Companies continue to face significant global economic uncertainty. Although U.S. economic prospects have improved in recent years, structural weaknesses in other regions pose significant challenges for multinational companies. To ensure their organizations thrive in this volatile environment, boards and senior executive teams must pay close attention to regional trends and international politics and how these affect the growing interdependence of markets worldwide. During a presentation at the 2015 NACD Global Board Leaders’ Summit, Kaushik Basu, chief economist and senior vice president of the World Bank Group, identified four major market conditions that will influence the growth prospects for many businesses.
The shape of the post-crisis recovery continues to change. In recent years economists have been hard-pressed to forecast how global markets will behave. After the 2008 financial crisis in the United States, economists initially anticipated a V-shaped recovery, in which the market hits bottom and then recovers. As it became clear that the recession would continue, they altered their predictions, asserting that the recovery would be U-shaped instead. When the European debt crisis occurred, economists then foretold a W-shaped recovery. The lesson seems to be that economic cycles have become less predictable and no longer adhere to historical patterns. In response to this increased uncertainty, directors and management teams must now expand their strategic planning process to incorporate a range of possible economic scenarios.
The economic fortunes of emerging economies are not uniform. Brazil, India, and China are often touted as emerging centers of economic power; however, . In the past year only India and China saw growth in their gross domestic products, while Brazil—which has endured corruption scandals, tax increases, and spending cuts—has experienced virtually no economic growth. When discussing potential investments in these foreign markets, boards should require management to provide forward-looking country assessments in order to responsibly evaluate the potential risk and rewards.
Economies are porous. Directors need to be aware that local economies are inextricably intertwined, and that deteriorating economic conditions in one country can therefore spread quickly to other nations. For example, the ramifications of slowing growth in China are significant because so many countries are increasingly dependent on continued Chinese investments and consumption. Africa, Latin America, and Germany are likely to suffer most as major exporters to China. Conversely, India’s economic growth has recently accelerated, due in part to structural tax reforms that have created a more welcoming investment climate, resulting in a rapid surge of foreign direct investment in 2014.
Increasingly disparate monetary policies among the developed nations will have global economic ramifications. Directors will be expected to understand the consequences of divergent policies—especially those of developed countries—for the world’s biggest economic blocks. For example, the Federal Reserve is debating a possible rise in interest rates after seven consecutive years of record-low borrowing costs. While a rate hike would ostensibly strengthen the U.S. dollar by encouraging investments in this country, it could also raise the prices on U.S. exports and undercut the economic viability of U.S. products in foreign markets. In the Eurozone, the European Central Bank (ECB) has in recent years maintained loose fiscal policies, increasing the supply of money flowing through international markets in hopes of facilitating economic recovery. A U.S. interest-rate hike would result in a weaker euro, which in turn could lead to a boost for Eurozone economies because buying trends would begin to favor domestic products. On the other hand, tighter U.S. fiscal policies could readily be undone by the European Central Bank injecting even more liquidity into the markets to keep euro values low and maintain the viability of Europe’s export market. Emerging markets, too, might experience a negative impact from these proposed policy changes. Because they have been borrowing money in U.S. dollars at near-zero rates, these countries will almost certainly see an increase in debt and decreased economic growth if U.S. interest rates rise.
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.
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.