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?
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.