Rebuilding Trust Through Better Risk Monitoring

A recent op-ed article in the Financial Times by noted author and professor, Frank Portnoy, raises the question about the need to hold corporate managers personally accountable for gross negligence when they do not monitor risks. Mr. Portnoy proposes having senior executives at major banks certify that they are actively monitoring the risks taken in areas such as trading desks that have resulted in recent losses due to rogue trading activities. He summarizes his view in the following way.

Current rules permit directors and officers to avoid personal liability for gross negligence. That is a wise rule for most business decisions: courts are generally not skilled at assessing business judgment. But risk is different. Why should a bank manager who is grossly negligent in supervising risk avoid liability?

Shareholders might never be able to understand the risks of modern banks, and current regulatory approaches will not give them much confidence. But if they knew that senior managers had agreed to be personally liable for gross negligence in monitoring risk, they might trust the banks more. Without trust, it is hard to see how banks can recover.

Mr. Portnoy is correct to promote the notion of greater accountability for monitoring risk. However, attaching personal liability to executives may not necessarily be the best method. It would be very difficult to define what is an adequate level of risk monitoring since it really differs for every institution. That is why the industry is so heavily regulated. However, Mr. Portnoy is certainly on point in the fact that stronger risk monitoring is needed to rebuild trust in banks.

New Breeding Ground for Risk Topics

Board members of public companies are accustomed to passing along any risk related issues to the Audit Committee and/or Risk Committee. However, many of these directors are discovering risk related issues are not necessarily the specific purview of those groups. One committee in particular is becoming a breeding ground for risk topics - the Compensation Committee. With incentive programs entering the spotlight through greater disclosure about their impact on risk taking and heightened investor scrutiny, a new set of board directors need to be concerned with risk management. Here is what a leading expert had to say recently about the change.

Finally, an important means for compensation committees to address the risks that they now face is to ensure that they and the compensation-setting process are fully integrated into the overall risk-oversight activities of the board and the company. The financial crisis and its legislative and regulatory aftermath have focused considerable attention on the relationship between incentives in compensation programs and the risks that arise for companies, and as a result the compensation committee has become a crucial component of the risk-oversight process. The compensation committee’s attention to risks—through a periodic evaluation of the compensation program and how pay elements could create risks—has now become a regular part of the analytical framework.

How is your Compensation Committee addressing risk? Having the ability to articulate the linkage between incentive programs and a company's risk appetite is critical to proactively addressing investor concerns.  If you or someone else in your company is interested in learning more about bridging this gap, contact us at NavigateSuccessfully@WheelhouseAdvisors.com.

NYSE Issues Corporate Governance Principles

The New York Stock Exchange ("NYSE") recently completed a report detailing the corporate governance principles that member companies should adopt in the wake of the financial crisis of 2008.  In the report, the NYSE's Commission on Corporate Governance defines the following ten fundamental corporate governance principles and focuses on the interrelationships of what it calls the three cornerstones of the corporation - boards, management and shareholders.

1. The board’s fundamental objective should be to build long-term sustainable growth in shareholder value for the corporation and its shareholders and the board is accountable to shareholders in its effort to achieve this objective.

2. While the board’s responsibility for corporate governance has long been established, the critical role of management in establishing proper corporate governance has not been sufficiently recognized.  The Commission believes that a key aspect of successful governance depends upon successful management of the company, as management has primary responsibility for creating an environment in which a culture of performance with integrity can flourish.

3. Shareholders have the right, a responsibility and a long-term economic interest to vote their shares in a thoughtful manner, in recognition of the fact that voting decision influence director behavior, corporate governance and conduct, and that voting decision are one of the primary means of communicating with companies on issues of concern.

4. Good corporate governance should be integrated with the company’s business strategy and objectives and should not be viewed simply as a compliance obligation separate from the company’s long-term business prospects.

5. Legislation and agency rule-making are important to establish the basic tenets of corporate governance and ensure the efficiency of our markets.  Beyond these fundamental principles, however, the Commission has a preference for market-based solutions whenever possible.

6. Good corporate governance includes transparency for corporations and investors, sound disclosure policies and communication beyond disclosure through dialogue and engagement as necessary and appropriate.

7. While independence and objectivity are necessary attributes of board members, companies must also strike the right balance between the appointment of independent and non-independent directors to ensure that there is an appropriate range and mix of expertise, diversity and knowledge on the board.

