24 Apr 2017
School for Scandal
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Some rather unpleasant boardroom scandals
The company boardroom is synonymous with images of grandeur from polished mahogany tables, to cut glass tumblers and men, yes mostly men, sitting in front of a vista of skyscrapers and towers.
The board has a serious role worthy of the setting. It monitors company performance, makes strategic decisions and sets targets, manages risk, ensures regulatory compliance and manages stakeholder communications.
Mostly it does this work smoothly and competently but, as in other areas of life, it is also prone to moments of scandal which wrecks careers and companies.
One of the biggest profile disasters was the bankruptcy of US investment bank Lehman Brothers in 2008. Its bankruptcy filing, with $639 billion of assets and $619 billion of debt, was the largest ever recorded and greatly exacerbated the then nascent global financial crisis by rocking equity markets in the US, Europe and Asia.
Lehman’s demise was triggered by its involvement in the subprime mortgage market which floundered as part of the collapse of the US housing market in 2007. Lehman, founded in 1850, had acquired a number of subprime lenders in the early years of the millennium whose basic business model was to offer mortgages to people with low credit ratings.
When the number of defaults on subprime mortgages began to soar Lehman’s executive team told investors that they would have little effect on earnings and that the risks, both to it and the US economy, were well contained.
Indeed, despite the worsening credit crisis and the continuing slump in the housing market, Lehman continued to underwrite more mortgage-backed securities.
Eventually, in June 2008, it reported a second-quarter loss of $2.8 billion. It said it had cut its exposure to residential and commercial mortgages but it was too late. Its creditors cut credit lines and hedge fund clients began to pull out.
Attempts to seal a takeover deal failed and in September it declared bankruptcy with the loss of around 27,000 jobs.
The profit and growth culture of the company was believed to have been a key culprit in its demise. Chief Executive Dick Fuld and the board were accused of failing to take into account the full risks of subprime lending, preferring to rake in millions of dollars of salary, bonuses, and options during the housing market bubble.
Chairman of the House of Congress’s oversight committee Henry Waxman said after the collapse:"You made all this money taking risks with other people’s money."
Fuld defended himself stoutly. “It was all about the team. My people were in it together. Regardless of what you heard from Lehman Brothers’ risk management, I had 27,000 risk managers, because they all owned a piece of the firm.”
Drexel Burnham Lambert
A similar disconnect between medium and long-term risk and profit chasing had come two decades before, in 1990, with the bankruptcy of investment firm Drexel Burnham Lambert.
At the end of 1988, the group was performing well with $1.4 billion of capital and 50% of junk bond underwriting.
However, within a year its market share had plummeted and it was losing tens of millions of dollars a month.
The culture of the group was a belief that they could, according to a Fortune magazine piece at the time, “leverage themselves and their clients to the hilt without preparing for the day debt would go out of fashion”. One former officer told Fortune: “You see, we thought we were invulnerable”.
“You see, we thought we were invulnerable”
CEO Frederick Joseph and the board of directors were not hot on employee supervision meaning that staff such as the head of high-yield bonds Mike Milken were accountable to no-one.
This partly led to Milken, who was said to sit in the middle of an X-shaped desk in California, trying to milk the system and ended in him being indicted for racketeering and securities fraud in 1989.
A former colleague said at the time that the West Coast office was run as “structurally antisocial entrepreneurship bordering on anarchy”.
Even after this blow the group still failed to implement adequate management control and a series of warnings from staff that a liquidity crisis was set to damage the firm were ignored.
A similar disconnection between the board, management, and employees was uncovered at Japanese conglomerate Toshiba last year. Chief executive Hisao Tanaka fell on his sword after he admitted knowledge of the company inflating profits by £780 million dating back to 2008.
“I see this as the damaging event for our brand in the company’s 140-year history. I don’t think these problems can be overcome overnight,” he said after bowing in apology at a press conference.
His predecessors, vice chair Norio Sasaki and adviser Atsutoshi Nishida also stepped down.
An independent panel looking into the issue said there existed a corporate culture at Toshiba where it was impossible to go against the boss’ will”. It described a systematic involvement including by top management and a deliberate attempt to inflate the appearance of net profit.
Toshiba was under pressure following the global financial crisis and 2011’s giant earthquake which led to the Fukushima nuclear power plant disaster.
But Koichi Uedo, head of the panel, said there were no excuses. “A company representing Japan to be doing something like this institutionally was shocking,” he said.
Accountancy plays a big role in boardroom scandals.
One of the most infamous is that of US energy firm Enron. A Wall Street darling in the 1990s it became bankrupt in 2002 after it began to use mark-to-market accounting to cover up and write off huge financial losses at its trading business and other operations. It also hid large amounts of debt and toxic assets. Investigations into Enron’s practices soon followed which resulted in the company having to restate earnings back to 1997.
Executives were charged with felonies such as insider trading and securities fraud. The scandal decimated $74 billion of shareholder funds and led to thousands of job losses. Its auditor Arthur Andersen also had to close its doors.
Another US scandal which sounds straight from the pages of a John Grisham novel was the Hewlett-Packard spying affair of 2006. The computer group, under the direction of chair Patricia Dunn, hired private investigators to find the source of a boardroom leak. Board members, employees and journalists were trailed by detectives who raked through bins and used a technique called pre-texting where they impersonated individuals to obtain phone records.
Dunn claimed she did not know the methods the detectives were using but later that year HP said she had resigned because her presence on the board was creating a “distraction”. Chief Executive Mark Hurd said the motives behind the investigation were appropriate though the techniques used were “very disturbing”. He vowed to transform the board into one “shareholders can be proud of”. For any company, not just HP, to be able to deliver this the genesis of dozens of other debacles over the decades must be fully understood.
Who remembers Polly Peck International and its owner Asil Nadir who stole around £29m from his companies and its shareholders in the early 1990s? Nadir was so powerful he could move money around the group without approval from any other director.
It landed in his bank account to spend on property, golf, prize cattle and sheep.
What of Italian food group Parmalat whose directors concealed a $14 billion black hole in its finances in the early 2000s through a series of accounting techniques? Chief Financial Officer Fausto Tonna chillingly telling reporters before going to court: “I wish you and your families a slow and painful death”.
IS THERE A CENTRAL THEME?
There is undoubted arrogance involved. The feeling, perhaps gained through the insularity of the board, that anything they do is permissible. They have the power and believe they have the authority, nous and intelligence to use it.
Why play by normal rules? For that to fester it means a breakdown in communications with the rest of the business and external stakeholders. Nobody questioned the boards of the scandal-hit companies because either there was a culture of not doing so or there were no mechanisms to do so. As companies become more global the task of managing different cultures and expectations becomes more difficult. But boards need to keep applying checks and balances both on their companies and themselves to ensure that investors, stakeholders and the public can believe in the maxim that big business can do good.