The Changing Role of the Audit Committee: Applying the Lessons

July 17, 2009 Andrea St. Rose & Associates

The Changing Role of the Audit Committee: Applying the Lessons

Presented by Andrea St. Rose & Associates

Bay Gardens Hotel – July 17, 2009

July 17, 2009


1. Global Overview of the Financial Crisis

2. Current Issues and Risks – What Regional AuditCommittees Should Know

3. Setting the Agenda for future Success in theCaribbean

4. Restructuring the Corporate Framework to Strengthen the Audit Committee

Agenda

July 17, 2009


5. Implementing Audit Committee Fundamentals & Best Practice

Agenda

6. Question and Answers

July 17, 2009

Global Overview of the Financial Crisis

July 17, 2009

Global over view of the Crisis

1.The Making of a Financial Crisis

3. Our Caribbean Experience – Jamaica, Trinidad, Antigua

Structure

2. The Global Experience

July 17, 2009

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.

July 17, 2009


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 1930’s

July 17, 2009

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.

July 17, 2009


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.

July 17, 2009


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.

July 17, 2009


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.

July 17, 2009


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.

July 17, 2009


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.

July 17, 2009

THE GLOBAL EXPERIENCE

CASE STUDIES –

A look at some failed institutions

July 17, 2009

Merrill Lynch & Co.

In 2005 CEO of Merrill Lynch pointed out:

“We’ve got the right people in place as well as good risk management and control.”

E. Stanley O’Neal, CEO, 2005

Source on Merrill Lynch & Co.: G. Morgenson, New York Times, November 9, 2008.

Prepared by: Timur Gok

July 17, 2009

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


July 17, 2009

Merrill Lynch & Co.

Ahmass L. Fakahany was vice chairman and chief administrative officer

He was responsible for the firm’s market and credit risk management as well as corporate governance and internal controls

“Weakened Merrill’s risk management unit by removing longstanding employees who “walked the floor” talking with traders”.


July 17, 2009

Merrill Lynch & Co.

Another key figure was Osman Semerci, who ran Merrill’s 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.”


July 17, 2009

Merrill Lynch & Co.

“The risk in Merrill’s business model became viral after AIG stopped insuring the highest quality portions of the firm’s CDO’s against default”


20

Merrill Lynch & Co.

Source: Wall Street Journal (April 18, 2008).

July 17, 2009


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, you’ve got to get up and dance. We’re still dancing.”

Chuck Prince, Former CEO, CitigroupFinancial Times, July 9, 2007


July 17, 2009

Lehman Brothers

Madelyn Antoncic, managing director of Lehman’s management committee and the firm’s 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.”


July 17, 2009

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.


July 17, 2009

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.”


July 17, 2009

The Decision Making Process

July 17, 2009


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


July 17, 2009


Lahde Capital ( USA)

In October 2008, Andrew Lahde, founder of California’s 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.


July 17, 2009

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 ruler—[a 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

July 17, 2009

A.I.G. Financial Products

Founded in 1987“By 2001, was generating $300 million a

year, or 15 percent of AIG’s profits.”AIG FP employees kept 30 to 35 percent

of the profits that they generated (the typical hedge fund keeps 20 percent)


July 17, 2009


In 2001, Hank Greenberg—and the AIG board—appointed Joe Cassano as the company’s third CEO

Presumably, Greenberg “saw in him a pale imitation of his tyrannical self and felt he could control him”


July 17, 2009


Under Cassano’s leadership, “AIG FP became a dictatorship”

“The way you dealt with Joe was to start everything by saying, ‘You’re right, Joe’.”

“Valued loyalty and obedience above all”.


July 17, 2009


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


July 17, 2009

OUR CARIBBEAN EXPERIENCE

A Look at what has happened – The Caribbean

July 17, 2009

OUR CARIBBEAN EXPERIENCE

Jamaican Financial Crisis ( late 1990’s)

Trinidad – Clico Financial

Antigua - Stanford International/ Bank of Antigua

July 17, 2009

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.

July 17, 2009

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.

July 17, 2009

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

July 17, 2009

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.

July 17, 2009

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 T’dad and abroad.

Very high leveraging of the Group’s assets which constrained the potential amount of cash that could be raised from asset sales.

July 17, 2009

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.

July 17, 2009

BANK OF ANTIGUA/STANDFORD INT’L 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.

July 17, 2009

Current Issues & Risks

What Regional Audit Committees Should Know

July 17, 2009

Current Issues and Risk

1.A breakdown of Risk controls vs. Financial Reporting Controls

3. Role of Audit Committee in Risk Management

Structure

2. What we already know

July 17, 2009


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)

July 17, 2009


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.

July 17, 2009


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.

July 17, 2009


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.

July 17, 2009


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.

July 17, 2009

Setting the Agenda for future success in the Caribbean

Emphasis on controlling risk exposures

July 17, 2009


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.

July 17, 2009


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.

July 17, 2009


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 organisation’s key risk.

(Source: The IIA : A Holistic View of Risk

July 17, 2009

Restructuring the Corporate Framework

Strengthening of the Audit Committee

July 17, 2009


1.Corporate Governance – an overview

3. Cases – Excessive Compensation

Structure

2. The Dual Role of Boards

July 17, 2009


It all come down to Proper Corporate Governance

July 17, 2009

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.


July 17, 2009

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


July 17, 2009

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).


July 17, 2009

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.


July 17, 2009

Challenge

In the shareholder-centric system, separation of ownership and control may lead to the violation of the fundamental promise

The “agency problem”


July 17, 2009

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


July 17, 2009

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


July 17, 2009

Law of Unintended Consequences

Target“Align” managers’ and shareholders’

interestsToolIncentive compensationOutcomeDistorted incentives


July 17, 2009

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.


July 17, 2009

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.


July 17, 2009

Idiots?

Stan O’Neal 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.


July 17, 2009

Role of Boards of Directors

Oversee and evaluate the business;Select, compensate, and, where

necessary, replace senior executives;Review the firm’s financial objectives and

its accounting.American Law Institute

Principles of Corporate Governance

J. Macey, “Corporate Governance,” Princeton University Press (2009).


July 17, 2009

Dual Role for Boards

Monitor

Manage

July 17, 2009

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).


July 17, 2009

Remedies

Insiders v. independent directorsSupervisory board v. management boardBoard committees


July 17, 2009

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.

July 17, 2009


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.

July 17, 2009


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.

July 17, 2009

Implementing Audit Committee Fundamentals & Best Practice

Implementation is key

July 17, 2009

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

July 17, 2009

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 auditing’s role and planned coverage, and meet periodically with the CAE to discuss the Risk Management process.

July 17, 2009

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)

July 17, 2009

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.

July 17, 2009

WHAT IT ALLCOMES DOWN TO

At the end of the day it all comes down to:

Good Old Corporate Governance and

Effective Risk Management.

July 17, 2009

Closing Remarks

Documents

The Changing Role of the Audit Committee: Applying the Lessons