8. The Commission recognizes the influence that proxy advisory firms have on the market, and believes that such firms should be held to appropriate standards of transparency and accountability.  The Commission commends the SEC for its issuance of the Concept Release on the U.S. Proxy System, which includes inviting comment on how such firms should be regulated.

9. The SEC should work with the NYSE and other exchanges to ease the burden of proxy voting and communication while encouraging greater participation by individual investors in the proxy voting process.

10. The SEC and/or the NYSE should consider a wide range of views to determine the impact of major corporate governance reforms on corporate performance over the last decade.  The SEC and/or the NYSE should periodically assess the impact of major corporate governance reforms on the promotion of sustainable, long-term corporate growth and sustained profitability.

This report is a wonderful guiding resource for board directors and management who are looking to strengthen corporate governance in a meaningful and practical way. It also provides some great recommendations for government regulators who are looking to implement new rules.  If adopted fully, these principles will go a long way to returning the U.S. and its capital markets to a position of prominence.

Clues to Board Ineffectiveness

The Harvard Business Review published a provocative article last week about the shortcomings of board directors in today's post financial crisis environment. The article was written by Roger Martin, dean of the Rotman School of Management at the University of Toronto. Mr. Martin is a frequent writer and expert in the field of Design Thinking. According to Mr. Martin, the following are six indicators of a bad board member.

1) They complain about how hard Sarbanes-Oxley has made it to be a director. Guess what? It has also become hard to be an investor. And hard to be a public company auditor and a capital markets regulator. It's hard all over. If your directors complain that they don't have time on the board to talk about strategy and succession and other important management issues because the formal SOX procedures have crowded that out, you have mice not men (or women) on the board. Every person in every organization has the personal choice to be a value-added contributor or turn into a useless bureaucrat. Directors have that choice; nobody is putting a gun to their heads. If they complain, they are likely to be useless to you.

2) They complain about how the fees for being a director aren't high enough to compensate for the onerous work involved. You don't want a director on the board because they think it is great money. If they complain about the money, it is because they are obsessed about making money by being on boards and want it to be a lucrative gig. If they think it is great money, they won't do anything to rock the boat and risk losing that gig.

3) They are paid in the top tertile of peer boards. Boards set their own compensation. If board members set their compensation significantly above the median of peer boards, they want to make the board a lucrative gig and that is a bad thing, per the point above.

4) They express excessive pride over being on the board. This is likely to mean that they are enamored with the prestige of being on the board. If that prestige is important to their sense of self then they won't do anything to rock the boat and risk losing the prestige associated with being on the board.

5) They express enthusiasm for the enjoyable social atmosphere on the board. This means they will be incline to avoid doing anything to rock the boat because that will reduce the enjoyment of the atmosphere on the board.

6) They express enthusiasm for the personal growth opportunities the board provides them. That is lovely for them, not for you.

As we continue to emerge from the rubble of the Great Recession, more companies will need to reflect on the effectiveness of their boards and, more importantly, their individual board members.

Boards Take the Lead on Risk Management

The Conference Board published a report this month about best practices in public company risk oversight. The report compiled interview insights from  20 members of U.S. public company boards, representing a variety of business sectors (including manufacturing, high tech, real estate, food services, retail, telecommunications, air travel, energy, health care, and banking) and ranging in size from $150 million to over $30 billion in revenues. The report ultimately demonstrates the need and desire of corporate boards to take the lead in improving risk oversight. The following ten insights are noted in the report with actual board member quotes in italics.

1. Assign the responsibility of risk oversight to the full board and the burden of risk oversight to the right committee(s). ("We are all collectively responsible for risk," said a board member, while another added: "Audit committees tend to have a checklist approach to risk oversight, which is dangerous; not enough prioritization, not enough of a business angle.")


2. Consider the full breadth of material risks that can impact the company. ("We benchmark against a range of companies to make sure we think.")


3. Push for a deep understanding of the key risks. ("We spend a lot of time reviewing the numbers and understanding risk processes: where the key numbers come from, how they get into the reports.")


4. Secure the right expertise on the board. ("Transformation of our risk approach was driven by two board members with risk experience elsewhere.")


5. Nurture a healthy tension borne by diversity. ("The biggest change we made in risk management over the last few years is focusing on having the most diverse board possible.")


6. Engage the broad management team. ("The board needs to interact with management in an open manner, not just hear what has been rehearsed three times.")


