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Governance & Ethics & Regulators & Public Policy Eleanor Bloxham on 15 Aug 2010

Legality and Morality

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In one of the many tapings I did about five years ago, one stuck out. It was a director who sits on several boards and made statements along the lines of – we figure out what is legal — and then we know the sphere of action — everything else is fair game.

I was shocked — but was so much so that I was speechless -  and didn’t  respond verbally as such on camera.

What caused this to come to mind was a group email I received with a similar theme this weekend — morality is defined by legality. It read “What ought to be is compliance with the law.”

Of course, if you have considered this idea before you recognize that requiring legality to define morality requires many laws. Ever since that incident about five years ago, I have wondered: is that what directors really want - enough laws and their sufficient enforcement to ensure that directors know what the moral lines are?

What happened to the idea of moral principles which go beyond the law? And law that was circumscribed to the fewest number possible that allow for a civil society and the preservation of rights?

I think we have entered a difficult passage if we are to accept that the law can proscribe all that is right and wrong. I think that we have lost our bearings if this is what we believe.

I like the idea of the fewest laws necessary — but if we insist that the law define our morality — we will need many more indeed.

The Value Alliance and Corporate Governance Alliance www.thevaluealliance.com

Eleanor Bloxham www.eleanorbloxham.com

Copyright 2010 The Value Alliance Company. All rights reserved.

Compensation & Governance & Boards in Crisis & Ethics & Risk Eleanor Bloxham on 15 Aug 2010

Culture and Risk

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I remember I gave the opening talk/keynote at a conference in 2004 in which I discussed the important role of the board with respect to corporate culture.

Here David Nadler and I very much disagreed — as on a later panel at the conference he said that corporate culture while critical was not the board’s responsiibility.  He also said that the largest influence on the culture is company leadership. http://www.allbusiness.com/corporate-governance/222157-1.html

But who is responsbile for the largest influence on culture i.e.company leadership? 

Who hires and fires the CEO? The board is responsible, of course.

Who decides if the CEO has done a good job with respect to the culture of the firm and in the choice of the top management team? The board.

How much can boards really do about this influence and thus culture? I think they can actually do a lot.

It’s very easy for boards to turn aside and hope for the best in the face of a CEO turning in results shareholders admire or seemingly turning around a company’s fortunes. In the HP case, the subsequent commentary by HP staffers about the culture is worthy of note.http://blogs.wsj.com/digits/2010/08/06/live-blogging-h-ps-announcement-to-investors/tab/comments/

Can boards be proactive in understanding the culture of the organization and the way in which the CEO views and uses his/her power?  I think a board can do a lot by evaluating the CEO’s context, interactions with staff, etc.

It isn’t that difficult to pick up on issues if you are socially aware. Addressing those issues is what is much more difficult.

CEOs need the board to oversee – and boards need to to ensure the power of the position is not corrupting  the individual in it. They need to also ensure that their own actions do not make it more difficult for the CEO to create a culture that mirrors the values of the firm, as many unwittingly do when they set short-sighted objectives and focus on the short term.

Boards need to provide independent, objective counsel and help the CEO stay grounded and able to make wise choices. Failure to address personality and cultual issues in the executive ranks create huge risks for the entire firm.

Who else but the board can address this?

This is another reason boards must control the agenda. Some of these are issues the CEO is likely not to put on the board agenda. But the board must in strategy sessions, executive session with and without the CEO and in performance review updates with the CEO ensure these issues are addressed.

To do this well requires directors with insight, dipomacy, tact and courage. Sometimes directors have the first three but the fourth is lacking.

Holding executive sessions at every board meeting that are more than perfunctory and cover these topics including ”what could our CEO use coaching on?” and “what is the culture of the organization and how is it evolving?”  and “have we provided the right goal and performance structure including the importance of how?” provide ways for the board to handle these issues early on.

Shared values such as HP espouses at its company including “We work together to create a culture of inclusion built on trust, respect and dignity for all” “each person’s contribution is key to our success” and “We effectively collaborate” if they are to be written must be lived.

It’s the board’s job to determine if these are the right values.

