Opportunities for Reform Born Out of a Market Collapse

by Chad Johnson, Bernstein Litowitz Berger & Grossmann LLP,

Tuesday, July 07, 2009 at 12:11 PM EDT

(Editor’s Note: This post is based on a recent article published by Bernstein Litowitz Berger & Grossmann in the Advocate for Institutional Investors.)

“When the music stops, in terms of liquidity, things will be complicated. As long as the music is playing, you’ve got to get up and dance. We’re still dancing.”

Former Chairman and CEO of Citigroup Inc., Charles O. Prince, July 9, 2007, four months before being ousted after reporting an unexpected $11 billion write-off of subprime mortgage losses.

The music has now stopped and the world has begun to deal with the complicated web created by the financial markets’ collapse, and to determine how to prevent future market catastrophes. One clear preventative measure is to ensure that companies create and support strong, independent and accounting-savvy boards of directors and executives charged specifically with risk management and control. As proxy season begins, concerned market participants are called upon to examine lessons from the largest loss of investment capital since the Great Depression, and enact reforms to better protect shareholder interests and help prevent future financial meltdowns. In proposing any reforms, however, it is necessary to first examine why existing critical governance standards failed to alert investors to a crisis in the markets. Only by learning from these shortcomings will new measures have a chance at preventing another financial disaster. In the broad context, corporate governance measures failed because of a lack of board oversight. The Organisation for Economic Cooperation and Development (OECD), an association of thirty member nations that accept the principles of representative democracy and a free-market economy, recently attributed the current financial crisis to “failures and weaknesses in corporate governance arrangements which did not serve their purpose to safeguard against excessive risk taking in a number of financial services companies.” The OECD’s conclusions necessarily raise the need to examine and propose board-level corporate reforms in order to strengthen market integrity and restore shareholder confidence. Immediate reforms are needed with respect to key corporate governance principles which failed to serve investors’ interests during the recent market turmoil; namely, risk management oversight and enforcement, consistent application of enhanced accounting standards, and executive remuneration tied to long term shareholder interests.

As an initial matter, investor advocates must demand direct board-level oversight of corporate risk management and the development of acceptable risk policies. Risk management breakdowns in the current financial crisis were not due to a lack of sophisticated modeling or technology; rather, they were attributable in large part to boards of directors’ limited access to, and understanding of, relevant risk exposure information. Substantial corporate risks were simply ignored or not communicated to boards of directors.

Indeed, the current crisis has made clear that boards of directors of investment banking firms recklessly, or at least negligently, failed to understand that increased exposure to subprime assets exceeded acceptable risk limitations until it was too late. For instance, in 2008, the Institute of International Finance (“IIF”) concluded that “events have raised questions about the ability of certain boards to properly oversee senior managements and to understand and monitor the business itself.”

In fact, the Securities and Exchange Commission noted that “Bear Stearns’ concentration of mortgage securities was increasing for several years and was beyond its internal limits,” yet the Bear Stearns Board of Directors did nothing to mitigate this exponential growth to the balance sheet and protect the company’s liquidity. Indeed, Bear Stearns only established a full risk committee of its Board of Directors months before it failed, too late to stanch the rising crisis. Other banks had risk committees, but they were not sufficiently involved to be of use. For instance, the now bankrupt Lehman Brothers had a risk committee, but it only met twice in 2006 and 2007. And at UBS, risk managers were apparently alerted to potential subprime losses during the first quarter of 2007, but it took months for UBS executives to even raise those issues with the corporate board and outline a comprehensive picture of the company’s subprime exposure. In fact, many banks took a “silo approach” to risk management, essentially walling off risk management staff, preventing centralization of information or a clear process for the escalation of red flags. This serves no purpose and chokes the flow of critical information to boards of directors. Given the current economic climate, directors are obligated to assume an active role in managing corporate risk by protecting the integrity of balance sheets and limiting threats to liquidity. To do so, boards must become aggressive and implement risk reporting mechanisms that provide them with companywide risk assessments in a timely fashion.

