It was a summer of unexpected calamity in Canada, from west to east. Who could have predicted an oil-filled train would derail, slam into the town of Lac-Mégantic, Que., and ignite, killing 50 people, leveling a swath of buildings and making multiple companies targets for damages, fines and, in the case of the prime culprit, Montreal, Maine and Atlantic Railway, bankruptcy protection? Or that Calgary and other Alberta communities and all their resident businesses would be hit with the biggest flood on record, with damages and recovery costs now estimated at $3 billion to $5 billion?
When companies think of risk, such high-profile disasters sit at one extreme on a continuum. But the fact that such events happen and the costs and impacts on companies, employees, shareholders and other stakeholders can be so severe, underscores the need for directors and senior management to have a handle on them. Sometimes, trouble can be prevented; but even when it can’t, if you’ve prepared properly, your company and your key personnel are much more likely to prevail.
What are the hot-button risks for boards and senior management today? The answers vary between companies, sectors and locations. But we’ve boiled it down to six major areas that continue to gain significance. To help our readers navigate and survive the potential impacts, we asked risk experts from law, governance and finance to tell us their best practices and best advice for each. Don’t say we didn’t warn you.
THREAT LEVEL: HIGH
KEY VULNERABILITY: DIRECTORS, SENIOR MANAGEMENT
Ambushed: Rona, Agrium, Telus and Canadian Pacific Railway. In the last year alone, some of Canada’s largest companies were targeted in dramatic proxy fights, and the number of these costly, public battles is increasing. A study this year by law firm Fasken Martineau counted 101 proxy battles between 2008 and 2012—up 84% from the prior five-year timeframe. The same study also found that dissidents won 54% of those battles. With shareholder empowerment on the rise (coupled with increased scrutiny placed on public companies) it’s imperative for boards to create a plan to protect themselves from the Carl Icahns of the world. And yet many haven’t.
“Look at two ends of the spectrum from the last couple of years. At one end is Canadian Pacific Railway, which was very visibly a poorly run company,” says Glenn Keeling, managing director at CST Phoenix Advisors. “On the opposite end of the spectrum is Agrium, one of the best-run companies that delivered great shareholder re- turns with an incredibly seasoned board. They came under that same scrutiny by an activist. Who would have ever seen that coming?”
Smaller and mid-cap companies, says Keeling, are also increasingly at risk. “The vast majority of activists are seeking a few seats and when you put up director election results that becomes a lightening rod,” says Keeling, adding these battles are no longer just about stock performance but wider governance issues as well.
“The thing management never seems to have as these events begin unfolding is time. They become emotional and highly charged. The battles become very public and the best way to combat that is to be prepared,” says Keeling. Priority one: knowing whom your major shareholders are. He says his firm runs scenarios with boards and senior management in which an artificial record date is set before they set out to identify as many of the company’s shareholders as possible.
David Salmon, partner at Laurel Hill Advisory Group, says once your shareholders have been identified, engaging with them on an on- going basis is important and that he’s shocked by how many times clients can’t identify their shareholder base when asked to. “You need to understand three main things,” says Salmon. “Who holds your shares? Where the shares are held geographically also makes a difference and what is the composition of your shareholder base? If you are mostly retail you will speak to them differently than if you have an institutional base. It helps define your message going forward.”
Meeting with top shareholders to find out what issues are critical for them, says Salmon, before discussing the feedback with the board is also good practice. “It’s about asking the right questions, like who does their voting? The person who is buying the stock isn’t necessarily doing the voting for them. Do they like your governance? Is majority voting a big factor for them?” he says. “If it is critical and they have a problem I’d rather find that out in a discussion than when a dissident is banging down my door saying you don’t have majority voting or in a proxy circular.”
Salmon adds that directors need to participate in ongoing shareholder engagement in order to foster an open dialogue about delicate topics. When investors are kept informed of long-term strategy they are less susceptible, he says, to arguments made by activists who are often only concerned with “short-term” gains.
THREAT LEVEL: MODERATE
KEY VULNERABILITY: DIRECTORS, KEY EXECUTIVES, SHAREHOLDERS
In July, a labour rights group published a report saying factory workers making Apple products at Chinese factories operated by Pegatron Corp. lead worse lives than those at the infamous Foxconn facility where 13 staff had recently committed suicide or attempted to do so. The report by China Labor Watch found that workers assembling the iPad and other Apple products worked at least 11 hours a day in hazardous conditions and lived in overcrowded and dirty dormitories.
