Confidence at the Board Table

When Managing Uncertainty, You Cannot Avoid “Dumb” Questions

2010-03-05T12:34:00.002-06:00

Do Boards Take Bets? (Part Two)

When Managing Uncertainty, You Cannot Avoid “Dumb” Questions

By
Hugh Goldie
Associate, The Exchange Group

[Author’s Note: This article is the second part of a two-part series on the governance of risk. The first article was published in the previous issue of the ICD magazine "Director."]

Would you buy a house if the only way you could see what is inside was to look through the windows? What if the only way to get information was to question the occupant – or the neighbours from the street? That is not unlike what directors are required to do. Unlike the CEO and senior management, directors cannot observe events as they unfold. They meet only six to eight times per year. They review information prepared mostly by the CEO.

Given those limitations, how can directors respond to the increasing demands for more effective risk management by boards? How can boards gather and assess the information needed to fulfil their obligation to the corporation and its shareholders? What windows can directors look through? What questions can they ask to manage the board’s bets and “buy the right house?” Part one of this series began to answer those questions.

Part one introduced Peter Bernstein’s rule that risk comes into play only when we place a bet on an outcome that will result from a decision we have made. (Risk does not exist in isolation!). Risk was defined in part one as an event or situation that could compromise or enhance our ability to achieve an objective. Part one also introduced Frank Knight’s generic risk spectrum with “measurable risk” at one end and “uncertainty” at the other. He portrayed measurable risk as being quantifiable using available data and probability theory. He portrayed uncertainty as being unquantifiable, emerging from situations for which there is little data, and for which probability theory is unusable.

Finally, part one concluded that boards place many bets. Most are at the uncertainty end of the risk spectrum. Hiring a CEO and approving a strategic plan are two examples for which the board has decision responsibility. While boards cannot manage enterprise risk, part one concluded prudence demands that boards manage their own bets.

What Windows to Look Through? What Questions to Ask?
An excellent place to start is with the ICD’s Key Competencies for Director Effectiveness. First published in 2005, they have become accepted for use by the Global Director Development Circle consisting of the Governance Institutes from Britian, the United States, Australia, New Zealand, and Canada. The ICD’s Director Education program is directed to developing the competencies directors need to operate in an environment of uncertainty.

The ICD Competencies document is a concise single sheet printed on two sides, handy for quick reference. On one side are the “Tasks” in which boards participate. On the other side are the “Key Competencies” directors require to effectively participate in those tasks. The Tasks are like windows through which directors can look into the corporate house. They are listed below, grouped into major task areas. (The items shown in italics are additions which in my view are important aspects of the board’s responsibility.)
A Setting Strategy and Approving Strategic plans
1. Understanding and evaluating strategic plans and reports presented by management
2. Recognizing and validating management’s and fellow director’s underlying decision assumptions
3. Ensuring appropriate risk levels
4. Prioritizing relevant risks
5. Monitoring financial performance.

B Ensuring Management Capacity
1. Selecting, hiring, developing and evaluating top management
2. Developing effective succession plans for top management
3. Setting and negotiating compensation for top management.

C Ensuring Board Capacity
1. Supporting an effective and efficient board meeting process
2. Selecting board members with appropriate skills and experience.

The flip side of the ICD document defines the “Key Competencies” directors need to effectively look through the widows and, as a group, use the data they gather.
1. Knowledge of Specific Industry, Company, and Executive Team
2. Knowledge of Board and Role
3. Financial Acumen
4. Group Decision Making Orientation
5. Process Orientation
6. Independent Thinking Skills,
7. Open-Minded/Information Seeking Skills
8. Ambiguity Tolerance
9. Effective Judgement
10. Integrity
11. Self-Awareness
12. Orientation to Resolve Conflict
13. Effective Communication and Listening Skills.

The ICD’s Key Competencies are the skills and experience required to know what questions to ask, what answers to expect and how to assess gaps that may appear. The task is made complex by the imperfections and uncertainties inherent in predicting the future.

Imperfection leads to Uncertainty in Formulating Strategy
Focusing on strategy formation, Frank Knight stated that we cannot predict our future with certainty because the activities we use to arrive at our decisions and execute our plans are imperfect. [1]
1. We cannot accurately judge the totality of our present situation;
2. We cannot assess how the future will unfold with any degree of dependability;
3. We cannot accurately predict the consequences of our own actions;
4. We rarely execute our plan in the precise form in which it was made; and
5. We cannot accurately know or predict the actions of others who could impact our plan.

When developing strategy in the absence of perfect knowledge and judgement, we are obliged to make assumptions about the cause-and-affect relationships that will drive our plans. In making those assumptions we put into play, long term uncertainties that shift and change over time.

Consider a management strategy to raise profitability by increasing revenues. Such a strategy must be driven by changes in selling price, sales volume, sales mix, or by a combination of these factors. Underlying these changes must be assumed cause-and-affect relationships defining how the changes will be made and how likely they are to succeed. For example, a strategy to increase revenues by increasing prices may assume that the revenue lost from any decrease in sales volumes will be more than offset by the price-per-unit increase.

