appreciation. Unethical executives might even be tempted to manipulate accounting rules.
Traditional executive compensation systems do not provide the appropriate framework for risk management because they motivate excessive risk taking. Moreover, the corporate structure creates potential conflicts between management and investors. In essence, executives are betting with “other people's money”: Heads they win, tails investors lose. To better align the interests of management and investors, long-term, risk-adjusted financial performance must drive incentive compensation systems. Boards and management must consider not only what business performance was produced, but also how. Companies can achieve this by incorporating risk management performance into their incentive compensation systems; establishing long-term risk-adjusted profitability measurement; and using vesting schedules consistent with the duration of risk exposures and/or claw-back provisions.
THE WHEEL OF MISFORTUNE REVISITED
In my previous ERM books I introduced the Wheel of Misfortune, which illustrates that risk management disasters can come in many different forms and can strike any company within any industry. Beyond purely financial losses, the mismanagement of risks can result in damage to the reputation of the companies, or a setback for the careers of individual executives. The Wheel of Misfortune is the response I use to those managers and executives who aren't swayed by the potential pain of ineffective risk management. These doubters will often express the sentiment that “it couldn't happen here” or “if it isn't broke, don't fix it.” In these cases, it is worth reminding the skeptics that history has repeatedly demonstrated how bad things can and do happen to good companies.
When my first ERM book was published in 2003, the direst illustration of how negative events can quickly escalate was the cumulative losses suffered by U.S. thrifts in the mid-1980s. These losses not only bankrupted individual companies, but also threatened the entire industry. There were other examples as well. Important spokes of the Wheel included accounting fraud, trading losses, and misrepresented revenue.
Now, however, risks are even more diverse and unpredictable. They can start anywhere in the world and quickly ripple across the global economy, affecting industries that on the surface had little in common with those at the epicenter of crisis. Figure 2.1 represents the new Wheel of Misfortune.
FIGURE 2.1 Wheel of Misfortune
A close examination of these disasters underlines the importance of risk management, including how the nature, velocity, and impact of risks have evolved. Here's a brief, woeful look at the some major corporate disasters, many of which are shown in the new Wheel of Misfortune. Take note that those caught up in the Wheel represent some of the world's best-known and most highly regarded brands.
Operational Risk involves any event that disrupts normal business operations. Losses resulting from operational risk may stem from inadequate or failed processes, people, systems, or external events. It includes employee errors, fraud, or criminal activities, as well as the failure of information, manufacturing or other systems:
• In 2012, UK-based drug maker GlaxoSmithKline paid a $3 billion fine for illegally marketing the depression drug Paxil. The company was found to have deceived and bribed doctors into prescribing the drug for children, with whom it has been shown to increase the likelihood of suicide.19
• Pfizer, the world's largest drug company, reached a $2.3 billion settlement with U.S. federal prosecutors in 2009 for promoting the painkiller Bextra for unapproved uses that endangered patients' lives.20
• In 2014, auto manufacturer Toyota, often lauded for its Toyota Production System intended to reduce error and waste, agreed to pay $1.3 billion to avoid prosecution for covering up severe safety problems with “unintended acceleration” and continuing to make cars with parts the FBI said the company “knew were deadly.”21
Bribery and Corruption are risks that any company working with governmental agencies around the world may face. The risks are multifold: costs associated with “shakedowns” of corrupt officials, loss of reputation, and, of course, the financial consequences of prosecution.
• German manufacturer Siemens paid fines and other penalties totaling $1.6 billion in the United States and Germany after pleading guilty to violations of the U.S. Foreign Corrupt Practices Act (FCPA) in 2008. The company admitted that bribery had become a common way win government contracts around the globe.22
• Alstom, a French power and transportation company, paid a $772 million fine in 2015 for FCPA charges related to a widespread corruption scheme involving at least $75 million in secret bribes paid to government officials in numerous countries; falsifying its books and records; and failing to implement adequate internal controls.23
Antitrust regulations in most countries aim to foster open competition and prevent market-share leaders from artificially manipulating price, supply, and other factors. What constitutes anticompetitive behavior is in the eye of the beholder, varying from country to country and court to court. As a result, some companies may face costly litigation for what they feel are legitimate business practices. Others, however, clearly intended fraudulent activity.
