The current credit crisis is of a new breed entirely, and executive management needs a new set of tools to overcome the many threats posed by the economic downturn. Risk management, cost reduction, and an emphasis on raising capital should be among the priorities of any director hoping to weather the storm.
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Managing in Today’s Troubled Environment: A Primer for Directors and Senior Managements
The Challenge
On Tuesday, October 7, 2008, The Wall Street Journal reported on page one: “The deepening malaise illustrates how the financial crisis has moved far beyond U.S. sub-prime mortgage troubles to a much more fundamental breakdown of trust. … The problem has become so severe that it’s affecting not only banks, but regular companies, which are finding it more difficult to borrow money for everyday activities such as paying workers and buying supplies. If sustained, the freeze in short-term-lending markets will weigh heavily on the weakening global economy. Investors are now coming to recognize this harsh reality.”
The credit crunch is constraining needed borrowing — and spending — not only by large and small businesses, but by consumers as well. The equity capital
markets as well have experienced a global meltdown. These circumstances, combined with weakening economic performance in the U.S. and globally, present an extremely challenging business environment — one which is wide-ranging, deep and of uncertain duration.
In this troubled environment, directors and senior managements of public companies should pay close attention to the risk profile of their companies. Many
companies — far beyond those in the financial sector — are or may be facing the
perfect liquidity and capital storm of declining operating cash flow, fixed (or increasing) costs and limited availability of new credit and equity capital and/or the withdrawal of existing credit.
This memorandum highlights for directors and senior management key matters they should consider as they address in the current environment their role as
overseers of the business and affairs of the public companies they serve.
Start With The Basics
Risk oversight is a basic function of senior management and directors of U.S.
public companies. State corporate law, Sarbanes-Oxley provisions and stock exchange rules each address this function.*
Under Delaware law, applicable to many public companies, directors and officers owe fiduciary duties of care and loyalty, including a duty of oversight to implement a reporting system or other controls allowing management and the board to monitor the company’s business and become informed about potential material risks. In general, they are expected to exercise informed, disinterested and good faith business judgment in seeking to identify and manage material business risks. If they act in this way, the decisions they make should continue to be judged under the deferential business judgment rule presumption. However, if there are “red flags” signaling risk — a judgment often made in hindsight after potential risks are actually realized to the detriment of the company — ignoring or paying little attention to them may well later lead to claims of failure of oversight, particularly questioning the directors’ good faith.
How does this apply today? Given the daily flood of reported events and commentary regarding the current credit crunch, the capital markets meltdown, the slowing economy and the adverse effects in general on financial and other businesses, boards and managements would be prudent to consider company specific risk reviews appropriate to their circumstances. In addition, given the lightening speed with which companies previously regarded as sound have been rendered distressed or even insolvent, boards and senior managements should also understand how to exercise properly their fiduciary responsibilities in the event that their companies were to become distressed or considered to be in the zone or vicinity of insolvency.
The importance of the risk oversight function at the board and senior management level is underscored by, among other things, the post-Enron Sarbanes-Oxley 404 requirement that public companies assess the effectiveness of their internal controls over financial reporting (and that senior officers annually certify as to their adequacy) and the NYSE requirement for listed companies that the audit committee, at a minimum, discuss the company’s guidelines and policies with respect to risk assessment and risk management and the company’s major financial risk exposures and processes by which management monitors and seeks to control such exposures.
Beyond legal and regulatory requirements, one reality of today’s world is the prospect that perceived failures of risk oversight, which arguably lead to demonstrable damage, will result in media, shareholder and perhaps governmental scrutiny. Prompt examination into currently identifiable or anticipated risks to the company’s business is the best way to avoid that spotlight.
What To Do Now
Few industry sectors would seem to be safe from pressure on their businesses resulting from the current troubled environment. Each sector and each company is different, and there is no “one size fits all” approach to identifying and dealing with risk. However, in the present environment, the initial inquiry seems clear: “show me the money.” Companies should examine their liquidity needs and sources and their capital needs and sources, factoring in the prospect of decreasing operating cash flow and more limited, more costly or perhaps no access to credit or equity capital.
Among the actions directors and senior management should consider are:
• Initiate a prompt review of the company’s current business/operating plan for the next 12 to 24 months, using the most current data and trends in doing so, with specific focus on liquidity and capital requirements and sources, and develop a revised plan as appropriate.
• Identify and, if appropriate, implement cost reduction and other cash conservation measures, including suspension/termination of stock buyback programs (in today’s environment, liquidity and capital preservation may well have priority over repurchases at “cheap” prices).