Prudence demands that the board examine the uncertainties associated with these assumed cause-and-affect relationships, conclude how likely they are to occur and whether the company has the capacity to implement the strategy successfully.

The recent purchase of Cadbury PLC by Kraft Foods Inc. provides an example of this kind of questioning. While in a different context, the form and rational for the questions is similar. In the midst of the takeover bidding, Cadbury published an update to its long range plan In its statement, Cadbury set aggressive new revenue and margin targets, projecting margins to rise from 13 percent in 2009 to 16-18 percent by 2013. The increases were based on assumptions of increased volumes and increase pricing. Kraft suggested that Cadbury Shareholders question the assumptions underlying these proposed increases, asking how they could be achieved given the uncertainties highlighted by Cadbury’s historical margin performance and given the current economic situation. The question left for shareholders to answer was whether they would benefit more from Cadbury’s initiatives, or from Kraft’s.

Directors need an opportunity to understand and verify the assumptions management intends to use in developing strategy. But reviewing assumptions only skims the surface. Directors need to understand the risks and uncertainties inherent in those assumed cause-and-affect relationships. They need to understand management’s approach to addressing the resulting uncertainty. They need to conclude whether management has the capacity to succeed in implementing the strategy. Management plans could be perfectly valid, or they could be flawed, or they could completely miss risks and uncertainties that are flying under management’s radar. Important as it is, the process of questioning assumptions and their underlying uncertainties is difficult for both the board and management.

Why the Dumb Questions?
The members of the management team are often wary of questions, the answers to which seem self-evident. They have spent long hours immersed in the subject, the details, and the choices made. As a result, they suffer from a cruel trick of human nature called the Curse of Knowledge. [2] They cannot understand why others do not share the same familiarity. They can feel their credibility is being threatened by dumb questions.

Directors are often wary of asking questions whose answers might be self evident to the management team, but are not evident to them. The little voice in their head asks, “What if this is a time-wasting, dumb question? Do you want to look dumb in front of your colleagues? People have planes to catch! Do you want to waste the valuable time of your fellow directors on dead end questions?”

But is the Board’s examination of assumptions not a point of opportunity and strength in strategy development? Part one suggested that managing uncertainty is a forward-looking, intuitive process done by a human brain, not a computer. It relies on an individual’s knowledge, imagination and capacity for solving complex problems. It requires a tolerance for ambiguity. It benefits from an ability to see the bigger picture and the ability to learn from previous experiences. Managing uncertainty requires objective thinking with an open mind in order to see possible trends, patterns and relationships which may not be readily apparent in any documentation. Some of the questions may seem dumb but we have all experienced “dumb” questions that turned out to be insights that others around the table had yet to experience.

But managing uncertainty is often hindered by being too close to the situation. Directors lack of familiarity with events as they unfold can give them the distance necessary to differentiate between the “forest and the trees”.

Management should welcome ‘dumb’ questions – and hard questions – from skilled people. They are simply directors’ ways of learning enough to feel comfortable about the strength of the plan, the metrics that could be used to track progress against the plan and management’s ability to carry it out. While directors’ questions may not change the plan, they often result in an enhanced set of contingency plans. The management team should not be offended by hard or dumb questions. The board is simply managing its bets.

Bottom Line? Boards Need a Plan
Boards make the most critical bets of all. Their bets spawn long term uncertainties that shift and change over time. They require considerable time to be realized. They require ongoing and focused attention to ensure that both the upside opportunities and the downside threats are identified and managed.

Part one of this series concluded from Knight’s “imperfections in predicting the future” that the fundamental downside risks are few, not many. They apply to all bets, including the board’s bets:
1. Failure to understand the cause and affect relationships that form current reality and are the source of the upside and downside of risk and uncertainty.
2. Failure to create a detailed execution plan that includes risks and uncertainties that can guide future decisions.
3. Sloppy execution of the plan by individuals who are unfamiliar with its details or insufficiently committed to its objectives.
4. Failure to monitor progress against the plan. “Never expect what you don’t inspect.”
5. Failure to act quickly when the objective is threatened.

The ICD’s Key Competencies for Director Effectiveness are an important component of a board plan to avoid “Knightian” failures. Boards need a plan to manage their own bets. They need the means to manage and monitor their plan. Some of the processes that are needed to manage the plan are known and used by some boards. They include involvement in strategy development; CEO evaluation; compensation reviews; board-member education and development; and senior management succession planning. Boards that use them must adapt to managing uncertainty if they are to adequately respond to widespread demands for improved management of the board’s bets.

[1] Frank H. Knight, Risk, Uncertainty and Profit, Hart, Schaffner and Marx; Houghton Mifflin Co., 1921

[2] Made to Stick, Chip Heath and Dan Heath, 2007, Random House

Do Boards Take Bets?

2010-02-14T14:58:00.001-06:00

Do Boards Take Bets?
Are Hot-Risks Simply Red Herrings?
Adding Clarity to the Debate on Risk

By
Hugh Goldie
Associate, The Exchange Group

Is everything we call a risk, actually a risk? Is everything we chase in the name of risk management worth chasing? The answer depends on whether your board is content to simply talk about risk or whether it wants to actively manage its bets.

