Let's Fix Risk Committees

This article is part of an ongoing series about the Shareholder Bill of Rights currently in Congress. Together, we can ensure that this bill truly represents our interests as shareholders and individual investors.

Back in September 2008, AIG (NYSE: AIG  ) teetered on the verge of bankruptcy, and threatened to bring down other financial giants. The list of its major counterparties reads like a who's who of finance: Barclays (NYSE: BCS  ) , Deutsche Bank (NYSE: DB  ) , Goldman Sachs (NYSE: GS  ) , Bank of America (NYSE: BAC  ) , and Citigroup (NYSE: C  ) .

We now know that the potential collateral damage was even worse than suspected. Fed Chairman Ben Bernanke believes that a collapse of the massive insurer at that time would have caused a "global financial and economic meltdown."

We've paid dearly for the risk AIG took. The fallout from just this one debacle has cost taxpayers and shareholders billions, and the meter is still running. Michael Lewis' investigation into the Financial Products unit at AIG portrays a group that pursued immense immediate profits with little understanding of the risks they were taking, prodded on by a greedy megalomaniac over whom executive leadership exercised almost no oversight. Clearly, something went horribly wrong with the company's risk management processes -- and AIG is just one example among many companies that have dropped the ball on risk management.

With this in mind, the recent Shareholder Bill of Rights legislation aims to require each public company to "establish a risk committee, comprised entirely of independent directors, which shall be responsible for the establishment and evaluation of the risk management practices of the issuer."

In other words, Wall Street, someone at your company is going to keep an eye on your bets next time.

The current situation
The idea of a risk committee at the board level is pretty straightforward. A fundamental fiduciary duty of boards of directors is to manage risk, so setting up a dedicated risk committee of independent directors along the lines of the audit committee seems like common sense.

Alas, common sense ain't all that common, as Will Rogers once observed. According to a recent Moody's study of some of the largest banks in the world, only half of all the banks had "a dedicated board-level risk committee covering all risks." And for many of those that did have risk committees, the independence of the committees was considered inadequate.

Few could deny that poor risk management was central to the recent financial crisis -- whether the company was a major bank like Bank of America, a megaconglomerate like General Electric (NYSE: GE  ) , or a traditional manufacturer like General Motors that went all-in on SUVs. So what could possibly be wrong with focusing the board's oversight on this area?

The pros and cons
"We'd like "Ineffectual Things" for $1,000, please, Alex."

"The answer is: vitamins, fish oil, and risk committees."

"What are things that should be beneficial but probably aren't?"

And that, of course, is a compelling critique of the proposed risk committee idea. Ultimately, these committees, according to their critics, will be merely an ill-informed and ineffectual body that will be unable to truly curtail the recklessness of irresponsible companies, which are intent on pursuing profits at the expense of sustainable shareholder value.

Where profit maximization regardless of risk is the sole core value at a company, managers will find ways around the independent risk committee. In fact, as things currently stand, where managers get huge paydays when risks pay off but don't suffer along with shareholders (and taxpayers) when they don't, managers are incented to do so. Independent directors will only deal in broad brushstrokes and may not have a solid understanding of the key details.

Proponents of risk committees, on the other hand, concede that boards may have been lax in this area in the past, but that they are capable of becoming more focused and better informed when it comes to risk management in the future. According to a recent post by Chad Johnson that appeared on the Harvard Law School Forum on Corporate Governance and Regulation, the Organization for Economic Cooperation and Development (OECD) recently attributed the financial crisis to "failures and weaknesses in corporate governance arrangements, which did not serve the purpose to safeguard against excessive risk taking in a number of financial service companies."

In order to address this breakdown, advocates of risk committees suggest that directors will need to become more knowledgeable on these issues, and more demanding when it comes to receiving all of the relevant information. After all, that is their job. If they don't possess the necessary expertise, Nell Minow recommends that risk committees solicit outside advice from risk management experts in order to assist them in their work.

