The coming 12 months will see some big corporate crises in apparently mighty companies that once seemed impregnable. We do not yet know their identities, but they will suffer serious long-term damage and possibly collapse altogether.

Every year brings its crop of company disasters, and recent ones have by no means all been related to the financial crisis. The BP Deepwater Horizon blow-out and the News International hacking scandal had nothing to do with the credit crunch and were largely internally induced events.

Whether or not we are directly affected by or involved in such failures, there is clearly great benefit and commercial advantage to be derived from studying them and learning the lessons.

It was with this in mind that my association, Airmic, commissioned the Cass Business School to analyse the causes of corporate failure. As part of its work it produced 18 case studies involving 23 companies with aggregate pre-crisis assets of more than $6trn, all of which had suffered potentially life-threatening corporate crises.

They include: AIG, Arthur Andersen, BP, Northern Rock and Cadbury Schweppes.

The result is the report, “Roads to Ruin”. Six of the firms had collapsed (three having to be rescued by the state), while most of the rest suffered large losses and significant damage to their reputations.

Around 20 chief executives and chairmen subsequently lost their jobs, and many non-executive directors were removed or resigned. The firms studied were all large and multinational, but the lessons are equally relevant to most SMEs.

The brief we gave the Cass team was to establish the extent to which there is a pattern to corporate failure: are there common themes that can be identified or are they apparently disconnected in their causes?

Is failure just a risk you have to accept in the quest for growth and increased profit? How can people with an interest in risk management benefit from understanding these case histories?

The report demonstrates convincingly how events that bring down or seriously damage otherwise successful companies do not just happen. It shows that they are commonly the result of boards being blind to the underlying risks to their companies.

And there is a link between the apparently disconnected circumstances that cause companies in completely different sectors to fail. It is one thing to identify the potential problems, quite another to determine a course of remedial action.

The report does not tell the reader how to run their company. Rather, it is intended as a resource, leaving different organisations to determine how best to apply the lessons.

Board effectiveness is critical. Get that right and the rest will fall into place. On the other hand, if the board merely pays lip service to risk management or sees it as a mechanical, box-ticking exercise, or just as an issue of compliance, then it is clear that is does not understand the importance of risk management.

CASE STUDY: AIG
Corporate failures do not come much bigger than the once-mighty AIG. Envied in the insurance world for its consistently big increases in premium income and profit, it was one of only two major players to enjoy a coveted AAA rating.

AIG grew with breathtaking speed to become the world’s largest insurance group, reaching a peak market capitalisation of $213bn in 2001.

At the end of the third quarter 2007, AIG’s consolidated assets were $1.072trn and shareholders’ equity was $104.07bn; in early 2008, it was the 18th largest public company in the world. Less than a year later it had notched up annual losses of nearly $100bn and was rescued by the US government with a lending facility of $182.5bn, meaning that it had effectively been nationalised.

Among the many people to lose their jobs and reputations were the legendary chairman Hank Greenberg and Joseph Cassano, who headed up its financial products subsidiary AIGFP.

AIG’s weaknesses stemmed in large measure from risk blindness and the over-riding need to grow the company and its profits by 15 per cent pa in an often extremely competitive environment.

It started to go wrong when the New York attorney-general Eliot Spitzer accused the company of bid-rigging with insurance brokers. Nothing was ever proven against AIG, but another more serious allegation was substantiated: that it had produced misleading accounts and used spurious reinsurance policies to inflate profits.

One executive went to jail, the company paid out $1.6bn to settle civil charges and Greenberg paid $15m to settle charges from the Securities and Exchange Commission (SEC), the US regulator, for having altered AIG’s records to boost results between 2000 and 2005.

The resulting fall in share price and, above all, reduced security ratings were a body blow to the company’s financial products operation in London.

When the AAA rating disappeared it became more expensive for the company to post cash collateral for its derivative products, destroying profit. And worse was to follow. The really devastating news came in the shape of the sub-prime crisis, which destroyed AIG’s credit default swap portfolio.

An apparently risk-free source of wealth turned almost overnight into a liability of unimaginable proportions. This is a classic example of risk blindness caused by a desire to pursue profit at almost any cost.

Lessons to be learned include:

• Always question the causes of success. Something that appears to be too good to be true probably is too good to be true.
• Beware the cult of personality – too many of Greenberg’s decisions were never adequately questioned by those around him.
• Have strong and independent non-executive directors (NEDs). AIG’s NEDs were overwhelmingly personal friends of the chairmen, loyal colleagues or senior politicians and officials not chosen for their understanding of insurance.
• Beware complexity. AIG’s structure, like some of its products, was mind-blowing in its intricacy.
• Align risk and remuneration. As with some banks, traders in the financial products division made a killing when profits were high, but (apart from losing some of their bonus money) were not liable when the risks they took went sour.

