The%20Changing%20Role%20of%20the%20Audit%20Committee:%20Applying%20the%20Lessons

1
The Changing Role of the Audit Committee
Applying the Lessons

• Presented by
• Andrea St. Rose Associates

Bay Gardens Hotel July 17, 2009
2
The Changing Role of the Audit Committee
Applying the Lessons
Agenda
1. Global Overview of the Financial Crisis
2. Current Issues and Risks What Regional
Audit Committees Should Know
3. Setting the Agenda for future Success in
the Caribbean
4. Restructuring the Corporate Framework to
Strengthen the Audit Committee
3
The Changing Role of the Audit Committee
Applying the Lessons
Agenda
5. Implementing Audit Committee Fundamentals
Best Practice
6. Question and Answers
4
Global Overview of the Financial Crisis
5
Global over view of the Crisis
Structure
1.The Making of a Financial Crisis
2. The Global Experience
3. Our Caribbean Experience Jamaica, Trinidad,
Antigua
6
The Making of a Financial Crisis

• Generally preceded by asset price bubbles and
  economic booms.
• In many instances there are regulatory lapses.
• Usually accompanied by Greed.
• Corporate governance is usually weak
• Risk Management Policies are usually weak or
  absent.

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The Making of a Financial Crisis

• What we know for sure
• Economies experience both upswings and downturns.
• During upswings companies tend to believe that
  the good times will never end.
• When profits are increasing entities tend to
  turn a blind eye to the attendant risks.
• Above average returns tend to be accompanied by
  above average risk taking.
• We have learnt nothing from past experiences
  e.g. The Great Depression of the 1930s

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THE MAKING OF A FINANCIAL CRISIS

• If we know for sure that upswings are generally
  followed by downswings then why is it that most
  companies are unable to weather the storm when it
  makes landfall?
• We prepare for hurricanes but not for the
  financial tsunamis.

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The Making of a Financial Crisis

• The Current Financial Crisis
• The Sub prime fiasco
• It is believed that the current financial crisis
  began brewing sometime during mid 2007.
• Prior to 2007, the US environment experienced
  high liquidity levels
• With such high liquidity levels, financial
  institutions in the US, responded to a general
  Govt push encouraging home ownership.
• Financial institutions offered adjustable rate
  mortgage loans to individuals who were unable to
  comfortably afford the repayment of those loans.
• Those risky loans were pooled and sold as
  investments repayment of which were secured by
  the cash flows from the underlying mortgages.

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The Making of a Financial Crisis

• The Current Financial Crisis
• The Sub prime fiasco
• In the face of rising oil prices and higher cost
  of living, homeowners suffered cash flow
  problems.
• As persons gained an understanding of the
  financial environment, confidence levels began to
  fall accompanied by a fall in demand for
  housing
• The sub prime mortgage owners found themselves in
  difficulty and were unable to make the monthly
  repayments which sometimes increased due to
  interest rate adjustments - hence they defaulted.
  
• The underlying cash flows were no longer
  available to service the mortgage backed
  securities the underlying securities became
  worthless.

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The Making of a Financial Crisis

• The Current Financial Crisis
• The Subprime fiasco
• The result was increasing losses for those
  institutions that had invested in those
  securities, coupled with reduced liquidity.
• Stock prices began falling and equity holders
  suffered huge losses.
• Investors began loosing confidence in the
  Financial System
• Asset prices were falling in values and
  investors wanted their monies back. Some
  institutions folded up while some with greater
  public interest were bailed out by
  Governments/Central Banks.
• As some institutions folded up employment rose
  and reached record levels in the USA.

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The Making of a Financial Crisis

• The Current Financial Crisis
• The Subprime fiasco
• Given the global network overseas institutions
  that had invested heavily in those risky
  securities also suffered losses and so the
  dominos came falling down.

13
The Making of a Financial Crisis

• There were some Smart ones or so it seemed.
• The Collateralised Debt Obligations
• Some smart people recognising the risks involved
  considered that the boom could not survive for
  long and took insurance to cover the possibility
  of default akin to betting that the entity
  would fail.
• When the entities defaulted, the security holders
  demanded payment from the insurance companies.
• Given the extent of the defaults, the insurance
  companies came under pressure and some like AIG
  had to be bailed out by the US Govt.