7. Embed risk discussions in all board processes. ("Every initiative presented to the board concludes with a simple page with three to four bullets on the key risks.")


8. Avoid the "bureaucratic trap"—more substance, less process. ("When you ask an executive to go in depth on a specific risk and you get a blank stare, you know risk management has become too bureaucratic.")


9. Make risk management actionable, not just an exercise. ("Follow-up is critical—managers come back to the board and are asked 'tell me what you have done'—it is more than just a plan.")


10. Take ownership of improving risk management in the organization. ("To make risk management a success at our company the board had to get involved—we never gave up.")

This represents the new shift by boards to become more risk focused.  How does your company stack up against these best practices?  What other insights should be included on the list?  How do you engage senior management to embrace practices such as these?  If you are interested in joining the discussion, email us at NavigateSuccessfully@WheelhouseAdvisors.com.

New SEC Rules Serve as a Warning to Boards

Large U.S. corporations were recently placed on notice by the Securities & Exchange Commission ("SEC") that shareholders will have a larger voice in determining board members going forward.  Just last week, the SEC adopted new proxy access rules that could have a significant impact on companies who anger their shareholders by not managing their risks well.  Crain's New York had a very interesting report on the potential impact of the changes on companies like Goldman Sachs.  Here's their view.

Goldman Sachs is target No. 1 for activist investors looking to shake up corporate boards now that the Securities and Exchange Commission has made it easier for shareholders to nominate directors.  Corporate governance activists are looking to replace Goldman directors at the firm's annual meeting next spring unless the board strips Chief Executive Lloyd Blankfein of his position as chairman.

The SEC determined that investors can nominate their own directors if they own as little as 3% of a company's stock and can combine their holdings with other shareholders to reach the threshold. It's a sea change for board elections, where candidates in most cases are selected by management only. While investors are limited to nominating 25% of directors in any year, the power they've been granted by the government is considered so worrisome that the U.S. Chamber of Commerce is threatening to sue.

Boards and senior management need to ensure that they are working well together to anticipate risk events like the one Goldman Sachs experienced to protect their shareholders and their positions.  The best way to achieve this goal is to have a strong enterprise risk management program in place.  To learn more about how Wheelhouse Advisors can help your company implement a strong ERM program, visit www.WheelhouseAdvisors.com.

More Change is on the Way

More change regarding how U.S. public companies disclose details about their risk management programs is on the way. The Wall Street Journal recently reported that the Securities and Exchange Commission is re-evaluating disclosure requirements on the heels of financial regulatory reform. Here is what they had to say.

The Securities and Exchange Commission will act quickly to revise corporate risk disclosure requirements and also consider more sweeping recommendations on executive compensation disclosures and easy-to-read corporate filings, SEC Chairman Mary Schapiro said Friday. The SEC also is looking at trading activities such as hedging, shorting, arbitrage and certain types of market orders, to ensure that all investors have access to a highly complex and technologically sophisticated trading market, Ms. Schapiro said in the text of prepared remarks.

SEC staffers now are re-evaluating all corporate filing forms and disclosure requirements, asking whether the information that is being sought is "still relevant," Ms. Schapiro said. "After this review, I expect the staff will present individual recommendations that we can act on quickly, such as revising the risk disclosure requirements," Ms. Schapiro said in the text of her speech to the Society of Corporate Secretaries and Governance Professionals.

Companies should be prepared to provide more substantive information regarding their risk programs. Wheelhouse Advisors can help your company with a complimentary risk program diagnostic review. For more information, email us at NavigateSuccessfully@WheelhouseAdvisors.com.

Mind the Knowledge Gap

Former SEC Chairman Arthur Levitt delivered some very interesting remarks in a recent speech at the Annual Audit Committee Conference sponsored by the National Association of Corporate Directors ("NACD").  Mr. Levitt challenged companies to improve the knowledge base of its board members to allow for more fulsome discussions on risk.  He also provided some recommendations for better governmental oversight and regulatory reform.  Here are a few of his thoughts.

Let’s talk about steps that need to be taken by corporate boards on their own. In general, I favor elements that improve transparency and accountability. Basic improvements, like giving investors access to the proxy, would push boards to be more proactive, and more sensitive to investor concerns.

