The complexities surrounding short-termism make it a tough nut to crack. Short-termism in this instance refers to a focus on short-term company performance results at the detriment of achieving long-term strategic goals. But in all its forms, short-termism is not sustainable in a rapidly changing world. That’s why directors need to ensure that the organizations they govern seek a healthy balance in addressing short- and long-term interests of the organization’s senior executives and stakeholders.
Short-termism is certainly not a new concept. In a recent survey of more than 600 public company directors and governance professionals conducted by NACD, 75 percent of respondents indicated that pressure from external sources to make short-term gains is compromising management’s focus on long-term strategic goals. This pressure can affect the board’s risk oversight.
Short-termism manifests itself in many ways. The more common example is focusing on quarterly earnings at the expense of funding long-term sustainable growth. But it can also lead to the pursuit of several risky activities, including: M&A deals for growth’s sake without clear linkage to the overall corporate strategy; releasing new products to market without sufficient testing; allowing cost and schedule considerations to undermine safety on significant projects (e.g., deferring maintenance or taking risky shortcuts); and taking on excessive leverage to pursue activities that are currently generating attractive returns.
Underlying the evidence of short-termism is a complex series of root causes. Globalization, technological developments, improved transparency, and reduced transaction costs have facilitated capital flows, enabling investors to reallocate their assets to seek higher yields with greater ease. Hedge funds and other activist shareholders are also acquiring small stakes in a company with the objective of steering profits to shareholders immediately (through higher dividends, stock buybacks, asset spinoffs, or downsizing in lieu of investing in innovation that will improve productivity and drive future growth, for instance). Still another cause is the existence of compensation structures emphasizing executive pay over the near term to the detriment of long-term shareholder interests. These compensation models skew management’s decision-making toward maximizing short-term profits even at the cost of taking on excessive risk.
Following are six concrete steps the board can take to ensure short-termism does not compromise risk oversight:
1. Focus the board’s oversight on risks that matter. If risk management is focused primarily on operational matters, chances are management is not focusing attention on the right question: Do we know what we don’t know? To face the future confidently, both management and the board need to focus the risk assessment process on:
a. identifying and managing the critical enterprise risks that can impair the organization’s reputation, brand image, and enterprise value; and
b. recognizing emerging risks looming on the horizon on a timely basis.
Even though the day-to-day risks of managing the business are important, they should not command the board’s risk oversight focus except when truly pressing issues arise.
2. Lengthen the time horizon used to assess risk. Focusing on quarterly performance, annual budgets, and business plans may lead to a risk assessment horizon of no more than three years. That period may be too limiting because strategic opportunities and risks typically have a longer horizon—even with the constant pressure of disruptive change on business models. For example, the World Economic Forum uses a 10-year horizon in its annual risk study. Longer risk-assessment horizons are more likely to surface emerging issues, along with new plausible and extreme scenarios, that might have been missed with a shorter time frame. Thus, the board needs to satisfy itself that management is using an appropriate horizon.
3. Understand and evaluate strategic assumptions. Management’s “worldview” for the duration of the strategic planning horizon is reflected in assumptions about several topics: the enterprise’s capabilities; competitor capabilities and propensity to act; customer preferences; technological trends; capital availability; and regulatory trends, among other things. Directors should weigh in on management’s assumptions underlying the strategy. Doing so could reveal insights into the external environment and internal operating impacts that could invalidate the critical assumptions underlying the strategy. This is a useful approach to understanding sources of disruptive change.
4. Integrate risk and risk management with what matters. Short-termism can render risk to an afterthought to the formulation of strategy. Risk management similarly can become a mere appendage to performance management. The strategy, therefore, may be unrealistic and may involve taking on excessive risk. In addition, performance management may be overly focused on retrospective, backward-looking lag metrics. The board should ensure the strategy-setting process considers risks arising from strategic alternatives, risks to executing the strategy, and the potential for the strategy to be out of alignment with the organization’s mission and values. Directors also should insist that prospective, forward-looking leading metrics be used to complement the more traditional metrics used to manage the day-to-day business operations.
5. Watch out for compensation imbalances. Publicly listed companies on U.S. exchanges are required to disclose in the proxy statement whether the company’s system of incentives could lead to unacceptable risky decision-making in the pursuit of near-term rewards. The compensation committee typically conducts a review for excessive risk-taking in conjunction with its oversight of the compensation structure. Board concerns with respect to short-termism are a red flag for the compensation committee to sharpen its focus on the potential for troubling compensation issues that could lead to bet-the-farm behavior. A key question: Do key executives have sufficient “skin in the game” so they will be incented to take risks prudently in the pursuit of value-creating opportunities?