If they are, they must ensure the CEO’s actions reflect them. They do that through oversight of the human resource practices of the firm (including compensation) and oversight of the manner in which the CEO and his/her team go about reaching their goals and objectives.

If it’s not the board’s responsiblity that sees to the CEO’s behavior — and by extension to his management of the culture — whose job would that be?

Footnote: Fortune invitied me to write about HP. You can read the article here. http://money.cnn.com/2010/08/10/technology/HP_post_Hurd_board.fortune/index.htm

The Value Alliance and Corporate Governance Alliance www.thevaluealliance.com

Eleanor Bloxham www.eleanorbloxham.com

Copyright 2010 The Value Alliance Company. All rights reserved.

Compensation & Governance & Ethics & Risk & Regulators & Public Policy Eleanor Bloxham on 18 Jul 2010

Pressure for Conformity leads to Lack of Innovation

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We always like to think that conformity and pressure to conform is externally driven. Of course, it isn’t. The pressure is internal — a desire to fit in, to be accepted and a fear of taking on this adventure called life. Maybe it was shaped in childhood but the choice to conform is one each adult must make.

Pressure for conformity does indeed lead to lack of innovation.

Jim McRitchie at Corpgov.net has an interesting story on his website about the reluctance of boards to participate in innovative programs despite the fact that there is a feeling that something more and different would be beneficial. http://corpgov.net/wordpress/?p=2397

Paul Hodgson had an entry in May on The Corporate Library Blog on the lack of conformity in governance thinking http://blog.thecorporatelibrary.com/blog/2010/05/corporate-governance-is-like-religion.html.

Despite this, much of what companies actually do is quite uniform. See http://money.cnn.com/2010/05/25/news/companies/say_on_pay_law.fortune/ and http://money.cnn.com/2010/06/17/news/companies/banker_compensation_finreg_risky.fortune/  on pay.

The uniformity of pracitce is so pervasie that it makes new ideas all the more appealing. It’s why I applaud Bebchuk and others for thinking about new approaches even though in any particular example I may think they aren’t the right solution. http://money.cnn.com/2010/07/02/news/companies/aig_executives_compensation_debt.fortune/index.htm

I had a refreshing conversation with a director a few weeks ago who put it this way: benchmarking is anti-American — it’s the antithesis of innovation.

I agree with this sentiment and even said so when I spoke for the Best Practices Institute a couple of years ago. (So called best practices are often used by firms to “benchmark” their own actions.) I told the BPI audience much of what I described on that subject in this Digest http://www.thevaluealliance.com/PDF/CGADigest122908.pdf i.e. it is important  to innovate beyond benchmarks and so called best practice.

Benchmarking in compensation has been taken to an extreme. Last week Fortune published this article I wrote on an IRRC and Proxy Governance study. http://money.cnn.com/2010/07/15/news/companies/compensation_committees.fortune/

The study showed that quite a few compensaiton committees in their benchmarking pick outsized peers — and quite a few pay markedlly more to their own CEO than the CEOs receive in the peer group selected.

Is this the veneer of conformity? Do the boards recognize that it’s veneer?

Of course, we also often have the reverse issue — the veneer of innovation, the veneer of considering new ideas.

In this article Fortune published on Friday, I talk about the situation of Tim Leech trying to take on that veneer and the conformity he has faced. http://money.cnn.com/2010/07/16/news/economy/COSO_SEC_flaws_Sarbox.fortune/  It is an important story because it goes to the heart of what is plaguing us, mired in conventional wisdom and failing to access the talent which could provide us solutions. It is also important because it gets at some of what caused the “Great Recession”. If you are wondering “why SOX didn’t work”  – and what could make a big difference — the specifics as well as the processes that need to be fixed are told in this tale.

Still the question remains: Will the Great Recession be motivation enough?

The Value Alliance and Corporate Governance Alliance www.thevaluealliance.com

Eleanor Bloxham www.eleanorbloxham.com

Copyright 2010 The Value Alliance Company. All rights reserved. 

