Dateline: November 5, 2007, Chicago
The vast majority of nonprofits cannot relate to Merrill Lynch's $8.4 billion loss for its third quarter. Most would say, "If only we had that type of money to lose." Despite the disparate numbers, Merrill Lynch's problems have great relevance to nonprofit boards, as should be apparent to anyone who reads the excellent article by reporters Graham Bowley and Jenny Anderson appearing in yesterday's New York Times—Where Did the Buck Stop at Merrill?, Oct. 4, 2007. Bowley and Anderson focus less on the astronomical losses and more on...
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the role of the board.
When lawyers speak to boards, be they for-profit or non-profit boards, they speak in terms of duties of loyalty and care. Unfortunately, the resulting discussion concerning these legal doctrines rarely tells boards what they are supposed to be doing in the boardroom. We have long argued that one specific function of any board is to monitor what we refer to as "core" risks. For example, if the organization is involved with child care, its board should be asking questions about procedures that are in place to prevent incidents of child abuse. That example should provide you with a sense of what we mean by "core" risks. These are risks that can quickly lead to an organization's downfall if not properly assessed and managed.
It is our view that boards have specific oversight responsibilities when it comes to the core risks, as opposed to the more mundane and minor risks that nonprofits face every day. This does not mean that the board must assume management responsibility. Let's return to our child care agency to illustrate what we mean. The board is not charged with and should not be conducting background checks on all employees, nor is the board charged with developing the specs for any video surveillance equipment. As part of the board's oversight responsibility, however, the board should be asking management about the controls and protocols that management has put in place to address the core risk of child abuse. The board must do more than just accept what management says it is doing. It must gain some expertise, ask questions, challenge the adequacy of controls and protocols, and demand frequent reports regarding efforts to manage the core risk of child abuse.
There is nothing that makes investment in mortgaged-back securities an inherently core risk. However, when a financial intermediary like Merrill Lynch makes what the reporters describe as a "headlong foray" into these assets as a core business activity, then that activity warrants treatment as a core risk, particularly when Merrill moves away, as it apparently did, from packaging and selling the mortgages to holding them as investments. In commenting today on Citicorp's announcement yesterday to write-down an additional $8.5 billion to $11.0 billion in these assets, CNBC's Steve Liesman asked why intermediaries like Merrill and Citicorp were taking such large positions onto their books. He recognized that these forays were unusual in terms of the business model. Implicitly, he was painting these positions as core risks because of their relative size, complexity, and impact on the core business model.
A number of experts in the Bowley and Anderson article comment on what degree of fault Merrill's board bears for the massive losses. One expert, H. Rodgin Cohen, the chairman of mega-corporate law firm Sullivan & Cromwell, draws a sharp distinction between oversight and day-to-day management. He points out that the board is responsible for the former, not the latter. We are not surprised that Cohen sees a sharp dichotomy. He is in the business of advising boards, according to the article. Any willingness to blur that distinction on his part runs counter to the perceived interests of his clients—we would argue that encouraging his client boards to be more proactive actually serves their long-term interests.
We, like some of the experts quoted in the article, are willing to blur that distinction a bit. That is not to suggest that board members should have been reviewing Merrill's books in greater detail, marking individual securities to market, standing in the trading room, or reviewing econometric models. However, the article lists some things that the board should have been doing as part of its oversight function. One financial analyst, Meredith Whitney said, "You would think you would want some experts on subprime because that was the risks they were taking on." In other words, once Merrill began to take large positions in sub-prime securities, the board should have retained an outside expert to help it better understand the issues that came with such positions, or even added an expert to the board. We should add, we don't know that they didn't do just that.
Bowley and Anderson also point to a "revolving door of talent in the upper echelons of the firm." The board should have been asking why this was happening and what effect it was having on Merrill's culture. The potential impact of a revolving door is reflected in today's headline over the Wall Street Journal's right-hand column: In Citi Shake-Up, Broader Troubles: Perform-or-Die Culture Leaves Thin Talent Pool for Top Wall Street Jobs. To set the tone at the top, the board must monitor what is happening throughout the organization. The turnover suggests that there may have been too much emphasis on short-term performance, which could lead to those running the organization taking on inappropriate risks. Citicorp's board should have been probing the implications of such turnover.
Other experts referred to in the Bowley and Anderson article pointed out that Merrill had become the top issuer of collateralized debt in the marketplace, resulting in soaring profits. That, according to the experts, "should have caused directors to ask whether the risks being taken to generate higher profits warranted better controls." While we are not fans of "the everyone else is doing it" mentality, the board might have also asked why others in the industry were not jumping on the bandwagon. That question was posed this morning on CNBC's Squawk Box, when one of the anchors asked whether Goldman Sachs had avoided the bullet by steering clear of the subprime market.
Some have argued that Merrill's board had no reason to be concerned because the rating agencies were blessing the investments with high ratings. Other experts quickly disagreed, noting that there was a lot of discussion in the marketplace as to whether the rating agencies had it right, particularly given the difficulty in valuing these securities and the apparent lax origination on the underlying mortgages. Still other experts suggested that the board could rely on the regulators given the signficant amount of oversight by the SEC, Federal Reserve, and other governmental regulators. Right or wrong, the lesson is quite clear: Boards cannot rely on others to do their jobs. Just because a nonprofit is filing reports with the state or the IRS does not mean that those bodies are reviewing the reports or analyzing them correctly. Boards should not rely on outside auditors to fill the gap when it comes to monitoring core risks, either. That is not the function of the outside auditors.
At the end of the day, most of the experts quoted by Bowley and Anderson aren't calling for micro management by the board. Instead, they are suggesting that the board be aware of the environment in which the organization is operating, obtain outside expertise, ask probing questions and demand thorough responses, continually monitor the situation, and demand that management put in place specific procedures and protocols to manage the core risk.
Returning to today's edition of CNBC's Squawk Box, we believe it was Steve Liesman who pointed out that it has been upper-level managers and two CEOs who have now received the axe on Wall Street, but that the officers who monitored risk have held their positions. That could be an indication that the advice of the risk managers was being ignored or not reported to the board. If that was the case, then these boards should be thinking of how they can develop more direct lines of communications with those in the organization who are charged with monitoring risk. It may have been that in the drive to maximize short-term profits, the warnings from the risk management officers located deeper in the bowels of some large financial institutions were filtered out before they could get to the boards.
As we said at the outset, most nonprofits couldn't lose $8 billion even if they wanted to, but each nonprofit has its own core risks that come with its business model. Nonprofit boards should take a close look at what is happening on Wall Street, as evidenced in the Bowley and Anderson article. The lesson is clear: They must be proactive in monitoring core risks. That means seeking unfiltered expertise either from outside the organization or from individuals within the organization who currently may not have ready access to the board. It means asking questions and demanding meaningful responses, reviewing the adequacy of written protocols, monitoring the environment and the practices of like organizations, and setting the right tone at the top.
Internal Revenue Service - Circular 230 Disclosure: As provided for in Treasury regulations, any advice (but none is intended) relating to federal taxes that is contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any plan or arrangement addressed herein.
THE FOREGOING IS NOT AND SHOULD NOT BE TAKEN AS LEGAL ADVICE. IF LEGAL ADVICE IS REQUIRED, THE NONPROFIT OR OTHER PARTY IN QUESTION SHOULD SEEK THE ADVICE OF QUALIFIED LEGAL COUNSEL. If you liked this post, please visit http://www.charitygovernance.com for a description of our training and consulting services. You will also want to acquire a copy of Jack Siegel's book, A Desktop Guide for Nonprofit Directors, Officers, and Advisors: Avoiding Trouble While Doing Good."
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