As the name implies, independent monitors provide an objective view of a company’s operations — a perspective that can lead to valuable insights about the company’s operations and business practices. While actions leading to the appointment of a monitor can damage a company’s reputation, not to mention shareholder value, a monitor’s presence can actually make a business stronger over the long term.

A Growing Emphasis on Monitors

Independent monitors were first used in the context of resolving local corruption and organized crime investigations, but their role has expanded over the past three decades. Most monitorships now come as part of a settlement agreement between an organization and a court or a government agency as a way to defer or avoid prosecution. Deferred prosecution agreements allow companies to avoid indictment if they pay a fine, cooperate with investigators and institute reforms. These reforms are often tracked under the watchful eye of an independent integrity monitor.

Not surprisingly, companies with court-appointed monitors tend to balk at their presence, even when they offer an alternative to prosecution. Executives rarely like the idea of an outsider looking over their shoulder and — in their view at least — intruding on their business.

Changing Perceptions — and Business Practices

However, once a monitor has been at a company for a while, employees begin to understand he is not there to interfere. He is there to observe and report back periodically to the government about what’s going on —which means he can also present the positive aspects of what an organization is doing. Once management sees that, they begin to feel quite different about the role. Properly administered, a monitorship can be an effective, efficient and economical way of resolving an enforcement matter and avoiding future violations — all while helping the company rebuild its relationship with regulators.

For this reason, selecting the right monitor is a critical step. Where the court or government agency allows a company to choose its own monitor — subject to approval — the organization should carefully evaluate its options as it would for any other service. A monitor who is ineffective in his role won’t sit well with the court or the government and could further damage the organization’s reputation.

A Multidisciplinary Approach

FTI Consulting was recently appointed as the monitor for PokerStars, one of the world’s largest online poker sites. Prosecutors in the U.S. Attorney’s Office for the Southern District of New York indicted an owner of PokerStars and also brought a civil suit to seize its domain name, effectively putting it out of business. Subsequently, PokerStars reached an agreement with the government that allowed it to reopen around the world on the condition that PokerStars block players from the United States from accessing the site to play for real money. FTI Consulting was selected to monitor PokerStars’ compliance with the agreement.

FTI Consulting’s multidisciplinary team comprised former prosecutors, investigators, technology experts, financial and enterprise data analytics experts and forensic accountants. They traveled to PokerStars’ headquarters on the Isle of Man and are currently in the process of analyzing all of PokerStars’ systems to measure its compliance with its agreement. This multidisciplinary approach can help a company avoid the perception that it’s not fully invested in compliance activities.

Consider the case of a construction materials supplier, which in 2007 hired an independent monitor as part of a plea agreement to resolve criminal and civil liabilities involving a large public works project. The monitor’s activities were limited to reviewing the company’s books every quarter. This narrow scope missed several infractions in the company’s field operations. When these incidents came to light, prosecutors demanded that a new monitor be appointed. FTI Consulting took over the monitor’s role, with a broader mandate for tracking compliance.

The construction company’s experience reinforces the point that monitors should not just be accountants — they must provide oversight and reporting on all parts of the business. The construction company is beginning to warm up to these benefits. They’re beginning to see the positive effect that the monitorship can have in changing the government’s perception of their company. As part of its efforts to increase transparency, FTI Consulting’s five-person team created an intranet that is accessible 24/7 by the government and the company. Information on findings is posted daily, including a report card that tracks compliance against benchmarks. Transparency leads to confidence in the company’s commitment to change its corporate culture to one of compliance.

An Opportunity

Corporate monitors are almost never invited in by the company they monitor. On the contrary, they are usually viewed with some suspicion. But instead of pushing back against independent monitors, companies can take advantage of them to present the organization in a better light to regulators, investors and customers.

They can help a management team improve the way it does business in two important ways. First, they enable management to devote its full energies to managing the business instead of managing compliance. Second, monitors can help companies instill better transparency and reporting, which lead to better management practices generally. Since companies are obliged to pay for the service anyway, it makes sense for them to extract the maximum benefit from it.

D.T. (Dee) Kapur, President of Navistar’s Truck Group since 2003, recently sat down with FTI Journal to share his perspectives on how the region’s unstable past is giving way to a more promising future for patient investors who can identify the right opportunities and address challenges creatively.

New Opportunities from Free Trade

FTI Journal: Navistar has a strong manufacturing presence in Brazil. Why is Brazil a better place to manufacture engines than the United States? Is it simply an issue of cost?

Dee Kapur: Brazil is not a low-cost country anymore. In fact, if we could get a free trade agreement and ship to Brazil tariff-free, we would think hard about manufacturing in the United States and shipping to Brazil. To qualify for lower tariffs and government subsidies in Brazil, products must have 60% local content by value and 60% local content by weight. Without adhering to these guidelines, you can’t price competitively.

FTIJ: How attractive is the Latin American market?

Kapur: I think the fact that we are investing there speaks for itself. These are growing markets, and they are part of the Americas; they’re strategic trading partners in many ways. We intend to grow in those markets because we know we can be profitable there.

FTIJ: Are any other free trade agreements involving Latin American countries in the works?

Kapur: Free trade agreements with Colombia and Panama were approved by Congress and will take effect this year. They will largely eliminate the tariffs on imports from the United States, which will be beneficial. So we can now dispense with having to do strange things like manufacture in Mexico, get content from Colombia into Mexico, and then ship it back so it meets certain local content requirements to minimize tariffs.

FTIJ: A free trade agreement seems to give more certainty to investors in this capital-intensive business. Do these agreements influence whether you export or manufacture locally?

Kapur: Several considerations come into play. The most important is: Does this align with our strategy? Is it a growth opportunity? Is their market large? If the answers are a firm yes, then you look at the costs and benefits of local manufacturing vs. exporting. Generally speaking, for very large markets like Brazil, with great prospects and great growth, we make the commitment to invest in local manufacturing.

Business Makes a Comeback

FTIJ: In our roundtable session with Latin American business leaders (see page 44), there was a sentiment that the United States is turning its back on Latin America and letting the Chinese and others play a more dominant role. What’s your view on that?

Kapur: Ten years ago I may have agreed with you. But today I look at our own company, at GE, Caterpillar, Ford, IBM — they all are pouring on the coals and gaining traction, so I think the days of uncertainty about the Latin American legal systems, the level of crime and the institutions are receding.

FTIJ: How do you think opportunities in Latin America compare with opportunities in Asia?

Kapur: They are obviously very different. The appeal of Latin America is that it’s close to us, and in many countries they accept U.S. standards. We have some level of cultural alignment just by virtue of being close by. But you can’t turn a blind eye to Asia’s huge and growing population.

A Troubled Past Recedes

FTIJ: How hard do you look at social unrest, political and economic instability, and other risk factors when you decide whether to operate in a Latin American country?

Kapur: We look at them pretty rigorously. That’s not to say that we won’t make a bet anyway, but we will find a way to work around those risks. For example, we’re not going to invest tomorrow in Venezuela, but we still have a dealer there and we still look to ship trucks to them out of the United States or Mexico.

FTIJ: Do you think most Latin American countries are good candidates for investment and business relationships?

,Kapur: I think that the benefits from thriving manufacturing and trade are influencing people who might have in the past turned to crime and drugs. When the political classes reinforce that, it lays the groundwork for a stronger economy.

FTIJ: Can these countries also provide adequate skills and infrastructure?

Kapur: In certain markets. Brazil is growing so fast and qualified people are becoming very marketable, so they move. Providing great career opportunities and professional challenges can help manage that. In other markets, you have to go through the work of training these people, as we did in Colombia.

Poised for Future Growth

FTIJ: In general, what is your outlook on Latin America for the next decade?

Kapur: We’re bullish, obviously. The world’s growing economies, most notably China and India, will need the commodities produced in Latin America — its foods, its natural resources, such as minerals and oil. Consider also that Latin America is improving its ports, roads, rail systems and the Panama Canal, and that Brazil is getting ready for the 2014 World Cup and 2016 Olympics. It’s hard to see a fundamental dislocation in that part of the world.

FTIJ: What advice would you give to other companies that haven’t yet “put their toe in the water” in Latin America, but for which there might be a market?
Kapur: The growth in the region, and the skyrocketing demand for consumer products, bode well for people getting in at the right time and growing with the opportunity. But if you think you can go there tomorrow and be wildly successful the day after tomorrow — maybe that happens, but in all likelihood it won’t. Smart companies will stake out some territory there, work hard to seed the ground, fertilize it and then harvest.

In June 2011, a Thomson Reuters survey of more than 400 senior compliance officers, risk managers, internal auditors and lawyers found that almost 40% were unprepared for the most significant update to U.K. bribery rules in more than 100 years.

In the past, U.K. bribery rules were typically seen as less stringent than those in the U.S. Foreign Corrupt Practices Act (FCPA). But now the United Kingdom’s bribery laws match, and in some cases exceed, FCPA rules in both scope and intensity.

It is important to note that both acts are extraterritorial — companies with significant business interests in the United States or the United Kingdom can be prosecuted for alleged bribery in other jurisdictions.
Here are some of the other key differences and similarities between the FCPA and the Bribery Act:

Bribery Laws Expand to the Commercial Realm

Previous U.K. regulations focused on bribery or attempted bribery of government officials. The new act adds penalties for the commercial bribery of nongovernment officials — for example, for bribing a purchasing manager to order more goods from your company. The U.S. laws still cover only governmental bribery.

Facilitation Equals Bribery in the United Kingdom

In some countries, companies are expected to give government officials small “facilitation payments” to expedite a transaction or even to perform their official duties. For example, a truck driver may be expected to pay a customs official $20 or $30 to allow a shipment to be imported. U.K. Bribery Act rules define these facilitations as bribery and call for prosecution of those who engage in the activity. In the United States, FCPA regulations still allow certain types of facilitation payments.

Bribery Cannot Be Outsourced

U.S. regulations already placed responsibility for the actions of corporate agents squarely on their employer; the United Kingdom now has similar rules.

Failure to Prevent a Crime is now a Crime

The Bribery Act vaults beyond its U.S. counterpart in creating a new category of offense: failure to prevent bribery. If the U.K. Serious Fraud Office (SFO) can prove that a corporate employee or someone connected to the organization paid a bribe as part of doing business, the corporation could be held liable even if it did not authorize the bribery. In fact, the law specifies that the company bears automatic guilt unless it can prove it had adequate procedures intended to prevent bribery and corruption.

Look Before You Merge

U.S. law states that companies may bear some liability for bribes that were paid by an acquired company, even if those bribes took place before the acquisition. The new U.K. law is comparatively vague about M&A bribery liability, but companies should still treat this area as a potential minefield and conduct due diligence.

Don’t Depend on Deferred Prosecution

The U.S. Securities and Exchange Commission and Department of Justice have the flexibility to offer deferred prosecution or nonprosecution agreements to companies that voluntarily report bribery problems, clean house and strengthen their antibribery controls. U.S. companies that scrutinize themselves by hiring third-party investigators and forensic accountants can often get a credit from the SEC against future fines and penalties. To date, no such deferred prosecution option exists in the United Kingdom. That can have severe consequences, since European Union procurement rules automatically and indefinitely bar firms convicted of corruption from competing for government contracts.

The Importance of Being Honest

It is still hard to predict exactly how the Bribery Act will be enforced. Deferred prosecution agreements may be put forward in the United Kingdom, but legislation could take at least a year. Meanwhile, the SFO may experiment with lower-cost, independent compliance-assistance models pioneered in the United States.

In the meantime, companies may wish to perform a comprehensive risk review to ensure that their policies and controls minimize the danger of running afoul of either U.S. or U.K. laws. The SFO has also indicated that it expects institutional investors to discuss Bribery Act compliance with the companies in which they invest.

FTI Consulting has partnered with respected anticorruption organization Transparency International and engineering consultancy Halcrow to produce a guide (transparency.org.uk
/working-with-companies/adequate-procedures) for companies reviewing their bribery prevention policies.

Companies that commit to stamping out bribery and that establish a reputation for honesty not only reduce their risks but also gain a competitive advantage among employees, customers, investors, suppliers and other stakeholders.

Across the globe, cyber attacks from outside the company get enormous attention. But much less attention is directed toward an equally perilous — and possibly more daunting — threat: employees absconding with intellectual property and other confidential information.

Since the economic downturn, cases of intellectual property theft by employees have been increasing significantly. A recent study by the U.S. Federal Bureau of Investigation found that 44% of companies it studied had experienced internal theft of intellectual property. Fearful of losing their jobs, some employees become desperate, and one way of protecting themselves is to walk off with information that would be valuable to a competitor — for example, lists of top customers, pricing schedules, strategy documents or computer code.

Helping oneself to company information is getting easier. Whereas pilfering information once meant photocopying it and sneaking it out, today more than 80% of a company’s information is stored electronically. Some 75% is never printed. As employees bring their own mobile devices to work and make use of “the cloud” to store and exchange information, it can leave the company’s control in seconds.

Employee intellectual property theft is difficult to detect. A company’s workers have legitimate access to proprietary information as part of their work. For example, few would question a sales representative’s copying contact lists, presentations or other material for easy access outside the office. Thus, employee theft of intellectual property often flies below the radar. Here are two examples of FTI Consulting projects:

• An industrial equipment manufacturer discovered information theft only after its suspicions were aroused by the resignation of the sales vice president and several direct reports all on the same day. They had formed another business and were using sales contacts, pricing models and other information to build it.
• Members of a financial services firm were conspiring to set up a competing business with confidential client information. They shared their plans through text messages on company-owned smartphones.

No company is immune to these attacks. Because so much company information is used legitimately outside the office, it is practically impossible to set meaningful alarms. But companies can better protect themselves. Management teams should tighten employee onboarding and exiting processes, and put proper forensic computer procedures in place.

Onboarding and Exiting

When companies bring on new employees, the process should thoroughly cover company policies on intellectual property and confidentiality. Ideally, these policies would be included in employment contracts and confidentiality agreements. Continually articulating these policies is crucial. It makes the company position clear and supports legal actions in which employees claim policies were vague.

The employee exit process is also an effective point for heightened scrutiny. Although it is not practical to conduct forensic computer investigations with every employee departure, management should identify key positions with potential risk. These could include sales representatives, whose contact lists often contain customer data that is protected by privacy laws, but also any employees with access to proprietary or confidential information that they might use after leaving.

Make Sure Information Works as Evidence

When companies suspect employee intellectual property theft, they often move hastily: IT or HR is contacted and the staff springs into action by opening files and saving information onto CDs or portable devices. On the surface it may appear that the evidence has been obtained. But in actuality, all the company has is data. That probably isn’t usable as evidence.

Evidentiary standards require detailed chronological documentation of everything that happened to the data. Opening, printing and saving files can permanently change metadata that records who did what to the file and when. Just booting up a computer can overwrite items such as caches and temporary files. Combined with altered metadata, these changes can make it difficult to prove what the employee actually did.

Sometimes computer experts can restore damaged evidence, but just as often they can’t. The process can be costly and take valuable time. To avoid the fire drill, management should be certain that proper computer forensic skills and processes are in place.

Move Quickly to Action

Stolen intellectual property can improve with age — the people who have taken it have more time to use it. Quickly understanding the facts and having reliable evidence allow management and legal teams to decide early what steps they can and should take. For example, the company could file for a temporary restraining order, pursue court orders to examine personal computers, or simply contact the employee’s new employer and inform the company of what has occurred. It is also valuable to tightly integrate computer forensic activity with other forensic processes in the company, such as accounting. Evidence of fraud or other misconduct is likely to be found in computer files and electronic communications. Early, coordinated and immediate action may be necessary to discover evidence and prevent its destruction.

In times of economic distress, the incidence of employee intellectual property theft by employees can jump. Although such theft is difficult to detect, companies can take steps to protect themselves and make strong defensive moves when theft is suspected.

The Demand for Better Risk Management

There are seemingly many regulatory requirements to address shareholder concerns. Companies undergo costly, lengthy audits to adhere to Generally Accepted Accounting Principles (GAAP) and receive objective opinions on their financial statements from accounting firms. Section 404 of the Sarbanes-Oxley Act of 2002 (SOX 404) assesses a company’s internal controls and requires a top-down risk assessment. The Public Company Accounting Oversight Board (PCAOB), concerned about the quality of independent audits, has recently embarked on audit reform to ensure that accounting firms render an objective opinion. In 2010, the U.S. Securities and Exchange Commission established rules that require boards to disclose risk oversight measures. The Dodd-Frank Act requires U.S. public companies to adopt clawback policies requiring the return of incentive compensation paid to executives based on erroneous financial statements. In addition, companies can no longer exclude proposals from proxies where shareholders are seeking more disclosure on risks related to major policy issues.

Yet these measures can be inadequate. While regulatory requirements address internal controls and attempt to measure risk, companies are ultimately responsible for managing it. Compliance with GAAP, for example, does not speak to how management decides to apply it. A company can be in compliance with regulations and still fail to effectively manage and mitigate risks. One multibillion-dollar company cleared its SOX 404 testing with significant liquidity issues and filed for Chapter 11 bankruptcy a few weeks later.

Many organizations have not yet developed robust risk management programs or embraced a culture of risk management. According to a 2010 survey by the American Institute of Certified Public Accountants, 45% of companies had no enterprise risk management framework in place. Of those that did, only a fraction described them as “mature” or “robust.”

To bolster and centralize risk management efforts, management and the board should consider turning to the CFO and finance organization. It is already the CFO’s responsibility to ensure that the company’s books and records can withstand scrutiny. He or she manages the risks associated with issues such as financial restatements, liquidity crises or even fraud. But CFOs can contribute more. Through their enterprise role in budgeting, raising capital, making investment decisions and providing operational oversight,

CFOs engage with every aspect of a business. These executives have a prime vantage point and possess the analytical skills to identify and quantify risks with an integrated enterprise view. Even in companies in highly regulated industries with long-established risk functions and officers, the CFO is becoming a more important partner in assessing systemwide risks.

The Transformation of the CFO

The finance profession within large organizations has been in transformation for more than a decade. Where it was once relegated to reporting, budgeting and cash management, finance professionals have become business planning partners by weighing in on strategies and contributing input to product development, manufacturing, marketing and other key functions.

As organizations struggle to connect strategic management with financial and other planning processes, the CFO and finance organization are taking on a more active business planning partnership role within many enterprises. It is not uncommon, for example, for CFOs to lead operational reviews, develop planning models and test assumptions in different business scenarios. Enterprise risk management is the next logical step in the transformation. CFOs and their staffs can harness industry and company knowledge and combine it with sophisticated analytical techniques to drive the assessment of enterprise risk and the decisions made to measure and mitigate it. Developing key performance indicators is a start; building a risk-aware culture is the continuum.

The CFO as Risk Manager

Since CFOs often lead enterprise performance management processes, risk management efforts can be tied into that work and role. In addition, CFOs bring to the table a long-term view with a strong focus on quantifying the financial impact of decisions and events. As a result, CFOs are increasingly making contributions to managing financial and nonfinancial risks beyond their purview of ensuring accurate financial information.

Some notable examples include developing risk metrics that tie directly to shareholder value, moving beyond narrowly focused measures that analyze currency or credit risk. CFOs also play a hands-on role in identifying and mitigating market risks. At Virgin Mobile, for example, the CFO saw the financial troubles at Circuit City early on and immediately tightened credit terms and started monitoring shipments daily.

CFOs can link capital structure to strategy, ensuring that the balance sheet isn’t overleveraged, and quantify and monitor the impact of investments. At Concentra, a healthcare services company, the internal audit team developed an annual risk assessment portfolio to evaluate the performance risks of the enterprise after an aggressive series of acquisitions.

To mitigate natural-disaster and environmental risk, CFOs can develop contingency plans in the event of work stoppage and associated cost/benefit analyses of these contingency measures. Technology executives can turn to CFOs to assist in quantifying security risks and their potential impact on the enterprise to justify investments in enhanced security measures. CFOs are also involved in managing risks associated with employee recruitment, retention and compensation, and may also manage risk associated with suppliers and third parties.

Some CFOs are also playing a greater risk management role with individual lines of business. In that role, they communicate critical issues internally and externally. It is not uncommon for the CFO and finance organization to spend time in the field deepening their knowledge of unique risks specific to individual businesses. They can translate these risks into “heat maps” that articulate levels of risk and then tie those risk levels to corporate scorecards. CFOs are also

involved in communicating with the analyst community and media by detailing how certain risks, such as currency exchange rates, may affect performance without also reflecting weaknesses in the company’s strategy.

Talking about risks is a first step. Acting on risk programs is prudent and protects enterprise value. CFOs who create a robust risk management architecture not only can minimize financial restatements, liquidity crises, or other embarrassing or catastrophic events, but they can also help a company increase efficiency and achieve its profitability and performance goals. CFOs can play a role and proceed logically to the next step in the transformation of their profession: moving beyond reporting and compliance to bringing their organizational purview and analytical ability to a more active role in enterprise risk management.

Some investigations result in the full recovery of disputed assets. Other times, fraud victims recover only a fraction of the missing funds. How can countries and companies maximize their asset recovery chances?

An FTI Consulting study carried out in December 2011 showed that U.S. investors are concerned as well. According to Investor Viewpoints on Public Policy, institutional investors overwhelmingly believe that decisions made in Washington have a significant negative impact on the value of their portfolios. And by more than a three-to-one margin, they want companies to do a better job of informing them about the potential impact of policy changes on their businesses.

With enterprise value at risk from the uncertainty created in Washington, some 85% of the participants in the study felt that CEOs must proactively engage with policymakers to help shape policies and regulations and protect shareholder value. Those respondents were four times more likely to view active CEO engagement as a positive than a negative. Furthermore, they are calling for CEOs to use their leadership platform to get involved, educate investors about ongoing efforts and become more actively and personally engaged in shaping national objectives and policies.

The message from the FTI Consulting research is that analysts and investors not just give their permission for CEOs to engage in the political process — they mandate it.

But many executives choose to focus on running the business and stay out of Washington. They view Washington as somehow impenetrable and sometimes inhospitable. However, this is not necessarily so.

Previous FTI Consulting research has affirmed that the American people no longer trust government, business or the media. A leadership vacuum has been created, and people are looking for new leaders who are willing to put aside narrow interests and contribute to broader solutions that address the nation’s real and significant challenges. A recent independent study by the National Journal found that a strong reputation built on respect and integrity is central to a firm’s ability to influence policy debates.

Transferring a corporate reputation into a credible and relevant policy platform requires a strategic civic engagement plan that complements and reinforces current government and investor relations messaging. It includes thought leadership, executive positioning and political engagement. It should support existing positive narratives about the company and its involvement in policy-making.

With more than 4,000 think tanks and policy centers inside the Beltway, Washington is still a place where ideas matter. FTI Consulting believes that companies can have influence there if they advocate for good public policy as well as for their own interests.

For example, investors were worried that a major industrial company would be unfairly compromised by new rules and regulations coming from Washington. Some of the company’s top executives felt the company should publicly repudiate the regulatory agency. Instead, the CEO and senior level executives worked with the agency in question to find common ground. The company’s strategy included thought leadership, enlisting public support, and developing relationships and networks that led to policy consensus and helped the agency see the unintended consequences of previous policy positions. This helped

to build a better regulatory blueprint for economic growth. Through regular speeches and briefings to investors, the executive team was able to demonstrate how working productively with the government benefited the company and the industry.

Developing a “CEO as statesman” platform helps position executives above the partisan fray as policy leaders and broad advocates for industry. It allows them to engage on multiple levels through multiple channels. Civic engagement may include attending and sponsoring conferences with leading NGO policy centers to issue white papers and research; using public forums to articulate policy concerns and solutions; and lobbying members and staff of the U.S. Congress as well as relevant state/local/foreign governmental entities.

Now that the Supreme Court’s Citizens United decision provides more flexibility for companies to engage in the political process, businesses have more channels to advocate their public policy positions. However, the decision also complicates things. Calls for companies to disclose their spending on lobbying and political campaigns are gaining support, and many shareholders are also asking for transparency and a say in how lobbying dollars are spent.

Informing investors of policy risks and the company’s response requires a balancing act. Companies need to talk about the risks, but they should keep the discussion high-level. An overly complex or detailed explanation of policy scenarios may actually unsettle investors rather than reassure them. Most important is to communicate that the company has anticipated policy decisions and has already taken steps to proactively manage the risk. A well-executed civic engagement program gives a company credibility and relevance, as well as access to policymakers and opinion leaders needed in these uncertain times. This is a winning strategy to shape policy consensus, meet the concerns of investors, and ultimately protect and enhance enterprise value.

Free trade significantly improves the lives of almost everyone on the planet and particularly those in developing countries. It is vital that an open and rules-based global trading system continue to be a tool for sustainable growth and poverty reduction.

Failure to defend free trade had dire consequences in the early 20th century and again in the 1930s, following two earlier great ages of international trade. By failing to speak up sufficiently for the social, political and economic value of an open global trading system, our predecessors were rewarded with two world wars.

This may be the year the free trade edifice gives way. The omens are there. The so-called Doha Development Round, which was intended to move the world toward dismantling subsidies and tariffs in areas such as agriculture, remains stalled at best. Many feel it is broken beyond repair. The most recent biennial ministerial conference admitted Russia but made no progress on Doha, which only reinforced the dark political mood clouding trade talks. And the growing risk of the consumer-rich parts of the world lapsing into a double-dip recession presages likely political pressures to stem the flow of cheap imports that are thought to cost local jobs.

With key parts of the global increased protectionism might seem so obvious an outcome that it barely merits a column. Yet as I write this, there has been a strange silence on trade. This is partly because last year the United States was able to make progress on bilateral trade agreements with Colombia, Panama and South Korea, which had been given up for dead in the gridlocked atmosphere of Washington politics. This gave perennial trade optimists fresh hope. More strikingly, a short and sharp trade contraction occurred with the first economic downturn in 2008 as trade credit dried up, but then trade and the global economy seemed to bounce back.

Hence the complacency about trade: It has survived worse. We may not be about to see breakthroughs such as a new global trade agreement, but good sense will prevail, goes the comforting argument. We will also not see trading partners poking themselves in the eye by throwing up trade barriers that will further slow global growth. We are all in this together and will either sink or swim. And anyway, there are bigger things to worry about: the euro, U.S. elections and the coming leadership transition in China.

The trouble with that orthodox complacency is that a lot of what is happening in politics and finance at the moment traces back to a dysfunctional global trading system. Further, the economics establishment is no longer so unqualified in its assertion that free trade lifts all ships.

This takes away the prop that free trade is intellectually unassailable and it’s just venal politicians who choose to think otherwise for their own self-interested purposes. Now most are seeing vast concentrations of wealth at one end of the global scale and an emerging markets working class at the other, selling its labor more cheaply than in the old industrial economies. These factors are creating a structural jobs deficit in the north as well as new and politically unsettling patterns of extreme economic inequality. All this is driven by the globalization of markets, or free trade by another name.

The perceived injustice of these new disparities, within nations and between nations, is driving a lot of anger on both ends of the U.S. political spectrum, from Occupy Wall Street to the Tea Party protests. Alan Krueger, Chairman of the White House Council of Economic Advisers, noted recently that the percentage of income going to the top 1% is bigger than the total income of the bottom 40% of earners. This is marking a sharp rise in income inequality and having significant effects on the country’s middle class, Krueger said.

Less noticed is its impact on the euro and European politics. The euro crisis is in part a trade crisis. Large parts of the European economy have become structurally uncompetitive because countries like Greece and Spain have been locked into overvalued exchange rates that reflect German, not Mediterranean, economic competitiveness. The same process of a growth of internal inequality is under way. As in other parts of the world, this inequality was hard to see because of cheap consumer, mortgage and sovereign debt, which has now become unsustainable and has turbocharged the markets’ assault on the euro.

So, 2012 could well be the year the edifice comes tumbling down, political bricks and mortar and the intellectual foundations giving way at the same time. If so, it will be a disaster for the world. Free trade may presently be provoking a nationalist and populist backlash in many quarters, and its contribution to jobs and growth may be more complicated than previously blithely asserted. Still, it remains a critical underwriter of a liberal global society. We let it go at our peril. Those of us in any walk of international life, be it business, the public or not-for-profit sectors, need to get up and say so before it is too late.

In 2009, Gucci America filed suit against a company, alleging it was selling counterfeit Gucci products. The United Overseas Bank found itself a third party to the suit. Its New York agent was subpoenaed to provide banking data in Malaysia, where the funds from the sales allegedly were. The bank protested, citing Malaysia’s strict banking secrecy laws. Nonetheless, the courts ordered the bank to comply, confronting it with the choice of being in contempt of a U.S. court or facing criminal prosecution and nearly $1 million in fines in Malaysia.

Dilemmas like this one are on the rise. Laws such as the U.S. Foreign Corrupt Practices Act and the U.K. Bribery Act cross borders. Unprepared companies face costly measures to comply and avoid penalties. The SEC, for example, can fine and even delist a company.

Personal Data Can’t cross borders Easily

More than 65 countries have enacted laws to protect personal information. Specific industries are also subject to privacy regulations, such as the U.S. Health Insurance Portability and Accountability Act and the Bahamas Bank Secrecy Act. Privacy laws often prohibit exporting personal data to certain countries, in some cases even if a court subpoenas the data. The European Union, for example, allows personal data to be exported only to Argentina, Canada, Guernsey, the Isle of Man, Jersey and Switzerland, but not to the United States.

Unfortunately, U.S. authorities are often unsympathetic when companies claim that EU laws prevent them from supplying information. For example, in 2007 Credit Lyonnais was sued in the United States under the 1992 Anti-Terrorism Act. The suit alleged that the bank maintained records for a charity that was a terrorist front. The U.S. court ordered the release of account data and assumed that France wouldn’t uphold its privacy laws in this case. However, French lawyers who released the data were prosecuted and convicted.

Companies with operations in both the United States and the EU must find ways to comply with both sets of laws. They might consider the U.S. Department of Commerce’s Safe Harbor program, or implement binding corporate rules. They can also adapt EU-model contractual clauses.

U.S. courts and regulators may grant extra time if they are informed of countervailing laws in another country, but there are no guarantees that the other country will bend on those laws. So management must be prepared to submit the data within the bounds of EU laws. This means developing systems and processes that efficiently deal with such requests.

If a Company is Not Prepared…

EU regulatory authorities may grant permission to export personal information needed for a U.S. legal proceeding beyond the solutions described above. However, the process must be extremely well executed and must keep the information secure. The first step is to work with local counsel and establish a collection-and-review protocol for the subpoenaed information. Documents should be reviewed in a secure environment — such as a “war room” — in the country where the information resides. The data should not cross any borders.

Next, determine precisely what the investigating authority wants, then take steps to minimize the disclosure of unnecessary personal information. For example, e-mail can be culled by relevant keywords or date ranges, and attorneys can pull out only relevant information from the remaining e-mails. If these steps are followed, it is much more likely that the local authorities will grant permission to export the data.

Avoid the Costs of Being Unprepared

Once a company understands the data privacy laws in each country where it does business, it can develop a strategy to provide subpoenaed information with far fewer headaches.

However, compliance can affect numerous operational decisions. For example, many jurisdictions outside the United States require a company to know where employee data are physically located. But today, cloud computing applications can aggregate and move data across borders.

Companies should regularly re-examine and update document retention and storage policies to reduce the burden of restoring and recovering data from legacy systems and archives. Management must also know the location of data that might be needed in future disputes or investigations.

Finally, companies should be prepared in advance to structure information with appropriate protocols to facilitate in-country review and expedite permission to export. Also, employment contracts could include clauses that grant rights to transfer personal information in response to legal requests and issues. Companies can utilize other mechanisms, such as Safe Harbor schemes and binding corporate rules, to expedite the transfer of data outside the EU.

The growth of national and industry efforts to protect private information can easily land companies between a rock and a hard place. However, the difficult choice between violating laws in one jurisdiction and being in contempt of a regulatory body in another can be averted. To do so, management should seek to develop structures and protocols that allow it to comply with the laws in each country where it does business. For companies that have not yet done so, now is not too soon to start.

Many U.S. citizens and politicians have made free trade the scapegoat for the country’s economic ills, from unemployment to the struggles of small business. Free trade has been seen as synonymous with “shipping American jobs overseas.”

But U.S. Trade Representative and Ambassador Ron Kirk, the country’s top trade official, has a broader and longer view of free trade’s many benefits. In a discussion with Edward Reilly, Global CEO of the Strategic Communications Practice of FTI Consulting, Ambassador Kirk — who has held his post since March 2009 — explained how free trade will be the engine for future growth and prosperity in the United States and elsewhere.

Here he discusses how free trade can benefit large and small businesses when the rules are fair and properly enforced.

Free Trade’s PR Problem

Edward Reilly, Global CEO, Strategic Communications practice of FTI Consulting: Is U.S. business leadership doing enough to support the trade agenda?

Ambassador Ron Kirk, U.S. Trade Representative: Over the past few years, businesses have been preoccupied with just surviving, like everybody else. But many are recognizing that our economy can expand and create jobs only if we can reach out to new consumers in emerging markets. That’s counterintuitive to many Americans who say, “Isn’t trade responsible for our factories closing and jobs going elsewhere?” But free trade can operate very much to the benefit of American businesses and workers and deliver more jobs as well as more options for consumers.

I think businesses get that. But they still need to acknowledge that many Americans don’t believe trade has been as good for them as it’s been for business.

Reilly: Are American businesses taking proper advantage of both the environment that you’re trying to create and the opportunities that are available to them in markets around the world?

ambassador Kirk: You could easily conclude that the Fortune 500 companies are heavily vested in global commerce because an increasing share of their income is coming from global sales in new markets. Historically the Chamber of Commerce, the Manufacturers Association and the Business Roundtable have been the most consistent, positive voices for a proactive U.S. trade agenda.

But average Americans just are not buying the argument that free trade is good. Whether it’s true or not, they have come to associate trade with manufacturing jobs being moved offshore and are increasingly fearful that more service and white-collar jobs will go there as well. We’ve strived for a balanced approach that addresses those concerns honestly. That means being attentive about enforcing our trade agreements to make sure that we realize the benefits.

We must prove that the one way to help sustain and create jobs — whether in Texas, Florida, New York, Detroit or Maine — is having a thoughtful policy that gives us access to new markets. We need to be able to draw a much more direct connection between our trade agenda and the #1 issue on the hearts and minds of most Americans: where the next wave of jobs is going to come from.

The WTO’s Work

Reilly: How important will the World Trade Organization be as we move forward to liberalize trade rules and actually attempt to enforce agreed trade protocols?

Ambassador Kirk: The World Trade Organization has the primary responsibility to make sure members abide by the pledges they make when they join this global trade network — because free trade works only when everybody plays by the rules. That’s going to be critical in a world where trade is going to drive economic growth as much as any other factor.

The economic stagnation in Europe, and even in some of the dynamic emerging economies, shows that government’s ability to “prime the pump” is limited. Countries are increasingly looking to generate economic vitality by selling more to new markets around the world.

The WTO must also guard against protectionism, which is a challenge when regions such as the United States and Europe are going through such economic difficulty. History has proved that protectionism actually operates against economic recovery. When the Smoot-Hawley Tariff Act was put in place during the Great Depression, the act helped prolong it.

Reilly: Most U.S. trade agreements are bilateral, involving just one other trading partner. Can the United States make more progress with multilateral agreements involving several countries?

Ambassador Kirk: Most of our agreements are bilateral, but as you begin to look for scale, you need to focus on where the customers are and be flexible. Some of these dominant emerging markets are in India, Brazil and Africa. We have thoughtfully looked at where economic activity is going to be more robust, where we have natural partnerships and where we can get a foothold.

The Trans-Pacific Partnership is a great example of an opportunity involving several partner countries. We are now negotiating with eight other countries that border Asia or the Pacific: Australia, Brunei Darussalam, Chile, Malaysia, New Zealand, Peru, Singapore and Vietnam. Our goal is to anchor the United States in this region, which economists say will continue to grow, and draft a trade agreement that meets the needs of our economy today.

In Detail

U.S. Trade Representative Ron Kirk, the country’s top trade official, has held his post since March 2009. A member of President Obama’s Cabinet, Kirk helped broker free trade agreements with Korea, Colombia and Panama, and advanced the ambitious regional Trans-Pacific Partnership talks. He also represented the United States in the World Trade Organization’s Doha Round of negotiations. Previously Kirk served two terms as mayor of Dallas — the first African American to hold that office — and was named one of the 50 Most Influential Minority Lawyers in America in 2008.

Reilly: Which countries or blocs are the highest priority for moving trade agreements forward?

Ambassador Kirk: The President has challenged us to double exports within five years. We’re about halfway through that time period and we’re well on track to achieve our goal. Our strategy must be to give American farmers, ranchers and entrepreneurs access to the most dynamic markets.

The countries in the Trans-Pacific Partnership are among those markets. We are also deepening our ties with Latin America. President Obama and European Union President Herman Van Rompuy have directed us to create a working group to begin deepening our economic integration with the European Union as well.

The Challenge of Emerging Countries

Reilly: Some people would say that the Doha [round of trade] negotiations, in the end, did not accomplish anything. Does this mean an end to seeking universal solutions for liberalizing international trade, or is there any hope for that?

Ambassador Kirk: Our efforts to bring about trade liberalization in the broadest form possible are far from over. But the WTO had to recognize that the path that we had taken with the Doha negotiations was not leading us to the result that all of us wanted.

Doha has shown us the difficulty of getting 150 countries with the most diverse economies in the world to come to an agreement on anything. We still believe it’s worth going back to the table and taking a fresh look at trade liberalization within the context of the Doha Round and what efforts we might take alongside that. It can lift millions of people out of poverty, particularly in some of the least developed economies in the world.

Free trade helps consumers worldwide by giving them access to more goods and getting government out of the way of those transactions. Many of the emerging economies in the WTO — India, China, and soon Russia and Brazil — are being transformed because they can now sell to markets in Europe, the United States and other developed countries. That’s a good thing, but these emerging countries now have a concurrent responsibility to help preserve that system by opening up their markets to our products.

Reilly: How can business leadership improve the environment for public dialogue around trade issues?

Ambassador Kirk: American business has a unique opportunity to recalibrate the message about the value of trade to America’s growth, and the need for America to continue to lead in global trade as we have done the last half-century.

It’s critically important that large businesses help their employees understand that their economic vitality and their jobs — even those based in Detroit, Chicago, Dallas or Des Moines — will be more secure if they can sell products in China, India and Brazil. That holds true even for products that are developed here but manufactured overseas.

Second, one of the best-kept secrets of our trade world is that more than 95% of U.S. exporters are what we define as small businesses. Yet most of our small businesses still see themselves as merely suppliers to larger companies, rather than to international markets. Larger businesses, which have the tools and resources and connections, should be educating smaller businesses about these opportunities and opening doors for them.

New Markets, Fair Play

Reilly: Moving forward, what are your top three priorities?

Ambassador Kirk: First, like every other Cabinet member who works for President Obama, our top directive is doing a better job of stimulating our economy and putting Americans back to work. That means using our trade policy to help American businesses sell more of what they make, grow and create to markets here and around the world.

Second, we must balance our energies between creating new market access and enforcing the rules of the game. One of the biggest complaints I’ve heard from frustrated Americans is that the U.S. markets are open to products from around the world, yet China, Europe, India and Brazil are still closing their doors to U.S.-made products. So opening up these markets can be just as important to our ability to sell as negotiating new agreements.

Third, the President has asked us to do everything we can to help businesses that are not yet involved in global trade to understand its power in helping them grow their business and finding new customers.

So the three things we think about are market access, enforcement and working with others to educate American businesses about the power of trade to grow our economy.

Reilly: Thank you for your time and perspectives.

Commerce depends on trust. Consumers purchase products on the Internet or in stores with the expectation that companies will protect their personal data — names, addresses, credit card numbers, purchase histories.

But it turns out that trust rests on somewhat shaky ground. A recent Ponemon Institute survey (Perceptions About Network Security, June 2011) of more than 500 IT and IT security practitioners in the United States found that 90% of their organizations had experienced at least one data security breach in the past 12 months, and nearly 60% said they had been hacked more than once during that period. Corresponding numbers for Europe from the same survey were 84% and 49%.

While not all security breaches result in the loss of personally identifiable information (PII), cybercrime’s damage can be far-reaching for both corporations and individuals:

• In April 2011, Sony Corp. announced that PII had been compromised for some 70 million users of its PlayStation Network. The company took heat from the public, politicians and privacy advocates for waiting nearly a week before warning customers that their personal data, including credit card numbers, could up costing parent company EMC $66 million in transaction monitoring and token replacement for corporate customers.

Not all breaches are this expensive, but many of them are still quite costly. The Ponemon survey found that 22% of attacks cost companies between $500,000 and $1 million in fines, liabilities and the IT costs of cleaning up, while 15% of attacks resulted in costs of $1 million to $2.5 million. In 2010, the Digital Forensics Association estimated that data breaches had cost companies a cumulative $139 billion over the previous five years.

As federal prosecutors, we work to protect the citizens of New Jersey from cybercrime, to defend the companies that do business here from cybercriminals, and to prosecute and convict anyone who uses hacking or other high-tech means to steal money or data or to cause other types of harm.

But our ability to stop this cybercrime wave and prosecute criminals is severely limited if the victimized companies don’t report the crimes. Wary of embarrassment, negative publicity and loss of customer trust, far too many companies fail to report the intrusion to us. In fact, we estimate that as many as 90% of data breaches and hack attacks go unreported.

Keeping a hack attack quiet may have short-term benefits for the corporate victim, but in the long run it only perpetuates the problem. Law enforcement authorities can use a wealth of resources to catch data thieves and bring them to justice. But we cannot act until we know about a breach.

Only by working closely with law enforcement authorities can corporations hope to gain the upper hand against hackers in the battle to protect data privacy.

IT Security is a Challenge, but Prison is a Deterrent

Given their high costs in money and in lost customer confidence, why do so many attacks still go unreported?

Many companies that are skittish about negative publicity think they can handle the problem internally. Or they’ll turn to an external forensics firm rather than call upon law enforcement.

Sadly, some companies find it easier to deny that a problem exists than to attempt to solve it. Internal investigations can be clouded by conflicts of interest. IT departments charged with investigating suspected breaches may be reluctant to admit that their data centers were inadequately protected. For example, when credit card companies flag suspicious activity and warn of potential data breaches, the victimized company may deny it after only a minimal investigation.

Even if a corporation or an outside forensics firm investigates a data breach more thoroughly, neither of them can issue warrants or subpoenas, or collaborate with domestic and international law enforcement agencies. Only we can do that.

Without the help of law enforcement, the best a corporation can hope to achieve is to control damage and tighten security to reduce the chances of another data breach. Corporations can almost never catch hackers on their own. To a hacker, IT security is just a challenge, not a deterrent. In our experience, the only lasting way to deter data thieves is to convince them that their actions will bring harsh consequences, including arrest, prosecution, conviction and imprisonment.

Don’t Make it Easy for the Hacker

While IT security alone can’t guarantee your data will be protected, it is still true that criminals seek out the easiest targets. All things being equal, a thief will be more likely to target a house where the windows are open and the jewelry is in plain view than one with a wall, barbed wire and a security system.

Corporations should implement all of the basic security steps — for example, requiring employees to create nonobvious passwords that are difficult for hackers to crack. Companies can also thwart hackers by implementing security and privacy standards such as ISO 27002, COBIT, NIST Special Publication 800-5 and/or generally accepted privacy principles. These standards are only starting points, and companies may want to go beyond them for additional protection.

Companies should also preempt attacks by disgruntled employees. One strategy is to separate powers within the IT department. This is standard practice in other organizational structures, but in IT some administrators still have access to all of a company’s data.

Organizations should be extra vigilant to guard against hacking at times of personnel changeover and disruption. Salary adjustments, hires, promotions, terminations and impending layoffs can trigger malevolent action against a company’s databases. Companies should implement policies that cut off systems access immediately upon termination. The day after the layoff is too late. And it is always a smart idea to keep database access logs for a long time so that law enforcement can quickly trace subsequent data breaches back to the point of origin.

Companies that receive warning of a suspected data breach from a credit card company must take that warning seriously and investigate it thoroughly. Several times, credit card companies have narrowed the source of a breach to a single company and issued a specific warning, only to have that company deny culpability. Expecting an IT department to investigate itself and unearth its own weaknesses goes against human nature. That’s why it often makes sense to bring in an unbiased third-party team to conduct a comprehensive investigation.

If a data breach has occurred, developing an ad hoc response plan while simultaneously trying to practice damage control seldom yields the best results. Develop that response plan before you need it. It should designate experts who will provide help and legal advice; a plan to preserve evidence; ways to inform the appropriate authorities; and a team for handling the crisis.

Treat Hacking as a Crime — Because It Is

Corporations routinely report other types of crimes. If a pharmaceutical company discovers counterfeit products in its New Jersey supply chain, it contacts the local U.S. Attorney’s office, the port authorities, and other relevant investigators and law enforcement personnel. The victim cooperates with law enforcement agencies to locate and prosecute the counterfeiter. The company is grateful for law enforcement’s help, and the authorities are grateful that the corporations have brought lawbreaking activity to their attention.

The same is true of shoplifting. For years, shoplifting was neither measured nor reported by retailers. Businesses hid shoplifting because they felt it gave them a black eye. By the 1960s and ’70s, shoplifting had become an epidemic with a serious impact on retailers’ bottom lines, and attitudes changed. They installed new technology, trained security staff, and started to measure and report shoplifting. Retailers posted warnings stating “Shoplifters will be prosecuted.” While technology and training were important, the most dramatic improvements came when retailers teamed up with law enforcement to arrest and prosecute shoplifters. This deterred them — and others like them — from repeating their crimes.

Corporate victims today can learn from the shoplifting example. Virtual “Cybercriminals will be prosecuted” signs should be posted across the cloud. As with counterfeiting and shoplifting, companies should harden their defenses and join with law enforcement to catch cybercriminals. Along with having more resources and powers than businesses do, police and prosecutors may already be investigating other data breaches involving some of the same individuals or organizations. We have learned that serious data breaches typically involve a core network of participants, each with a specialized role in acquiring, selling or monetizing stolen PII. Our insights into crime trends across jurisdictions put us in the best position to connect the dots and find relationships among hacking attacks at different companies.

For example, in 2003, Lowe’s suffered a data breach. A hacker named Brian Salcedo gained access to a corporate data center via a Wi-Fi hotspot outside a store in Southfield, Michigan. Salcedo planted software to scrape credit card data so that he could access it later. When Lowe’s IT department discovered that its data center had been breached, the company faced a difficult choice: Plug the data breach or keep it open long enough for law enforcement to assume an active role. Rather than trying to handle the situation on its own, Lowe’s contacted law enforcement. The FBI quickly isolated the source of the data breach and caught Salcedo in the act of hacking. He was arrested, prosecuted and sentenced to nine years in prison.

Medco Health Solutions is another success story. In 2003, Yung-Hsun Lin (a.k.a. Andy Lin), a Unix administrator who was upset by the possibility of impending layoffs, created a ticking “logic bomb” within some server code. Programmed to go off on Lin’s birthday in 2004, the bomb malfunctioned due to a programming error. Lin attempted to correct the error and reset the bomb, but a Medco computer systems administrator discovered and disabled the bomb a few months before its new trigger date. Rather than just trying to fix the problem itself, Medco referred the matter to law enforcement. Our office prosecuted Lin, who pleaded guilty. He was sentenced to 30 months in federal prison and ordered to pay $81,200 in restitution. The conviction, which was widely reported, sent a strong message to disgruntled employees that cybercrime carries real risks and penalties.

Misconceptions Keep Hackers in Business

Many corporations don’t realize how seriously law enforcement treats hacking crimes, or they might think the costs of asking us for help after a data breach or data theft are too high. They also underestimate our ability to stop the crimes or catch the criminals. Given these misconceptions, it is not surprising that many companies believe they can depend only on their own IT staff for protection from hackers.

In reality, cybercrime is a huge priority for our office and the Department of Justice across the country. Investigators and prosecutors alike recognize that a criminal with a laptop may be able to steal more than a household burglar, a bank robber or even a sophisticated fraudster can. Today we dedicate substantial resources to investigating and prosecuting cybercrime. And even though IT departments can strengthen a company’s technological defenses, they can’t shut down networks and put hackers behind bars.

Even some companies that recognize this still prefer to handle the situation quietly and internally because they fear “going public” will hurt their stock price or their reputation. Some corporate attorneys talk C-suite executives out of reporting a crime because of the potential liabilities rising from the admission that PII may have been stolen. Companies also may worry that a law enforcement investigation will victimize them

all over again by confiscating their servers, thus making life even more difficult following the traumatic attack.

These fears were understandable in the past. Stock prices often do suffer for a short period after a data breach is revealed, although they usually rebound just as quickly. But with data breaches becoming more prevalent, they have become less newsworthy, and their effect on stock prices is often negligible. And corporate attorneys should consider that a short-term hit is a small price for protecting against SEC action or shareholder lawsuits if the data breach is exposed at a later date.

While heavy-handed law enforcement investigation techniques might have caused companies trouble in the past, nowadays we take care to avoid disrupting a company’s ongoing operations during an investigation. Corporations are our allies in the fight against cybercrime, and we want to strengthen that alliance by making it easier for them to work with us.

Help Take a Byte Out of Crime

Cybercrime, hacking, data theft, data breaches — all are ubiquitous and underreported. As a result, criminals feel that they can act with little serious risk of prosecution or imprisonment. If one firm neglects to report a hack attack, it makes all of us less secure.

Law enforcement and corporations have the same goal: to catch and prosecute criminals, thereby deterring future crime by showing would-be hackers the harsh potential consequences of their actions. Along with private forensics firms, we all have important roles to play in the fight against cybercrime. Only by working hand in hand can we start to turn the tide.

FTI Journal recently convened a panel of business leaders with deep knowledge of Latin America to discuss the region’s untapped opportunities, its future in the world marketplace and the challenges that business leaders must overcome there.

The moderator was Mark Malloch-Brown, Chairman of Europe, Middle East and Africa for FTI Consulting. Panelists included Conor McEnroy, Chairman of Sudameris Bank and founder of the Abbyfield Group; Ron Denom, President of SNC-Lavalin International, Canada’s largest engineering and construction company and an investor in infrastructure concessions around the world; Frank Holder, Chairman of Latin America for FTI Consulting; and Juan Pablo del Valle Perochena, Chairman of the Board of Mexichem, the world leader in fluorspar production and the Latin American leader in plastic pipes and fittings.

Latin America’s Untapped Opportunities

Mark Malloch-Brown: From your business perspective, just what are both the trade and investment opportunities in Latin America?

Conor McEnroy: South America is going through a renaissance. It’s a low-cost producer for hard commodities: metals, oil and gas. And its role as a supplier of food to the rest of the world is underpinning very substantial growth. Brazil in the past 10 years has gone from being an importer of almost everything — chicken, meat, eggs, flour and spaghetti, for instance — to being an exporter of all of those things. Practically every chicken in Europe now comes from Brazil.

Ron Denom: Infrastructure is an important part of agribusiness. Getting the product to port and to market requires warehousing, cold chain roads and ports, and that is just one sector in Latin America.

The region is relatively short on good infrastructure, and there is a need for an enormous build-out program. But immature financial markets hold it back. The mechanisms, the legal and regulatory frameworks, and the contracting structures are not yet in place.

Malloch-Brown: There is a huge process of urbanization going on across Latin America, with still quite a lot of population growth. With incomes rising, people want better homes and better infrastructure.

Denom: I think governments are coming to recognize the need for public/private partnership models. And once this realization takes place, there will be an effort to adopt those practices.

Malloch-Brown: Chemicals are also a sector that expands when there’s economic growth, right?

Juan Pablo Del Valle Perochena: Absolutely. Latin America, in terms of gross national product, is similar to China. And 200 cities in Latin America account for 260 million people. That accounts for a GDP of $3.6 trillion, which is India and Poland combined. Consider that within 10 years we’ll have 350 million people living in those 200 cities, making an additional $3.8 trillion of GDP. That’s almost four times the GDP of Spain. So if that growth doesn’t excite businessmen and entrepreneurs, what does?

Frank Holder: I think the real underpinning of the renaissance in Latin America is based on hard and soft commodities, such as soy in Argentina and mineral and agricultural wealth in Brazil. The opportunity, however, is much broader than that. You’ll find that there are many new people being added to the middle classes, so consumer products are extremely interesting in the region.

The roadblocks to increased trade

Malloch-Brown: Let’s talk about the constraints or challenges to growth.