 

Governance & Regulators & Public Policy Eleanor Bloxham on 10 Jul 2010

SEC’s Next Steps

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On November 16, 2009, I sent in comments to the SEC in response to their request for comments on their strategic plan. http://www.thevaluealliance.com/PDF/sec_comments_nov2009.pdf

One section of my comments was entitled: “Issue: Conflicts in the Mission” and stated “In articulating its strategy, SEC articulation of how it intends to reconcile the competing elements in its mission statement is key. ‘The mission of the SEC is to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation.’  How does the SEC reconcile and evaluate its responsibilities (actions or inactions) when the different elements of the mission come into conflict. For example, when facilitating capital formation conflicts with investor protection – what trumps? How does the SEC reconcile this? A pinch of this and a pinch of that?  What in other words are the governing principles?

When the SEC asks for issuer comments on the difficulty in complying with a new investor protection, the conflict between issuer requirement and investor protection comes into focus. What is not clear is how the SEC in each instance thinks strategically about how it is reconciling the different parts of its mission to the actual decision and activities it undertakes.  A similar conflict occurs when the SEC makes determinations about what may or may not be included on the proxy. How in these instances is the SEC choosing ‘protect investors’ vs. ‘maintain fair, orderly, and efficient markets’ vs. ‘facilitate capital formation’ or something else.

Clear articulation of this decision-making process would be very helpful in evaluating the SEC’s proposals and strategic objectives and in strengthening and building a bridge of trust between the SEC and the public related to its own transparency and integrity.”

In her speech to the Society of Corporate Secretaries and Governance Professionals July 9, 2010, Mary Schapiro addressed some of these issues in her remarks. “The SEC has a three-pronged mission: protecting investors; maintaining fair, orderly and efficient markets; and facilitating capital formation. Obviously, each of these mandates is intertwined with the others—investors are better protected when markets are fair and orderly; markets are more orderly and efficient when investors have access to honest brokers and accurate information; and capital formation is more efficient when markets are functioning smoothly and investors are confident.But if there were to be a conflict between, for example, investor protection and efficient markets, the debate would be settled by asking the question I have posted on the door to my office: ‘How does it help investors?’ And so, investors are the focus of our agenda.”

This statement is a step in the right direction in terms of articulation of purpose — and it  will help to flesh this out further.

What helps investors more? The definitons of “helping” and “investors” become the issue. That’s why in my November 16, 2009 comment letter, I also suggested that SEC define what the SEC means by investor and what is encompassed in protection.

Issue: Who is Being Protected?  – In articulating its strategy, the SEC’s definition of investor is key.

One issue in the current dialogue on proxy access and other matters relates to the mission of the SEC in protecting ‘investors’. While the document, ‘The Investor’s Advocate: How the SEC Protects Investors, Maintains Market Integrity, and Facilitates Capital Formation’ provides valuable information about the mission and objectives of the SEC, it does not address the issue of whom the SEC is protecting.  This definition is critical. Are flippers and traders the subject of protection? Are retirees? Are institutional investors?  What about small versus large holders?  What is meant by protection for each kind of investor? And if the protection of the different categories of investors creates a conflict, how will the Commission resolve that conflict between the different categories?

I believe that the SEC should strive to address this vital issue in writing with clarity before providing guidance on significant issues.

For example, in the area of proxy access, by clearly articulating the meaning of the mission statement with respect to this matter and addressing the SEC’s responsibilities and protections of the different investor classes, a roadmap would be in place which would make it simpler to understand the outcome of proxy access related to: who and why them?

In this strategic plan, the issue is raised also in Outcome 2.1, the first performance metric where ‘the SEC plans to conduct a survey of financial analysts and institutional investors to elicit feedback on the quality of disclosures and the Commission’s disclosures requirements’.  This raises the clear questions of:  why them and not individual investors? Why would the input of short term financial analysts and institutional investors trump that of long term individual holders?

The Values of the SEC state that ‘the SEC treats investors … fairly’. Clarity and clear articulation of the implicit assumptions around who is ‘the investor’ i.e. the assumptions which represent the SEC’s operating model of decision-making would be very helpful in evaluating the SEC’s proposals and strategic objectives and in strengthening and building a bridge of trust between the SEC and the public related to its own transparency and integrity.

Issue: Protection  — In articulating its strategy, the SEC’s definition of ‘protection’ is key.

