Many people have analyzed the meltdown of platinum-branded financial institutions, amazed at how quickly they went from supposedly sound and powerful to being taken over or filing for bankruptcy. The lessons to be learned, and hopefully not forgotten, are far-reaching at several levels.
Boards of directors can look to recent words of Jim Kristie, editor and associate publisher of Directors & Boards, whom I respect as knowledgeable about governance matters. His words: “Frankly, boards have let down the nation and its capital markets. Boards have not had the right leaders in place; they have not adequately analyzed risk; they have not had the depth of knowledge of their company’s operations that they should have had; they have not done a sufficient job of helping management see the big picture in front of them and in seeing around corners as to what lies ahead, and they have not acted smartly and speedily as conditions deteriorated and management faltered.”
Some may view that as a harsh assessment, but based on what transpired, challenging it is difficult. I’ve written extensively over past months on where too many boards went wrong and where they must improve to carry out their responsibilities effectively. This month, we’ll look at where management “faltered” in one particular case: Merrill Lynch.
Leading Up to the Cliff
Published reports describe Merrill Lynch’s then-CEO Stanley O’Neal as an “autocratic leader” overseeing a group of trusted lieutenants, who led Merrill’s profitable but “belated” push into the market for collateralized debt obligations. One executive, the overseer of the firm’s mortgage operations, often played the “tough guy … silencing critics who warned about the risks the firm was taking.” Another, who oversaw risk management, contributed by “loosening internal controls.”
What immediately comes to mind is a tone at the top not only allowing, but driving, the firm toward the edge of the cliff. We know too well how a chief executive and loyal team can have a take-no-prisoners approach, mandating action while stifling dissent.
Also telling is the phrase “belated push.” More than a few financial firms in the last few years saw competitors reaping bushels full (or more like warehouses full) of profit. Merrill Lynch reportedly was one of the late-arrivals, envying Lehman Brothers and other early birds for the cash they were hauling in. Regular readers of this space may remember my column from several months ago that discussed the pitfall of keeping up with the Joneses. Disaster awaits those late to the party, playing catch up and struggling to gain on competitors, because that is when rules get broken and common sense is ignored.
Looking Deeper Into the Abyss
Particularly telling are observations of John Kanas, then CEO of North Fork Bancorp, which was considering a merger with Merrill Lynch several years before. After spending some time getting acquainted with Merrill’s management team, he said, “in the end, we were put off by the fact that we couldn’t get comfortable with their risk profile, and we couldn’t get past the fact that we thought there was a distinct possibility that they didn’t understand fully their own risk profile.”
It only gets more interesting. Consider some of the other published reports out there:
The vice chairman responsible for credit and market risk management, corporate governance, and internal control allegedly “weakened Merrill’s risk-management unit by removing longstanding employees who ‘walked the floor,’ talking with traders and other workers to figure out what kinds of risks the firm was taking on,” according to former Merrill executives.
Replacements of those employees were loyal to the chairman and his lieutenants, pushed to be “more concerned about achieving their superiors’ profit goals than about monitoring the firm’s risks.”
Another senior executive, known to carry a notebook with daily profit and loss information, “would chastise traders and other moneymakers who told risk-management officials exactly what they were doing.”
The toxic environment was reported to be such that “there was no dissent … so information never really traveled.”
Against this backdrop, and unlike Goldman Sachs and J.P. Morgan Chase, which seemed to understand the dangers of the CDO and synthetic CDO markets and managed their risks, Merrill “seemed unafraid to stockpile CDOs to reap more [and more] fees.” Within four years, Merrill went from a bit player to reportedly the world’s biggest underwriter of these products.
Rejection From the Likes of AIG
And it only gets “better.” The reports point to a scenario where American International Group, which had been insuring Merrill’s CDO exposure, decided to pull out. But did this stop or even slow Merrill? When Merrill “couldn’t find an adequate replacement to insure itself [and] rather than slow down, however, Merrill’s CDO factory continued to hum and the firm’s unhedged mortgage bets grew, its filings show.”
Lessons All Too Obvious
My sense is that many readers of this column are smirking, nodding your heads, concluding that these are no-brainers. How could this be allowed to happen? Where was the logic, the risk management, the common sense? Who allowed controls to be ignored? Weren’t there established risk tolerances, and a portfolio view of risk in relation to the firm’s risk appetite? Where was the infrastructure? Where was the board?
Unfortunately, what happened at, and to, Merrill has happened before—and, regrettably, I’m comfortable predicting that it will happen again. The reality is that when a senior management team decides to drive at breakneck speed toward the edge of a cliff, only a few things might be able to save a company and its shareholders:
One (or more) senior line or staff personnel—such as knowledgeable operations executives, a chief risk officer, chief compliance officer, or chief audit executive—with sufficient understanding of what’s happening and ability and courage to go straight to the board. Such action is fraught with personal danger, and may well cost the individual his or her career, especially when the communication falls on the board’s deaf ears.
Communications channels that allow personnel who see a company heading for danger to provide warnings outside normal reporting channels, up to the board level, with enough strength to gain attention.
A board of directors that truly understands the company’s culture and tone at the top, strategy, operations, and risks, and knows where the company is going, and is willing to confront a strong CEO and top management team.
A regulatory system that has a similar understanding, and is positioned and willing to take action to provide protections. Clearly this has not been the case heretofore, and we need to wait to see what the coming regulatory changes will bring—and to what extent a future regulatory structure will focus on individual firms versus systemic risk.
As we consider what can help save a company from the blindness that ruined Merrill, a few fundamental necessities emerge. The board of directors must ensure the company’s strategy makes sense, that the internal environment is healthy, that an effective control infrastructure is in place and operating well, and that risks are well understood and communication channels open.
We began by focusing on the board of directors, and now wind up at the same place. Directors have an incredibly difficult job, with significant risks inherent therein. They work part time, outside the mainstream of a company, with tremendous responsibility. But there is no role more important to Corporate America, and corporate boards must have the right participants, protocols, and skills to do the job well.
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