McEnroy: As a banker, I would argue that South America has the elements it needs to put together an organized society: cash, people, water, land and energy. What it lacks is know-how and access to market, the essential elements that it needs to develop its own products and export them.

How do we increase trade between the United States and South America? The answer is in financing and in bilateral help in terms of technology transfer. Help the government get organized. Help it develop a digital land registry. Help it digitize its identification process for its citizens.

There are many opportunities for countries like the United States to do a lot of trade with South America over the short and long terms. In Paraguay, where we are heavily invested, we have huge amounts of land that need to be plowed and planted. Every tractor there now is a John Deere; every

spraying machine is a Valley — both U.S. brands. And customers will increase if there is financing from banks. But our farmers can’t afford to pay for a tractor in six months. They need three years.

Denom: Another facet of technology transfer is the transfer of know-how. Certainly in the engineering business, we can see a clear gap between the workforce available across South America and what we need to successfully carry out the business. Countries like Brazil have benefited from a strong currency, but wages and costs are rising and productivity’s not going up. They have huge potential here, but you really have to get through this productivity bottleneck.

Malloch-Brown: What are the other really constraining issues?

Holder: Long-term capital usually requires a macroeconomic environment that is relatively predictable and stable. Latin America has had long periods of hyperinflation, fiscal irresponsibility and political instability. From the time most Latin American countries bid on a piece of public infrastructure work to the time it’s actually built is about nine years. It is extremely difficult to envision any sort of long-term planning in that kind of environment.

Other challenges are weak institutions, a weak regulatory environment, corruption, and the difficulty and time it takes to resolve a dispute. Investors require a fair playing ground, and there we have a lot of work to do.

The biggest challenge to the region actually is infrastructure. A number of economies are right up to the ceiling of what they can do with the infrastructure they have — the electrical grid, production of petroleum and gas, seaports, roadways, trains.

Denom: Free trade and globalization are all about the free passage of goods, services and people across national borders. We have a success story in Mexico, but looking across the rest of Latin America, not every country is ready to sign on to a free trade agreement. In many cases, it’s quite the opposite, and there’s a kind of nationalism.

McEnroy: Economists have pointed to a referendum on democracy in Latin America. There were 12 elections in the same year across the region. Certain countries have opted out: Venezuela, Ecuador, Nicaragua, Bolivia and Argentina. They are going for their own 21st-century socialism model.

The rise of a middle class

Malloch-Brown: Paraguay is still a rural country where people are earning a living off the land, but are you seeing a democratic middle class emerging that is fighting for its political rights and demanding a say in the country’s direction?

McEnroy: If you look at Paraguay’s population curve, you’ll see that half the citizens are under age 20 and two-thirds are under 30. And 85% of them have a mobile phone. And the reality is that when you give young kids mobile phones, when they have Skype so they can talk for free with their cousins in New York or Madrid, the world begins to change. And they see consumer advertising and want the same things everybody else wants. They are incredibly hungry for education, unwilling to live like their parents did, and now getting enfranchised with the vote. I think that this is an unstoppable force.

Denom: This young population is rejecting existing political structures, political hierarchies, even hierarchies in business, and changing to much flatter, much more participatory structures.

Malloch-Brown: Are we going to see a Latin American Spring? Will governments be threatened by this kind of youth movement?

Holder: If one wants to understand how Hugo Chávez keeps getting re-elected in Venezuela, one really has to look back at the way an entire class of the population had been treated by all the prior presidents. The Chávez phenomenon has a lot more to do with social inclusion and with wealth for the most impoverished portion of society than anything else. It’s a lot less attributable to “We don’t care about democracy” and a lot more attributable to “We would like food to eat and cell phones to use.”

Weak institutions and corruption and cronyism and everything that comes with them are a threat to the region. We need to strengthen those institutions so that you don’t have personality-driven governments over and over again. And I also believe that the incredibly high concentration of wealth in the very top of society is a big threat.

Malloch-Brown: It can be said that the political problem of the region is that the Gini coefficient — the way economists measure inequality — is the most extreme of any in the world.

McEnroy: Nobody questions that inequality is severe, but I question the embedded conclusion: Let’s tear down the people who have accumulated wealth and redistribute it.

Holder: There’s a broad consensus that the strategies that have tried to redirect wealth have failed. What has worked is where the state has tried to make the rules or the playing field more level and to create an appropriate safety net for the most needy in the society. It’s really about making it possible for others to move up within the classes.

The problems of drugs, crime and violence

Malloch-Brown: As the United States looks south, it doesn’t see the kinds of issues we’ve been talking about: economic development and opportunity, and remaining problems of inequality. What the United States sees is drugs, crime and violence.

Del Valle Perochena: It’s funny that you say what the United States sees. The problem starts in the United States with the demand for drugs. If no people in the United States are smoking marijuana or using cocaine, you won’t see problems with crime, guns and dead people in Mexico and elsewhere in Latin America. So it is a big problem. It is sad to see that the United States generally thinks of those problems as widespread in Mexico.

They don’t want to go to Mexico on vacation or business because of what they see happening in Ciudad Juárez. But what happens in Ciudad Juárez is totally different from what you see in the Riviera Maya or Puerto Vallarta or Ixtapa. So the perception is very different from reality.

Malloch-Brown: Do you see the violence and drug-related problems getting better or worse?

McEnroy: Well, I actually see them shifting around. As one state cracks down, the drug dealers just pick up shop and set up next door.

There are some misconceptions about Mexico. Recently a Geneva declaration on armed violence and development counted violent deaths around the world. In the past year there were 526,000 violent deaths, with 25% of those deaths in 14 countries. Six of the countries are in Latin America: El Salvador, Honduras, Colombia, Venezuela, Guatemala and Belize, but not Mexico.

We see the drug problem another way. When I travel in South America, I see security guards everywhere. The cost of the security guards in Brazil is horrendous. It’s something on the order of $8 billion a year, equivalent to what the United States spent on companies like Blackwater the first four years it was in Iraq. It is a tremendous drain on the economy. On top of it, public transport is not safe, so everybody sits in cars in massive traffic jams. That’s another penalty on productivity. Then there is the whole issue of money laundering. It has to be brought under better control.

I don’t believe the real issue starts with the demand. It starts with the supply. The farmer who is growing the coca leaf — does he want to be in the narcotics business? If the global trading companies could give him a little bit better price for his carrots or his wheat or his sunflowers, he wouldn’t grow that stuff. A farmer with 20 hectares doesn’t plant 20 hectares of marijuana or cocaine; he plants half a hectare as an insurance policy against the rest of the crop failing or not getting a decent price.

Holder: I believe we have a problem with public insecurity in Latin America because the institutions of government do not function properly. Crime does pay in Latin America. You can commit a crime 98 times and maybe on the 99th time you’ll get caught. The judiciary is so slow, and it suffers from corruption and under-resourcing and lack of technology. And the police have the same problems.

Every year, FTI Consulting produces a public insecurity index on the region, which tracks trends in countries and cities. The good news is that in the past three years, we’ve had countries and cities that have been improving for the first time in a decade. The improvement actually started in Colombia, which is

profoundly different from what it was just a short while ago.

Unfortunately, it’s like squeezing the balloon. Where did that problem go? Well, it left Colombia and went to Central America.

So in the end, there’s a more productive and efficient way to resolve this problem. It has to come in some ways from the government getting better at doing its job of policing and justice, and in some ways from the private sector collaborating in an intelligent manner with the public sector in getting it done.

The changing dynamics of trade with Asia

Malloch-Brown: As Latin America diversifies its exports and moves upmarket, will it find as ready a market for those exports in China, or will we start to see exports shifting back more toward the United States and Europe? Will south/south trade be the major avenue of export growth?

Del Valle Perochena: As commodities specialize and become more valuable products, countries like Brazil and Argentina will find new markets. There is a clear opportunity there, even though the United States is a mature market that won’t grow in a significant way in the next five or six years. So I would say that they will find significant opportunity in the United States or in Europe, but China will still play the stellar role because that market will also develop.

Holder: Interestingly enough, in the latest five-year plan published in China, they are looking at moving away from the heavy, energy-intensive polluting industries. They say they have paid a tremendous environmental price supporting these industries, which are basically to make products to export principally to the United States. China wants to move upmarket into value-added, knowledge-intensive products.

These heavy industries will be moving out into China’s neighbors in South Asia. So I think for commodity exports from South America, we will see a gradual shift away from China and more into the surrounding region.

If you look at exports as a percentage of total GDP, they’re very small in most countries in the region — less than 10% of GDP — with the exception of Mexico. So the real challenge is in imports. A lot of finished products need to be brought in, and this creates a trade imbalance. Latin America needs more infrastructure to be able to export more. China in that sense has been a wonderful boon for the region, which once basically exported mostly to the United States and Europe.

China is now a top foreign investor in most of the region’s markets, and it’s also one of the top five trading partners of almost every country in the region, including Mexico.

But intraregional trading is also interesting. Argentina’s biggest trading partner is not China, and it’s not the United States; it’s Brazil. So Brazil is doing a lot to try to integrate itself with the countries around it because it realizes it’s a lot easier to do that than to ship stuff 8,000 miles.

So you’ve got two interesting phenomena going on. One is the growth of intraregional trade. The other is a sort of diversified growth of trade to the three principal markets in the world, which are China and its neighbors, the European Community and the United States.

McEnroy: Whether your view on the world is political, economic or social, a big challenge is to make the small boats rise in South America. I do see pockets of activity where countries are hauling people out of the various classifications of poverty to what we generically call the middle class in the States. For example, in Lima, over time people are moving out of the favelas into well-organized, planned urban communities and little townships and municipalities within the broader Lima, and this has had a tremendous effect. The average discretionary spend every time somebody moves into an apartment
in Lima is $2,000. I see a nascent but growing domestic consumption, and I think we know that South Americans, if they have the money, will buy the brand.

Malloch-Brown: Thank you all for a very good discussion. It’s clear that some of the perceived challenges to doing business in Latin America are real and some less so. But underlying everything you have said is that the potential is enormous. And that’s something that should be of interest to many potential trading partners in other parts of the world.

At first, the discussions were muted

— local business leaders and government officials had gathered last September in Dubai for FTI Consulting’s second annual seminar, “Anti-Corruption and Bribery: A Compliance Workshop for Global Business Success.” George Etomi, a workshop faculty member and prominent leader in the Nigerian Bar Association, warmed up the discussion by raising a dire consequence of pandemic corruption: the risk of severe civil unrest. Participants agreed. Ensuing conversations drew out their concerns and ideas about how to stem illegal practices. But the discussions also revealed a stumbling block that can thwart Western companies from instituting successful global compliance programs: a cultural divide.

Although compliance with anticorruption laws may be a straightforward legal issue in the West, in many developing and emerging countries, cultural norms and values exert a powerful countervailing force. Ignoring these norms can make local managers business pariahs. Sharie Brown, another member of the workshop faculty and a partner with the law firm DLA Piper LLP, points out that local compliance officers in countries with high levels of corruption can face extreme financial, career and safety risks. If they probe issues too deeply, they and their families may find themselves unemployed with smeared reputations — or worse.

The workshops FTI Consulting developed help cross this cultural divide. We don’t focus on the corruption in a given country; instead, we stress the value that business partners in emerging and developing countries can offer if they are savvy about international standards of compliance — they can be more attractive to global companies than their peers. And from our experience, we can also show global companies ways to develop compliance programs that bridge the cultural gap.

A Deep Divide

Common cultural norms can fly in the face of Western business standards — including the expectation that decisions be made primarily in the interests of shareholders.

In China and much of Asia, for example, relationships and reciprocal obligations in social networks (i.e., guanxi) can trump obligations to Western legal and business requirements. Given the history of family-owned businesses, it is not uncommon for family members or friends of a CEO to sit on boards or audit committees. In Russia and other former communist economies, the ubiquity of shortages and bottlenecks made bribes and other private payments practically essential. These practices were so commonplace that they became ingrained social norms. Nigeria is perhaps the poster child: The role of tribal ties and the resulting favoritism and nepotism are so predominant that there is an adage that if one doesn’t become rich as a public servant, he is a failure.

Many companies are investing in more rigorous compliance programs. Yet when working with partners or employees in high-risk jurisdictions, they often give short shrift to cultural barriers that, if not managed effectively, can impede cooperation and destroy trust.

Companies need to develop policies and educate partners and employees in a way that recognizes the cultural realities. The cultural value of saving face, for example, can make even the discussion of compliance extremely awkward: A standard due diligence request, such as verifying the lack of any criminal convictions, may be taken as grossly offensive. The creation of a culturally aware compliance program provides a platform for intercultural trust that can boost transparency and lead to more open discussions of compliance concerns or requests.

Crossing the Divide

The first step in crossing the divide: Make compliance requirements realistic. Russell Ryan, a member of the workshop faculty and a partner with the law firm King & Spalding LLP, points out that Western companies often fear the worst and then plan for it. They may seek as many concessions as possible to show an investigating authority that the company took every preventive measure. In doing so, however, they can strain the relationship by overcompensating.

In working with a potential distribution partner, for example, Western companies may insist on full audit rights, including access to customer lists and transactions on behalf of all companies that work with the partner. The distributor, of course, will often resist, arguing that its customer lists are proprietary — as they are considered everywhere else in the world — and that its dealings with other companies are confidential. Limited audit rights may be both more realistic and, if exercised judiciously,

more effective. Another problem, Brown points out, is that Western companies are prone to placing impractical demands on local compliance officers — insisting, for example, that third-party contracts require investigations of vendor and company conduct. Such investigations can put compliance officers at personal risk.

Nonetheless, compliance officers can move the compliance effort forward. For example, they can create training programs and protocols for vendor agreements and payments. They can also disseminate ethics policies. In short, they can improve compliance and ethics in the local company. Once that company culture becomes acclimated to new standards, the officer can then phase in more punitive components.

Compliance policies must also be flexible. A one-size-fits-all approach won’t work in all jurisdictions. A prohibition against gifts, for example, may work in the United States and Europe, but not in China, where a moderately priced gift such as a $250 smartphone may be de rigueur and not considered a bribe. Policies need to be clear yet fluid enough to accommodate different cultural norms.

Don’t Mandate — Educate

Perhaps the most important step in crossing the divide is to engage partners and employees in an educational dialogue that builds trust and transparency. It’s one thing to declare what someone can’t do; it’s another to explain why. If a policy prohibits payments to government officials, for example, articulating the negative consequences to the company in cases of violation can help build buy-in. It is also important to define parameters. In the case of payments, what specifically constitutes one? Is the gift of a $250 smartphone considered a payment? If so, what is the cost limit for an acceptable gift?

A thorough educational effort can also provide a powerful defense in an investigation. Documenting training dates, materials used and the names of participants can tell a story of compliance that is arguably more powerful than simply having a contract with numerous requirements that employees and partners are likely to resist.

Working with partners requires more effort than working with employees. Management has more influence over its employees and can readily look over their shoulders and impose penalties. In the case of partners, however, there is less control, and hence more risk. A major compliance breach and breakdown of trust can destroy a relationship. In some markets there may not be another viable choice.

A pillar of building trust with partners is educating them about how the company monitors compliance. It is important to underscore that compliance programs are common in many industries. Such an explanation sets a productive tone by making it clear that monitoring is not the result of suspicions about the partner or the singling out of a country. It is simply a routine process. Exercising audit rights is a good example. We suggest that companies not wait until there is a concern before exercising them. Regular examinations, which don’t have to be full-scale audits, underscore that compliance is an ongoing process. Such examinations also help companies spot, early on, any potential wrongdoing and anchor ongoing discussions about the local application of corporate policy. Spotting compliance issues quickly also helps bolster an industry’s reputation by averting compliance breaches and government investigations.

A candid discussion of compliance expectations should also be part of partner negotiation. A partner agreement could include audit rights, periodic certification of adherence to local and international law, and company policies and procedures. Partners could also be asked to complete the same training programs
as employees.

Creating a Virtuous Circle

Educating partners and employees as part of a compliance program creates a virtuous circle. Locals become savvier in dealing with Western partners through their ability to address compliance issues. This knowledge gives them a competitive advantage over other locals in doing business with the West. That competitive advantage then becomes a counterweight to cultural pressures and helps diminish their importance.

FTI Consulting recently gathered six of the world’s top financial leaders to discuss the financial crisis, the new reforms, and whether they can truly protect global markets from another meltdown. Discussion leaders were former Federal Deposit Insurance Corporation Chairman William M. Isaac, who is now Senior Managing Director and Global Head of Financial Institutions at FTI Consulting, and Stephen Kingsley, Senior Managing Director in FTI Consulting’s London office. The panel comprised Mark Carawan, Chief Internal Auditor at Citigroup; John C. Dugan, former Comptroller of the Currency and now a partner at Covington & Burling; Cornelius K. Hurley, Director of Boston University’s Center for Finance, Law & Policy and Senior Provost Fellow Professor of the Practice of Banking Law; and Simon Samuels, Managing Director, European Banks Equity Research at Barclays Capital.

WILLIAM M. ISAAC: We have four topics to cover, and we will lead off with John Dugan. The first question: Will the global financial reforms prevent the next crisis?

JOHN C. DUGAN: I don’t think we’ll ever fully prevent the next crisis, whatever it will be. I do think it was very important to increase the amount of common equity capital in the banking system. Once we did that, the crisis began to ease. But there has been too little work done on developing liquidity standards for the banking system, and I don’t think what is being put in place now is right yet — it needs a lot of work.

ISAAC: Was Dodd-Frank necessary? Regulators have always had the authority to deal with capital and liquidity issues.

DUGAN: I think the most important thing was to raise capital across the board, not just in the United States but also in other countries. You need an agreement among regulators, but you didn’t need Dodd-Frank for that or for setting new liquidity standards. Dodd-Frank addresses those subjects, but they’re not really at the heart of what Dodd-Frank gets at. I do think some of the Dodd-Frank reforms were necessary, especially the regulation of systemically significant nonbanks — but some reforms went too far.

CORNELIUS HURLEY: We are not better off with Dodd-Frank, mainly because there’s no structural reform. We’ve just nibbled around the edges. The Vickers Report proposes real structural and competitive reform.
I would have recognized the too-big-to-fail genie for what it is: a loose, destructive spirit in the land. Dodd-Frank called every financial institution over $50 billion systemically important, and that’s just not credible. The Vickers Report suggests a much more reasoned approach. It would confine the retail bank and allow the separate investment bank to do proprietary trading.

SIMON SAMUELS: I personally think the crisis was fundamentally about credit underwriting standards and liquidity. And ultimately the reason why Lehman fell was not from its starting position of capital, which was fine. It was due to a liquidity failure because people didn’t trust the underwriting.

DUGAN: I also believe that if we’d had some bare minimum mortgage underwriting standards, real documentation of income and even modest down payments, the whole crisis would have been much smaller. I would say, though, that a lot of people thought Lehman was very undercapitalized.

ISAAC: When I was running the FDIC my highest priority was increasing tangible equity in the largest banks. Going into the recent crisis, many of the largest firms simply did not have enough tangible equity capital, and the regulators allowed them to get away with it. The liquidity crisis occurred in significant part because the markets perceived that the banks had insufficient capital in relationship to the risks in their portfolios.

HURLEY: I think the lawyers were to blame too. Entire legal careers are spent looking for ways around regulation. I don’t see anything in the culture of the legal profession that says lawyers won’t do the same thing with Dodd-Frank or the Vickers Report — “We’ll guide our clients around regulations rather than helping them to comply with the spirit of the law.” That’s the gorilla in the room that no one dares to talk about.

MARK CARAWAN: One of the areas that we’ve not focused on is the role of management. While we are looking at enhancing capital and liquidity regulation, we should also ensure that management is ultimately responsible and held accountable for ensuring adequacy. Do we need more rules or is there scope to better enforce the ones we have?

ISAAC: It seems to me that we in this country didn’t make the structural reforms to prevent this crisis from happening again. Dodd-Frank slapped the regulators on the wrist and said, “Start worrying more about capital and liquidity. Do your job right.” But regulators already had the authority to get out in front of this crisis and take action if they had recognized the problems and had the political will to deal with them.

DUGAN: As comptroller, one of the problems that I saw was that there were a lot of practices that were okay, not great, inside the banks. But they were much worse outside the banks. There was no way to have a common set of rules that applied to both banks and nonbanks. I think odd-Frank has addressed that, although at times in a very cumbersome way. We will now have common mortgage underwriting and risk retention standards for all mortgage providers, although a lot of regulators have to agree on the rules. The CFPB [Consumer Financial Protection Bureau, the new consumer protection agency] will set common consumer protection standards for all providers too. Also, while the SEC [Securities and Exchange Commission] did not do a good job of regulating some of the investment houses that had increasingly become like banks, these companies are now deemed bank holding companies and can be regulated as such.

ISAAC: Okay, that will have to be the last word, as we need to move to the second topic: “too big to fail.”

STEPHEN KINGSLEY: How you think about too big to fail depends on where you are in the world. The United States has been used to banks failing regularly. In the United Kingdom, until Northern Rock, the last time we had a run on a bank was when Queen Victoria was on the throne. The cost of rescuing the banking system in some countries, including my own, has been very substantial. In some places, like Ireland and Iceland, the impact is going to be felt for decades. And taxpayers may not have the appetite for repeating what they did in 2008 and 2009.
One question is whether larger financial institutions will be allowed to fail next time or whether the politicians will rush back in. And can one large firm fail without precipitating a wider market collapse?

CARAWAN: We should be figuring out how to put in place the appropriate frameworks to ensure that government agencies focus on a robust commercial solution and not a politically driven one. They should be ready to make the tough decisions and close down banks that are insolvent so that there are market consequences for those that don’t manage or restructure properly.

DUGAN: Does anyone think that the existence of too big to fail caused the crisis?

ISAAC: I think it played an important role. The perception that some firms are too big to fail diminishes discipline that would otherwise be present in the marketplace. The suppliers of wholesale funds and capital need to believe that they are truly at risk. If they do believe that, behaviors will change in banks. I do not believe things could have gotten so far out of hand precrisis had suppliers of capital and liquidity believed they were at risk. Once thecrisis hit, the government going back and forth — bailing out one large firm and then letting the next one fail — utterly confused the markets and created panic.

HURLEY: Too-big-to-fail banks get a subsidy because they can buy funds at a cheaper rate, just like Fannie [Federal National Mortgage Association] and Freddie [Federal Home Loan Mortgage Association] did, knowing the sovereign will come to their rescue. We should quantify that subsidy and require those banks to segregate it on their books as a reserve account. That reserve account would be capital in the event of a bankruptcy.

SAMUELS: I’ve never understood the idea that you’d somehow act recklessly if you get bailed out, because you would long ago have been fired. And from a shareholder’s perspective, you get wiped out. So this is purely about the debt market.
This is the kind of debate that you have years down the line but not months down the line. The funding markets are so extraordinarily fragile. There’s a lot of uncertainty in the wholesale funding markets in the United Kingdom because of the Vickers Report. The presumption is that if you’re outside the ring fence, your wholesale funding costs will be higher. You’ve seen senior bondholders suffer haircuts [absorbing losses] in Denmark, and now large Danish banks are struggling with funding.

KINGSLEY: The liquidators of Lehman faced problems on both sides of the Atlantic because Lehman was very complex. Lots of institutions continue to live in that complex global environment. And it strikes me that those organizations are going to find it very hard to do a proper living will.
ISAAC: The Vickers Report is essentially a living will. You take the part of the institution that the people on the street worry most about in a crisis — checking accounts, mortgages, small business lending — set that aside and then put the more complex parts in another part of the organization.

CARAWAN: Both retail and commercial customers want global capability, low cost and instant information about their accounts. To compete in the marketplace means that you offshore, outsource and have service centers around the world in many jurisdictions. In a crisis, each regulator will ring fence activities in its own jurisdiction and follow its own course to stabilize its marketplace and resolve insolvent institutions. To structure readily resolvable global institutions is very complex and will involve huge organizational coordination, a web of service-level agreements and ample time to make things happen. One must not underestimate the challenge.

ISAAC: Let’s turn to question three: Are we focused too much on regulation and too little on improving prudential supervision of financial institutions?

SAMUELS: I think ultimately credit bubbles will damage financial institutions when the bubbles burst, regardless of what supervisors do. And arguably banks in some of the bestsupervised systems in the world, like Spain, have suffered terribly as the credit and housing market bubbles collapsed. I also think the complexity of some of the new rules that they’re being asked to apply represents a huge impediment to economic recovery.
The macro prudential angle is very important. Fixing things like the structure of the U.S. housing market, the nonrecourse lending in many states and loan-to-value caps would help the industry tremendously to withstand subsequent cycles and avoid bubbles.
Also, the Basel III capital framework includes a buffer to deal with market bubbles. The idea is that capital requirements will increase as a cycle reaches a crescendo, essentially to choke off that last piece of the bubble. In theory that could help enormously. But somebody has to decide, “We’re in a bubble and it’s now time for that buffer to kick in.”

KINGSLEY: A highly empowered, rightminded person at the center of the financial system in each country could say, “That’s enough, guys. We’re now going to stop the party, and we’ll raise capital requirements for particular kinds of loans. We will actually outlaw particularly unsound loan-to-value ratios,” or whatever it happens to be. And the fascination for me is: In a democracy, how do you actually empower somebody who can face off against the elected politicians?

ISAAC: I’m old enough to recall when the Federal Reserve, back in the 1970s, got concerned about the economy, and it told expansion-minded financial companies, “No. Your capital is too low, considering how overheated the economy is getting. Increase your capital and then we’ll think about your application.” We need to get back to the days when regulators actually had to think and use judgment.
The system needs firm underwriting standards, and firm capital and liquidity standards. And we need to allow the examiners to go in and actually look at assets and off-balancesheet exposures. That’s the job of management and the board of directors first, and regulators are a check on that system. But they should all
be using some judgment rather than just blindly relying on flawed models they don’t really understand — models that told us that residential real estate loans and sovereign debt were relatively riskless assets.

DUGAN: I think you do need some firm rules; it can’t be all about discretion and judgment. I just don’t know how much of this you can legislate — how much you can tell someone to be a better supervisor. When the system goes wrong, it’s hard to sort out how much failed supervision or failed regulation was at fault. The only way policymakers can react is with increased regulation. They can’t mandate better supervision.

KINGSLEY: That is a perfect segue to the last discussion topic: the impact — unintended or intended — of these regulatory and other changes on the banks and the economic recovery.

SAMUELS: I see a very slow economic recovery happening. I expect credit shrinkage or very anemic credit growth and I see banks being required to hold more capital. But I am just not sure that there is a clear linkage between all three. I think it is realistic to expect that when a recession was created by too much debt, then its recovery process will likely result in lower levels of debt. Whether or not banks need more capital now, it’s entirely reasonable to expect the economic recovery to be very sluggish because that is what usually happens after a financial crisis. I should also point out that the banking industry in Europe spent the whole of the 1980s and 1990s generating a return on tangible equity below its cost of equity. Today the bankers cry, “If you do this and this, our return on equity will go down too much and it will be unacceptable to our stakeholders and eventually we won’t be able to provide credit for the economy.” But throughout the ’80s and ’90s, economic growth across Europe was fine.

ISAAC: I’m chairman of Fifth Third Bancorp, and it has increased its capital rather dramatically. The bank is eager to make loans, but it can’t find enough decent ones to grow the loan book after you net out the paydowns of existing loans. A lot of people are deleveraging voluntarily or they’re bypassing the banking system and going right into the markets to lock in long-term debt at low rates. Having said that, if we keep increasing capital and liquidity requirements and imposing other significant regulatory burdens on banks, credit will continue to be less available and more expensive, which will impede economic recovery.

HURLEY: In each of our countries, the largest five or six banks occupy about 80% of the banking system, so they dominate the field. Their too-bigto- fail subsidy, depending on whose study you read, is between 25 and 75 basis points. In this kind of economy, there’s little incentive for the mega banks to do anything that is going to stimulate the economy when they can sit back and enjoy the bounty of that subsidy. So I think this question of the subsidy is linked inextricably with the capital issue and the timing of when we emerge from this crisis. Until there’s a sense of urgency, we will not get out of it.

DUGAN: I’m not sure I agree with that, for the reason Bill said. I think bankers make money through loans and want to put that capital to work — especially in a low interest rate environment where they can’t earn much spread by investing in Treasury securities or Fed funds. So I think they have every
incentive to try to make loans right now; it’s just hard to find them.

HURLEY: And the No. 1 problem facing bank management these days is “What do we do with all this money?” Banks in New York have started charging large depositors to put deposits in the bank!

SAMUELS: I think one of the enduring features, post–financial crisis, is that the idea of a level playing field goes out the window. Take capital: If you’re a regulator of a very large banking system that collapsed, your view toward how that should be regulated would differ from the view of a regulator of a smaller banking system that didn’t collapse. And so the United Kingdom’s starting point is a banking system that is, depending on how you measure it, between five and six times the gross domestic product of the United Kingdom. The starting position of the United States is a banking position that is a tenth that size relative to the U.S. economy. And so the chances of those two regulators agreeing on the same magic capital ratio number, I’d say, is zero.

HURLEY: When we use the term regulation, it means different things to Republicans and Democrats [in the United States]. Just the word regulation has become an attack these days. Regulation comes in many forms — I have a list of about 35 different types. And some of those regulations are really designed to promote market discipline, especially in the area of disclosure. So often the debate about regulation or overregulation or underregulation ends up being just a political diatribe where the parties never really have a discussion. They never start from the point, “What are we trying to accomplish, and what is the least burdensome way of getting there?” If we could just have that discussion, we might get to a place that yields a stronger, more resilient financial system that fosters sustainable economic growth.

ISAAC: That is a perfect thought to end on, Con. I wish we could continue all day, as this has been a fascinating discussion. Thanks to each of our panelists for taking the time to share your thoughts and wisdom.

To understand the risks in CEO transitions, the Strategic Communications segment of FTI Consulting recently studied the impact of CEO transitions on enterprise value. FTI Consulting also surveyed members of the financial community to learn how CEO changes affect their investment decisions, expectations and performance guidelines.

CEO transitions are far from rare. Among companies with market capitalizations in excess of $10 billion, nearly a third (31%) announced a CEO transition between July 1, 2007 and June 30, 2010. Among these transitions, 43% were unplanned. In all, the FTI Consulting study evaluated 263 CEO transitions across companies based in 35 countries.

The study also found that the reputation of a CEO is a critical factor in investor decisions to buy or sell a company’s shares. In fact, on average nearly a third of investment decisions are based on perception of the CEO. As a result, leadership transitions put a significant portion of the investment decision at risk as opinions of the new leader are formed.

Knowledge of the industry dynamics and a firm grasp of the company’s challenges and opportunities are crucial for new CEOs, according to investors. However, investors generally grant new CEOs a six-month “honeymoon” to set the vision and strategy for the company while establishing appropriate expectations for key stakeholders. Once this honeymoon period has ended, investors expect CEOs to begin delivering on their strategy.

How investors assess new CEOs

The reputation of a new CEO matters to investors. According to the study, investors indicated that nearly a third (32%) of their investment decision, on average, is based on perception of the CEO (see chart below).

In addition, when asked to name the key factors affecting an organization’s reputation in the investment community, CEO reputation was among the top six factors cited. That was nearly on par with the company’s historical reputation itself and more important than the brand equity of a company’s products and services.

When CEOs change, investors are more than twice as likely to sell shares in a company as they are to buy them. All things being equal, nearly 40% of investors said they would sell a stock solely on the basis of the new CEO, the FTI Consulting survey found, while only 15% said they would buy the stock on the same basis.

Not surprisingly, when a CEO transition occurs, investors will perform due diligence on the new CEO’s qualifications. Their perceptions will be based primarily on the CEO’s track record, which is by far the single most important factor that investors use to evaluate a new CEO (see chart, opposite page).

However, investors are also mindful of the circumstances surrounding a CEO’s departure. Essentially, with greater surprise comes greater value at risk. For this reason, planned successions present the lowest risk (see chart, page 62) and can even have a positive impact on stock prices at the time of the announcement.

While much attention is paid to the market reaction to the announcement of a CEO change, in reality the months that follow present an even greater period of risk — and reward — with a higher potential for both value destruction and value creation. The outcome depends, in part, on how well the new CEO sets the agenda and manages the transition.

As stated above, investors are generally willing to grant new CEOs a six-month honeymoon. This honeymoon, handled well, can buy the CEO time and maintain the company’s value. But handled poorly, this period may lead to serious risk to both the company’s value and the CEO’s reputation.

For example, in late 2010, after Leo Apotheker became CEO of Hewlett-Packard, he failed to establish a clear strategy. Some nine months into his term, HP confused the market by first discontinuing its TouchPad line of mobile tablets, then selling them at a deep discount, and then restarting production. At about the same time, Apotheker said HP might sell its profitable PC division, then said it might not after all. Investors reacted by dropping the price of HP shares some 20% on a single day of trading in August 2011, erasing about $12 billion in market value and leaving the company’s stock near six-year lows. (By
comparison, the S&P 500 that day closed at 1,123.52, down 17.12, or 1.5%.) Including earlier share price declines under Apotheker’s leadership, HP’s stock had lost more than 45% of its value. In September 2011, Apotheker was dismissed from the company.

Once a CEO’s honeymoon ends, he or she must quickly begin to deliver on the new strategy and performance goals. During this period, investors seek evidence of successful execution of the strategy. This should not be confused with financial performance per se, which most investors expect will take at least 12 months to see traction. When a CEO handles this execution period well, the company’s stock value tends to increase; when handled poorly, the company’s value — and the CEO’s career — may suffer.

At Yahoo! Inc., Carol Bartz’s nearly threeyear term as CEO provides an example of the latter. Bartz started with a splash in early 2009, bringing an impressive agenda for a corporate turnaround. Then, during her first six months, she upended Yahoo!’s organizational structure, replaced executives, cut costs and laid off 5% of the workforce. Industry analysts and investors were impressed; the moves, they said, were just what Yahoo! needed. But when the honeymoon ended, Bartz failed to deliver the promised turnaround. In September 2011, less than three years into her reign, Bartz was replaced as CEO; three days later,
she also resigned from the board.

A road map for CEO transition

Given the impact of CEO transitions on enterprise value, companies should take concrete steps to prepare for and carefully manage leadership change.

CEO succession planning helps reduce the surprise of a transition and should be an integral part of any company’s preparation for leadership change. However, it must be accompanied with and informed by a robust due diligence on all CEO candidates. In addition, having a deep knowledge of stakeholder opinions on the company, its strategy and competitive position can help to align board decisions with stakeholder expectations, permissions and needs. This can be particularly helpful in addressing the ongoing risk inherent in transitions involving fraud, regulatory investigations, strategic transformations, bankruptcies and restructuring.

Equally important, new CEOs must align their organizations to respond to change by setting the vision and strategy, establishing the appropriate expectations across stakeholder groups, and then engaging with stakeholders through new and diverse communications channels. The study found that six months after the start of the new CEO, stock performance often reversed from the knee-jerk euphoria or disenchantment at the time is critical, 80% of new CEOs have no prior CEO experience. Therefore, there is often minimal publicly accessible independent information of past performance available. For internal candidates, the board and management team can address this paradox by showcasing the depth and breadth of the management bench (and one or more potential successors). This increased level of exposure and positioning can be instrumental in managing unplanned transitions.

Apple Inc. provides a case in point. CEO Steve Jobs’s surprising resignation for health reasons, in August 2011, could have been perilous for the company’s stock. Never before, it seemed, had any company been so closely associated with its top executive. Yet on the day of Jobs’s resignation, Apple’s stock price dropped by only 5% in afterhours trading. This relatively small change resulted from several factors: Apple had announced a succession plan more than two years earlier; Jobs had previously revealed his illness to the general public; and Jobs’s heir apparent, Timothy Cook, was well known and well liked by key stakeholders.

As a result, even the shock of Jobs’s death mere weeks later was quickly absorbed by investors.

Of course, it is not enough for a board to simply name a CEO candidate. The board must also perform due diligence, ensuring that the candidate possesses the qualities investors and other stakeholders seek. In this way, the board helps protect share value.

How do investors assess a CEO? Mainly, they expect a positive track record of past execution, as well as some industry experience. In the FTI Consulting survey, industry experience was identified by nearly 20% of investors as a key factor shaping their initial opinion of a CEO.

Apple again provides a good example. Cook, successor to Jobs and now the company’s CEO, had earned a solid reputation for both execution and industry experience during his 14 years of working for Apple. As the company’s COO, Cook had outsourced much of Apple’s manufacturing, improving the company’s margins. Also, because Cook is an Apple insider, he knows the company’s business and industry, and this smoothed the transition after Jobs’s surprising resignation.

Yet industry outsiders can succeed too, as long as they can demonstrate an understanding of the company’s situation and a relevant track record of execution. For example, Alan Mulally has successfully led Ford Motor Co. despite his lack of prior experience in the auto industry. Mulally became Ford’s president and CEO in late 2006; he had previously served as CEO of Boeing Commercial Airplanes. Under Mulally’s leadership, Ford — which had lost tens of billions of dollars during the recent recession — has posted eight consecutive quarters of net profits. Ford is also the only one of the Big 3 U.S. car companies to have avoided a government-sponsored bankruptcy.Investors, as part of their due diligence on a new CEO, will seek insights from a broad range of information sources, including internal and external stakeholders, both past and present. In particular, the FTI Consulting study found that customers, partners and the candidate’s former colleagues were the sources that most influenced investors’ opinions of new CEOs. In addition, investors will look to the board for reassurance that the candidate’s management approach is likely to be in harmony with the company’s situation and overall approach. Accordingly, companies should leverage perception studies and anecdotal evidence to better understand the stakeholders’ views on a CEO candidate. For the new CEO. During the first six months in office, a new CEO should be dedicated to articulating a new vision and strategy, establishing appropriate expectations and managing internal talent. Investors, in their initial interactions with a new CEO, will be watching to see how well the CEO takes command. It is no longer sufficient to serve as a command and control executive. Instead, investors are looking more for “hard” attributes — including a grasp of the company’s situation and plans for the future — than for “soft” ones, such as leadership style, charisma and personality.

During the CEO’s second six months, investors expect to see evidence that the strategy is being executed successfully (see chart below). To stay ahead of investor expectations, a CEO should carefully set the expectations against which he or she wants to be measured. Then the CEO can begin to meet stated financial objectives, improve the company’s financial performance, and boost market performance and valuation over the ensuing 12 months, which is in line with investor expectations. Also, in evaluating performance success, the study reinforced the principle that the investment community values metrics associated with stewardship of capital and cash flow, such as return on invested capital and free cash flow, far more than bottom-line metrics such as earnings per share and net income.

The high value of good communication

For a new CEO, communicating effectively with all stakeholders is critical to managing risk and its impact on a company’s enterprise value. While communications are important at any time of major change, they are especially vital during a CEO transition.

How to communicate effectively? New CEOs should begin by listening to the market. For example, CEOs can conduct research to gauge perceptions and test company messaging. This can help them identify any gaps between what the company says and what its stakeholders actually hear. New CEOs also need to have a well-honed corporate narrative to tell the company’s new story. To achieve this, a CEO should develop a comprehensive communications strategy that is linked closely to his or her vision and strategy. This may involve the development of appropriate messages and channels for different groups, according to what will best reach and persuade them. For example, at The Coca-Cola Co., CEO Muhtar Kent has made a point of communicating his strategy and other changes through new channels to better engage with the company’s workforce, especially those based outside its headquarters. Kent does so, in part, by conducting town halls at bottling facilities and sending text messages to workers’ mobile phones, as many employees of Coca-Cola cannot readily access e-mail, video or other means of communication during the workday.

Also, while many companies focus their communications efforts on the media, the FTI Consulting survey indicates that it is not a terribly influential constituency for investors. When investors were asked for the key external source shaping their opinion of a company, only 27% named the media, far less important than those much better placed to judge the capabilities of an executive, such as customers, business partners and former colleagues (see chart, opposite page).

Call to Action

Because CEO transitions create a potential risk for enterprise value, all companies should make CEO succession planning an integral part of their riskmitigation strategy. At the same time, companies should be aware that CEO succession planning cannot take into account all factors that affect stock value.

When announcing a CEO succession plan, the board should also emphasize the CEO candidate’s track record of execution. Again, this track record is by far the most important factor for investors. Industry experience and personal reputation are a distant second and third.

Once the new CEO is in place, he or she should align the organization by communicating with stakeholders, establishing credibility and setting reasonable expectations among stakeholders.

To protect share value, all companies should remember that surprises increase risk. Therefore, boards should strive to create CEO transitions that are both smooth and well thought out. A CEO’s planned retirement, for example, involves far less risk than a forced resignation. But even when a CEO transition hurts the stock price in the short term, the right management initiatives later can often restore value over the long term.

The Toxic Mix

One thing that went awry in the run-up to the crisis: The banking sector grew too large as it responded to the huge imbalances in the global economy and the resulting liquidity. At the same time, interest rates were low, so money was not just abundant but also cheap.

The result was that asset prices were chased upward and risk was widely mispriced, particularly in the real estate market. Of course, that market was distorted by something else too: financial engineering. Securitization and derivative “technology” combined to convert highly risky portfolios into allegedly bombproof financial products. Bankers and supervisors alike seemed to believe that judgment was no longer key to running a risk-based banking business.

What the world needed in 2007 was William McChesney Martin, chairman of the Federal Reserve from 1951 to 1970, who famously said his job was to act as party pooper during boom times and “take away the punch bowl.” Instead, we got the legacy of Alan Greenspan’s unshakable belief in the “rightness” of market forces. In the United Kingdom we had “light touch” microsupervision and a near-complete absence of supervision at the macro level.

Where it Hurt the Most

Some countries fared better than others when the problems surfaced. The severity of the experience seems to have been correlated to relative bank sector size and to the extent to which each sector was internationalized. While Wall Street and Main Street might see it differently, the United States didn’t do too badly. Australia, Canada and France (at least until very recently) were hardly troubled. Other countries such as the United Kingdom, Ireland and, of course, Iceland did much worse. As the chart on the next page indicates, the U.K. government now controls a significant portion of the banking sector, whose missteps included poor lending practices, overly aggressive funding and, in two cases, ill-judged acquisitions.

Of course, the story is by no means over. Sovereign debt is still a serious problem, global imbalances persist, and money is still cheap. Legacy financing of the real estate market is still not fully unwound. Salvation for the banking industry will only come as a result of sound political leadership and economic growth, neither of which appears to be in abundant supply, at least currently.

Solutions and Mitigation

Regulators have taken a number of steps to fix the problems and to mitigate the effects of any future downturn.

Capital adequacy and quality. The crisis exposed the defects of Basel II, the attempt to put bank capital, disclosure and supervisory standards on a global footing. Basel III will remedy this by raising so-called Tier 1 core capital requirements and by requiring additional capital buffers in the form of loss-absorbing securities such as contingent convertibles.

Liquidity. Basel II was nearly silent on the need for proper management of bank liquidity. Basel III puts liquidity on the risk-management agenda.

Consumer protection. Among the issues that emerged from the crisis were the extent to which retail deposits were used in risky lending and retail mortgages as raw material for complex securitization and derivative products. In the United States, the Dodd-Frank Wall Street Reform and Consumer Protection Act is the result. In the United Kingdom, at least at the time of this writing, the notion of “ring fencing” retail banking operations has considerable support.

Regulation and supervision. In the United Kingdom, the Financial Services Authority, which oversaw regulation, supervision, consumer protection and promotion of the markets, is being dismantled and its functions assumed by three different agencies, the Bank of England assuming most of the prudential work. The Dodd-Frank Act and the conversion of the leading investment banks into bank holding companies will, meanwhile, tighten regulation and supervision in the United States.

What is Still Broken

However, these measures have not solved all the sector’s problems. There is still quite a lot to worry about.

Capital. Capital requirements are being increased throughout the sector under Basel III. Where will this capital come from? Even if it is raised, the impact on bank profitability will be serious and will likely be transmitted to the wider economy through higher charges. Further, Switzerland and the United Kingdom have tabled proposals that potentially go beyond Basel III, while, on the other hand, the United States may delay implementation. We risk an uneven playing field and, through excessive capital requirements, damage to the banking industry and its customers.

Regulation. Many countries have introduced or are proposing significant new regulations. The interplay between the revised capital requirements and re-regulation of the sector is not well understood. In the United Kingdom an independent commission on banking has proposed “ring fencing” retail banking operations, a measure that will need to be carefully evaluated and executed if it is not to cause unintended consequences.

Disintermediation. We are back to the position we were in during the ’80s, when corporate creditworthiness was superior to that of banks’. That led to the growth of the commercial paper markets. Today we have an even stranger situation in that sovereign ratings can be inferior to that of the banks that they host and to whom they act as lender of last resort. There is a growing likelihood that banks will be taken out of parts of the money flow equation, with unpredictable consequences for the supply of credit.

The economy. Many countries are still struggling to move out of recession. The market for property remains in a state of dislocation in key areas, and there is evidence that loans are being rolled over rather than foreclosed. The same can be said for some sovereign debt. Lending markets will continue to be difficult, and we will continue to see loan charge-offs.

Management stretch. It has not been easy to run a bank over the past four years, and the next two or three years won’t get any easier. Economic growth depends on robust banks, and they need motivated managers.

What Regulators Should Do Now

There is more that regulators and banks could and should do to address the outstanding risks.

In the United Kingdom, more robust supervision. The most obvious failures in the United Kingdom can be blamed on poor management and poor supervision. The remedy: supervisors placing much greater emphasis on management’s ability to run the business and on the effectiveness of the banks’ governance arrangements.

Reward long-term performance. Banks should drop the focus on the short term and on quarterly earnings, and instead link executive pay to earnings quality and risk management.

Macroprudential supervision. The banking sector is the mechanism through which a government’s monetary policy is transmitted to the economy. If that policy allows the party to continue unabated, then, as we have seen, the results can be dire. Each country therefore needs an agency empowered to counter this effect — to play the role of Mr. Martin. A call to stop the party will be seriously unpopular and politically difficult to make. Nevertheless, we need it, particularly because the global imbalances that were present before the last crisis are still there.

It would be good if politicians understood these things and acted accordingly. Let’s hope they do.

The Push and the Pull

Today, European corporations find themselves at a crossroads. Governments and commissions are pushing organizations to diversify the gender composition of their boards by adding more female directors. This regulatory push has created some momentum toward diversification.

Corporations in Europe and elsewhere also have access to studies showing that companies with gender diversity on their boards typically outperform their competitors in terms of profitability and good-governance performance. This knowledge constitutes a pull that adds to the diversification movement.

And yet, despite the combined force of these powerful push and pull motivators, gender diversification still is moving far too slowly in many countries. Consider the situation in the United Kingdom. The annual Cranfield University Female FTSE Board Report for 2010 noted an incremental increase of just three additional women on FTSE 100 Index boards over the prior year, a change it called “barely perceptible.”

The Nordic Way

Thus far, authorities in the United Kingdom have chosen persuasion over regulation in their efforts to encourage board diversity, but regulators and political leaders in other parts of Europe have not trodden so lightly.

Norway led the pack with its 2002 mandate stating that at least 40% of the seats on public boards be held by women. State-owned enterprises had four years to comply, while other companies were given until 2008. The mandate has been met. Today, women constitute just over 40% of Norwegian board directors, according to 2010 data from Corporate Women Directors International (CWDI). Norway is the clear frontrunner when it comes to gender diversification at the board level, but other Scandinavian countries also have made impressive strides in this direction. The same CWDI report shows that Sweden (21.9%) and
Finland (16.8%) both are ahead of the United Kingdom in terms of female representation on corporate boards.

These changes are only the tip of the iceberg. Several other European nations, including Spain and France, have passed laws that mandate 40% female board composition for large, public companies within the next four to six years. Additional countries, such as Iceland, Denmark and Ireland, have also passed quotas, with the Netherlands and Italy considering doing the same.

Is the United Kingdom also headed toward a quota system? For now it appears that U.K. regulators prefer to rely on more gentle pressure. As a case in point, the Consultation Document: Gender Diversity on Boards was introduced in May by the Financial Reporting Council (FRC). For the first time, the FRC included a principle recognizing the value of diversity in the corporate boardroom.

The principle states that “the search for board candidates should be conducted, and appointments made, on merit, against objective criteria and with due regard for the benefits of diversity on the board, including gender.”

Outside observers might view such pronouncements skeptically since they do not have the force of actual law, but the United Kingdom has a strongly ingrained corporate culture of “Comply or Explain.” The FRC notes that both U.K. companies and their shareholders have broadly accepted the notion that corporations should comply with FRC codes or explain transparently and convincingly how the alternate path they have chosen constitutes good governance.

More Women, Better Governance

Of course, the assertion that having more women on a board really does represent good governance lies at the crux of the push for greater female board representation. Policy-makers certainly believe that having more women on a board is good for a company’s bottom line. “The business case for increasing the number of women on corporate boards is clear,” wrote Lord Davies in his Women on Boards report, commissioned by the British government and published this past February. “When women are so under-represented on corporate boards, companies are missing out, as they are unable to draw from the widest range of possible talent. Evidence suggests that companies with a strong female representation at board and top management level perform better than those without and that gender-diverse boards have a positive impact on performance.”

In making these claims, Davies cited a 2010 McKinsey & Company report called Women Matter that shows companies with the most women on their executive boards outperformed their sector competitors with all-male boards by sizable margins. Looking at data from 2007 to 2009, McKinsey found that the most gender-diverse boards surpassed their competitors by 41% in terms of average return on equity while achieving 56% higher EBIT margins.

The McKinsey study is not an outlier. Other research findings support the notion that women can make a strong, positive contribution in leadership positions. In 2001, a researcher from Pepperdine University in California analyzed 19 years of data (1980 to 1998) and concluded that the 25 Fortune 500 firms with the best record of promoting women to the executive suite were 18% to 69% more profitable than the median Fortune 500 firms in their industries (Adler, Roy D. “Women in the Executive Suite Correlate to High Profits” [European Project on Equal Pay]).

How can we explain the performance gaps in favor of companies with greater gender diversity on the board? Perhaps diversity has some inherent benefits at the board level. Naturally there are many criteria that make someone a good board candidate. Intelligence, accomplishments, capabilities, skills, credentials — these all go into the assessment of a board candidate, but we should not ignore the attributes a candidate brings to the boardroom by virtue of his or her background and personal experience.

When you have 10 men in a room who all have similar backgrounds, experiences and formative influences, their viewpoints and opinions often will be less varied than when people from a range of backgrounds with different experiences and ways of thinking are thrown into the mix.

A case in point: One of the U.K. boards on which I serve has an Italian director, a French director, two American women, a German director and a British chairman. As we look at vital strategic issues, we all come at the problem from slightly different ways, which frequently provokes a healthy and productive debate.

Having women on the board is in some ways a proxy for saying that we want people with different experiences on the board. It is an indisputable fact that most women in the United Kingdom who have achieved corporate success have done so by taking a path somewhat different from that of their male counterparts.

When the Financial Services Authority (FSA) conducts its ARROW governance reviews, it checks diligently to make sure there is an appropriate amount of challenge occurring at that board level. If we look at the big governance failures from the last decade — for example, the Royal Bank of Scotland — we see governance nightmares and homogenous boards dominated by the CEO. Board diversity might have led to more challenge and risk evaluation.

Having a diverse board prone to lively and spirited debate is not an ironclad guarantee against fraud and mismanagement, but it certainly can help from a risk-management standpoint. The Conference Board of Canada recognized this fact nine years ago with a report drawing a link between female board membership and good-governance credentials. The report found that boards with higher female representation tended to pay more attention to audits and risk oversight. Boards with three or more women turned out to be far more likely (94%) to insist on conflict-of-interest guidelines than all-male boards (58%). And nearly three-quarters of boards with two or more women directors conducted formal board performance evaluations, compared with less than half of their all-male counterparts.

Quotas: Necessary or Not?

At the moment, a majority of both political and business leaders in the United Kingdom seem to favor the current approach of using recommendations and exhortations to build the momentum toward greater female participation on executive boards. The Davies report urged FTSE 100 companies to strive for
at least 25% female board member representation by 2015.

But is this goal realistic? Even Davies had to acknowledge that 18% of the FTSE 100 companies and nearly half of the FTSE 250 companies do not have a single woman in the boardroom. Given the apparently glacial pace of progress toward diversification of FTSE 100 boards, can top U.K. companies possibly double the number of female board members in just five years? Would not hard quotas such as those employed in Norway be a more reliable way of achieving the desired goal of more equitable, diverse and effective boards?

I believe the current path is the right one and that quotas are not necessary. Even without quotas, the Fortune 500 companies in the United States have achieved a higher rate of female board member representation (15.2%) than many of their European counterparts (CDWI 2010 Report: Accelerating Board Diversity).

