The road to ruin

RECENT EVENTS at News International are a powerful reminder that apparently well-run, successful companies can suddenly find themselves in the depths of a crisis. Although this case was too late for our report, entitled Roads to Ruin, we looked in detail at 18 other crises during which enterprises came badly unstuck.

Seven of the firms collapsed and three had to be rescued by the state, while most of the rest suffered large losses and significant damage to their reputations. About 20 chief executives and chairmen subsequently lost their jobs, and many non-executive directors (NEDs) were removed or resigned in the aftermath of the crises. In almost all cases, the companies and/or board members personally were fined, and executives were given prison sentences in four cases.

One of our main goals was to identify whether these failures were random or had elements in common. We studied a wide range of corporate crises, including those suffered by AIG, Arthur Andersen, BP, Cadbury Schweppes, Coca-Cola, EADS Airbus, Enron, Firestone, Independent Insurance, Northern Rock, Railtrack, Shell and Société Générale.

And our conclusion? To quote Paul Hopkin of Airmic, the risk management association that commissioned the research: “This report makes clear that there is a pattern to the apparently disconnected circumstances that cause companies in completely different areas to fail. In simple terms, directors are too often blind to the risks they face.”

We divided the potential causes of failure into seven underlying risk factors, which are likely to be just as relevant to SMEs as they are to the type of company that we analysed. In many cases, the seeds of failure were known within the organisations, but not communicated upwards.

For finance directors and other senior executives, this report represents an opportunity to learn from other people’s misfortune. While the findings will need to be applied differently to different organisations, we identified several areas to investigate.

Start by considering the composition of the board. Do the NEDs have the skill sets and independence required to hold the board to account? Or is the board more like that of AIG, where chief executive Hank Greenberg surrounded himself with loyal friends and former colleagues? Or like that of Enron, where supposedly independent directors had separate lucrative consultancy contracts?

Question the reasons for success even more rigorously than the reasons for failure. If something seems too good to be true, it is probably hiding some weakness. Independent Insurance’s apparent market-beating performance was ultimately revealed to be down to non-recording of large losses. Northern Rock’s business model was over-reliant on the wholesale money market, and it had no plan B when this market seized up.

Review the flow of risk information both across and, more importantly, up and down the organisation. BP was lambasted by an official report after the Texas City Refinery explosion because it had not learned lessons from similar failings at its Grangemouth facilities. Make sure junior staff feel able to report concerns to their superiors. At Independent Insurance, middle management and senior staff departed rather than report their fears to their superiors.

Follow through on mergers and acquisitions. Doing the deal gets the adrenaline flowing, but completing the necessary organisational restructuring is less exciting and very demanding. Resist the temptation for senior executives to just move on to the next big deal.

Addressing issues such as these does not, of course, guarantee continued success, but we believe it greatly reduces the risk of failure.

Risk factors that underlie corporate failures

The seven areas of underlying risk weakness were as follows:

1. Board effectiveness: Limitations on board skills and competence, and the ability of NEDs to monitor and control senior executives effectively. For instance, BP’s board director responsible for refining at the time of the Texas City explosion had no refining experience. Independent Insurance’s NEDs did not have insurance industry expertise.

2. Board risk blindness: Failure of boards to engage with important risks, such as risks to reputation and licence to operate, to the same degree that they engage with reward and opportunity. For instance, Railtrack’s licence to operate depended on the UK government, but Railtrack outsourced responsibility for track maintenance. The Hatfield rail crash destroyed Railtrack’s reputation, and it was effectively nationalised.

3. Poor leadership on ethos and culture: The lack of a moral compass led the audit partners at Arthur Andersen to condone Enron’s aggressive and fraudulent behaviour. Double standards were perceived to be in operation when Maclaren dealt with its US and UK pushchair recalls and when SocGen ignored Jerome Kerviel’s breach of trading limits.

4. Defective communication: Railtrack and Network Rail had poor communication with subcontractors. In the EADS Airbus A380 case, problems of non-matching aircraft sections were kept from senior managers for six months.

5. Excessive complexity: The EADS Airbus A380 project involved immense complexity at the level of aircraft design, information technology, procurement, manufacture and assembly. In addition, it had to achieve Franco-German political balance, with two CEOs. The merger of BP and Amoco made BP’s management structure overly complex.

6. Inappropriate incentives: Arthur Andersen rewarded those who doubled audit fees through consultancy and punished those who did not. BP’s bonus scheme gave little credit for health and safety.

7. Information glass ceiling: Inability of internal audit or risk management teams to report on risks originating from higher levels in their organisations’ hierarchy. When concerns are raised, they are often ignored or over-ruled by senior executives. For instance, red flags raised by internal compliance over Kerviel’s trading patterns at SocGen had no effect.

Alan Punter is visiting professor in risk finance at Cass Business School