6. Pay attention to the culture. Short-termism can contribute to a dysfunctional environment that warrants vigilant board oversight. For example, management may continue to execute the same business model regardless of whether market conditions invalidate the underlying strategic assumptions. Also, operating units and process owners may be fixated on making artificial moves (e.g., deferring investments) and manipulating processes (e.g., cutting costs to the bone) to achieve short-term financial targets. Instead, the strategy should be focused on fulfilling customer expectations and enhancing the customer experience by improving process effectiveness and efficiency. These and other red flags warrant the board’s attention because they signal the possibility of unacceptable risk-taking that must be addressed.
If short-termism is a concern of the board, directors need to ensure their risk oversight process isn’t compromised by it. A strong focus on linking risk and opportunity can help overcome some of the “blind spots” that a myopic, short-term outlook can create.
Effective risk assessment is fundamental to the management and oversight of risk. While the risk assessment process must be tailored to the individual needs of each organization, the hallmark of a successful risk assessment is one that helps directors and executive management identify emerging risks and face the future confidently. Rather than shuffle “known knowns” around on a risk map, a risk assessment should help decision makers understand what they don’t know.
To that end, 10 practices are summarized below that will help management and directors maximize the value derived from the risk assessment process.
1. Involve the appropriate people. Surveys we have conducted over the years indicate, without exception, that viewpoints and perspectives about risk often differ across a broad range of senior executives, operating units, and functional leaders. Therefore, it is important to involve appropriate stakeholders across the C-suite and vertically into the organization in the risk assessment process to ensure relevant points of view are heard.
2. Reduce the danger of groupthink. The risk assessment process should encourage an open, positive dialogue among key executives and stakeholders for identifying and evaluating opportunities and risks. As a safeguard against executives forming opinions or reaching conclusions without robust debate or considering dissenting views, management should ensure that all perspectives are heard from the right sources and considered in the process. Accordingly, anything an executive truly fears should be out in the open and any concerns about opportunities missed should be aired. The board should set the tone for this kind of open process.
3. Focus comprehensively on the distinctive dimensions of strategic risk. According to the Committee of Sponsoring Organizations of the Treadway Commission (COSO), there are three dimensions to strategic risk: the implications from the strategy; the possibility of strategy not aligning with an organization’s mission, vision and core values; and the risks to executing the strategy. All three dimensions need to be addressed if the company expects to avoid unintended consequences that could lead to lost opportunities or an unacceptable loss of enterprise value.
4. Understand the assumptions underlying the strategy. Boards and executives that are navigating the risk assessment process should consider how the organization’s strategy and risk appetite work in tandem, and how it will drive behavior across the organization in setting objectives, allocating resources, and making key decisions. Are risks evaluated in the context of their impact on the organization’s strategy and operations? Is adequate consideration given to macroeconomic issues? Is there a business intelligence process for monitoring the environment to ensure that critical assumptions remain valid? Is the board informed when assumptions are no longer valid? Are strategic assumptions stress-tested?
5. Consider the impact of disruptive change. The rapid pace of change in the global business environment is risky for entities of all types. Change alters risk profiles. The unique aspect of disruptive change is that it represents a choice: On which side of the change curve does an organization want to be? With the speed of change and constant advances in technology, rapid and innovative responses to new market opportunities and emerging risks can be a major source of competitive advantage. Conversely, failure to remain abreast or ahead of the change curve can place an organization in a position of becoming captive to events rather than charting its own course. The risk assessment process must be dynamic enough to account for significant change.
6. Consider appropriate criteria to assess “high impact, low likelihood” risks. When considering extreme risk scenarios, the operative question is: How resilient is our organization in the event one or more of these scenarios occurs? Velocity of the impact as the scenario evolves, persistence of the impact over time, and the entity’s response readiness are useful risk criteria to consider when answering this question.
7. Understand the sources of risk. One of the most difficult tasks in risk management is translating a risk assessment into actionable steps in the business plan. Risk owners often don’t know what to do to address significant risks based on risk assessments displayed on the traditional two-dimensional graph. Accordingly, it may make sense to source the root causes of the most significant risks to better understand them and design more effective risk responses. Therefore, the process should be designed to identify patterns that connect potential interrelated risk events—risks that are not necessarily mutually exclusive.
8. Inform the board of the results in a timely manner. Directors should agree with management’s determination of the organization’s significant risks and incorporate those risks into the board’s risk oversight process. In addition, significant risk issues warranting combined attention by executive management and the board should be escalated to directors’ attention in a timely manner. A process for identifying emerging risks should be in place to supplement the ongoing risk assessment process.
9. Integrate risk considerations into decision-making. As important as the risk assessment process is, it may be just as important to consider the impact of major decisions on the organization’s risk profile. If risk is understood to be the distribution of possible outcomes over a given time horizon due to changes in key underlying variables, it should be noted that major decisions either create new or different outcomes, some of which may be unintended, or alter previously considered outcomes. Significant decisions, therefore, should involve the board’s understanding of the organization’s appetite for risk and consider how those decisions impact the entity’s risk profile.