• After years of litigation, Visa and MasterCard reached a $7.25 billion settlement in 2013 for a class-action lawsuit claiming that the companies conspired to force merchants to pay excessive fees and follow onerous rules for accepting their credit cards. The settlement was recently thrown out by a federal appeals court as “unfair to retailers.”24
• In 2014, chip-maker Intel paid a $1.45 billion fine in Europe for unfair and damaging practices against its rival AMD. This was in addition to a $1.25 billion settlement with the United States in 2009.25
• Taiwan-based AU Optronics paid $500 million in the United States for participating in a conspiracy to fix prices on LCD panels. Two of the company's senior executives were sentenced to three years in prison and fined $200,000. The Justice Department claimed that AU Optronics was part of a price-fixing cartel involving every major manufacturer of standard-sized LCD panels, including LG and Samsung.26
Mortgage Underwriting
• Bank of America paid a cumulative total of $50bn in U.S. government settlements between 2009 and 2014, when it coughed up a record $16.65 billion to resolve allegations it misled investors in its mortgage-backed securities.27 In similar cases, JPMorgan Chase paid $13 billion,28 and Citigroup $7 billion.29
Foreclosure Practices
• In 2012, the U.S. Federal government and state attorneys general reached a $25 billion agreement with the nation's five largest mortgage servicers: Bank of America, JPMorgan Chase, Wells Fargo, Citigroup and Ally Financial. Violations included the use of “robo-signed” affidavits in foreclosure proceedings, deceptive practices in the offering of loan modifications, failures to offer alternatives before foreclosing on federally insured mortgages, and filing improper documentation in federal bankruptcy
Harris, Gardiner. “Pfizer Pays $2.3 Billion to Settle Marketing Case,”
Cowan, Jane. “Toyota to Pay $1.3 Billion for Deadly Defect Cover-Up,” Australian Broadcasting Corporation, March 19, 2014. Retrieved from http://www.abc.net.au/news/2014-03-20/toyota-pays-1-3-billion-for-defect-cover-up-statements/5332894.
Lichtblau, Eric and Dougherty, Carter. “Siemens to Pay $1.34 Billion in Fines,”
U.S. Department of Justice. “Alstom Sentenced to Pay $772 Million Criminal Fine to Resolve Foreign Bribery Charges,” Press release, November 13, 2015. Retrieved from https://www.justice.gov/opa/pr/alstom-sentenced-pay-772-million-criminal-fine-resolve-foreign-bribery-charges.
Stempel, Jonathan. “Visa, MasterCard $7.25 Billion Settlement with Retailers Is Thrown Out,” Reuters, June 30, 2016. Retrieved from http://www.reuters.com/article/us-visa-mastercard-settlement-idUSKCN0ZG21E.
Lohr, Steve and Kanter, James. “A.M.D. – Intel Settlement Won't End Their Woes,”
Hurley, Lawrence. “UPDATE 1 – U.S. Top Court Rejects AU Optronics over $500 Million Price-Fixing Fine,” Reuters, June 15, 2015. Retrieved from http://www.reuters.com/article/usa-court-pricefixing-idUSL1N0Z10QC20150615.
Protess, Ben and Corkery, Michael. “Bank of America Offers U.S. Biggest Settlement in History Over Toxic Mortgage Loans,”
Barrett, Devlin and Fitzpatrick, Dan. “J.P. Morgan, U.S. Settle for $13 Billion,”
U.S. Department of Justice. “Justice Department, Federal and State Partners Secure Record $7 Billion Global Settlement with Citigroup for Misleading Investors about Securities Containing Toxic Mortgages,” Press release, July 14, 2014. Retrieved from https://www.justice.gov/opa/pr/justice-department-federal-and-state-partners-secure-record-7-billion-global-settlement.
