Archive for the ‘Integrated Reporting and Accountability’ Category

Derivatives May be Ungovernable

The recent loss of 2Billion dollars by JPMorgan confirms what is now a blindingly obvious governance reality. Board of directors do not understand derivatives and cannot control management’s use of them. The same may be said for regulators.

One job of a board is to identify risks and ensure a proper system of risk management. If you cannot do this, you should not be on a board. This means that a director needs to assess the adequacy of the design and effectiveness of internal controls to mitigate the risks. Of the over 300 interviews I have undertaken in my research, including directors of large banks, only one director claimed to understand complex derivatives. How can directors assess internal controls when they do not understand the very instrument itself?

Other than Jamie Dimon, CEO of JPMorgan, not a single director of the board has any experience in banking. See the roster of directors here. Even if some directors were from the sector, it is debatable whether they would still understand the complexities of these products. For a basic explanation of what derivatives are, see here. U of T Rotman professor John Hull, a derivatives expert, has stated in an email to me “There is no question in my mind that a large financial institution should have on its board people (perhaps 2 or 3) who understand derivatives and other complex financial products.” Unless bank boards that oversee derivatives are prepared to have subject matter experts on their board who can effectively question management and insist on proper risk controls, other governance or oversight structures are needed.

Not only are boards incapable of controlling derivatives, but regulators may not be any better. Warren Buffett has said “Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts. In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” See Warren Buffett on Derivatives.

The question is what have we learned from 2008? Banks are bigger than ever, with most American mortgages concentrated in only a handful of banks, yet the risky bets and use of complex derivatives continue. Harvard law professor Elizabeth Warren yesterday called for a new version of the Glass Steagall Act. Yet independent Senator Bernie Saunders pronounced that Wall Street “runs” the Senate, implying that any attempt at further regulation would be forestalled. Mitt Romney has vowed to unwind Dodd-Frank on his first day as President. Look at the long list of political donations made by JPMorgan in 2011, here. And this is just one bank.

If derivatives are going to continue, regulatory conflicts of interest need to be addressed and boards need to have the directors with the expertise to oversee them.

Does Canada have a White Collar Crime Problem? A Red Flag Checklist for Directors

“This city, this province, this country has a reputation of being the best location to carry out white collar crime, corporate fraud, in the industrialized world.”

These public words are not from some scholarly journal but from a hard-hitting, no-nonsense corporate director, Spencer Lanthier, (PDF profile) as he received his award at the annual Institute of Corporate Directors dinner last year – a sort life-time achievement award for a select few directors. Guests at my table were shocked to hear this, as was I, so I followed up to interview Mr. Lanthier for an illuminating interview. I also went for lunch with former colleague Al Rosen who wrote the book “Swindlers,” which I am now reading and equally eye-opening.

Flash-forward to 2012 where the Nortel trial is now underway to examine what role directors or officers might have played in that alleged fraud. See a headline from last week: “Toronto lost nearly $1M to fraud in 2011, auditor-general reveals”and the twelve cases identified by the auditor general. See this excellent report (PDF), courtesy of Tim Leech in my LinkedIn group Audit Committee.

Here are some questions: Do directors on boards play a role in detecting and deterring fraud? Can they be held responsible or even liable if they do not fulfill this role properly? Increasingly the answers are “yes,” especially given UK and US legislation since the financial crisis. I remember one of my very first board meetings I observed. It was of a bank. At the break, a director got up and shook my hand. He leaned over and whispered in my ear that the number one role of a director was to watch for fraud. I never forgot this.

Here is a list of 10 red flags and suggestions I have compiled based on my work recommending governance enhancements for companies accused of fraud or other malfeasance, including very well known Canadian companies.

1. The Audit Committee must fully understand how the company’s business model, estimates and judgmental choices by management give rise to potential manipulation of financial reporting by that management. Audit Committee members should be selected and educated on this basis. Financial literacy is a low bar and is not enough. Educate yourself on how fraud happens if you are a director or audit committee member. If necessary, hire an expert to report to you individually or in closed session with the Audit Committee without any member of management present.

2. If your organization does not have an internal audit function, install one appropriate for your organization. The head of Internal Audit must report directly and confidentially to the Audit Committee and cannot be over-ridden by any company officer. If necessary, Internal Audit should report directly to the board.

3. The Audit Committee must approve the independence, budget, work-plan and succession of the head of Internal Audit. The board should direct the CEO and CFO to commit resources for further design and test of internal controls whenever necessary.

4. As a director, you are entitled to any piece of information and access to any personnel in fulfilling your duties under any circumstance. If any manager blocks you from doing your job, this is a red flag. Go on unscripted company tours unaccompanied by management to test for tone and culture whenever you can.

5. Direct management to conduct a survey on company culture, assisted by an independent firm, with results reported directly to the board. Act on the results. You may have a toxic workplace with undue influence, internal control override and bullying and not even know it.

6. The independent whistle-blowing hotline must have a protected mechanism for people to come forward. When fraud happens, fellow employees know and are your best source of defense. If employees do not have confidence they can come forward and have a proper investigation conducted, they won’t and fraud will fester. Whistleblowers can go to regulators directly (in the US) now and participate in a monetary reward. If they don’t have confidence in the hotline, they will quit, acquiesce or go directly to the regulator.

7. Direct independent advisors (consultants, and now auditors) to conduct a risk assessment of all management compensation packages to ensure compensation is not driving potential fraud, such as bonuses awarded on profit.

8. If any company officer is not 100% transparent with you, this is a red flag. You should meet in executive session without management in the room to discuss your concern, which is likely shared by other directors. If the CEO or CFO lack integrity, the tone at the top is broken and you have a serious problem. You do not need a reason to fire your CEO.

9. Your responsibility as a director is to direct if and when necessary. Legislation gives you this power but protocols enable it. If management has undue influence and keeps you at bay, your protocols are likely deficient. Boards, committees, chairs and directors all need terms of reference now. Don’t let management draft these important documents as they have an interest in not giving you the power you are entitled to by law. Draft your own protocols or have someone independent do it if you have a concern or want best practices.

10. Above all, be vigilant and assertive if or when necessary. No amount of compensation can ever make you whole for the reputational damage inflicted and protracted litigation that could follow allegations of fraud or other misfeasance for a company of which you are or were a director. The number one regret directors have is not speaking or acting when they could have or should have. Don’t let this happen to you and follow the above steps.


Back to top