British business leaders already have shown their capacity and willingness to rise to the occasion and take the necessary bold actions. For example, Sir Win Bischoff of Lloyds Banking Group and Sir Roger Carr of Centrica have led the creation of the 30% Club, a group of chairmen from some of the leading British corporations who have promised to use cross-company mentoring programs, industry forums and political debate to keep the topic of board diversification front and center.

As the name of the group boldly proclaims, the 30% Club hopes to surpass the 25% standard set by the Davies report and rally FTSE 100 businesses to achieve 30% female representation on executive boards.

There are indications that this approach is starting to gain traction. A recent article in The Independent newspaper noted that just the threat of quotas implied in the Davies report had caused a major jump in the number of women hired as nonexecutive directors to FTSE 100 companies (“Boards Double Number of Women Members,” The Independent, May 29, 2011). The paper found that 23% of all new nonexecutive board appointments in the previous six months had been filled by women, a staggering increase from 2010, when less than 10% of such appointments went to female candidates.

The article also notes that French companies are on a similar path, with a 38% rise in the number of nonexecutive board appointments between 2008 and 2010. Surely that trend will only accelerate, since France passed a bill in January that calls for 40% female board membership by 2016 for listed companies, companies that have more than 500 employees or companies with a turnover of more than €500 million.

Take the Carrot or Get the Stick

Guidelines may be preferable to quotas, but if businesses in the United Kingdom and the rest of Europe do not move in the direction of diversifying their boards, these countries soon may find themselves facing them. Lord Davies has said, “I won’t be recommending quotas to the government, as the best solution is one of natural evolution. But if companies don’t take a radical change in attitude and hire more women at the top, then we will have to introduce quotas.”

This sentiment was amplified by EU Justice Commissioner Viviane Reding. In March, Reding challenged publicly listed European companies to sign a pledge representing their commitment to increasing the percentage of women leaders on their boards to 30% by 2015 and 40% by 2020.

Reding warned companies that her committee would be evaluating their progress toward the inclusion of women in executive decision making. “If this has happened by March 2012, I will congratulate the European business world,” she said. “If it has not happened, you can count on my regulatory creativity.”

Whether by carrot or by stick, it seems as though Europe is destined to move toward gender parity on corporate boards. The question for U.K. firms is whether they want to reap the advantages of being in the vanguard of this movement. I believe they should join the wave now rather than get caught later in an ugly
undertow of mandates and quotas.

But Brazil still lags the United States and other developed countries in a key area — corporate governance at its stock market, the BM&FBOVESPA. For example, only 23 of the 500-plus listed companies trade more than 50% of their shares on the exchange. One important reason is that over the past 10 years, the Brazilian government has increased its investments and control in many publicly traded companies. Although its goal is to influence business decisions in the interests of local economic growth, these decisions often rankle investors, sap profits and drive down stock prices.
Ironically, the counterforce to these trends is the very group many government actions are meant to bolster — the burgeoning middle class. Its investment savvy and expectations are on the rise and forcing the BM&FBOVESPA to respond.

A Reversal of Fortune

In the late 1990s, Brazilian President Fernando Henrique Cardoso launched economic reforms to stabilize the Brazilian economy. The Real Plan eliminated the country’s staggering hyperinflation, which reached more than 2,500% in 1993. The government also began privatizing state-owned companies to leverage the power of a market economy.
Cardoso’s successors, however, Presidents Luiz Inácio Lula da Silva and Dilma Rousseff, have been reversing this trend. The Brazilian Development Bank now has significant investments in more than 150 Brazilian companies. The government is a major shareholder in many, and its actions lay bare the governance issues.
Petrobras arguably is the poster child. It is Brazil’s largest energy company and the fourth largest oil and gas company in the world. The government holds a 56% stake along with golden share rights. Petrobras’s share price peaked at more than $70 in 2008. By September 2011, shares were trading around $25.

Many analysts attribute fluctuations in Petrobras’s share price to government intrusions that have had a decidedly negative impact on profitability. Most oil drilling in Brazil, for example, is offshore, and Petrobras is a world leader. Oil rigs are a major investment, costing up to $1 billion each. When Petrobras decided to build new rigs, it sought bids from companies in South Korea and Singapore, major centers of shipbuilding and offshore industrial equipment. Bids from these companies were almost 50% lower than those from Brazilian firms. Yet the government insisted that Petrobras “buy local” to support job creation and economic growth. Ironically, such actions are eating away at middle-class investment wealth. In 2000 the government allowed — and encouraged — individual investors to purchase Petrobras stock with funds from their government-run retirement accounts. Routinely, individuals are forced to place these moneys in a government fund that yields less than a typical savings account. However, for some, their Petrobras investments have been worse.
Companhia Vale do Rio Doce also was a victim of government intrusion. CVRD is the largest mining company in the Americas and the largest iron ore miner in the world. From 2001 to 2010, shares in CVRD produced a total return of 38%, which, according to CVRD, was the highest among its peers. In early 2011, its stock was trading around $35 per share. By the end of August 2011, the price had fallen to about $28 per share.

Roger Agnelli, the highly regarded former CEO of CVRD, ran afoul of President Lula. Agnelli had led the company’s impressive growth during his 10-year tenure. Toward the end, however, he decided not to buy local and awarded major shipbuilding contracts to a Korean firm that bid 40% less than its Brazilian competitors. Lula publicly denounced Agnelli, and Lula’s successor, President Rousseff, ousted him. Investor concerns about the company’s future soared.

A Revival of Fortune

Although the Brazilian government intends to bolster the economy, its agenda will confront the implacable force of the middle class it has helped create — and that class’s expectation that business decisions be made in the interests of shareholders.
There is a growing investment mentality in Brazil’s middle class that wasn’t there 10 years ago. Where once discussions of investments were rare, it now is a common topic at social gatherings. From 1999 to 2009, 31 million people entered the Brazilian middle class, bringing the total to 95 million (52% of the population). These individuals have disposable income and are investing in the stock market.

The BM&FBOVESPA is making efforts to improve corporate governance practices. In 1995, the Brazilian Institute of Corporate Governance was established. Its mission is to raise awareness of corporate governance standards and disseminate best practices. In 2000 the BM&FBOVESPA launched its New Market. This listing segment includes companies that voluntarily implement corporate governance standards beyond those the law requires. One of the goals is to broaden the market of individual investors by requiring that public share offerings use mechanisms that favor capital dispersion and broader retail access.
Brazil still has a long way to go with its stock market. But as Brazil moves toward better governance standards, companies will create greater value for their shareholders. Harvard Business School professor Paul A. Gompers proved the point in landmark research published in 2003. He created a governance index as a proxy for shareholder rights at 1,500 large U.S.-based companies. He found that companies with stronger shareholder rights had higher firm value and sales growth. These companies also had lower capital expenditures and made fewer acquisitions.

In the 1970s and ’80s, it was common to describe Brazil as a sleeping giant. The giant is now awake. With improved corporate governance, its companies will see even greater growth. Stay tuned.

The shift in power from management to shareholders is inexorable and, most recently, has been furthered by the 2010 Dodd-Frank Act. The era of the proxy process as an annual rubber-stamping ritual of a company’s policies and actions has passed. Investor actions on a myriad of issues such as Say on Pay (SOP) and Say on Frequency (SOF) are growing.

Investor concerns aren’t seasonal. Trying to influence or change investor votes during proxy season is risky at best. It is too late in the game to capture investors’ attention and change their minds. Companies need to engage shareholders systematically throughout the year to understand and address their concerns.

Companies May Have Gotten a Break in 2011

By many broad measures, it might seem as though the 2011 proxy season passed without the storms that SOP and SOF votes threatened. Most executive pay plans were approved, even the majority of plans that received negative recommendations from proxy advisers. According to the global law firm Latham & Watkins, only 2% of the companies that filed proxy statements by June 23, 2011, failed SOP votes — 71% of the Russell 3000 secured more than 90% approval.

However, the 2011 proxy season may not have fully reflected the depth of investor sentiment and the pressure that investors will continue to apply. Research conducted by FTI Consulting (“What Are Investors Saying About Say-On-Pay?” February 2011) found that investors viewed SOP votes as more than an issue of pay. Many saw SOP as a referendum on company and executive performance and a forum to air their displeasure. This past year, investors had to digest thousands of compensation packages. We suspect that they didn’t have sufficient time to fully digest the implications of SOP and SOF. Nevertheless, their strong preference for annual SOP votes clearly indicates a desire to keep management on a tight leash. We expect investors to keep leveraging their newly acquired rights — and for them to be better prepared to do so in the future.

Companies were not sufficiently prepared for SOP and SOF votes either. Many were surprised by shareholder pushback and negative recommendations from the proxy advisory firms. A key factor in the negative recommendations was a disconnect between compensation and performance as measured by total shareholder return. A prominent financial services company, for example, received a recommendation against the chief executive’s pay. Although it finally passed, it did so with less than 60% of the vote. And three other management recommendations (of eight) were thwarted.

Other companies with negative recommendations passed the vote. But average support was only 72% vs. 92% for those with a favorable recommendation. Companies with pay/performance disconnects and subpar shareholder support (70% is generally regarded as the inflection point) are essentially “on notice.” Support for their SOP votes could erode next year if management doesn’t discover and remedy the issues.

It is important to note that although SOP and SOF votes are “advisory,” they have teeth. Their influence extends into boardrooms and legal domains. Negative investor sentiment on SOP can be directed at compensation committee directors. To wit, at companies where SOP votes failed, these members garnered an average of 13.5% fewer votes than other directors on the ballot. Furthermore, losing a vote on pay can expose a company to damaging litigation. Four companies that failed to secure SOP approval had shareholder derivative lawsuits filed against them, alleging breach of fiduciary duty and corporate waste.

More Investor Concerns Are Brewing

Historically, strong recoveries following recessions have generally produced a calming of the public mood and dissipation of the rancor previously targeted at those institutions perceived to be poor corporate citizens. Given the muted economic recovery, corporate performance may not sustain its current pace, fracturing business confidence and undermining shareholder returns. Public angst, represented by the Occupy Wall Street protests, along with regulatory agency actions and government legislation, may continue to influence investors and drive demands for more influence over corporate affairs.

Some areas to watch

Oversight of Political Spending. Support for disclosure and oversight of corporate political spending is surging on the heels of the 2010 U.S. Supreme Court Citizens United decision. While a high-profile proposal at Home Depot was soundly defeated, a corporate political disclosure and accountability resolution captured a majority vote — at Sprint Nextel the resolution passed with 53% of votes cast. Close on these heels, resolutions from the U.S.-based Center for Political Accountability, which requires companies to divulge details of their political contributions, gained more than 40% of the vote at the annual meetings of four more companies.

Proposals concerning the oversight of political spending are multiplying, and support for them is rising:

• In the first half of 2011, according to Institutional Shareholder Services, shareholders filed 78 proposals seeking disclosure and oversight of corporate political spending, up from 48 during the first half of 2010.
• According to the Council of Institutional Investors, the average support for the 39 proposals that came to vote as of June 2, 2011, was 31%. Six years ago it was 9%.

Proxy Access
While not enacted as planned by the Securities and Exchange Commission, proxy access is back. Companies will have to allow shareholders to submit proposals requesting that the board implement proxy access or that the company’s bylaws be amended to implement proxy access.

The consequences are difficult to anticipate. It is likely that some companies will be targeted by investors in 2012, particularly poorly performing ones with long-standing governance issues or those with weak or shareholder-unfriendly boards. The chairman of the SEC supports broad-based proxy access, so there might be further developments.

For most companies the window for shareholder proposals opens in November. The next few months should provide some visibility into whether activists will avail themselves of this opportunity. Given the time lines for distributing proxy materials, managements will not have much time to evaluate and craft responses to these proposals. Companies that might be vulnerable should preempt the situation — they should start the process early and be prepared to respond if necessary.

Environmental Sustainability Measures
Investor concerns over corporate responsibility and the environment have been nascent for some time. It is difficult to know when an idea reaches an inflection point and becomes front and center, but these topics may have already done so:

• A record 109 proposals were filed with 81 companies in the United States and Canada during the 2011 proxy season.
• Ernst & Young reported that corporate social responsibility proposals grew to 40% of all shareholder proposals in 2011, vs. 30% in 2010.

Other issues on our watch list include:

• Shareholder actions by written consent
• Shareholder power to call special meetings
• Forthcoming SEC regulations on the ratio of CEO pay to median employee wages (which are strongly supported by the public sector, unions and socially responsible investors)

Although shareholder proposals on these topics are generally rejected, a few have passed and may be indicative of growing support. We expect that more will pass.

Many corporate governance protocols being implemented in the United States, such as SOP, were adopted in Europe years ago. Companies should be attuned to developments in the European Union. The United Kingdom is instituting the Stewardship Code, requiring institutional investors to attest to their responsibility for the companies in which they invest. A key provision of the Corporate Governance Code requires annual re-election of all directors. Gender balance on boards is being debated, and the European Commission is examining how corporate governance overall can be improved.

Keeping Shareholders onBoard

It’s essential that companies engage shareholders throughout the year to address concerns. Ongoing engagement can yield dramatic improvements to a company’s credibility with investors, as the Dow Chemical Co. experienced between 2008 and 2011.

Dow was hit by a near “perfect storm” of events that shook investor confidence and drove its stock price down 60% from late 2008 to the market bottom in early 2009. Immediately upon Dow’s commitment to the large and transformational acquisition of Rohm & Haas, the global economy plunged, causing uncertainty in the credit markets, unprecedented low demand for chemical products and ultimately the collapse of a $17.4 billion joint venture in Kuwait just 48 hours before its expected close.

To rebuild investor confidence and build support for the transformation story, Dow launched an investor engagement program. Milestones for execution were laid out, and as each one was met, Dow communicated to investors that it was following through on its near-term strategic objectives and executing ahead of schedule. As performance strengthened, the company expanded its dialogue with investors and the media to include the more innovative aspects of the company’s transformation and to highlight the growing investment and value of its R&D portfolio, which long-term would play a major role in the company’s transformation. To ensure that Dow’s message was resonating with investors, the investor relations team regularly measured the impact of its communications on different stakeholder groups and refined the message when needed. The team also provided greater transparency through more detailed operating information, access to more of the company’s leadership and use of more pervasive, digital communications methods. Dow ultimately succeeded in restoring investor confidence — its stock price recouped the losses of late 2008, and 87% of Dow’s shareholders approved of the company’s executive compensation, a strong endorsement.

Few companies manage investor sentiment as well as this, and yet many could easily do much better. In our experience, companies that build investor confidence and manage their concerns follow these practices and recommendations:

Understand the Company’s Points of Vulnerability

The 2011 proxy season provided a number of indicators of what investors view as good practices regarding compensation. Highly desired: transparent disclosure of how compensation is determined, performance-based compensation and longer vesting periods. Large severance payments and “golden parachutes” are objectionable (McCahery and Suatner, Tilberg University research paper). Ahead of the next proxy season, companies should analyze their compensation plans to identify disconnects between pay and performance and identify best practices.

Understand the Composition and Sentiment of the Shareholder Base
It is critical to know which shareholders are influenced by proxy advisers. Companies should target new shareholders who have a history of filing proposals or who take social issues into account when investing; in particular investor classes most likely to take their governance grievances public, such as socially responsible investors; activists; foundations; faith-based organizations; special interest groups; and state, municipal and union pension funds. Companies can also revisit the 2011 votes to identify the active shareholders and determine where the company’s responses were weak.

Work with the proxy advisers
If a company received a negative recommendation on SOP from the proxy advisers, it should consider engaging with them during the off-season to make its case. Companies subjected to inappropriate peer group comparisons, incorrect compensation calculations or any other inaccuracy should attempt to resolve the issues. An early resolution or correction is less stressful than tackling the issue during proxy season.

Engage Shareholders
Companies should engage shareholders and stimulate a dialogue on policy changes and the reasons driving them. Management should put mechanisms in place to hear investor concerns and respond with communications that explain decisions and demonstrate that it listens to investors. If shareholder sentiment on an issue is strong and broad-based, management should consider changing policy.

It is important to know how shareholders evaluate performance. In our research we have found that investors prefer measures related to value creation and executive stewardship, such as return on invested capital and free cash flow generation. They are less interested in earnings per share or overall growth statistics. This may not apply to all shareholder bases, but it pays to ask the question.

Shareholders have spoken. They want to vote on SOP every year. As proxy season approaches, companies need to articulate their compensation strategy and how pay is determined. The proxy is the selling document. It should present the case completely to avoid additional filings. Supplementary filings can be perceived as evidence of shareholder resistance.

Be Prepared

Proxy season is not the beginning and end of a company’s engagement with its shareholders. It is a point in time that reflects the effectiveness of management’s relationship with its investors.

Even now shareholder advocates are working to exploit the shifting balance of power and taking on more corporate governance issues. They are using the off-season to shape the discussions and air their side of the debate. If companies wait until the 2012 proxy season to air their positions, they could very well find themselves scrambling to respond to concerns that have been festering for months.

The eurozone’s weaknesses have sat in plain sight from the start. The group of countries that constituted the eurozone did not meet the preconditions for a single currency to operate sustainably. Productivity and prosperity vary widely from country to country, and there are no financial transfers between them on a scale that would correct for those differences. And linguistic, cultural and economic barriers to migration hinder the labor mobility that would alleviate persistent unemployment.

The consequences have been felt most keenly in the country of my birth: Greece. In 2001, Greece was allowed to join the eurozone, ostensibly having met the economic preconditions. In reality, Greece had manipulated and falsified its economic data.

Entry into the eurozone gave Greece’s consumers, businesses and government access to credit at much lower interest rates than they otherwise would have had. The risk of Greece’s taking a haircut through devaluation disappeared, and the financial markets assumed that the eurozone would stand behind any of its member countries’ debts.

The result was unsurprising: Greece went on a spending spree. In the meantime, it failed to press ahead with the difficult reforms that might have improved its productivity and competitiveness relative to other members of the eurozone, such as Germany. In fact, taking real unit labor costs as a measure of industrial competitiveness, the gap between Germany, the eurozone’s largest economy, and the peripheral economies (those of Portugal, Ireland, Spain and Italy, as well as Greece) widened rather than narrowed.

This could not go on forever. In 2010 the markets decided that Greece’s debt was unsustainable. The risk premium on government debt soared, and Greece faced insolvency. The International Monetary Fund, the European Central Bank and the European Commission financed a bailout. Greece now is implementing major fiscal consolidation and structural reforms, such as improving public sector efficiency, opening up the professions and liberalizing markets.

But austerity programs themselves reduce demand in the economy and slow economic growth. The latest forecasts for Greece are that 2012 will see the fourth consecutive year of falling gross domestic product, with a cumulative fall in output of some 12%. A second bailout package has been agreed to that will involve a significant element of debt forgiveness. Although the risk of Greece defaulting on its debts has been reduced somewhat, the markets still think there is a high chance of it happening within the next two years. Portugal and Ireland also have been forced to take bailout packages because they could not finance their debts at sustainable rates.

A default by any one of these countries would deepen the financial crisis among banks in France, Germany and elsewhere that hold those countries’ debt. Economic and political tensions are high. Certainly Greek politicians of all parties are responsible for the country’s crisis. But the European Commission and the other member states are not blameless. They did not effectively scrutinize Greece’s economic data. They watered down the Stability and Growth Pact, the eurozone’s rulebook, when it became clear that France and Germany might fail the budget deficit test. And the technical assistance the EC provided Greece was inadequate given the scale of structural reform it needed.

Can the eurozone hold together? I believe its long-term viability will require stronger economic and fiscal governance, including:

• Limits — backed by the risk of sanctions — on member states’ ability to run up budget deficits
• Greater consistency between the economic and social policies that underpin productivity and competitiveness in each country — including traditionally sovereign decisions such as retirement ages, pension financing and healthcare systems
• Much larger fiscal transfers between “rich” and “poor” members of the eurozone, either through making direct transfers (such as the current Structural Funds but on a larger scale) or by allowing members to issue debt backed by the eurozone collectively
• Radical reform of the governance structure in Europe to cope with the emergence of a lender of last resort: the ECB, with enhanced powers and the European Financial Stability Facility, currently at €440 billion, but the intention is to expand it to €1 trillion
• Closer monitoring of individual governments’ fiscal policies and greater involvement of the European Commission

These are controversial ideas that, if implemented, would profoundly strengthen political integration while affecting national sovereignty. Many policies that currently are the choice of member states and their electorates in effect would become collective choices determined in some way by eurozone members. But already, alongside the negotiation of bailout packages for troubled member states and an ongoing debate about the size of the facility available for such rescues, we see the emergence of stronger economic governance mechanisms within the eurozone.

Such a system of governance will not emerge overnight. The politics are extremely difficult. We see that in Germany’s strong negative reaction to the idea of euro bonds (debt issued by member states that is backed by the European Central Bank and thus by member states collectively). German voters do not wish to subsidize the more profligate peripheral states. The Germans might be persuaded to change their position if reforms included much stronger controls over the policies and actions of member states that receive aid, but those states, of course, might see that as an unacceptable intrusion into their internal business. We have seen in Greece that popular resistance to austerity can derail measures agreed upon by elected governments.

There also is the question of how stronger links within the eurozone might affect the relationship with those members of the European Union that remain outside the eurozone, including the United Kingdom, Sweden and Poland.
One should not doubt the determination of the eurozone’s political leaders — especially those in France and Germany — to keep the union together and make the single currency work. But at this stage, the eurozone’s future is uncertain. If it is to survive, it needs much greater economic and political convergence. It is questionable whether the voters of Europe are ready for that.

“Our survey respondents have a front-row seat to the increased scrutiny brought on by stricter regulatory enforcement,” says Stephen Dillard, head of Fulbright’s global disputes
practice. When times are tough, companies sue to recoup money owed them and laid-off employees seek redress. In the United States, and for larger multinationals in particular, intellectual property and patent litigation also were high on respondents’ radar.

Regulatory action, too, seems to be waxing, with 28% of respondents expecting such suits to increase this year. “Businesses are operating in a global climate of intense scrutiny and significant enforcement. Companies are handling increasing numbers of internal investigations and regulatory proceedings, often as a result of whistle-blowing allegations,” says Lista M. Cannon, managing partner of Fulbright’s London office and co-chair of the firm’s International Investigations practice.

In another sign of greater regulatory scrutiny, securities suit filings in the United States are on track to set a new record this year, according to Advisen Ltd.’s firstquarter report on securities litigation. “The credit crisis was a watershed event in this arena,” says John Molka III, the report’s author. “The easing of the credit crisis, however, hasn’t resulted in fewer securities suits being filed. The elevated level of filings in 2010 and 2011 may represent a ‘new normal.’”

As the litigation landscape continues to sort itself out, company executives need to be ready to head off an even more litigious future. Here are some flash points.

Host Countries Are Stepping Up Enforcement

Even in the developing world, once known for lax rules, many nations are increasing regulatory actions involving export controls, customs, labor and employment rules, data privacy and antibribery regulations. Hot spots of international regulatory risk include China, Mexico, Southwest Asia, United Arab Emirates, West Africa and Western Europe.

The U.K. Bribery Act Is Making Itself Felt

April 2010 saw the enforcement of the Anti-Bribery Reform Law and a sharp spike in U.K. companies hiring outside counsel to help with internal investigations. This year the percentage of companies doing so has declined.

Contracts Continue to spark disputes

In the Fulbright & Jaworski survey, more than 40% of U.S. companies and more than half of those in the United Kingdom faced pending legal action related to contracts in 2011. In the United Kingdom, contracts sparked the highest number of suits, whereas labor and employment posed a larger problem in the United States.

In Japan, Securities Suits Are Also on the Rise

Various types of claims have been increasing steadily since 2004, when Japan revised its Securities and Exchange Law. One notable crossborder case involved Toyota Motor Corporation’s U.S. shareholders, who filed a class action suit alleging that the company’s insufficient disclosure of risk related to widespread vehicle recalls was a “misstatement” — a kind of claim more likely to lead to damages under the revised securities statute.

Regulators Increase Scrutiny

More companies are finding themselves the targets of regulatory investigations by a wide range of government agencies in both the United States and the United Kingdom. Some 40% of respondents had attracted government attention, up from 37% in 2010. Approximately 50% of the insurance, energy, healthcare and manufacturing sectors have had at least one regulatory proceeding commenced against them.

A few recent headlines underscore the danger:

• The Carlyle Group lost $105 million after the Hong Kong Securities and Futures Commission suspended trading in China Forestry Holdings and brought criminal charges against its CEO.
• Shares of China Natural Gas plunged 59% after the company “restated earnings.
• Paulson & Co., one of the world’s largest hedge funds, lost more than $550 million after financial fraud was revealed at Sino-Forest.

Investors aren’t always cognizant of the role of audit firms. These firms primarily serve to verify documentation behind financial statements, not probe for evidence of fraud. Many investors also make the perilous assumption that an Asian company listed on the Hong Kong, New York or other established exchange meets the same standards of disclosure as Western companies listed there. Moreover, investors don’t usually have the resources needed to investigate a maze of jurisdictions and languages to verify a company’s claims.

But the next big corporate failure has already happened. It just hasn’t surfaced. When considering Asian opportunities — particularly in emerging markets such as mainland China, India, Indonesia, the Philippines and Thailand — investors need to conduct deeper and broader due diligence, beyond just reviewing audited financial statements. They need to scrutinize corporate governance and business structures, and examine in depth what lies behind the assets on the books.

What to Look For

Investors should dig deeply into these issues to vet opportunities and protect their interests.

Corporate Governance

Look carefully at corporate governance structures. An Asian company may not have the clean segregation of duties between board, CEO and management that is common in the West. Family relationships and personal networks play an enormous role in Asia. In many ways, these relationships hold the society together. Reciprocal obligations with extended family, or even someone who hails from the same village or town, can be a counterweight to the more objective business decisions expected in the West. Many publicly traded companies, for example, began as family-run enterprises. Family and friends may sit on boards or even audit committees. It is also not uncommon for the head of a family to be both CEO and chairman. Weak governance structures can allow for company investments to be based on family ties and needs vs. all shareholder interests.

Complex Business Structures

Unnecessarily complex business structures may be designed to conceal inappropriate activities. For example, Peace Mark (Holdings) Limited, a Hong Kong–based watch manufacturer, distributor and retailer, collapsed in the wake of financial irregularities. When FTI Consulting investigated, we discovered that the $900 million company had more than 300 corporate entities. The annual report disclosed 60. The complex group structure was being used to conceal various transactions and financial arrangements.

Assets and Holdings

It is crucial to verify the assets and holdings a company claims it has. Among the issues that led to suspension of trading for China Forestry: The company did not have the logging permits it claimed it did and the company also materially misstated its cash balances. China-Biotics, a provider of probiotics used as dietary supplements and food additives, reported that some 25% of its revenues came from 100-plus stores it owned and operated. Most did not exist.
Inventories and receivables are the asset types most often misstated by troubled companies trying to deceive stakeholders. There are countless stories of companies in China financing the same purchase multiple times and making sales to parties that don’t exist. Several companies may even pool inventories at audit time.

Reporting large levels of cash while increasing debt levels can be a warning sign. The company may be trying to conceal operating or other losses — or the cash may not have existed to begin with. Moulin Global Eyecare, a Hong Kong–listed company with operations primarily in China, shifted cash into a subsidiary from outside the group just before the financial year-end and then back out again immediately afterward. The purpose was to artificially inflate its consolidated cash balances.

Companies that regularly raise capital should also be scrutinized. Management may be trying to fund its way out of inherent operational weaknesses.

More than one acquisition every two or three years is a red flag as well. The company may be trying to mask underlying financial problems by increasing the size of the business.

It is not atypical for Asian companies in financial trouble to misrepresent their assets and transactions. Western investors can be caught by surprise if they do not look hard for troubles before they commit.

Arguably, the crisis was fueled by a vicious cycle in which fears over the potential downfall of a single financial institution reduced confidence in other institutions. To minimize future economic risks, global political leaders and regulators have made stability a top priority since the 2008–2009 crisis. As examples:

The G20 has committed to clear over-the-counter (OTC) derivatives through central counterparties and to encourage their trading on exchanges in order to reduce counterparty credit risks and enhance transparency.

The Basel III framework raises the quantity and quality of banks’ capital requirements and introduces liquidity standards. It aims to reduce the probability and severity of future banking crises while protecting financial stability and economic growth.

The European Financial Stability Facility (EFSF) was created — and later enhanced — to help indebted euro-area countries. Its bonds have already aided Ireland and Portugal.

The Thorny Dilemma: Stability vs. Competition

Despite the recent emphasis on stability, most politicians and regulators would agree that competition plays a vital role in the financial sector. It drives down prices and improves service for customers and performers.
Yet competitive markets have losers as well. As winners gain market share, less efficient competitors lose customers, become insolvent or are acquired by other companies.

European regulators and politicians clearly face a dilemma: They want to inspire trust among savers and investors by helping stable financial institutions thrive. They know that even the possibility of insolvency or bank failure could cause widespread panic and damage.
Yet efforts to improve stability by ruling out the possibility of insolvency run counter to the natural market dynamics. Strong competition means insolvency risks for the least efficient, weakest players that can’t match competitors’ prices and services.

To complicate matters, different public authorities have been given statutory responsibility to pursue one of three conflicting objectives:
Central banks and treasuries try to protect financial stability
Antitrust authorities promote competition and prevent monopolies
Some regulators and legislators must simultaneously promote stability and competition

In the European Union, the Directorate General for Economic and Financial Affairs (DG ECFIN) and the European Central Bank (ECB) have the role of ensuring financial stability, while the Directorate General for Competition (DG COMP) enforces European competition policy.

Similarly, the Directorate General for Internal Market and Services (DG MARKT) of the European Commission must reconcile these opposing goals in the legislative proposals it makes to the Council of Member States and the European Parliament.

For example, following Basel III, DG MARKT suggested increasing bank capital requirements to give banks a larger buffer to withstand financial shocks. It might seem hard to fault measures that promote stability. But in fact, higher capital requirements hinder competition by making it more difficult for new players to enter the market.

Moreover, by making capital requirements larger and more complex, regulators also increase compliance costs, which in turn drives consolidation and reduces the markets’ competitive vigor.

Three Outcome Scenarios for the Stability-Competition Rivalry

How will regulators and legislators escape from the stability-competition conundrum? Will one objective be prioritized over the other? What outcomes are most likely, and what are the strategic implications for companies in the European financial sector?

The most prudent course of action would be to develop a strategy for each of the most likely scenarios:

The Stability Scenario.

In this situation, regulators and legislators favor financial stability over competition. The recent multinational government emergency rescue of French/Belgian/Luxembourg bank Dexia shows that EU politicians and regulators still hesitate to let large financial institutions become insolvent.

Given ongoing political instability and financial market turmoil, policymakers may be willing to reduce competitive pricing pressures, helping financial companies earn greater margins and staving off insolvencies and the instability that follows.

The Competition Scenario.

In the second scenario, authorities enforce competition policies despite the risk of financial instability. Regulators and legislators may believe that the financial crisis has finite boundaries and that the long-term value of competition outweighs short-term stability risks. But given all of the pro-stability pan-European initiatives now under way, unbridled competition is unlikely in the short term.

The Balanced Scenario

Finally, it’s likely that regulators and legislators will continue their attempts to find that elusive middle path that balances stability with competition. As a result, industry stakeholders should expect that DG MARKT will continue to weigh competition arguments against financial stability concerns in issuing its legislative proposals.

This scenario is unsettling for financial firms, because legislators may decide their fates — insolvency or survival — case by case rather than “by the book.” This means that firms with a stake in such matters must influence the political debate in their favor. Winners will probably be those who act quickly, build a strong case for their position, and find allies who support their cause.

Victory to the Swift and Persuasive

In a balanced competition-stability world, financial market stakeholders should recognize the importance of early positioning. Stakeholders who engage constructively with regulators — not just stating problems, but offering creative solutions — can help shape their decisions.

To have the greatest success in favorably influencing the policy debate, stakeholders should:

• Establish a broad base of support among a diverse constituency, including other market players as well as nongovernmental organizations, the media, shareholder advocacy organizations and the general public
• Anticipate other stakeholders’ opposing arguments and plan to counteract them
• Enlist industry organizations to advance their viewpoint
• Most important, build a solid, fact-based economic foundation for any stability or competition viewpoint. Data should clearly show officials how taking the preferred position in the competition-stability debate will benefit the industry, consumers and the market in the long term.

Unintentionally, the ongoing political tension between competition advocates and pro-stability legislators has created a new field of competition among financial firms. It is no longer enough to serve customers, develop new products and operate efficiently. Now, to capture market share from weakened competitors or to simply survive until their fortunes rebound, financial organizations must help shape the debate.

And regulation has spawned not only its own industry of advisers and lobbyists, to help comply or change the regulation, it also has shaped the competitive environment of today’s business. The modern playing field is not so much tilted as turned into a maze where the winner is not the fastest or the cheapest but the one who knows how to navigate through.

There appear to be three reasons for this plague of regulation. The first is that, as officials have been forced to vacate large areas of their national economies through privatizations, and as private service providers have risen, authorities have not been able to resist leaving land mines behind them. Often viewing the private sector as the enemy, those booby traps are constructed in the name of maintaining the “standards” of service provision.

Such policies also are an expression, though, of the growing irrelevance of national government in many areas of global life. The local matters — building codes or tax arrangements in Shanghai or Buenos Aires; and the global matters — Basel III agreements on banks’ capital ratios, or standby arrangements in the case of a breakout of a global communicable disease such as a flu epidemic; but the national often doesn’t.

Now, of course, national government is not ready for its funeral rites quite yet: tax rates, personal and corporate; the quality of the macroeconomic environment; or trade and investment liberalization remain critical factors of national competitiveness that are determined by national politicians. Nevertheless, in many areas of economic life the writing is on the wall. The rules are going to be set elsewhere, hence the blizzard of national regulation set off by the self-important snowmakers of national government — officials and their political masters. They want to prove they still matter.

As a former member of a British cabinet, I was rarely presented with a problem that my domestic political colleagues did not want to legislate against. And legislation is of course the tree from which most national regulation falls and takes root. I remember a cabinet divided over whether a colleague’s complaint of school bullying was best addressed by a law or by a program of, say, £100 million, suggested by the Prime Minister, or both. I was almost alone in gingerly proposing that the problem was best left to good headmasters and responsible families and that outlawing it was beside the point. But the cabinet wanted to do something, reflecting the politician’s most primal need: to be seen to act. That politician’s itch is the mother of nearly all national regulation.

There is, however, a second root to the regulatory upsurge: the rise of the global. As we have globalized our economy, fashioning as close to a single market as the world has ever seen, we finally are grappling with regulating that economy. And excuse my bias, for while I consider much national regulation a mountain of red tape that should be set fire to, I am rather a fan of global regulation.

Without regulation, I do not see how we can build a global economy that can enjoy long-term political support. Yet while this mild statement in support of global regulation may seem commonsensical to some, it is to others anathema. Global markets have been seen by some people as a chance to escape national rules, not exchange one yoke for another. These advocates have defended their regulation-“lite” vision by claiming that markets discern the good from the bad, and reward the former. Yet this market fundamentalism, as some have dubbed it, often fails to produce what those involved would consider fair results, for pretty self-evident reasons.

For globalization to work, the markets must be seen as fair, transparent, noncorrupt. Further — and here is the nub of regulation — all players must be seen as subject to the same rules. Global capital, like global health or global security, needs uniform rules of the road.
Another, third reason universal regulation will spread is that countries and industries alike will want to end the free rider problem: countries that will not accept environmental standards on emissions, thereby perhaps winning a comparative cost

advantage; or jurisdictions that go easy on international financial services located in their territories. Finally, as businesses come to operate globally, they will seek common standards that offer predictability.

Such universal regulatory regimes will not deal national authorities out of the process, but instead task them with implementing globally agreed-upon rules and standards at the national level. So Basel III, negotiated as it has been by national officials fulfilling a political framework set in forums such as the G-20, is translated into national regulation by the national financial authorities. The global oak tree that spawns national saplings will not be a global legislative body. Rather, it will consist of international coalitions of interested parties — governments and also industry representatives and often not-for-profit advocates — arriving at common global standards that are likely to be endorsed and adopted by a universal body such as the United Nations. These policies will then be returned to countries for national legislation and regulation to implement the agreed-upon global standards.

So, contrary to what many readers might instinctively believe, global regulation is often broadly a good thing, and a lot of national regulation is basically a bad, redundant thing when it does not conform to global standards.

The difficulty is that governments seem incapable of tearing up the old national rulebook and replacing it with the national version of a global one. Rather, they just pile on the extra regulation, thereby making the maze
I described at the start.

Our battle cry needs to be “The old king is dead (national regulation), long live the new king (global regulation, made local).

Challenging Sacred Cows

Wells Fargo famously navigated the financial crisis better than most of its peers. Now the man who led the bank through the crisis to the high ground, former Wells Fargo chairman and CEO Richard Kovacevich, challenges what is becoming conventional wisdom about what drove the financial crisis.

Kovacevich argues that a bank’s risk has nothing to do with its size — banks fail because their risk is too concentrated. He firmly believes that TARP, stress tests and mark-to-market accounting did not stem the crisis; they made it worse by creating panic. Legally combining commercial and investing banking didn’t fuel the crisis — this particular crisis would not have occurred had the Glass-Steagall Act not separated the two industries in 1934. And the Dodd-Frank Act absolutely does not end “too big to fail.” Kovacevich also brings his experience to bear on the vexing challenge of emerging from the crisis and spurring U.S. economic growth.

The following are excerpts from the interview conducted by William M. Isaac, Senior Managing Director and Global Head of Financial Institutions at FTI Consulting. He is the former chairman of the Federal Deposit Insurance Corp. Isaac also serves as chairman of Fifth Third Bancorp.

The complete interview is available at fticonsulting.com/critical-thinking. It further illuminates the dangers still inherent in the financial system and is a must-read for all who work in, regulate and analyze the banking industry — or, like most, simply rely on its health.

William M. Isaac: What event or events do you think turned the recent crisis into a panic?

Richard Kovacevich: One of the most critical was the process of bailing out Bear Stearns and then days later not bailing out Lehman. The biggest mistake was not, as most people think, failing to bail out Lehman. The mistake was bailing out Bear Stearns and then not bailing out Lehman. The investors just said: “We have no idea what’s going on. We don’t know what’s happening next. We are getting out of the market.”

And for the Fed and [former Treasury Secretary Henry] Paulson to say, as they have, that they had no authority to bail out Lehman is simply not true. How can they say they had the authority to bail out AIG but they had no authority to bail out Lehman?

In my opinion, we should not have bailed out Bear Stearns, which was much smaller and much less risky than Lehman. It could have been handled more easily.

If that had happened, there was no question in my mind that Dick Fuld [CEO of Lehman] would have said “Uh-oh, game’s up. I’d better sell this thing right away at whatever price I can get.” He may have been able to sell it. I’m told it was close many times. And if Lehman could have been sold, then you may not have had the run on the other investment banks.

Isaac: You’re arguing that they should have let Bear Stearns go and then Lehman would have taken care of itself.

Kovacevich: Because if they bailed out Bear Stearns and also Lehman, everyone would know that every financial institution was going to be bailed out. Then you’re back to too big to fail, squared. I think the reason Lehman was allowed to go bankrupt, and I know Hank [Paulson] pretty well, I think he said to himself, “Well, if we rescue Lehman, then we have to do it for everybody. And we don’t have enough money or political will to bail out everyone.”

When they let Lehman go down, and the markets all crashed and liquidity dried up, they then realized the world was coming to an end. They ran to Congress to get the $700 billion to purchase toxic assets under the TARP program. Then they realized that the $700 billion for assets would not even put a dent in the problem, so they ended up bailing out everybody by supplying capital.

To cover their mistakes, they claimed they had no authority to bail out Lehman and, with a straight face, bailed out AIG a few days later. Chaos occurs when people don’t think in terms of what’s the next step if we do such and such now.

Isaac: You and I are probably the two people in the world who hate mark-to-market [MTM] accounting the most. What role did it play in the crisis?

Kovacevich: A huge role. People thought the world was coming to an end because everyone was reporting huge book but not actual losses because of MTM accounting.

We had to write off $900 million on a prime mortgage portfolio that we thought had a maximum loss exposure of $100 million. Our current loss estimate for that portfolio is now just $35 million. But we had to report nearly a billion-dollar loss that never came to fruition. And that was just one relatively small portfolio. I could give you many more examples.

Also, we wanted to purchase some assets because we knew they were undervalued. We were very reluctant to be a purchaser, however, because we would have to take an MTM loss if the asset went down further, even though we knew over the cycle it would be profitable.

This caused the markets to cease functioning. It destroyed a lot of companies and ultimately forced the Fed to intervene with trillions of dollars and be the buyer of last resort. Mark-to-market accounting was a huge culprit in the financial crisis and caused unnecessarily massive damage to the economy, and to housing in particular.

Kovacevich: I quickly learned that the riskiest part of the banking business is lending. If your loan risks become concentrated, whether geographically, by borrower or by industry, a bank’s total risk becomes excessive, even if you’ve underwritten those loans well. Banks fail due to concentrated risk. Risk has little to do with the size of the bank…. In fact, more small banks fail than big banks because they are generally more concentrated geographically, by product and by industry. Now if a big bank is concentrated, then obviously it is a higher risk.

Even if you underwrite well, when real estate goes to hell or the economy slows significantly, you’re going to get hammered. So you must underwrite well. But then to mitigate the macro factors you can’t control, you have to spread the risk. Risk management in banking should be more like it is in an insurance company. There you spread and diversify the risk.

I believe that the chance of Wells Fargo’s failing today at $1.2 trillion in assets is less likely than when I joined Norwest. It was a $20 billion company with a narrow product line concentrated in the upper Midwest and in agriculture-related lending.

Isaac: I’ve noted that the five largest institutions control more than 50% of the financial system and that is an undue concentration. Do you agree with that?

Kovacevich: I don’t. Five or fewer companies control more than 50% in every industry, from cereal to automobiles. Five banks control more than 50% of their industry in about every country in the world.

Isaac: You don’t believe banking is different or special compared with, say, the beer or cereal industry?

Kovacevich: No. In any given product line or geography the largest bank has, on average, 15% of the business. Some banks are big only because they have product and geographic diversity. That reduces the concentration of risk. If U.S. banks had been allowed to bank nationally from the get-go, as was the case in most other countries, few would even question their market share today. Texas banks in the 1990s were small by today’s standards. But they all failed because they were not allowed to bank outside of Texas. Savings and loans in the 1980s, individually, were not big. But they were excessively concentrated and required hundreds of billions of dollars of taxpayer money to be resolved. In the recent crisis, the taxpayer is unlikely to pay a dime for bank failures.

When we acquired Wachovia, it doubled our size but reduced our risk because it doubled the geography in which we operate. I believe that deal reduced risk for the system — as it increased our ability to serve more customers, with more products and in more geographies — and is absolutely positive for the economy.

Isaac: Do you believe that we have, through the Dodd-Frank Act, ended too big to fail?

Kovacevich: Absolutely not. But too big to fail must be stopped. No bank, none whatsoever, should be too big to fail. I worked on this issue with the Minneapolis Fed 20 years ago. Gary Stern [former president of the Federal Reserve Bank of Minneapolis] has been writing books and papers about this for two decades. It’s very simple — the only way we can solve too big to fail is when it’s clear that everybody that supplies capital to a failed bank, except insured depositors, is going to take a haircut [absorb losses] in a failure. That includes the failure of a $300 million bank or a $1 trillion bank. Until we force haircuts on all suppliers of capital to failed banks, we will be living with too big to fail.

Administering haircuts requires a huge liquidity fund from the Fed or from the FDIC because it could take months to fully wind down the bank, and there’s not going to be enough liquidity to do that without the government supplying the temporary funding. But banks should be able to be wound down at no cost to the insurance fund or taxpayers. The cost will be borne by the debt holders, the uninsured depositors, and the common and preferred stockholders. I believe that haircuts will cause those who provide capital to banks to be more disciplined about determining to whom and how much will be provided. Capital suppliers will monitor a bank’s risk appetite more closely, and will restrict additional capital when the risk grows too large and banks become too concentrated. In fact, I believe self-interested vigilance on the part of capital suppliers will be more effective in reducing bank failures than our regulators have been.

Kovacevich: The Fed called us after they completed our stress test and said we needed to raise something like $15 billion in additional capital. I was shocked. I said: “How did you get $15 billion?” They had reduced our earnings forecast. There was very little difference in projected credit losses. In fact, the Fed actually had our credit losses a few million less than ours really were. Where you would expect there might be differences, such as operating expenses, there were no differences. Instead the Fed had reduced our revenue forecast by more than 30%, which was the sole reason they had reduced our earnings forecast. I said: “What?” Just making sure I understood.

Isaac: Something tells me you didn’t just say “What?”

Kovacevich: “So you are saying that between May and November, our revenue is going to decline by 30%?” The answer: “Yes, that’s what our model shows.” I said: “That’s mathematically impossible. I couldn’t do it even if I tried. Let me see your model.” And they said: “We’re not going to show it to you.” How’s that for transparency in prudential regulation?

I pushed back: “How can I accept needing $15 billion in capital when it is based on a revenue assumption that is mathematically impossible?” “That’s it,” they said. “You need $15 billion.” As we stated in our earnings press releases in subsequent quarters, our actual revenue turned out to be even higher than our own forecast. So the Fed’s 30% revenue reduction and $15 billion capital raise as a consequence of that were totally wrong.

Now that’s what happens when you have a strong single regulator.

Isaac: Do you believe that the repeal of the Glass-Steagall Act helped lead to the crisis in 2008 and 2009?

Kovacevich: Not at all. In fact, if we had eliminated Glass-Steagall 40 years ago instead of nearly 15 years ago, this crisis is unlikely to have happened. The biggest problem of this crisis was the nonregulated investment banks that grew to an enormous size and with substantial and concentrated risks under the protection from competition by the Glass-Steagall Act.

One reason why this particular crisis will not happen again is because there aren’t many of these bad guys left. The ones that survived are regulated by the Fed, and therefore there is less chance that they will make these obviously bad decisions of high leverage, liquidity issues and concentrated risk that the SEC totally ignored.

Wells Fargo can now do investment banking, such as underwriting debt and equity and doing customer hedges. We don’t have to originate risky structured products or take proprietary trading risk. We have 95 other businesses from which to make profits. There’s no way investment banks can make attractive returns, in my opinion, with their limited product line and their lack of a deposit base, without taking excessive risks and crossing the line of ethical behavior. That’s why we were never in that business, in a major way, prior to the crises.

the Wells Fargo Way

The benefits of cross-selling in financial services

Kovacevich: If you’re only a lender, the only way you grow is by making more loans. But as you do that, you are increasing your risk and your concentration.

The loan is the hook — that’s what customers want the most. So you have to give them the loan and hopefully some deposits will come in return. But customers buy 14 products from financial institutions — both consumers and businesses — and the majority of those products don’t entail credit risk. They might involve operational risk, but it’s a different type of risk. So you can grow your bank while reducing and diversifying your risk.

Now if you do that, three other things that you haven’t thought of turn out to be true. The cost of selling an incremental product to an existing customer is about 10% of the cost of selling that same product to a new customer. You don’t open up a new account. You don’t advertise. You don’t take other risks.

You can say to the customer, if you bring over your treasury management product, your business or personal insurance, your credit card, your 401(k) or whatever, I’m going to give you a better deal than the competitor who is selling you only one product because of the 10% cost versus that 100% cost. You give a better deal to your customer, and they want to buy more. You benefit because you’re making more profits. You benefit from lower risk, and then finally you have the phenomenon that the more products that customer has with you, the longer they stay with you.

So it’s magic. We reduce cost, increase revenue, make higher profits, have less risk, and the customer gets a better deal. This is a business model for financial services that is far superior to any other one that I am aware of.

Execution

Kovacevich: Let me ask you, is this easy to do or hard to do?

Isaac: Well, I think it’s easier relative to the other approaches because you can sleep better at night.

Kovacevich: No, it’s harder, much harder, because you need to manage hundreds of businesses and products. Systems have to be capable of aggregating products and profitability by customer so you know what more to sell them and what better deals you can give them to incent them to give you more business. You need to be geographically dispersed. We have 100 different businesses out there doing some very complex things that are difficult operationally, and yet they have to work together as if we are one business from the customer standpoint. And that’s why most people don’t do it.

Relevance to management of risk

Kovacevich: Wells Fargo can now do investment banking, such as underwriting debt and equity and doing customer hedges and all the standard investment banking activities. We don’t have to originate risky structured products or take proprietary trading risk and so on because we have 95 other businesses to make profits from. There’s no way that an investment bank can make attractive returns, in my opinion, with their limited product line and their lack of a deposit base, without taking excessive risks and crossing the line of ethical behavior. That’s why we were never in that business, in a major way, prior to the crises.

Isaac: So you’re saying that you believe affirmatively that investment banking and commercial banking need to be mixed together?

Kovacevich: Absolutely, for diversity of risk. And what got us into trouble was they weren’t. I’m telling you that as bad as Citicorp was, if we didn’t have Bear Stearns, Lehman Brothers, Merrill Lynch, Morgan Stanley, and Goldman Sachs, this crisis would never have reached the level it did. Citicorp survived this crisis, despite doing most of the same things as the investment banks that failed, because it was more diversified, including a deposit base.

The Path To The Precipice

When Sheila Bair became chairman of the U.S. Federal Deposit Insurance Corp. in 2006, the housing market was faltering and subprime delinquencies were on the rise. But even so, analysts were predicting only an 8% drop in home prices and a 15% loss rate in subprime mortgages. No one was taking precautionary action. Within two years, regulators were scrambling to avert the collapse of the banking system.

The following are excerpts from an interview of Chairman Bair by William M. Isaac, Bair’s predecessor at the FDIC under Presidents Carter and Reagan, and currently Senior Managing Director and Global Head of Financial Institutions at FTI Consulting. Bair gives a unique behind-the-scenes view of how the FDIC came to terms with the scope of the crisis and how improvements in transparency can prevent one in the future. She also voices a strong concern for the vibrancy of community banks and the regulatory demands that could stifle their role in economic growth.

As a financial crisis silently loomed in 2006, the FDIC was among the first to see the early warning signs.

William M. isaac: How did you come to realize, so early, that the banking system was in grave danger?

Sheila BAIR: To the credit of the FDIC staff, on the day of my arrival they were talking about the deterioration in mortgage lending standards. We were seeing a marked increase in subprime delinquencies, even in 2006. We bought private data on mortgage-backed securities to try to get a better handle on what was going on. As you know, most of this information was not on the bank balance sheets and therefore not reported to us. What we saw was pretty frightening.

There was already an effort under way to tighten standards for nontraditional mortgages, which are basically the negative amortization products like option ARMs [adjustable rate mortgages]. There were clearly some problems there. Subprime mortgages were deteriorating. So we pushed very hard to tighten lending standards for subprime mortgages and to get the states involved because they had the authority over the nonbank mortgage originators.

I was somewhat in tune with these issues from my days at Treasury, but I credit the FDIC staff for identifying the problems early on. Congress had bills pending to deal with subprime lending issues, but those bills weren’t going anywhere. Ironically, the Federal Reserve had authority to set lending standards across the board for bank and nonbank mortgage originators. But it had decided not to use it.

People said we were being alarmist, and the problem was contained. In researching my book, I’ve gone back to look at the financial market commentary during late 2006 and 2007. Analysts were saying, “Oh, it’s going to be maybe an 8% decline in home prices over a couple of years and maybe a 15% loss rate on subprime mortgages.” That was in line with the groupthink back then. Everybody said housing was going to correct a bit, but it would just be ones with subprime mortgages. The losses would be manageable. So I credit the FDIC staff with being on top of that early and understanding it could affect the insured banks as well. However, nobody, including people at the FDIC, thought it was going to get as bad as it did.

A lot of that will be contained in the living wills and resolution plans. The critical exposure reports, if properly implemented, could be a huge boon. A key bit of information that we were missing: If a financial institution goes into an FDIC resolution process, or if a nonbank goes into a bankruptcy, what’s going to be the impact? Who’s going to take the losses? We just didn’t have that information. We didn’t know who the counterparties were. We didn’t know who the bondholders were. It was very, very difficult. And so the credit exposure reports now put the onus on the institution to basically tell the regulators: If they fail, who else could be materially affected? Or, if some other institution fails, will it have a material impact on the bank or its holding company? I think that’s huge.

Isaac: A lot of people are concerned that we’re going to lose a large part of our community banking system.