The Values of the SEC state that ‘the SEC treats investors … fairly’. Whom and what are investors being protected from? (This list could include bad disclosure, unfair solicitation practices, poor governance; it could also name the possible actors who might be involved.) Is it the same for every class of ‘investor’? Being explicit, here as well, will help to resolve seemingly intractable issues like proxy access more deliberately and thoughtfully. It will also help validate (or not) specific objectives in the strategic plan and the recommendations related to future disclosure requirements.”

In her speech, Mary Schapiro referred to the pending review of proxy access this way: “we will be looking at ways to improve the voting process; we will be looking at communications and shareholder participation; and we will be looking at the role of proxy advisors, among other subjects.”

To do this carefully and critically, I believe the SEC needs to carefully consider the issues of “who is to be protected” and “what protection means”.

The Value Alliance and Corporate Governance Alliance www.thevaluealliance.com

Eleanor Bloxham www.eleanorbloxham.com

Copyright 2010 The Value Alliance Company. All rights reserved. 
 

Compensation & Risk Eleanor Bloxham on 03 Jul 2010

Risk Transparency and the Purpose of Incentives

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Yesterday Fortune published this article which I had written on incentive compensation design. http://money.cnn.com/2010/07/02/news/companies/aig_executives_compensation_debt.fortune/index.htm

Later in the day I submitted comments due into the FDIC (12 CFR Part 327  RIN 3064–AD57) on their new proposed assessment scheme and I realized the two had been related. 

In the FDIC’s proposal, they stated: “The FDIC has found that debt issuer ratings, particularly for the largest institutions, do not respond quickly to an institution’s changing risk profile.”  In saying that, they had made one of the points I had made in the article, and actually it would have been quite useful to have realized they had said it and quoted them.

I believe the purpose of incentive compensation is to shape and mold behavior. If you simply wanted to retain someone and felt more money was necessary, just up the salary.

Incentives really are about creating an incentive to behave in a certain way. What is key is the impact that the incentive has on the behavior of the recipient. And that is why performance metrics are key (a point the Federal Reserve makes in their guidelines to banks).

For this reason in the article for Fortune I set out two tests that should be applied to any incentive scheme  – (1) can managers control the outcome of the measure? and (2) if they can control it, is it an outcome we really want managers focused on? If they can’t control the outcome, the purpose of having an incentive is missing. So that’s either a waste of a good incentive or a distraction — neither good. If managers can control the outcome but it isn’t a proper area of focus, why dilute their actions? Again, a waste of a good incentive and a distraction - or worse, it may cause them to take actions that are not in the best interests of the company, all shareholders and stakeholders.

The failure of incentives was clear in this last crisis. As I wrote to someone who had sent me a message about the article yesterday, my interest in the incentives is from the perspective of the behaviors of  executives and shaping that behaior in advance of the markets’ understanding/catching on to the full picture. My interest is in ensuring executives are motivated from the beginning to manage risk before markets catch on. I am interested in changing behavior as much as pay.

And as I note in the article, internal views of risk will always be more robust than what any market player without inside information can glean. In this BP article for Fortune http://money.cnn.com/2010/06/22/news/companies/bp_horizon_macondo_whistleblower.fortune/index.htm  I quoted Michael Griffin’s thoughts on reflecting on the Challenger accident - which is applicable to the financial crisis too:”When we investigate, we always find that there were people who did see the flaw, who had concerns which, had they been heard and heeded, could have averted tragedy. But in each case the necessary communication — hearing and heeding — failed to take place.” There were people who understood. They either did not speak or were not listened to.

Financial institutions manage risk and know much more about those risks than the markets ever will. If executives were paid based on properly designed risk based metrics, incentives could act in advance of the catch up markets do in understanding.  

While I have always felt strongly about these issues, I feel even more strongly post-crisis. Before the crisis and the markets had recognized what was happening, on December 6, 2006 on CNBC, I was asked about executive pay at investment banks and I questioned the huge bonuses from the standpoint that it did not seem to me that the performance results for the banks were long term sustainable. The stock price was the argument used against what I said. (Therefore I have  issues with equity based pay as my article outlines.) At the time, the CDS spreads, had someone used that argument, would have gone against me too. (They spread later according to this paper by Bolton, Mehran and Shapiro. http://www.newyorkfed.org/research/staff_reports/sr456.pdf)

I believe we need to fix incentives properly. I’d like to stop the (gravy) train before it ever leaves the station and support the aims to get bankers focused as they should be — and the behaviors aligned.

