President Obama recently implored American business leaders to “get in the game” by spending trillions of dollars in corporate cash reserves on investments that would spur the economy. But he may have been preaching to the proverbial choir.
After years of stockpiling cash in the wake of the 2008 financial collapse, American businesses appear poised to do just what the President requested: invest and create jobs. Consider the latest NACDBoard Confidence Index (BCI), in which a majority of directors forecast that their companies will expand their current workforce in 2011. This is a significant development in what has been, in many key respects, a lethargic economic recovery.
Even after the economy began emerging from the depths of the recession in 2009, American corporate leaders remained fearful of another downturn, prompting companies to safeguard their cash reserves, now estimated to be about $2 trillion. That, of course, has contributed to a mixed economic picture today: many companies, while profitable, are unwilling to make the kind of large-scale investments that would put millions of unemployed Americans back on the payroll.
But as the NACD BCI for Q4 2010 suggests, the widespread fear of a double-digit recession appears to be over, with many corporate directors saying that they see the prospect of continued economic growth over the next year.
Now is the time for directors to begin looking at what best practices their companies should be putting in place to help position them for growth in the year ahead—whether those policies focus on compensation, ethics, accountability or competence.
In Thursday’s NACD Directors Daily, the Wall Street Journal reported on the actions large companies have taken in response to the SEC’s proposed whistleblower program. While the SEC has received hundreds of comment letters opposing various provisions of the proposed rules, the Journal reported on more than two dozen of the country’s largest companies that have asked the SEC to revise the proposed rules. One of the more contentious issues is the proposed “bounty” that would be rewarded to a whistleblower if the company receives a sanction of more than $1 million. That bounty could range between 10 and 30 percent of the penalty paid by the company.
The article covers both sides of the debate surrounding the new whistleblower program. Businesses fear that employees will bypass the internal compliance programs and whistleblowing hotlines mandated by Sarbanes-Oxley, and report directly to the SEC. On the other hand, attorneys defending whistleblowers argue that requiring the use of internal reporting channels prior to the SEC would discourage fraud reporters for fear of losing anonymity. The SEC has just weeks to issue final rules that balance the use of internal reporting systems with reporting fraud.
Since the SEC first proposed rules on the new program last fall, NACD has worked to amplify the voice of the director on this issue. In our comment letter, we voiced concerns similar to the reservations expressed by the companies in the Journal article. Our letter stressed that the SEC should work to enhance and strengthen the internal reporting channels already in place, rather than bypass those channels by going directly to the SEC with an issue. Encouraging internal reporting can help management address and solve issues in the early stages, which in many cases are best solved by internal human resources professionals.
In the past months, NACD has also met and discussed the possible consequences of the proposed whistleblower rules with key members of the regulatory and investor communities to discuss your concerns and suggestions as we heard them in our survey prior to submitting our comment letter. In addition, last week’s edition of NACD BoardVision features NACD’s Managing Director & CFO, Peter Gleason discussing the whistleblower provisions with PwC’s John Barry.
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.