But being more accountable is a lot easier when you have the right expertise. Right now, independent board members often don’t have the base of knowledge they need. When someone working every day inside a corporation is presenting information and analysis to the board, there will always be a gap between what they know and what the board knows. This gap is inevitable, but it need not be permanent. That is why I would strongly favor that boards of directors include individuals with financial market experience, and especially expertise in understanding, pricing, and managing risk. With even one  member regularly raising challenging questions and issues, boards would be able to press management to think far more creatively about issues such as counter-party risk, operational risk, and so on.

Mr. Levitt is right in his view that the knowledge gap must be bridged to ensure board members are truly effective in their roles.  It will take renewed efforts on both sides - management and board - to accomplish this feat. However, not only will they benefit, their shareholders will as well.

Reckless Drivers at Lehman Brothers

Today, the U.S. House Financial Services Committee will conduct a hearing to examine the failure of Lehman Brothers. One of the panelists slated to testify is the bankruptcy court appointed examiner, Anton R. Valukas.  Mr. Valukas will testify that like many financial services firms, Lehman Brothers had a robust risk management program.  However, Lehman Brothers' fatal flaw was the fact that it routinely overrode the risk controls and limits to achieve greater short-term profits.  Here is what Mr. Valukas found.

We conducted an extensive investigation to learn how Lehman managed, monitored and limited its exposure to risk. Lehman had adequate corporate governance procedures in place. It had quantitative risk models that accurately calculated risk and that accurately warned that Lehman was taking on significant levels of risk in excess of the limits generated by the models. Lehman’s procedures included reporting of the limits, and exceedances of the limits, to senior management and the Board.

But we found that Lehman was significantly and persistently in excess of its own risk limits. Lehman management decided to disregard the guidance provided by Lehman’s risk management systems. Rather than adjust business decisions to adapt to risk limit excesses, management decided to adjust the risk limits to adapt to business goals.

Much like a reckless driver who consistently exceeds speed limits and other traffic laws, Lehman Brothers eventually crashed.  In the short-term, the reckless driver may get to his/her destination quicker.  However, it is at the risk of not only his/her own life, but also the lives of everyone else in the way.

Risk Management Moving to the Fore at Board Meetings

Risk management is increasingly moving to the fore in boardrooms across corporate America.  At least that is what some board members shared with finance professionals last week at a conference in Orlando, Florida.  According to a report in CFO magazine, risk management concerns among others are driving the desire for more exposure from the finance team.  Here is a summary of their report.

With board members more concerned about risk management and succession planning these days, CFOs should make sure they — and their staffs — have a strong presence in the boardroom, a group of retired CFOs-turned-board members told financial executives attending the CFO Rising conference in Orlando last Wednesday.  "The board wants to make sure they hear all opinions," said Ellen Richstone, former finance chief of several public companies, including Sonus Networks, and now on the board of Blue Shift Technologies. "They don't want to hear just the CEO." If the CFO and other members of the management team aren't available to the board, it sends up a red flag, she said.

Any red flags at your company's board meetings due to a lack of involvement by the finance team?  If so, there is no time like the present to remedy the situation.

How Trustworthy Is Your Company?

Last week, an executive roundtable session was held here in Atlanta at the Carter Presidential Center to discuss views on the increasing need to rethink corporate governance.  During the session, Walter Smiechewicz from Audit Integrity provided some compelling insights into measuring corporate governance practices and the overall value of having a strong corporate governance program.

Audit Integrity bases their analysis of corporate governance practices in a proprietary ratings methodology they refer to as Accounting and Governance Risk or AGR.  The firm has analyzed public financial statements and related disclosures to calculate an AGR rating for every U.S. publicly traded company.  Using these ratings, Audit Integrity has also determined a strong correlation between higher AGR ratings and higher shareholder returns.  As a testament to the accuracy of the AGR rating, Forbes magazine has used the AGR as the primary basis for their 100 Most Trustworthy Companies List for the past three years.

If you are interested in improving your AGR rating or simply want to learn more about better corporate governance, visit www.WheelhouseAdvisors.com.

Pathway to Restoring Trust

The Committee for Economic Development recently issued a briefing on how companies can restore trust in corporate governance.  Well known business leaders participate on this committee and provide periodic guidance for companies based on current events.  A significant piece of this briefing focuses on how companies should be managing risks.  Here is an excerpt discussing the role of both the board of directors and management.

