Surviving and Thriving in Uncertainty

Creating The Risk Intelligent Enterprise

Frederick Funston, Stephen Wagner

• Publisher: Wiley
• Year: 2010
• Print ISBN: 9780470247884
• eBook ISBN: 9780470617489
• Edition: 1
• Topic: Business
• Subtopic: Managerial Accounting
• Index: Business

A new book to help senior executives and boards get smart about risk management

The ability of businesses to survive and thrive often requires unconventional thinking and calculated risk taking. The key is to make the right decisions—even under the most risky, uncertain, and turbulent conditions.

In the new book, Surviving and Thriving in Uncertainty: Creating the Risk Intelligent Enterprise, authors Rick Funston and Steve Wagner suggest that effective risk taking is needed in order to innovate, stay competitive, and drive value creation.

Based on their combined decades of experience as practitioners, consultants, and advisors to numerous business professionals throughout the world, Funston and Wagner discuss the adoption of 10 essential and practical skills, which will improve agility, resilience, and realize benefits:

• Challenging basic business assumptions can help identify "Black Swans" and provide first-mover advantage
• Defining the corporate risk appetite and risk tolerances can help reduce the risk of ruin.
• Anticipating potential causes of failure can improve chances of survival and success through improved preparedness.
• Factoring in velocity and momentum can improve speed of response and recovery.
• Verifying sources and the reliability of information can improve insights for decision making and thus decision quality.
• Taking a longer-term perspective can aid in identifying the potential unintended consequences of short-term decisions.

PART I

When Risks Become Brutal Realities

CHAPTER 1

To Survive and Thrive

A Matter of Judgment

Life is short, art long, opportunity fleeting, experience misleading, judgment difficult.

—Hippocrates

The goal of every species is to survive and thrive, yet about 96 percent of all species that have ever lived on earth are now extinct.¹ Life is also short for individuals and—more to our point—for many of the enterprises they create. In 1997, the average life expectancy of a Fortune 500 company was about 45 years.² By now, it has likely become even shorter, as demonstrated most recently in the number of stressed and failed industrial and financial institutions in the crisis of 2007-08 and in the recession of 2008- 09. While the events of that period have been well documented, a quick review of selected highlights will set the stage for our examination of risk and risk management in this part.

• Between the market highs of October 2007 and the final days of 2008, an estimated $8 trillion in value was lost, as measured by the Dow Jones Industrial Average, where every 500-point decline equals about $700 billion in losses.

• The U.K. hedge fund Peloton had been ranked the world’s highest performing fund in 2007 with an 87 percent return on investment and $10 billion in assets. On March 5, 2008, Peloton was forced to dissolve when its liquidity dried up almost overnight.³ That spring, the failure of 85-year-old Bear Stearns occurred in just over 20 days.⁴

• Within 20 months after the end of 2006, 274 major U.S. lending operations “imploded.”⁵ Between January 1 and the end of August 2008, nine U.S. banks failed, and by September 2009 there were 552 on the Federal Deposit Insurance Corporation’s troubled list.⁶

• General Motors and Chrysler underwent federally assisted bankruptcies, while thousands of retail stores, restaurants, travel, luxury goods, furniture, and other businesses that depend on consumer spending experienced severe decreases in revenue and pressure on profits.

• During 2008, U.S. residential mortgage foreclosure activity increased 81 percent over 2007 levels and 225 percent over 2006 levels.⁷ Nationally, more than one in every 400 housing units was in some stage of foreclosure.⁸

Who is responsible? That question has been debated since the onset of the crisis, and it will be for years to come. Yet senior executives and boards of directors have clearly been held responsible in many quarters, representing a trend extending back to Sarbanes-Oxley in 2002, and it’s a trend that we expect to continue.

The reasons should be obvious. People rightfully look to senior executives and boards to exercise judgment: to survey the environment, understand the organization, and make tough decisions in difficult and uncertain situations. The enterprise will either survive and thrive or wither and die on the quality and timeliness of its leaders’ judgments.

