Excessive financial risk and inattention to warnings led to the downfall of MF Global.
MF Global, the securities firm spearheaded by former CEO Jon Corzine, is in shambles. The company declared bankruptcy in 2011, and congressional hearings are investigating whether client funds were fraudulently misused to pay off debts. But the saga of how the firm imploded and the role the board played in its collapse both serve as valuable lessons that other directors and senior executives can learn from.
The details of what destroyed MF Global provide a case study of what not to do when governing a financial services company – in fact, MF Global’s demise is filled with enough conflict and intrigue to inspire the plot of a Shakespearean tragedy. One key element is the story of a powerful CEO who may have suffered from hubris but still outmaneuvered and swayed a board of directors to its downfall.
The timeline reads like this: Michael Roseman, MF Global’s chief risk officer (CRO), identified mounting losses in 2010 and took his concerns to Corzine, the powerful former governor and senator of New Jersey and ex-CEO of Goldman Sachs. Roseman warned Corzine that the company’s aggressive trading, including a $6.3 billion bet in European debt, could undermine the firm’s liquidity.
Dismayed by the CRO’s findings, Corzine accused Roseman of incompetence and said his research was flawed. He forced Roseman to submit his resignation in January 2011. The board sided with the powerful CEO, and by the end of 2011 the company faced financial ruin, vindicating the risk officer. Roseman told a congressional committee that MF Global’s European debt led to its downfall, and without it, the company might have survived.
So what can other boards learn from this debacle? Michael Peregrine, a partner at Chicago law firm McDermott Will & Emery, says the primary questions in this situation revolve around the independence of MF Global’s board and whether it was subservient to Corzine and acquiesced to his demands.
‘Where was the board when the CRO got pushed out?’ he asks. What exactly was the board’s response to the red flags raised by Roseman? Did the board ask sufficient questions of him? Was it digging for the truth of the firm’s financial dilemma, or did it yield unquestioningly to the CEO’s directives?
Lesson 1: Investigate the CRO’s findings
One key takeaway involves the critical financial advice offered by the CRO. How was that information vetted? How active a role did the board play in researching the risk officer’s advice? And what happens when the CEO downplays or rejects the CRO’s analysis?
To be effective the board must operate independently, not cater to the CEO’s viewpoint. Peregrine believes risk officers are frequently ‘marginalized’ and viewed as troublemakers by CEOs because of the due diligence they perform and the pointed questions they ask about risk-taking. The demise of MF Global, he says, suggests that ‘when you reject and belittle the advice of the risk officer, you’re asking for trouble.’
Nell Minow (pictured left), board member at GMI Ratings and co-author of the book Corporate Governance, agrees. ‘If the CEO doesn’t understand that the risk officer is his or her best friend, there’s a real problem there,’ she says. Legally, ethically and practically, the board must work for the long-term interests of the shareholders and the long-term sustainability of the company, not just the CEO’s interests.
Lesson 2: Don’t be overly deferential to the CEO
Peregrine invokes a new term to describe this learning experience for boards: the Corzine rule. The Corzine rule states that no matter how strong the executive’s credentials, you should never fall in love with the CEO and adopt a deferential attitude. Boards must be skeptical and resourceful, do their homework and ask pointed questions, no matter who the CEO is or how impressive his or her press clips are.
Thomas Lys, finance professor at Northwestern University’s Kellogg School of Management, says excessive deference to ‘star’ CEOs such as Corzine, Kenneth Lay of Enron and Dennis Kozlowski of Tyco has been a recurring problem with boards. According to Lys, these boards questioned whether ‘they were smart enough’ to keep pace with the brilliant CEO and in turn ‘violated their fiduciary duty to supervise the CEO’. If a board is to live up to this mandate, it must regulate the CEO, not be controlled by him or her.
Lesson 3: Consider having risk officers report directly to the board
One solution that arises from the MF Global meltdown involves having key risk executives, including audit partners and CROs, report directly to the board rather than to the CEO. If the risk or audit managers report to the CEO, the CEO can control or squash them; if they report to the board, this ensures that their financial risk evaluation will be listened to and considered. Had that been the case at MF Global, Roseman’s analysis might have been heeded.
Lesson 4: Pursue all red flags to their logical conclusion
When Roseman’s conclusions on MF Global’s European debt conflicted with Corzine’s, it was incumbent upon the board to dig deeper and conduct further due diligence to arrive at the truth behind the numbers. Since the CRO said the firm’s European debt load jeopardized the company’s stability, that issue should have been explored much further. The board ‘missed the warning signs and missed asking follow-up questions,’ Lys says.
Lesson 5: Hire external consultants to review findings
When the risk officer and the CEO clashed about the level of risk at MF Global, the board should have asked for a second opinion and hired an external consultant to investigate the financial issues raised, says Lys. In fact, provisions in the Sarbanes-Oxley Act permit boards to hire external experts at the company’s expense.
Lesson 6: Board independence reduces the chance of financial wrongdoing
Unfortunately, several members of the MF Global board conducted business with the company, and that conflict of interest diluted the board’s independence, Minow explains. MF Global should have nominated a more rigorous board, as its directors had earned a D grade from proxy advisory firms because of the board’s lack of independence.
Lesson 7: Monitor the success of your business strategy
It was MF Global’s CEO and management team’s responsibility, not the board’s, to devise the company’s business strategy. However, the board must monitor that strategy to make sure it’s on course to move the company forward, expand revenue and build shareholder worth, explains David Larcker, director of Stanford Graduate School of Business’s Corporate Governance Research Program.
If the company is indulging in too many risky strategies, such as MF Global’s large bet on European debt, it’s incumbent upon the board to ask questions, be skeptical and ensure that these strategies are steering the company in the right direction.
Moreover, Larcker says boards can’t just evaluate the current strategy but must be proactive and look to the long term. Business, technology and competition are changing so rapidly that boards must constantly plan ahead and collaborate with CEOs to determine successful strategies for the future. More advance planning and strategy sessions might have helped deter MF Global from its reliance on excessive European debt.
Lesson 8: Make sure some board members possess financial expertise
The make-up of the board should include a minimum of two directors with financial savvy, says Larcker. Having that financial savvy and knowing how to evaluate derivatives and collateralized debt obligations can help directors ask the right questions and find out whether the CRO is evaluating risk properly or if the CEO’s objections are legitimate. ‘Just having good businesspeople on the board isn’t enough,’ Larcker says.
Lesson 9: In a crisis, supervise in real time and create warning signals
Many boards meet on a quarterly basis to supervise the company and oversee its financial controls, but when a financial crisis strikes, monitoring the company’s finances in real time is a must – otherwise problems can easily be exacerbated, explains Lys. Since boards can’t meet on a daily basis, they should establish financial warning signals. That way, when a significant or material internal control issue arises, the board can step in, monitor the issues and respond more quickly to resolve them. Waiting for the next quarterly meeting could mean leaving it too late to address the crisis.
Lesson 10: Frame compensation packages to send a strong signal to the CEO
‘The MF Global board forgot to ask its CEO some key questions when he was hired, such as How will you demonstrate your integrity to us?’ says Minow. If the company faces reputation risk and severe financial loss, the CEO’s compensation package should be affected. ‘Money talks, and if a board is going to give a CEO incentive compensation without provision for reputation risk, the company is likely to experience reputation risk,’ Minow concludes.