CASE STUDY: SHELL: Oil and gas reserving
Immense damage was done to Shell after it confessed to a 23 per cent overstatement of its proven oil and gas reserves. This led to record fines, director resignations and a radical restructuring involving a reduction of Shell’s independence.

Shell is a long-established FTSE 100 company. It is one of the largest international energy companies, operating in at least 90 countries.

At the time of the event it formed part of the Anglo-Dutch giant, Royal Dutch Shell Group.

Royal Dutch Petroleum owned a 60 per cent interest in the group and Shell Transport and Trading UK had a 40 per cent interest. The group had an unwieldy dual board structure and was listed on the New York, London and Amsterdam stock exchanges.

A major part of the value creation of an oil company is the location of new oil and gas reserves to replace those it extracts. These reserves, still in the ground, represent many billions of dollars, but investors cannot easily verify the amounts of oil and gas they contain.

This uncertainty prompted the SEC to implement rules for the calculation and reporting of “proven” and “unproven” reserves.

Proven reserves are those where there is a high certainty as to the quantity of oil and gas in the ground, and how much can be extracted. Unproven reserves are those where there is less certainty over volume or how much can be extracted. The latter have significantly less value for investors.

For a number of years prior to 2004, Shell used a different basis to calculate reserves than that of the SEC. After the implementation of the rules, the SEC and the Financial Services Authority (FSA), the UK regulator, examined stated reserves more closely.

They became uneasy about Shell and in 2001 gave the company indications that they felt the figures were incorrect, followed by stronger warnings in 2002 and 2003. Shell’s senior management appeared to have rejected these concerns.

On 9 January 2004, Shell announced that its “proven” reserves were 20 per cent less than it had reported. It revised the figure three more times (on 18 March, 9 April and 24 May) before admitting it had overstated its reserves by around 23 per cent. This amounted to tens of billions of dollars (depending on the future price of oil). It had to make a further restatement on 3 February 2005.

Shell also twice restated its financial results for 2001 and 2002, and once for 2003. Shell’s audit committee commissioned an independent review by US law firm Davis, Polk & Wardwell. In April 2004 the review severely censored the chairman who had previously been Shell’s head of exploration and responsible for the reserve figures, and his successor as head of exploration.

They were obliged to step down, and were followed by the finance director. Particularly damaging was the disclosure of a series of internal emails, including one dated 9 November 2003 in which the head of exploration said he was “sick and tired of lying about the extent of our reserves issues”.

The January 2004 revision caused Shell’s share price to fall by more than nine per cent. It trailed the FTSE Oil & Gas Producers sector thereafter – as shown in the chart. In July 2004, the SEC fined Shell a record $120m after an inquiry found that the company had violated record-keeping and anti-trust rules in relation to the reporting of proven reserves. The company also had to pay an FSA fine of £17m in relation to the same matter.

Three senior directors resigned. Over the next two years, the chairman fought to clear his name. The FSA (2005) and the SEC (2006) decided not to take action against him. He had maintained from the beginning that he had acted in good faith.

It should be noted that under new SEC rules on oil and gas reporting, Shell reported a significant increase in proven oil and gas reserves for 2009 that may go some way towards supporting the previous chairman’s views.

The replacement chairman, Jeroen van der Veer, was brought in to restore the company’s credibility. He scrapped bonus schemes linked to oil reserves as he believed they provided an incentive to exaggerate such reserves.

Indeed, The Wall Street Journal reported that internal auditors had mentioned this, together with “systemic problems with the company’s reserves reporting procedures”, to the external auditors as early as 2002.

Chart: Shell share price compared with the FTSE Oil & Gas Producers sector and Brent Oil price

In November 2004, the group said it would change its unwieldy dual board structure to a single capital structure, with one board of directors. It achieved this by creating a new parent company, Royal Dutch Shell.

A lawsuit based on the over-reserving resulted in a payment of $352.6m to non-US shareholders in 2007. As part of the settlement, Shell agreed to request that the SEC distribute to shareholders the $120m Shell paid to the SEC in 2004.

A class action for US shareholders was settled for $82.85m in 2008. Van der Veer changed the corporate culture. By 2010, trust was restored to the extent that the company, now known as Royal Dutch Shell, was voted third in Management Today’s peer group survey of Britain’s Most Admired Companies.

Lessons to be learned include:

• Admit mistakes quickly and gracefully.
• Don’t appear to reward failure.
• Incentives must inspire the desired behaviour.
• Ethical best practice can’t be adopted selectively.
• Organisations need a fully effective and functioning conscience.
• Directors need to be vigilant at all times.
• Financial irregularities can have an exceptionally high impact.
• Fresh faces may occasionally be needed at the top of the organisation.

Paul Hopkin is technical director at Airmic, the UK-based association for corporate risk managers and insurance buyers, which commissioned the Cass Business School report “Roads to Ruin”.