• Establish a program for monitoring, on a real time basis, the key indicators of the company’s performance, with prompt reporting to the board (or appropriate group within the board) of material variances and their potential consequences.
• “Stress test” the company’s business plan against downside scenarios, including, if of concern, possible negative credit rating agency announcements.
• Pay particular attention to assumptions regarding key contributors to operating cash flow — such as projected year-end holiday sales (for a retail business), projected level of parts orders (for a parts supply business) or projected vacation traveler bookings and cancellations (for a travel-related business).
• Understand and take into account direct and indirect exposure to derivatives and risks around “mark to market” assets.
• Identify and evaluate risk issues related to the increasingly globally interconnected nature of many U.S. businesses, such as business process outsourcing or supply chain interruptions or shutdowns in Asia or elsewhere.
• Determine what capital expenditures in the company’s existing plan are “essential” and those commitments which can or should be deferred or are discretionary.
• Re-examine the company’s sources of liquidity and capital underlying the current business/operating plan, and assess whether and the extent to which they should be considered reliable going forward. In particular, assess the accessibility, and risks to accessibility, of the company’s (1) short term liquidity resources, including cash and cash equivalents temporarily invested in third parties, revolving credit facilities, open lines of credit, normal deferred payment terms for third party goods and services, and commercial paper markets, and (2) longer-term capital resources, including free cash flow and capital markets for debt and equity. Consider contingency planning for access to alternative sources of liquidity and capital beyond the company’s traditional sources.
• Review debt agreements (including affirmative, negative and financial covenants) and the company’s other material agreements against the company’s current plan, and downside scenarios, to evaluate potential compliance issues with respect to covenants and agreements (for example, collateral calls, covenant defaults, cross defaults and accelerations, put rights and joint venture governance rights).
• Consider communications planning, internally and externally, on a contingency basis, should circumstances develop to the point where special communications to the company’s various constituencies are warranted.
• Consider (with experts) whether and how to respond to misinformation and rumors which may be having an immediate impact on the company’s stock price.
• Review the company’s current disclosures and continue to oversee them going forward, in light of the company’s financial position and risk profile under current and developing conditions.
• Evaluate the appropriate frequency of board and senior management meetings in order to devote the time necessary to understand the issues facing the company, the options available to it and the risks of each, and then properly and contemporaneously document the efforts of the board and senior management.
• Undertake a thorough corporate governance review (including a review of exculpatory charter provisions and the scope and limits of liability insurance coverage, as well as the financial strength of the carriers) and implement (or continue to monitor compliance with) corporate governance best practices with an emphasis on the board’s and senior management’s good faith exercise of their responsibilities and reaffirming the right “tone at the top” of the company.
Not all of the actions outlined above will be appropriate for each risk review. What is important is that an informed assessment be made as to whether, in the current environment, a particular company needs to initiate a risk review and, if so, which of the outlined actions (or other actions) make sense to take in order to implement an effective review.
Disclosure
Directors and management should recognize and be prepared to deal with disclosure requirements which may apply to the risk review and related matters discussed above. The management discussion and analysis (md&a) section of periodic reports on Forms 10-K and 10-Q filed by SEC-registered companies expressly requires discussion of liquidity and capital resources. Moreover, the SEC has provided detailed guidance on what the md&a section should address with respect to liquidity and capital resources. Any risk review program undertaken should have the benefit of this guidance. Beyond quarterly reporting, disclosure issues related to liquidity or capital resources may arise on an interim basis, including in response to certain Form 8-K reporting obligations or to correct or update prior company disclosure. Previously issued forecasts should be evaluated carefully to determine whether they need to be modified or withdrawn, and forward-looking statement “safe harbor” language should be reviewed in light of the current environment. Furthermore, the disclosure rules of the various exchanges and the duty of candor under state corporate law should be considered.
Use of Experts
To be timely and effective, and to enable directors to rely on expert advice, in many cases it will be prudent to engage outside assistance in planning and executing a review of the type described. Almost always this will include legal counsel familiar with the type of review contemplated, including the duties of directors and senior management in these potentially difficult situations, the processes used and issues addressed, the manner in which the review should be documented, and the disclosure issues which may arise and how the company can satisfy its disclosure obligations. Accounting firms, financial advisory firms and communications firms specializing in these types of situations often prove helpful, as well.
Conclusion
Many businesses are under real pressure from external sources — a severe credit crunch, an equity markets meltdown and weakening economies in the U.S. and elsewhere — which may well present unusual business risks. Directors and senior managements need to focus on their responsibility to oversee the business and affairs of their companies, and to take action reasonably designed to identify and respond to these risks. Prompt consideration is the best means of mitigating damage and satisfying their responsibilities.