Talk about risk became popular following the demise of Enron. It became big news following the collapse of Lehman Bros. and the emergence of our present recession. Recent talk about risk has initiated an alternative approach to risk and risk management that is simple and easily understood. In reality, it is misleading and dangerous.

Prior to its emergence as big news, “risk management” was a generic concept that lacked much appeal beyond a few professionals. It was hard to visualize and difficult to communicate. The standard definition of “risk” says it all:

A risk is an event or situation that could impact (compromise or enhance) our ability to achieve an objective.[i]

The 2008 bank failures in the U.S. and elsewhere piqued public interest about risk and the failures of risk management. Those who thrive on hot topics and headlines latched onto the use of “hot-risk” labels to stoke the discussion. As a result, “hot-risks” are news. Terms like reputation risk, compensation risk and the catastrophic Black Swan event[ii] create pictures of dangerous situations that are easily understood by the public and require little explanation.
Risk labels have been a boon for the general media, financial commentators and some consultants. The more risks they can identify, the more they have to talk about. Now, it seems that everything we do has a risk label attached to it. In a paper about pension plan management, the authors identified 54 different types of risk.

But risk labels have three serious downsides. Misdirecting risk management efforts is one. Risk labels direct our focus to the “back end” of the problem rather than the “front end”. Reputation risk is a good example. While the label “reputation risk” seems logical, threats to reputation are not a risk. They are a secondary impact, activated only when a risk event or situation has occurred. It is more prudent, and far less costly, to avoid the risk situations or events that could cause threats to reputation.

Yes, preparations to manage possible threats to reputation are important. The makers of Tylenol, the producers of Maple Leaf foods and TV host David Letterman demonstrated that good management can minimize their impact. In the Maple Leaf case, it is known that listeria bacteria consumed in processed meat can cause illness or death - and threaten the meat processor’s reputation. The real culprit, the real risk to be managed, is the possibility of bacteria collecting in the processing equipment.

Commoditization of risk is a second downside. When everything is a risk, then nothing is a risk. Risks become freestanding entities and risk checklists abound. When boards are constantly called upon to deal with a litany of risks like IT risk, reputation risk, litigation risk or fraud risk, they lose their sensitivity to risk. Boards intuitively know that everything is not a “red light” issue.

But boards are subject to fear. The commentary around hot-risk topics creates fear, the third downside. It discourages the prudent risk taking that is at the very centre of innovation, change and healthy growth. Peter L. Bernstein, the recently deceased guru of risk management,[iii] emphasized that “Risk doesn’t mean danger. It simply means not knowing for certain what the future holds.” Events we encounter as we execute our plan could cause the outcome of our bet to be better than we expected, or to be worse.

Richard L. Thompson, Chair of Lennox International, comments that, “The secret of success lies not in avoiding risk but in managing risk; avoiding ‘bet-the-company’ types of uncertainties, developing contingency plans for identified risks in the event they materialize and closely monitoring progress in order to respond quickly if the ‘bet’ is threatened.” [iv]

Start at the Front End
Bernstein zeroed-in on the critical starting point for risk management. Risk does not come into play until, “... we place a bet on an outcome that will result from a decision we have made.” In deciding to make our bet, we initiate a process to achieve that outcome. We cannot be certain about our success in predicting our future because the activities we use to arrive at our decisions and execute our plans are imperfect.
These imperfections were first catalogued by Frank H Knight as follows:[v]

1. We cannot accurately judge the totality of our present situation;
2. We cannot assess how the future will unfold with any degree of dependability;
3. We cannot accurately predict the consequences of our own actions;
4. We rarely execute our plan in the precise form in which it was made; and
5. We cannot accurately know or predict the actions of others who could impact our plan.

To that list we add an observation from recent research by Kahneman & Tversky:[vi]
6. We cannot be sure that we will recognize, or take advantage of, the upside opportunities that will occur as we execute our plan because we are hard-wired to be more concerned about imagined loss than potential gain.

Knight segmented generic risk into two categories, “measurable risk” and “uncertainty”. He saw “measurable risk” as being quantifiable using probability theory and available data. For example, computer models are built to quantify, hedge, and predict the future values of pension plans and investment portfolios. He saw “uncertainty” as being unquantifiable, resulting from unique situations for which no data are available for analysis.

The Generic Risks are Few
The fundamental downside risks are few, not many. They apply to all bets.
1. Failure to be detailed and disciplined in the examination of the cause and affect relationships that form our current reality and trigger our decision to proceed. Some of those relationships are specific to our business. Many are generic, common to business in general. As a bonus, when we understand our current reality at its most fundamental level, our options for future action are also clarified.
2. Failure to create a detailed execution plan that includes the inevitable downside risks and upside opportunities, to guide our decision-making.
3. Sloppy execution of the plan by individuals who are unfamiliar with its details or insufficiently committed to its objectives.
4. Failure to monitor progress against the plan. “Don’t expect what you don’t inspect.”
5. Failure to act quickly when the objective is threatened.