While most companies focus on financial, legal or political risks when entering an emerging market, the Apple example demonstrates employment and safety issues that are often overlooked when assessing emerging market risk. “Safety regulations in a foreign jurisdiction, for example, could be just as strict as in Canada but not enforced so your own internal enforcement of those regulations fall by the wayside,” says Peter Dent, partner at Deloitte Forensic Services. “Because they don’t enforce that legislation, companies often feel they don’t have to live up to those standards in a foreign market, but that’s a huge reputational risk.”
Dent says energy and resource companies need to be especially wary of this because they often operate in areas where corruption is an issue. “You can essentially pay your way out of any problem including getting a concession or safety concerns,” he says. “In many emerging markets the governance, controls and enforcement of domestic bribery legislation is nonexistent. You go into those environments at your own peril.”
To help arm itself against this type of risk, a representative from head office (who speaks the local language) should be handling domestic affairs in the foreign environment. This representative should also deal with the local government since they are immune to pressures the local staff may face. “It’s much more difficult for [locals] to say no to a government official,” Dent says.
THREAT LEVEL: MEDIUM-TO-HIGH
KEY VULNERABILITY: DIRECTORS, STAFF, SHAREHOLDERS, COMMUNITY AT LARGE
In a letter to shareholders, Warren Buffet once wrote the “supreme irony of business management is that it is far easier for an inadequate CEO to keep his job than it is for an inadequate subordinate… if the board makes a mistake in hiring and perpetuates that mistake, so what?”
Entrenchment today is a major risk for boards, says Sylvia Groves, founder of the Governance Studio, a Calgary-based governance-consulting firm. The causes: lengthy directorship terms, poor succession planning and self-evaluation processes. “Name your disaster, whether it was Enron or the most recent financial crisis—in a lot of cases these were boards who had very long-serving members,” says Groves. “Often the newest director is 10 years in and more experienced directors can be 20 to 40 years in. They’ve been so close to management and other board members for such a long time that we have to give some credit to the idea that they may not be as objective as when they first started.”
Entrenchment isn’t a board’s only potential flaw, but many other related concerns such as gaps in skills, industry expertise or risk awareness flow from it. That also helps explain why, according to a survey by Reputability, a UK-based risk consultancy, boards’ lack of skills and a lack of independence from management are at the root of 88% of all company failures.
Groves says awareness of entrenchment risk is growing in Canada, while in other countries, such as the UK, age and term limits for directors are becoming the norm. Annual, anonymous third-party self-evaluations that allow directors to be frank, she adds, can be an effective tool against entrenchment: “Asking questions is critical and yet you don’t want to look like you don’t understand something in front of your peers. Entrenchment is group dynamics, psychology and team work and how that plays out in the boardroom,” says Groves.
Making succession planning a priority long before a board seat becomes available is also good practice. Despite the fact that the director population is aging, Groves says having regular discussions about what skills are required for the company to achieve its goals and creating a plan to obtain them is something too many boards still put off.
CORRUPTION AND BRIBERY
THREAT LEVEL: MODERATE
KEY VULNERABILITY: DIRECTORS, SENIOR MANAGEMENT, SHAREHOLDERS
On June 18th, legislation to amend the Corruption of Foreign Public Officials Act was passed, upping the maximum jail term for individuals convicted of foreign bribery to 14 years in prison (from five) in addition to unlimited fines. The biggest change, however, was closing a loophole that made it difficult for authorities to prosecute outside of Canada. Canadian authorities now have jurisdiction over Canadians and Canadian companies regardless of where an alleged activity takes place.
And south of the border as well, the U.S. Securities and Exchange Commission has enforced anti-corruption measures by slapping heavy fines onto several well-known multinationals. In the last two years Pfizer, Eli Lilly and Co., Ralph Lauren Corp. and Total S.A. were ordered to pay millions in fines and to settle criminal charges (US$398 million in Total’s case), for activities ranging from bribing officials for oil and gas contracts to failing to prevent a subsidiary from making unauthorized payments to phony vendors in India.
The damages aren’t limited to fines and prosecutions, of course. In April 2012, Wal-Mart Stores Inc. felt the wrath of investors upset over bribery investigations in the U.S. and Mexico and the company lost $10 billion in market value.
Solutions? Well, just don’t do it. Beyond that, according to Mark Morrison, partner at Blake Cassels & Graydon, companies must ensure that have in place a robust anti-corruption program that begins at the board level. He says leaner-run junior companies in the resource sector often don’t have an anti-corruption program in place despite working in risky environments and can run into problems when they experience rapid growth. “Anti-corruption is a perfect example of a measure being taken up front preventing a major issue down the road, especially for companies who are in high-risk and emerging markets,” says Morrison.