BAIR: I believe community banks should be strengthened by recent events. People are not angry at them. People want the high-touch banking that they can provide. Though we had a fair number of small bank failures, on a percentage basis the amount of distress in the smaller banks was significantly lower than it was with the large institutions.

Small banks weathered the crisis pretty well. The big issue is regulatory burden. I’m a regulator. But I believe in common sense and efficient regulation. A lot of the reforms are targeted toward practices that you find in larger institutions. If we just layer lots of new regulations on everyone, even though they don’t really have anything to do with what small banks do, we are going to hurt the community banking sector.

So before I left the FDIC, I started a community bank impact analysis of any proposal that we were going to move forward. We did a community bank impact statement once a rule or proposal went out.

I hope the new consumer protection agency in particular will be sensitive to this issue, because many consumer compliance rules can be quite daunting to a smaller bank. A lot of smaller banks would like to do more in the consumer banking space, but they are reluctant because of the expense. There is some valid concern there.

At the same time, we need to simplify the rules because, frankly, one of the reasons consumer regulation has been weak is that it’s so complex. Consumers can’t understand what their rights are, much less the products. So simplification could really help the community banks and consumers.

Restoring A Shaken Citi

When Richard Parsons was named chairman of Citigroup Inc. in January 2009, the bank had just announced an $8 billion quarterly loss. It was on the brink of being nationalized.

Parsons sat down with William M. Isaac, Senior Managing Director and Global Head of Financial Institutions at FTI Consulting, to recount the harrowing experience of preventing one of the world’s largest banks from collapsing. To Parsons, the government played a major role, and he is less critical of its actions than many of his peers. He argues, for example, that TARP [Troubled Asset Relief Program] and its follow-on measures helped restore confidence in the banking system.

Fast-forward to the present: Citi posted profits of $10.6 billion in 2010 and $6.2 billion in the first half of 2011. Having brought Citi back to life, Parsons articulates the bank’s leadership role going forward, including its commitment to housing finance.
The following are excerpts from the interview.

William M. isaac: What was it like being at the top of Citi during that period?

Richard Parsons: Citi was perceived to be the worst of the worst of the big guys. So trying to navigate that was a challenge. In my view, and I’m certain that it was the view of Tim Geithner [then president of the Federal Reserve Bank of New York] and every thoughtful person in Washington, we just couldn’t let Citi go down. The federal regulatory establishment was committed to the general proposition that we had to figure out how to get this big bank through this crisis — and in a way that was defensible given the toxicity of the environment. We had to figure it out and try to avoid making a mistake that could cause the bank to implode.

It was dicey because it’s all about confidence — whether it’s depositor confidence or counterparty confidence. One of Citi’s issues was that a huge part of its balance sheet and operations was funded in the wholesale markets. If those markets were closed to you, or if investors got spooked, your funding might disappear overnight. So we had to make sure we were doing the things needed to keep the markets calm. Then there was the heat of the battle in Washington. Every bank and all the bankers had become pariahs to many of my good friends and colleagues in the Washington establishment. Bank bashing and fat cat bashing were in vogue.

Isaac: How do you view the way the government handled the crisis? How would you grade its effort?

Parsons: B+. I’m talking about how the government handled the crisis once it was on us. I really do think the system could have melted down. I was told by the Treasury Department that there was about an hour on the Tuesday after Lehman collapsed when interbank trading around the world stopped. Nobody would clear anything. It just halted.

The financial world could have been thrown into total chaos. The government’s response, putting TARP in place and the follow-on measures thereafter, salvaged at least some confidence in the system. The bottom line is we worked through the crisis.

Isaac: But Lehman is part of that story in terms of the government’s actions, right?

Parsons: Certainly, it started off badly. But even if Lehman had been bailed out the way Bear Stearns had been, then the next one would pop up. There could have been more forethought to the handling of Lehman. But I’ve heard people argue that Lehman had to happen, so the sooner the better.
From the failure of Lehman forward, the government’s response was pretty good. But neither our government nor the industry did a good job of communicating why the financial system is different from other privately held industries, and the consequence of letting the financial system slip into chaos. So the angst and the anger caused by the crisis and the government’s response to it were higher than they needed to be. The situation was not helped by the handling of AIG — how we dealt with credit-default swaps and who was made whole without participating in any of the pain. In hindsight, I’m sure people would look at that and say we could have done a better job.

Isaac: What is Citi’s future?

Parsons: Here’s the way I think of it. Citi right now thinks of itself as being in three businesses: institutional or wholesale banking, retail banking, and global transaction services. GTS operates in about 96 countries but serves clients in 140 countries around the world. We have by far the biggest global footprint of any U.S. bank. HSBC is a distant second to Citi in terms of its global footprint.

I think of this GTS system as a circulatory system of the corporate body. It doesn’t have the highest amount of reported net income, although it’s highly profitable. But it connects all the other parts, both in country and across borders. We have a new tagline at Citi, which hasn’t actually been publicly promulgated yet: “America’s Global Bank.” Citi is going to continue to provide connectivity for its largest institutional clients and particularly for the top 5,000 corporations in the world.

Isaac: You said that the GTS is not the most profitable part of Citi. What is?

Parsons: It will bounce back and forth between the securities and banking business and the retail business and cards. Credit cards for a long, long time were a quarter of Citi’s earnings.

Isaac: Is there a future for housing finance at Citi?

Parsons: Yes, there has to be. The most stable and therefore valuable source of funding is deposits. If you’re going to be in that business, you’re going to be dealing with retail customers. You have to have a full suite of products and services to keep them there. You can’t just say, “Look, we want to take your deposits, but we don’t do anything else.”

There will continue to be a significant residential and commercial real estate component to Citi here in North America. But the old business of having a whole network of mortgage brokers out there so that you can get the mortgages and run them through the warehouse, package them up and sell them off as securities — that’s gone.

Premature prognosis? Hardly. The U.S. healthcare system has reached a precarious tipping point, the culmination of decades of spiraling healthcare costs. Despite many attempts during the past 30 years to enact reform and control costs, the financial ecosystem that links up clinicians, hospitals and health systems, and insurers is clearly unsustainable. Past cost-control initiatives have not kept pace with the continued cost increases because of changing demographics, expensive new medical technologies and ever-longer life expectancies.

U.S. healthcare costs now account for more than 17% of GDP, up from 12% in 1990. Annual spending today averages about $7,000 per person. And now baby boomers have officially begun their slow march onto the rolls of Medicare, the government health insurance program covering everyone age 65 and older. These 78 million Americans born between 1946 and 1964 are expected to boost Medicare enrollment from 45 million in 2010 to 64 million by 2020.

That so-called tipping point seems more and more like a breaking point for the U.S. healthcare system.

The Accountability Cure

With the nation’s healthcare system facing economic crisis, legislators passed a historic healthcare reform act in March 2010 to address the spiraling costs. To bend the cost curve, one measure encourages the creation of accountable care organizations (ACOs). The ACO model ties reimbursements for medical providers to two key components: strict adherence to quality metrics, and reduction in the total cost of care for a defined population of patients.

While ACO may be a new term for many, in truth the healthcare industry has been moving away from traditional “fee for service” relationships toward quality-based reimbursements for some time. Pure fee-for-service reimbursement is going away. In some markets the rate of change is faster than in others. But most payers are seeking to base a significant percentage of payments on performance.

The ACO model is understandably attractive to organizations that pay for healthcare. This is especially true for health insurers, which are squeezed between the demands of large employers to reduce premiums and those of providers concerned about diminishing revenues. But while payers are embracing ACOs’ transfer of risk to providers (especially in California, where assumption of clinical risk by providers is still prevalent), most providers are not nearly as enthusiastic, and few have adopted the model.

Many healthcare providers argue that the uncertainty around ACOs makes it difficult to buy into the model, which in most cases requires a significant financial investment to ensure success. The cost of implementing technology, reorganizing physician practices and instituting performance measurement systems can be substantial.

In particular, providers make the following arguments:

• There is far too much uncertainty in the guidelines on ACOs issued by the Centers for Medicare & Medicaid Services (CMS). Hospitals are being asked to reorganize and invest in a system that is not clearly defined.
• Providers are not proficient with the new regulations because the legislation is new and they haven’t fully digested its actual and implied changes.
• The current legislation applies only to Medicare and Medicaid (a joint federalstate health insurance program for the poor) patient reimbursements, a sizable but still limited portion of the entire population.
• It may not make sense to invest in updated systems with the real chance that healthcare legislation may be repealed under a new administration.
• The ACO model may not actually save hospitals money. In part, ACOs reduce costs by lowering demand for unnecessary procedures. Providers worry that lower demand will cut into their bottom lines.

All of these arguments have merit. But they miss the point that the ACO model includes approaches that providers should adopt regardless of the specifics of future payment models. Providers that don’t start making these changes soon will find themselves at a competitive disadvantage.

Because of changing demographics, the payer mix is shifting, with a higher proportion of patients qualifying for Medicare and Medicaid. Whether or not ACOs become a model for the health system at large, it seems inevitable that the future reimbursement model for CMS-qualified patients will be based on pay for performance. As a result, providers need to begin standardizing best clinical practices, support disease prevention, reduce overutilization and take responsibility for medical outcomes. Those that do not will likely see declining reimbursements.

Achieving these things requires much closer alignment of physicians and providers than is found in most healthcare systems today. Physicians need to work toward the same objectives that hospitals do: reducing the length of hospital stays, minimizing resource consumption and improving outcomes. What’s more, physicians from different specialty areas must work more closely with one another to improve the outcomes for patients who need to be treated by several specialties. These strategies are not incremental changes for physicianprovider relations in many healthcare systems but transformative ones in an already embattled industry.

One Goal, Mulitple Approaches

It is becoming clearer by the day that most healthcare providers must start implementing elements of the ACO model. Early adopters can also gain the favor of consumers and advocacy groups seeking quality and price transparency.

The ACO model holds physicians and hospitals jointly responsible for improving quality and reducing costs. Yet it is up to both groups to determine how best to achieve the goals. For instance, hospitals can lower the cost of treatments by standardizing a “proven” best practice. One group of South Carolina hospitals, for example, embarked on a program of evidencebased care and reduced the rate of mortality from acute myocardial infarction from 12% to less than 5% in the first year.

Providers can reduce costs and improve outcomes by helping patients look after their health. Some providers are educating patients and giving them incentives to do that. For instance, an Alabama program in 2004–2007 to help diabetics manage their condition reduced their emergency room visits by half.

Another way to reduce healthcare costs is to steer patients away from unnecessary hospital visits altogether. That requires establishing the local primary care clinic — not the hospital — as the core of the healthcare delivery system. Recent studies have shown that a patient-centered medical home model benefits both patients and medical staff, giving patients more one-on-one time with a physician, improving caregiver cooperation and providing more preventive care.

Hospitals can improve efficiency, too, by better managing complex patients — that is, those with more than one condition. Studies have shown that patients in hospitals employing hospitalists — attending physicians for individual patients — tend to have shorter stays, especially in cases requiring close clinical monitoring or complicated discharge planning. Most of these changes require strong clinical integration: primary care physicians, specialists, nurses and hospitals coordinating their activities to improve outcomes for every patient.

Better Quality, Lower Costs

Baptist Health, a San Antonio, Texasbased five-hospital system with 1,741 licensed beds, was an early participant in a CMS-sponsored Acute Care Episode Demonstration (ACE Demo) project, a Medicare program launched in 2009 that pays participating hospitals a lump sum for hospital and physician services.

The goal of ACE Demo is to give hospitals and physicians the right incentives to improve quality and lower the cost of care for 28 cardiac and nine orthopedic diagnosis-related groups of illnesses.

In the first year, Baptist consolidated vendors and reduced the costs of implants by 15%, from $6,000 to $5,000 per case. Baptist tracked 22 CMS quality metrics, of which a subset was used to calculate savings to be split equally between the physicians and the system. By the beginning of 2011, the program had saved Baptist $4 million, and hundreds of thousands of dollars had been paid out to physicians and patients in shared savings.

In addition to savings, Baptist reported dramatic improvements in patient care and quality, including:

• Quality at or approaching 100% for all metrics
• Improved physician alignment
• A shift toward evidence-based practice
• Higher physician satisfaction

Despite many providers’ cautiousness about ACOs, Baptist and other health systems are demonstrating real savings and quality improvements by following the precepts of an ACO model. As with Baptist, that means getting the hospital and doctors in formerly segregated clinical disciplines to work closely to produce better outcomes at lower cost for every patient. Such strong collaboration around patient outcomes is referred to in medical shorthand as clinical integration. And clinical integration depends on two factors: better alignment of physicians and the ready availability of clinical data, on both individual patients and populations.

Physicians Take The Lead

A few health systems, such as Kaiser Permanente and Cleveland Clinic, employ the majority of their physicians. As a result, it is easier for them to get hospitals and physicians working toward the same goals. But for almost everyone else, getting physicians who aren’t employed by a hospital system to buy
into standardized processes will be a major challenge. Still, it is possible.

Let’s look at how one health system is getting its hospitals and independent physicians on the same page.

Consider the success of the Henry Ford Health System (HFHS), which was once a closed system consisting of the Henry Ford Hospital, the 1,300-doctor Henry Ford Medical Group, and a fully owned health insurer, Health Alliance Plan. But in recent years, HFHS has built or acquired four community-based hospitals, creating relationships with many physicians who are not part of the medical group. The challenge for HFHS: How can it partner with private-practice physicians and those employed at other hospitals? Many of these physicians want to remain independent and do not want, for example, to participate in the education and teaching requirements of the medical group.

HFHS began looking at how to increase clinical integration back in 2009. The initial motivation was not healthcare reform. Rather, large local employers expressed to Health Alliance Plan their desire to engage with a highperformance network. HFHS leadership realized that if it could integrate physician groups and thereby reduce medical costs and improve quality, it would have something attractive to offer the broader marketplace.

Eighteen months later, the hospital system has the entity in place: the Henry Ford Physicians Network (HFPN). To date, the physician network includes all Henry Ford Medical Group physicians, hospital-employed physicians and almost 200 independents.

Engaging the physicians early in the process and letting them lead it were critical, according to Matt Walsh, HFPN’s vice president of operations. The board of HFPN has 15 members, of whom 13 are physicians. Walsh believes that physicians agree quickly to the core tenets of clinical integration — partnership and value creation through improved quality and efficiency — because physicians intrinsically believe in these principles. Payer contracting is another matter, however. The dollars and fee schedules quickly engage the interest and concern of all stakeholders. Careful development of a management structure that builds trust in this area is critical.

Walsh advises health networks moving toward greater clinical integration to communicate to physicians how it benefits them. For the independent physicians in HFPN, those advantages include continuing medical education, performance feedback, and access to best practices and affordable information technology tools and support. All these give physicians opportunities to improve their practices and create access to future contracting opportunities. As more and more physicians realize that fee-for-service reimbursement will fade into the past, such benefits become important incentives.

Data Reveals Opportunities For Improvement

The collection and processing of data are also critical to better clinical integration. First, integration of services for each patient is much more effective if there is a patient-centric health record — an electronic health record, or EHR. Second, if healthcare systems are proceeding to a full ACO model, they must report performance metrics to CMS to share the savings benefits beginning in 2012. Most important, it is impossible for hospitals to know where to make improvements without knowing their current performance.

Norton Healthcare is a five-hospital, 500-physician, 100-location Kentuckybased nonprofit healthcare system. Long before the acronym ACO made its way through the halls of Norton Healthcare’s Louisville headquarters, the healthcare system was bullish on using data to improve its services. It has long shared performance data with the public. On its Website, it publishes performance metrics for more than 600 quality criteria, each benchmarked to national averages.

Impending healthcare reform was one reason Norton started moving toward greater clinical integration. But it also wanted to leverage its skills in data collection and usage.

As Steven T. Hester, M.D., senior vice president and chief medical officer, explains, “We have much more data than we did 20 years ago, and we can use the data to find opportunities. Everyone always thinks they are doing well, but until you can show them data on how they compare with their peers, internally and externally, they don’t know how well, or where the opportunities for improvement might lie.”

Given the breadth of data available to Norton physicians, the organization can influence a wide range of quality indicators. As an example, Hester explains how the hospital can focus on reducing the length of stays. “We have specialists who work with hospitalist groups on how they manage care,” he says. “We can give them data that compares their indicators with their peers on, for instance, readmissions or length of stays. This information is key to helping them understand how to move patients through the system. Consider a neurosurgery patient. His specialist may be in the operating room and not be able to discharge him until the end of a busy day. But now the hospitalists see where the bottleneck is and can keep the process moving without having to wait for the specialist to be free.”

Comparing practices has been important in just about every industry. Healthcare is no exception. As Hester points out, “Benchmarking data is critical. Clinicians need to see where they sit versus others in the community, both within their own health system and outside.”

This cannot be done manually, at least not for any meaningful length of time. Every health system with several hospitals, hundreds of physicians and thousands of patients needs to report dozens of metrics and monitor hundreds more. That requires information technology. Norton has made, and continues to make, significant investments in IT for clinical data collection, processing and reporting.

As Baptist and others have demonstrated, there are financial and quality benefits from organizing as an ACO. Clinical integration brings a range of benefits, including the following:

• Higher quality and efficiency through better-coordinated care
• Improvements against pay-forperformance measures
• A more collaborative relationship with medical staff, leading to higher physician loyalty
• Greater physician support for hospital initiatives

Despite such benefits, healthcare providers trying to migrate toward an ACO model must overcome significant barriers:

• Uncertainty about the future of healthcare reform. No institution relishes investing significant capital in projects without a clear mandate. The possibility of wholesale changes to current reform legislation creates uncomfortable ambiguity for executives.
• The complex task of technology implementation. History is littered with the debris of large healthcare IT projects, and IT challenges in healthcare seem no smaller than they were 20 years ago.
• The challenge of managing change and gaining the trust of physicians. Private-practice doctors are often inherently distrustful of hospitals. It takes time and effort to convince physicians that their needs will be heard during times of reorganization.

The most powerful ways to overcome these barriers are engaging physicians early and giving them leadership roles in which they can shape the future organization. It is especially important to involve physicians who are influential and believe in the change. In addition, identifying very early in the process what data is needed and putting in place the systems to collect and report it is vital.

The ACO Advantage

Given the inevitable migration from the fee-for-service model toward reimbursement on outcomes, health systems should not wait for the future of healthcare reform to arrive definitively. Whether or not the current version of reform or of ACOs survives, greater clinical integration will soon define the higher-performing health systems.

The ACO model’s core tenet of greater clinical integration is simply good patient care and good business. It reduces costs and improves quality in an industry that badly needs both. What’s more, for organizations willing to commit to the hard work of quality measurement and clinician alignment, there is the prospect of first-mover advantage. Patients are acting more and more as healthcare consumers; they, too, are advocating for quality, efficiency and transparency.

For providers, there’s really no reason to wait.

Common Issues

Causes of poor care include lack of universal coverage and/or inadequate capacity of the healthcare system, creating uneven access to care, and gaps in quality from the underuse, overuse or misuse of care or services. Rising costs leave an increasing number of people without coverage and/ or access to care, and often restrict the services they are allowed access to. Numerous studies support the fact that underuse of effective services is a huge problem.

Indeed, people who would benefit from services — be they preventive in nature (such as screening for colon cancer) or helpful in controlling the symptoms or progression of a chronic disease — receive those services only half as often as they should. Similarly, with respect to overuse, many studies have shown that 30% to 50% of services offer no value to the individual receiving them. In fact, in some of these cases the individual is more likely to suffer harm than benefit. While there is less information to support the incidence of misuse, this dimension of poor quality also contributes significantly to the challenge of providing quality care. These gaps in quality can be linked to specific problems within the healthcare system. They include (in no specific order of importance):

• Flawed payment methodologies
• Information gaps relative to patients’ health needs in planning and at the point of service
• A lack of or diffuse accountability for results
• Fragmentation of the care delivery system, with poor coordination or communication between caregivers
• Little experience in collaborating between organizations

All of these have contributed to the complexity of the healthcare system and make it difficult for providers, not to mention patients, to navigate. While these system issues are responsible for the gaps in quality, other forces are the major drivers of costs. The three major factors driving the unsustainable trends in healthcare costs are aging populations, resultant increases in chronic diseases such as diabetes, cardiovascular conditions and cancers, and the proliferation of new technology. In addition, it is clear that compensation methods for providers are a major enabler — if not an absolute driver — of current cost trends.

Solutions

Managing Chronic Disease

While nothing can be done about the aging of populations, we can certainly do a far better job of preventing or managing chronic diseases. There is great promise in care redesign via patient-centered medical homes (PCMH) or advanced primary care models (which I will discuss later). That said, the most promising results in fostering improved health behaviors in individuals are coming from efforts such as the Robert Wood Johnson Foundation’s Aligning Forces for Quality (AF4Q) initiative, which helps providers, individuals and communities in the United States redefine their roles and responsibilities and work together to deliver more effective healthcare. Such programs work because much chronic disease stems from individual decisions about behaviors — diet, exercise, smoking, and seeking proven effective preventive services such as cancer screenings.

One example: In 1994 Brazil launched the Family Health Program, which is now the world’s largest community-based primary healthcare program. Under this program, teams of at least one physician, one nurse, a medical assistant, and four to six trained community health agents delivermost services at community-based clinics. They also make regular home visits and conduct neighborhood health promotion activities. Between 1999 and 2007, hospitalizations in Brazil for ambulatory-care-sensitive chronic diseases, including cardiovascular disease, stroke and asthma, fell at a rate almost twice that of hospitalizations for all other causes. In municipalities with high Family Health Program enrollment, chronic disease hospitalization rates were 13% lower than in municipalities with low enrollment, when other factors were held constant.

Accountable Care Organizations

In the United States, there is considerable interest in a new approach to managing care — accountable care organizations. ACOs are seen as a way to provide better-quality care at lower costs. The need for more accountability in caring for patients is clear. Unfortunately, there is too much talk about the organizations that will do it and not nearly enough about what accountable care looks like when done well. Providing accountable care means using a specified amount of money to maintain or improve the health of a defined group of people. Health insurance companies have had this responsibility for some time. Unfortunately, the contractual relationships with the providers, as well as the payment systems and/or methodologies, have not transferred this accountability effectively. While some insurers have put payment systems in place to reward providers for better outcomes, in large part providers have been rewarded for delivering volumes of services without regard to cost. The healthcare reform enacted in the Netherlands in 2006 goes a long way toward addressing this problem. The new system uses a combination of regulation and an insurance equalization pool run by the state to transfer responsibility. Insurance companies are mandated to provide at least one policy that meets a government-set minimum standard level of coverage, and all adult residents are obliged by law to purchase this coverage. Insurance companies receive funds from the equalization pool to help cover the cost of coverage and compensate for different risks presented by individual policy holders; insurance premiums cannot be based on health status or age. Patients dissatisfied with one insurer have an opportunity to choose another at least once a year. As a result of this system, health insurers are effectively responsible for the health

of a self-selected population. Because it is built around a fixed price, they have every incentive to keep that price down and deliver better outcomes. In a 2010 study, the Netherlands’ healthcare system was ranked first in a comparison with systems in Australia, Canada, Germany, Great Britain, New Zealand and the United States.

Patient-Centered Medical Homes

There is mounting evidence that the efforts to develop patient-centered medical homes (PCMH) or advanced primary care practices are making significant progress in delivering quality care. A PCMH practice is accountable for defined elements of care for a specific patient population. Reimbursement models differ among PCMH models, but there is movement away from fee-forservice reimbursement. The Colorado Clinical Guidelines Collaborative, a nonprofit coalition of health insurance plans, physicians, hospitals, employers, government agencies and other entities working together to improve healthcare in Colorado, recently instituted a PCMH pilot. The pilot was initially set up with 16 family medicine and internal medicine practices, representing a total of 17 sites. Health insurance plans, large employers, key hospital groups, physician societies, the Colorado Department of Public Health and Environment, and the University of Denver Health Science Center were also involved in the implementation and operation. The outcomes, both financial and clinical, are impressive, and include a return on investment of 3:1 and a 22% decrease in emergency room visits, for example, at one health plan.

Information

What information will be needed for each population of patients is a key issue and will take a lot of effort to decide. The local or regional disease burden will be unique to each area’s population. So decisions on which services are needed and how they should be delivered should reflect the needs of the population, the values and priorities of the region, and the capabilities of the region. Local stakeholders should have much more say about how resources should be allocated than should a central resource like the U.S. government health program administrator Centers for Medicare & Medicaid Services (CMS) in Washington or a health department authority in some state capital.

When discussing accountable care organizations, policymakers should ask to whom and for what these organizations are accountable. It is not enough to understand what care they will be required to provide. It must also be very clear who will be responsible for making sure that care is provided well and adequately. Of course providers will answer to CMS about Medicare enrollees, but there needs to be similar accountability to state, local and regional stakeholders for both Medicaid and commercial enrollees.

Technology

While technology has been an incredible tool in advancing healthcare, it is only a means to an end. Healthcare will remain a relationship “business” where the trust and relationships between people set the stage for better results. Current payment systems and policies have encouraged the rapid and sometimes premature adoption of new technologies. In the United States, where more than 30% of Medicare spending is devoted to highly technical care during the last few months of life, many individuals could benefit from more discussion about how to approach care decisions at this time.

Clearly the coordination of care and communication will be enabled by technology such as electronic health records and health information exchanges. Understanding the needs of patient populations will require information technology new to many organizations. Physician groups and hospitals have previously not needed to profile the populations of patients they serve in order to understand the disease burden the population carries. Predictive modeling tools to identify those patients at highest risk of experiencing an adverse event will allow the allocation of resources to help avert those situations. In 2001 health insurance provider BlueCross BlueShield of Tennessee (BCBST) began applying predictive modeling techniques to member health and claims data in an effort to improve both the delivery and the quality of care. BCBST first used these techniques to make sense of mountains of clinical information and to pinpoint clusters of diagnoses, procedures and patterns of illness. Having this information allowed for the deployment of specialized service programs, such as promoting the use of beta blockers, enhancing medication compliance and coordinating care. This allowed them to avoid disease progression while providing a high level of patient support, which in turn drove down costs by reducing the amount of acute care these patients needed. Today BCBST has a sophisticated data warehouse and business analytics operation. It can, or will shortly be able to, serve up analytics to major consumers, deliver individual history and predictions to members, give near-real-time performance management, and capture structured and unstructured information.

Regional Planning

In the United States, regional health planning authorities have played an important role in helping to allocate resources. In New York these regional authorities were mostly eliminated in the late 1980s and early 1990s. One of the few that remained active and effective was in Rochester. Six years ago, the state put together the Berger Commission to make recommendations about downsizing health system capacity across New York to better reflect the actual healthcare needs of each region. The only region that didn’t require any downsizing: Rochester. France recently undertook a similar effort that underscored the importance of regional planning. It rationalized eliminating service duplication and excess capacity according to the needs of regional populations. In both cases the emphasis on understanding the region’s capabilities and its population’s needs led to rational decision-making. In the United States, population health assessments such as the recent work published by the University of Wisconsin Population Health Institute can be used as a basis for assessing the overall health needs of groups within a specified geographic region. Once the geography has been defined and the health needs of the population have been carefully delineated, the next important task is determining the workforce needed to provide the requisite services. The right mix of caregivers — primary care physicians, specialists, nurses, pharmacists and other professionals — will depend on both the population’s health needs and the chosen care delivery model.

New Roles

Both the teamwork within the primary care practices and the coordination of care between primary care physicians, specialists and other providers speak to the need to have clearly defined roles and responsibilities within the systems of care. New roles for care coordinators, health educators, community case workers and clinical informatics experts will all be important building blocks as we better understand the gaps in the care system and how best to close them.

Co-Opetition

The inevitable decrease in total resources available for healthcare means that countries, states and regions will have to learn how to do more with less. Here is where the concept of “co-opetition” comes into play. Many investments can be made — particularly in the area of IT — in which competitors or nontraditional partners may find that investing together lets them lower costs and increase collaboration while continuing to preserve a strong basis for competition. Some regional health information organizations, such as the Western New York Clinical Information Exchange, are good examples of this. Seven competing healthcare organizations in the Buffalo region have joined to create a dedicated information system that preserves the ability of the individual organizations to compete on the use of their own data. Areas that can strike a balance between collaboration and competition will enjoy a significant advantage in the resourceconstrained future.

Conclusion

To ensure maximum value for the resources invested in healthcare, several things must happen: Accountability needs to be defined; data systems and standards have to be established for tracking populations’ health needs as well as for evaluating the success of interventions; new roles must be defined, with teamwork and communication more important than ever before; and new skills must be brought to bear, not the least of which is the ability to collaborate across previously impenetrable boundaries. Only by doing these things can we bring people the healthcare they deserve, at a price they can afford.

Even if the perfect system could be divined by selecting the best from everywhere, implementing it anywhere would range from painful to impossible. The large number of stakeholders in any country’s healthcare system — patients, providers, government, insurers, regulators — plus the fact that healthcare is an emotionally charged issue means that change is never easy.

But there are some lessons that each country can learn from others, including what developed countries can learn from developing ones about the necessary role of government and the pivotal role of local communities. To focus on some of these lessons, FTI Consulting convened a roundtable of healthcare experts chaired by Mark Malloch-Brown, FTI Consulting’s Chairman, Europe, Middle East and Africa.

In conversation with him were Michael W. Cropp, M.D., President/ CEO, Independent Health; Anne-Toni Rodgers, Payer Capability, Regional Lead — Europe, AstraZeneca; Meg Guerin-Calvert, Vice Chairman and

Senior Managing Director, Compass Lexecon; Vicky Pryce, Senior Managing Director of FTI Consulting’s Economic Consulting practice; Liz Shanahan, Senior Managing Director, Health & Life Sciences, Strategic Communications, FTI Consulting; and Dan Corry, Director, Economic Consulting, FTI Consulting.

Mark Malloch-Brown: I feel I perhaps know less about this subject than anyone else here today. But I was involved in running large international public-development organizations for a decade at a time when communicable diseases and the absence of healthcare investments in developing countries were as salient a pair of development issues as you could find. So I will press you during this discussion to not forget the 2 billion people at the bottom of the economic ladder in our solutions for healthcare coverage worldwide. Meg, what are the underlying drivers for change in healthcare?

Meg Guerin-Calvert: The single greatest challenge for developed economies is the proportion of GDP going for healthcare expenditures in virtually every country. In general, for major Organisation for Economic Cooperation and Development countries it’s somewhere between 8% and 16%. As we have moved through the financial crisis, the rate of economic growth in many countries has slowed or stalled, yet the rate of healthcare expenditure has not. As a result, the proportion of overall GDP consumed by healthcare in many countries is increasing. Depending on the importance of public sector funding, a very high proportion of government budget is allocated to healthcare. And despite that level of spending, certain countries, such as the United States, believe that quality and access achieved do not meet expectations. Those are substantial challenges.

Vicky Pryce: The developing world, where population growth is high, faces huge pressures to provide any kind of sensible healthcare system. At the same time, in some of those countries the emerging middle classes are looking for much more than just the basics.

Michael W. Cropp, M.M.: The cost of care relative to the value created is an increasing challenge that is emerging in every country. Everyone is or should be grappling with how we can afford to provide care for the entire population and get the maximum value. It is quite simply the cost of doing business as a nation, and it has huge economic implications.

Malloch-Brown: Since this is a global challenge, what lessons can we learn from each other? China, for instance, has made good progress against smoking through social marketing. It didn’t have fully developed healthcare options available. Can other countries learn from such successes?

Cropp : I think so. I just visited France, where government statistics show the country spends 11% of its GDP on healthcare. France has compelling statistics to suggest the results are worthwhile. For example, I was struck by the percentage of money spent on the physician component of healthcare overall, and that pharmaceutical spending is overrepresented relative to the United States; hospital expenditures are too. But smokingrelated cancers aside, France stacks up exceedingly well on most of the mortality measures, such as deaths related to diabetes and heart disease.

Anne-Toni Rogers: Many people are taking note of what’s being done by the United Kingdom’s NICE [National Institute for Health and Clinical Excellence]. But while most of the focus is on technology appraisals of drugs and devices, the way they developed clinical guidelines was quite clever. NICE funded the Royal Colleges and the professional associations to produce the guidelines, so the guidelines were being produced for the professionals by the professionals. That has made the guidelines much more likely to be widely adopted. Therefore they are likely to have a greater impact on healthcare overall.

Malloch-Brown: How transferable are practices? Can you easily take them from one country and implement them in another?

Dan Corry: It is very difficult to make sound cross-country comparisons on health expenditure; even if we did have the right figures, would that persuade us that if something worked for France or the United States or wherever, we should change our system to match? I think that’s very questionable. Each system has evolved over a long period of time, which creates significant inertia that makes it very tricky to completely change it. And there may be reasons that it works in one country and not in another. Another challenge for policymakers is that it’s very hard to say what the right answer really is. As economists, we like to know we’ve done our analyses and econometrics so we can tell you the right answer. But in healthcare there are so many complications that make it very, very hard to model well. But progress is being made. So you’re seeing proposals in the United Kingdom for changes in health that some people are convinced would work. Yet there’s another set of people — just as genuine, just as clever — who don’t think they will work. And the public is sitting there thinking, “What’s the right answer?”

Guerin-Calvert: Looking behind the successes to understand the sources of improvement is critical. I would agree with your sense that sound analytics are important tools. In addition, there needs to be a way to measure and track on a common basis.

liz Shanahan: I agree that healthcare systems can learn from each other, but analytics and metrics are not sufficient on their own to drive change. The way the learnings are communicated, cognizant of cultural differences, will also be pivotal to their success.

Rodgers: There are structural issues in the way, too. In Europe, technology that’s been around for 30 years could enable patients to be treated at home. But they’re not given the choice because the system rewards physicians for providing care at a medical office or hospital. For example, there is hardly any home-care dialysis in Germany, as compared to the rest of Europe, possibly because German physicians are rewarded for owning and running the treatment centers.

Malloch-Brown: France is a fascinating example to me because I believe that French health statistics are entirely driven by red wine consumption. And let me add that most of the FT I Consulting leadership would agree. But joking aside, there’s a serious point here: Many French policy leaders argue that there are broad lifestyle issues involved. This is, after all, a country that has championed a kind of quality-of-life index where work-lifestyle balance is a key issue.

Rodgers: I think lifestyle issues are very relevant, and you don’t only see differences between countries. There’s actually strong regionalization within France, and you see incredibly different statistics across the regions, as indeed you do in other countries.

Cropp : That is a very important point. We see tremendous variations in the United States as well. Even though Buffalo might have a culture very similar to those in Pittsburgh and Cleveland, the differences in health statistics are dramatic. When you trace the underlying drivers, they often relate back to chronic diseases and simple personal choices about exercise, eating and smoking.

Guerin-Calvert: In the United States there has been extensive study of the drivers of spending on Medicare [the U.S. government health insurance program covering everyone age 65 and older], looking at not just cost but also utilization — for example, the use of inpatient services vs. preventive care or the rate of readmissions. As an economist, what I find intriguing are the large variances in the utilization of services such as diabetes care, cardiac care, testing and so on across geographies. There are many factors that account for these differences, and demographics play an important role.

Malloch-Brown: How important are local structures and incentives?

Cropp : As we’ve mentioned, local conditions are very different, so there has to be local ownership and accountability to make things happen effectively. Whatever works in Buffalo may or may not work in the next community. So I’m a strong believer that local solutions must emerge in every country we’re talking about. But sometimes it’s going to require support at the state or federal level to facilitate the right dialogue. Key to effective local implementation is balanced metrics. It can’t just all be about cost and affordability. Only now is the United States beginning to go from a robust set of economic data — which is mostly complete for the Medicare population — to an almost equally robust set of quality data and a less robust data set on patients’ experience. Pulling all of that together is essential to being able to say, “Hey, they’ve figured something out in Cleveland that’s worth replicating.” And to understand what it was that made Cleveland a success. You can see from the data, for instance, that La Crosse, Wisconsin, is a very efficient area where the annual costs per Medicare enrollee are about $5,000. That’s at the bottom of the national range, which is $5,000 to $25,000. Plus, the quality of care and the patient experience are good. If you ask people from La Crosse what’s going on, they’ll tell you that as a community — of physicians, patients, faith-based institutions and others — they’ve tackled end-of-life issues. So if you live in the La Crosse area and you’re over 65, you have a 95% chance of being enrolled in hospice and only a 5% chance of dying in a facility, which is the opposite of the rest of the country. And that’s a local solution.

Guerin-Calvert: We can learn a great deal from cross-community comparisons as to what types of structures, incentives and metrics worked well to achieve desired cost, quality and access goals.

Shanahan: In the United Kingdom, general practitioners have been heavily incentivized to achieve improvements in screening and managing high-risk patient groups such as those with diabetes. The GPs have hit almost all of the relevant targets, capitalizing on the many exclusion criteria, and have been generously reimbursed for doing so. Still, it’s hard to know the true benefit, and we have yet to see the improvements in outcomes promised by these incentives.

Malloch-Brown: For healthcare systems being built in the developing world, how much of this is relevant? What would be your top lessons for someone in Chengdu, China, or wherever, which he might or might not learn from Buffalo as he starts to build a healthcare system?

Pryce: The first thing to note is the huge differences between countries in the developing world, as well as between them and developed countries. You can’t just take what works in the developed world and superimpose it on developing countries; it’s not going to work.

Rodgers: These developing markets often trust the industry more than the Western markets do, and they are keener to have partnerships. They will often accept that the industry is investing in infrastructure because they want the right medicine to go to the right patient at the right time, and they want that inward investment. In India, for example, some device manufacturers have worked with local communities to figure out how to get dialysis to a population that doesn’t have refrigerators or electricity. They’ve come up with entirely different products and solutions, because that’s what the community needs — for example, a box that delivers clean water to do the dialysis. They don’t really need to know how it does it, and they just accept that it does it. So my biggest recommendation is to capitalize on the level of trust and not start to overregulate, because the minute you do, you stifle innovation and increase cost.

Guerin-Calvert: I agree completely; you do not want overregulation. You want to rely on the market as much as possible. But you need to take a realistic look at what the market can easily provide and what things you might need to do to encourage new or different sources of funding to make that happen. By encourage, I mean new kinds of coordination, organizations coming together to exchange data and practices. Critical elements are the availability and use of data on quality, cost and other metrics.

Rodgers: If you look at what’s happened in China, you’ll see that wealthy Chinese are spending on plastic surgery and the diseases of wealth, and therefore it’s more attractive for clinicians to go into plastic surgery, cardiology, etc. For the health of the country as a whole, China needs hematologists, pediatricians and mental
health physicians — specializations that perhaps aren’t as appealing. How you regulate and how you reward the clinicians in those markets will have a big impact on how the healthcare system develops.

Malloch-Brown: We’ve talked a lot about how national and local variations make it difficult to transfer learnings from one place to another. What are some other impediments to change?

Guerin-Calvert: I have seen many industries go through transformative change, from regulation to deregulation, and in my experience healthcare is the most challenging. To make change possible will require a complex balancing of competition, government and consumer choice, combined with development of new organizations and increased coordination.

Corry: As Meg says, there are some very complicated economics, very complicated stakeholder issues in all countries, and an awful lot of emotion. People care about nothing more than health. You only have to see how every newspaper in every country wants to have a health story high up every day. So it’s a very interesting but very difficult area of policy.

Shanahan: Very few market sectors are as emotive as healthcare, and this makes it very challenging. There are clear tensions between physicians, management, insurers, pharmaceutical companies and providers. Balancing the needs and biases of each group demands a good understanding of the commitment phases individuals and groups go through, where they move from self-concern to exploration to adoption, and finally where the changes become institutionalized. This can take many years.

Corry: In addition, in most industries we think that competition is a good thing and it’ll drive down costs, but in healthcare that may not be the case. In fact, for various reasons — asymmetrical information among them — we think it may be the opposite: that more competition might lead to higher costs.

Shanahan: Dan is right. Competition vis-à-vis health is viewed differently in some countries, though not universally. There is mixed evidence of benefit, with some recent data from the United Kingdom showing that local competition has raised standards and improved patient outcomes.

Cropp: Physicians are generally smart. They want to do good, and they want to do right. But they haven’t had the right kind of accountability structure to deliver a value proposition for a defined population. So if we sit down with physicians and say, “Let’s talk about what excellent care looks like,” they’ll describe it, they’ll be consistent about it, and they’ll think they’re doing it all the time. But they don’t know what they don’t know.

Shanahan: Inertia and entrenched habits play a role here too. I’ve done a lot of work in psychiatry, where the clinical community has recognized that there is a serious problem of obesity and diabetes in the patient population. To address this, they galvanized the support of their relevant cardiology and diabetology colleagues at a European level to develop pan-European guidance. However, four years down the line patients have yet to see any tangible benefit. Wanting to do the right thing and then actually doing it require huge investments in time and education, which often don’t follow from the original well-intentioned concept.

Rodgers: As spending on pharmaceuticals moves increasingly toward prevention or lifestyle conditions, such as vaccines or even obesity, a challenge I see is the length of time to payback. The budget may go up now, but the real economic benefit is in 30 or 40 years. So people see the budget going up, and they may object to
their money being spent on antiobesity therapies, even though in 30 years the benefit to the public balance sheet may be substantial.

Malloch-Brown: We’ve talked already about the importance of local structures and incentives to making implementation successful. Are there any other things that can help overcome those barriers?

Rodgers: Education is critical. The original purpose of NICE was to drive innovation because U.K. doctors were some of the slowest to adopt new technology, and access to treatment varied by postal code. As I recall, when NICE looked at taxanes for breast cancer, only two out of 10 women who could benefit got access to the
medication. Within eight weeks of NICE saying these women should have access, it had gone up to eight out of 10. It’s also important to educate young people. All the evidence shows that educating the young drives change. Recycling was a good example. And it’s as true of doctors. When you’ve introduced change in clinical guidelines, for example, you might find that the consultant who’s been in practice for 30 years isn’t following them, but the junior doctors are all trained to work within guidelines now and are doing so. There’s also a role here for pharmaceutical companies to communicate directly with patients, which is one of the things the European Union has been trying to effect for about four or five years now. Patients want to communicate with the people who have data on their products. But it’s been continually blocked by member states who are afraid “communication” is going to turn into advertising prescription drugs on TV.

Cropp : Key for me is that we think beyond organizational boundaries and figure out how to bring various organizations and parties together to collaborate. I’ve started two nonprofit organizations in our community. One brings different parties together to create a culture of health in the community by looking at behaviors and helping individuals make choices and reinforce those choices across the community. The other is a regional health information organization through which all the health information in our community flows. We need competition to spur innovation, but I am sure we also need more collaboration in order to affect the cost/benefit ratio for healthcare.

Shanahan: Patients and consumers can be major drivers of change, and the growth in social media has removed many barriers. New data show that 70% of consumers now get their health information online, and doing so has increasingly become an interactive experience, with consumers asking each other for advice and guidance on their treatments/interventions. Given that their patients are armed with this knowledge, physicians often have little choice but to change.

Malloch-Brown: What do you all think is the role of innovation in helping us make progress?

Shanahan: I think a major challenge for innovation, particularly for the pharmaceutical industry, is the relentless pressure on costs, reducing medicines to no more than a cost base rather than an investment in patient health. Almost every new medicine or health technology has been developed by the commercial sector. If governments and healthcare providers continue to drive down reimbursement and undervalue these innovations, where will the hundreds of millions of euros that are required to develop new medicines and technologies to treat or prevent conditions such as Alzheimer’s come from?

Cropp: There’s another challenge too. According to the Institute of Medicine, it takes 17 years from the time when something’s proven to be effective to its finding its way into everyday use. With the profusion of new technology has come an implementation/innovation gap that could be better managed. So while there might be an innovation gap at the front end [in developing new therapies], you could argue that there is a bigger gap when it comes to getting proven technology to reach and have an impact on the broader population.

Malloch-Brown: To wrap up, it’s clear that there’s value in this iterative global knowledge exchange around what works, which is not just one approach. The point was made that some of the most interesting broader public health interventions are learned from developing countries that couldn’t rely on fully developed hospital systems. Second, we should not defer to markets alone, but also have a kind of strategic hidden hand. A 20-year view of where the shortages are is key. An example of that is the World Health Organization’s big push this year on noncommunicable diseases. It is an astonishing fact that obesity is now a bigger global problem than famine. So I think there is a sense that we’ve started to create a little bit of a global public policy health debate, which helps set some priorities. Finally, we’ve seen that structures, incentives and collaboration locally are essential to effective implementation.

From a patient’s perspective, all care is local and personal. But healthcare is a global industry, so declining resources and physician shortages in one country may be acutely felt in others. In the United States, almost 25% of the 680,000 practicing physicians were born or trained in other countries, and some of those physicians are heading home, lured by higher salaries. To take one example, more than 1,200 physicians will be recruited from around the world to staff a $1.3 billion public-private enterprise sponsored by the government of Kuwait, which has the resources to pay very well.

Such market-driven shifts in medical manpower come on top of demographic trends that could also lead to imbalances. In many developed countries, older doctors are preparing to retire just as those nations’ aging populations need more and more care. But solutions to physician shortages aren’t likely to come from cash-strapped government health ministries. Rather, private enterprise, well-funded and free to innovate, will increasingly fill the gap.

More than Government can do

Poland is a good example of a nation where entrepreneurs are adding capacity to a system that has struggled to keep up with demand for medical services. Two years ago, the government delivered all of the country’s healthcare; there were waits of six months or more for some surgical and diagnostic procedures.

But because the government lacked the resources to develop enough specialty care capacity, it began to aggressively engage private industry, physicians and investors to develop and run such healthcare enterprises. Now, medical specialty facilities are springing up, both in cities that had lacked healthcare services and in densely populated areas where there haven’t been sufficient physicians and hospital beds. Many of the new clinics are single-specialty facilities — for orthopedics and cardiology, among others — that have been able to leverage specialized staffs and equipment to achieve stellar clinical outcomes.

For investors in both the operations and real estate of healthcare, meanwhile, such ventures often provide substantial returns. Specialty clinics in two cities in western Poland aim to earn more than 20% for the investors who own the real

estate (comparable projects in the United States routinely see returns in only the high single digits and low teens). In just two years, 7% of Poland’s specialty care has been privatized, and the government projects — probably incorrectly — that within another four years, 40% of such care will be delivered privately.

India, in contrast, has a long history of private healthcare, which now accounts for 80% of all medical expenditures and the majority of new enterprises. Government-run facilities are vastly overcrowded and have a reputation for delivering substandard care. India continues to struggle with access to care: There are only 1.5 hospital beds per 1,000 people, compared with 2.5 beds in China, 3.2 in the United States and 8.3 in Germany. Meanwhile, the rapid growth of India’s middle class has led to escalating demand for higher-quality medical services.

Until two years ago, there was just one comprehensive diabetes clinic to serve the 7.5 million people in Chennai. (India has the world’s highest prevalence of diabetes, which affects 50 million people.) That meant many cases went undiagnosed until complications had set in. A newly planned diabetes clinic, ambulatory surgery center and hospital in Chennai, funded by a group of investors that includes physicians, an insurance company and real estate developers, will help meet that demand. Soon many patients will be diagnosed earlier and will be better able to manage this condition.

These new facilities are marketed to those who can afford to pay for care out of pocket (only 6% of Indians have private insurance), employers offering employee benefits, and state governments seeking to meet their social mandate through the provision of private insurance to citizens. It’s possible that as more patients with private insurance or the ability to pay flock to new private clinics and hospitals, the government will be able to redirect its resources to providing care for the poor.

Stretching technology

Using private equity to finance medical services is only one solution to providing greater access to healthcare. Another approach, undertaken by the owners of the Aravind Eye Care System in India, is to use technology more effectively. As part of its mission, the nonprofit eye institute serves the poor in rural areas, but rather than send an ophthalmologist to small villages, it dispatches a mobile kiosk and a technician to take digital photos of villagers’ eyes and record their symptoms. Then an ophthalmologist can use that information to make a diagnosis and determine whether treatment is required. Because of its strong reputation, 40% of Aravind’s patients pay for care, enough to allow it to subsidize care for the rest of its patients.

Integrating less expensive providers (such as nurse practitioners and physician’s assistants) with physicians can also reduce costs without sacrificing quality of care. Technicians can be trained to take patients’ blood pressure, for example, and nurses can handle many aspects of routine patient care. Telemedicine and other digital technologies can help mitigate the physician shortage by connecting patients with medical consultants in another locale or even another country. But governments and private payers have to be willing to create a regulatory environment and payment schemes that support such entrepreneurial solutions. How, for example, should providers in Turkey be paid to diagnose a patient in Algeria? And how will liability for careor misdiagnosis through digital and telemedicine consultations be handled? Without answers to such questions, digital technologies may fall short of their considerable potential.

The health dividend

Private healthcare enterprises may also eventually upend conventional reimbursement practices that reward providers for treating patients and performing procedures rather than for keeping them well. The publicprivate integrated health maintenance organization that the Hammes Company and FTI Consulting are involved with in Kuwait will charge a single annual premium to cover all care that a patient may need. Organized as a public company, the HMO will own its hospitals and clinics and employ its own physicians, helping it manage costs and boost quality of care while enhancing the return on investment.

In Kuwait the expatriate population will have only one HMO choice, but in other countries patients may choose among HMOs, private insurance and other private enterprises, all competing on the quality of their care. It seems reasonable that in integrated systems such as HMOs, in which the enterprise collects a premium and provides care, owners will decide which resources will be allocated to treatment and promoting good health. For example, if yoga is proven to keep patients healthy — and to make them less likely to require highcost treatments — then offering yoga classes will make good business sense. Crisis, too, can be the mother of invention, and the global health system is close to a crisis point. It’s time to let the entrepreneurial process work to improve healthcare for all.

Programs target wide-ranging conditions

Among companies currently offering NCD-oriented health and wellness programs, eight in 10 have initiatives aimed at preventing cardiovascular disease, with almost as many helping workers quit smoking. Diabetes, obesity and women’s health (family planning and pre- and post-natal care) tied for third at 68.4%.

Both kinds of programs - for communicable and noncommunicable diseases - have been effective

Eight in 10 companies offering noncommunicable disease programs reported the programs have made a difference, with 34% terming that impact “significant.”

Private vs. Public Responsibility Companies viewed business as having a responsibility at least equal to that of government for addressing diabetes, obesity and behavioral issues such as alcohol abuse and physical inactivity.

Where Companies Can Make A Difference Respondents ranked comprehensive wellness as the area in which corporate NCD programs can make the strongest impact, followed by physical inactivity and cardiovascular disease.

13.8% 10.3%	Alcohol abuse	8.6% 5.2%
5.2% 13.8%	Cancer	6.9% 22.4%
8.6% 10.3%	Cardiovascular disease	13.8% 5.2%
8.6% 13.8%	Chronic respiratory disease	10.3% 15.5%
13.8% 3.4%	Comprehensive wellness	27.6% 3.4%
8.6% 8.6%	Diabetes	12.1% 8.6%
8.6% 13.8%	HIV/AIDS	10.3% 15.5%
5.2% 36.2%	Lack of clean water	3.4% 43.1%
10.3% 19.0%	Malaria	6.9% 22.4%
6.9% 22.4%	Maternal & child health	5.2% 25.9%
10.3% 12.1%	Mental health issues	6.9% 19.0%
6.9% 20.7%	Nutritional deficiences	5.2% 13.8%
8.6% 6.9%	Obesity	10.3% 10.3%
17.2% 5.2%	Physical inactivity	17.2% 6.9%
12.1% 13.8%	Tobacco use	8.6% 19.0%
8.6% 22.4%	Tuberculosis	6.9% 25.9%

The root causes of this disparity range from government corruption to a lack of access to clean water and electricity to shortages of medical equipment and clinical acumen. Addressing these myriad issues is daunting. Yet, since 2004, Developing Health Globally™, an initiative from GE , has been combining product resources, engineering expertise and best practices drawn from business to create holistic “enterprise solutions” for health facilities in Africa, Latin America and Southeast Asia. Through DHG, GE has invested $40 million in more than 100 hospitals and clinics in 13 countries, an effort that has affected an estimated 4.8 million lives. In the process, the company has also created a model for addressing the global health crisis — a model that’s driven by innovations in planning, implementation and sustainability.

What’s the problem?

The first step in this approach is to define the needs of each country by working with local ministries of health. Tim Reynolds, project and infrastructure consultant for Assist International, has been involved in DHG projects in Cambodia, Ghana, Honduras, Rwanda and other countries. “GE starts with a countrywide assessment of selected hospitals to determine the specific equipment needs of each facility,” says Reynolds. “How many beds and patients does it have? How many surgeries and deliveries per month? What are the mortality rates? Is it lacking power, water or communications infrastructure?”

