Tuesday, October 27, 2015

Preventing the Next Existential Moment

By Roy C. Smith

VW is facing an existential moment, one like BP’s after the Deepwater Horizon oil spill that cost its shareholders $70 billion in market value. Surely, someone on VW’s Supervisory Board must have asked “what could we have done to prevent this from happening?”

The same question must have been asked by the Boards of Directors of the dozen of so major banks who between them have paid out approximately $200 billion to settle lawsuits brought by the US Department of Justice, the Federal Housing Authority, the SEC, the CFTC, State Banking Regulators, and British and European regulators since 2008. 

These various and numerous regulatory offenses leave the impression that today’s Big Business firms ignore or deliberately flaunt laws and regulations intended to contain their power and influence.  Observers must wonder whether anyone has ever asked the question of any large corporate board members.

There is, alas, little evidence that anyone has.

Boards are the bodies charged under the law with looking after the interests of the shareholders of private corporations.  They are required to appoint CEOs, but otherwise their duties are unclear, having to do with “monitoring” things, making sure takeover offers are handled fairly, looking after social responsibilities, and, of course, avoiding the existential moments.

How to prevent those moments from occurring is of utmost importance to their shareholders, so boards need to consider some different approaches to doing so. Here are four ideas:

Challenge Strategies

Boards not only appoint CEOs, the CEOs establish business strategies that boards must approve and fund. This may include VW’s strategic initiative to use its diesel engine performance to rise to the top of the auto industry.  If people independent of management had challenged this idea rigorously then the plan’s Achilles heel (they can’t do it without violating emissions standards) might have been revealed.  But it wasn’t.

After the merger of Citicorp into Travellers to form Citigroup, there were dozens of other mergers of big banks.  None were seriously challenged by their boards, all of whom seemed to go along with the idea that being bigger was always better, even when it plunged them into a realm of new businesses and risky activities they knew little about.  Almost all of the litigation settled by the major banks is the result of missteps in trading, underwriting, mortgages, or other activities the banks were not in a decade before.  More pushback from the independent board members (supported by their own experts and advisors as needed) might have made a difference. At least they could have focused attention on the difficult implementation of the strategy that proved to be their Achilles heels.

Rethink Middle Management

Goldman Sachs became a public company in 1999 after 130 years as a partnership.  It wanted to preserve some of the uniform cultural and managerial aspects of the partnership, so it devised a different kind of management structure from other banks, one that put a lot of emphasis on middle management to enforce professional standards for the whole firm.  Today, Goldman Sachs has about 34,000 employees, of whom 2,100 or so are Managing Directors, the firm’s principle culture carriers.  Of these, approximately 20% are Partner-Managing Directors, a senior position that is entitled to partner-like compensation based on a share of the whole firm’s annual income. Managing Directors are selected based on their performance as middle and upper mangers responsible for revenues, risks, costs and legal exposures.  The units they supervise are under constant surveillance to maintain high standards, and to detect and prevent any form of misconduct or wrongdoing. Things fall through the cracks sometimes, but with 2,100 of these guys continuously roaming the halls, there are fewer accidents than might occur otherwise.

Learn from Mistakes

Every legal or regulatory settlement that occurs can be a teaching moment. There is something to learn from a thorough discussion of the events that ended in lawsuits, especially by the standards-enforcing middle and upper managers of a firm. The need to know what motivated the troublesome events, why they went undetected and what the outcome of the litigation was, but can only do so if someone prepares the information (from the extensive legal proceedings) on the cases and enables a full discussion of them by the entire middle management cohort group, however large, though the discussions must be held in small groups overseen by someone in touch with top management.

Few firms do this – they don’t want to highlight their own settlements, or take the time necessary to send everyone to school periodically on such matters.  They should. It would improve everyone’s understanding of what happened, what was wrong with it, and to clarify for everyone’s benefit how such things should be handled at their own firm should they crop up.

Pay and Promote Differently

Increasingly, it seems necessary to replace “you-eat-what-you-kill,” pay-for-performance compensation programs with ones that are more holistic and take into account defensive and preventive measures taken by managers. If the word gets out at the mid-manager level that performance is to be judged by several factors, not just profits contributed, including how well one’s unit performs over time and what managers have done to prevent harm, things will change quickly. Boards should be willing to pay well for good managers that do these things well. They are scarcer than good engineers or traders.

Pay, of course, also needs to be increasingly in company shares as managers rise in the firm, and always subject to “clawback” provisions, including in cases in which a subordinate is charged with wrongdoing. The firm should also make it clear that individuals charged by regulators may not be reimbursed for legal expenses, and the firms will cooperate with prosecutors in their prosecution of the individual.

Existential events are not often fatal, but few companies escape the years of lackluster performance that follow the thumping that the events engender. Boards of Big Business companies need to wake up and recognize that they can lower the probability of such events in the future by reshaping the cultures and middle management cadres that have enabled them.

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