The Board’s Bets

Boards do not develop plans or execute them. But when directors approve their CEO’s plans, they place a bet. Boards make the most critical bets of all. They bet on a CEO, they bet on a strategic plan, they bet on a management team, they bet on an executive compensation scheme, they bet on a group of board colleagues and they bet on management’s financial statements, to cite some of the key bets. Using Knight’s definitions, these are all uncertainties that prudence demands be managed. That implies gathering information to demonstrate whether:

· The management team is committed to the project, has taken a disciplined and detailed look at the current reality surrounding its proposal and has developed a reasonable approach to strategic deployment.
· The execution strategy and plans consider upside opportunities as well as the downside risks and have the capacity to respond to both.
· The execution team is familiar with the plan and committed to its objectives.
· Progress against the plan will be monitored and routinely reported to the board.
· If the project goes off the rails, management has the capacity to respond appropriately.

Boards Manage “Uncertainty”; Management Manages “Measurable Risk”;

Many argue that boards do not manage risk; rather, they oversee management’s risk-management activity. That argument is correct, given the understanding that the board develops its own processes that are appropriate for managing uncertainty. These processes are known; CEO evaluation, compensation reviews, board evaluations are some that boards use. These processes and the boards that use them must adapt to managing uncertainty if they are to adequately respond to widespread demands for improved management of their bets.

An earlier article in Director [vii] referred to one process for managing uncertainty, namely three steps for engaging management and the board in strategy development. The three steps, Educate, Engage, and Refresh, provide the board with a vehicle to gather the required information and remain informed of both progress and problems with the strategic plan.

Managing uncertainty is a forward-looking, intuitive process done by a human brain on the basis of an individual’s knowledge, imagination, capacity for solving complex problems, tolerance for ambiguity, ability to see the bigger picture and ability to learn from previous experiences. Managing uncertainty requires objective thinking with an open mind in order to see possible trends, patterns and relationships which may not be readily apparent in any documentation. These are the attributes of skilled directors, not computers. They are the reason why a skilled, experienced and balanced board is critically important.

Mr. Goldie can be reached at (204) 947-7129 or hugh.goldie@exg.ca .

[i] Conference Board Report, R1398-07-WG, Emerging Governance Problems in Enterprise Risk Management. This report uses the following definition for risk taken from COSO, “The possibility that an event will occur and adversely affect the achievement of objectives.” We find this definition too narrow and believe that Peter Bernstein would have agreed since it did not consider upside opportunity.
[ii] Taleb, Nassim Nicholas (2007). The Black Swan: The Impact of the Highly Improbable. New York: Random House
[iii] Peter L Bernstein, Against the Gods, John Wiley and Sons, Inc. 1996
[iv] Personal communication, 2009.
[v] Frank H. Knight, Risk, Uncertainty and Profit, Hart, Schaffner and Marx; Houghton Mifflin Co., 1921
[vi] Kahneman, Daniel and Amos Tversky, 1979, “Prospect Theory: An Analysis of Decision Under Risk.” Econometrica, vol. 47, No. 2, pp 263-291
[vii] “Learning from the crisis: How the board’s role in strategy fulfills a risk management responsibility”, Goldie, Smith, and Stephenson, Director, 2009

Benchmarking Your Board Evaluation

2009-11-02T16:15:00.002-06:00

During a board evaluation there is often an elephant in the room that no one wants to acknowledge. It’s the question, “How does our Board compare to other boards? Are we really as good–or as bad as we think? If we wanted to make a comparison with others, how would we do it?” There are two ways to deal with the elephant.

The first is to ensure that your board has a regular injection of new members who have experience with other boards. That is the long and preferred way, but a topic for another day.

The shorter way is to treat board evaluation for what it is; a means of measuring year-over-year improvements in the capacity of your board to work effectively. Accepting that approach begs two questions:
1. How do we measure where are we now?
2. What actions should we take to make the greatest and most important year-over-year improvements?

To answer those questions, you need a starting point, a means of identifying what the greatest improvements should be, and an approach to measuring progress.

Typically a board evaluation questionnaire consists of a series of statements, (or questions.) Directors are asked to express their level of agreement with those statements on a multi point scale. There are two kinds of questions; those relating to board mechanisms that should be in place such as a code of conduct or a strategic planning process; and those relating to the accomplishments produced by those mechanisms. Examples of the latter would be, “Our CEO is clearly aware of what the board expects the organization to accomplish in the next year and has created a plan to do so.”

The questionnaire is completed, the results prepared, the board discusses them, and the whole exercise is put to bed ’till the next year. There is little to which to compare the report except last year’s, and only a vague suggestion of areas that could be improved.

A more directed way to manage the process is to start with a benchmark questionnaire. It uses the same statements, but for each of the statements two responses would be sought. Consider the following example. The statement on the questionnaire would read:

“The Board has established a mechanism for setting risk tolerance and monitoring risk exposure.”

The board would be asked to rate the importance of the activity to the effective functioning of the board using a five point scale.

