IS YOUR COMPANY AT RISK?
Corporate failure: few reasons, enormous consequences
By Professor Stewart Hamilton (July, 2006)
Professor Stewart HamiltonExcerpt from webcast: Europeans take heed! (3:35)
A decision to save $20,000 a year by not subscribing for a second Reuters terminal ultimately cost Allied Irish Bank’s American subsidiary, Allfirst, some $690 million in 2002: possibly the worst bargain ever. Allied Irish was big enough to absorb the losses and did not suffer the same fate as Barings Bank, which had failed some seven years earlier after a ‘rogue trader’ ran up even greater losses. It was abundantly clear that Allied Irish had learnt nothing from that high-profile disaster. Sadly, this was only one of many such omissions that have led to history repeating itself so dramatically in the first years of the new century.
A thorough understanding of what has gone wrong, what the major causes of corporate failure are and where the responsibility lies is essential if we are not to continue repeating the mistakes of the past.
The reasons why companies fail are few, and common to most, and that this holds irrespective of industry or geography. The main causes of failure can be grouped into six categories:
A board is supposed to provide a non-partisan judgement of senior management’s actions and strategic proposals and to look after the interests of shareholders. The directors may not do this effectively if they are financially beholden to the company (other than by way of proper compensation for work as a director), as their judgement might well be clouded. Many so-called independent directors may not have been so independent after all.
Poor strategic decisions
Companies often fail to understand the relevant business drivers when they expand into new products or geographical markets, leading to poor strategic decisions. For example, Marconi did not clearly understand where rapid technological change was driving the market. Similarly, Tyco did not understand how GE had made a success of GE Capital or, as with Enron and WorldCom, how growing overcapacity in fiber cables would impact its investment. The board of Barings did not understand how the derivatives market worked, and therefore did not comprehend the risks associated with it.
Many companies, frustrated by their inability to grow organically sufficiently quickly, turn instead to acquisitions. The risks of expansion are often compounded when companies not only expand into new geographical markets but simultaneously into new businesses. Despite all the empirical academic studies which have shown that less than half of all acquisitions deliver the sought-after or promised returns, AOL and Time Warner being a prime example, this tendency shows little sign of abating.
These individuals usually emerge after a period of successful (or apparently successful) management. The company becomes packed with likeminded executives who owe their position to (usually) him and are reluctant to challenge his judgement. A complacent board, lulled by past achievements, stops scrutinizing detailed performance indicators and falls into the habit of rubber-stamping the CEO’s decisions.
Greed, hubris and a desire for power
People tend to be naturally greedy, rarely content with what they have achieved. High achievers, such as top executives, are particularly ambitious and eager for more power and wealth. Since there is a clear, positive correlation between size of corporation (measured by revenue or by capital employed) and executive pay and status, CEOs have every incentive to grow their companies.
Failure of internal controls
Internal controls can fall short in a number of ways. The deficiencies are often compounded by complex or unclear organizational structures. Blurred reporting lines leave gaps in control systems, nowhere more obvious than in the case of Barings, where no one believed that they had overriding responsibility for the activities of rogue trader Leeson.