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THE GLOBAL EXPERIENCE

• CASE STUDIES
• A look at some failed institutions

15
Merrill Lynch Co.

• In 2005 CEO of Merrill Lynch pointed out
• Weve got the right people in place as well as
  good risk management and control.
• E. Stanley ONeal, CEO, 2005

Source on Merrill Lynch Co. G. Morgenson, New
York Times, November 9, 2008. Prepared by Timur
Gok
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The Global Experience

• Merrill Lynch Co.
• In 2007 and the first two quarters of 2008,
  Merrill had lost about a quarter of the profits
  it had made in its 36 years as a listed company
  (after-tax losses of 14b and 52b of
  write-downs).
• Financial Times, August 28, 2008
• Prepared by Timur Gok

17
Merrill Lynch Co.

• Ahmass L. Fakahany was vice chairman and chief
  administrative officer
• He was responsible for the firms market and
  credit risk management as well as corporate
  governance and internal controls
• Weakened Merrills risk management unit by
  removing longstanding employees who walked the
  floor talking with traders.
• Prepared by Timur Gok

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Merrill Lynch Co.

• Another key figure was Osman Semerci, who ran
  Merrills bond unit
• Former employees described him as an
  intimidating manager who would chastise
  traders and other money makers who told risk
  management officials what they were doing
• There was no dissent. So information never
  really traveled.
• Prepared by Timur Gok

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Merrill Lynch Co.

• The risk in Merrills business model became
  viral after AIG stopped insuring the highest
  quality portions of the firms CDOs against
  default
• Prepared by Timur Gok

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Merrill Lynch Co.
Source Wall Street Journal (April 18, 2008).
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The Global Experience

• In 2007 Citigroup CEO indicated
• Citigroup
• When the music stops, in terms of liquidity,
  things will be complicated. But as long as the
  music is playing, youve got to get up and dance.
  Were still dancing.
• Chuck Prince, Former CEO, Citigroup
• Financial Times, July 9, 2007
• Prepared by Timur Gok

22
Lehman Brothers

• Madelyn Antoncic, managing director of Lehmans
  management committee and the firms chief risk
  officer, was sidelined because of her unease with
  the huge bets the bank was taking
• There was risk management, but the prevailing
  atmosphere was for fast growth and special
  fast-track treatment for what we now know were
  toxic deals.
• Prepared by Timur Gok

23
UBS

• Used to Be Smart
• The shareholder report gave three broad reasons
  for what went wrong
• The investment-banking arm's preoccupation with
  growth
• Reliance of the control team on flawed measures
  of risk.
• The culture of the bank.

Source The Economist, April 24, 2008. Prepared
by Timur Gok
24
HBOS

• HBOS dismissed Paul Moore, head of group
  regulatory risk between 2002 and 2005, for
  raising concerns about risks
• They were not inclined to listen to a different
  view I was one person speaking out with
  experience who did see, in a generic sense, the
  writing on the wall.
• Prepared by Timur Gok

25
The Decision Making Process
26
The Global Experience

• Shocked!!!!!
• "Those of us who have looked to the self-interest
  of lending institutions to protect shareholders'
  equity, myself especially, are in a state of
  shocked disbelief.
• Alan Greenspan
• Prepared by Timur Gok

27
The Global Experience

• Lahde Capital ( USA)
• In October 2008, Andrew Lahde, founder of
  Californias Lahde Capital, a hedge fund, quit
  the business. One of his funds had made a return
  870 percent last year.
• In his farewell letter, he attacked the idiots
  running the banks who were willing to take the
  other side of his bets.
• Prepared by Timur Gok

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A.I.G.

• The bail-out of AIG cost US taxpayers 182.5
  billion so far
• Between 1968 and 2005, Maurice Hank Greenberg
  had been the CEO of AIG
• A bullying, omnipotent rulera boss who did
  not so much build a company as tailor it to his
  character and render it incapable of being run by
  anyone else.

