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.