It’s a tough task. And I think regulators have a very important role in encouraging this tough work to prevent what happened from happening again. Every day I see what not doing the tough work has cost so many people and I do not like what I feel inside as I think about it.

We can do this. Happy July 4th.

The Value Alliance and Corporate Governance Alliance www.thevaluealliance.com

Eleanor Bloxham www.eleanorbloxham.com

Copyright 2010 The Value Alliance Company. All rights reserved.
 

 

Governance & Ethics & Risk Eleanor Bloxham on 29 Jun 2010

The Butterfly’s Wings: Choices and their Risks

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My latest Digest publication available at http://www.thevaluealliance.com/PDF/CGADigest062810.pdf weaves a number of themes from current news into a picture.

Some of those themes and their meaning may be more apparent than others.

One term I coined in the discussion was “invisible features”. The use of the term ”invisible features” was used to convey the idea that consumers and capital providers are looking beyond what they used to. They are looking beyond what immediately impacts them to “how” something is made. They are looking beyond what immediately impacts them to “how” a company generates its returns. For example, is the environment being polluted? Are human rights being violated? Are stakeholders being harmed?

They are looking at  a whole set of criteria unrelated to the narrow performance criteria that individuals used to use in the past when deciding to purchase an item or buy a stock.

The narrow decision making of the past focused on the performance of the item in relation solely to the individual - does the product perform for me; does the stock perform for me. “Invisible features” mattered less — and when they mattered it usually related to notions of consumer protection in the narrow sense — of the performance features of the item for me. (For example, does the manufactured food contain a harmful ingredient or the toy a feature that may harm the child.)

As a world, we still have a foot in both places — the narrow decision making and the broader one — but the broader one exemplified by the broader “invisible features” contingent is growing larger and more vocal yearly, monthly.

I used the term “invisible features” rather than refer to governance or human rights or the environment or other related descriptions of how products are produced, services are conducted, or companies are run — because using those words creates certain connotations. And more than that, using those words tends to make people think of the ideas as separated concepts, distinct concepts — different from the process of making and selling a product or building a company and selling a stock.

Separate, however, is not the way  those who care about these matters view them — they see them as integral albeit “invisible features” — invisible features to the products and services they fund through purchases and invisible features to the companies they fund through purchases or through stock ownership. So I was hoping this use of the phrase would convey that.

Why is this important? As an example of “separated” thinking, there are directors who sit on boards who will say we don’t care about govenance — we are here to create value for the shareholder. Their statements are presupposing that the ideas of governance and shareholder value are separate and distinct.  I believe that is because the separate naming of the thing “governance” or “shareholder value”, along with the narrow way these things are described in common parlance, create an illusion of “otherness” — as if the concepts are not related. The separateness of the language contributes to a “separate camp” mentality i.e. “We are in the shareholder value camp, not the governance camp”. To my mind, in the long run, this “separate camp” thought process only produces lack of understanding not more.

So the usage of “invisible features” was there to try to bridge the chasm. We can all relate to these ideas from that standpoint I think — a feature creates a reaction in the mind of the customer. Nothing very controversial about that.

This edition of the digest was also seeking to present the conundrum of the choices we collectively make toward stability and instability — and how these are not either/or decisions. Humans exist with a need for both — and there are long term consequences that occur related to our choices. In the short run transfering risk to others could seem good in a very narrow sense, for example, but it has boomerang effects to those that transfer risks elsewhere that often are overlooked.

The digest also hoped to portray (without using the words) the concept of the butterfly effect, the sense that small motions like the flapping of a butterfly’s wings can set in motion impacts that are large — and unimaginable. For example, the digest explores the idea of the impacts of the movement over the last 30 years toward defined contribution plans. The digest also explores the idea of the impacts of the commonplace use of layoffs. Both were adopted as mechanisms to promote corporate flexibility. Both transfer risk from the corporation to the individual. But have they produced the intended consequences? (This is a question the digest explores.)