We opened this chapter with a quote from Hippocrates, who spoke and taught with humility (to the point of choosing “First, do no harm” as the opening of his eponymous oath). He must have known how little physicians of his time knew about the unknown. Bacteria, brain chemistry, even various organ functions were yet to be discovered. Then, as now, physicians—and executives—must exercise judgment, and do so amid uncertainty.

We mentioned that 96 percent of all species that have appeared on the planet are now extinct. We implied that organizations aren’t doing much better. Yet virtually all species except Homo sapiens operate mainly on genetics and instinct. Only we have judgment. We have what neuroscientists refer to as “executive functions” in our brains, the capacity to gather and process information and to make rational decisions and plans based on that information and on our wants and needs. Shouldn’t our organizations—also equipped with “executive functions”—be doing better, exercising better judgment, even amid uncertainty and the difficulties it brings?

We think so, and we are not alone.

The Revolving Door to the Corner Office

The door to the corner office has been revolving at increasing speeds. In December 2008, National Public Radio (NPR) reported, “Corporate boards are holding chief executives accountable for falling stock prices as well as huge losses suffered in the credit and mortgage markets.” According to the Corporate Library, the CEO turnover rate exceeded 18 percent in 2008. The NPR report noted, “CEOs are also spending less time at the helm—their median tenure is down to four years.”⁹

In general, CEO turnover doubles in bad times, particularly when shareholder returns suffer. In 2008, 61 companies in the S&P 500 stock index changed CEOs. Boards typically oust CEOs a year or two after shareholder returns slip, and that “grace period” may decrease further.¹⁰ (The average chief financial officer has 18 months to get the job done, according to CFO Magazine.¹¹)

The truth, however, is that a new CEO rarely reverses the losses. The shares of 30 companies at which chief executives were removed actually declined more than they gained.¹² More recently, CEOs in general have had their powers diminished, relative to their boards. According to a study by the University of Southern California (USC) Center for Effective Organizations and Heidrick & Struggles, 82 percent of directors believe that their “CEOs have less control over their boards, with 49 percent indicating this has happened to a great or very great extent.”¹³

These trends may well affect management’s view of risk. Jeff Cunningham, Chairman, CEO, and editorial director of Directorship, says, “There is no question that CEO power and prestige have fallen. The unintended consequence is that this can make the CEO overly risk averse. His or her decision making can become reflexive, conventional, and, from a business development point of view, unremarkable.”¹⁴ CEO tenure has been reduced to the point where leaders often cannot see significant initiatives through to completion, which can shift their focus to only short-term goals, since they won’t be around to achieve long-term ones. Nor are CEOs the only leaders affected.

Broad Concerns about Boards

The business acumen of the board often fails to match the needs of the enterprise. Cunningham says, “A lot of people will dispute this, but CEOs complain they are just not getting the ‘brain trust’ and strategic counsel from their boards that they did years ago, although they are getting heaps of advice on the governance issues du jour—compensation, compliance, and succession.”¹⁵ A 2005 McKinsey survey of more than 1,000 directors reinforces these concerns:

• Only 11 percent of directors reported that they have a complete understanding of key enterprise strategies or risks.

• More than 50 percent have no clear sense of their companies’ prospects five to ten years down the road.

• Just 8 percent of directors claim to have a complete understanding of long-term risks; 37 percent admit they have little or none.

• More than 50 percent of directors admit that they have no way of tracking changes in risks over time, leaving them vulnerable to unforeseen shifts.¹⁶

Note that these are directors’ self-assessments. Moreover, the overall trends they identified seem to have continued. The above-noted USC/Heidrick & Struggles study found that 95 percent of directors rated themselves as highly effective in monitoring financial performance, representing shareholders’ interests, and ensuring ethical behavior (compliance and monitoring).

However, they rated themselves much lower on shaping long-term strategy, identifying threats or opportunities, and planning for succession.¹⁷ Those opinions square with reality. The Wall Street Journal reported on September 22, 2008, “Many U.S. boards don’t cope well with a crisis.” Consequently, “some directors are now ratcheting up efforts to anticipate, and avert, trouble.” Going forward, boards need to “take a bigger role in risk management.”¹⁸

Voice of Experience

“Even though there have always been challenges, they were on a different level. We are experiencing ‘a perfect storm.’ First, there is the economic environment—volatility in foreign exchange, raw material costs, oil, and other energy sources. Second, the general public is more vocal and more demanding. And third, public outcry is producing strong pressures for regulatory responses, which in turn create even more flux and unpredictability, not just in the United States but in the rest of the world as well. We are not used to this, and we are not trained or equipped to deal with it effectively.