Source on AIG and AIG FP M. Lewis, Vanity Fair,
August 2009. Prepared by Timur Gok
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A.I.G. Financial Products

• Founded in 1987
• By 2001, was generating 300 million a year, or
  15 percent of AIGs profits.
• AIG FP employees kept 30 to 35 percent of the
  profits that they generated (the typical hedge
  fund keeps 20 percent)
• Prepared by Timur Gok

30
A.I.G. Financial Products

• In 2001, Hank Greenbergand the AIG
  boardappointed Joe Cassano as the companys
  third CEO
• Presumably, Greenberg saw in him a pale
  imitation of his tyrannical self and felt he
  could control him
• Prepared by Timur Gok

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A.I.G. Financial Products

• Under Cassanos leadership, AIG FP became a
  dictatorship
• The way you dealt with Joe was to start
  everything by saying, Youre right, Joe.
• Valued loyalty and obedience above all.
• Prepared by Timur Gok

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A.I.G. Financial Products

• No one questioned it when AIG FP was insuring
  billions of dollars worth of subprime mortgages
• Not only that, but along the line, Cassano had
  agreed to triggers that required the firm to post
  collateral if it were to lose its AAA credit
  rating
• The company unraveled when the housing bubble
  burst
• Prepared by Timur Gok

33
OUR CARIBBEAN EXPERIENCE

• A Look at what has happened The Caribbean

34
OUR CARIBBEAN EXPERIENCE

• Jamaican Financial Crisis ( late 1990s)
• Trinidad Clico Financial
• Antigua - Stanford International/ Bank of Antigua

35
Jamaican Financial Crisis

• Followed the bust of an asset price bubble.
• There existed a relatively high interest rate
  environment.
• Significant increase in non performing loans when
  property prices fell.
• Dominated by a high level of related party
  transactions.
• Legislative environment was relatively laxed.

36
Jamaican Financial Crisis

• The first Group to come under pressure was the
  Caldon Finance Group.
• The result was contagion and a run on other
  financial institutions
• The Government stepped in and formed Finsac to
  manage the sale of toxic assets.
• The situation was brought under control
  relatively quickly.

37
CL Financial Group

• The group controlled assets in at least 28
  companies located in the region and throughout
  the world.
• Its insurance arm are the main insurance
  companies in the Eastern Caribbean Clico and
  British American Insurance Company.
• In 2004 it was alleged that the Group had entered
  into certain high risk ventures

38
CL Financial Group

• Concern was raised by investors in respect of the
  impact of falling real estate prices and a
  decline in the price of methanol on the Groups
  overall financial situation.
• In early 2009 CIB faced liquidity challenges and
  a subsequent run on the Bank.

39
CL Financial Group

• The Financial difficulties had to do with
• Excessive related party transactions which carry
  significant contagion risks.
• An aggressive high interest rate resource
  mobilisation strategy to finance an equally high
  risk investment much of which were illiquid
  in Tdad and abroad.
• Very high leveraging of the Groups assets which
  constrained the potential amount of cash that
  could be raised from asset sales.

40
CL Financial

• The Central Bank later announced that the Min of
  Finance took over control of the assets and
  liabilities of CLICO, CIB and CMMB.

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BANK OF ANTIGUA/STANDFORD INTL BANK

• In 2009 it is alleged that certain companies of
  the Stanford Group were involved in a Ponzi
  scheme.
• This was apparently triggered by a review into
  the high interest rate policy of certain
  companies in the Group following the Madoff
  investigation.
• One Caribbean interest , SIB, an offshore Bank,
  was specially named.
• The result was a loss of confidence and a
  subsequent run on Bank of Antigua Ltd, a related
  company.
• The Central Bank stepped in and took temporary
  control of Bank of Antigua.

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Current Issues Risks

• What Regional Audit Committees Should Know

43
Current Issues and Risk
Structure
1.A breakdown of Risk controls vs. Financial
Reporting Controls
2. What we already know
3. Role of Audit Committee in Risk Management
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Current Issues Risks

• Risk Controls Vs Financial Reporting Controls
• The current Global Financial crisis is not about
  cooking the books or not consolidating risky
  SPVs.
• It is about companies pursuing risky strategic
  activities Boards and Senior management.
• Unlike controls over financial reporting which
  has been legislated ( Sarbanes Oxley Act), excess
  risk taking i.e. greed has not been legislated.
  (Compliance with SOX could not stop the current
  crisis)

45
Current Issues Risks

• What do we already know
• The Audit Committee plays a major role in the
  oversight of Risk Management.
• Internal auditors are required to evaluate and
  make recommendations for improving risk
  management processes.
• The toxic Mortgage Backed Securities were
  purchased by sophisticated institutional
  investors.

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Current Issues Risks

• Role of the Audit Committee in Risk Management
• To provide effective oversight members of the
  audit committee are to have an in depth knowledge
  about the business, the major risks that it faces
  and the control environment within which the
  organisation operates.
• This means that Audit Committee should obtain
  some level of training with respect to Risk
  Management otherwise they may not be in a
  position to effectively dispense their oversight
  obligations.