A typical blueprint for improving a hospital may include an ultrasound machine, patient monitors, incubators, an X-ray machine and sterilization equipment, though gauging the needs of a particular facility requires a holistic understanding of local conditions. Air-conditioning units, for instance, a creature comfort in the developed world, might be essential to keep an operating theater sterile in a hot, buggy, humid area. And water filtration systems that can be cleaned manually are better than those depending on expensive, difficultto- replace cartridges.

Once needs have been established, GE teams create appropriate equipment configurations for local conditions. Assist International, a nonprofit humanitarian organization with more than two decades’ experience in the developing world, gets the gear to the hospital, where GE engineers and specialists install the units and train local clinicians. This approach has already had an impact, with infant mortality rates dropping by about 40% at six DHG sites in Honduras. And in Rwanda, referral rates from outlying hospitals to the hospital in the capital, Kigali, plunged from 42% to 3% with no spike in mortality, a sign that the
remote facilities were better able to handle cases on their own.

Learning to think outside the box

But this delivery model isn’t only about getting up-to-date equipment and basic user training where it’s needed. The model also aims to bring medical expertise to the countries in which DHG operates. Rachel Moresky, an emergency physician and assistant professor at Columbia University’s Mailman School of Public Health, directs the Systems Improvement at District Hospitals and Regional Training of Emergency Care (sidHART e) program, another GE partner. Since 2009, sidHART e has run training programs for doctors and nurses at district hospitals in Ghana. Using GE - donated equipment, sidHART e trainers teach medical providers to use available resources to treat cases locally rather than automatically referring patients to more advanced facilities in distant cities.

For example, a district hospital may have an ultrasound machine but not a CT scanner. Though ultrasound is used most often in obstetrics cases, physicians working with sidHART e trainers learn how to employ that technology to see whether traffic accident victims, for example, have internal lacerations. Those who don’t have complicated injuries can be treated on-site, slashing costs and making care more immediate. Integrating equipment donations with training in clinical acumen, Moresky says, is essential to creating sustainable improvements in care.

Engineering sustainability

Of course, modern medical machines are of little use if they’re not working, and according to the WHO, at least half of the laboratory and medical equipment in “resource poor” settings is partially or completely out of service at any given time. To improve on that dismal statistic, GE has partnered with Engineering World Health, a nongovernmental organization based in the United States, to implement a threeyear training program for biomedical equipment technicians in Cambodia, Ghana, Honduras and Rwanda. Local technicians are taught more than 100 basic technical assistance and troubleshooting skills, and they learn to make creative use of whatever resources are available. They might take the bulb from a car’s headlight to fix a lamp in an operating theater, for example, or use the plastic liner from the inside of a bottle cap and a standard sewing fastener to fashion a reusable pad for an electrocardiograph machine. Equipment that’s beyond repair can be cannibalized to keep other machines in working order.

To gauge the impact of such training, the Duke University Department of Biomedical Engineering, which partners with EWH, recently conducted a study of the biomedical engineering technician training program in Rwanda that involved 10 hospitals and more than 500 pieces of essential medical equipment. On average, the study found, equipment in hospitals in which technicians had been trained by EWH was 54% more likely to be in service than was equipment in hospitals whose technicians had not yet undergone the training. In addition, trained technicians were 27% more likely to be able to resolve problems with the medical equipment. The ultimate goal is to make the training sustainable, allowing the current generation of technicians to teach the next.

“As in most developing countries, our needs are many in terms of human resources, equipment and financial resources,” says Agnès Binagwaho, minister of health in Rwanda. “The GE program has been very helpful in terms of medical equipment maintenance and the training of local personnel to keep that equipment operating. The program has provided crucial support for our district hospital initiative, which focuses on delivering high-quality medical care as close as possible to where people live. Ensuring that medical equipment in these district hospitals is available and operating is very important to the success of this program, and the GE training initiative has dramatically improved equipment availability.”

Such gains could be duplicated in many other regions with similar needs, suggests Robert Malkin, a co-founder of EWH, who believes the broader engineering mind-set that drives the seemingly simple techniques put to use in the Developing Health Globally program could have a far-reaching impact. “Situations in the developing world look very different to an engineer than to the average person,” Malkin says. “We’ve seen the kinds of solutions engineering has brought to the developed world, and now that kind of innovative thinking is being translated into advances for the developing world as well.”

(A model of health promotion in Rwanda and other developing countries, the GE-sponsored program is attacking the scourge of preventable maternal and infant deaths.)

Across the world the provision of this politically sensitive service is running into a core contradiction. Technological and scientific advances do not make healthcare cheaper, as happens, say, with computing power, electronics, or other consumer goods and services; rather, like defense technology, science increases costs as treatments grow in their ambition. Life can be extended by clinical and drug programs that may amount to tens of thousands of dollars per year for a life extended.

Yet growing numbers of people expect access to such life-extending treatments. Nobody fighting for care foroneself or a loved one can be expected to stop and weigh the accumulated GDP cost of these interventions to the national economy.

So where health administrators cannot gather the authority or courage to ration and make choices — and, understandably, few can — the market steps in. Whether a health system is deemed public or private, rising costs are returning spending choice, beyond basic public or insurance coverage, to individuals and their capacity to pay. Hence, across the world, the rich enjoy the prospect of access to a glistening new array of treatments while poorer patients are returning to fearful patterns of denial of illness as the health outcomes they yearn for slip out of their reach.

It is a moral and public dilemma of enormous consequence at a time when I meet growing numbers of health entrepreneurs from countries such as India who casually observe that with the current pace of medical breakthroughs, there is no reason a child born now should ever die. That is a dangerous dream to old out because whatever its literal truth, miracle health solutions will drive up health spending ever further, keeping the financially and the politically powerful alive rather than the middle class and the poor well.

There are areas that we in the FTI Consulting family are engaged in that can help mitigate some of this and contribute to keeping healthcare as broadly available and affordable as possible.

First, through our Strategic Communications practice, we are assisting clients in the pharmaceutical and health management sectors to drive home the message that disease patterns globally are shifting with the sharp rise of noncommunicable diseases. Effective primary care and social messages, together with lowercost primary, nonhospital care, can sharply reduce a huge unnecessary cost for health services.

Second, through our Economic Consulting practice, we can bring clear analysis to the choices that healthcare faces around value — both ethical and financial — in the care provided and the care excluded. Similarly, we contribute to the debate on fair drug pricing and the impact on R&D as well as the debates about public and private provision and competition.

Third, through our work on restructuring healthcare systems, we can both help ensure massive cost reductions and establish appropriate allocation of funds between primary care physicians and hospitals. We can assist those developing countries still increasing their health spending to build new systems wisely, learning from the mistakes of others.

And within this restructuring work, we can address one of the ironies of healthcare. While within the laboratory and the operating theater a technology revolution is taking place, the support systems frequently are antiquated. In the back office, billing, accounting and administrative systems often remain mired in a largely pre–information technology age. In Britain, where doctors still write out prescriptions by hand, sometimes in a dangerously illegible hand, the NHS has just given up on its controversial and hugely expensive effort to computerize medical records.

When policy, restructuring of healthcare delivery and innovation come together, costs can come down dramatically. When I took charge of U.N. development activities around the world, treating a single person with AIDS with an effective cocktail of antiretroviral drugs that controlled the illness cost more than $15,000 a year. Consequently, almost nobody in Africa was being treated. In a few years, the cost had dropped to a few hundred dollars a year. As a result, there are now millions getting treatment — although many more still do not receive it.

The Economist attributes this “to an alliance of science, activism and altruism.” In fact, it was some hard bargaining among activists, the health community and pharma chiefs who accepted that they must move to a marginal cost pricing model for these markets and recoup their R&D costs elsewhere. This was combined with simple innovations in delivery, which largely empowered the patient, and which overcame concerns that the drugs would not be properly administered and would therefore build up resistance.

Now infection rates are down 25%, and 5 million lives have been saved. This public health achievement, even though there is still much more to be done, makes my broader point: Costs can come down and treatment reach can be expanded when the right coalition of players is assembled.

Health is a matter of life and death for all of us. In the poorest countries, expenditure per head, beyond AIDS treatment, remains in the tens of dollars as expenditures soar elsewhere. We all want health, and we need to tackle every step in the critical path of its provision if more of us are to enjoy it. After all, it is a matter of life and death.

Then, European corporations sent their treasurers from bank to bank shopping for the best deal, and capital was there for the asking.” Today, however, there are new banking regulations, loan structures and products, and the bankers themselves have changed. “It might take 10 calls within a bank to find the right person for a CFO to speak with, and then she still might hear ‘No’ several times before she hears ‘Maybe,’” says O’Callaghan. That, he notes, is especially true in Europe, where “a mountain of corporate refinancing” is chasing a competitive, finite pool of capital. “C-suite executives who never viewed refinancing as a priority will be getting a rude awakening during the next 18 months,” he predicts.

A Revitalized U.S. Loan Market In the United States, where acquiring capital through the high-yield bond market is a much more accepted and developed business practice than it is in Europe, most companies find that route open again after steep declines in 2009. The high-yield bond market had one of its best years on record in 2010 in terms of volume, with $259 billion of new issues. Merger and acquisition activity was also strong, with $43 billion in leveraged buyouts and $37 billion in dividend recapitalizations. By the fourth quarter of 2010, U.S. lending was up 100% from the previous year. “The increased inflows to the bond market and the leveraged market meant there was more capital available to lend,” says Kris Coghlan, senior managing director, Corporate Finance/Restructuring, in the Philadelphia office of FTI Consulting.

From the perspective of U.S. bankers, “the loan market is the healthiest it has been recently, certainly since the fall of Lehman Brothers and arguably since the summer of 2007,” says Joseph P. Powers, senior vice president and marketing manager for Bank of America Business Capital. “Once banks built fences to contain their problems and began to get their own capital ratios in order, they started seriously looking for opportunities to lend.” A dramatic improvement in corporate-bond default rates — from more than 10% of all bonds in 2008 to less than 2% recently — also reassured banks that companies again had become reasonable credit risks. “For quite some time, Bank of America and other institutions have had many billions of dollars of available credit that went unused because companies reacted rationally to the severe economic downturn and weren’t borrowing to build plants, invest in inventory or start hiring,” says Powers. This situation is beginning to change, though, as companies become increasingly bullish on the recovering economy. “Our outstanding loans are still down from where they were before the crisis, but we are prepared to lend aggressively, and that’s true for mostbanks,” says Powers.

Good Credit, Bad Credit

As lenders compete to get loans on their books, companies with high quality credit profiles are being offered interest rates 50 to 100 basis points lower than what they could have gotten a year earlier, along with more favorable covenant structures. Dividend recapitalizations are also being considered, Powers says. Large deals of more than $100 million might command rates of London Interbank Offered Rate plus 250 to 300 basis points, while interest rates may be even more competitive for middle-market companies seeking smaller loans. “There is less discipline for banks doing local lending on smaller deals than there is in the broader syndicated market,” says Powers. “Middle-market companies, even those with somewhat marginal credit, may be able to get great deals from local lenders, especially if there are a number of banks vying for that business.” Companies with a more challenging credit story face an evolving plateau. “Companies that have had some trouble can still get loans, but they are not priced anywhere near as favorably as they were before the crisis,” says Carlin Adrianopoli, senior managing director, Corporate Finance/Restructuring, in the Chicago office of FTI Consulting. “Nor are banks lending as much to these companies.” Each situation is unique, but in general, says Adrianopoli, a bank will lend a troubled company as much as 3½ times EBITDA , while, for those with good credit, it’s 4½ times EBITDA . “And whereas before the downturn, there could be a spread of 100 to 150 basis points between the two types of loans, now you’re looking at a spread of 200 to 300 basis points,” he says.

Even companies that haven’t had past credit problems may face skepticism about overly bullish business projections. “Banks these days are much less forgiving of a hockey-stick business plan for which a bridge to an acceptable EBITDA or an acceptable level of earnings is built into the forecast but hasn’t yet been achieved,” Adrianopoli says. “You will have a much tougher time commanding competitive pricing with a business plan that has an unproven level of growth than you will with one that demonstrates a track record of earnings.” Companies turned down by their banks have other options, including mezzanine lenders — hedge funds that will take a second lien or a junior position behind a bank on lending in exchange for a higher return on an investment. “Hedge fund lenders are out raising capital again and have resolved many of their portfolio-management issues,” says Coghlan. “They’re optimistic that they’ll get back into the lending market, which will create available funds for underperforming or distressed companies.” And while a traditional lender won’t lend these companies more than 3 to 3½ times EBITDA , a mezzanine provider may be willing to go as high as five to six times EBITDA , says Powers. Private equity investors are another option. “Companies without good credit that are looking for capital don’t have to restrict themselves to a traditional bank lender,” Powers notes.

A More Stringent Europe

In Europe, however, to be considered for a loan, companies may have to measure up against a much longer list of criteria. Some banks will lend only to corporations with headquarters in their local jurisdiction, for example. Others routinely turn down loan requests from companies in certain industries, including construction and real estate, or they may court only those in sectors in which the banks have had successful deals in the past. “If you understand a bank’s sweet spot and can tailor your request, asking for financing becomes an easier conversation,” says Mark Dewar, senior managing director, Corporate Finance/Restructuring, in the London office of FTI Consulting. Banks can afford to be highly selective because there are far fewer traditional institutions willing to take a pure lending position on deals in Europe today. “In the past a number of banks would have been quite happy putting £30 million to £40 million to work at LIBOR plus 250,” says Dewar. “Now banks have to pay an internal capital charge against that money, and the economics don’t work out unless the bank can, for example, also underwrite a bond issuance for the company or generate additional income through ancillary business such as hedging or cash-management services.”

That’s not a concern for very large corporations or very small ones. “If you are on the top of the pile, you’ll always get your financing, no problem,” says O’Callaghan. “And there are political pressures on banks to keep lending to small companies so they’ll also get the financing they need. It’s the midmarket corporates wanting to borrow $50 million to $200 million that can end up in a difficult place because they’re not big enough to go to the debt capital markets — you need a minimum of $200 million to $300 million for that — and they don’t generate enough ancillary fees to support a large syndicate of banks. Many of these mid-market companies have loans that are maturing, and it’s unclear where they’ll get the money to pay off those obligations.”

One strategy for dealing with that uncertainty is to refinance existing loans now, even if a loan doesn’t mature for another year. “You may pay a premium over today’s rates to refinance early, but that may be a price you’re willing to pay to secure future financing,” says O’Callaghan. And that approach could be preferable to seeing your company’s valuation take a hit if investors get worried. “There’s a tangible link between securing refinancing and valuation of shares,” O’Callaghan says. “If there are concerns about your ability to refinance, then it clearly will affect investor sentiment.”

European executives also need to embrace the American model of asset-based lending and bonds as part of a company’s financial model, O’Callaghan adds. “As a result of regulatory requirements, traditional European credit lines and products now can carry some of the highest capital charges for the banks, whereas asset-based lending often carries the lowest charge, and bonds are even better for banks because they involve only a fee and not a hold position,” he says. “In America asset-based lending is highly sophisticated and accepted, but some European corporations wrongly see it as a last resort. And there is a much longer history of U.S. companies going to the bond market to finance debt than there is in Europe. It’s going to be a cultural adjustment for European companies.”

Lenders as Strategic Partners

On both continents, forging strong relationships with bankers, always important, has become an absolute necessity. “More than ever, CEOs and CFOs need to view their lenders as strategic partners,” Adrianopoli says. “The business environment can change quickly, so you need lenders who are willing to stand by you through business cycles and are ready to capitalize on opportunities. You don’t want to be the CEO who comes to his bank group only when something is wrong. Lenders hate surprises, and they hate it when you talk with them only when things are bad.”

Adrianopoli recommends that companies with a syndicated loan involving several lenders use the lenders for each aspect of their financing needs, such as for hedging and cash management. Developing multiple relationships within your banking group may cost you more in banking fees, “but your lenders will be more in tune with your financial needs than if you’re viewed as simply another loan,” he says. Often, flexibility is at least as important as pricing. “You want to make sure that your loan gives you an adequate line of credit for short-term liquidity needs, that it has a flexible capital structure so you can repay your debt early with limited penalties, and that the lenders will be receptive to a business acquisition opportunity or foreign expansion if that’s what you need,” says Adrianopoli. A lender that markets itself to your industry may be a good fit for your company, but only if the bank has a track record of staying with businesses through good times and bad, he notes. “A bank’s expertise in lending to particular sectors shouldn’t be the only deciding factor,” he cautions.

Also new is the need for the CEO and the CFO to get involved in choosing lenders and “proactively engaging in the lending process,” says Dewar. That’s a departure from the passive slamdunk refinancing that a corporation’s treasurer would have handled in years past. Talking with bankers today requires the same careful crafting of mission and message that corporations rely on to prepare for a stock offering or an M&A deal. “You have to be ready to articulate your credit story in a concise and compelling way and realize that bankers are carefully listening to what your customers, your creditors and the analysts are saying about you,” says Dewar. “Demonstrating that you have complete control over your company’s finances is key. You can’t have overdue receivables, your inventory turns must be in line with industry norms, and you need a clear view of your cash flow requirements for the next 18 months.”

Proceed With Caution

Though most bankers now appear eager to lend to highly creditworthy companies, any number of economic problems could cause credit markets to seize up again. “Several troubling macro indicators — sovereign foreign debt; U.S. federal, state and local municipality debt; underfunded public pensions and other medical benefits; and long-term unemployment — are present despite a growing bullishness about the economy,” says Adrianopoli. “Until we have true fixes to these problems, be prepared for lending choppiness to come back.” Banks seeking new business may later pull back on their lending criteria and pricing. That’s why it’s crucial to develop a strong relationship with a lending group, says Adrianopoli. “You need to cultivate the relationship so your bank group won’t just walk away from you if the lending and business markets become harder. If you have a flexible lending line and strong relationships, you’ll have access to capital when you need it, you’ll have competitive pricing, and you’ll be able to prosper and grow your business in any lending environment.”

A trillion dollars is hard to miss, and with almost that much cash on the books, U.S. corporations have attracted the attention of hedge funds and other activist shareholders who want to know just how companies plan to put the money to work. According to Moody’s, U.S. nonfinancial companies had $943 billion in cash on their balance sheets at mid-year 2010, up from $775 billion at the end of 2008, and with interest rates at historic lows, that stockpile of dollars isn’t adding much value to the companies that hold it. Activist shareholders are pressing corporate management and boards to buy back shares, increase dividends, make acquisitions or otherwise deploy the cash in ways that explicitly benefit shareholders. But that pressure puts directors in an uncomfortable position.

Board members well remember the depths of the recent recession, when credit markets froze and liquidity was precious. They understand the need to invest in the business but want to be prudent and responsible, as global competition is fierce and the economy is susceptible to another decline. At the same time, trends in regulation and corporate governance, such as “say on pay” and proxy access, are giving shareholders more input into strategic and other corporate matters. If boards fail to heed the complaints of shareholders, activists could launch proxy fights or propose slates of directors who might disrupt corporate functions or result in the ouster of company officers. So as global economies improve and visibility into the future increases, how should boards respond to the tradeoff between preserving liquidity and pursuing investment during 2011? And beyond that, what should a board’s role be in setting strategy, working with management and monitoring performance? For insights, FTI Journal convened a roundtable of veteran board members.

Meeting in FTI Consulting’s Manhattan office, the panel included Robert Dinerstein, chairman of Crossbow Ventures and a former vicechairman of UBS Investment Bank; Rita Foley, director of Dresser-Rand and PetSmart; Stuart R. Levine, director of Broadridge Financial Solutions; and David Meachin, chairman and CEO of Cross Border Enterprises. Unable to attend but weighing in during separate interviews were Edward A. Kangas, chairman of the board of Tenet Healthcare; Philip R. Lochner, who serves on the boards of Clarcor, CMS Energy, Crane Co. and Gentiva Health Services; and Blythe McGarvie, CEO of consulting firm LIF Group and a board member for Accenture, The Travelers, Viacom and Wawa.

FTI Journal (FTIJ): In a recent survey of activist shareholders and corporate executives, the law firm Schulte Roth & Zabel found that both groups expect shareholder activism to increase during 2011, though they disagreed about what issues will provoke that activism. Activists said excessive cash holdings will be the primary catalyst, whereas executives thought financial performance would be the main catalyst. What is the sentiment of your boards? Are you concerned that activists will force you to change strategy and/or make premature decisions to commit capital?

David Meachin: If you sit on a big cash position for several years, you could have a huge political problem. But this is not a time to throw around a lot of cash just because activists tell you to spend. The economy still is deeply troubled, and it will be a long, slow process before the markets fully recover. And with the global marketplace becoming increasingly competitive, companies need to have a big cash war chest. There are any number of Western-educated Asian executives who now are running companies back home. They are very dedicated, and they have employees who will work hard for comparatively low pay. To meet that competition, many U.S. companies may have to spend money acquiring smaller businesses. Say you are a big pharmaceutical company. You could spend $1.8 billion developing a drug that may not succeed — or you could buy a small company that has strong research and development and a solid pipeline of new drugs.

Stuart R. Levine: Shareholders should give us advice, and we should listen. But at the end of the day, it is the responsibility of the chief executive and the board to make strategic decisions. Boards should develop long-term strategies that ensure shareholder value through R&D, M&A and organic growth.

FTIJ: In the wake of the financial crisis, how should boards look at the issue of holding cash vs. putting it to work?

Blythe McGarvie: Since the crisis began in 2008, corporate boards and managers have needed to answer three questions: Has the company restructured its debt to take advantage of some of the lowest interest rates in years? Have we reconsidered our discount rate when computing net present value analysis for potential investments? And what is a reasonable threshold, or “investment rate hurdle,” to use when comparing various potential investments? With interest rates so low, most companies can invest in their operations or in acquisitions for much higher returns than can be made in money markets. With returns on cash low, this is exactly the right time to invest in developing markets and in products to remain competitive and to capture market share. The rest of the world, particularly China, is not waiting to expand its reach into new markets. One of the best uses of cash now is to travel around the world looking for innovative products, services and processes that you can use in your own business.

Edward A. Kangas: If a company is generating strong cash flow and has more than adequate cash on hand, shareholders are going to want to know its plans for using that capital. One way to articulate that is to use return on invested capital to compare internal and external uses of cash. But if the ROIC on a stock buyback or dividend is much higher than you get from acquisitions or R&D, investors will question your priorities, and it will hurt the valuation of the company and its stock price. And though some companies want to keep “dry powder” for game-changing acquisitions, it’s generally better to arrange a large line of credit for that purpose rather than to keep a lot of cash.

FTIJ: By the time activist shareholders knock at your door, it may be too late to head off a confrontation. How can companies avoid becoming targets?

Rita Foley: By maintaining open communication with shareholders, who are less likely to side with activists if they understand your strategy. Some of that will come through individual meetings with investors, but companies also should hold strategy days that are open to all analysts. At these meetings, management can lay out a company’s five-year strategy and explain why it makes sense.

Levine: Some companies have effectively reviewed strategy through retreats. The sessions are designed to explore the future and are grounded in the reality of available capital and results. Reflecting on investor concerns helps enrich the discussion. This process helps the CEO continue to respond to these issues appropriately.

Kangas: It’s also important not to generalize about activist investors. They worry boards, which don’t appreciate the scrutiny. But some activists can add real value. And while they’re often seen as just wanting share buybacks, the really good activists can help companies improve their approaches to capital allocation.

FTIJ: Are there other effective forums for communicating with shareholders? And is it possible to communicate too much?

Levine: It’s important to talk with the general counsel about the best way to communicate so you don’t run into problems with fair disclosure regulations. I was a lead director at a company when a hedge fund took a substantial position in the stock. When a manager of the fund reached out to me, I listened for a reasonable amount of time while the investor shared his ideas about strategies on mergers and acquisitions. I thanked him for his ideas and assured him that I had heard his suggestions but explained that it would be inappropriate for me to get into a lengthy conversation. When people ask to talk with an independent board member at Broadridge, we refer the request to the CEO and determine which director would be the most appropriate person to respond, e.g., chairman of compensation, governance or audit.

Robert Dinerstein: There might not be much we can do to change the views of activist shareholders. But we need to find ways to reach retail investors. They have lost confidence in the market, and they are turning to brokers for advice. We need to provide focused communications for the brokers. It no longer is enough just to send out a press release.

Foley: You also can’t ignore Facebook, LinkedIn and Twitter. Someone has to be actively monitoring what is being said about a company in the new social media and respond accordingly.

FTIJ: One of the hottest topics for the next proxy season involves the “say on pay” provisions of the U.S. financial reform legislation passed last year. Under the rules, companies must give shareholders the right to provide advice on executive compensation. Some people see this as an intrusion on the rights of boards. But there has been an arms race to pay CEO s — if one CEO makes a certain amount, competitors feel they must match the figure. Could the new rule make boards more thoughtful about compensation policies?

Foley: Surveys of board members suggest that “say on pay” won’t have a great impact. Similar rules have existed in the United Kingdom for a long time, and there hasn’t been much fallout. Many boards already listen to shareholders and are transparent about compensation, so they will have little resistance to change. There will be more pressure to show how you measure executives relative to the business results. Activist shareholders often complain that companies spend too much to hire senior executives from outside, in part because you typically have to compensate people for stock options or other payments they give up when they leave their old jobs. Now there could be even more focus on such payouts, and to avoid controversies, companies may put a renewed emphasis on promoting from within. But that will require boards and management to spend more time grooming executives and having a robust succession plan. That could be a positive development.

Meachin: Whether or not say on pay has an impact, globalization could put pressure on salaries in the United States, which tend to be higher than those at competitors abroad. To compete internationally during the next 20 years, you’ll have to cut costs to the bone and adjust compensation.

FTIJ: What role should a board play in developing strategy — what businesses and markets to be in, how cash is used, how executives are compensated and other important issues? Should the board actually formulate plans or simply oversee management as it develops ideas?

Meachin: It used to be that management would give a six-hour PowerPoint presentation to the board, which then would essentially give management the go-ahead to proceed with its plans. These days, the CEO and management are still responsible for making strategy, but to compete on a global stage, management has to harness the brainpower of everyone on the board, which needs to be involved in critiquing ideas and ensuring that plans make sense. Also, many board members serve for 10 years or more, while CEO s often are there for a much shorter time. So the board must take more responsibility for determining and implementing longterm strategy in case it needs to bridge a management transition.

FTIJ: We’ve talked about the important impact that globalization is having on business. Are boards doing enough to make sure that strategies are aligned with the demands of operating in a global environment?

Foley: Many people on the boards of U.S. companies have management experience only in the United States, and that really limits their ability to take a truly global perspective. It’s important to have people who have lived in different countries and have immersed themselves in those cultures. Some boards of multinationals are discussing where a company’s headquarters should be. Just because the company has always been run from the United States doesn’t mean it should stay there. If you have big operations overseas, it could make sense from a client standpoint to locate somewhere else. And you may be able to save on taxes.

Levine: If you are traveling and working abroad, it changes how you look at things. You look in the faces of people, and you can see how your product may not be suitable for particular markets.

FTIJ: The credit crisis and recession exposed the ignorance of many directors and boards about the companies they oversee. How can directors come to understand a business at a fundamental level? Do they need to go into the field and get their hands dirty?

Meachin Board members should visit plants and operations, and if plants and operations are overseas, that’s where board meetings should be. Procter & Gamble divides its board into groups and sends three board members to one country and three to another. You don’t have to travel 300 days year, but board members have to recognize that part of their job today is to travel to wherever major business is done. The point is to get a good understanding of the products and the customers.

Foley: Board members also need robust training. I serve on a board that includes several CEO s with experience in the industry. But everybody had to go through training, which consisted of getting tutorials and visiting clients as well as company facilities. It was helpful because some of those CEO s had come up through the financial ranks and were less familiar with the field and with manufacturing.

Levine: I have served on the board of a nonprofit hospital group for 25 years, and I find that field trips are always helpful. We recently toured a hospital and visited an emergency room and operating theaters. We talked with doctors and nurses. That provided important perspective about the reality of the organization and its operations.

FTIJ: Should board members seek to develop information sources that are independent of the CEO?

Philip R. Lochner: As long as a board has confidence in management’s willingness to report both good and bad news accurately and impartially, it’s entirely appropriate for boards to rely on management reporting. The CEO has access to performance measures and details the board couldn’t get from other sources. But intelligent boards supplement that information with industry analysts’ reports, SEC filings, trade publications and trade shows, other media coverage and so on. Boards need to have independent sources of information against which to test management assertions — not because anagements are dishonest but because, like all of us, they may have blind spots or get carried away with their own enthusiasm for the direction they’ve decided to take.

Foley: An outside perspective is important, and our board asks to see all of the analyst reports on the company. We also ask for an analysis of the competitive environment. That may come from someone in management, but it is helpful to look at reports from other sources as well.

Levine: Having access to independent analysts who follow your company is important. I was on a board that brought in one of our analysts. That direct conversation enhanced our board’s understanding of more indepth market realities that were contained in her report. Doing that, you find subtleties that aren’t in writing. In cases where I’ve been concerned about a particular issue, we have retained an independent counsel that reports to the board.

Another way to learn about a business is to get involved in succession planning. Board members should take the time to have a cup of coffee with candidates for CEO . That doesn’t mean just meeting with the top five candidates. You should consider talking with people in the top three tiers of management. By meeting with people at a variety of levels, you can learn a lot about the nuts and bolts of how the business works. Understanding how a consumer utilizes your product or service is huge. Understanding strategy requires you to view the service through the eyes of the end consumer of your product, with a global view of the future.

By sitting on mountains of cash until the recession has safely passed, companies may think they are acting prudently. On the contrary, they could be setting themselves up to be overtaken by competitors that have been strategically using their financial resources to make acquisitions, launch new products and create more efficient ways of doing business. Over the course of the 2007–09 recession, as credit markets froze and revenue plunged, companies jettisoned millions of workers and took the scalpel to their budgets, especially in Europe and the United States. Of course, those moves boosted corporate earnings, and companies’ coffers swelled. In Europe, for instance, cash makes up 12% of total assets on corporate balance sheets and is almost a third higher than at any point in the last economic cycle, according to UBS.

Globally, nonfinancial corporations are sitting on $4 trillion in cash today, a full trillion dollars more than they had on their books in 2007, according to Citigroup’s Corporate Finance Advisory Group. Yet, while the National Bureau of Economic Research in the United States reports that the recession officially ended in June 2009, many companies have maintained a viselike grip on liquid capital. Whether they worry about a double-dip recession, a lack of investment opportunities or the need to rearm against Asian competitors, their financial prudence risks becoming a liability. The reason: Competitors are already investing strategically and are gaining substantial ground. In industry after industry, companies like Netflix, W.R. Grace, Banner Health and Maersk have used the recession to invest aggressively in new products, markets and operations. As the global economy recovers, these companies will have first-mover advantages that will be hard for others to overtake.

Firms that keep hoarding cash face a big risk of being left behind competitively and frustrating multiple constituencies that want them to deploy their capital. Because returns on cash are at historic lows, investors are taking a dim view of many companies’ cash positions. A survey by the law firm Schulte Roth & Zabel in late 2010 showed that excessive cash positions would be the primary catalyst of investor activism over the next 12 months. Political pressure is being brought to bear as well. In February 2011, in an address to the U.S. Chamber of Commerce, President Obama implored CEOs to start investing and hiring, pointing out that “American companies have nearly $2 trillion [in liquid assets] sitting on their balance sheets.”

Yet the most important reason for getting off the sidelines and deploying that cash is neither shareholder pressure nor political cajoling. It is that companies will lose competitive advantage. According to numerous studies, companies that emerged in the best shape from past recessions had invested more and saved less than their competitors. As a 2002 McKinsey & Co. study found, the companies that came out of the 1990–91 recession the strongest had outspent peers in R&D (by more than double) and acquisitions while maintaining cash balances 40% lower than their competitors’. By spending their cash on pursuing market share, developing new products and opening new markets, they had significantly strengthened their competitive positions. It isn’t too late for companies that have been conservative with their cash to catch up. But the window of opportunity is closing.

Spending cash in all the Right Places

A number of companies have used the recession of 2007–09 to enhance their prospects. Even though the days of economic turmoil are not far behind them, they are already reaping the benefits of their contrarian investing ways. How they invested in the downturn while most of their competitors pulled back is instructive ways. How they invested in the downturn while most of their competitors pulled back is instructive. Consider the case of W.R. Grace. As the recession took hold in 2008, the $2.6 billion (revenue) global specialty chemicals company moved quickly to slash working capital and operating costs. By reducing net working capital days by half (from 106 to 53), Grace freed up $350 million in cash, an amount that was triple its 2007 operating earnings. As the credit markets tightened, that cash became pivotal to Grace’s overseas expansion. The U.S.-based company bought and acquired manufacturing capacity in growing markets from China to Saudi Arabia to Brazil.

Those investments are already paying off. In 2010, Grace’s sales from overseas markets increased 13% over 2009 — more than four times the firm’s overall growth (3%). More important, the company, whose products include catalysts for oil refineries and plastics manufacturers, expects emerging markets to be virtually the only source of growth in those two industries over the next three to five years. Grace’s new factories are critical to its participation in that growth. Grace’s lesson: Reinvesting cash strategically is as important as reducing costs and working capital to free up that cash. “There is a direct correlation between the reductions we made in working capital and the cash we had available to make investments in emerging markets,” says the firm’s chief financial officer, Hudson La Force. These lessons apply to companies that are as different from process manufacturers like Grace as baseball is from cricket. Take Banner Health, a $4.7 billion (revenue) U.S. healthcare provider that owns 22 hospitals.

In the recession, the company not only had to contend with flat or declining patient volumes, but it also had to prepare for the healthcare industry’s looming day of reckoning: healthcare reform legislation. Hospital systems like Banner face a future of declining public and private reimbursements for treatments and hospital stays. And because future reimbursements will be tied to the quality of care, Banner’s senior management knew the company had to upgrade facilities and medical equipment. Indeed, it has — to the tune of more than $1 billion in construction projects for new and existing hospitals. W.R. Grace and Banner Health could have conserved their cash until the financial storm had long passed. The stockpiles of cash that companies around the world are sitting on today suggest that many firms have done just that. Yet both companies decided to invest and strengthen their competitive positions. They and other companies that exit the recession having laid the building blocks for growth are likely to outrun competitors that continue to hoard their cash.

Deciding where to Invest: The stories of Netflix, Polo Ralph Lauren and Maersk

So if companies decide it’s better to spend strategically today than continue to save, where should companies invest? To be sure, the answer will be different for every firm. The right opportunities depend upon a firm’s unique circumstances: the markets in which it sees the greatest potential, its core capabilities and competitive position, the unfilled needs of its customers and more. The stories of companies that have aggressively deployed their cash during the recession provide useful insights on where to look. I’ll organize these stories into three categories: new products, new markets, and redistributing work around the world.

New Products Netflix is the world’s largest movie subscription service. The firm has gone from launch in 1997 to $2 billion in annual revenue today and has 12 million subscribers. It is led by Reed Hastings, its CEO and co-founder. Hastings has long believed that, although DVD rental by mail will be a source of growth for Netflix for many years, subscribers will increasingly want the immediate response of movies streamed over the Internet to their television screens. In 2007, Netflix began investing in software that would enable streaming on other companies’ devices, such as Blu-ray players, set-top boxes, game consoles and TiVo DVRs. Netflix was faced with a big investment, one that could have appeared untenable as the economy began backsliding into recession. But the company didn’t flinch, making streaming a focus of its research and development efforts. Between 2007 and 2009, Netflix doubled R&D spending from $70 million to $140 million. Meanwhile, it ran down its cash balance by two-thirds, from $400 million at the close of 2006 to $134 million at the end of 2009. Today, Netflix’s investments during the bleak years look prescient. In the third quarter of 2010, two-thirds of its subscribers were streaming movies online, nearly double the number in mid-2009. The company’s revenue last year was 80% higher than 2007’s, and profits have soared 140%. At the end of 2010, Netflix’s cash position was on the mend, rising to $194 million. These numbers have clearly dazzled investors. Netflix’s stock more than tripled in value in 2010 alone. Since 2007, the share price has risen tenfold.

New Markets History shows that recessions spread pain unevenly around the globe. While demand can be moribund in a company’s home market, emerging economies can offer lucrative opportunities. The combined gross domestic product of the BRIC countries (Brazil, Russia, India and China), for instance, is now almost 70% of Europe’s aggregate GDP. But what’s more remarkable about the $11 trillion BRIC GDP is its impressive growth. Between 2000 and 2008, the BRIC countries contributed almost 30% to global growth, compared with 16% in the previous decade. Since the start of the crisis in 2007, the BRIC countries’ contribution has risen to 45%, according to analysis by Goldman Sachs. Companies like Grace believe that rapid growth requires participation in emerging markets. “If you are a global company, as we are, and you are not investing in these markets today, you really run the risk of falling behind,” says CFO La Force. Polo Ralph Lauren is another global company that took this to heart three years ago and ramped up its investments in Asia-Pacific. The $5 billion (revenue) apparel and fragrances company began buying its Asian licensees in 2008, believing the product range they offered was too narrow and their inventories too low. With sales of luxury consumer goods exploding in Asia, the company needed to capture a bigger share of the pie. At the beginning of this year, it acquired its South Korean distributor, the seventh successive purchase of a Polo Ralph Lauren licensee in Asia. In a February earnings call, COO Roger Farah made it clear that the firm’s $1.3 billion in cash and investments was at its disposal for more investments in Asian markets. Analysts and investors appear to have no problems with that. The stock has risen from the $70s last July to more than $120 this February.

Redistributing work around the World

This investment category is less obvious than the other two, and many companies have ignored it. But others have made substantial investments and have seen sizable returns. It is about redistributing the work of an organization — the activities of the finance department, information technology, customer service and other support functions — to take advantage of such conditions as lower labor costs and preferential tax treatments in other regions. A great example is the $60 billion Danish conglomerate A.P. Moller- Maersk Group. A major ocean shipping and energy firm, Maersk has been slowly but steadily building global “shared services” operations since 2003. Based in six centers in India, China, the Philippines and Denmark, these operations have enabled Maersk to standardize and reduce the costs of support functions, such as finance, accounting, human resources and IT.

In 2008 the global economic downturn produced the most challenging year ever in the container business. In response, as well as taking aggressive steps to cut costs, Maersk accelerated its investments in shared services. The company set a target of increasing the share of finance and accounting work done by the centers from 30% to 70%. Over 18 months Maersk hired 1,200 additional people for shared services, absorbing finance and accounting operations from 85 countries. The result: The operations are better standardized; the costs of those operations were reduced by 10% in 2010; the savings will increase as the remaining countries are rolled in and the new processes stabilize; and Maersk has a cost structure that better positions it to compete as the global economy recovers.

Getting past the obstacles to investing in lean times

Should every company follow the lead of Netflix, Maersk, Polo Ralph Lauren and W.R. Grace and make major investments in new products, markets or operations in spite of uncertain economic times? Shouldn’t some companies hang on to their cash until better times are clearly ahead? For most, we think not. almost every company has opportunities for growth in bad times as well as good.

Take the chemicals industry. Even though it doesn’t seem like a sector with high potential during a global manufacturing downturn, W.R. Grace found prosperity in distant lands. In any event, it isn’t necessary to hold on to a pile of cash for future needs such as making an acquisition. As Tenet Healthcare chairman Edward Kangas says in our roundtable discussion in this edition, “It’s generally better to arrange a large line of credit for that purpose than to keep a lot of cash.” Highly leveraged companies may have more urgent priorities for their cash, such as shrinking their debt. Firms uncertain about repaying maturing loans might consider refinancing and extending maturity dates first. (See “Restricted Access,” page 34.) But once they’ve straightened out their capital structures, even these companies should seek profitable investment opportunities. We do excuse some companies from investing during the downturn. Managers in mature sectors with more capital than they can profitably invest should consider returning it to shareholders through share repurchases or dividend increases. Or they might consider merging or being acquired, especially if they operate in a sector that is consolidating. But there is risk in doing nothing: Companies that are neither acquirers nor acquired may be marginalized by their shrinking market share, or their shareholders may take the decision out of management’s hands by forcing a sale, breakup or return of capital.

We continually hear executives argue against investing too soon. “The economy could tank again.” “Domestic markets are flat.” “Overseas markets are risky.” “We are in a mature sector.” “Deals are too expensive,” and so on. While there is truth in all of these objections, leading companies have managed around them, and in many cases investors are rewarding them for it. Several recent acquirers have seen the values of their shares increase after they announced acquisitions, in contrast to the normal market reaction. Danaher Corp.’s stock rose on the announcement of its acquisition of Beckman Coulter Inc. in February, despite paying a 45% premium on Beckman shares. Cliffs Natural Resources Inc. stock rose nearly 3% on Jan. 11 after it announced the purchase of Consolidated Thompson Iron Mines Ltd. At some point, the majority will follow the minority, and a stampede will commence. Several indicators say it is about to begin. History tells us that companies that deploy their cash before their slower-moving competitors can overtake them.

Three forces are converging to shape this new regulatory environment. First, regulatory bodies are employing sophisticated technology to detect and prosecute transgressions. The U.S. Securities and Exchange Commission’s Office on Market Intelligence, for example, has equipped its new task force on market abuse with the technology to conduct “Facebook investigations,” essentially mining data on traders’ personal relationships and communications to flag potential incidents of insider trading. Second, a “whistle-blower lotto” provision in the Dodd-Frank Wall Street Reform and Consumer Protection Act offers informants a bounty of 10% to 30% of any fine of more than $1 million resulting from a tip. And third, penalties for paying bribes in foreign markets are poised to escalate significantly under the U.K. Bribery Act of 2010.

The Importance of Being Integrated

This trend of intensifying exposure to myriad regulatory actions around the globe strongly suggests a need for multinational corporations — the most likely targets for government enforcement action — to develop integrated compliance programs that collect and monitor data in real time. Such systems could, for example, automatically monitor vendors and transactions, flagging those involving people or firms on government watch lists. If a company suspects a particular kind of violation, a custom inquiry can be written to mine the data and identify transactions for internal and compliance review. Deterring violations or detecting them early through a comprehensive, integrated program is a crucial first line of defense. Yet many large multinationals continue to employ piecemeal, often incompatible systems. That’s particularly likely when a company has grown through multiple acquisitions or has taken a decentralized approach to managing foreign subsidiaries. For example, if a U.S. company using Oracle’s financial management software buys a European firm running SAP and then buys a company in Asia that relies on a proprietary or a bespoke financial system, it may hope to avoid the thorny issue of integrating the three systems. But that leaves its internal audit team facing the manual and ad hoc challenge of collecting and interpreting data from each system. In today’s regulatory environment, that kind of disjointed effort is unlikely to succeed because companies need an effective way to deter and detect violations enterprisewide.

New technology provides a better solution, letting a company connect the dots — collecting and analyzing transaction data from disparate financial systems in real time. Responding to government investigations often costs millions of dollars in time and resources — and any resulting penalties, or criminal and civil judgments, can double or triple the bill, not to mention the impact on a brand or a corporate reputation. Establishing effective realtime automated compliance controls can also reduce external audit and insurance fees. And penalties may be lighter when a company can show it has an effective compliance program in place. That might have saved DaimlerChrysler, which settled a U.S. Foreign Corrupt Practices Act charge by the SEC for approximately $185 million, almost half of that penalty. An effective compliance program is a defense under the new U.K. Bribery Act.

Understanding Good Practises

In May 2010 the Organisation of Economic Co-operation and Development released “Good Practice Guidance” for antibribery compliance programs. The document outlines what companies are expected to do regarding antibribery policies, training, internal controls, reporting systems, discipline for violations, compliance incentives and accountability for program management. It also emphasizes the importance of having periodic third-party audits of compliance measures and reviews to ensure that programs keep up with evolving technology and with national and international standards. For multinational companies operating in this increasingly aggressive regulatory environment, now is the time to rethink their approach to compliance on a global scale.

Managing through crisis has never been easy. But in today’s increasingly complex, interconnected world, the challenges have grown ever more daunting. Climate change, poverty, terrorism, and financial and credit instability are just a few of the intractable issues confronting both heads of state and corporate chieftains, for whom the stakes have never been higher. Two FTI Consulting experts have recently published their perspectives on the issues.

The Unfinished Global Revolution: The pursuit of a new International Politics

(Penguin Press, 2011). Lord Mark Malloch-Brown lays out a road map for navigating an uncertain future. FTI Consulting’s chairman of global affairs, Malloch-Brown draws from a wealth of experience on the international stage — as a World Bank vice president, head of the United Nations Development Programme and deputy secretary-general to U.N. Secretary-General Kofi Annan. A former journalist, Malloch-Brown also has served as minister of state in the Foreign and Commonwealth Office of the United Kingdom with responsibility for Africa, Asia and the United Nations.

In The Unfinished Global Revolution, Malloch-Brown argues that, just as the worldwide economic crisis of 2008 demonstrated that a global economy requires global financial institutions, today’s political and social challenges demand unprecedented international cooperation. In the 21st century, trade, technology, economics and social change continually push people of disparate geographies and cultures together, but national governments aren’t equipped to handle the complex global issues they face, and there are no international organizations empowered to fill the void. Changing that won’t be easy, given the suspicions people and their political leaders have of the U.N. and its like.

Part of the remedy, says Malloch- Brown, is a “simple global social contract” through which individuals, corporations and governments can establish powerful international institutions that value human rights and the rule of law, and offer a voice for participating nations. Through intimate portraits of politicians he has advised and observed, including Bill Clinton, George W. Bush, Jacques Chirac and Tony Blair — and through an engaging political history of governments that have failed to live up to the demands their citizens place on them — Malloch-Brown offers an agenda for managing globalization. And he suggests that the corporate leaders of tomorrow won’t be the imperial CEOs of yesteryear, but rather visionaries who can reach across cultures and engage shareholders to build alliances, bringing together apparently disparate interests. That leadership will require a multicultural sensibility, emotional intelligence, and an ability to listen, persuade and understand different points of view.

Turnaround Leadership: Making decisions, rebuilding Trust and delivering results after a crisis

(Kogan Page Ltd., 2010). Shaun O’Callaghan, senior managing director in FTI Consulting’s Corporate Finance/ Restructuring business segment, lays out a proposed framework for coping with crisis, drawing on more than 15 years of experience as an adviser, executive and board director and as a founder of Quartet Research, a leadership research and development organization for senior executives.

In Turnaround Leadership, O’Callaghan starts with the premise that all companies, if they’re in business long enough, eventually will go through a period of upheaval resulting from shifting consumer preferences, economic recession, management scandal or some other kind of shake-up. Whatever the cause, crisis presents an opportunity for managers to become leaders and to develop a recovery plan that will put the organization back on its feet as painlessly and productively as possible. O’Callaghan outlines five key areas of leadership he considers mandatory in building a successful recovery plan: beginning anew by making the right promises to stakeholders, including customers, investors and lenders, employees and suppliers; gathering a range of alternative perspectives, no matter how contrary; developing core business skills necessary for recovery, including cash flow and time management, strategy development, sales management and cost-base restructuring; delivering results through savvy relationship building; and rebuilding trust through authentic communication with all stakeholders. One of the most common mistakes managers make is failing to recognize and challenge their own assumptions about a business, O’Callaghan says. For example, had CEOs of financial firms questioned their assumptions — that the wholesale lending spigot would remain open and that property values would continue to climb — the 2008 housing market collapse might have been averted. While hindsight is always 20/20, Turnaround Leadership contends that with the right tools in their belts, corporate leaders can be prepared forwhatever comes their way.

In 2010 the United Kingdom’s Bribery Act went into effect, superseding 19th-century legislation that was widely regarded as no longer fit to tackle overseas corruption. The new legislation, one of the world’s toughest anticorruption laws, makes it a criminal corporate offense to fail to stop bribes from being paid on a company’s behalf. Ian Trumper, senior managing director with FTI Consulting in London, explains what the law, which will start being enforced sometime this year, means both to companies based in the United Kingdom and to foreign firms doing business there.

What was the impetus for these reforms?

There has been increasing international pressure for the U.K. government to introduce an effective anticorruption measure similar to the Foreign Corrupt Practices Act in the United States. The existing U.K. law had a very poor track record in prosecuting overseas corruption cases and had been criticized for failing to meet its obligations under the Organisation for Economic Co-operation and Development (OECD) Convention on Combating Bribery of Foreign Public Officials. Pressure increased when the U.K. Serious Fraud Office, citing concerns about national security, decided to abandon a major part of a case against BAE Systems concerning alleged corrupt practices in securing contracts with Saudi Arabia.

What are the key goals of the new law?

The primary objective is to create an effective legal framework to combat bribery in both the public and private sectors. The Bribery Act creates four prime offenses: two that cover offering, promising or giving an advantage, and requesting, agreeing to receive or accepting an advantage (Sections 1 and 2); one for bribing a foreign public official (Section 6); and a corporate offense of failing to prevent a bribe from being paid (Section 7).

The first two offenses cover bribes in both the public and private sectors, but a person (or corporation) is guilty only if there was an intention to induce another to do something improper or to reward someone for such an action. These types of bribes already were illegal, but under the new law it will be easier to bring charges. The offense of bribing a foreign public official brings the U.K. law into line with the OECD Convention, which criminalizes bribes intended to influence a public official in obtaining or retaining business. But if the first three offenses merely clarified or modified existing legislation, the fourth is entirely new. Under Section 7, any corporation with a business presence in the United Kingdom can be held criminally liable if any person associated with it, including any of its employees or agents anywhere in the world, is found guilty of giving or receiving a bribe. The only defense will be that the organization had put adequate procedures in place to prevent such bribery.

What does that mean for companies based in the United Kingdom?

You have to look at specific wording within Sections 6 and 7 to understand the new law’s significance. For example, in Section 6 there is no test for improper performance, so if you offer anyone working in a public capacity a financial reward with the intention of influencing that person to obtain or retain business, that is an offense — even if that person does nothing improper.

But there’s no definition of what constitutes a “financial or other advantage.” What if a company pays for a government official to fly overseas to inspect its manufacturing plant or to attend a business meeting? Where do you draw the line between bona fide marketing to display a company’s capabilities and more lavish expenditures that may influence the official’s decision? There also is no exemption for de minimis payments, including facilitation payments. In addition, companies are questioning what constitutes adequate procedures under Section 7 and how much responsibility they must take for the actions of overseas subsidiaries, agents and suppliers. What if you are working with an agent and you don’t know that person is paying a bribe? The new law has been drafted to enable prosecutions of bribery; the onus is on the company to prove its defense. The defense to a charge under Section 7 is the ability to demonstrate that the company had adequate procedures in place to stop bribes from being paid. [These provisions are similar to accounting rules in the United States that focus on ensuring that there are policies and procedures in place to prevent fraud or embezzlement.] It may be difficult, however, for a company to convince a prosecutor that its procedures were adequate.

What are the implications for companies based outside the United Kingdom?

The jurisdictional reach of this law is very wide. Anyone who is a U.K. resident and any company incorporated in the United Kingdom is subject to the act. Beyond that, though, if you have a place of business in the United Kingdom, Section 7 applies. For example, if a U.S. or Chinese company carried on only a small part of its business in the United Kingdom, say, through a small representative office, and that company is shown to have paid bribes in Africa, the company could be prosecuted in the United Kingdom. My own view is that enforcement will continue to focus on companies with extensive operations in the United Kingdom. But I think we can see the United Kingdom following the approach of the U.S. Department of Justice on Foreign Corrupt Practices Act investigations — many more cases being settled through large fines, with some individuals being prosecuted.

What procedures should companies implement to ensure that they remain in compliance with the new law?

The U.K. government has published draft guidance based on the Committee of Sponsoring Organizations model. [COSO of the Treadway Commission provides international guidance on organizational governance, business ethics, internal controls and financial reporting.] In essence the advice was to assess a business’s corruption risks, devise appropriate control and compliance procedures, and implement continuous monitoring. These principles were accompanied by some examples of appropriate procedures. Transparency International, with funding from FTI Consulting, also published guidance that sought to provide practical advice. In recent weeks there has been a lot of lobbying by businesses arguing that there is insufficient guidance on certain features of the act, particularly about facilitation payments and marketing expenditure. The government’s publication on the adequate procedures has been delayed, as has guidance from the Ministry of Justice on prosecution policy. As a result, the act, which was due to come into force in April, is more likely to become effective as of early summer.

