There is no better time to prepare for an economic downturn than when times are good. With the memory of the severity of the 2007–2008 financial crisis still fresh in the minds of many directors and executives, how should companies prepare for a downturn in the cool of the day, rather than reacting in crisis mode?
Most business plans do not currently anticipate economic downturns; however, a contingency plan makes good business sense because it positions companies to act decisively when recessionary storm clouds loom on the horizon.
Organizations develop contingency plans to address market opportunities should they arise and document specific action steps that are triggered if certain events occur. Such events might include natural disasters, cybersecurity breaches, terrorist attacks, fire, fraud, theft, or embezzlement. These perils may never occur, but the plan nonetheless stands ready with a response team organized to implement it.
The focus of this discussion is how to prepare for an economic recession that causes revenues to decline below a predefined threshold. It is virtually irrefutable that a recession will occur, which is why it’s wise to create a contingency plan to (a) mitigate the financial impact of a severe economic downturn on earnings and share price and (b) position the company to gain market share during the recovery.
In preparing a contingency plan to accomplish these two objectives, action steps are sequenced, prioritized, and grouped by corporate function and operating unit so that ownership of each step is clear. Targeted cost savings in the current and subsequent projection years should also accompany each action step. Key plan elements for most companies include.
Headcount and hiring changes. Distressed operating environments present a time for shepherding the talent most critical to retain. Focused retention, objectively determined workforce reductions, and changing hiring practices are often important components of a contingency plan.
Compensation, benefit, and incentive plan adjustments. Temporary revisions to compensation, benefit, and incentive plans may be necessary to stabilize the firm’s financial condition. Vetting the economic realities of a declining top line and the need for adjustments to the reward system with key personnel before a downturn creates a broader support base for the plan when it is implemented.
Asset divestitures. Management should categorize the company’s assets—underperforming versus high-performing, strategic versus nonstrategic—so that a plan can be developed for each asset category. The plan should consider the timing and the immediate and long-term financial impact of asset sales, and the need for such sales as signs of extreme economic scenarios appear. Timing can be a critical factor due to the difficulty of selling assets in a depressed market. Sale-leaseback transactions for certain facilities are also an option for raising capital.
Selling, general and administrative (SG&A) expense cutbacks. SG&A offers many cost reduction opportunities. In the context of a contingency plan, the objective is to adjust the cost structure to support stabilization and preservation of the enterprise.
Consider other options. Other steps a company can take include:
Hedge raw material costs and lock in sales prices, thereby stabilizing margins — at least for a time;
Consider outsourcing non-core activities that are not strategic to the business, if it will reduce costs such as certain human resources support, accounting, manufacturing and transportation activities;
Focus marketing on sustaining brand awareness during a recession;
Discontinue underperforming operations; and
Address the impact of upstream and downstream interconnectivity within the value chain, e.g., what steps would the company take if a major supplier were to go under due to the downturn?
Hierarchy for cost-savings initiatives. Management should outline a comprehensive menu of prioritized cost-savings initiatives that could be implemented either in part or in its entirety, depending on the severity of the downturn.
Communications plan. In times of economic uncertainty, timely and open communications are vital to preserving morale so that employees know where they stand, and how they and the organization can get through the crisis. Straight talk and transparency are important because, from an employee perspective, no news does not necessarily mean good news.
An effective plan should determine the metrics to be managed against the enterprise’s specified targets such as net operating income percentage, gross margin percentage, acceptable variance from budget, earnings per share, minimum cash reserves, and maximum debt levels. With targets identified, a financial forecast over an appropriate period should be prepared to establish a baseline. Considering different scenarios—revenue declines of, say, 10 and 20 percent— the costs and expected benefits from the various elements mentioned above should be considered to ascertain specific actions management should take under the circumstances.
Once completed, the plan should be reviewed with and approved by the board. The company then resumes its growth strategy with full knowledge that the contingency plan is ready when the time comes—and, unfortunately, it will come. A vetted, actionable contingency plan saves precious time during a crisis because there is a broader base of support for its execution. Preparedness leads to decisiveness under fire.
Management should review the plan on a regular basis to ensure it remains current and apprise the board of any significant changes made to the plan. Going forward, management should monitor the external and internal economic indicators appropriate to the company, and periodically review the analysis with the board. Once the plan is initiated, a project management office should be designated to drive its implementation. The project management office monitors the achievement of the assigned initiatives and provides status reports to senior executives and the board.
Developing a response plan under sunny skies rather than when the recessionary storm breaks would demonstrate a board’s due care and sound business judgment in discharging its oversight responsibilities to address a credible threat. Further, entering a distressed operating environment without a thoughtful, comprehensive plan can lead to hasty decisions, inefficiencies and costly delays. An organization’s stakeholders deserve better.
In June, NACD convened general counsels (GCs) from across the country for a one-day meeting in New York City on the role of the GC in supporting boards of directors. Program panels consisted of directors, GCs, and subject-matter experts on legal issues affecting board decision making.