1- Unable to assess (i.e. I don’t know enough to answer the question)
2 – Low
3 – Moderate
4 – Medium
5 – High

In the second part of the question, Directors are be asked to rate the boards capacity (skill) to accomplish this activity (i.e. Setting risk tolerance and monitoring risk exposure) again using a five point scale.

1- Unable to assess (i.e. I don’t know enough to respond)
2 – Low
3 – Moderate
4 – Medium
5 – High

Activities that require the Board’s attention show up in the results as being ranked High in importance and Low in skills. Contrary to expectations, the number of activities so highlighted by this exercise is usually relatively low.

The report provides several pieces of information.
-It identifies areas the board should examine for improvement projects in the next year and indicates a level of priority for the improvement.
-It identifies statements that are not necessary to include in future evaluation surveys.
-It identifies types of statements that should have higher representation in the survey.

A year from now, the modified survey can be run with relevant questions resulting in a true evaluation of progress in areas where improvement was identified.

Board evaluation should be about improving your board’s ability to function effectively. Employing this benchmarking approach makes that objective easier.

Your Board Can Make Time For Risk Management

2009-04-01T15:59:00.006-05:00

Authors note. The ideas in this article parallel the ideas presented in, “How the Boards Role in Strategy fulfills a Risk Management Responsibility,” featured in the April, 2009 edition of Director magazine, written by Hugh Goldie of the Exchange Group, Ken Smith of SECOR Consulting, and Peter Stephenson of Meridian Consulting.
________________________________________
Risk is a hot topic for boards and they are being challenged to make the time to become more involved in risk management. This article illustrates how boards can make the time.
Risk is like the “elephant” in the Indian legend, The Blind Men and the Elephant. The six men experienced the elephant as something small, like a snake, a spear, or a rope. They didn’t experience the big picture; the whole elephant. They were like those in the financial services marketplace who were aware of the bubble in their own corner, but failed to see the industry-wide risk contagion.
What does the “Risk Elephant” look like?

It's bigger than we typically think. Frank Knight, (1) a University of Chicago Professor, identified two distinct types of risk. We are most familiar with “Measurable risk.” It’s the type we manage when we buy car insurance. Insurance companies measure past car accidents and use probability theory to create models that predict the likelihood that we, and the others in their insurance pool, will have an accident in the future.
The risk models used by the failed banks in the financial services market place, failed to manage this type of risk.

Boards Work with Uncertainty
Boards tend to work with the second type of risk characterized by Knight as “uncertainty risk.” Probability theory has little relevance in managing uncertainty risk because we have nothing to measure. For example, if we decide to invest $50 Million in developing a new product we’re unlikely to have a large data bank on which to build a probability model to predict our success. We do know that events or situations will occur, created by the economy or our competitors, that could help or hinder our success. We can’t be sure of how or when they will appear. And we can’t be sure of how it will affect us. That doesn’t mean we can’t manage uncertainty risk and prepare for its possible outcomes.

Lighting the Road
We manage uncertainty risk in order to light the road we follow in executing our plans. Managing uncertainty shines a spotlight on the dark corners and rough turns we may encounter so we can attempt to avoid them or minimize their affects (downside risks). It sets up beacons that can help us find the smoother stretches that could hasten and expand our our success (upside opportunities).

Brains not Computers
Managing uncertainty is a forward-looking, intuitive process done by a human brain (not a computer) on the basis of its knowledge, imagination, capacity for solving complex problems, tolerance for ambiguity, ability to see the bigger picture, and ability to learn from previous experience. Managing uncertainty risk requires us to think objectively and with an open-mind in order to see possible trends, patterns, and relationships presented by the data which may not be readily apparent in any documentation.
These are the attributes of skilled directors. They are the reason why a skilled, experienced, and balanced, board is so important. They are the reason why, for boards, risk management is a legitimate task.
The Challenge.

Skill is only one factor in the governance equation. Time is another. Ten years ago time was not an issue for directors. With today’s increasing demands from shareholders, regulators, and their own workplaces, directors are hesitant to add to their workload.
The Question.

How can your board make better use of director time to engage in managing uncertainty risk?
The Answer.

Make management of uncertainty risk the explicit method for executing your board’s responsibilities. Doing so will formalize an approach which many boards are already using by default. Channel your board’s agenda, the mindset of directors, and the understanding of the CEO, into a formal approach for managing uncertainty risk. You will build on existing director skills, clarify the relationship between the Board and CEO, and create better governance as a result.
Three steps are required.
1. Build uncertainty risk management into existing board activities and processes.
2. Better use available director time by adding additional resources to gather data, and to analyse and prepare risk assessments.
3. Ensure directors have the skills and experience required to work in this new reality of managing uncertainty risk.
Build Uncertainty Risk Management into Existing Board Activities.

Your board likely uses some or all of the processes necessary to manage uncertainty risk. They are strategic planning, CEO oversight, management succession, board development, and the audit of management’s regulatory submissions.
1. Create a formal map for each process including expected outcomes. (You likely have the map for audit review and use it every year)
2. Define each process step in terms of the calendar timing, expected outcomes, and task responsibilities for both the board and the management team.
3. Create a “process introduction” for use just prior to the start of activities for the year. This will put both the board and management on the same page as the process begins.
Identify the Data Required and the Means for Analysis.