POINT

VICKY PRYCE, Senior Managing Director, Economic Consulting, FTI consulting

In 2002, when euro notes and coins entered circulation, the dominant view among the 15 (now 23) member states using the currency was that it represented a big step toward ensuring peace and prosperity for the Continent. What people in individual European countries tended to overlook was that a single currency brings greater interference by members of the union in each state’s monetary, fiscal and political affairs. Tension over such intrusions, coming to the fore in the wake of sovereign debt crises in Greece, Ireland and elsewhere, casts serious doubt on the survival of the euro as the single currency for most of Europe. During the next few years, member states will do whatever they can to avoid a split because the practical inconveniences would be enormous. Weaker countries, such as Greece, would face a radical devaluation of their currency and essentially would have to close their fiscal borders to prevent a flight of money. Stronger nations, such as Germany, would suffer as well. The inevitable rise in a German-dominated currency would make exports — a cornerstone of the German economy — far less competitive on the world market.

That’s why leaders of financially robust member nations will continue to support bailouts despite grumbling from their citizens about shouldering the lion’s share of the cost; it’s also why weaker nations, such as Greece and Ireland, will continue to accept austerity measures despite protests from their citizens about cuts in government services. But over the longer term, say, a decade or so, the survival of the euro in its current form will become much more problematic. In order for the bailouts to succeed and the single currency to remain viable, the productivity gap between weaker and stronger countries must close significantly.

Yet during the past decade, technological advances and wage moderation have helped Germany widen the gap with southern Europe in terms of manufacturing unit labor costs, a standard measure of export competitiveness. Since 2001, when Greece locked in its exchange rate with the euro, its unit labor costs have increased by more than 240%, according to the Organisation for Economic Co-operation and Development, while Germany’s costs have risen less than 70%.

• First, we faced a credit risk when a part of the American domestic mortgage market went into default.
• Second, a liquidity crisis was brought on by counter-party risk. The fall of Lehman Brothers was its most visible manifestation, along with the rescue of AIG, but inside the crisis the fact that the wheels seemed about to come off the capital markets was more mundane but perhaps more frightening. We all remember the last months of 2008 and early 2009 when a simple letter of credit for routine trade exports became almost unobtainable. As Prime Minister Gordon Brown’s envoy for the G-20 at the time, I remember the scramble to get some official money behind the world’s oldest, and until then most routine,  international financial transaction. World trade plummeted 20%. In a globalized world, we feared, if trade stops, the world stops.

• Third: Last year investors saw their safe haven, sovereign debt, buffeted by weakness in the eurozone. This year, that credit crisis continues to play itself out as so-called rescue packages still avoid addressing the real sustainability of the public finances in Greece or Ireland or Portugal or even U.S. municipal finances. The recent Economist cover spoofing fictitious U.S. state names, such as Califoreclosia, New Yoke, No Hopeshire, Mess (for Massachusetts), Horrida and I.O.U.wa, is the satirist’s and cartoonist’s art at its most effective. It tells a story we would prefer to overlook: America’s states are drowning in red ink.
• And hence to the fourth crisis: geopolitical risk. The Arab world is convulsed. Petrol flirts with $100 a barrel. Food prices have risen above their 2008 peak. Natural disasters are omnipresent. It’s suddenly a dangerous place out there.

So what have these four crises done to expectations and a generation of investors, especially those looking at Asia? The answer is not simply bulls vs. bears. Rather, I believe we have undergone an undernoticed shift in psychology that makes us warier of indiscriminate grand trends in investing, embracing whole countries or sectors, and more cautious and careful “opportunity pickers.” Of course, trends still matter: Are we shifting our global economy onto an IT-enabled platform? Almost certainly, so that gives the technology sector a step up before you get to evaluate individual companies. Similarly, the long-term future of highgrowth markets — namely Asia, Latin America and parts of Africa — seems on a stronger trajectory than, say, Europe or North America.

Seeking Markets Without Morals

But let me scratch a bit further at this somber new psychology before applying the same lessons to Asia in particular. In my view, two of the apparently hardwired assumptions about the recent past that came from the 1989 fall of the Berlin Wall have been changed by the 2007– 11 credit shock. First, governments
are no longer necessarily safer than companies, which throw on its head the most basic principle of portfolio allocation between safe but low-return government bonds and corporate debt and equity. And that came to pass in considerable part because the socialization of Western bank bad debt has implications for Western political systems that have not yet played out. Look out, for example, for the return of hard-left political parties demanding much more draconian anti–Wall Street and -business measures than anything we have seen so far.

Gordon Brown, who, as England’s Chancellor of the Exchequer, presided over the dramatic expansion of the London financial services sector, in his post–prime ministerial memoir waxes angrily about irresponsible and reckless banker greed and demands markets with morals. For a man from Adam Smith’s hometown whose political career is behind him, a call for morals may be enough. I suspect younger Labour leaders harbor hopes for taking a clenched fist to markets.

In this way, the “popular capitalism” model of growth that drove social cohesion in Europe from Margaret Thatcher’s day onward — where people got richer, bought their own houses, put a second car in the garage and saw their children off to fine, and largely free, university educations — may be ending in tears.

Shadows over Asia’s rise

Although Asia has embarked on a similar inclusive period of political and economic growth, where, despite vast income disparities, everybody feels they could be part of an Americanstyle aspirational dream — where each generation is better off than its predecessors — it, too, will be affected if European markets grind to a halt and a new “them” and “us” politics metastasizes from Europe into Asia.

But at a time when we are anxiously peering through the telescope and trying to understand future risk, we need to look hard at Asia and the geopolitical factors that threaten to cast long shadows over Asia’s rise. What are Tunisia’s and Egypt’s lessons for Asia? The first thing to say is that it probably is not the democracy deficit that will trip up Asia in the way it recently has the Arab world. For all its exceptionalism, Beijing remains sharply attentive and responsive to local issues, as though its political life depended on it — and it probably does.

Rather, the roots of Asia’s risks are growing income inequality, border disputes, environmental and natural resource pressures, and the scramble to control the strategic commodities that feed the Asian manufacturing engine. On each, there are clouds. Though East Asian incomes have increased by 1,100% between 1970 and 2010 compared with an average of 184% in developing countries, income inequalities have also grown sharply in a number of East Asian countries. These inequalities create new disparities, new winners and losers and new tensions. The 2010 confrontation in Bangkok between angry rural supporters of the opposition and the more prosperous urban groups that supported the government reflected this reality, and it clearly lies behind many of the tens of thousands of social protests each year in China. Asia entered the 21st century with a positively European, beginning-ofthe-20th-century list of unresolved border and sovereignty disputes: the South China Sea, Taiwan, Kashmir, the Korean Peninsula and so on. If Europe’s experience a hundred years earlier tells us anything, such disputes are exacerbated by differential rates of economic growth. Germany’s industrial success fed its resentment at unsatisfactory border arrangements. It wanted more room and power. The other analogy to Europe is that when a region is a global economic powerhouse, its disputes have a nasty habit of going global. Germany’s border grudges led us into two world wars.

The region also faces destabilizing environmental and resource trends: Water scarcity in India is one of several factors having a major impact on Indian agricultural productivity; changing dietary habits in China, India and the rest of the region with the substitution of meat for grain requires heavy increases in the use of both grain and water. Environmental destruction of the Indonesian rain forests has made this one of the top hot spots for global climate change. The fact that more than 80% of the world’s natural disasters occurred in Asia in the past few years indicates how population growth, poor location of expanding human settlements, soil degradation and the loss of forest cover are combining with more extreme weather patterns to create an enhanced level of human vulnerability to natural disaster.

Beyond these kinds of issues, as Asia faces new competitors, Africa embarks on a low-cost, commodityexport- led boom backed by a lot of internal diversification. Many Asian countries seek strategic partnerships to secure access to Africa’s minerals and energy, but this also forces them into mounting a much more global national foreign policy than in the past. There are Indian peacekeepers in Congo,

Chinese traders and development experts in Malawi, and both countries’ engineers and diplomats, along with those of South Korea and Malaysia, pursuing resource deals across the African continent. Without the same
ambition for political control, this Asian scramble for African resources emulates Europe’s similar late-19th-century scramble. Asia has its hands full.

Investor, Tread Carefully

What does all this mean for the investor? My own view is that none of this undermines the long-term bet on Asia, but it does suggest that investors should be discriminating. The world is a tricky place. Although Asia’s concentration of people, wealth and growth makes it an indispensable centerpiece of any global investment strategy, that strategy must be accompanied by a tolerance for risk and the tools to manage it. Too many Western investors still assume that growth will banish politics and that a vast consumer suburbanization is under way across this large and varied region. This way of thinking assumes that with growth, every country will become a Singapore or a Hong Kong, forgetting that both have unique histories and geographical opportunities that enabled them to become high-end service providers and trade centers for their regions. Neither is a replicable model for its much larger, teeming neighbors that are still struggling to make growth inclusive and government viewed as fair and legitimate. For much of Asia, the real dramas of development, political as well as economic, lie ahead. For the investor, this is not a reason to stop but rather to proceed through these dangerous seas with the right charts. Above all, it requires rigorous understanding of individual corporate strategic plans, financial strength and market positioning. The big trends are sufficiently prone to geopolitical shock, sector risk and continued financial volatility that the lifeboat is the investment target within the trend. Is it the IT company that will survive a bubble or the construction business that can now weather a long downturn?

And in cases where the investment is essentially a bet on a country’s stability and growth, investors need to do their homework, and above all not fall victim to the wishful thinking that growth equals stability. If the political system is not expanding to represent both the new middle class as well as those who fear they are getting left behind, prepare for trouble. Asia has enough variety of political systems operating effectively that the key test is not a neat Western democratic form but broad representation, accountability and legitimacy.

Growing Pains

Growth will propel this region forward, as well as Africa, Latin America and other emerging regions, even as the mature Western markets fall back. But at times this growth will fall into that category of things we warn our children about: Be careful what you wish for because growth brings the stresses and strains of new inequalities, resource scarcities, infrastructure bottlenecks,inflation, pressure on borders from growing populations, and competition between countries. In the long run, people will look back and see a generation of difficulties and wonder why we had not seen it coming, and why, when it came, some probably lost sight of the more lasting truth. These difficulties were growing pains and not a lasting threat to Asia’s rise. What investors must surely do is keep their heads and hold on to their wallets in the coming years, while never losing faith in the region’s transformation. Markets have never been so global and yet local knowledge so important.

Faced with a sluggish economy that puts pressure on profits and hinders early sales to buyers or public markets, private equity firms often have to keep companies in their portfolios longer than they would ordinarily prefer. But what should happen during these extended holding periods to increase the value of a company? How much assistance can a firm provide without undermining the company’s ultimate independence? And what can a firm do during a prolonged period of ownership to reassure a company’s key audiences — from management and rank-and-file employees to customers and investors — that their efforts continue to strengthen the portfolio company over time?

Taking a less hands-on approach may have been a less risky proposition when the economy was booming and portfolio holdings could be resold quickly and profitably. But these days, most companies are struggling to rebound from the recession, and if a PE fund is not responsive to the needs of a company
on a real-time basis, its future value will be negatively impacted.

At the other extreme, some private equity firms react to hard times by immediately replacing management, slashing costs and assuming complete control of the business. But that, too, brings risks, including damaging employee morale, lowering productivity and slowing the timetable for getting the company in shape to be sold. Rather than being able to exit within four to seven years, the private equity owner might have to stay invested considerably longer, waiting for the new managers to establish the kind of track record that could attract buyers willing to pay a premium price.

Often the approach is to split the difference, not only keeping most or all of current management but also bringing in temporary outside help that can speed the rehabilitation of the company. The idea isn’t to dictate changes but rather to aid in analyzing problems and developing solutions that the managers will embrace. If the ideal balance is struck, the company’s management team will emerge with a record for succeeding despite adverse conditions, and the private equity firm may be able to take its leave on profitable terms — and to build a reputation for turning around troubled businesses, which can help it attract the next round of investors.

Particular success can be achieved when the PE fund and its specialist teams are brought in to work with management to improve particular areas of a company, providing expertise on human resources, information technology, merger integration or underperforming departments.

For example, Wynnchurch Capital, a private equity fund in Rosemont, Ill., recently accomplished a textbook transition, improving a portfolio company by providing management with targeted specialized assistance and developing a framework to drive improvement across the entire organization. In 2007, Wynnchurch acquired two struggling automotive rubber seal manufacturers, GDX Automotive and Metzeler Automotive North America, with the plan to merge the two operations into a newly formed company, Henniges Automotive. The potential efficiencies were substantial, but so were the challenges of combining the two businesses. Wynnchurch had to establish a new management organization, install new management processes and frameworks, dramatically improve operating efficiencies and quality, and replace two incompatible information systems that affected a range of essential functions — from accounting and purchasing to sales and customer relations.

A major attraction of GDX was its strong customer base and product mix, but prior to the acquisition the company suffered from poor quality, inefficient manufacturing and significant operating losses. In some cases as much as 20% of the parts rolling off the production line were flawed and had to be scrapped, and the productivity of certain operations was half of industry averages. Management had to rebuild customer confidence in the business while also completing the integration of the two companies. Since the merger, Henniges has not missed a single launch date and has dramatically improved quality and efficiency. As a result the company has re-established itself as a preeminent global supplier.

Many of GDX’s quality control and efficiency problems, says Wynnchurch partner Terry Theodore, stemmed from old-fashioned organizational structures and work practices. Management had not engaged the workforce to help solve performance issues and instead relied upon an archaic system of management-labor relationships. Changing that system was a priority, and Wynnchurch used the acquisition of GDX and its merger with Metzeler to engage the workforce, including the unions, to solve performance issues. The employees on the plant floor knew what the problems were, and so management provided them with the information, training and authority to solve issues quickly. The labor unions provided a highly constructive conduit to engage the workforce in a dialogue regarding required changes. In exchange for agreeing not to cut wages or health care benefits, the company was able to establish flexible work rules that allowed Henniges to dramatically improve quality, delivery times and efficiencies. One example of these changes involved a union practice known as bumping. Whenever a job opened up, union rules dictated that the employee with the most seniority could take the position. This encouraged workers to shift jobs whenever they wanted a change of routine, which meant that most employees didn’t stay in one place long enough to develop the expertise to optimize performance.

Yet even with that essential compromise in place, countless additional details had to be taken care of in merging the two companies — from getting the new technology system up and running and training employees to use it, to changing plant signs and all communications to carry the new name of the combined company, Henniges Automotive. All the while, managers had to assure customers that changes were being made in an organized way that would not disrupt production.

The merged company’s CEO, who had worked with Wynnchurch on a prior investment, and the CFO, who had worked for Metzeler, oversaw the massive overhaul. But Wynnchurch also brought in its teams of specialist advisors to help create uniform systems for accounting, human resources information technology conversions and other functions. In most cases the advisors stayed for less than 12 months, working closely with Henniges’s management to develop sustainable systems that were built by and for the management team. With the two companies effectively integrated and poised to take part in the auto industry’s rebound, the company has performed exceptionally well and won several new programs with its major customers.

THE IMPORTANCE OF COMMUNICATIONS

Regardless of how the relationship between the PE firm and the portfolio company is structured, the mere arrival of a new owner always causes a stir. Therefore, establishing an effective communications strategy is crucial — though it’s often beyond the capabilities of a newly acquired company’s existing communications team. Handling announcements of layoffs and other cost-cutting measures clumsily, for example, may provoke job actions by unions and denunciations from local politicians and media. To limit a backlash, PE firms can lend support by helping the portfolio company conduct a thorough assessment of its many stakeholders, determining who they are and how they’re connected to the business. For example, this could include an evaluation of how town officials will likely react to a significant reduction in workforce. If the team knows what to expect, it may be able to address and/or mitigate concerns before a public announcement by stressing the potential long-term benefits of necessary cutbacks.

CONSIDER THE BROADER MESSAGE

More complications can arise if the new owner isn’t sensitive to the company’s long-term relationships or commitments. For example, a company may have a long history of supporting hospitals or other philanthropic causes. If a private equity firm, in its cost-cutting efforts, simply eliminates that support, it may be taken as a sign that the company’s new owners are not interested in the community’s welfare. Similarly, the decision to relocate a company’s headquarters can be a communications disaster without careful preparation. Proactive communications aimed at building relationships with these stakeholders from the onset can establish a baseline of understanding and support that can preempt negative outcomes.

All such communications tasks are difficult for a company’s management to handle at a time when the business is struggling to rebuild. But with the support of the private equity firm, management can handle all these delicate jobs to pave the way for a smoother transition and preempt unforeseen interferences — ultimately succeeding in the task of enhancing a company’s value.

When we buy a company, probably the most important way we add value is by making sure the senior management team shares our vision. Of course, whenever possible we make this appraisal before a deal closes. Changing management midstream is hugely disruptive and costly, and it usually extends the time it takes to prepare a company for sale. Whereas private equity firms overall wind up replacing senior management about half the time, we keep our rate ataround 20% by being very careful before we invest.

Then we try not to get involved in daily operations. We won’t hire or fire a plant supervisor, for example, because you can run into lots of problems trying to shadow-manage every company in your portfolio. Yet we do follow the progress of our companies very closely. The closer you can get to being on the same page as a company’s management team, the better your chance of working together to increase that company’s value.

We once owned a company called Nimbus, based in Virginia. The management was particularly good at communicating with and supporting employees. I remember going to a company picnic where the CEO, other managers, board members and I put corn and burgers on the plates of employees. Later we talked to them and answered their questions. You don’t always get that level of communication and trust between company managers and private equity investors, but when you do, it’s a beautiful thing.

The best private equity firms excel at picking merger targets that will enhance the value of companies in their portfolios. They will look for compelling opportunities to increase market share, extend product lines, expand manufacturing capabilities or push into new geographic regions. Sponsors have carefully modeled the cost savings and related operational synergies. So why do as many as four out of five mergers fail to fully realize their merger objectives?

Consider a merger of two companies with combined revenues of $500 million. A reasonable expectation of annualized savings in this case equates to 8% to 10% of revenue, or approximately $50 million. But often enough, two years after the deal has closed, the new corporation may have realized cost efficiencies of only $10 million — dealing investors $40 million in unachieved savings each year, inhibiting margins and profitability. If the merged companies are in an industry in which the average valuation is seven times EBITDA, the impact of an incomplete integration in this case may decrease the valuation by hundreds of millions of dollars.

All M&A transactions have their own intricacies, and it can be a challenge to consolidate manufacturing facilities, legal and regulatory departments, supplier agreements, customers and sales channels, information technology, supply chains and each of the other functional areas of the business. There are many ways for a flawed integration to erode the anticipated returns on private equity’s invested capital. But as we have seen from our intimate work in many of these transactions, overlooking any of these five common pitfalls guarantees that an investment will not realize the full value envisioned.

Cutting too little too late. Probably the toughest task facing merging companies is deciding how many employees, including senior and middle managers, to eliminate. Many companies wait too long to reduce duplicate head counts, assuming — or hoping — that revenue will expand quickly or that internal politics will cause delays.

Two merging automotive supply companies made this mistake, failing to anticipate an economic downturn that occurred a few months after their deal closed, drastically reducing sales. Despite deep personnel cuts that were then made across the company, it was unable to bring about cost reductions fast enough and ultimately had to file for bankruptcy, wiping out equity. In hindsight, it was clear that if the company had eliminated excess jobs starting the day after the transaction closed, the resulting savings would have provided the company a buffer sufficient to avoid violating key debt covenants despite shrinking revenue.

An alternative approach was taken by two publishing companies that merged. But instead of going only far enough to meet merger model synergy targets, management took a more aggressive approach of planning for additional economies. After 18 months, the combined company had exceeded its cost synergy targets by more than 80%. That overachievement of synergies allowed the company to keep its costs in line with unanticipated revenue losses and to survive in an economic climate that was particularly hard on media companies.

Not understanding true profitability. It might seem obvious, but if a company cannot accurately quantify the cost of producing individual products and supporting customers, it becomes nearly impossible to make informed decisions about how to eliminate duplicate costs, rationalize product or service lines, or understand where investment will generate the highest returns. Inefficient companies tend to analyze profitability in terms of gross margins for each operating unit rather than to look at the profitability more directly by individual product and/or customer, for example. By breaking down profitability by customers, products, service offerings and manufacturing plants before merging, two printing companies learned what was and was not working. They avoided folding unprofitable elements of the businesses into the merged company, instead electing to churn the bottom tier of the combined customer base, collapsing small business units into a more efficient infrastructure, exiting two major customer contracts and shutting down 20% of the manufacturing capacity.

In contrast, operating with inaccurate assumptions about line of business profitability could also stop a merger cold, as it did for a communications company that was embarking on acquiring a large competitor. During due diligence, it became apparent that the acquiring company was not nearly as profitable in key business segments as originally assumed. Without the necessary cash flow and valuation to raise funding for the acquisition — and finding itself out of strategic options in a consolidating industry — the would-be buyer was acquired by another company a few months later. Had the company dug deeper in analyzing its costs before embarking on an acquisition, it would have realized it had to fix its cost structure first and assert more control over its destiny.

Getting IT wrong. Merging databases and IT systems is often the most challenging — and most time-consuming — element of merger integration. Yet companies routinely minimize the difficulties. As a rule of thumb, merging the IT elements of two medium-size companies with combined revenues of $500 million to $1 billion will take 18 months to two years and cost a third to half of a normal year’s IT operating budget.

But until the systems are thoroughly consolidated, the merging companies could endure a heavy “swivel chair” burden, with employees forced to work with multiple computer applications and operate unrelated software systems to complete transactions.

Merging corporations also have to be concerned with database capability and accuracy — a step one telecommunications company ignored at its peril. In trying to rush the integration of its systems with those of a company it had acquired, the company was forced to “flash cut” the acquisition’s databases — essentially importing the data and going live with minimal testing. Almost a third of the combined company’s invoices ended up having incorrect addresses, and half contained errors six months after the integration of the two systems. Annoyed customers stopped paying their invoices, reduced their monthly services and/or turned to another provider, which ultimately forced the company to file for bankruptcy protection.

Contrast this experience with that of a transportation company that acquired a major competitor a few years ago. The acquiring company had exhausted accounts receivables of 28 days sales outstanding (DSO) while the target achieved 47 DSO. Before integrating the acquired company’s customer and billing data, the firm went through an intensive database cleanup to eliminate erroneous customer information, align the necessary fields, and confirm billing terms and mechanics. Once the database was modified, the acquiring company was able to smoothly integrate the customer and billing IT data into its own system and was easily able to perform root cause analysis on the high DSO customers. As a result, the acquired company’s DSO was reduced to 35 days, and $9 million in cash flow was accelerated.

Not sweating the small stuff. In advance of closing a deal, merging companies typically establish a program management office (PMO) to oversee transaction integration activities. This is the nerve center, a unit that coordinates thousands of tasks and tracks their progress against the integration plan to make sure the merger will close on the target date. It also identifies potential impediments throughout the pre- and post-close periods with enough lead time to permit them to be addressed. But too many PMOs passively tick off completed tasks, rather than proactively forcing adherence to schedules, confronting issues and pushing senior managers to make decisions.

There is an enormous amount of interdependency in an integration plan, with every area of a business affected by when and how well other business areas plan and execute their part of the integration — and it falls on the PMO to keep all the moving parts synchronized. At any given moment after the close, the PMO should know how much of the integration has been completed, how much it has cost and what else is needed to achieve the targeted benefits.

Another critical role of the PMO is to coordinate communication about the merger with employees from each company, managers not directly involved in the integration, suppliers, customers, and government and regulatory agencies. The PMO needs to manage expectations and to minimize the spread of rumors and speculation that can damage the new company.

Forcing the issue on corporate culture. Companies may democratically try to merge their ways of doing things, or the acquiring firm may attempt to force its culture on its target. Neither works. After a successful integration, a new corporate culture will emerge on its own, helped along by leadership from top managers. Involving middle and upper management from both organizations in setting a path for the merged company will help avoid the perception that there are winners and losers and, ideally, will promote people, processes and technology that are the “best of the best” from both companies.

Private equity sponsors, hedge funds, capital markets, bankers and companies all realize that M&A is about creating value through revenue and cost synergies. But finding and capitalizing on those synergies can seem paradoxical: It involves charting an integration path that is sufficiently comprehensive (without paralyzing the organization) and rapid enough that executives focus without promoting the “ready, shoot, aim” mentality. A carefully considered and managed integration that aligns with the transaction’s strategic objectives is most likely to deliver the returns that made the merger so compelling in the first place.

During the period leading up to the acquisition, the sponsor presumably has communicated its investment thesis clearly to management of the acquired company and had frank discussions on how it expects to achieve the goals that underpin its rationale for the investment. These should include realistic expectations about the level of involvement the sponsor expects to have, reporting requirements it expects to institute and the various metrics it expects to employ to monitor the company’s progress toward its investment goals. (Sponsoring companies commonly complain about the sometimes cloudy distinction between the roles and responsibilities of their CEO and those of the acquired company’s CEO.)

Once an acquisition takes place, it is important that the sponsor and company management finalize a concrete plan for achieving the investment objectives; and doing so within the first 100 days takes maximum advantage of the relationships and momentum that have been established during the negotiations. Management should be charged with preparing a bottom-up business plan that sets forth the tactics it proposes to achieve the agreed-upon near- and mid-term goals for the company, the metrics it recommends that the sponsor employ to measure progress, and a road map of middle management responsibilities, milestones and timelines that will be used to implement the plan. The plan should then be presented to the board (that is, the sponsors), for (first hand) input and approval. If the portfolio company operates in a sector that is not well known to the sponsor, or the sponsor believes that the company requires dramatic changes to either its business model or operations, the board might be well-advised to retain experts with executive level experience in that sector to provide additional guidance during this process. The agreed-upon business plan can then be used to establish annual incentive plan targets (potentially reflecting a mixture of financial and nonfinancial goals) and performance rewards that incentivize the actions deemed necessary to achieve the business plan’s goals.

A detailed one-year plan is particularly important, but we would recommend that the plan encompass at least a three-year horizon so that the management team and sponsor can agree on the nature of the medium-term direction that will be pursued to reach the goals that have been established, and the steps that they expect will be required to get there.

SIX KEY FOCAL POINTS FOR THE FIRST 100 DAYS

Each of the following issues is critical in positioning a new acquisition for success. While some may seem commonsensical, each requires thoughtful planning and execution.

Clearly communicate with all key constituents on day one and again during the first 30 days. A comprehensive communication plan should be developed to address the anticipated concerns of key constituents, including customers, suppliers, employees (including unions or workers’ councils) and financial stakeholders. If the acquired firm has various operating entities resident in different countries, it is possible that this will require tailored communications in terms of both content and local language. In many cases, this plan will be developed and implemented before the acquisition, but once the transaction is complete, these stakeholders will want to learn more about the sponsor, its goals and objectives in making the acquisition, its vision for achieving those goals and objectives, the thinking behind any announced management changes and a report on the financial stability of the company after the acquisition. Consideration should be given to having the sponsor and senior management meet individually with key customers, critical vendors and valuable employees to share their vision and enthusiasm, calm fears, solicit concerns and gather input. Directly or indirectly, these conversations should address the sponsor’s level of commitment to the company and the opportunities that are created for each constituency.

Establish control of cash from the first day, even if there is an abundance of it. Many acquisitions, particularly divisions carved out of larger businesses, are more focused on profit and loss than on the cash flows. First identify all of the ways obligations can be entered into cash (such as by field staff, individual store location, corporate, p-card and contract) and how cash disbursements can be made (such as check, wire transfer and petty cash). Armed with this inventory, evaluate and adjust authorization limits to levels the sponsor is comfortable with, then modify the related procedures accordingly. Tightening down the many ways cash can be committed to and disbursed will often save the company significant dollars in situations where controls were somewhat loose under prior ownership. In addition to maximizing cash flow in the short run, taking this step in the first 100 days fosters a culture of cash maximization that is often critical to achieving the long-term goals of the sponsor.

Implement corporate governance policies that provide the appropriate level of oversight by the sponsor and establish authority limits at different levels within the portfolio company. Companies permit varying degrees of authority to obligate the company and disburse funds. In more decentralized organizations, significant authority sometimes lies at relatively low levels. A sponsor needs to evaluate commitment and disbursement authority levels from senior management down to the most junior levels and adjust them as necessary. At the senior management level, authority limits establish the degree to which the sponsor desires to be involved in decision-making beyond approval of a business plan and monitoring of results.

The proper balance will depend on the unique facts and circumstances of each situation — the important point is to explicitly address the issue, and establish well- thought-through incentives and the necessary governance procedures, in the first 100 days. For example, negotiating an owner earn-out that focuses exclusively on revenue metrics might encourage management to enter into major post-acquisition customer contracts at margins that generate little net cash flow. On the other hand, management might respond to incentives to improve profits by seeking to implement price increases on large customers with other options who could respond by taking their business elsewhere. In another example, one would want to make sure management did not commit significant marketing dollars to repositioning its brand before having fully implemented the product changes that underpin the repositioning, or before quantitatively assessing the potential ROI of the marketing initiative. These lessons demonstrate the need for a sponsor to balance management’s latitude in running the business with necessary sponsor oversight. In thinking about how to incentivize desired behavior on the part of portfolio management, it is critical that the sponsor examine in a nuanced way how those incentives could backfire, and then establish corporate governance procedures accordingly.

Establish financial and operational metrics and tools to ingrain financial discipline and accountability in the business from the outset. This often involves adjusting the mind-set of the existing management team to reflect the sponsor’s core objectives of cost containment, profitable growth and efficiencies that will drive positive cash flows and generate the contemplated return on investment. Within the first 100 days after acquisition, the sponsor should work diligently with management to establish the specific process and reporting that will be implemented (e.g., “bottom up” budgets, cash flow forecasts, cash conversion plans, detailed cost containment initiatives and financial metrics). Once in place, these new procedures can be used to evaluate product development, portfolio and product offerings, and distribution and manufacturing alternatives. And in undertaking these changes, sponsors should not ignore other metrics such as customer satisfaction, win/loss rates, upsells, same-store sales, sales force productivity, shipping costs, on-time delivery, days to close the books or employee retention, all of which provide valuable insight into how well the business is being run. The key for sponsors is to agree with management about the most important metrics and seek weekly and monthly reporting and, in some businesses, such as restaurants and retail, daily reporting of certain key metrics.

Assessing human capital requirements should begin in the due diligence phase but continues to be crucial throughout the first 100 days. In the due diligence phase, the sponsor seeks to predict whether the existing senior and middle management teams have the experience and leadership to execute and to design compensation structures that reflect appropriate incentives to do so. Seeking to complete whatever management changes are necessary within the first 100 days — including identifying and retaining key individuals who can act as “change agents” by being visible proponents of the deal and the elements of the going-forward plan — will allow the dust to settle and reduce the inherent anxiety associated with uncertainty within the leadership ranks. Often companies are paralyzed if a pending management change is anticipated. Committing to a go-forward management team as early as possible, and certainly within the first 100 days, is important. In carve-out situations, sponsors will probably need to recruit a new senior management team, such as a CEO, a CFO, a controller and other key executives.

Ensuring the technology infrastructure is adequate to implement the necessary financial and operational discipline, as well as report on established metrics, is critical to instituting and measuring change and performance. The supporting systems go beyond the traditional accounting system and may extend to the point of sale, customer relationship management, work flow, enterprise risk management, forecasting tools, inventory management, scheduling and procurement, among other areas.

Information systems and infrastructure can play an invaluable role in leveraging an acquisition’s value and overall performance, particularly where target company operations are decentralized and IT assets are critical to tracking the progress of 100-day initiatives. Sponsors need to ensure that the technology platforms provide what is needed, and they must implement plans (upgrading or outsourcing) to ensure that IT does not hinder the company’s success.

With any acquisition, a fast-track approach to aligning the management team with the sponsor’s investment thesis is a vital step. During the first 100 days, the sponsor needs to address with management the six pillars discussed on the previous page, implementing policies, strategy and reporting with an overlay of risk management. In “cross border” acquisitions, particular attention also should be placed in defining and effectively communicating goals for what will be perceived as “remote” or “foreign” parts of the organization. Developing an agreed-upon plan to achieve the sponsor’s investment thesis through finalization and formal adoption of a three-year business plan in the first 100 days lays the foundation for a successful path forward.

That’s not an unheard-of approach for private equity firms, of course; successfully resurrecting a dysfunctional business is one reliable path to maximizing investors’ returns. Yet Cerberus differs from many traditional firms in that it has developed a proprietary team of operating executives on which it relies to help it perform due diligence, underwrite, evaluate, execute and monitor its operational control investments. Because of its team, Cerberus can focus not only on traditional buyouts of distressed companies but also on corporate carve-outs — taking only a piece of a company rather than buying a stand-alone business. In part because carve-outs have little existing management structure — a deficiency that must be quickly remedied — Cerberus can take a different approach from that of many firms, which tend either to avoid carve-outs completely or to look outside for the expertise to rebuild companies. Cerberus depends on its proprietary team of 85 industry-hardened executives and only a small, handpicked group of Tier 1 consultants. Led by Robert Nardelli, former CEO of The Home Depot and Chrysler, the firm’s internal team works out of an affiliate called Cerberus Operations and Advisory Co. (COAC). “COAC is populated with former operating executives, including CEOs, CFOs and COOs,” says Neporent. “And we have about 100 other former COAC members who are currently situated in our portfolio companies occupying key management positions.”

What are the advantages of maintaining a large staff?

NEPORENT: We can take on projects in which the entire management infrastructure must be built from scratch. That includes installing complete systems for accounting, IT, sales and marketing, and human resources. One of our recent successes involved Talecris Biotherapeutics, a blood plasma company we bought from Bayer. The transition services agreement covered a very brief period, and we had to get everything in place right away. Thanks to our internal team and support from strategic consultants such as FTI Consulting, the outcome was highly successful.

Yes. That was a very successful transaction, with more than 20 times return on investment reported. Touching further on the topic of exiting from investments: With the IPO market still slow, do you end up holding companies longer these days? Do you get more involved, even after a business is up and running?

NEPORENT: In the past, we tended to exit investments after we completed our restructuring task and restored the company to operational and financial health. In this market, we are often holding our investments longer. So once we have fixed a company operationally, we have to figure out how to grow it during what could be an extended holding period. That means we are paying much more attention to the top line and sales and marketing than we have in the past. Since Bob Nardelli came onboard full-time a year and a half ago, we have stepped up our surveillance of the companies in our portfolio. The technology we have developed is unmatched. We try to spot problems and see trends much earlier than we did when the economy was more robust and there was more room for error. You have to be able to measure things, and Nardelli and his team have deep experience and use comprehensive models that they check every day.

But doing an IPO is just one of many exit strategies. If that can’t happen, maybe you sell to a strategic buyer. Each investment is unique, and conditions vary from industry to industry and region to region. We have had exits and partial exits this year in all forms of transactions and industry sectors. You need to be nimble and resourceful. For example, one European deal collapsed because the IPO market reacted badly to the Greek financial crisis. Two weeks later we got a deal done in a different industry sector elsewhere in Europe despite the lingering crisis.

Has the economy also affected your ability to make acquisitions? Financing has got to be tight.

NEPORENT: Blue-chip companies are expensive now, and capital is dear. We were able to source and sign up three significant middle-market deals so far this year. And though you have to put up more equity, financing is available for the right acquisitions and the right sponsors. Our sweet spot is the middle market, despite all of the media attention paid to iconic transactions such as GMAC and Chrysler. We target the corporate widows and orphans. These are noncore businesses that good companies are shedding because they want to focus on their core competencies. That creates opportunities for us that others may shy away from because they don’t have the management and operating talent in-house.

How are your companies performing this year?

NEPORENT: There are pockets of good news and areas in which sales are flat or down. Auto supplier revenues are up, but sales at paper companies are down. We have been able to enhance earnings by continuing our relentless focus on operational efficiencies. But there is a limit to how much you can cut costs. You have to worry about cutting so deeply that you start to impinge on what a company can do.

What about new markets? Are there different geographic regions you are focusing on now?

NEPORENT: We spend a lot of time thinking about Asia, looking at relationships and opportunities. We’ve invested billions of dollars in acquisitions and debt in Japan. And though we have yet to make any meaningful acquisitions on mainland China, we are actively looking there. And our portfolio companies are constantly looking for opportunities for outsourcing and efficiency.

As the global economy struggles to shake off the lingering effects of the recession, private equity firms, with approximately $500 billion in uncommitted funds, are facing mounting pressure to identify desirable targets that will deliver a solid return on investments. The resulting competition has driven up the purchase prices in many deals: To outbid more than a dozen firms for Virtual Radiologic Corp., Providence Equity Partners paid a 41% premium. While private equity firms have always been known for their exhaustive due diligence, the postrecession climate has made them more susceptible to the misstatements of companies desperate to be acquired. As many buyers are discovering, the frenzied rush to close a deal can obscure issues that later come back to haunt the buyer. It’s been said that “love may be blind, but marriage is a real eye-opener.” The hard work of post-acquisition integration is now more likely to uncover errors and misrepresentations that can have a significant impact on the purchase price. As a result, an increasing number of M&A deals are involving some litigation. Since 2% to 5% of the purchase price — often a substantial sum — can be kept in escrow until disputes are resolved, companies have added incentive to settle matters expeditiously.

By understanding the common trouble spots in typical acquisitions, private equity firms can put themselves in a better position to resolve potential disputes. If problems do arise, determining the appropriate channel for addressing them — from early dispute resolution and mediation to arbitration and litigation — can be critical.

TRADITIONAL SOURCES OF DISPUTES

The complexity of M&A deals has the potential to create a range of issues, but certain areas are more likely to result in post-acquisition disputes.

During the deal, the seller will make certain assurances and formally confirm facts and figures. Representations (an account or statement of facts, allegations or arguments) and warranties (allocating financial responsibility for the accuracy of those statements of fact) can range from verifying that interim financial statements have been prepared according to GAAP and/or disclosing pending lawsuits to stating the value of inventory and outstanding accounts receivable.

Indemnification provisions. These measures are intended to protect the buyer and seller from each other’s actions. Indemnification provisions can cover representations and warranties and covenants. During negotiations on the purchase price, each side will insert language to cap damages arising from specific areas. However, these caps can be negated in the case of intentional fraud or on public policy grounds, such as in disputes arising from gross negligence.

Working capital. Within a certain time period after the closing date, the seller must provide a closing balance sheet that includes its working capital. The working-capital “true-up” determines the amount of actual working capital at closing compared with what the seller estimated. Since the buyer will seek to deduct any shortfall (a potentially substantial sum) from the purchase price, calculating the true-up can be particularly contentious.

Earn-outs. An earn-out is a contingent element of the acquisition’s purchase price that is determined after the closing based on the target business’s performance against contractually defined criteria or benchmarks. Disputes can arise, for example, from business decisions that negatively affect the performance of the purchased entity, how that performance is measured or how amortization and depreciation is recorded for accounting purposes.

THE EFFECT OF THE RECESSION ON M&A

In the postrecession landscape, several trends have emerged that are affecting not only how deals are being structured but also the most effective channels for resolving disputes.

Financial constraints slow deals. The overall decline of deals can be directly attributed to financing constraints. Private equity firms can no longer rely on banks to provide ready funding for highly leveraged buyouts. Because of this, not only have acquirers been pulling out of deals prematurely after failing to secure the necessary credit, but financial institutions have also backed out of acquisitions they deemed too risky. As a result, other arrangements such as club deals, where two or more firms form a consortium to acquire a company, have become more prevalent.

Increasing reliance on earn-outs. As buyers look for ways to finance deals that require less cash up front, purchase agreements are featuring earn-out provisions more frequently. Indeed, more than 30% of deals now include such provisions. The structure of earn-outs, however, lends itself to disputes over control, business decisions and accounting practices. The buyer can face allegations of acting in its own interests in ways that adversely affect the acquired company’s performance and, thus, the earn-out payment to which the seller is entitled. Attempts by the seller to exert its influence can be perceived by the buyer as maximizing the target’s performance at the buyer’s expense. Agreements will often include covenants by the buyer to operate the business consistent with past practice or in normal course, although that can still allow for substantial variance in interpretation. So if earn-outs are such magnets for disputes, why are they being included in more and more deals? The postrecession landscape and lack of available credit are two drivers. For the buyer, an earn-out not only reduces the cash necessary at closing but also acts as an incentive for the seller to perform up to expectations after the closing. Indeed, private equity firms want additional assurance that the companies they are buying will meet their high expectations. On the seller side, earn-outs offer potential for increasing total compensation, especially advantageous given the current climate. For these reasons, we expect to see more earn-outs over the next two to three years — and a corresponding rise in resulting post-acquisition litigation.

More MAC litigation. Purchase and sale agreements typically include a clause on material adverse change (MAC), defined as any event, development, circumstance, change or effect that would have a materially negative impact on the business, financial condition or results of the operations of the acquired company. MAC actions involve disputes that emerge from the failure on the part of the seller to disclose material contingencies and liabilities, a loss of a key customer, or other developments that represent a significant and lasting change in the business. Since the recession destroyed the value of many companies, litigation offers an opportunity for acquirers to recoup a portion of their losses. A MAC is very difficult to prove, however; in fact, the Court of Chancery of Delaware, the forum for 30% of all M&A litigation, has never issued a MAC ruling in favor of the buyer. Therefore, buyers should incorporate specific economic targets into the purchase agreement’s MAC clause. Clearly defining what is meant by the term “economic downturn” (in terms of duration and dollar amounts), what constitutes a material difference between projected and actual results, or a material loss of customers can more concretely define failed performance and can provide a more defensible basis for adjusting the purchase price. In addition, the recession has created a breed of professional bargain hunters that have honed their skills in using disputes as a strategic tool to wring more value out of deals. Suits based on the MAC clauses of purchase agreements have become a way for the buyer to get a second bite at the apple during the post-acquisition closing.

RESOLVING POST-ACQUISITION DISPUTES

Given the complexity and the compressed time frame of most acquisitions, it’s nearly impossible for private equity firms to foresee and preempt all potential issues. If disputes do emerge, buyers have several tools at their disposal that they should evaluate based on the type of dispute and the dollar amount under consideration.

Early dispute resolution. Corporations that are well versed in M&A often devote significant time and resources to resolving disputes as soon as they are identified. Some agreements call for senior executives of each company to meet and try to resolve the problem before it can proceed to arbitration. Given the recessionary climate, companies are increasingly turning to mediation as a means to avoid more costly litigation. In this nonbinding process, the companies agree on a judge, an attorney or an accountant to help them reach a settlement. The mediator then conducts “shuttle diplomacy” between the two parties until a settlement is reached. Mediation is especially effective when both parties are motivated to settle and when the legal issues underlying the dispute aren’t complicated. Similarly, if both parties have a lot to lose, mediation is a natural channel to pursue. Some companies, however, treat mediation merely as a tactic to demonstrate to the courts that they have exhausted every means at their disposal before pursuing litigation.

Neutral accounting arbiters. For claims that arise from accounting-related disputes, such as those involving working-capital true-ups, earn-outs and interpretation of GAAP, companies may opt to retain a neutral accounting arbiter to adjudicate the dispute. Purchase agreements will often require the use of a neutral arbiter and provide a list of accounting firms that the buyer and seller have deemed acceptable. The arbiter will engage in a multistep process, including interviews, a review of position statements, interrogatories and hearings. Once all of the facts have been presented, the arbiter renders a binding judgment. By highlighting the strengths and weaknesses of each party’s claims, the arbiter can facilitate an expeditious settlement. A neutral accounting arbiter offers several benefits: The process is a truncated version of arbitration, so it saves the buyer and seller time and money. Since the arbiters are drawn from accounting and consulting firms, they are very well versed in the intricacies of these disputes, ensuring an informed judgment. Last, a neutral arbiter can be empowered by the parties to settle disputes regarding access to information and people and the production of documents, serving to expedite the process.

Arbitration. Arbitration can be a useful path for disputes involving more substantial claims that relate to such issues as benefit of the bargain, fraud, and warranties and representations. The majority of sale or asset agreements include arbitration as the dispute resolution mechanism. While arbitration isn’t necessarily less costly than litigation, it can offer several important advantages that must be weighed against the other factors of the case. First, arbitration generally offers a speedier resolution than litigation: A final judgment can be reached in as little as six months, which allows each party to focus on business operations rather than on the disputes. Second, companies can select arbitrators who have expertise in accounting, specific industries or certain areas of law. Since complex cases can often be misunderstood by juries, arbitration can represent the best path to an informed ruling. Last, arbitration proceedings are private, allowing companies to keep the details of a case from being dissected in the marketplace. One potential disadvantage of arbitration is a perceived tendency for the arbitrator to “split the baby” — that is, to settle somewhere in the middle rather than granting one side or the other full redress. If a company has identified the potential for a large settlement or if it has built a strong case, litigation may be a more beneficial course to pursue. In addition, the right to appeal a decision is not part of arbitration proceedings, so a company must abide by the ruling. In some cases the buyer or seller might make a claim of fraud in an effort to bring the matter out of arbitration and into litigation. This strategy has been used by companies looking to avoid escrow limits, for example. If the dispute qualifies as a game changer, with a significant amount of damages at stake, litigation may end up being the best course. However, many companies are still favoring settlements rather than going to trial to avoid reputational damage, the disclosure of private information and drawn-out court proceedings.

Given the degree of complexity in M&A, companies that recognize the common sources of disputes during negotiations will be in a much better position to address them during the post-acquisition phase if they do occur. Since litigation often represents the most costly and least efficient channel for resolving disputes, private equity firms that understand the alternatives will be able to devote more of their energy to the core objective of any acquisition: creating value.

CONDUCT THOROUGH DUE DILIGENCE AT EVERY STAGE

Certain due diligence steps traditionally regarded as routine have taken on added importance. The seller’s interim balance sheet should receive particular scrutiny, since in uncertain economic times or cyclical businesses it often isn’t as precise as the quarterly or annual statements. In addition, buyers should augment the accounts prepared specifically for the acquisition process by reviewing the management accounts, which may be more detailed and provide a different picture.

Due diligence tends to be focused on a tightly controlled “data room” where the buyer sees only what the seller wants it to see. Therefore, the challenge for a buyer is to gain access to the people who know about the business, such as employees in key functions who might inadvertently share information. Acquirers should also obtain representations from the seller regarding key valuation assumptions and high-risk accounting areas, such as inventories, accounts receivable and the like.

ESTABLISH CLEAR LINES OF COMMUNICATION

Companies should agree on the accounting policies and methods that the deal is based on — for example, by explicitly discussing the target working capital and how it will be calculated prior to signing the merger agreement. Since issues can emerge once the acquirer transitions the seller’s information to its systems and uncovers discrepancies in how assets and liabilities have been recorded, reaching consensus on accounting standards beforehand can reduce the likelihood of such claims. Access to information can be a key advantage in the event of litigation, so the buyer should seek to “freeze the scene” — that is, retain a copy of all the accounting records that could be used to resolve a dispute. If possible, this information should extend to the e-mail accounts of directors and senior staff as well as file servers. The seller should also keep a full copy of the accounting records on its system; in fact, many companies have been unable to defend themselves adequately because they relinquished access to this information during the course of the deal. Both sides will want to negotiate to prepare the closing balance sheet in an effort to maintain control.

PREEMPT COMMON EARN-OUT DISPUTES

The buyer should clearly define the accounting methods to be used during the earn-out period in order to develop sufficient reserves for balance sheet items such as inventory obsolescence, collectibility of receivables, warranties, returns and other contingencies. Companies should also keep earn-out criteria simple, easily measurable and unambiguous — for instance, by addressing whether or not overhead expenses will be included in earn-out calculations. Last, an earn-out should avoid cliff-vesting earn-out amounts — for example, when revenue hits $20 million, the seller receives $5 million. By making targets and related payments more gradual, sellers can significantly reduce the risk of intentional manipulation.

He is equally well versed in global markets, economics and investing. After an earlier career in consulting, he was the Vice Chairman of Soros Fund Management until he entered the British government. Throughout his career he has had frequent interactions with finance ministers, principal economists and
high-profile business leaders. Moreover, his heavy involvement in the G-20 summits, his tenure at the World Bank and his private sector experience providing financial services and investment strategies for various funds, as well as his early years as a journalist for The Economist, afford Malloch-Brown a unique and nuanced perspective on a wide array of global economic, political and social issues, including private equity and capital flows.

For this issue of FTI Journal, the editorial staff sat down with Malloch-Brown to discuss private equity in emerging markets — especially those beyond the BRIC countries — and to outline some of the opportunities and challenges facing private equity firms seeking to invest overseas.

From your vantage point, what is the current investment climate in emerging markets, and how should private equity investors consider it?

MALLOCH-BROWN: Right now developed markets are experiencing an economic hangover. There are limited growth prospects for companies providing goods and services in these markets, which have matured and continue to face structural deficiencies that impede demand. The prevailing wisdom is to invest in markets showing prospects for rapid growth — whether it’s private equity seeking investments or multinationals doing M&A — and these areas are increasingly not only in the BRIC countries but also beyond them in a second circle of growth, which includes Indonesia, Malaysia, Thailand, Singapore, South Africa, Nigeria, Colombia, Chile and Mexico.

In the BRIC countries, asset values are already high, and it’s hard, although not impossible, to find attractive deals. In contrast, a number of attractive opportunities clearly exist in the second circle. On the other hand, deal sizes can be smaller and exits can be a challenge. As a result, successful investing in these areas requires a very careful balance between deal size, due diligence, knowledge of local environment and an ability to get involved in the operations.

What would you say are the most attractive geographic targets?

MB: Attractive geographic markets that lie outside of the BRIC states include countries in Asia, Africa, Latin America and the Middle East, but the pros and cons of each of these regions must be weighed carefully.

Asia as a long-term option is one of the more important investment alternatives, largely because of its sheer size. Asia already accounts for more than half the world’s population; in contrast, by 2050 the U.S. and Europe will account for less than 15%. The size of the Asian market of consumers and industries means that investors can’t ignore it.

But Asian assets can be expensive, and depending on what you characterize as Asia — India, Pakistan, North Korea, Thailand, Myanmar — it is a region of the world where there is considerable territorial and sectarian conflict, and the effects of very rapid economic growth on economic inequality are also risks. Finally, while the sheer size of Asia makes it attractive, the rapid population growth and rate of urbanization have led to major environmental challenges. So this idea of Asia as El Dorado is not accurate, as attractive as the macroeconomic picture may be.

By contrast, Africa is just now finding its feet in terms of being a target for private equity investors. It is a very small market — unless you have an Africa-wide roll-up strategy — but especially for the long-term players, there are pockets of opportunity across the continent. Corruption remains a challenge in some countries, as well the fact that outside of such countries as South Africa and certain North African ones, investments in roads, infrastructure, health and education are only being made in fits and starts.

Would you say these areas are pro private equity? Are they accepting of Western private equity investment?

MB: Across much of Asia there is a continued desire to attract overseas investment. Hong Kong and Singapore are already highly sophisticated financial centers with homegrown private capital and public markets. But Vietnam and its neighbors — Cambodia and Laos — are now increasingly opening up to overseas private equity, as are South Asian countries such as Bangladesh. Asian countries are divided into the “fashionable” markets, if you will, which are more expensive but easier to enter, and the “less fashionable” markets, which are cheaper but in which success is perhaps harder to achieve.

In Africa, South Africa has a well-managed and sophisticated financial sector. Nigeria is a huge market that is rapidly developing, but it lacks the rule of law and transparency that Western investors generally seek.

Chile, Colombia and Mexico are also well-run countries with investor protections, solid infrastructure and a pro-investor mind-set.

How would you describe changes in the landscape for global private equity investment over the past 20 years? Have the strategies shifted for investors?

MB: Twenty years ago it was clearly more of a buyer’s market. Countries as geographically disparate as Hungary, China and Mexico were desperately competing for the same foreign investment. Now it is more of a seller’s market, by which I mean a country has the opportunity to choose between investors, and private equity investors are therefore going to have to prove that they can be long-term partners prepared to contribute to local society and the growth of the country. They are going to have to be focused on job creation, demonstrate commitment to corporate social responsibility and contribute to tax revenues. In other words, investors seen as friends and partners of the region, as opposed to just foreign money, will have a definite advantage. To achieve this, they will have to strike the right balance.

In Asia, for example, there’s a history of “financial nationalism” that was born in 1997 with its financial crisis and then was reinforced by the 2008–09 crisis. As a result, private equity investors now need to have more sensitivity toward local markets, businesses and leaders. It’s the same in South Africa, where there are a lot of services available locally and resistance to importing services.

In many ways, it is no longer about simply buying and maximizing the value of the components of businesses, but about buying “sleeping national monopolies” that need capital, infrastructure and technology. They have to be shaken up to make them stronger regional performers in a competitive global economy. They need to be capable of becoming acquirers themselves.