“We have spent the past five years struggling with overkill of compliance and internal control issues, which are not always correlated with managing the uncertainties of a business. But we sort of took our eyes off the ball for what was on the horizon. That makes us even less prepared.”

—Rolf Classon, Director

What’s Reasonable to Expect of the Board?

The board’s power emanates from the shareholders, whose interests the board represents, and its responsibilities center on governing, guiding, and when appropriate assisting management in protecting and increasing shareholder value. But how much actual responsibility for risk management can be laid upon directors? It’s an open question. For instance, Jeff Cunningham says, “I think the public at large and, add for safe measure both politicians and regulators, may not understand how the board interrelates with the C-suite in the area of risk management, and so they lack some of the basic tools needed to understand the risk environment.”¹⁹

Many boards and management teams also don’t understand that interrelation, at least not fully and in practice. In fact, most conventional guidance on the board’s governance role has far more to do with legal obligations, structures, and functions than with how key decisions are made.

For example, in Corporate Governance, Colley and colleagues state that the board is responsible for governance based on their articles of incorporation, bylaws, and shareholder agreements.²⁰ The authors go on to present three broad duties of the board: the fiduciary duty, the duty of fair dealing, and the duty to perform functions in good faith. Other standard expectations call upon directors to:

• Act as an ordinarily prudent person would reasonably believe to be in the best interests of the organization

• Fulfill the paramount duty of oversight, with the ability to delegate that authority

• Understand the corporation’s operations, performance, and proper responses to problems

• Establish policies, such as specifying decisions requiring board approval, establishing codes of ethics and conduct, and ensuring accurate financial reporting

The vast majority of directors do their best to execute these responsibilities. However, they are often constrained by the limits of time and a lack of the right tools. In addition, a move toward increased director independence—a newfound priority for many shareholders and regulators—may have adverse, as well as positive, effects. While conflicts of interest and “coziness” with management may decrease, directors’ insight into the business may also decrease.

Directors must understand the mechanisms by which the value of the enterprise is, and can be, created and destroyed, so they can provide sound governance and useful guidance. Absent understanding and processes that promote sound governance and useful guidance, the board will likely revert to the default setting of raising objections and roadblocks on the one hand, or, on the other, to rubber-stamping management’s decisions and initiatives.

Indeed, many experts and enterprises preoccupy themselves with board structure. To their credit, Leblanc and Gillies note, “It is ‘board effectiveness’ not ‘board structure’ that must be analyzed, for it is the effectiveness of the board in the decision-making process that in the final analysis determines corporate performance.”²¹

Unfortunately, many boards simply adopt a risk-averse posture rather than develop a decision-making process. Adopting a risk-averse posture in an attempt to protect shareholder value will hobble efforts to create value and, over time, actually erode value. Yet boards require time and certain tools if they are to improve their effectiveness and decision making.

Voice of Experience

“I can’t emphasize enough the fact that continuing on a board is not an automatic entitlement. The board needs to take an inventory of the capabilities it needs to be a complete and an effective board, in terms of skills and experience. It needs to look at what it has relative to what it needs, because more often than not, there will be a historical mismatch. Your board’s composition will reflect what you were in the past rather than what you need to be in the future. The board needs to manage that proactively.”

—David Nierenberg, Director

Barriers to Board Effectiveness

In a Deloitte survey of 250 executives and board members,²² respondents identified the two biggest barriers to effective risk governance systems as a lack of tools needed to analyze nonfinancial issues and skepticism that nonfinancial indicators relate dir...

Table of contents

• Praise
• Title Page
• Copyright Page
• Dedication
• Acknowledgements
• Foreword
• Preface
• Introduction
• PART I - When Risks Become Brutal Realities
• PART II - Ten Essential Risk Intelligence Skills
• PART III - Creating the Risk Intelligent Enterprise
• Notes
• About the Authors
• Index