Understanding the causes of corporate failure

Judging by experience, the coming 12 months will see some 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 blowout and the News International hacking scandal had nothing to do with the credit crunch and were largely internally induced.

Whether or not we are directly affected by 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 their work, the researchers produced 18 case studies involving 23 companies that had suffered life-threatening corporate crises. The companies, which had aggregate precrisis assets of more than $6 trillion, include: AIG, Arthur Andersen, BP, Northern Rock, Railtrack, Société Générale, Maclaren, EADS, Independent Insurance and Cadbury Schweppes. The result is the report Roads to Ruin.

Six of the firms had collapsed (with three of these having to be rescued by the state), while most of the remainder suffered large losses and significant damage to their reputations. About 20 chief executives and chairmen subsequently lost their jobs, and many nonexecutive directors were removed or resigned. Although the firms studied were all large and multinational, the lessons are, in my view, 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 cases?

The report demonstrates convincingly how events that bring down or seriously damage otherwise successful companies do not just happen. The findings show that they are commonly the result of boards’ being blind to the underlying risks that threaten their companies. And there is a link between the apparently disconnected circumstances that cause companies in completely different sectors to fail.

The researchers grouped the significant risk factors that lead to corporate failures under seven headings. Many, and sometimes all, of these factors can be identified in every one of our case studies.

It is one thing to identify the potential problems, quite another to determine a course of remedial action. The report does not tell readers how to run their companies. Rather, it is intended as a resource, leaving organisations to determine how best to apply the lessons.

The factor that appears at the top of the list – “board effectiveness” – is critical. Get that right and the rest will fall into place. On the other hand, if the board 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 it does not understand the importance of risk management.

Corporate disasters can nearly always be avoided but, sadly, we know there will be more.

RISK FACTORS BEHIND CORPORATE FAILURE

1  LACK OF BOARD EFFECTIVENESS
Ineffective boards suffered from limitations on skills and competence, as well as on the nonexecutive directors’ (NED) ability to monitor and control senior executives effectively. For instance, the board director who was responsible for refining at BP at the time of the Texas City refinery explosion had no refining experience. Independent Insurance’s NEDs did not have insurance industry expertise.

2  BOARDS' RISK BLINDNESS
This is characterised by a board’s failure 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 example, Railtrack’s licence to operate depended on the UK government, but the company outsourced track maintenance, despite the fact that this was one of its core responsibilities to its customers.

3  POOR LEADERSHIP ON ETHOS AND CULTURE
Double standards were perceived in cases such as Maclaren’s dealing with its US and UK push-chair (baby stroller) recalls and Société Générale’s ignoring breach of trading limits by Jérôme Kerviel.

4  DEFECTIVE COMMUNICATION
Railtrack and Network Rail did not communicate effectively with subcontractors. In the EADS Airbus A380 case, problems of nonmatching 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 to the need to achieve Franco-German political balance between two chief executives. The merger of BP and Amoco made BP’s management structure overly complex.

6  INAPPROPRIATE INCENTIVES
BP’s bonus scheme gave little credit for achieving good health and safety standards.

7  INFORMATION "GLASS CEILING"
This is characterised by an inability on the part of internal audit or risk management teams to report on risks originating from higher levels in their organisations’ hierarchy. For example, red flags raised by internal compliance over Kerviel’s trading patterns at Société Générale had no effect.

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 only one of two major players in the sector 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 $213 billion in 2001. At the end of the third quarter in 2007, AIG’s consolidated assets were $1.072 trillion and shareholders’ equity was $104.07 billion; 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 $100 billion and had to be rescued by the US government with a lending facility of $182.5 billion, meaning that it had effectively been nationalised.

AIG’s weaknesses stemmed in large measure from risk blindness and the overriding need to grow the company and its profits by 15% per year in an often extremely competitive environment.

It all started to go wrong when then New York Attorney General Eliot Spitzer accused the company of bid-rigging with insurance brokers. Although nothing was ever proven against AIG, another even more serious allegation was substantiated: that AIG had produced misleading accounts and used spurious reinsurance policies to inflate profits.

One executive went to jail, and the company paid out $1.6 billion to settle civil charges, while former Chairman Maurice “Hank” Greenberg himself paid $15 million to settle SEC charges that he had 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 next in the shape of the subprime crisis, which destroyed AIG’s credit default swap portfolio. An apparently risk-free source of wealth turned almost overnight into a liability of almost unimaginable proportions. 

This is a classic example of risk blindness caused by a desire to pursue profit at almost any cost. Lessons to be learnt include:

• Always question the causes of success. Something that appears to be too good to be true probably is.

• Beware the cult of personality. Too many of Greenberg’s decisions were never adequately questioned by those around him.

• Have strong and independent nonexecutive directors. AIG’s NEDs were, overwhelmingly, personal friends of the chairman or loyal colleagues or senior politicians and officials not chosen for their understanding of insurance.

• Beware complexity. AIG’s structure, like some if its products, was extraordinarily intricate.

• Ensure that risk and remuneration are correctly aligned. 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.

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. To obtain the report, e-mail: mark.taylorson@airmic.co.uk

Illustration: Borja Bonaque