Detailed accounting checks to track business expenditures are also crucial, since auditors or accountants often spot issues. “More often than not a company hires an in-country or third-party agent, and unknowingly to the company, after getting paid the agent hands the government a chunk of that money,” says Morrison, adding companies should care- fully screen who they do business with. “Are they trustworthy? Do they have any previous convictions?’ Are you getting detailed invoicing and have a contract with terms and conditions regarding anti-corruption and bribery warranties?”
GLOBAL ECONOMIC UNCERTAINTY
THREAT LEVEL: MEDIUM-TO-HIGH
KEY VULNERABILITY: SENIOR MANAGEMENT, SHAREHOLDERS
Global economic uncertainty has been a persistent source of anxiety and risk for boards and executives worldwide since 2008. While Canada’s domestic economy has been solid, if sluggish, since 2010, many countries and regions, especially in the Eurozone, have seen defaults, currency shocks, layoffs and unemployment. If you’re doing business there or have other ties, what do you do?
According to a recent report from Deloitte, the most common answer is that you take a closer look at the viability of local parties you rely on. A full 90% of the companies surveyed said they had done this; nearly half (42%) have severed some relationships; almost 33%, meanwhile, have already taken steps to protect them- selves against the possible “unwinding” of the euro.
At a more general level, on the board front, directors are encouraged to look ahead. “Traditional board meetings are set up to be too focused on earnings and not on forecasting,” says Harry Blum, managing partner of Collins Barrow Toronto, and a director on the board of Pure Nickel Inc. (TSX:NIC). Although each business has unique financial risks, Blum says proper economic forecasting can help most boards better arm themselves while strengthening the ability of directors to challenge management’s assumptions.
One piece of advice for directors is to establish pre-determined quarterly meetings with the accounting team in order to review future business risks along with present financial details. Blum suggests these financial forecasts fall between 12 and 24 months. “After that the quality gets compromised. But boards today need to be far more forward looking than backward looking.”
The next piece, advises Blum, is maintaining a culture of transparency and integrity as a management core value. “It’s human nature not to want to share bad news and we are highly regulated but you need that culture. If it could impact the business and value of the company it has to be disclosed.”
ENVIRONMENTAL, SOCIAL AND GOVERNANCE RISK
THREAT LEVEL: HIGH
KEY VULNERABILITY: DIRECTORS, MANAGEMENT, SHAREHOLDERS, OTHER STAKEHOLDERS
Over the last decade, disasters like the BP spill in the Gulf of Mexico and the Enron collapse have forced the way companies handle environmental, social and governance factors into the spotlight, says Andrea Bonime-Blanc, CEO and founder of GEC Risk Advisory of New York. And shareholders, she says, are using this information when making investment decisions.
According to a global poll by the Institutional Investors Group on Climate Change, for example, a survey of asset managers and owners in 10 countries (representing $14 trillion in holdings) found that about 53% of the asset managers made decisions to divest from or avoid a company because of climate change investment policies.
“Human rights, supply chain and governance issues effect everybody. You don’t have to be in the resource extraction industry for this to be relevant,” says Bonime-Blanc. “True or not, we live in an age where anyone can post anything about anyone. Reputations are being damaged overnight. Management has become more aware that they have to manage environmental, ethics and compliance concerns partly because there are more investigations and collaborations between governments than ever before.”
“Environmentally speaking, this goes beyond [physical disasters]. Climate change risks can affect potential supply chain,” says Bonime-Blanc. “If you are a beverage company and need access to clean water to manufacture and there are predictions of a water scarcity issue in that area that’s an environmental risk that’s become an operational one.”
Bonime-Blanc recommends that boards ask management to develop an operational risk framework, identifying the various types of risks (including ESG factors) specific to their business and dividing them into categories such as the ones most likely to occur or issues most costly to corporate reputation. “Boards need to ask the CEO and management team to present what they are doing to mitigate these risks,” says Bonime-Blanc, adding cyber security is the next type of risk stakeholders are pressuring companies over. Inviting risk experts (such as a climate scientist) to organize an educational session for the board regarding industry-specific best practices, and incorporating quarterly updates from management on how various risks are being managed, she says, are part of a good risk management program. Creating a risk committee to oversee these issues is another best practice, as is incorporating new risk factors into strategic conversations about entering new markets for example.
“The big trend here is that it’s not all about financials anymore, it’s about the other stakeholders beyond shareholders who have skin in the game, whether they are customers, local communities or employees,” says Bonime-Blanc. “Boards have to start thinking more holistically about their mandate.”