lehman world. Tony refined and expanded upon Mr. Pozen’s thoughts during his recent keynote address at KPMG’s Audit Committee Institute, and suggested that the Lehman board could have asked questions such as:

  • What is causing risk limits to be exceeded?
  • Why are we raising limits rather than reducing risk?
  • What specific investments or classes of investment have caused prior limits to be exceeded?
  • What further investments are in the pipeline that will add to risk? What alternatives exist to closing on those investments?
  • Do we have stress tests in place that actually measure risk?
  • Have we fully and adequately disclosed our risk situation to investors?
  • Are we using any off-balance sheet accounting transactions which have a material impact on leverage or other key indicators?
  • Are there any recurring transactions which occur at quarter’s end? If so, why?
  • Are we using any alternative accounting methods to present material financial information? If so, why is that alternative justified over the other?
  • Are we accounting for material items differently than our peer group? If so, why?
  • Have any analysts or regulators criticized any of our accounting or disclosures?

Had they asked these questions, the answers might have helped the board steer Lehman on a different, safer course. Tony does not necessarily criticize the board for not asking the questions, since they did not have the benefit of knowing then what we know now. But now we know it, and future boards need to inquire.

In the spirit of what Albert Einstein once said, that “out of chaos comes opportunity,” I hope that all corporate board members learn something from this case study: to ask tough questions in the boardroom and encourage their fellow board members to do the same.

Thanks for your hard work, determination and dedication to advancing exemplary board leadership.

Risky Business: The Eight Red Flags Every Director Must Heed

June 24th, 2010 | By

Last month, I was interviewed by BusinessWeek (read the article or listen to the podcast) about the role of corporate directors in risk management. As the financial crisis forces the issues related to risk management front and center, many of us in the corporate director community have got to get prepared to expand our roles in overseeing and managing risk.

What are the warning signs no director should ignore?

  1. Unusual financial results –both positive and negative. If there’s been a sudden downturn or vast improvement in the financial performance of the company, directors should probe management about the reasons for it and make sure the answers they get are both plausible and acceptable.
  2. Faulty accounting estimates – when management assumptions underlying numbers estimates just don’t seem to add up. The accounting estimates – loan losses, aspects of fair market value accounting, tax reserves – are all good places for boards to “stress test” by looking at the numbers and their related assumptions. Adjusted numbers or faulty assumptions are critical red flags.
  3. Rationalization – circumstances where there is a significant discrepancy between what happened and what you thought would happen, alongside attempts to try to rationalize that this doesn’t really make sense. Don’t ever be afraid to challenge rationalization.
  4. Surprise factor – typically, when results are dramatically different from what the board has been led to believe they would be, directors question whether management really has a handle on the business. This surprise should also lead you to question whether there is something going on that you haven’t been told about.
  5. Lack of independence – this tends to lead toward bias and lack of objectivity. One example of this problem is that which occurred in the Delaware Court of Chancery case re: Emerging Communications. There, the board member advocating a transaction, the CEO and chair, had a conflict of interest. The board formed an independent special committee that included someone with financial expertise,  but  the court found that this director relied too passively on the  advisor’s opinion on the transaction, despite the member’s own valuation expertise as an investment banker.
  6. Lack of competitive data – a lack of knowledge about what others are doing – primarily other companies in the same industry. Management should always be keeping abreast of key competitors, industry peers and others – rather than taking an insular view.
  7. Abnormal results – when the company’s results differ notably from others in the industry, it is worth taking a second look.  It is not always a bad thing to significantly outpace your industry, but it is definitely something to be aware of. This can be an indicator of higher risk/reward trade-offs.
  8. Unclear strategy – an apparent disconnect between strategy and risk.  Most of the key risk factors relate to the company’s strategy, yet many directors seem to not fully understand the strategy, or to have been engaged in strategy development and review in a way that would give them a good understanding of some of the risks that may emanate from that strategy. Make sure a clear strategy is always front and center.

As a board member, it is critical to ask questions until you are genuinely satisfied with the answers; at a certain point, it may even be a good idea to bring in a third party to make assessments. The bottom line is that as board members we have a responsibility to conduct the proper due diligence and stay attuned to the alarm bells before a situation arises.

Download NACD’s complimentary boardroom discussion guide to delve deeper into questions you should ask of your board to better understand these red flags, or check out the Report of the NACD Blue Ribbon Commission – Risk Governance: Balancing Risk and Reward for leading corporate governance practices.