Most boards rely on data provided by the CEO. They are reluctant to bypass the CEO or to incur the additional cost to engage outside sources. Effective management of uncertainty requires access to a broader understanding of the issues; including industry issues, and a need for independent perspectives beyond those of the CEO and management. Boards need assistance in gathering and assessing this broader spectrum of data.
1. Define the data required in each process for the boards understanding of the issues, the source(s) of the data, and resources required for analysis prior to use by the board. Sources could include the CEO, the Internal Auditor and external experts.
2. Establish the time and means for presenting data to the board for its understanding and assessment. This includes the typical board package and presentations by the CEO, but may also include outsider presentations or individual interviews with directors outside of board meetings. The usual board meeting routine may change.
3. Establish the criteria and means by which the board will accomplish its evaluation of each issue.
Acquire Directors Whose Skills and Experience Reflect the New Reality
The Institute of Corporate Directors (Canada), the National Association of Corporate Directors, (USA), the Institute of Directors, (Britain) the Institute Company Directors, (Australia) and the Institute of Directors in New Zealand Inc. have adopted “Director Competencies.” This document specifies sixteen desired competencies and the board tasks to which they relate. They match the needs for risk management. We recommend Director Competencies as a guide for director recruitment.
Risk is a hot topic for boards.
Increased board involvement in managing uncertainty risk is a legitimate challenge for boards. Your board can respond positively by adopting uncertainty risk management as the explicit means by which it executes its responsibilities. Better governance will result.
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Hugh Goldie is a Director, and Past Chair of the Manitoba Chapter of the Institute of Corporate Directors. His recent book is titled, Confidence at the Board Table; How Directors Manage Risk and Deliver Superior Governance. Hugh is an Associate of the Exchange Group and can be reached at hugh.goldie@exg.ca.

(1)Frank H. Knight. (1885 -1972) Professor of Economics, University of Chicago. First book published in 1921, Risk, uncertainty and profit. He was responsible for injecting reality into risk management.

What Directors Should Know About ... Managing Risk

2008-10-04T19:24:00.004-05:00

Do bankers know how to manage risk? Did the boards of Lehman Brothers or AIG recognize that a financial crisis was impending? Did they ensure their companies were strong and could preserve shareholder’s equity when the crisis occurred? If that’s the objective against which you judge their risk management performance, then the answer for them, and those that failed with them, must be no.

Boards manage risk. It’s their only job. The measures used to judge their performance are the strength of the company and the value of their stock. So what happened? Part of the reason for failure was their approach to managing risk.

Computers don’t manage risk—People manage risk

Banks rely on computers to “manage risk.” So do many others. But computers can only use an algorithm to massage data, compare the results to a benchmark, and report whether the data deviates from the benchmark. When the characteristics of the situation extend beyond the assumptions of the algorithm, then the data is worthless and worse, misleading. You experienced the result. Computer programs don’t manage risk. Humans manage risk.

Managing risk is a forward-looking, intuitive process done by a human brain on the basis of its knowledge, imagination, capacity for solving complex problems, tolerance for ambiguity, ability to see ourselves in the world around us, paranoia, and previous experience. And the deeper the paranoia, and more painful the experience, the better. Managing risk takes place against a set of objectives. It looks in all directions. It takes time. It becomes suspicious when, “everyone is doing it,” or “it looks too good to be true.” It isn’t loyal to old friends for loyalty sake. It’s best done in a group where the experience is diverse (but relevant) and where the members can freely discuss their views, and challenge the views of each other. Some call this kind of group a Board of Directors.

The directors of Enron failed in their duty to shareholders. Kurt Eichenwald’s book, Conspiracy of Fools: A True Story, told the tale. The stories of what happened at Bear Sterns, AIG, Fanny Mae, Freddie Mac, and Washington Mutual have yet to be written. Will those stories reveal that their directors failed as well?

Let’s stop right there. It’s not my intent to criticize. I don’t know that the boards of Enron, Lehman Brothers, or AIG were the fat cats and uncaring people that some have portrayed them to be. I doubt they were. What I do know is that the expectations placed on directors changed dramatically with the demise of Enron and the introduction of Sarbanes-Oxley. And the challenge for boards ever since has been to find a means to effectively meet those expectations.

How can they do that?

They can start by recognizing that boards are risk mangers, and that risk management is their only job.

1. Risk management is an organized process in which Directors (not computers) routinely examine major risks critical to the business. Those risks are simple and straight forward. Moreover, most everyone knows them. The just don’t take the time to execute them well; the risk in the CEO and the CEO’s management of the business, the risk in the strategic plan at time of formulation and execution, the risk in the senior management team, the risk in the composition of the board, and the risk in the creation and presentation of financial information. Boards are the last stop in the risk management process, the endpoint in the company’s Enterprise Risk Management program.

2. Make risk management a proactive process in which Directors, like smoke detectors, are always sampling the air and checking for bad smells. They never go off the air. They are always listening, watching, and analyzing the results for events or situations of that could stop or deter their company from reaching its objectives. That’s the definition of risk, “An event or situation of that could stop or deter the company from reaching its objectives.”