The Evolving Role of the GC
According to Richard D. Buchband, senior vice president, GC, and secretary for ManpowerGroup, the GC must clear the way for the board to focus on strategic matters. Though each company is different, long past are the days when the GC’s role was to take minutes in the corner of the boardroom.
A clue to how a general counsel will be perceived in any given company may be found in the interview process, when a candidate should take note of whether board members participate. Also, in assessing how the board will utilize the GC, a candidate or sitting GC should be aware of whether board members hail from countries in which the GC traditionally takes a smaller role, reporting not to the CEO but to the CFO, according to Yvonne E. Schlaeppi, director for Stallergenes Greer and former GC for several companies, including Johnson Controls Europe.
Once connected to the board, the general counsel can be of value for many facets of the enterprise, leveraging his or her unique position in the organization to assimilate information and data from across the business. Several suggested that the general counsel should always offer a recommendation when providing input to the board. In fact, judgment is a critical part of what a GC offers the board. “The crux of a GC being a strategic advisor to the board is having your good judgment on the complex mix of puzzles which general counsels deal with all the time—including commercial, legal, and people challenges—recognized and valued,” said Schlaeppi.
Further, the career of Robert Bostrom, senior vice president, GC, and corporate secretary for Abercrombie & Fitch Co., illustrates how the general counsel can be the glue for an organization in turmoil. During a prior role as general counsel at Freddie Mac, he saw several CEOs and CFOs come and go around the time of the 2008 financial crisis and when the government appointed a conservator. Today, Bostrom co-chairs Abercrombie’s enterprise risk management group and leads the organization’s crisis management team, taking point on risks affecting the company’s reputation.
Moving the Board Forward
Of course, given that the GC is often the most knowledgeable person about issues of corporate governance, the GC brings tremendous value by providing advice and counseling on governance matters. Gillian A. Hobson, partner, capital markets and mergers & acquisitions at Vinson & Elkins, pointed out that such governance matters include issues such as independence, diversity, proxy access and others outlined in Commonsense Corporate Governance Principles, published in 2016 by a group of leading executives and investors. In addition, in order to move a board forward, the general counsel has a number of specific tools at his or her disposal. The general counsel can:
Suggest formats for a board evaluation and skills matrix;
Bring outside information (such as NACD’s Blue Ribbon Commission Reports) and outside perspectives (such as those from ISS, BlackRock and others) to the board; or
Develop relationships with board members, including board leadership and more progressive board members.
William E. McCracken, director for MDU Resources Group and for NACD, suggested that when boards get “stuck,” the GC is in a “unique position to lift the board’s vision up to see what else is happening out there.” Steven Epstein, corporate partner and co-head of mergers and acquisitions at Fried Frank, agreed. “The GC will be up to speed on the general M&A landscape and the latest thinking of the courts and will be well-positioned to combine that knowledge with the business objectives of the company, which is extremely valuable to the board.”
No Surprises and Keep It Short
Several times throughout the day, panelists espoused the best practice of imparting “no surprises” to the CEO or the board. For example, if the GC sets up lunch with a board member, Buchband suggests a check in with the CEO after the meeting is set but before the lunch takes place. “I ask the CEO if there are any issues he would like me to raise or discuss,” said Buchband. Keeping the board informed on matters affecting governance is equally important.
Also, all panelists reiterated how important it is for the GC to keep materials short and topline for the board. “We can be victims of our own desire to be thorough,” noted Buchband.
Enterprise Risk Management and Compliance Make the GC’s Job Easier
The role of risk assessment is not to avoid all risk, but rather to identify and manage risk, said George J. Terwilliger III, partner at McGuire Woods. In fact, Bostrom noted that enterprise risk management at Abercrombie helps him and the company prioritize risks. If a risk rises to the top, then a cross-functional, high-level team has agreed that it should be there, and he doesn’t have to champion the cause as a lone voice.
Daniel Trujillo, senior vice president and chief ethics and compliance officer for Wal-Mart International, stressed that a culture of compliance must start at the top. A program must then be implemented that is effective, consistent, data driven, efficient and sustainable. Terwilliger echoed that compliance has to be part of the fabric of the company, with the compliance council acting as a convener rather than as “internal police.” Today, predictive analytics help his team spot trouble early at Walmart, at the country or even the store level.
Consider Cross-Border Complexities
Just as Wal-Mart operates globally, so too do companies like Abercrombie. David H. Kistenbroker, global co-head of white collar and securities litigation at Dechert, reminded the audience to consider cross-border complexities when advising the board. Long-arm statutes in the United States and United Kingdom can impact deals all over the world. Due to such complexities, the GC is in a unique position to be a strategic asset to companies operating globally, especially where board members are all based in in the United States.
NACD would like to thank the panelists for sharing their experiences with attendees, and for these generous sponsors for their support of the event: Dechert, Fried Frank, KPMG, and Vinson & Elkins.
Kimberly Simpson is an NACD regional director, providing strategic support to NACD chapters in the Capital Area, Atlanta, Florida, the Carolinas, North Texas and the Research Triangle. Simpson, a former general counsel, was a U.S. Marshall Memorial Fellow to Europe in 2005.
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.