This is not to say there is an absence of good management in the emerging markets, because it is typically the younger, more highly trained generations running these businesses. But there is an absence of aspiration in terms of where businesses need to go. And the reporting and transparency and so on must be fit for a private equity market exit strategy down the road.

What do exit strategies look like in these emerging markets?

MB: In all these regions, without doubt, exit strategies at the end of a seven-year investment cycle, for example, are not as straightforward as they are in the developed world — there is not always a liquid local stock exchange on which to list the business. In many cases the journey between acquisition and exit will be longer than seven years because investors are buying family-owned companies without a listing, with limited disclosure and with significant restructuring to do. In other cases these companies are operating in single national markets, but the likely private equity strategy will be to make them players across an entire subregion. For example, the plan may be to acquire a company in Bangladesh and take it to market in India, where the market is much more active. Whatever the plan, it will almost always require a bigger corporate 3transformation than a private equity investment in Europe or North America. It will require more human capital as well as monetary capital, and therefore it will be a hands-on investment.

In terms of global regulation, are there any reforms or trends on the horizon that will impact private equity in emerging markets?

MB: I think a significant inflection point will be the November G-20 Summit in Seoul, South Korea. While the principal focus will be reform of the banking sector, France and Germany have insisted that private equity remain on the table for reform discussions. Since the April 2008 G-20 Summit in London, which I helped organize, a lot of the energy for reform has dissipated. This is because we’re now viewed as being on the other side of the crisis, and looking back, many are saying it was a subprime crisis or a crisis created by overleveraging and that private equity was peripheral to the meltdown. But others see private equity as a potential source of future crises, so there is not exactly consensus. And, of course, were there to be further economic setbacks and anything approaching a double-dip recession, the Seoul meeting would acquire the same political crisis stages that the London meeting had in 2008, in which case all bets would be off as to what leaders might choose to do.

As the head of investigations at the Manhattan District Attorney’s office for 15 years, my office brought case after case against companies and individuals seeking kickbacks, rigging bids, issuing false invoices and engaging in outright theft. This took place across a wide scope of industries and all manner of public projects. The theft routinely amounted to a tenth of the value of contracts. In fact, one group of insurance fraudsters went as far as to brand themselves the “Ten Percenters.”

With the equivalent of hundreds of billions of dollars being pumped into economies via a tangle of national, regional and local authorities, only the least ambitious thieves are not actively engaged in gaming stimulus systems. Take the U.S. bank bailout package, or Troubled Asset Relief Program (TARP). In its latest report to Congress, delivered in late January, the auditor of the $700 billion program noted that its confidential fraud hotline received nearly 10,000 tips in its first year of operation. The suspected frauds run the gamut, including “accounting fraud, securities fraud, insider trading, bank fraud, mortgage fraud, mortgage servicer misconduct, fraudulent advance-fee schemes, public corruption, false statements, obstruction of justice, money laundering, and tax-related investigations,” according to the audit report.

The auditor describes its fraud-fighting arm as a “sophisticated white-collar investigative agency.” This group contributes to a special task force created to fight financial fraud related to stimulus programs, with other members drawn from a variety of criminal and civil law enforcement agencies and regulatory bodies. This approach is not ideal. Government agencies have a tendency to take too long to staff up – for example, the financial fraud task force held its first meeting in December 2009.

A Little Goes a Long Way

The problem is not confined to the world of high finance. Significant shares of stimulus funds are being devoted to construction and infrastructure projects, areas highly susceptible to fraud (see table overleaf). Late last year, the U.S. Department of Energy’s inspector general published a report, Management Challenges at the Department of Energy, that lamented staffing shortages and other internal weaknesses. Similar agencies around the world face major challenges in keeping track of the flood of stimulus money meant to subsidize everything from large public works projects to small home-improvement measures. The influx of funds is putting already understaffed offices under great strain, providing opportunists with an easy route to ill-gotten gains.

The solution is to devote a small share of stimulus funds to fraud prevention and detection programs. This way, the authorities can protect projects without struggling to stretch already thin resources.

When it comes to fighting fraud, a little goes a long way. Meaningful prevention, detection and investigation can be funded with no more than 2% of the stimulus money dispensed. Thus, a local authority receiving $50 million for an infrastructure project should set aside $1 million to fund anti-fraud efforts. If, in the end, the fraud-fighting initiative costs less than this, the remainder can be returned to the project’s budget.

In addition to funding adequate prevention budgets, the effectiveness and efficiency of spending can be enhanced further by engaging private-sector players. Former government prosecutors, regulators and detectives with experience in investigations abound in private practices. If these resources are tapped, watchdog programs become both more agile and less costly, as greater competition among bidders drives down the overall price of prevention.

Some might object to a perceived windfall to private companies. But these concerns are easily addressed, as it should be seen as spending 2% in order to save 8% in forgone fraudulent waste. The alternative, however well intentioned, involves shuffling resources among law enforcement agencies that are already swamped with corruption cases growing as fast as governments can approve bills to boost stimulus spending.

The appetite of fraudsters to siphon off money from public projects is insatiable. Whatever the intentions or circumstances that surround a particular stimulus plan, by its nature these funds represent a pay day no criminal can ignore, particularly when times are tough. As a result, a precondition of putting honest people to work is putting fraudsters out of business.

Amid the hubbub, it is important to remember a central fact about the banking crisis: it was caused by the failure of the sector to deliver in its fundamental societal role – i.e. to provide the economy with its money cabling and pipework, efficiently assess and spread risk, transform maturities and allocate resources where they are needed. The big question is why? Clearly banks are not the only ones to blame, but if we are to avoid an early repetition of the events of the past three years, it makes sense to work out some of the reasons for those events and to address them.

A Higher Purpose

Banks are different than other companies. If a Walmart or a General Motors goes bust, the consequences will be painful for thousands of workers and investors, perhaps even taxpayers. But there are alternative suppliers. The failure of a bank, however, creates serious practical problems for its customers, triggers panic and has repercussions that can be difficult to contain.

Our banks are essential to our way of life to a degree greater than their mere commercial role would indicate. But that lesson was not learned from the costly savings-and-loan problems at the end of the 1980s or the LTCM hedge fund crisis at the end of the 1990s, or the many other incidents that might have been taken as warnings that all was not well with the financial system.

This obliviousness had a parallel in the culture. Oliver Stone had intended Gordon Gekko – with his “greed is good” ultra-laissez faire credo – to be a cautionary tale. What happened? Thousands of young bankers emulated Gekko’s look, with greased-back hair, two-tone shirts and colorful suspenders.

Similarly, in a widely cited article in the November 2008 issue of Portfolio, author Michael Lewis recounted that when he wrote his 1989 book Liar’s Poker, which told of the reckless culture he found as a young banker working for Salomon Brothers, he too expected it to serve as a warning to readers. As Lewis writes: “I expected them to gape in horror when I reported that one of our traders lost $250 million, but six months after Liar’s Poker was published, I was knee-deep in letters from students who wanted to know if I’d any other secrets to share about Wall Street. They’d read my book as a how-to manual.”
These stories characterize a view of capitalism as being most effective when untrammeled. But the lesson of the past three years – at least from this European’s point of view – is that it ain’t necessarily so.

Feeding the Beast

Lewis’s Portfolio article goes on to chronicle, mainly through the more recent experiences of hedge fund manager Steve Eisman, how the culture fomented in the 1980s culminated in the subprime feeding frenzy of the past decade.

Subprime can be taken as the near-fatal symptom of the collision between Main Street and Wall Street, brought about by the reversal in their traditional relationship. Whereas the banks’ primary role should be to lend to businesses and individuals to facilitate their commercial activities, they encouraged people to borrow, sometimes recklessly, in order to feed the “originate-and-distribute” model that relieved them of any responsibility for loans that defaulted.

In a reality-based market, subprime lending should have been a small, specialized corner of banking, lending at appropriate terms to those with bad credit risk. Instead, it grew to account for 14% of all first-lien U.S. mortgages, with a nominal value approaching $2 trillion. Other variations of mortgage-backed securities and collateralized-debt obligations grew and proliferated, with credit-default swaps supposedly mitigating the risks.

The terms of the loans – eight or 10 times loan-to-value against mobile homes and low-cost urban dwellings – were virtually guaranteed to lead to default. It was a transaction-driven market that gave little attention to traditional models of risk management.

Because banks are essentially “virtual” businesses – their products are almost all variations of accounting entries wrapped up in legal contracts – they can scale up to the extent their regulatory capital ratios and processing systems allow. They also have a nearly limitless appetite for complexity.

So not only did banks balloon in size but too many managers didn’t fully understand their products or appreciate how these products impacted each other. When the financial system began to implode, another inherent weakness of banks was exposed: the fragility of liquidity. Funding short term in order to lend long makes banks susceptible to issues of confidence in both retail and wholesale money markets (as Bear Stearns learned after losing access to the overnight repo market). To paraphrase Warren Buffett, when asset prices fell and the liquidity tide went out, some banks were caught naked.

Regulatory Renaissance

What allowed this to happen was a combination of several factors:

• the blurring of the lines that had separated commercial banks and investment banks since the passage of the Glass-Steagall Act in 1933;
• high liquidity and low interest rates;
• neffective regulation in areas such as capital standards and the use of ratings;
• a focus on “fair value” as an accounting driver.

The dismantling of the Glass-Steagall Act was done bit by bit under various governments over more than two decades, with legislation usually following practice; but the biggest symbolic piece in the U.S. came with the Gramm-Leach-Bliley Act – also known as the Financial Services Modernization Act – in 1999, which essentially reversed the last vestiges of Depression-era rules.

U.S. President Barack Obama now appears likely to rebuild some of this regulatory architecture, with proposals tabled to separate federally insured bank business from proprietary and speculative activities. There are also proposals to overhaul the oversight structure, with some calling for a lesser role for the Federal Reserve, giving senior authority in an oversight council to the Treasury. Whatever structure is adopted in the U.S., it is likely to set the tone for the rest of the world.

The UK is on course to rebuild some of its regulatory defense walls that had been dismantled, and strengthen its key regulators, such as the Financial Services Authority. But specific proposals to shore up the capital bases of UK financial institutions – including “contingent capital,” a kind of quasi-equity, and a levy-based resolution fund – are controversial and still under discussion. As countries steer a course between the need for a better-regulated system and maintaining competitive advantage, it remains to be seen what oversight gaps might be left unfilled.

However, change must go beyond legislative reform, for it wasn’t simply deregulation on its own that can be blamed. Regulators on both sides of the Atlantic went into this crisis with the powers to approve or disapprove key management, the powers to vary capital to their own requirements and the power to stop individual institutions from doing business they didn’t like the look of. But most regulators didn’t exercise those powers.

Macro-Prudential Supervision

There was also egregious failure in terms of macro-prudential supervision – i.e. supervision at a level that takes into account the broader economy – with no one looking at the whole market and saying, “we have high asset prices, too much liquidity – we need to prick the bubble.” Or, to borrow the phrase attributed to William McChesney Martin, the Federal Reserve’s longest-serving chairman, central bankers failed in their primary role, which is “to take away the punch bowl just as the party gets going.”

In the UK, there was no role for macro-prudential supervision in Prime Minister Gordon Brown’s regulatory construct, where it fell between the stools of the Treasury, the Financial Services Authority, and the Bank of England. One of the starkest illustrations of this was the way Icelandic institutions were able to collect £10 billion from UK depositors. That couldn’t have happened in France, where bank regulation has historically been more intrusive.

The New Normal

What should a new regulatory system look like? There are three main elements required for effective regulation, two of which are relatively simple conceptually and one that requires a fundamental shift in thinking about bank governance.

The first element is macro-prudential supervision. This will help to keep banks safe from policies that may facilitate asset price bubbles that draw in borrowers and lenders alike, often at the wrong point in the economic cycle. Oversight requires less bureaucracy and more bright people (with lots of data) who are savvy enough to spot out-of-control liquidity and asset prices, and consequent bad borrowing and lending practices, and are empowered to stand up and say “Okay, we are approaching dangerous territory.”

The second element is customer protection. While fairly straightforward to design, implementation is another matter, as highlighted by the opposition to the proposed U.S. Consumer Financial Protection Agency. Opponents have argued that such an agency could stifle competition and raise the cost of finance for consumers. Its supporters argue that buyers of financial products are inevitably at a knowledge disadvantage compared with the providers, and need protection. It’s a battle about getting the right balance of red tape and market freedom.

The final element is also the trickiest: prudential oversight at the institutional level. Any well-run financial institution is comprised of management; the business; the platform – i.e. technology, processes and information systems; liquidity; and capital. Supervisors need to ensure that all of these functions are present and fit for purpose. In particular, regulators must ensure that management is equal to the challenge of running the business and is adequately challenged – by internal firm functions (finance, risk, internal audit, compliance, and legal) as well as by external functions (non-executive directors, auditors and regulators).

The real issue with supervision at the level of an individual firm is the competence of management and how they’ve organized the business. Oversight challenges have been brought to light by the financial crisis. To cite just one example, the head of group regulatory risk at HBOS, the fifth largest UK bank, claims he was forced out by management in 2004 when he raised concerns over excessive risk-taking, particularly in large commercial and real estate lending. Fast forward to September 2008, and HBOS is taken over by Lloyds in the days after the collapse of Lehman Brothers. The credit losses which have emerged at HBOS are far larger than anyone could have anticipated.

In the year ahead, a number of regulators are set to introduce requirements for better governance. The new norm will be a separate risk committee with wide-ranging powers and a chief risk officer (CRO) who can only be fired by the board. A further step to strengthen CROs’ independence would be to establish a statutory direct line to the external regulator. This change will be reinforced by new requirements around non-executive directors and the engagement of institutional shareholders. And, of course, the supervisors themselves are reinforcing their processes and their people. However, these changes will not amount to much unless there is a clear benchmark of what constitutes robust internal governance.

Accounting philosophy also needs fundamental reform. Accounting has not served banking as well as it might, with the failure to harmonize between different jurisdictions and the aggressive adoption of “fair value.” Fair value can be the wrong type of transparency – it cements a disconnect between real investment horizons and what the numbers show. It tends to accelerate profit recognition (and therefore bonus and dividend payouts), operating in ignorance of the business cycle to which banks are prone. Bank accounting should be more about evaluating cash flows – a “maturity ladder” approach.

It is somewhat bizarre that regulators determine banks’ capital requirements and accountants determine the quantity of capital in place, yet the two have no formal coordination. Having those two sets of people talking would send the right signal to bankers about the kind of regulatory regime they can expect. It is starting to happen, but there are obstacles in the way – not least a difference of opinion between the U.S. and everyone else.

Sorting out regulation is partly about returning to banking’s first principles. As economist John Kenneth Galbraith said, “The process by which banks create money is so simple that the mind is repelled.” Over the past two decades, the accuracy of that observation seemed to diminish. The banking crisis creates the chance to simplify and clarify, and it’s an opportunity that governments should grasp.

Executive compensation does not simply mean base salary; it is the total remuneration an upper-level manager receives in a corporation. This typically includes benefits such as bonuses, deferred and restricted stock, vesting periods, pensions and perquisites, as well as terms of employment including performance metrics, clawback provisions, and golden parachutes.

A Real Opportunity to Improve Incentives

Today’s situation risks more than bad public relations for public companies: there is a danger of missing out on an opportunity to improve incentives for top managers to increase the long-term value of their enterprises. Taking advantage of this opportunity has major ramifications not only for corporate stakeholders, but for society in general, as it has the potential to create more productive, durable, and valuable companies.

There is a real need to bring a dispassionate analysis to executive compensation and go beyond the superficial caricatures of unbridled greed. Economics can help by shining a light on the purpose of a corporate form of organization and the costs and benefits of comparative mechanisms for aligning executives’ behavior with shareholders and the broader stakeholder community. Keep in mind that well-constructed executive compensation packages are necessary but not sufficient for long-term value creation. 

Recognize the Objective

What is the goal of a corporation? Maximizing the long-term total enterprise value of the firm has long been understood as the chief corporate mission. Simply put, this means expanding the organization’s market reach or improving real productive capacity. Establishing a culture of long-term value creation entails gaining the loyalty and commitment of all constituencies, including employees, suppliers, and the wider community. The key challenge for management is to create the corporate vision, strategy, and tactics to unite and guide all constituents. So much depends on the stock of trust and flow of honest information.

Aligning Interests

A corporation needs to ensure that executive leaders’ incentives are aligned with shareholder interest in long-term value creation. Unlike owner-managers of small firms, executives at large enterprises often have only a small portion of their own equity at stake. However, this disparity leads to a gap in their interest as the “agent” looking after the interest of the “principals” (e.g. shareholders and debtholders). What’s more, they have an information advantage over principals, which can give rise to a serious conflict of interests and accountability problems. The economics of principals and agents helps organize thinking about how the structure of the CEO’s compensation will affect managerial behavior in pursuit of the objectives of the firm’s various stakeholders.

The principal-agent relationship is difficult and costly to maintain effectively over the long run, which means it is critical to take advantage of alternative alignment forces and mechanisms such as government regulation to monitor against fraud and accounting manipulation. In addition, the market for corporate control offers outside active investors and strategic companies a way to act as a disciplinary force against managers who do not maximize the value of their firms and stray too far from their shareholders’ interests. But recent events suggest that this discipline has limitations, especially in the recent era of overvalued equity.

The Role of Corporate Governance

Corporate governance is a mechanism for aligning principal-agent interests and incentives, encouraging accountability. How does it accomplish this? Corporate governance seeks to reconcile the relationships among the CEO, board members, stockholders, and the outside financial community of analysts, bondholders, and other creditors by clearly assigning responsibilities, measuring performance, and rewarding or penalizing managers in line with their impact on the firm’s long-term value creation.

There are some convincing examples that the sine qua non of a well-run, healthy company is effective coordination of the terms of executive compensation with the corporate governance function: rules, monitoring, and other incentives promoting effective relationships among important constituencies. Corporate governance, in theory at least, serves as a kind of “check and balance” for a corporation to ensure that executive compensation packages attract and retain the right people, hasten the departure of the wrong people, and provide incentives for high performance.

Dealing With Short-Termism

A significant part of the problem in executive compensation can be traced to how compensation packages evolved and became more closely tied to short-term stock prices. For example, pay plans have tended to move away from using fixed salaries. Compensation plans are now concentrated in stock options. And deferred stock and stock purchase options, which tend to vest over short time periods, are common. Moreover, options are typically tied to short-run publicly traded stock prices. The table overleaf shows the recent trend of executive compensation increasing in the form of equity.

Of course, CEOs are supposed to be paid for performance, but this shift in the make-up of compensation packages has led to some unexpected consequences: it has skewed managerial decisions to favor the short term and created a marketplace hothouse of overvalued equity. 

The introduction of stock options and restricted stock grants with such features as short-term vesting periods seemed to be the panacea for aligning shareholder and manager interests. Equity compensation soon evolved into the greatest portion of total executive compensation. Simultaneously, its growth facilitated a climate where information became less reliable, although superficially more plentiful, making it increasingly difficult for analysts or investors to make reliable decisions – for example, financial analysts underestimated Microsoft’s quarterly earnings 41 out of 42 times, according to an SEC investigation and cease and desist order in 2002. 

Imagine the CEO of an international engineering and construction company wrestling with whether to bite the bullet and overhaul the firm’s engineering software and invest in an even more costly three-year employee training program. If implemented, the costs of the investment could impact earnings and the company’s share price, affecting the CEO’s various stock options and restricted stock share over the next three years. Delaying the investment may benefit the value of the CEO’s personal stock options, but the longer he waits, the greater the decline in long-term company and shareholder value as his engineers continue to fall behind.

Linking Compensation and Corporate Governance

So, what can this analysis tell us about the present controversy over executive pay packages? Is the controversy symptomatic of a real problem, or an unfortunate matter of timing and appearances? What is clear is that executive compensation and corporate governance are inextricably linked and substantial effort and cost are required to better align incentives and reduce opportunism of all corporate stakeholders – top executives, board chairs and members, stockholders, debtholders – and the financial community.

The seminal idea behind the use of restricted stock grants and stock options was to enhance the performance of managers, or make “pay for performance” a reality in the corporate world. But the situation was still far removed from the ideal of all responsibility and the fruits of performance concentrated in the owner-manager. Granting stock options or restricted stock shares that vested quickly or over short time-horizons contributed nothing toward managers having “skin in the game.” (Private equity, hedge funds, LBOs and other similar entities have largely solved the “skin in the game” problem in the way that managing partners are compensated.)

It soon became clear that grants of stock options and restricted stock were not free of cost to companies and were also failing to have the desired effect of making top management more vested in companies’ long-term goals. In response, a number of corporations began to require CEOs to purchase and hold stock with after-tax dollars or variants with similar effects. Some companies that exchanged cash bonuses, grants of options or restricted stock for their longer-term equivalents include ADC Telecommunications, Arkla, Avon, Baxter, Black & Decker, Clorox, EKCO and General Mills. FTI Consulting will be monitoring the performance of these companies and others that adopt similar compensation strategies over the coming years.

There are other examples of large corporations changing the way in which they incentivize their leading talent. The CEO and COO of fuel wholesaler World Fuel Services have introduced compensation plans with equity grants that vest only after five years or more and the CEO is reported by Forbes.com to have two-thirds of his personal wealth tied up in stock in the company. Meanwhile, energy holding company PG&E Corporation uses an earnings-per-share hurdle to set its bonus for its CEO. To receive the full amount, the CEO must also meet customer and employee satisfaction targets.

The president of upscale retailer Nordstrom, who happens to be a descendant of the company’s founder, receives a portion of pay in performance shares that vest three years after they are granted and only
if total shareholder return is positive and above the average among retail peers. His shareholdings in his company have an approximate worth of $60 million.

Changing Corporate Culture

Building a culture of responsibility and accountability is essential to address issues around executive compensation. Greater transparency and credible, independent checks and balances are the minimum requirements to regain shareholder and broader stakeholder trust. Companies should also put in place a system that identifies potential conflicts of interests and implements countervailing measures. These include:

• Avoid the inherent risk of hiring the same compensation firm for the rank-and-file employees and the CEO or other top managers.
• Implement a set of measures to monitor accounting and other reporting practices that suggest weaknesses in corporate governance.
• Do not provide multi-period compensation packages.
• Carefully monitor CEO and financial analyst relationships.
• Establish an independent compensation committee composed of board members without CEO participation.
• Commission financial analysis of compensation packages with alternative scenarios and expected outcomes in terms of attraction, separation, and incentives.
• Limit to only the CEO and certain top executives the grant of options and deferred stock, and with these, make every effort to establish true estimates of costs to the company and their impact on the CEO and firm value.

As a critical component of corporate governance, executive compensation must constantly strive to align the incentives of top managers with shareholders and broader stakeholders. As the value added by management is difficult and costly to measure, monitor and verify, this is a complex and challenging undertaking for which much is at stake.

Clearly, ensuring effective measurement and monitoring of the value added by top management is complex and costly but, equally, it is essential for protecting stakeholders and increasing long-term total enterprise value of the firm.

A legal or regulatory investigation, lawsuit or a government audit has a voracious appetite for records. Records often show what people did and what they were thinking when they did it.

But the quantity of records in any enterprise is swelling thanks to the incessant growth of computer processing and storage capacity, increasing modes and usage of digital communications and the proliferation of multimedia applications. According to a 2008 study by International Data Corporation, around 1,200 exabytes (1.2 trillion gigabytes) of digital data will be created this year. But managing all those records is challenging. It is easy to lose them or render them practically unfindable.

In a surprising way, the rise of electronic records is changing the law. Legal authorities are increasingly suspicious, even frustrated, when an enterprise (private or public sector) fails to keep good e-records. For the authorities, the attitude is that all those computer records are critical for accountability and dispute resolution, and therefore they should be kept available for electronic discovery. Further, if records have been buried or destroyed, authorities are prone to sense wrongful intent.
 
As more legal rulings declare that e-records must be retained and organized, corporations and government agencies are in a quandary. Trying to keep everything forever is absurd. Traditional record retention practices, which were developed when paper dominated, now seem out of date, but there is little consensus on what practices to follow instead.
Meanwhile, though courts are not the most tech-savvy institutions, neither are they clueless. The court system is learning fast about topics such as digital forensics and backup tapes. Leading judges such as U.S. Judge Shira Scheindlin are issuing thoughtful opinions on the growing responsibility of counsel to locate and preserve e-evidence as soon as a lawsuit is anticipated – and those opinions quickly become famous via the Internet.
Two other ideas are gaining currency among judges. One is that the discovery of electronic records should be a cooperative process, where litigants are expected to be candid and forthcoming, even in an adversarial court system like the U.S. Another is that records should be found and revealed in phases, such that the easier-to-find records (e.g. more recent emails) are divulged promptly, and other records are resurrected later, but only if the progress of the lawsuit justifies the effort.

Although U.S. courts have been at the vanguard of e-discovery, the phenomenon is global, as the timeline below shows.

What does the future hold? First, the interest of legal authorities in electronic records will only grow. Second, as businesses continue to embrace social networks such as Twitter and rich media such as video conferences, the quantity of e-data will continue to skyrocket. 

At the same time, the cost of storing and searching records will continue to fall. Technologies such as cloud computing promise to make enterprise archiving more effective for internal control and for responding to e-discovery. It’s not all good news, though. The pressure on corporations and governments to improve the way they preserve data is only going to increase.

From authorities, one message rings clear: they tolerate early record destruction less today than in the past. For management, this message means the enterprise must re-examine its policies on which records to keep and how long to keep them. Although no single solution fits every enterprise, simply to stick with historical practices is dangerous. Those who do not up their game should expect to be penalized (see the implications in the Philip Morris case on our timeline).

What’s more, among enterprises that hold records, an old idea is losing favor. The idea that records are dangerous – and should be purged quickly – holds less merit. Plentiful, computer-searchable records are a valuable asset, which can help management maintain control and be marshaled to defend against bogus allegations.

Many enterprises are retaining more records, especially emails, for longer time periods. These records can constitute a valuable day-to-day journal of activity. Retained records present the opportunity to demonstrate that a corporation is a good organization, employing good people, trying to do their best. Sure, people will make unfortunate utterances in email. But in an enterprise of largely well-intentioned people, there should be a negligible number of smoking guns.

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This may be a striking example of international investment gone wrong, but three factors are contributing to an increasing number of companies having to engage in disputes abroad. First, today’s global economy demands greater participation in foreign markets, sometimes involving investment into those markets; second, these foreign markets often have dispute resolution processes and practices unlike those that companies are familiar with in their domestic markets; and third, many cross-border investments are protected by international treaties that stipulate that any associated disputes will be resolved via a particular form of international arbitration.

Success or failure – should arbitration be required – depends on a number of factors: the governing law, the seat of arbitration, and the legal precedent or contractual mechanisms for defining and calculating damages specified in the arbitration clauses of contracts or investment treaties. Company executives and boards of directors would be advised to treat arbitration clauses that establish the protocols for resolving commercial disputes as key business terms and to familiarize themselves with processes of international arbitration.

The statistics speak for themselves. There has been a steady rise in international arbitration during the past 20 years but the current climate marks a spike in new cases, sparked by the prolonged global economic crisis. At the London Court of International Arbitration (LCIA), new claims filed increased by 55% between 2007 and 2008, and again by over 14% in 2009 to 243 cases. Statistics from the Paris-based International Chamber of Commerce (ICC) and the Swiss Chambers’ Court of Arbitration and Mediation (SCCAM) tell the same story. ICC new cases increased 11% in 2008 and a further 23% in 2009, to 817 new claims. New SCCAM claims rose 15% in 2008, before leaping 53% in 2009 to 104 requests for arbitration (the majority of which involved non-Swiss parties). The Dubai International Arbitration Centre reported a doubling of cases in 2009 compared with 2008, as the economic crisis finally caught up with the Middle East. Similar trends have also been observed in Asia. In response, major law firms around the world are expanding their specialist teams to cope with the demand and relocating arbitration specialists to emerging economies and centers of arbitration, principally in the Middle East and Far East.

What Is International Arbitration?

International arbitration is often used instead of litigation conducted through domestic courts when resolving cross-border commercial or investment disputes. These disputes are often large and complex, and the amounts in dispute regularly run into hundreds of millions or even billions of dollars. According to statistics from the LCIA, 25% of the claims filed with it in 2008 included damages claims valued at more than $5 million. The ICC reported a sharp rise in the number of high-value claims in 2008, with 31 new filings for damages of more than $100 million and four for amounts in excess of $1 billion.

National laws are of limited relevance to warring parties from different jurisdictions, with their contrasting legal systems and procedures. As a result, international arbitration operates beyond national borders, where parties have significant influence over the identity of their arbitrators, can often choose in advance the law and procedure under which any cases will be heard, and can agree to convene in a neutral venue.

Unlike litigation, there are no judges, juries, public courtrooms, or intrusive media. There can be limited formal procedure, and extensive discovery and electronic discovery are rare (in contrast to jurisdictions such as the U.S.). Instead, arbitration is flexible, decisions are often confidential, and cases, in principle at least, are cheaper and quicker than litigation in courts of law. The confidential nature of arbitration means its protocols and practices (which can vary between different arbitration forums) are not widely known and there are comparatively few legal and subject matter experts who are familiar with the ways in which particular issues have been treated.

An arbitration panel can consist of a single arbitrator. More commonly, and certainly for the larger disputes, the panel typically consists of three people – one appointed by each party, and a chairman selected by the two party-appointed arbitrators. The arbitrators may be selected for their expertise in specific areas of law or industry (greater specific expertise than might be the case with a trial judge assigned to a case), depending on the issues. Getting the right chairman can also be crucial given the need to manage the complex procedure adroitly and, as a result, the world’s top arbitrators are in high demand. In practice, given the calls on the leading arbitrators’ time, assembling a three-person panel for procedural rulings, hearings, and preparing judgments can add significantly to the timetable for resolution of the dispute.

Despite arbitration’s less formal structure than traditional court proceedings, awards are binding and typically easier to enforce internationally than court judgments. This is due to mechanisms embedded in the international treaties underlying the main types of arbitration.

Commercial Arbitration and Investment Treaty Arbitration

There are two main types of international arbitration. Commercial arbitration has close parallels to litigation. Cases arise when the parties to a dispute have a pre-existing agreement, often enshrined in the contract giving rise to the dispute, to settle any difficulties by arbitration rather than litigation. The parties to commercial arbitration are mostly private companies and, to a lesser extent, state-owned enterprises.

Investment treaty arbitrations on the other hand arise out of one of the various existing investment treaties. Some such treaties are well known – the North American Free Trade Association (NAFTA) treaty being the best example – or have recently risen to prominence, such as the Energy Charter Treaty (ECT), under which Russia faces claims of many tens of billions of dollars from former investors in the Yukos Oil business.

Many of this second category of disputes, however, arise out of Bilateral Investment Treaties (BITs), under which pairs of countries have agreed to reciprocal obligations toward investors from each other’s jurisdictions. There are as many as 3,000 such treaties in existence. Some international investors have made investments via subsidiaries established in countries other than the parent’s jurisdiction but which are considered to have more favorable BITs with the investee country than the parent company’s jurisdiction. Little known to the public, BITs are also attracting attention for two reasons. First, due to the increasing number of claims they generate – seven new investment arbitration cases were registered each year with the International Centre for Settlement of Investment Disputes (ICSID), the main institution hearing such claims, on average between 1995 and 1999, compared with 26 new cases a year on average between 2005 and 2009. Second, due to the size of some claims and awards. FTI’s International Arbitration team was recently involved in a claim pending against a South American government worth up to $12 billion and also in an award of more than $125 million – the largest made by the ICSID Tribunal to an individual claimant – against a Middle Eastern country in connection with an expropriated leisure development.

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Venues for Arbitration

Arbitrations are organized by a number of institutions. The Washington-based ICSID hears the majority of investment treaty disputes, including most BIT disputes, as well as ECT and NAFTA disputes. The leading commercial arbitration bodies include the ICC, the LCIA, and the SCCAM. Arbitral bodies are raising their profiles in rapidly developing parts of the world – for example, Dubai’s DIAC was established in 1994 as the “Centre for Commercial Conciliation and Arbitration” (the LCIA opened in the Dubai International Financial Centre to operate free from influence of the local government). And others are forming – for example, a new arbitration institution has just been announced in Australia. Arbitral institutions each have their own procedural rules, and their secretariats coordinate the selection of arbitrators and the handling of cases.

Unlike litigation, hearings can take place at locations selected by the parties, not necessarily in the country of the arbitral institution. Although many ICC hearings are heard in Paris, they are also held in London and other cities. Popular cities for conducting hearings generally are New York, Washington, London, Paris, Vienna, Geneva, and Stockholm – locations perceived as neutral, well resourced, easily accessible, and attractive to parties and arbitrators alike.

The Appeal of Arbitration

A major factor in the growth of international arbitration is neutrality. It’s one thing to bring a claim for breach of contract in one’s home jurisdiction, it’s quite another to tackle the laws, language, and perceived limitations of foreign jurisdictions. This is particularly challenging in the developing world, where legal systems and legal precedent may be at earlier stages of development, and where dispute resolution may be more susceptible to political or other influence.

If the contract is with a national government (or equivalent), resolving the dispute locally may be particularly problematic given the potential immunity issues and enforcement challenges. If relations with a foreign party turn sour, no multinational would want the other party to have “home advantage.” In one recent case involving our experts, a contract between a Japanese supplier and an Indian sales and marketing company contained a dispute resolution clause stipulating arbitration in London through the LCIA.

What Are the Trends?

As the table on page 39 shows, the total number of new international arbitration cases across a representative set of major arbitration forums fluctuated in the range 2,100 to 2,400 between 2000 and 2005. The number of cases began to rise in 2006 (+11%), ahead of the credit crunch, and accelerated in 2008 (+19%). On the basis of the available statistics, this trend appears to have continued in 2009. The increase has been observed across nearly all forums but the proportion of cases handled by Western-based arbitration bodies has fallen steadily from a high of around 62% in 2003 to around 55% in 2008.

We expect this drift towards Middle and Far Eastern arbitration centers to continue, in part because of the relocation of some resources to these regions by leading law firms, increasing their ability to handle such disputes locally rather than in the European or U.S. arbitration centers. We might also expect most of the major disputes to continue to be handled by the Western-based bodies, at least in the medium term, given their greater experience of such cases.

Historically, many investment treaty cases have related to large infrastructure investments in utilities and disputes over natural resources. In 2009, 25% of all ongoing ICSID cases related to oil, gas, and mining, with disputes relating to electricity and energy generation (13%), transportation (11%), and water and sanitation (8%) also prominent. Commercial cases also often relate to natural resource issues – for example, in 2009, around 30% of LCIA referrals related to commodities contracts, presumably fueled to a certain extent by recent volatility in commodity prices.

It is tempting to ascribe the recent surge in claims solely to the global economic crisis, with the total number of cases falling off once economies and companies recover. However, the underlying economic trends may suggest a different view. One illustration of the scale of investments, and hence the potential for cross-border disputes, is the Foreign Direct Investment (FDI) dataset compiled by the United Nations Conference on Trade and Development.

The tables below and left set out FDI statistics for developing economies globally and transition economies (the latter term refers to the former Soviet Union and Central and Eastern Europe). They show investments in enterprises (via equity, loans, and retained profits) both on an annual basis (“flow”) and the estimated cumulative total (“stock”). Inbound and outbound investments are shown. Many of the investments in enterprises in developing and transition countries will be in strategic industries potentially exposed to expropriation by governments, or to unexpected revisions to regulatory, fiscal, or tariff regimes. Other investments will be via joint ventures with a local partner. The FDI statistics therefore provide a guide to the scale of the exposure to cross-border disputes under both investment treaties and commercial arbitration.

The growth in both annual flows and the cumulative stock of investments, since 2000 in particular, is clear. This recent body of investment could prove significant for future levels of international arbitration as recent LCIA statistics indicate around 30-40% of new cases each year relate to contracts signed between seven and 10 years earlier. Importantly, these data exclude contract-based arrangements such as agency agreements, distribution agreements, and intellectual property licenses. We would expect these forms of cross-border commercial arrangement to increase over time as developing countries mature, and the services component of their economies grow along with the demand for Western goods and services. The potential for future cross-border disputes may therefore be even greater than suggested by the FDI statistics.

Although international arbitration is often thought of as relating to investments by North American or European parties in developing economies, the growth of outbound FDI by the emerging economies themselves is also significant (such as recent commercial investments announced by Chinese and Middle Eastern investors and sovereign wealth funds in various African countries). We would expect this trend to continue as these territories’ share of the global economy grows.

It is important, as well, to recognize that the future of international investment treaty arbitration is not solely about emerging economies. For example, in 2009, Swedish power generator Vattenfall brought an ECT case against the Federal Republic of Germany. The action also illustrates the possibilities (and the complexities) presented by the different strata of national laws, regional law (such as European law), and international law such as the ECT.

Commercial cases have historically been more diverse in nature than investment arbitration, arising from disputed contracts across a wide range of industries. FTI experts have recently been involved in commercial disputes in mining, construction, hedge funds, telecoms, chemicals, and ports. In the current economic climate, disputes arising out of troubled M&A deals are particularly widespread. Commercial disputes are pursued through arbitration, rather than through the courts, only if both parties have assented via an arbitration clause in their contract or at the time the dispute arises. Accordingly, certain types of claims, which do not rest on an underlying contract, are less frequently arbitrated. Such claims include patent infringements, most antitrust claims brought by companies, and many product liability claims.

In response to this complex picture, many leading international law firms are increasing their commitments in selected markets. For example, law firms have reinforced their local presence in Hong Kong in response to the rapidly rising number of cases in the region. However, the level of resources based in Asia is still less than in Western cities.

An informal review of law firm websites confirms that despite the recent relocation of international arbitration specialists to the Middle East and the Far East, firms continue to concentrate the large majority of their practices in traditional centers such as New York, London and Paris. Although the strategies vary, it also appears that the leading UK law firms have moved somewhat faster than their U.S. counterparts to establish international networks of arbitration practitioners.

The Shortcomings of International Arbitration

Of course, international arbitration is not without its detractors. While its flexibility and limited discovery – certainly compared with U.S. norms – should mean shorter hearings, less preparation, and significantly lower costs, participants sometimes complain that in practice it can be as expensive and time-consuming as litigation. Take the battle for Poland’s leading mobile operator, PTC, between Vivendi, Elektrim, and Deutsche Telekom, which has mushroomed into a complex web of litigation and arbitration in various tribunals across Europe. One of the challenges has been the interaction between the rulings of different domestic courts in Poland and various arbitral panels. Then there’s the ongoing saga of the Ä50 billion claim brought against the Russian Federation by former shareholders of Yukos Oil. Running since 2005, this is the largest arbitration claim to date and one that is unlikely to be resolved for many years.

Arguably, with such significant amounts of money at stake, parties are not anxious to rush proceedings. Such cases involve multiple parties disputing sophisticated issues, and doing so takes time. However, due to the widespread binding consent given to arbitration in many commercial contracts and investment treaties around the world, international arbitration is here to stay for the foreseeable future. Moreover, experts in the field agree that, until a better system is devised, parties will continue to incorporate arbitration clauses into their contracts and to agree on arbitration as a mechanism for resolving investment treaty disputes.

The focus is therefore on how parties can strike a balance in terms of time and cost on existing cases, and on whether changes can be made to improve the current system. One influential body based in Paris, the Corporate Counsel International Arbitration Group – comprised of 50 leading multinationals such as Exxon Mobil, General Electric, and Siemens – is lobbying hard for reform. Suggestions include encouraging arbitrators to rule on key legal issues as early as possible, and ensuring greater transparency that would allow the performance of individual arbitrators and arbitration institutions to be assessed.

Implications of Arbitration

In order to minimize the likelihood of an undesirable arbitration outcome, businesses must understand the implications of the arbitration clauses contained in their commercial contracts, as regard both liability and damages. Getting the arbitration clause right can be the key to avoiding costs and delay further down the line. However, some lawyers say that many companies still are not placing enough emphasis in this area when negotiating their contracts; to many, the inclusion of an arbitration provision is viewed as a “boiler plate” clause in an extensive business agreement.

Critical points to consider are the governing law of the contract and the seat of arbitration. The former defines the national laws that will apply should a dispute arise, and that means that a detailed understanding of such laws should be achieved before agreeing to be bound by the laws of a country other than your own. FTI experts were recently involved in an international arbitration involving a leading energy company and an Asian firm over the misuse of confidential technical information. A neutral European country was identified in the contract as the venue for hearing disputes and its law was adopted as the governing law. However, many years later when a dispute arose and arbitration commenced, it transpired there was limited legal precedent (certainly relative to the U.S. or the UK) to establish how to calculate damages for this particular breach.

The seat of arbitration can also crucially affect the outcome of the arbitration. The location of the seat normally determines the lex arbitri (or set of procedural rules) that forms a backdrop to the arbitration, as well as the courts that will have supervisory jurisdiction over the conduct of the arbitration and hear any challenges to decisions of the tribunal. The courts of different countries can have significantly different approaches to such issues. When choosing a seat, it is therefore important to evaluate the likelihood that the courts of that jurisdiction will intervene in the arbitration process. A company may wish to choose a “pro” arbitration seat in a neutral venue, and it can do so by reviewing any interventions made by local courts in past cases.

In terms of potential damages, the contract may contain provisions on liquidated damages – for example, stipulating a formula for damages in the event of late completion of a project – or limiting damages to specific pre-agreed sums or categories of loss. Definition of terms can vary by jurisdiction, so it is best to define the compensation of an aggrieved party as precisely as possible in the contract.

If the arbitration proceeds to a hearing, this will typically have the same features as a court hearing: oral presentation of cases and cross-examination of witnesses of fact and expert witnesses. There are, however, important differences. Proceedings are generally less formal than court hearings, and tribunals can be more interventionist than judges, particularly as regards witnesses. Witnesses, including expert witnesses, may find themselves in extended dialogue directly with the tribunal. Another growing feature is expert conferencing, or “hot tubbing,” whereby expert witnesses engage in open debate over the issues, sometimes both responding to the same question from the tribunal. This unfettered approach can rapidly highlight the differences between the experts and assist the tribunal in judging which expert has the greater expertise or the more compelling viewpoint. This can be an unnerving process for clients, counsel, and experts who are used to the more structured cross-examination and re-examination processes followed in courts.

Planning for Disputes

It is important for businesses to consider international arbitration as a dispute resolution mechanism when planning and implementing their cross-border activities – either in crafting the dispute resolution clauses in their contracts with overseas partners, or in understanding the level of investment protection that will be afforded in the event of host government actions against investments made.

If companies do find themselves needing to engage in arbitration proceedings, it is important to obtain legal advice from experts in international arbitration, which operates in a different legal and procedural environment from court-based litigation.

Levels of cross-border trade and investment are on a rising trend across the global economy, particularly following the demise of the former Communist bloc and the rising levels of economic activity in parts of the developing world, including China and India. The evidence strongly suggests that, as a result, the resolution of disputes via the mechanisms of international arbitration will continue to grow in prevalence over the coming years. Partly as a result, leading businesses are thinking about ways of enhancing the existing mechanisms and practice of arbitration. This field of dispute resolution, practically unknown even 20 years ago, is set to form an ever-larger part of boardroom agendas in the coming years.

According to the 2009 Survey of Credit Underwriting Practices, the U.S. Comptroller of Currency’s annual bank poll, 96% of the banks polled expected credit risk in their middle market loan portfolio to increase over the next year. The same poll had 67% of banks tightening their middle market underwriting standards this year, the most since the poll’s inception.

Middle market lending picked up smartly in the last quarter of 2009 but remains far below the levels of the mid-2000s. With money center banks focused on larger clients and relationship banking, and many regional banks still capital-constrained by poor loan performance, it’s unlikely that middle market lending will return to these volumes any time soon.

One thing is clear: middle market companies seeking bank loans need to be prepared for a limited appetite for leverage, tighter financial covenants, lower advance rates, shorter tenors, and higher spreads than in recent years. Above all, reluctant lenders are looking for another “C” from potential borrowers:

Credibility

While the balance of power between borrowers and lenders has shifted, borrowers should remember that they are far from helpless bystanders. Here are some of the key issues that bank underwriters are most focused on in evaluating a middle market financing:

Collateral Is King – Right now, collateral is crucial and most senior debt will be secured. Companies with tangible assets of determinate and material value are in a far more favorable position than those with fewer tangible assets. Valuing collateral is also a key issue, as real estate and some types of equipment have been severely depressed over the past year. Those seeking financing should go into bank negotiations with a clear understanding of the value of those assets to be pledged, preferably verified by a third-party source.
Remember that assets are only useful as collateral if they can be controlled by a lender in the event of default and subsequently monetized in a timely and cost-effective manner. 

Evidence of Quality Management Is Crucial – Often overlooked, this factor is of paramount importance in the underwriting process. Banks need to be comfortable with a management team’s qualifications and character. Banks are also scrutinizing managerial performance, since in many cases this provides an extreme data point. Management should have answers to the following questions when approaching lenders for financing: How have revenues held up in this downturn? How were costs kept in line with falling sales? How was working capital managed in the face of the recession?

Ensure Your Financial Data Is of the Highest Quality – The integrity of the borrower’s accounting information is critical. Financial statements must be audited, and controls must be strong. Demonstrating the internal control systems in place should be part of a presentation to lenders, as emphasizing the reliability of the company’s financial reporting systems can go a long way in mitigating any skepticism.

Understand the Role of Projections – Lenders generally expect a sluggish economy to impact the financial performance of middle market companies to a greater extent than large firms, negatively affecting cash flow and staying power. For this reason, upbeat projections are greeted skeptically and it is up to the borrower to convince lenders that realistic economic conditions are incorporated. Management should be prepared to provide detailed support for their projections and underlying assumptions. Even if banks accept these projections as reasonable, financing is unlikely to be provided at anything greater than a senior debt-to-EBITDA ratio above three times.

Use Scenario Analysis – Borrowers should have a firm understanding of a worst-case scenario and a detailed plan to deal with it. Many private equity firms started undertaking scenario planning in early 2008. This planning enabled sponsors to reduce the amount of additional equity injected when refinancing. In 2009, one large European private equity firm was able to refinance more than $1.5 billion of debt with additional equity of less than $10 million. Management should follow suit and prepare a line-by-line plan of how costs will be cut and debt will be serviced if sales fail to meet expectations. In the same vein, management should evaluate potential liquidation scenarios as banks will certainly need to understand them thoroughly.

Understand Your Industry – Traditionally, attractive industries for underwriters are those with low cyclicality and low technology/obsolescence risk because cash flows are more predictable. This downturn has spared few industries, but the risk of obsolescence and the intensity of competition continue to be heavily scrutinized in the underwriting process. Additionally, due to the renewed reluctance of banks to underwrite cash-flow loans for middle market borrowers, companies in asset-light industries such as software, technology, and services may find it more difficult to obtain financing, particularly if there is more than one lender. Those seeking financing should have a firm understanding of their industry, and be prepared to make a strong case to lenders on its attractive aspects, while explaining the company’s plan to mitigate risk from its negative elements.

Know Your Business – Attractive borrowers have compelling products and services, a strong brand name, little customer concentration, and highly credible management teams. Even in lean times, bank funding is usually available to high-performing companies with solid track records. Those seeking financing should know their business inside out, and be prepared to present a strong case on how the company stands apart from its competition. Unfortunately, most middle market companies currently in need of refinancing are doing so in the context of weak demand and stagnant revenues. These companies need to demonstrate how well they have been able to reduce costs and rescale their businesses to maintain margins and profitability. Management should also understand and be able to explain the company’s positioning relative to competitors in the event of a normal recovery and a prolonged downturn.

Reconfigure the Capital Structure – Banks are trying to cushion their exposure to the total leverage in a borrower’s capital structure, often requiring principals to have more “skin in the game.” Additionally, many middle market companies seeking refinancing are faced with weaker recent operating performance and more conservative covenant ratios, meaning less debt will be available to them than when the previous financing was put in place. As a result, companies may need a high equity or junior capital contribution to obtain bank debt. Personal guarantees may be required for smaller companies. In this case, the owners’ finances and credit history will be on full display and can be prepared in advance. Make-whole or capital call agreements, particularly in companies with non-public fund-held equity, may be required.

Be Prepared to Concede on Covenants – Banks are demanding tighter covenants. Borrowers should now expect tight covenants regardless of their credit history or relationship with the lender. More frequent reporting and valuation of collateral may also be required. Management should go to lenders with a willingness to accept these restrictions on any issue made in the near future, with the understanding that if the company does outperform these covenants, they can probably refinance their way out of this burden. 

Examine and Reconsider the Use of a Bank’s Other Services – A history of using the bank’s services such as treasury management or merchant services helps the company secure lending in two ways. First, it makes the company more attractive for the future fees these services will generate. Second, it frames the financing as relationship banking, based on a history of proprietary information gained through multifaceted business interactions.

Self-Help Can Help – Companies can make the process of refinancing faster and easier by undertaking their own self-diligence prior to discussions with lenders. As well as knowing their own strengths and weaknesses, companies can also prepare a thorough analysis of their operating performance, financial metrics, and collateral. It may be worth asking an external advisor to assist with this – a good advisor can bring independent analysis, industry knowledge, greater credibility, and additional manpower.

The FTI Global Pulse picks up consensus forecasts for the largest companies around the world to synthesize what analysts are thinking. It takes a quarterly look at analysts’ year-ahead expectations for growth in sales and EBITDA (earnings before interest, tax, depreciation, and amortization – a surrogate for operating cash flows), grouped by the companies’ main centers of operations. It allows comparisons over time, across regions, and between the top and bottom lines.

We have selected the 1,050 largest companies across seven geographic regions, and aggregated forecasts from tens of thousands of analyst reports and estimates. The result is a consensus view for each region.

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Positive Outlook

The overall story for 2009 is one of recovery of confidence. In most regions, forward estimates of revenue and earnings growth were increasingly positive. Given the importance of confidence – it drives investment and employment – this is welcome news.

Within the regions, only Asia showed any significant weakening in growth expectations, and even there, the outlook remains strongly positive, with revenue growth expected to be in excess of 5%.

Across the rest of the regions, the prospects for Russia and Eastern Europe are expected to see the most rapid improvement, reflecting a focus on energy and the faster-than-expected recovery in oil prices. Analysts are more optimistic about sales growth in the U.S. and in Australasia than they are about sales growth in Western Europe, and similarly more optimistic about earnings growth.

Focus on Costs

Operating earnings – or EBITDA – growth, however, is generally expected to be stronger than sales growth, as shown in the chart below, which captures expectations in Q4 2009. This data point hints at a continuing corporate focus on costs, and suggests that companies are generally recovering sales volumes within their existing capacity (so that costs are not rising as fast as sales).

This in turn suggests that sales growth is more likely to be non-inflationary – at least for the 12 months ahead.

The 2009 data that we have modeled shows a broadly based global recovery during 2009, and the expectation of that recovery being sustained over the next 12 months. That, combined with increasing confidence, has to be good news.

The numbers highlight a continued focus on costs. From our perspective, that is very much consistent with the story that our consultants hear in their interactions with boards around the world.

In any recovery, though, the greatest gains go to those who determine earliest when the time to regain confidence has arrived. As the advice goes, the time to buy is when the blood is running in the streets. The FTI Global Pulse – with an indication of improving confidence, and earnings recovery in the largest companies – may help to identify when to switch from a focus on keeping costs under control to a focus on revenue building.

This new landscape has altered the way corporations conduct international business, bringing serious long-term consequences for violations. Boards and executives who are unprepared to deal with this challenge are increasingly finding themselves in the crosshairs of regulators – and paying a steep price.

Over the past several years, government authorities have extended the focus of their investigations and prosecutions beyond corporate entities to include individual executives. Indeed, in 2009 nearly 70% of the 40 FCPA actions brought by the DOJ and SEC targeted individuals, resulting in fines, jail time, and other penalties – a noticeable increase compared with recent years (see table overleaf). In 2009, the DOJ prosecuted 44 individuals, significantly more than 2008 (11 individuals), 2007 (10), and 2006 (three) combined. The trend of targeting and prosecuting individuals has continued into 2010: in January, the DOJ arrested and indicted 22 individual defendants as a result of a wide-ranging sting operation focused on overseas bribery in the military and law enforcement products industry. Speaking in February this year, Lanny Breuer, Assistant Attorney General for the DOJ, stated: “The prospect of significant prison sentences for individuals should make clear to every corporate executive, every board member, and every sales agent, that we will seek to hold you personally accountable for FCPA violations.”