The idea of layoffs has not always been commonplace but has been adopted in a somewhat “me too” fashion over the years similar to the idea of “offshoring”.

With respect to layoffs I was witness to a dramatic event in the life of corporations which occurred when I was attending a disaster recovery seminar in New York City. I don’t recall the exact date though a New York Times article seems to indicate it was February 16, 1993. That’s the day “I.B.M. ended its no-layoff policy” according to the article. I remember that day because as you can imagine there were a lot of IBM’ers at this seminar, given the subject matter. They were in shock. This was a reversal of the tradition of a 100 year old company.There was a sense of betrayal that day that IBM’ers felt that was palpable even if they were not the ones impacted. It represented a change in a social contract not required or instituted by government but a social contract honored by a highly regarded corporation, one that had been in place for many, many years.

When we think about the causes for any event, we often think of the immediate causes. It’s human nature — but we think less often about other causes and conditions that created consequences but are not immediately near to what we are exploring.

Take, for example, the financial crisis. All the reasons given for the crisis are part of the equation and I’ve written about them and discussed them elsewhere.

But all our dialogue hasn’t really addressed the intentions which we must address. There has been talk of greed, of course, but this has been in a narrow context.

Our dialogue hasn’t yet sufficiently addressed some root issues and our intentions with respect to them which we must address if we are to move forward in a non-knee-jerk way. 

What I haven’t seen discussed is the series of choices we have made collectively, over the last decades, related to risk and instability which influenced the crisis we have faced. Of risk transfers which exacerbated the financial follies.

Coming out of the great depression, a decision was made that stability in employment was a worthwhile social goal as was retirement security. Since then, that resolve has been forgotten in corporate life.

That choice has consequences to financial markets and political systems. Obviously there are elements of society that can make money because of risk and instability — they can turn it to their advantage. What is more difficult, however, is for us all to not suffer the consequences of that short term choice.

The digest ends on a note of hope — that we can take stock and make other choices, recognizing that what we thought might generate flexibility actually may stand in its way –  something to consider as we make our way through the new complexities we have created in a world of butterfly wings and interdependency.

The Value Alliance and Corporate Governance Alliance www.thevaluealliance.com

Eleanor Bloxham www.eleanorbloxham.com

Copyright 2010 The Value Alliance Company. All rights reserved.

Compensation & Governance & Risk Eleanor Bloxham on 15 Jun 2010

The Risks in Budgets and Plans

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Early in my career I ran a strategy and financial planning area — and designed and coordinated the budget process for thousands of employees. I gave up at least a couple of summers to this work which at that time was all consuming.

First hand I had the oppportunity to reflect on the downsides (that went beyond the long hours I put in) of traditional approaches to corporate financial planning, of budgeting processes, and tying bonuses to meeting or exceeding financial plans.

I’ve spoken about these downsides at conferences and written about them in my book Economic Value Management: Applications and Techniques http://www.thevaluealliance.com/economic_value_management.htm and in published articles. 

Now those downsides have been writ large in the story that is emerging about BP.

Yesterday, the House Energy and Commerce Committee released a letter to Tony Hayward explaining five instances in which BP’s employees had chosen to take cost saving rather than safety enhancing measures in the construction of the well.

References in the emails released by the Committee suggest that individuals at BP were highly cognizant of cost over-runs — and justification to “a plan” not necessarily explicitly discussed in-depth but ever “present in the room”.

In my book, I discuss some of the reasons traditional planning processes have become so popular. And despite that, what a small role (compared to the one they do play) they should play in corporate management. If nothing else, BP serves as an example of the harm they can do and the havoc they can wreck writ large across the Gulf of Mexico.

If we are to take heart that there is a lesson, beyond the event itself, one can be found in this. As a director, consider carefully the regularity with which plans are faulty and evaluate how good any company really is at planning (did your company forsee the breadth and depth of the financial crisis?). Consider this carefully before you consider tying peoples’ performance, reputation, promotion and pay to “plans”.

Consider carefully also the harm, as BP has shown, of doing so.