10. Never end with just a list. Following completion of a formal or informal risk assessment, management should designate the appropriate risk owners for newly identified risks so that appropriate responses and accountability structures can be designed for their execution. “Enterprise list management” is aimless, loses its novelty over time, and can lead to trouble if risks are identified and nothing is done to address them.
An effective risk assessment process lays the foundation for executives and directors to navigate a changing business environment with confidence. The above practices can assist organizations in defining their most important risks and enable the board to ensure that its risk oversight is appropriately focused.
Overseeing risk is no small task for boards as a company’s footprint is no longer confined to local or even national boundaries. The globalization of business—spurred in large part by the Internet—has simultaneously expanded business opportunities while also introducing new worlds of risk that an organization must contend with.
The National Association of Corporate Directors (NACD) invited Joan Meyer, a partner at Baker McKenzie LLP, and SecureWorks Chief Threat Intelligence Officer Barry Hensley to offer their insights on these issues as part of a larger panel discussion at the Leading Minds of Governance–Southwest event.
Highlights from their conversation with NACD Directorship Publisher Christopher Y. Clark follow.
What is your outlook on the complexities of being an international company?
Joan Meyer: It’s becoming extremely complex because there is increasing enforcement from other jurisdictions. Five or six years ago, the U.S. was the predominant regulator and multinationals only had to deal with certain European countries in addition to the United States. Now, we are seeing emerging markets that are getting extremely aggressive. They are also putting in more restrictive laws and data privacy rules about the transfer of data. It’s a real conundrum for companies because they not only have to comply with U.S. law but the more robust law of various regimes, which create conflicts. Some of that risk may be theoretical because certain jurisdictions have not begun enforcing these laws —but it’s out there.
If you are disclosing information to a U.S. enforcement authority but you can’t get information out of a foreign jurisdiction, a U.S. regulator might not care— they just want the information. In this situation, not only is executive management caught in a bind, but the board will be asked: “What do we do?”
The U.S. Department of Justice is also pursuing individual prosecutions of mid-level managers and the C-suite, and there is increasing pressure on companies dealing with U.S. authorities to get cooperation credit by identifying individuals who are culpable for the misconduct. And it’s not only in the U.S. where that’s happening. Because the government wants real-time cooperation in pursuing individuals, it’s frustrating for companies because they are being pushed to provide investigatory conclusions to the government which they may not have completed. On a global basis—whether it’s Saudi Arabia, China, Russia, or Brazil—individuals are being actively pursued. The problem is compounded if they are expatriates who are working in these foreign countries for a limited period of time, don’t understand the culture, and are suddenly being subjected to detention or prosecution. This puts managers working outside countries with an established legal system at real risk because they may be pursued by authorities simply for a perceived failure to exercise their supervisory responsibilities in the right way.
What questions should a board chair ask the chief information security officer [CISO]?
Barry Hensley: First: What are our top five risks? Only by thinking like the enemy can the CISO begin to itemize and categorize the company’s security risks. Consider the following ways you may be attractive to cyber threats: your brand and how you’re perceived on the world stage; your digital capital, such as intellectual property, electronic currency, and personal data and how it’s secured; and your internet-exposed vulnerabilities.
Second: Does our security program have the visibility to detect an advanced adversary whose work eludes security controls? The threat does not remain static nor does the network. While some tactics and tradecraft are well known, the adversary is innovating, always seeking opportunities to bypass traditional protections. For example, while implementing multi-factor authentication is important, bad actors are finding ways to impersonate users and hijack credentials. Does your risk assessment learn from the headlines and adapt? It’s important to keep risk assessments current and update your mitigation strategies and budgets against these threats.
Third: Does your staff collectively understand the term “breach” and the conditions that trigger a formal response? Are you prepared with a meaningful, rehearsed, cross-disciplinary crisis response plan? While no company wants to dwell on the potential for serious incidents and breaches, preparation is still essential. This requires a real understanding of what constitutes an addressable incident, what triggers it, the steps that must occur to resolve the incident, and the people involved. Key tenets should be established, such as: knowing who’s in charge, how the board contacts the key players, and what the measurable actions we take to address the incident are.
Fourth: Is security training tailored to ensure appropriate audiences are aware of threat actors and their tactics? Different segments of the workforce present different risks, and the CISO must make sure each segment is aware of the tactics being used to exploit all avenues of compromise. Boards need to ask: Do employees understand how phishing works? Do administrators know the value of frequently changed passwords and vulnerability scans? Do web designers understand the importance of secure coding practices? Do executives and financial managers recognize that they are extremely lucrative targets for social engineering? And remember: there is no such thing as one-size-fits-all security training.
Want more? A panel of Fortune 500 company directors and subject matter experts will offer their insights on issues ranging from cyber resilience to the latest regulatory trends at Leading Minds of Governance–Southeast. Join us on March 16 in New Orleans, LA. Space is limited—register today.
Click here to read addition coverage of the Leading Minds of Governance–Southwest event with highlights from a discussion on the board’s role in overseeing talent and tone.