Shareholders, be heard!
Given the complexity of some of the financial products out there, combined with the greed of many Wall Street executives, it's only wise to be skeptical about directors becoming better at managing risk in the near future.

Yet that is precisely what is necessary in order to provide greater oversight of our public companies. Someone needs to ask the unpleasant questions. Directors need to make the time to understand the issues and deliver tough recommendations. And if they are unwilling to do that, then they must be replaced.

What do you think? We want the Shareholder Bill of Rights to come from all of us. So post your comments at the bottom of this article (or any other in this series). Cast your vote in our online polls. Or send us an email at ShareholderRights@fool.com. Let's all tell Wall Street and Washington what rights we shareholders really need.

Once you’re done, remember to check out "It's Time for a Shareholder Revolution" for more on the Shareholder Bill of Rights.

John Reeves doesn't own shares of any companies mentioned. The Motley Fool is investors writing for investors.


Read/Post Comments (5) | Recommend This Article (18)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 02, 2009, at 8:47 PM, Sail285 wrote:

    In addition to risk management committees, the independent auditors for the company should be required to include a report on risky practices.

    Although not covered in this question, allowing a corporation to become "Too Big to Fail" is the biggest risk for this country and the economy in general. Something must be done to avoid this situation now and in the future. I don't like the idea of "Big Brother" or a government that has too much power of business but I dislike AIG even more. Unfortunately there are many situations like AIG based on the "Too Big to Fail" analysis.

  • Report this Comment On October 02, 2009, at 9:17 PM, jsackley wrote:

    The thing about good risk management is that the devil is often in the details. Small nuances can mean the difference between good risk control or reputational havoc. I note three things: 1) board members are usually big-picture types; 2) the unspoken board culture is often "do not ask too many questions" lest it appear you are micromanaging the CEO; and 3) the senior execs brought in to address the board may not be well versed in the nuances so, when questioned about a detail, they make it up on the fly. The board often won't usually catch anything that causes the CEO to change course unless it's in the M & A arena, and even then a detail is missed (bonuses, anyone?).

    In the end, a Risk Committee can provide value by making sure the firm's risk assessment and mitigation process is viable, robust and centric to the firm's culture. And the risk chair should have open communications with the Chief Auditor and Chief Risk Officer.

    Jan Sackley

    Fiduciary Foresight

    Fiduciary risk assessment and regulatory compliance

    jansackley@gmail.com

  • Report this Comment On October 03, 2009, at 7:54 AM, mabar2000 wrote:

    Independent risk asesment is key. Perhaps the comm ittee should be independent of the Board, formed by experts and work with the auditor.Its evaluations and conclusions should be mandatory to the CEO.

    Risk rating companies and SEC members should be paid independently of the companies beeing evaluated, perhaps through a percentage of transactions.

    Investment and Banks should be totally independent by law.

  • Report this Comment On October 10, 2009, at 11:25 PM, MBLacey wrote:

    Mabar2000 is absolutely right - risk assessments must be independent, unbiased and performed by risk experts. They also need to be binding - if a risk assessment determines that a practice, acquisition, new product, etc., is too risky, that assessment cannot be allowed to be ignored without mitigating strategies being put into practice and the risk being reassessed. The elimination of Glass-Steagall walls between investments, banking, etc. would not have happened if a proper risk assessment had been done at the SEC and paid attention to by the Government that decided to do away with them when they did. New safeguards would have been required to eliminate or substantially mitigate the risks that were identified at the time. The fact that it could take many years for a risk to manifest itself does not mean that the risk does not exist. Therefore, risk assessments of current practices also need to be performed and those risks also mitigated with identified strategies.

  • Report this Comment On October 11, 2009, at 9:35 AM, yogahelps2 wrote:

    Yes, risk committees must be independent, but is there any way to achieve that as long as they are hired by the companies under evaluation? Haven't we seen that independent audits are never truly independent?

    Unless the risk committees are paid for by us taxpayers (and who want to pay more taxes for THAT?) they'll never be truly independent.

    I think the other provisions giving shareholders more rights is the best we can do to minimize risk.

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