3. Engage the company’s internal auditor to be the board’s eyes, ears, (and nose,) reporting directly to the board; operating with the board’s direction. The job is simply too big for ten, drop-in-directors, to do the investigation themselves.
4. Change the relationship between the Board, the internal Auditor, and the CEO. The preservation of the corporation and shareholder’s equity requires a team effort. There is no room for egos or petty jealousies.

What Should I know about CEO Evaluation

2008-09-18T12:05:00.010-05:00

Background

CEO evaluation is not an end in itself. It is a major step in managing leadership risk, and building and maintaining excellent leadership that propels the organization into the top 20 percent.

Stephen R. Covey said, "I am personally convinced that one person can be a change catalyst, a transformer in any situation, and organization. Such an individual is yeast that can leaven an entire loaf. It requires vision, initiative, patience, respect, persistence, courage, and faith to be a transforming leader.

Leaders, whether we call them CEOs or Executive Directors, are the catalyst of any organization’s performance, whether significant change is required or not. They are the catalyst for the vision that ignites the enthusiasm of employees, clients, funders and other stakeholders. They are the pathfinders that guide the accomplishment of the vision. They are the pillars that provide resilience when the going gets tough.

For owners, the presence of strong leadership is the most convincing measure of the Board’s capacity to act on their behalf.

The challenge for Directors

Directors manage risk

The most significant challenge for any Board is to ensure that the organization’s leader is the right catalyst, the right pathfinder, and the right pillar for the time and the situation. A significant part of the challenge is finding internal candidates who fit or can grow into the profile. The Board manages leadership risk and ensures the right leadership is in place?

How Directors manage the risk

For more on this topic go to my website

Drop-In Directors

2008-09-10T13:48:00.004-05:00

Being a Director is like buying a house—and not being allowed to go inside to look around. Would you buy a house if the only way you could see what was inside was to look through the windows? That’s, in a sense, what every Director is required to do.

Directors aren’t around day-to-day, unlike the CEO and senior management. They can’t observe events as they unfold. Instead, they “drop in” to attend six to eight Board meetings a year that last from two to ten hours, and they review information prepared by the CEO.

How can Directors fulfill their responsibilities for monitoring and supervising the CEO? How can you be held accountable for the reputation and financial well-being of the enterprise you serve when you’re only an outsider looking in? What windows do you look through to gather and assess the information you need to “buy the right house”? That’s the challenge faced by all Directors, from non- profits to major corporations.

To bridge the time and knowledge gap, effective Boards rely on their capabilities as risk managers. They specify the information they want to see through ten risk windows that give the Board an almost compete view of the inside of the house. By examining the CEO’s management through each risk window, the Board can monitor and supervise the CEO, contribute to the CEO’s decisions, and fulfill its mandate of preserving the reputation and financial well-being of the enterprise.

Risk management is a key skill for Directors. Fortunately, it’s a skill at which you’re probably already proficient. You’ve been identifying and managing risk for most of your life. With experience you’ve learned to apply it to complex situations like buying a house, considering a promotion, or making an investment. You assess the risk, weigh your options, and consider the consequences. With each decision, you become more skilled and confident in your ability.

For more information on the risk windows and how to use them, visit our website at www.GovernanceTools.com.

Confidence at the Board Table

2008-08-27T09:31:00.004-05:00

The value others see in us as Directors is what we contribute to the combined wisdom of the board, and to the success of our organization. It takes confidence to be a contributor.

You may have reached this site looking for information that would help you contribute, with confidence, at your next board meeting. Were you looking for Strategic planning? Board evaluation? There are lots of websites that talk about how to create a strategic plan, or the importance of board evaluation. Good for you for working to be prepared.

But is the confidence you are looking for, built from knowing the mechanics of strategic planning or board evaluation? Will knowing how to prepare a plan, help you with the questions you will have to answer when the board is asked to approve the plan?

Do you believe this plan is the best for our organization? Do you believe this plan can be successfully executed? Do you believe that risks in this plan are acceptable? Will you vote “yes”?

While knowing how to prepare a plan is valuable, Directors are concerned first about risk, not mechanics.
1. Boards manage the risk in management’s proposal and actions
2. Directors contribute by bringing their experience with risk situations to the board’s discussion.
3. Your value to the board discussion is your ability to identify and manage risk.

Risk management is a Director’s fundamental skill. Knowing risk management is the foundation for director confidence. When you see yourself first as a risk manager, then the rest of your role as a Director becomes obvious and makes sense. It’s the dividing line between the role of the Directors and the role of the CEO.

This site will help you build your skills as a risk manager and build your confidence at your board table. It’s designed around specific topics such as strategic planning or board evaluation.

2007-11-12T13:57:00.000-06:00

Mark’s question about asking questions

Mark asked about questioning a strategic plan. I’ll answer his question in two parts,
1. How do you ask questions
2. What questions should you ask

If you know how and what to ask, the courage to ask follows.

