Risk Management Reports

August 2002
Volume 29, Number 8
 

Credibility Again

Credibility Again

Two months ago a long-time friend and reader, following dinner and several glasses of wine, suggested that I should write about more practical ideas and procedures for today’s risk managers. He argued that I was too esoteric and philosophical. I plead guilty! It’s the result of advancing age and my growing distance from the day-to-day problems that I once encountered when an active management consultant. I also read too many periodicals and journals that are crammed with purported handy “how-to-do-it” suggestions, and I sense that my commentary and perceptions, born of long experience, may be more valuable than touting current quick fixes. I may be wrong, however, and I will try to put forward more practical counsel.

I thought of one suggestion that, at the same time, is both practical and impractical. It has to do with organization credibility and executive compensation. In January I listed the credibility of an organization as the top risk management issue for 2002. Enron was then evaporating before our eyes and the egregious conflicts of interest in the investment community were just surfacing. Those developed into a deluge. Andersen, Tyco, Global Crossing, Worldcom, Qwest, Xerox, Merck and Adelphia are some of the prominent names that have soiled the press in the past seven months. More will inevitably follow, and all undermine the credibility of not only these corporations but also the entire system. The U. S. Congress proclaims outrage, posturing for the media, despite the fact that most elected officials willingly accepted the contributions of many of the corporate names in the scandal. Can senior executives be trusted? What about reported numbers, . the opinions of auditors, audit committees of Boards, the regulators who supervise companies, and financial advisors cannot. Is it possible that we’ve lost trust in all of them?

Our market economy is built on trust, and when it disappears it threatens the entire system. Credibility is an elusive and evanescent quality. It can’t be measured quantitatively and that may lead some of those who rely entirely on numbers to suggest that “credibility” doesn’t really exist. Yet it is critical to the successful survival of any organization, profit, nonprofit or governmental. It exists as constantly changing perceptions of various stakeholders. It is painstakingly built and easily crumbled, like a beach sand castle, when a rising tide of change obliterates it.

Much of the public and investor outrage of current months arises from the losses sustained by employees and shareholders while directors, senior executives, and their families escaped with fortunes. We learned of huge low or no interest loans, bonuses that beggar the imagination, obscenely inflated salaries, and, of course, those outrageous stock options, often prompting stock sales suspiciously close before the disclosure of bad news. Executive compensation was a malicious adjunct to the dot-com bubble of the end of the century. It skyrocketed beyond all reasonable limits, despite warnings from North America and Europe, in a form of feeding frenzy of the executive elite, each trying to outdo the other in gross pay packages. Too many listened to the film character Gordon Gecko and believed that “greed is good!” Too few argued that the system was out of control.

Absurd and irrational executive compensation was a major contributor to the current credibility debacle. A few years ago I suggested in RMR that the situation was out-ofhand. I suggested that risk managers should alert their management of the problem, but I acknowledged immediately that any risk manager (at that time I knew of no Chief Risk Officers) who had the temerity to question a CEO’s pay package would be out on the street. Reining in the excess was a start to re-establishing some credibility, but no one, not board members, nor regulators, nor even shareholders, wanted to question the express train that was the stock and compensation bubble.

So here we are, sitting amid the rubble of failed technology companies and the growing pile of restated earnings reports. What to do? My practical and impractical suggestion is the same as before: go to both senior management and the board and suggest that executive compensation be completely overhauled, and fast! What is the ratio of the annual income of the top 1% versus the bottom 1% of employees? Is it well over 40? Bring it down quickly. Smart CEOs will themselves suggest a radical realignment of income, making sure that bonuses, if any, are paid only when and if their efforts result in real and material gains for shareholders. Stock options are expenses and should be treated as such, not through panicked and politically inspired legislation of Congress but through careful revisions of accounting standards, firmly enforced by independent auditors, rotated periodically, whose sole responsibility is auditing (no consulting). Pay packages should be approved by shareholders and receive serious scrutiny of independent financial observers. Inflated senior management compensation corrodes the entire organization. Kevin Phillips wrote, “ As long as corporations are top-down mechanisms driven by the bottom line of their compensation packages and their institutional investors, it’s difficult for me to see what difference it makes if there’s spirituality or religion at the bottom half of the employee roster.” (from Across the Board, July/August 2002).

A risk manager, be he or she a Chief Risk Officer with real corporate authority, or a lower-echelon insurance, security or derivative manager, must stand up and shout that exorbitant executive compensation is a major problem for organizational credibility. In my opinion, it’s the practical place to start in the necessary revival of trust in our organizations and our system. For some, it will be dangerous, putting employment itself at risk. Under those circumstances, the best course of action may be to enlist allies with more organizational clout to advance the idea.

Finally, recognize that credibility can wax and wane for reasons well beyond our immediate control. I found that out this summer as I was organizing a new junior sailing program in Maine. I hired three instructors, developing considerable information on each through personal biographies, interviews, and references. My board and I knew a great deal about them, but they knew little about our nascent program other than the brochure that I sent them and my personal description. Yet I found that I had great credibility, simply because, as they became certified as instructors by the US Sailing Association, each of them received from a guidebook on sail training, one in which I had written (several years ago) a short chapter on risk management. I had forgotten that it was in the book, but its existence provided needed additional credibility for our new program!

I receive no remuneration so there is little risk that executive compensation will be a credibility problem for this foundation!

Re-establishing trust among critical stakeholders and the public continues as the most important risk management goal for this year, and it will be a critical issue for years to come. What role will you, as a risk manager, play in changing the public perception?

The defining end came because the managers took aim at the very heart of the system by gobbling it up to satisfy their own cupidity. When the gross greed at the top displaced the shareholders as Number One, the foundation of the whole structure caved in.

Peter L. Bernstein. “Shareholder Value for Whom? For What?” Economics and Portfolio Strategy, July 1, 2002

Copyright H. Felix Kloman and Seawrack Press, Inc.

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