The Value Alliance and Corporate Governance Alliance www.thevaluealliance.com

Eleanor Bloxham www.eleanorbloxham.com

Copyright 2010 The Value Alliance Company. All rights reserved.

Ethics & ERM & Risk Eleanor Bloxham on 03 Jun 2010

Models of Thinking: Risks and Strategic Considerations; Ethics and Competence

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As I was perusing the Financial Crisis Inquiry Commission website, I ran across an exhibit  “Moody’s Correlated Binomial Default Distribution”.

It made me think about a conversation I had with someone at Moody’s about issues in capital attribution models using the binomial, in which I pointed out that the binomial modleling wasn’t an accurate way to model capital requirements.  

The math was easier to do using the binomial, I was told. (And everyone agreed that it was and did it that way.)

I talk about the fix to using the binomial for risk capital calculations and why it is important, in my book, Economic Value Managment: Applications and Techniques  http://www.amazon.com/exec/obidos/ASIN/0471354260/thevalueallia-20. The book shows an example of how the binomial consistently understates the risk/the amounts of capital required.

It also reminded me of a conversation I had yesterday with a group of directors in which I was discussing the importance of considering risk costs when making decisions.

One of the directors present asked me to relate an example where I’d used this so I picked one which impacted the financial crisis.

I told them about the securitization analyses I’d been involved with related to the risk of securitizing sub-prime and credit card portfolios.

If one ignored risk costs, securitizing these assets might make sense. Securitization provided a pop to earnings, which  managers liked. It had a downside though that has been likened to cocaine — a merry go round once started it is difficult to get off - once you had that pop to earnings it was difficult to resist replenishing it.

In contrast, I explained that if you included the risk costs of securization in the decision making model, securitzing these portfolios was “non-economic” i.e. non-value creating for the bank originators — all the advantage went to the investment banks who earned fees for putting them together.

The point of my story was that including risk costs in decisions can make a big difference and should be a regular part of financial and strategic decision-making — but it’s not often done. (I talk about this too in my book - i.e. how to include risk cost in decision making — and I outline the securitization example/analysis.)

Maybe of interest, I also told them this personal story related to the selling of securitizations by investment banks early in the life of my firm, which I founded in 1999.

I was approached by a person from an investment bank and another from a credit rating agency because they wanted to work together to sell securitizations and they wanted my assistance, to bring my “value cache’” as a sort of imprimateur in recommending securitizations to the banks.

I remember saying to them that every analysis I’d seen showed it was not in the best interests of the originating banks — it was non-economic for them –    Did they still want me to do it?

And the answer I received was yes.

I didn’t, of course.

For me, this is an example not just of risk modeling and making of strategic decisions but also how ethics and competency can get all muddled up.

Ethics and competence in a situation — Which is the chicken and which is the egg?

Guessing you have stories you have lived like this too where ethics and competence seem to intersect and become tangled.

The Value Alliance and Corporate Governance Alliance www.thevaluealliance.com

Eleanor Bloxham www.eleanorbloxham.com

Copyright 2010 The Value Alliance Company. All rights reserved.

 

 

Compensation & Governance Eleanor Bloxham on 26 May 2010

Short-termism and Performance Criteria

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Short-termism is often lamented for a time and then the issue fades to be revived again in fits of passion.

It is a subject I have written about for years and put into practice in the design of performance criteria for compensation plans.

The Corporate Governance Alliance Digest discussed the CFA (chartered financial analyst) community and the Business Roundtable coming together to plea to “Break the Short Term Cycle” in 2006. http://www.thevaluealliance.com/PDF/CGADigest072406.pdf

With the financial crisis, calls were renewed to address the issue in the banking community. Regulators, including the Federal Reserve and FDIC, have sought to describe in guidelines for the banking community the importance of longer term thinking in setting performance criteria. See http://www.thevaluealliance.com/PDF/arkansas_banker_feb2010.pdf  or listen to http://www.compensationstandards.com/nonMember/InsideTrack/2010/01_05_Bloxham.htm for discussions of the Federal Reserve’s recommendations.