There should be a board entity—whether the Audit Committee or a new Risk Committee—which has the task of assessing the direct economic risks noted above (capital, leverage, liquidity, credit, market, operational) confronting the company. Working with management, it should review and agree upon the fundamental systems, processes and measures for assessing, mitigating and monitoring risk, as described immediately above. It should receive timely updates on the status of high risks facing the company. It should also receive reports from relevant risk officials in a company on whether those receiving compensation above a certain level have identified relevant risks and taken appropriate risk-mitigation steps. (This activity is relevant both to accountability and to compensation.)

Does your company operate in this manner?  If not and you are interested in learning how to build a program to support this activity, visit www.WheelhouseAdvisors.com.

Navigating the Proper Course on Pay

Reports about new regulations on compensation practices at U.S. financial institutions emerged today in the Wall Street Journal.  Evidently, the Federal Reserve is working on new rules designed to reduce excessive risk taking such as incentives for mortgage loan production that fueled the current economic crisis.  Here is what was reported.

Among ideas being discussed are Fed rules that would curb banks' ability to pay employees in a way that would threaten the "safety and soundness" of the bank -- such as paying loan officers for the volume of business they do, not the quality. The administration is also discussing issuing "best practices" to guide firms in structuring pay.

Government officials said their effort, which is just beginning, isn't aimed at setting pay or establishing detailed rules. "This is not going to be about capping compensation or micro-management," said an administration official. "It will be about understanding what is the best way to align compensation with sound risk management and long-term value creation."

Solid corporate governance practices and effective risk management programs should be enough to limit excessive risk taking through well designed compensation plans.  However, it seems the U.S. Government is not convinced that companies will navigate the proper course.

 

Sound Advice About Corporate Governance

Companies looking to strengthen their corporate governance practices typically seek legal counsel to ensure the methods used will stand up against potential challenges from plaintiff attorneys and regulators.  Terry M. Schpok, a leading corporate governance attorney, was interviewed this week about the advice he is providing boards of directors during the current financial crisis.  Here is what he had to say about risk management.

A number of surveys have recently ranked risk management as one of the top concerns of a board. The cliché "desperate times breed desperate measures" has particular relevance today. Many boards are focusing on ensuring that management does not take desperate measures that may ultimately be challenged as improper, illegal, or exceptionally risky. The board should assure itself that the company is dedicated to enterprise risk management, meaning a top-down, holistic approach to risk management, including an assessment of operational, financial, strategic, compliance, and reputational risk. This approach eschews looking at each category independently in favor of assessing the company's overall risk.

Because the current financial crisis is generally attributed to poor risk management, boards should consider whether they have the ability to effectively monitor risk management. They should assure that the company has an education program that provides directors with a good understanding of the company's business and the major risks it faces. Depending on the nature of the risk and, particularly, new risks, a company may need to consider changing or adding board members with expertise in particular areas of concern. There also should be an oversight structure within the board to assure that regular periodic reports from those involved in the risk management function are provided to the board.

The entire board should remain engaged in the risk management process and be kept informed by any board committee that is reviewing details of the process on an ongoing basis. Finally, directors also need to be sure that they are getting information that they need to understand the company's risks as well as management's assessment of those risks. They need to be sure that management is properly assessing risks. They should review current risk management practices with the company. The board should also know what the company is doing to respond to and assess counterparty risk that may be posed to the company by lenders, insurers, suppliers, customers or other parties to business relationships the company.

This is sound advice from a leading expert in the field of corporate governance.  Wheelhouse Advisors is prepared to help companies implement the practices he suggests.  To learn more, visit www.WheelhouseAdvisors.com.

Better Ingredients. Better Governance.

This weekend, the Wall Street Journal included the opinion of John Schnatter on the current financial crisis.  For those of you who do not recognize his name, Mr. Schnatter is none other than "Papa John" of the famous pizza franchise, Papa John's.   As Chairman of the Board at Papa John's International, Inc., Mr. Schnatter points out that the failings of the many corporations that were involved in the carnage started in the boardroom.   With weak oversight, these companies did not possess the strong level of governance required to hold the CEO accountable as the bubble expanded.  Mr. Schnatter explains,

"As our nation works its way through this crisis, and we look for explanations as to how we reached this point and how to avoid another crisis in the future, let us keep in mind that a significant set of checks and balances -- ultimately ending with the boards of directors -- has failed."

Checks and balances must be improved, beginning with the board and ending with strong controls throughout the enterprise.  As Papa John himself says, better ingredients lead to better pizza and, in the case of enterprise risk management, better governance.