47
Current Issues Risks

• Role of the Audit Committee in Risk Management
• The case studies on the failed institutions
  pointed to lapses in risk management.
• As an audit committee member can you confirm the
  following?
• The overall risk management strategy of the
  organisation has been well articulated.
• You fully understand the business and its
  exposures to significant risks.
• You have a good understanding of the products
  offered and the level of risks attached to same.
• A risk management culture is instilled throughout
  the organisation.

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Current Issues Risks

• Role of the Audit Committee in Risk Management
• Number of audit committee members present.
• Number of internal auditors present
• No of persons who have received training in
  Business Risk and Controls / Risk Management.

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Setting the Agenda for future success in the
Caribbean

• Emphasis on controlling risk exposures

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Setting the Agenda for future success in the
Caribbean

• In Setting the agenda for future success it is
  critical that risk issues are prioritize the
  keys risks should be a top agenda item.
• An understanding of risks should focus not only
  on the downside risks but also on the upside
  risks.
• Focusing on the downward risks while ignoring
  upside risks results in the erosion of
  shareholder value.

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Setting the Agenda for future success in the
Caribbean

• Six Key Recommendations for effective Risk
  Oversight
• Full responsibility for risk oversight should be
  clarified, structured and reflected in charters.
• The Board should be well prepared for assuming
  its risk oversight role by undergoing training in
  risk management and providing analysis of the
  organisation risk profile.

52
Setting the Agenda for future success in the
Caribbean

• Six Key Recommendations for effective Risk
  Oversight
• There should be appropriate oversight of
  management's assessment of risk, the controls in
  place to mitigate risks and the monitoring of
  risk.
• The Reporting framework should include company
  level risk reports in conjunction with Board
  Papers.
• A process should be in place to assess and
  monitor risk management performance including
  such issues as the effectiveness of committee
  structures and charters the level of the boards
  understanding of risk policies and the level of
  productivity of management and board
  communications.
• There should be direct board level with managers
  most acquainted with the organisations key risk.
  
• (Source The IIA A Holistic View of Risk

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Restructuring the Corporate Framework

• Strengthening of the Audit Committee

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Restructuring the Corporate Framework
Structure
1.Corporate Governance an overview
2. The Dual Role of Boards
3. Cases Excessive Compensation
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Restructuring the Corporate Framework

• It all come down to Proper Corporate Governance
  

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Corporate Governance

• The set of rules that shape and constrain how
  effectively corporate managers deliver on their
  promises to investors in general and shareholders
  in particular.
• Corporate governance rules may be explicit or
  implicit they may be defined by laws and
  regulations, contracts, and social norms.
• Prepared by Timur Gok

57
Norms

• Shareholder wealth maximization is a norm in the
  US and the UK, but not in the civil law countries
  such as France, Germany and Japan
• Prepared by Timur Gok

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Comparative Norms

• A corporation belongs to
• Its shareholders US (76 percent), UK (71
  percent)
• All of the stakeholders Germany (82.7 percent),
  France (78 percent), Japan (97 percent)

Source Allen and Gale (CFS). Quoted in Macey
(2008). Prepared by Timur Gok
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Promise and Premise

• Promise
• In the U.S., the fundamental promise is to
  enhance the value of the firm.
• Premise
• The financial crisis is partly the outcome of
  failed governance mechanisms that led to the
  violation of that fundamental promise.
• Prepared by Timur Gok

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Challenge

• In the shareholder-centric system, separation of
  ownership and control may lead to the violation
  of the fundamental promise
• The agency problem
• Prepared by Timur Gok

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Eloquent

• The directors of joint-stock companies,
  however, being the managers rather of other
  people's money than of their own, it cannot well
  be expected that they should watch over it with
  the same anxious vigilance with which the
  partners in a private copartnery frequently watch
  over their own.
• Adam Smith, The Wealth of Nations
• Prepared by Timur Gok

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Solving the Agency Problem

• At least in the U.S., much of the burden of
  solving the agency problem was placed on
  incentives and compensation schemes.
• Ever-increasing pay to align managers and
  shareholders interests
• Prepared by Timur Gok