As a remedy, risk management must be proactive rather than reactionary. As the OECD indicated, “it is a prime responsibility of boards to ensure the integrity of the corporation’s systems for risk management.” To fill this need, one innovative proposal is to establish a Chief Risk Officer (CRO) who also operates as a full board member. If independent and experienced, CROs could be extremely useful tools for boards in assessing corporate risk. Additionally, CROs could provide a direct point of risk policy enforcement and immediately raise unacceptable or troublesome exposures. In turn, with information provided by CROs, boards could then quickly assess violations of a company’s risk guidelines instead of waiting for untimely and filtered assessments. Accordingly, boards that assume greater responsibilities and gain direct access to risk exposure levels through CROs, or other similar measures, are likely to prevent catastrophic threats to corporate viability.

Hand-in-hand with an increased board level understanding of risk exposure is the need for more meaningful corporate disclosures. Again, this is a board responsibility that has suffered in recent years. As more and more complex securities entered the marketplace and appeared on corporate balance sheets, boards improperly delegated risk disclosures to others without fully investigating and disclosing the true exposure associated with novel financial instruments such as collateralized debt obligations and credit default swaps tied to toxic mortgage assets. Again, a CRO style board appointee could operate to review and improve corporate disclosures and augment investor understanding of risk and liquidity.

In addition to increased board oversight of risk management, directors must seek uniform and appropriate application of accounting standards that improve transparency for investors instead of obscuring liabilities. This requires improving the quality of audit committee membership and active supervision of company audits by boards of directors.

For instance, in recent years, banking entities were encouraged to engage in a form of accounting arbitrage by moving deteriorating mortgage assets off balance sheets to various special purpose entities. For example, Citigroup essentially created a liquidity “put” associated with its collateralized debt obligations that allowed buyers to sell back the faltering securities at their original value to Citigroup. This strategy only worked if the value of the assets remained healthy; once the assets’ value tanked because they were tied to subprime mortgages, Citigroup was forced to bring back approximately $25 billion worth of toxic assets on to its balance sheet in November 2007. In essence, by moving liabilities off balance sheets, investors were never informed of the immense risk posed by faltering mortgage assets. Clearly, in such instances, the audit committee was missing in action, thwarting transparency and failing investors.

While regulatory proposals are in the works to clearly articulate the use and risk of special purpose entities, boards of directors remain responsible for maintaining adequate accounting standards. For instance, the Financial Accounting Standards Board issued new guidelines requiring enhanced disclosures for securitization and asset backed financing arrangements. The increased disclosure requirements are intended to provide more information to investors concerning the risks of special purpose entities and the accounting associated with off-balance-sheet transactions.

At the same time, enhanced disclosures require audit committees to exercise objective and independent judgment, test accounting assumptions, question audit findings, and not merely rubber stamp audits or perform purely ministerial functions. Several steps need to be taken to reach these goals. For example, it is clear that, at a minimum, given the complex financial instruments in the financial markets, audit committees must be staffed by independent appointees with accounting experience sufficient to ensure proper oversight of corporate audits.

Moreover, executive compensation needs to be restructured so that executives are not rewarded for short term profits at the expense of long term health. Rewarding risk provides tantalizing rewards for both executives and investors, but taking unacceptable risks for short term gains erodes shareholder value, and can reward failure. Corporate boards can play a key role in revising executive pay by aligning long term strategy goals with compensation packages. In this regard, boards should look to reduce bonus systems tied to immediate financial returns in favor of a system that measures compensation “on a risk adjusted basis,” favoring deferred compensation structures and aligning executive performance targets with long term shareholder value. Moreover, rather than delegating this task to a compensation committee, boards should look to include remuneration considerations as a function of either the risk or audit committees to more closely align pay with capital risk and its financial impact. Indeed, independent auditor KPMG has noted that “[w]hile oversight of compensation plans may generally fall within the responsibility of the remuneration committee, audit committees are focusing on the risks associated with the company’s incentive compensation structure.” Given this, risk or audit committees should review executive pay to understand the true impact that incentive programs play in encouraging unacceptable capital risks and put an end to such behavior on the part of executives.

Failure of corporate boards to manage risk and properly account for liabilities threatens the viability of a free market democracy. Investors now know that there were woefully insufficient risk controls in place, and that the lack of risk control allowed the financial crisis to get out of hand. Investors will only be willing participants in the capital markets if financial transparency and oversight are restored by corporate America. Enhanced corporate oversight is necessary starting from the top down. Boards of directors must become more robust and independent in order to ensure that shareholders are protected. Only then will markets revive and trust be restored.

This article originally appeared on The Harvard Law School Forum on Corporate Governance and Financial Regulation.