Questions are the directors’ tool to gather data. If you don’t ask questions you don’t get information. If you ask in a way that threatens or embarrasses, you risk defensiveness or anger. If either happens, the effectiveness of the board declines.

How do you ask questions?

The questions below solicit the same information but in very different ways. They are from a real situation.

1. Why should we continue to support the Vancouver branch? It’s losing money.
Or,
2. Would you help me to understand your strategy in keeping our Vancouver branch open?

The first question challenges the CEO. It suggests the CEO is wrong in keeping Vancouver branch open. It puts the CEO on the defensive, particularly in a sensitive meeting dealing with a company’s struggle for profitability.

The second question is open and non-threatening. Is offers the possibility of an explanation that goes beyond current profitability. (In my example, the CEO responded by describing a strategy to keep valuable and talented staff in the branch while rebuilding sales–which he did.)

The Directors around the table are bright. They want to do the right thing. They also have egos. The board is more able to help the CEO find solutions in a calm and deliberate environment, than in one marked by confrontation.

Sometimes you can use a series of questions to make a point or find an answer. Each successive question uncovers a part of the issue, building logical path to an answer, or a better understanding of the issue. This is the Socratic method of questioning. To learn more about the Socratic Method I suggest reading two papers by Dr. John McCallum of the University of Manitoba. The references are at the end of this discussion. *

What questions should you ask?

Ask material questions that add useful information to the board’s discussion.

1. If, in a planning discussion you ask about the cost of postage stamps, you will (or should) get groans from around the table.

2. If you ask whether management has the capacity to handle a new initiative, then you have asked a material question.

The value of your question increases if it carefully works down to underlying issues that may not be obvious. The Socratic Method aids in asking these kinds of questions.

How do you decide if a question is about a material issue or not? I use the risk screen from GovernanceTools. It identifies ten risk windows Directors can use to question and understand most management proposals.

The risk windows are:

1. Direction, strategy, and goals (the plan and execution).
2. Management strength (quality and stability of the management team).
3. Financial systems and controls (including all information technology).
4. Financial strength (balance sheet).
5. Compliance (both regulatory and non-financial).
6. Communication transparency (with shareholders, regulators, employees, and other stakeholders).
7. Security and use of corporate assets (human, intellectual, and physical).
8. Relationship between the board and CEO (mutual accountability).
9. Competence of the CEO (capacity to lead into the future).
10. Competence and effectiveness of the board (capacity to provide appropriate advice and supervision).

Ask yourself, “Are we examining an issue of direction? Are we examining an issue of management strength? Are we examining an issue of communication?” The list will help you to discover most material issues worthy of questions.

We hear a lot about how Directors should to ask “Tough Questions.” The name, “Tough questions,” implies they should be challenging and put the CEO on the spot. Nothing is more counter-productive in a board meeting. Tough questions are careful, material, questions. They get to the root of an issue without destroying the calm and deliberate process required for an effective board meeting.

Mark asked a good question. Material questions, asked in a non-threatening way, make an important contribution to a planning discussion. The risk windows help with materiality.

* Directors: The qualities that matter, Dr. John S McCallum, Ivy Business Journal, July/august 2005, Reprint # 9B05TD05
The Socratic Director, Dr. John S McCallum, Ivy Business Journal, May/June 2003, Reprint # 9B03TC01

2007-11-02T12:17:00.000-05:00

What was I supposed to do?

No one told me what a Director is supposed to do when I first joined a Board. I didn’t want to look stupid by asking dumb questions, so I sat back and observed what was happening. It took me a long time, and many experiences (good and bad) to learn.

Years later, I find that things haven’t changed. Most of the new board members I speak with are doing what I did, and dealing with the crises that preoccupy boards that don’t do their job right the first time.

A Different Approach

I’ve found a way to avoid that long and unsure road. It starts by learning Risk Management; it's the basic governance skill supporting everything a director does.

Learning Risk Management gave me the same sense of freedom that I gained from learning how to ski. The first day I went up a chairlift and watched the skiers below me gliding gracefully down the hill, I had no way of knowing the basic skill of shifting my weight over my skis to control my descent. But when I learned how to do it, the mountain was mine.

Risk Management is the basic skill of recognizing red flags, the potential events or situations that could threaten what we want to accomplish. It’s not a mystery. We use it every day. When the forecast calls for rain we take an umbrella. To protect ourselves from a car accident we buy insurance. To protect ourselves from a break-in we install intruder alarms in our homes.

GovernanceTools helps you to use risk management and make risk-sensitive decisions. The GovernanceTools.com© website http://www.governancetools.com/is an open, comprehensive information centre, for Directors of SMEs and not-for-profits. Check it out.

It’s for people like you who want to be better board members; who want to contribute to their communities and the organizations they serve as Directors; people who want to make sure they are not in personal danger of being embarrassed or sued because of a mismanaged board.

This GovernanceTools Blog will share my experiences–and yours–as we perform our roles as Directors, Board Chairs, CEOs, or Executive Directors. Send your questions or add your own experiences to this Blog so all our readers can benefit from them.

I'll be adding more ideas about risk management as well.