Despite the discussions, issues exist. Fast forward to yesterday when the the Wall Street Journal’s “Best on the Street” survey for 2010 was published. The “Best on the Street” singles out analysts who have performed better than their peers.

So what is the performance criteria for analysts to be considered best on the street? I checked with Factset to get my facts straight. Performance returns used in determining the best on the street are based on one year or less of performance. Specifically, the returns attributed to an analyst are calculated as of the date of a recommendation (sometime in 2009) and last through the time of change of that recommendation (sometime in 2009) — or the end of year (2009), whichever comes sooner.

The awards of best on the street are therefore based on the ability to call short-term movements in stock price. The performance criteria are constrained within the  prior year i.e. an ancient astonomical measurement of the time it takes for the earth to revolve around the sun.

I think a different and longer time horizon is warranted, one suited to the long term investor.

It may seem a minor thing but performance criteria and time horizons matter even for non-cash payoffs. I have known people who go to what I consider extreme lengths to win awards.

With say on pay coming as a result of the recent financial reform measures passed by the House and Senate last week, performance critieria — and pay for performance will come into the spotlight even more.  Here’s an article I wrote for Fortune on that yesterday.  http://money.cnn.com/2010/05/25/news/companies/say_on_pay_law.fortune/index.htm

The Value Alliance and Corporate Governance Alliance www.thevaluealliance.com

Eleanor Bloxham www.eleanorbloxham.com

Copyright 2010 The Value Alliance Company. All rights reserved.

Governance & Boards in Crisis Eleanor Bloxham on 18 May 2010

The Massey Board Crisis, Risk Management and Shareholder Relations

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Preliminary results in the Massey election show the director election was very close.

According to a Wall Street Journal report by Kris Maher and Joann Lublin this afternoon: ”Michael Garland, a representative of CtW, cited preliminary results from a proxy voting agent and said Massey President Baxter Philips won reelection with 49.6% of votes withheld by shareholders, while outside directors Dan Moore and Richard Gabrys won reelection with 49.8% and 48.5% of votes withheld, respectively.”

In a press release today, Massey said that this was a “show of confidence” from shareholders. Final results will be available in Massey’s 8k filing in the next few days. 

Facing a criminal probe of its directors and officers, there is still much work to be done by the Massey board with respect to safety oversight as I explain in this article I wrote for Fortune which you can read here.

http://money.cnn.com/2010/05/17/news/companies/massey.shareholder.meeting.fortune/

Beyond the issues I cover in that article, there seem to be other issues with oversight.

For example, the proxy shows that Massey has a management risk analysis committee.

From the proxy: “A management risk analysis committee holds regular meetings to identify, discuss and assess enterprise risk from current macro-economic, industry and company-specific perspectives. The management risk analysis committee is comprised of the Chief Financial Officer, Chief Compliance Officer, Corporate Counsel, Sales Companies CFO and a Special Assistant to the Office of the Chairman.”  

Of note, no one wearing a safety or environmental hat sits on this committee.

Further, the interaction the board seems to have with this committee according to the proxy relates to financial risks only. “On a quarterly basis, the Finance Committee receives a report from the management risk analysis committee on our most significant financial risks, including a summary of the risks assessed and risk mitigation strategies.”

No where in the “Board’s Role of Risk Oversight” or elsewhere in the proxy does it state that the Safety, Environmental and Public Policy committee receives a similar report for the risks it oversees. 

Beyond these issues, shareholder relations at the firm need a boost. As an example of what not to do provided in this case, when shareholders are expressing concerns, boards, in their response, should take a deep breath and try to avoid antagonistic phrases such as:

  • As I am sure you are aware
  • You claim
  • This is patently false
  • I fundamentally disagree with the substance of your argument and do not subscribe to the formulaic approach you have outlined
  • You go on to mention a list of generic corporate governance issues without acknowledging
  • Narrow interests

Shareholder “relations” require a “relationship”. Polite discussion and even disagreement are possible but having a relationship is incongruous with a high level of antagonism.

The Value Alliance and Corporate Governance Alliance www.thevaluealliance.com

Eleanor Bloxham www.eleanorbloxham.com

Copyright 2010 The Value Alliance Company. All rights reserved.

 

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