Leading in Troubled Times

Everyone loves a scapegoat. The financial crisis that started in 2008 is no exception. When share values plunged worldwide, companies closed and millions lost their jobs, homers and savings. Shareholders, the public and politicians pointed fingers. Directors of troubled companies found themselves in the line of fire, regardless of whether their companies were the “cause” of the problem or simply caught in the general economic decline.

Following the financial crises of 2000, Congress enacted the Sarbanes-Oxley (SOX) Act in 2002. SOX implemented important certification, governance, auditing and risk analysis mechanisms.

Since then, companies have assessed their risks, although the degree to which they have done so varies. Even the best risk analysis would not have predicted the severity of the 2008 economic decline for most companies, at least for those outside of the financial services and real estate arenas.

While many debate the extent to which corporate governance was to blame for these financial crises, all companies can evaluate their governance mechanisms and assess whether improvements are appropriate. The following are suggestions for boards to consider. Of course, each company’s situation is different and should be analyzed in light of its particular circumstances.

Enhancing director qualifications

Many board members are appointed due to their friendship with executives or other board members. Some are appointed to fulfill perceived needs or add diversity to the board along gender or racial lines. While those goals are laudable, they should not be at the expense of ensuring the board is capable of exercising its oversight duties. A sophisticated company needs experienced and dedicated directors who understand the complexity of matters before them.

Director qualifications can be enhanced through appropriate “on-boarding” and periodic training to ensure directors understand the company, their duties and the technical aspects of duties related to compensation, financial risk and otherwise.

Conduct a robust risk assessment

As the recent crisis has demonstrated, risk assessments should include challenging assumptions regarding potential financial and business risks. Is the company focused on capital preservation as well as growth? Does it have access to capital if it stumbles? Companies should develop contingency plans to address those risks if encountered.

Appoint a chief risk officer

Companies might enhance risk assessment through the creation of a chief risk officer (CRO). An independent CRO, who reports to and is compensated by the board rather than the CEO, may exercise sufficient independence to candidly assess risk and efforts to mitigate that risk.

Splitting chairman and CEO roles

Having a separate chairman from the CEO can provide an independent perspective to help guide the board’s oversight of the company; it also reduces the ability of the CEO to control the board’s agenda. In addition, it provides a person with whom the CFO, CRO, general counsel and others can discuss concerns. In the absence of an independent chairman, the audit or risk committee chairs can also fulfill this function.

Independent board advisers

Boards are well served when they have access to and receive counsel from independent advisers. SOX granted boards the freedom to engage counsel and other advisers when desired, but boards appear to exercise this prerogative infrequently. Boards should consider engagement of advisers to guide them on issues involving board independence, duties, risk management and liability. These professionals can be the same as those supporting the company’s risk analysis.

Evaluate compensation programs in light of the risk analysis

Do the compensation programs create incentives that lead to overly risky behavior? Are executives and employees encouraged to preserve equity, not just to create short-term growth that may be unduly risky? Boards would be well served to understand the impact of the programs undertaken by the company.

In addition to ensuring that the companies have the appropriate governance mechanisms in place, it is important to help ensure that they are functioning as intended. For example, Enron’s board approved numerous transactions involving “related parties,” but it did not conduct an overall assessment of the risks associated with the aggregate of those transactions. Similarly, Lehman Brothers had a risk committee that met only twice before the company’s demise. Ensuring that the mechanisms are allowed to fulfill their intended purposes can help companies avoid some of the issues recently encountered by the plethora of troubled companies.

While widespread governance reform is not clearly necessary, all boards can benefit from an honest assessment of their risks, strengths and weaknesses in determining the course of their company’s future endeavors.