63
Law of Unintended Consequences

• Target
• Align managers and shareholders interests
• Tool
• Incentive compensation
• Outcome
• Distorted incentives
• Prepared by Timur Gok

64
Merrill Lynch Co.

• In 2007 and the first two quarters of 2008,
  Merrill had lost about a quarter of the profits
  it had made in its 36 years as a listed company
  (after-tax losses of 14b and 52b of
  write-downs).
• Financial Times, August 28, 2008
• Merrill Lynch Co. CEO Stanley O'Neal was paid
  172 million from 2003 to 2007.
• Prepared by Timur Gok

65
Others

• Executives of seven troubled companies received
  almost 500 million in performance pay since 2005
• American International Group, Bear Stearns,
  Citigroup, Countrywide Financial, Lehman
  Brothers, Merrill Lynch and Washington Mutual.

G. Morgenson, After Losses, a Move to Reclaim
Executives Pay, New York Times, February 22,
2009. Prepared by Timur Gok
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Idiots?

• Stan ONeal left Merrill Lynch with a package
  (stock options, unvested shares, deferred
  compensation, pension payments and other
  benefits) worth about 160m
• Bear Stearns Cos.'s James Jimmy Cayne made 161
  million before the company collapsed and was sold
  to JPMorgan Chase Co.
• Prepared by Timur Gok

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Role of Boards of Directors

• Oversee and evaluate the business
• Select, compensate, and, where necessary, replace
  senior executives
• Review the firms financial objectives and its
  accounting.
• American Law Institute
• Principles of Corporate Governance

J. Macey, Corporate Governance, Princeton
University Press (2009). Prepared by Timur Gok
68
Dual Role for Boards
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Irreconcilable

• No man should be allowed to be a judge in his
  own cause, because his interest would certainly
  bias his judgment, and, not improbably, corrupt
  his integrity. With equal, nay with greater
  reason, a body of men is unfit to be both judges
  and parties at the same time.

James Madison in Federalist 10 as quoted by J.
Macey (2008, p. 54). Prepared by Timur Gok
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Remedies

• Insiders v. independent directors
• Supervisory board v. management board
• Board committees
• Prepared by Timur Gok

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Problems Run Deeper

• Groupthink
• Independent Directors lose their independence
  as long as they collect directors fees from the
  organisation.
• If the are not paid fees they value may not be
  great
• Independent Directors with limited knowledge of
  the business contribute little to its strategic
  direction.

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Restructuring the Corporate Framework

• What can be done?
• There is a need for the Audit Committee to play a
  role in monitoring the nature and extent of
  incentive schemes that are offered to management.
  
• There should open lines of communication between
  the Internal Audit Function and the Risk
  Management Function so as to ensure that evolving
  risks are understood and addressed.

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Restructuring the Corporate Framework

• To assist in their oversight function of risk
  the Audit committee in particular should receive
  training in best practices for managing risk
  exposures.
• The qualifications and experience of Board and
  Audit Committee Members should reflect the needs
  of the Organisation There are few Risk
  Professional or financial analysts on many Boards.

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Implementing Audit Committee Fundamentals Best
Practice

• Implementation is key

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BEST PRACTICE

• The Institute of Internal Auditors have provided
  some guidance with respect to best practice for
  Audit Committees in dispensing their oversight
  function ( Regard Risks)
• The Audit Committee needs to know the extent to
  which management has established effective Risks
  Management systems.
• Be aware of and concur with the organisations
  risk appetite.
• Meet periodically with those responsible for risk
  identification, assessment and management
  throughout the organisation

76
BEST PRACTICE

• Discuss with management how risks, including
  fraud risks, are identified and how those risks
  are assessed in regard to likelihood and impact.
• Understand internal auditings role and planned
  coverage, and meet periodically with the CAE to
  discuss the Risk Management process.

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BEST PRACTICE

• Review financial reporting risks, weigh them
  against the organisations risk appetite and
  discuss with management how effective the
  controls in place are to mitigate those risks,
• All Audit Committee members should receive
  information needed so that effective evaluation
  of the risk management process can be made.
• ( Source The IIA)

78
BEST PRACTICE

• A structured process should be in place to review
  the performance of the Board, as well as the
  performance of Committees of the Board in
  particular the performance of the Audit Committee
  of the Board.

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WHAT IT ALLCOMES DOWN TO

• At the end of the day it all comes down to
• Good Old Corporate Governance and
• Effective Risk Management.

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Closing Remarks