These developments have given corporate executives the added incentive to exert more oversight and due diligence regarding their company’s operations. Boards and senior executives must get up to speed quickly to protect their corporations – and themselves – from the effects of overseas business corruption and related enforcement actions. To be effective, forward-thinking and responsible board members and senior executives must gain a basic understanding of the FCPA, its application, and the repercussions of violations. Once equipped with this knowledge, board members should verify that their company has implemented the necessary steps to ensure compliance. By taking these actions, a company can avoid the costs associated with violations and, if corruption occurs, have more flexibility to navigate a government investigation.

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A Spike in Multinational Enforcement

Until the past several years, the prosecution of overseas business corruption was viewed as a U.S. phenomenon, and principally through the prism of the FCPA. Today, however, some 38 countries have adopted FCPA-like statutes, and many countries have domestic anticorruption legislation that applies to a foreign company and its employees doing business in their country. While the level of commitment to enforcement and collaboration varies among international jurisdictions, there’s no question that countries around the world have taken a more concerted and coordinated international interest in combating commercial corruption, as evidenced by multinational investigations and prosecutions of Alcatel, Siemens, and Statoil. Indeed, in May, a new bribery bill is expected to become law in the UK, which will be even stricter than the U.S. FCPA and will provide for more serious penalties.

In general, the FCPA and similar statutes have three essential elements. First, employees or representatives of companies are prohibited from offering money or anything of value to officials of foreign governments to obtain or retain business. Second, companies are required to keep books and records that are an accurate reflection of their transactions and payments (for example, a payment to a foreign government official must be reflected as such). Third, companies must design and implement internal controls to uncover and prevent FCPA violations. The first element, known as the antibribery provisions, are criminal violations enforced in the U.S. by the DOJ; and the remaining two, known as the books and records provisions, are principally enforced by the SEC.

While enforcement actions under the FCPA by government authorities against global corporations have been rising steadily for several years, prosecutions and penalties reached an all-time high in 2009. The DOJ brought a record 26 actions in 2009, the highest number ever, and the SEC brought another 14. Several recent trends have pushed overseas business corruption and fraud to the forefront:

• There is a growing global awareness that engaging in corrupt activity is an improper way to conduct business.
• Effective FCPA enforcement in the U.S. has required companies to do more to deter and detect overseas business corruption and investigate allegations of improper activity.
• Increased resources for enforcement combined with better cooperation among government agencies around the world have led to more vigorous prosecution.
• Law enforcement is now explicitly targeting individual executives, in addition to companies.
• Regulators are undertaking more creative legal theories to pursue and charge companies and executives.
• Law enforcement agencies are using more aggressive investigative tactics, such as sting operations and wiretaps, to detect and prosecute corrupt behavior.

As a result, government regulators are imposing higher fines while still committing comparatively modest (but growing) resources. Ten years ago, fines and penalties might have ranged from $100,000 to $10 million; they are now much larger. Siemens settled a case for $1.6 billion in 2008, and Halliburton paid a penalty of $559 million in 2009 to settle a case involving its former subsidiary KBR.

The Impact of an FCPA Investigation

Boards and senior executives have an opportunity – and the responsibility – to protect their companies and themselves in the face of increasing global investigation and enforcement of anticorruption legislation. The costs of being unaware or underprepared are substantial: as noted above, the penalties resulting from an FCPA investigation have increased exponentially.

Recent developments have only added to the total financial impact on companies. Government regulators are able to force companies to “disgorge” profits related to corrupt activity, and regulators are pursuing broader, more creative methods to calculate these profits and exact a higher price from companies. Furthermore, companies found guilty of bribery are barred from bidding on contracts with U.S. and European Union governments. (See sidebar, right, “Proactive compliance.”)

Beyond the already formidable fines and penalties, the organizational disruption of mounting a defense against FCPA or similar allegations can be significant, and the legal fees astronomical. There is also the specter of massive collateral litigation, including class-action lawsuits; costs of investigation and remediation, including forensic accountants, investigators and other consultants; reputational damage; and the unappealing and expensive prospect of a third-party monitor to oversee a company’s compliance and reporting efforts. In the Siemens case, U.S. investigators and the company’s own defense attorneys collected more than 100 million documents, necessitating the creation of special facilities in China and Germany to house them all. Siemens’ legal and compliance fees over the course of the litigation reportedly totaled $1 billion.

While more difficult to quantify, the effect of a public FCPA investigation or conviction on a company’s reputation can be substantial. From investors who see a tainted company as a risk not worth taking to executives who don’t want to be associated with corruption, the knock-on effects can be lasting. For the UK defense contractor BAE Systems, the investigation into alleged bribery of Saudi officials to secure a £43 billion defense contract first surfaced in the 1980s. After several years of negative press comment and allegations of UK government intervention in the investigation, the matter was finally brought to a close in 2010 with the payment of fines totaling $445 million.

Of course, a legal settlement is not the end of the story. Companies that have been the target of an investigation must then go to great lengths to rebuild their reputations and demonstrate their commitment to anticorruption measures.

Boards Must Take Action

To mitigate the huge costs and other negative consequences of enforcement actions, board members have a responsibility to ensure their company has taken appropriate measures to deter and detect overseas corruption. By instituting measures such as those outlined below, the organization will be in a good position either to avoid a protracted government investigation or, if one is inevitable, at least manage it on more palatable terms.

Board members and executives in industries targeted by regulators – such as medical devices and supplies, energy and pharmaceuticals – may already be well aware of the FCPA and its overseas equivalents. Leaders at other companies, however, are much less familiar with the risks. All board members and senior executives should be prepared, and should consider the following preventive measures:

Develop an Awareness and Basic Understanding of the FCPA

Board members should be aware that the statute, and foreign counterparts, exist and prohibit a far broader set of activities and conduct than it might initially appear. Proscribed actions go well beyond a simple payment of cash to a government official in exchange for the awarding of a contract. What many companies consider standard sales and marketing practices, for example, might violate the FCPA, especially in countries where the customer is a government agency, state-owned business, or nationalized industry. Similarly, board members and executives must understand their liability for FCPA violations that occur across the entire organization. Although board members and executives don’t need to be well versed in the intricacies and nuances of the FCPA, they should have a thorough understanding given the international regulatory environment. (See sidebar, “How well do you know the FCPA?”.)

Understand Which Parts of Your Organization Are at Greater Risk

This means determining which parts of the company have greater exposure to foreign governments. Anticorruption enforcement activities, by definition, focus on the parts of a company that interact with governments or government officials. Accordingly, board members should identify the company’s core businesses or business segments for which governments, government agencies, or state-owned companies make up a significant percentage of the customer base. Moreover, heavily regulated businesses or those that routinely have substantial “touches” with foreign government officials are inherently riskier and more susceptible to corrupt activity by virtue of their more extensive foreign government contact. Board members would be wise to identify the principal points of intersection between their company and foreign officials.

Certain industries have been singled out for FCPA investigation: oil and gas, pharmaceuticals and medical supplies. Companies that aren’t part of these industries shouldn’t consider themselves absolved from regulatory scrutiny. Indeed, any international business – such as multinational construction companies, real estate investment firms, or defense contractors – that shares key characteristics of the oil and gas or medical-device industries may be targeted in the future, and those companies should be more vigilant, particularly regarding partners, competitors, and third-party representatives.

Moreover, traditional multinational corporations aren’t the only organizations at risk. Large private equity firms might be exposed to increased risk by virtue of their portfolio of a diverse, international set of companies. Some private equity firms are highly decentralized, so the parent has less insight about the portfolio company’s daily operations and conduct. However, the parent has FCPA exposure because it’s legally liable for its operating companies. Given the enforcement climate, the deep pockets of private equity firms may present an attractive target for government regulators.

Understand Which Nations Are High Risk

Executives must be aware that the government officials of some countries have the reputation for accepting bribes as a matter of course to conduct business. Rightly or not, certain countries are commonly deemed to be “high-risk” jurisdictions – those more susceptible to corrupt business practices and the bribery of government officials. Countries that control the largest petroleum reserves, for instance, have been hot spots for foreign bribes. Similarly, in countries with state-run healthcare industries, the business contacts are often direct representatives of the national governments, making them likely targets for corrupt businesses.

Transparency International (TI), a nongovernmental organization, helps to promote awareness about global corruption. As part of its efforts, TI publishes an annual Corruption Perceptions Index that ranks the corruption levels of 180 countries. As the map opposite illustrates, certain countries in each region have gained a reputation for corporate bribery, so board members and senior executives of companies that do business in these places should be on alert.

Examine Company History and Any Previous Allegations

Board members – especially new ones – need to determine whether their company has ever faced significant allegations of overseas commercial bribery, regardless of whether a regulator has been involved.

Moreover, if the company had previously been the subject of an investigation related to the bribery of government officials, find out the underlying issues as well as the result or resolution. Since rooting out corruption in a multinational corporation requires a prolonged effort, violations that have occurred in the past can often indicate other problem areas.

Verify That the Company Has Appropriate Compliance Mechanisms in Place

Executives and board members at global companies with far-flung operations face the daunting task of being responsible – and potentially liable – for the actions of employees around the world. To address this challenge, an organization needs to adopt compliance mechanisms to ensure business conduct consistent with the FCPA, as well as the FCPA equivalents and local anticorruption laws of other countries in which the company has significant operations. Board members should be satisfied that a robust compliance program exists.

In general, CEOs and boards should verify that their company’s anticorruption compliance program is global, consistent, and effectively communicated. Where appropriate, the program should be customized to account for cultural differences and local anticorruption laws.

Board members should also ask whether the company is performing periodic risk assessments of its larger operations in high-risk jurisdictions. These assessments typically involve internal auditors or outside professionals interviewing key personnel in foreign operations, reviewing contracts and other relevant documents, and conducting transactional testing of certain accounts that are more susceptible to corrupt activity. Transaction types that should be tested for indicators of corrupt payment include:

• payments to agents/distributors;
• travel and entertainment expense reimbursement;
• petty cash;
• taxes;
• other expense accounts, such as gifts, political contributions, charitable contributions, seminars and trade shows, educational grants;
• free products; and
• after-the-fact credit memos.

Boards must also ensure their organization has the necessary personnel to address the issue. In many companies, the general counsel or chief financial officer oversees compliance activities. However, given the time required to monitor global operations effectively, and the stakes, larger corporations should have a dedicated global chief compliance officer.

Ensure Robust Due Diligence in Acquisitions of Overseas Businesses

It’s possible to literally “buy” a significant – and costly – FCPA problem, and a number of companies have inadvertently done so. As the global economy recovers and international M&A becomes more active, board members need to make sure their company is conducting robust due diligence on international companies in high-risk industries or countries.

This effort is twofold. First, companies should conduct external due diligence, focusing on the reputation of the target company, its principals and primary agents; understanding any history of improper business practices; and examining relationships with foreign government officials. Second, potential investors or acquirers should analyze the target company’s internal books and records, to identify any red flags for corruption, such as:

• customers that include government entities, such as state-owned companies;
• involvement in any joint ventures with government entities;
• details on the government approvals and licenses a company requires to operate;
• customs requirements in foreign countries; and
• relationships with third-party agents or consultants who interact with foreign officials on the company’s behalf.

Since a company can be liable for the FCPA violations of an acquired company or even a joint venture, companies should rigorously follow a standardized due diligence protocol and procedure for evaluating international growth opportunities.

Promote a Company Culture to Combat Overseas Corruption

The degree to which senior management is truly committed to conducting business honestly sets the tone for the entire organization. A board member can discern how much an organization values ethical conduct by probing, in an appropriate fashion, the views of senior management on the issue.
Companies that actively address global corruption use a wide range of measures to raise awareness among their employees. Encouraging a culture of transparency and vigilance – through a robust FCPA compliance and training program, staff handbooks, and annual training sessions, for instance – will help an organization avoid disregarding issues that could have serious repercussions down the line. If a company has significant operations in high-risk jurisdictions, such training should be done in person. As part of the hiring process, prospective employees should be screened for any relationships to government officials.

Successfully Navigating a Government Investigation

Should a company find itself the target of a government investigation related to overseas business corruption, CEOs and boards need to be aware of their options. By working with FCPA experts, companies can identify the best path forward. Although managing through a government investigation is complex and has many elements, board members and senior executives should engage in several ways:

Take Allegations Seriously

Companies can’t afford to dismiss internal reports of improprieties. Instead, upon the first indication of corruption, executives should dedicate the necessary energy and resources to understand the potential violations, conduct a preliminary and proportionate inquiry, and remediate corrupt activity if it is found to exist.

Assemble an Outside Team of Advisors

In the face of a credible allegation, a company should consider retaining an experienced team that might include legal counsel, a forensic accounting and investigative firm, and communications specialists with expertise in issues management. The board or audit committee should consider counsel and consultants that are independent from the company. It’s important that the forensic accounting and investigative consultant be multidisciplinary, experienced in FCPA and international investigations, and have capabilities across international jurisdictions. Many multinational companies have vetted and retained anticorruption counsel and advisors in high-risk foreign jurisdictions or regions to work proactively on compliance matters, but also in case credible bribery allegations surface. Even if a team of advisors does not need to be fully activated, it’s prudent to have them assembled and prepared.

Conduct a Parallel Investigation

If a government investigation does occur, the company and the board will want to do what they can to understand activity that might pose a problem. While conducting a parallel investigation is appropriate, it should proceed in a way that is not viewed as an act of obstruction by the government. The company must also preserve the evidence – whether witness statements, email and other electronic evidence, or physical documents. 

Weigh Up the Benefits of Self-Disclosure

If the company finds that corrupt activity has occurred, one of the key issues is whether to disclose information voluntarily to government authorities. Executives should begin to consider self-disclosure if a preliminary internal investigation uncovers a reasonable basis that the allegations of corruption have merit. The firm’s professional advisors will help the board weigh the pros and cons of disclosing to the government.

While such action is appropriate in many instances, it’s not always required or justified. If a company decides to disclose, however, it must be forthcoming about the violations it has uncovered. Moreover, while self-disclosure can offer a valuable opportunity to negotiate with the government and set parameters for the investigation, the scope of the government investigation is ultimately beyond the company’s control.

Understand Non Prosecution Agreements (NPAs) and Deferred Prosecution Agreements (DPAs)

If the government is inclined to pursue charges, the case may be resolved through an NPA or DPA. An NPA is a contract between the DOJ and a company stipulating that if the company fulfills certain requirements, the government won’t file criminal charges. In a DPA, the government files charges that are then withdrawn once certain conditions are met over a three- to five-year period. Both agreements create incentives for companies to cooperate with government authorities and implement reforms to prevent misconduct. By entering into either agreement, a company can avoid being convicted of a criminal offense. In both an NPA and a DPA, fines are assessed, and often a monitor is assigned to assure compliance with the terms of the agreement. While many aspects of NPAs and DPAs are unappealing, they may be better than having the lasting stain of a criminal violation on the company’s record.

These steps represent a starting point for board members and senior executives as they review their company’s anticorruption efforts. As recent prosecutions have shown, government authorities expect executives and board members to take an active role to ensure compliance. Ignorance of a violation at a subsidiary will not absolve a company – or its leaders – from substantial fines and further compliance measures.

By understanding the full reach of FCPA enforcement actions, board members can protect their company against the effects of overseas business corruption and put their company in the most advantageous position should a government investigation ensue.

As economic historians debate whether or not Lehman Brothers could have been saved, it’s clear that the global financial markets crisis of 2008 was entirely a self-inflicted wound, which had been years in the making. There were no external factors or shocks to blame. Quite simply, investors collectively lost confidence in the decision-making and risk-taking practices of large financial institutions, private investment capital and large swathes of Corporate America – arguably with good reason.

In the corporate sector, credit quality had never been so poor going into a recession. As we entered the maelstrom a little over a year ago, some 62% of rated U.S. non-financial corporate issuers were considered speculative-grade by Standard & Poor’s (S&P), of which over two-thirds were considered “deeper junk” (B+ or worse) – a significant deterioration in the distribution of credit ratings compared to a decade earlier. The leveraged buyout (LBO) craze of mid-decade contributed greatly to this phenomenon, with some $400 billion of LBO-related loans made in the U.S. between 2005 and 2007, according to Reuters LPC. European borrowers got in on the act too, with the equivalent of some $580 billion of leveraged M&A loans made during this same period, over half of them earmarked for LBO transactions. Already that fallout has begun; S&P recently noted that 42 of 46 European debt defaults of credit-rated or credit-estimated issuers that occurred in the first half of 2009 were LBO deals gone sour.

Today, even after cleansing the pool of rated issuers of hundreds of defaults that have occurred since early 2008, corporate credit quality remains exceptionally weak. Operating and financial challenges for high-risk borrowers still abound. The damage inflicted on a fragile global financial system from the combination of excessive risk-taking, high leverage and sharp economic contraction cannot be repaired in haste, notwithstanding the impressive rally in global credit markets since March 2009. This article will explore how risky borrowers have responded to largely inaccessible credit markets since late 2008 and the challenges that remain firmly in place even as the global economy seems poised for recovery in 2010. 

How are Financial Markets Faring?

Following the near-death experience in capital markets last fall and the precipitous price declines that continued into early 2009, the recovery in global financial markets has been striking. Conversations have moved on from open-ended bailouts, the nationalization of troubled industries and other dire rescue plans to, ultimately, the realization that the collective commitments and bold actions of policymakers in the developed world appear to have prevented the Depression-like scenario that seemed plausible last December. Yet this is no guarantee of smooth sailing in the months and years ahead, and it is certainly not a harbinger of borrower-friendly credit markets. Capital markets have opened up again to investment-grade and near investment-grade corporate issuers, but global fixed-income investors remain highly selective (and demanding) for riskier issuers.

One striking feature of the environment today is the growing divide that has opened up between investment banks and their corporate and retail counterparts. Investment banks – particularly in more traditional business areas such as foreign exchange – are delivering exceptionally good results. This is because a lot of capacity and capital has been withdrawn from the wholesale markets. By contrast, retail and corporate banking continues to struggle with asset quality and a lack of attractive new business.

As might have been expected, the first beneficiaries of government intervention programs have been financial markets. Equities, in particular, have rallied globally, while corporate credit markets have returned to pre-Lehman levels.

What’s Happening on Main Street?

The recession, which officially began in December 2007, is both a by-product of credit tightening and a contributor to its perpetuation; and this recession has been particularly brutal in terms of its impact on U.S. employment and economic activity and the destruction of personal wealth. Real U.S. gross domestic product (GDP) contracted by nearly 6% in the six-month period ended March 2009: its worst two-quarter slump since 1958. Real median household income declined 3.6% in 2008 – erasing gains of the past three years; and household net worth has fallen by 22% from its peak in mid-2007. Consequently, consumers and businesses alike have become exceedingly cautious in their spending and finance decisions of late – largely by choice, but also driven by market-imposed discipline.

Consumer spending, the main driver of U.S. economic activity, remains in deep doldrums. This is hardly surprising, given that three pillars of consumer confidence have crumbled: house prices (down nationally by nearly one-third), the unemployment rate (more than doubling to 9.8% – its highest level in 26 years) and the value of financial assets such as savings accounts and 401(k)s (down by more than 20% since the peak).

There are clear signs that many consumers have downshifted to survival mode. Monthly discretionary spending totals by U.S. consumers have been consistently lower by near double-digit rates or worse (year-on-year) in most product categories outside of consumables.
Despite talk of early recovery, there is virtually no evidence that consumers are willing to open their wallets without steep incentives, such as the ‘Cash for Clunkers’ program. Survey data consistently shows that about three-quarters of all Americans have cut back on personal spending. Credit-card debt outstanding has contracted at a record rate so far in 2009, while the personal savings rate has moved from nearly zero to its highest level in more than two decades – distinct signs that behavioral changes afoot may be more than just temporary adjustments. 

This state of high anxiety within the private sector is not just an American storyline. Consumer-driven demand in much of Continental Europe remains in contraction and massive government intervention has been required to prop up economies in most Western European nations. Despite recent indications that the recession may have ended in Germany and France, the outlook for private consumption in Europe remains poor in 2010.

Clouds are mostly gray in the corporate sector. Operating earnings for the S&P 500 Index have declined 53% from their peak in 2007, considerably worse than the 32% peak-to-trough decline in the 2001 recession and the 25% decline in the 1990-91 recession. Most companies that are meeting or exceeding earnings estimates in 2009 are doing so as a result of aggressive cost-cutting rather than generating top-line growth.

These tough measures are driving employers to shed staff in record numbers, blunting consumer confidence and reinforcing their reluctance to spend. Until there is discernible improvement in consumer sentiment, it is difficult to foresee any meaningful growth in their current timid spending patterns. Yes, a Depression-like scenario may have been avoided, but a period of prolonged economic weakness or anemic growth remains a distinct possibility.

We should remember that while equities are in recovery mode, the default and employment cycles are lagging indicators, which will continue to generate bad news for many months to come.

What are the Prospects for Corporate Borrowers?

Over the past two years, we have also seen a dramatic change in the composition of the lender landscape. There

are now fewer financial institutions, and those that remain are significantly more risk-averse. New paper issuance by collateralized loan obligations (CLOs), structured finance vehicles which provided so much cheap capital during the peak years, has largely dried up. Other non-bank lenders, such as hedge funds and pension funds, which also fed the leveraged loan market, have pulled back in a big way.

Traditional banks, many of which are either capital-challenged or propped up with federal assistance, are significantly more cautious lenders than previously. All told, new leveraged loan activity remains several hundred billion dollars below peak levels (see Chart A), and this decline dwarfs any buoyancy of new issuance activity in high-yield bond markets so far in 2009.

This much is clear. Big changes in the regulation of banks are coming. The effect of events over the past two years has prompted regulators in major countries to revisit rules and consider sweeping changes. The area of change most likely to affect corporate borrowers is that of capital requirements for banks.

Regulators are almost certain to introduce new rules to limit both the risks that many banks retain and the size of their asset base for any given level of capital. The message here is that banks will need to raise fresh capital just to stay where they are in terms of size. Meanwhile, loan underwriting standards are being raised, too. At best, all of this will make refinancing more challenging and expensive; at worst, over-zealous rule-making could lead to severe deleveraging and credit contraction.

Throw in the unfolding collapse of real asset values, and you have a heady cocktail likely to cause a lingering hangover. Declining residential property values, negative home equity and rising foreclosures have dominated business headlines for a while, but there is widespread belief that commercial real estate defaults are the next headline-makers.

Collateral values underlying commercial real estate debt are widely expected to drop by 35%-40% from peak 2007 levels during this down cycle. Transaction activity has plummeted and Commercial Mortgage-Backed Securities (CMBS) markets, previously a major source of real-estate finance, remain dormant, making the prospect of refinancing maturing debt without additional equity incredibly difficult.

A recent article in The New York Times (citing a widely read Deutsche Bank report) noted that “as many as 65% of commercial mortgages maturing over the next few years are unlikely to qualify for refinancing because of the drop in property values and new stricter underwriting standards.” Deutsche Bank Securities expects loss rates from defaulting real estate loans to exceed 10% of outstanding CMBS loan balances, a loss rate that would exceed the real estate crash of the early 1990s.

Until there is some persuasive evidence that the economic recovery has traction and that businesses are finally starting to expand again, markets for commercial real estate are unlikely to improve. Generally speaking, commercial real-estate markets tend to lag behind the economic cycle by at least one year.

A dearth of deal activity and depressed values in the M&A market are also impeding corporate turnarounds. There is little appetite to do deals at what might have once been considered ‘fair value,’ limiting the options of distressed corporates looking to dispose of assets to provide liquidity or refinance debt. Companies that can afford to do so are biding their time until the deal-making environment improves.

It is against this backdrop that hundreds of billions of dollars worth of leveraged corporate debt and commercial property loans will be maturing over the next five years. The ability of borrowers to meet or otherwise satisfy these upcoming obligations will depend on market-place conditions and economic circumstances outside their control, thus prolonging uncertainty in credit markets and corporate turnaround prospects.

Quantifying the Potential Size of the Refinancing Problem

An S&P study published in May showcases the scope of the future debt threat. The study analyzed nearly $4.4 trillion of U.S.-issued rated non-financial corporate debt, which included loans, notes and bonds. About $2 trillion (or 45%) was rated as speculative-grade debt, and $1.3 trillion of this total – or nearly two-thirds – was rated single-B or lower, a common threshold of ‘deep junk.’ Moreover, of the $1.4 trillion of speculative-grade debt scheduled to mature within the next five years, nearly $900 billion is rated single-B or worse. This is especially worrisome, given the ongoing difficulties of low-rated issuers in accessing credit markets despite the 2009 rally, and the materially higher default rates for issuers rated single-B or worse. The current skew of S&P’s ratings distribution of speculative-grade debt towards deep junk is one big reason why the rating agency is projecting an all-time high spec-grade default rate of 14% during this cycle, and a solidly double-digit default rate one year from now. Charts B and C show breakdowns of maturing debt by current rating and by debt type over the next five years.

For many leveraged loans, most maturities in the 2010-2014 time frame represent incredibly borrower-friendly deals originating from 2005-2007. Renewals at previous levels, terms and rates are most unlikely even for compliant, well-performing borrowers. Furthermore, a sizeable slug of these maturing loans represents LBO financings for deals that were aggressively structured and favorably priced.

In many cases, the new math simply won’t work come maturity time. Reuters LPC data indicates that some $230 billion of U.S. LBO-related term loans will mature within five years. This phenomenon is by no means endemic to the U.S.; Western European nations were also caught up in the leveraged buyout craze and the equivalent of $140 billion of LBO-related term loans will likewise be maturing by the end of 2014. 

Access to revolving credit continues to be reined in as traditional lenders seek to cut the size of new facilities, increase pricing spreads, shorten maturities and enhance collateral packages – in short, reduce their exposure to high-risk corporate borrowers. In May, Sears Holdings agreed to a bifurcated extension of its existing $4 billion asset-based revolver that was scheduled to mature in March 2010. Sears could only manage to get its lending syndicate to extend $2.4 billion of the original first lien facility by two years, despite a generous pricing margin increase of over 300 bps, a LIBOR floor, upfront fees and a BB+ rating. Now that’s risk aversion! It’s hard to believe the original ABL revolver was priced at only 88 bps over LIBOR in 2005.

The withdrawal or restriction of a line of credit can drive trade creditors and other critical suppliers to reduce their own exposures, by changing credit terms or placing riskier accounts on limit. This can intensify the pressure on a struggling company’s working capital when they are most likely to need it. In today’s new credit environment, the negotiating advantage has undoubtedly shifted back in favor of lenders, following several years when it was the borrowers that tended to call the shots. While large global companies often have access to alternative financing options or the ability to generate working capital spontaneously, those inhabiting the most precarious end of the borrowing spectrum typically have little choice but to accept more onerous terms and conditions offered by lenders.

Conservative lending practices and capital rationing by banks will disproportionately hurt small and middle-market companies, since the new emphasis on relationship banking and key accounts naturally favors the largest and most diverse clients that generate business volume and can be cross-sold an array of banking services. Middle-market borrowers are already feeling the neglect.

Patching Up the Wounded

Despite the daunting parade of upcoming corporate-debt maturities, there are no outward signs of panic just yet. Scheduled maturities for 2010 are relatively light (Chart B) and most likely to be manageable under current market conditions. However, the refinancing burden will intensify in 2011 and beyond. Concerned senior executives of underperforming businesses may be working hard to create a meaningful earnings recovery by then, but few are banking on it to save the day, judging by their actions of late.

Compelling evidence of highly cautious attitudes about the corporate credit environment can be found by examining the flurry of amends and extends (A&Es) carried out in 2009, often pre-emptive and usually on very costly terms, for debt maturities that were one or two years away. A&Es are essentially short-term deals that allow a company to extend loan maturities.

For borrowers, A&Es can push out maturities that cannot be refinanced outright, or they can grant financial covenant relief or added headroom until operating results improve. Lenders typically get to re-price these loans closer to market spreads, insert tougher loan covenants and extract lucrative fees as well. A&Es account for much of the recent leveraged lending activity, with S&P reporting over 200 rated borrower requests for loan amendments in the first half of 2009.

The problem with the A&E solution, known as ‘forward-start agreements’ in Europe, is that often it just delays the inevitable day of reckoning. It is a leap of faith by borrowers and lenders that the lending environment and operating conditions will be substantially better in the not-too-distant future. It does nothing to remedy the fundamental problem: too much debt. And given the mountains of debt due for refinancing before 2014, there is no assurance that credit markets won’t be just as tight or selective as these revised maturity dates approach.

Similarly, on the bond side, debt-exchange offers – whereby companies offer bondholders the opportunity to exchange maturing bonds for new bonds with a later maturity date and/or equity positions – have figured prominently in restructuring activity this year. Through August, S&P tabulated 74 distressed debt exchanges of rated securities in 2009 – easily more than twice as many as in the whole of 2008. Like A&Es, these transactions are often viewed as short-term fixes that allow distressed borrowers to buy some time to repair their businesses while achieving some degree of near-term financial relief.

This option is only possible because junior creditors often recognize that they are unlikely to see any meaningful recovery under a bankruptcy scenario, given the present economic environment and marketplace conditions. Ironically, it is the distressed borrower that often has the upper hand in these colorful, if not contentious, negotiations with bondholders, by using the prospect of a Chapter 11 filing as a cudgel to get creditors on board with an exchange proposal. Despite these fervent efforts to stave off payment defaults and bankruptcy, history tells us that many companies orchestrating distressed debt exchanges today will eventually file for Chapter 11 relief.

Both A&Es and distressed debt exchanges are practical responses to the scarcity of fresh capital for perceived high-risk borrowers in today’s new lending regime. But what other options are available, and what should companies facing significant maturities in 2011 and 2012 be doing now to prepare for the refinancing that’s just ahead?

The Potential Fallout

For the legions of companies that financed their growth with piles of cheap debt, the double-whammy of a recession and a stringent credit environment is likely to hasten a showdown with lenders or creditors. While A&Es and distressed debt exchanges might paper over the cracks in the short term, by allowing struggling companies to limp along in an uncompetitive fashion, the pain is merely prolonged, and recoveries for creditors may ultimately worsen.

This backdrop is likely to mean heightened levels of bankruptcies well beyond the end of this recession. Once upon a time, a failing business might still have had new money thrown at it. Nowadays investors or lenders are more likely to be throwing in the towel, or at least be looking at other ways to extract value and maximize recoveries – without necessarily saving the enterprise. Turnaround professionals and interim managers will be utilized more extensively as key players lose patience with incumbent executives in floundering organizations.

While deal-making continues to be difficult, there has been a huge upturn in distressed M&A activity. The Deal recently reported that Section 363 sales – the equivalent of auctioning off a failed entity’s business or assets – have almost doubled in 2009. These days especially, it may take a while to get to a Chapter 11 filing, but once there, the timetable really accelerates for some debtors.

Vulnerable sectors going forward will include a raft of consumer-dependent businesses that are asset-intensive, and burdened with debt or other onerous financial obligations. This extends well beyond the retail sector itself and includes airlines, travel and lodging, gaming, consumer finance, media and entertainment and consumer product makers, among others. In the healthcare sector, retirement homes and assisted-living communities are also looking vulnerable as the falling value of residential real estate and retirement accounts is frustrating the ability of potential new customers to take on units in these communities.

Lastly, consider the state of the banking sector. While some Wall Street banks were considered too big to fail, smaller regional banks will end up being too small to rescue. The irony is that many regional banks were conventional lenders that mostly avoided material exposure to toxic paper, risky financial derivatives and other structured investments that embroiled Wall Street. However, sliding values for commercial real estate, a business mainstay of regional banks, will inevitably impair their collateral and erode capital levels. Many believe the knock-on effect on balance sheets could prompt smaller regionals to fall by the wayside. No doubt the best assets of these failed institutions will be snapped up at bargain prices by national money centers and large investment banks – some of which qualified for previous bailout assistance. 

In all of this, antitrust authorities will likely seek to play a more active role, but their voices may ultimately favor measures that restore corporate profitability and the preservation of jobs. It follows that strong companies should have a good opportunity to pursue in-market acquisitions successfully over the next year or two, particularly if the target would otherwise struggle financially, or go bankrupt.

There Are No Magic Bullets

So what can be done? Most important is for companies to address the appropriateness of their capital structure and debt layering long in advance of refinancing dates, bearing in mind both the new tolerances and valuation parameters of capital markets and the expected persistence of weaker operating earnings in light of the recession.

As previously mentioned, a distressed debt exchange, especially one involving a substantial debt-for-equity swap, is a means by which a troubled borrower can reconfigure an unsustainable balance sheet in the absence of new money, and possibly without the need for filing for bankruptcy. But it requires Herculean negotiating efforts with recalcitrant creditor groups which may end up on the courthouse stairs in any event.

Secondly, companies must focus ruthlessly on driving business efficiency. Many have done so admirably during this downturn, with the retail sector coming to mind first. Large U.S. retailers generally surpassed Wall Street’s low earnings expectations in the second quarter, despite slumping sales and gross margin compression. Such results can be achieved through a combination of cost-cutting, vendor and landlord negotiations, reduced capital investment and better inventory management. Senior executives should keep an eagle eye on subtle changes in critical trends that impact their business, and should understand how key performance indicators can be utilized.

Companies with marketable assets might consider selling some of the family silver to pay down debt. While M&A markets are slow, the deal environment is gradually improving. Sometimes such measures are painful, but necessary. Struggling retailer The Talbots sold the J Jill Group – a business segment it could no longer support, given the distress at its namesake chain – in June to a private equity shop for $75 million. Talbot’s purchased the J Jill chain some three years earlier for $500 million in cash. Even if a sale is not possible straight away, companies can start positioning some dispensable businesses or assets for sale as soon as markets improve.

Which Way Now?

We know that refinancing the dozens of billions of high-risk debt slated to mature over the next few years will be a challenge for most, and impossible for many. While there is a good chance that economic conditions may be showing signs of improvement as we move into a new decade, the consensus points to a slow, below average recovery. It is likely to take several years for corporate earnings to return to 2007 levels, for job prospects and personal wealth to recover enough to kick-start consumer spending and for lenders to shake themselves free of the noxious overhang of bad assets and bad practices that they acquired during the halcyon days of the credit boom.

However, some just can’t hold out that long; others will be unable to earn their way out of their financial predicaments. The term ‘jobless recovery’ is already being bandied around with a casualness that belies the grim reality of the expression for many millions of Americans. To make matters worse, federal budget deficits and borrowing needs will remain exorbitant. It’s not exactly a recipe for optimism.

2010 is certain to be a pivotal year for the U.S. and global economies – a ‘show me’ year in the minds of both equity and credit investors who now fully expect to see fresh, indisputable evidence of positive economic growth and solid earnings recovery, and who have already priced such expectations into capital markets. Many economists, though, are less sanguine about any rosy growth scenario as long as stricken consumers stay planted on the sidelines. The interplay between corporate operating performance and credit market conditions will likely be reinforcing: better than expected earnings may further embolden credit investors and ease access to capital, which will in turn bolster corporate results. But it could work the other way too, with vast pockets of economic weakness that persist into 2010 finally causing financial markets to doubt the adequacy or sustainability of a recovery. How the economy unfolds in 2010 may very well determine whether the debt maturity challenge eventually rises to the level of a crisis. We’ll be watching closely.

Dominic DiNapoli is Executive Vice President and Chief Operating Officer of FTI Consulting, responsible for the day-to-day operations of the company’s five business segments.

Based on more than 1,000 hours of research into advertising spending across 12 sectors, a recent study by FTI Consulting forecasts a 13% decline in advertising spending in 2009 and another 1% decline in 2010. This follows decreases of 2% and 5% in 2007 and 2008 respectively. While the report predicts a small upturn in 2011, real advertising spending will not climb back to 2008 levels of $284 billion until late 2014.

Looking at the trend in spending patterns, traditional print media (particularly newspapers) will continue to bear the brunt of the spending decline, and will regain prior years’ market shares only in rare cases. Internet substitution has permanently changed print media’s market share. Over the coming years, the Internet’s share of advertising spending is expected to grow at a steady pace, rising from current levels of roughly 9% of total advertising spending to 15% in 2015. Exacerbating the problem for traditional media companies is that one dollar of advertising spending on traditional media is replaced by just 33 cents on Internet sources. Thus, the fastest-growing segment of advertising spending substitutes digital cents for each previous dollar spent.

The Impact of Online Advertising on Traditional Media

Our forecast research considered historical advertising spending patterns by medium to estimate the rate of growth of the Internet over the next five years, determined what percentage share will represent a steady state for the Internet and assessed its impact on traditional media.

The research indicated that television was the best analogy to the Internet in terms of its impact as a disruptive technology. The relationship between household penetration and advertising market share of TV is very similar to that of the Internet. After its introduction in 1949, television experienced rapid household penetration, reaching 50% of homes in four years and 90% in only 13 years. It captured about 15% of the advertising market during that time period, 20% after 25 years and eventually settled, 40 years later, at its current level of about 25%. Television put dramatic pressure on newspapers, which accounted for 37% of advertising spending in 1949 but only 29% of advertising spend by 1962. Radio’s share of advertising spending contracted by 50% over this time period.

The Internet also took approximately four years to reach 50% household penetration. In comparison to TV’s 15% ad share in 13 years, Internet ad-spending share is expected to reach 10% by the end of 2009. This is 15 years after Internet usage debuted in the home and 11 years after broadband connections were introduced. FTI’s research suggests that the Internet will eventually peak and settle at approximately a 25% advertising market share. This forecast is based on a dynamic advertising-spend regression model, which uses the historical relationship between five variables to predict future ad spending: consumer spending, private investment, the unemployment rate, online market share and the incremental impact of either a U.S. presidential election or the Olympics.

Until 2000, real GDP growth and real advertising spending correlated quite directly. Advertising spending represented about 2% of GDP. When the economy grew, advertising spending grew and when GDP contracted, advertising spending contracted disproportionately. Since GDP is comprised of roughly 70% consumer spending, 10% private investment spending and 20% government spending, FTI found a stronger relationship between advertising spending and consumer outlays and private investment.

But spending and investment alone did not predict the trends experienced since 2000 quite as well. Therefore, to improve the accuracy of the model, particularly as GDP contracted, we also factored into our analysis three other variables.

First was the impact on consumer spending of employment, which we captured with changes in the unemployment rate. And, because of the effect of online price performance on total advertising spending and the resulting pricing pressures on traditional advertising media, we added a variable to reflect the change in online advertising market share. Finally, we captured the average boost in advertising spend during a U.S. presidential election and Olympic Games years.

The result of these additional factors was significant. The historical correlation from using our five factors was high, and the post-2000 correlation held even better.

As part of economic stimulus legislation passed earlier this year, the U.S. Federal Communications Commission is charged with developing a national broadband strategy “to ensure that all people of the United States have access to broadband capability.” Indeed, even though broadband adoption has incre
ased more than sixfold since 2001, some 43% of U.S. households have yet to adopt high-speed access in their homes. The Compass Lexecon findings underline the potential benefits of accelerating broadband adoption.

Size of the Prize

In a survey of American consumers in April, the Pew Research Center found that around one third of respondents considered high-speed Internet a necessity. And broadband was one of the few items to grow in importance in surveys over the past three years.

But just because something is desirable doesn’t necessarily make it useful. Thus, the researchers at Compass Lexecon sought to quantify the benefits of household broadband for consumers, deploying an array of econometric tools in the process. The goal was to identify the ‘consumer surplus’ associated with broadband access – that is, the value of the service to subscribers above what they actually paid for it. If the actual value of a service is less than its price, nobody will buy it. On the other hand, if the value surpasses its price, buyers receive benefits from the service that are not captured simply by how much is spent on a particular service. 

To determine the actual surplus from broadband Internet access, Compass Lexecon’s researchers analyzed a sample of broadband purchasing data for 30,000 households from the largest 100 metropolitan areas in the U.S. between 2005 and 2008, and then extrapolated up their findings to the U.S. population. Based on pricing and adoption rates in the sample, the researchers could estimate consumers’ willingness to pay for broadband under a variety of conditions.

A 10% rise in the price of broadband would have led to a 15% decline in demand in 2005 whereas, in 2009, a 10% rise in price would result in only a 7% decrease. Thus, growth in the value of broadband to consumers increasingly outstrips a rise in its price, implying that the size of the total consumer surplus is growing. At current prices, the net consumer surplus for broadband is $31.9 billion per year, Compass Lexecon estimates, up from $20.1 billion in 2005.

Onwards and Upwards

There are strong reasons to believe that the true value of broadband is significantly larger than these estimates. The research looked only at fixed-line broadband use at home and estimated the aggregate consumer surplus. Outside of the scope of the study were mobile wireless broadband, consumer gains as the productivity gains from business users are passed on, and the producer surplus enjoyed by broadband providers, as well as firms whose services become more economical or feasible as the speed of Internet access increases.

Finally, broadband access can also be considered an ‘experiential good’ – once consumers experience high-speed Internet access, they tend to value it more highly than if they had not experienced it before. The size of the consumer surplus would therefore grow if the current share of households with dial-up or no Internet access were to try broadband for the first time.

For companies, the case for greater broadband adoption is compelling. Compass Lexecon researchers found that 22% of workers with broadband regularly access their employer’s network from home versus only 8% of employees with dial-up access. Given the well-established benefits to employee productivity and retention that stem from flexible working practices, anything that can be done to make working away from the office easier should be encouraged. Broadband also allows firms to open new sales channels, develop new product markets and expand customer-service possibilities.

The steady expansion of Internet access over the past 15 years has revolutionized the workplace, not to mention the world. The next step is expanding access and affordability to broadband, which promises to deliver billions of new opportunities across all segments of American society.

The global financial crisis has heightened employee anxiety about job security. This underscores the need for effective engagement with employees, as this will help to build trust and morale. For example, customer service, business performance and the ability to attract and retain talent are all affected by employee morale. During volatile economic times, organizations without trusted and credible employee communications are likely to see their reputations erode and underperform relative to those companies with more effective programs for engaging and aligning employees.

In a new report, A Question of Leadership: How Can Business Leaders Best Engage with their Employees in the Downturn?, FD, the strategic communications segment of FTI Consulting, critically examines the engagement gap leaders face in today’s business environment. FD commissioned the respected polling organization YouGov to conduct the United Kingdom survey in the spring of 2009. More than 500 respondents were polled, representing a broad cross-section of white-collar workers in the UK private sector.

The report’s authors concluded that business leaders should be intensifying efforts to realign how they communicate with their employees about overcoming challenges associated with the downturn. In one of the survey’s more important insights, many respondents felt that strong leadership and a clear sense of direction and trust were lacking in their organizations. This suggests significant and potentially negative responses when it comes to employee morale and business performance.

Most of those surveyed think their leaders are not being open enough about how their respective employer is performing. And many don’t trust what they are being told about how their employer is coping with the economic downturn. As indicated in Chart 1, fewer than 30% of the respondents put a lot of trust in the messages they receive from the CEO. Moreover, fewer than 45% of employees think their CEO or Managing Director has shown strong, decisive leadership.

The report makes it clear that business leaders who fail to address employees’ concerns do so at their peril: poor employee engagement could damage performance and customer service, and create problems in retaining talent when the economy – and the job market – improves.

The findings illustrate the real danger of erosion of goodwill in the workplace when employers fail to address employee concerns about the recession (see 2). While goodwill can be lost quickly, winning it back generally takes much longer and can incur a significant outlay of resources.

Chart 3 shows that the overwhelming concerns of white-collar workers are for their immediate personal futures – job security, financial and career prospects, and having to work harder under more stress. Fears about personal financial and career development can create negative morale, and motivation problems that may ultimately have a serious and negative impact on company performance.

FD’s report acknowledges that it is difficult for employers to offer guarantees on jobs in the current market. However, employees still need to be reassured of their continued value, and understand the need to realign their expectations, given new economic realities. Leaders who wish to build trust and credibility with their employees must balance the need for candid discussions about the economic challenges that their organizations face with the importance of communicating clearly the value and role of employees in responding to these challenges.

As shown in Chart 4, only a minority of respondents felt that their role in helping their organizations weather the recession was well explained or that they had the opportunity to voice their concerns.

Face-to-face contact with managers and team meetings are the most trusted forums for talking about their organization (see Chart 5). Time invested in direct communications with employees will enhance loyalty and motivation, and thus ultimately protect the value of the business. FD’s findings suggest that ‘official’ channels of communication often lack credibility, with the grapevine and rumor mill trusted in many cases over the company newsletter or intranet. Company leaders should also pay close attention to how employees respond to internal communications.

Some 13% of respondents said their employer had never communicated to them about the challenges of tackling the recession. Email was the most common form of communication for those who did receive some information from their employer, closely followed by team meetings and face-to-face contact with a line manager (see Chart 6).

In turbulent economic times, when there is great uncertainty about the future viability of business organizations, employees are naturally anxious and value frank dialog with bosses. With a high degree of cynicism for official company communications, direct face-to-face engagement is most effective at establishing trust. It’s clear that business leaders need to provide candid explanations of the challenges facing their respective companies, demonstrate that there is a plan to meet these challenges, and show what role employees can play. This will build employee trust and morale, which will help to retain talent and motivate employees to strive for the high performance needed to survive today and thrive tomorrow.

Anyone who predicted in the beginning of 2008 that some of the world’s leading financial institutions would be wiped out, that others would require rescuing via massive government bailouts or that the global economy would teeter on the brink of a new Great Depression would have been laughed at.

The size and speed of the financial tsunami last fall illustrated how ill-prepared the corporate world was for such a meltdown. 

While there are now some early encouraging signs that the worst may be over, uncertainties still abound. This is precisely when organizations should assess their ability to handle the unforeseen and to make wise decisions in crisis environments. 

From a corporate perspective, the most common crises are generally found in three key areas:

• Natural disasters – including floods, fires, typhoons and earthquakes;
• Environmental and health-related problems – including epidemics, accidental spills, hazardous material issues, nuclear or chemical scares, sudden reversal of government policy or the intervention of NGO environmental groups;
• Man-made events – including arson, sabotage, terrorism, aggravated labor issues and the public exposure of substantial corporate fraud or corruption, resulting in threats to the enterprise.

In Asia, we are routinely exposed to all of these risks. Natural disasters have occurred and continue to occur in South Asia and elsewhere in the region, and there is always a threat that Tokyo or Osaka will experience a major earthquake.

China is particularly vulnerable to health-related problems, given its explosive growth and attendant environmental problems. Over the past year, China has experienced widespread chemical-related problems and issues involving tainted milk and other food products. These incidents have had a global impact since China is increasingly the workshop of the world. Within China, it was recognized that these issues could potentially pose a threat to the legitimacy of the ruling party, and possibly impact internal stability.

From a corporate point of view, these crises issues require careful planning, execution and sensitivity.

In Asia, one of the most common ‘man-made’ crises is in the area of significant and sudden corporate fraud. In the coming months, we are likely to see further disclosures and significant failures, particularly related to corporate malfeasance. Companies need to be able to react swiftly and effectively in order to preserve their brand, reputation or market valuation.

Many companies have developed plans to deal with business interruption and continuity plans, perhaps following the occurrence of a ‘set piece’ event (e.g. a natural disaster or environmental crisis). Unfortunately, most organizations are ill-prepared to deal with the practical implications of substantial corporate fraud, terrorism or other man-made crises. Our experience is that the larger the company, the less likely it will be able to respond effectively and in a timely fashion to avert the fallout of a major crisis.

Larger companies frequently seek to identify risks and combat them by utilizing risk registers and other mechanical measures. These are helpful but not sufficient. The key after having conducted this process/exercise is to develop practical and realistic plans to actually deal with the problem in a hands-on manner.

How Prepared is Your Company to Handle a Crisis?

Company directors should be asking a number of questions:
• Do we have systems and protocols in place now?
• Have they been tested?
• Can we respond quickly and efficiently to a crisis?
• Do we have an effective infrastructure in place?
• Can we find the designated people who are part of our crisis containment team?

Directors need to know that in times like these, the company has sufficient resources, both internal and external, to respond to any major corporate emergency or challenge.

In the experience of FTI-International Risk, the first 48 hours from the onset of any crisis or emergency is the most critical period. The key to success is to support senior management in mobilizing resources, focusing them on resolving the core issue while also minimizing the impact to personnel or disruption to day-to-day operations. It is important, therefore, that the crisis containment team is activated at the earliest possible opportunity.

Where it is evident that management does not have the necessary knowledge or experience ‘in-house,’ organizations should seek the support of an independent risk mitigation consultant. For the first few days of the crisis, there is a need for someone, often an external firm, to act as the ‘aggregate’ to hold together the various disparate elements involved in the corporate response to a crisis situation. Organisations with matrix management structures are often ill-suited to deal with sudden and unpredictable events, which to be correctly addressed require a defined leader, and a clear chain of command with no room for equivocation, internal politics or finger-pointing.

While the size and composition of crisis containment teams in corporations varies according to their size and geographic disposition, they are usually comprised of elements of senior management, finance, operations and legal. Externally, specialist consultants in both crisis containment and crisis communications are often retained. Many public relations firms are not specialists in crisis communications, and it is important to make this distinction.

The collective goal of the team should be to facilitate well-informed decisions that are implemented in a consistent and timely fashion. While crises come in all shapes and sizes, the response tends to follow a classic pattern: the initial step is to comprehensively assess ‘Ground Zero’ and to realistically estimate the damage or likely future or continuing damage to the entity. For example, in the event of a catastrophic fraud or corruption issue, this is often determined via the swift examination of relevant documents, including phone records, emails and other computer files, meeting schedules, travel patterns, and so forth.

Ninety-five percent of the world’s business records are estimated to be in some form of electronic medium. Therefore, electronic evidence recovery and e-discovery protocols are vital in the support of almost any corporate crisis.

Once the team has a better understanding of the situation, efforts can be made to identify possible options, and the relative merits and disadvantages of various courses of action can be discussed.

CEOs are unlikely to be able to manage a significant corporate crisis as well as normal business operations for more than five consecutive days, without failing at both. Therefore, it is imperative that senior management be presented with sufficient information and recommendations to make the best strategic decisions. It is equally important that they be kept sufficiently above the fray so as not to be over-involved in the minutiae to the detriment of the ultimate objective of ‘seeing through the crisis and visualizing its resolution.’

Crisis Containment and Resolution

Throughout the handling of any significant crisis, the designated crisis containment team should be regularly addressing and readdressing the following issues:

• Is this an enterprise-threatening issue?
• Do we have sufficient resources in-house to deal with it?
• What is the likely long-term financial impact on the bottom line?
• Have we plugged all immediate and identifiable gaps to prevent further losses?
• Can the losses be recovered, or are they covered by insurance – fidelity policies, bankers’ blanket bonds or a directors’ and officers’ policy?
• Which controls failed and are we still exposed?
• Who was involved / what damage has been done / what are we doing about it?
• Should an immediate report be made to the police or to other local authorities?
• Is there a requirement to report to regulators?
• Crisis communications – are we prepared to deal with the media even if we have not yet had time to plan?

Crises are, by their very nature, unpredictable, but with a well-designed and tested structure in place, companies can mitigate the damage to their reputations and their share value, while also preserving the loyalty of their customers and staff.

Healthcare costs of approximately $2.4 trillion are substantial (about 17% of GDP in 2008/2009 up from about 15% in 2005 and a mere 5% in 1965) and are anticipated to increase to about 19.5% of GDP by 2017, without comprehensive reform. The growth rate of healthcare expenditures has exceeded that of GDP by more than double over the past four decades. During the same period, there have been dramatic improvements in technology, communications networks, electronic media, treatments for a vast array of illnesses, better understanding of preventive care, improved longevity, and substantial evolution in the organizational structures for delivering care in the U.S. across plans and providers.

Pending legislative proposals involve a wide array of alternatives for addressing costs, quality and extension of care. The national discussion has been focused on cost reduction efforts, including widespread discussion of organizations that have accomplished substantial cost reduction while enhancing quality of service. For example, in his September speech to the U.S. Congress, President Obama mentioned two such organizations – InterMountain Health and Geisinger Health – as examples of healthcare organizations with success in both improved quality and cost reduction (other frequently touted studies include other examples). An open question, which is subject to both policy and empirical examination, is how these ‘localized’ examples can best be replicated in more localities or at the national level. What are their secrets to success and how can they be taken into consideration in forming national policy? The effort to replicate those experiences, and to identify how and why such gains were accomplished, has become a key part of the legislative agenda. The intense focus on cost-reduction solutions is also reflected in the proposals made by healthcare industry representatives – including pharmaceutical manufacturers, insurers, hospitals and physicians.

The discussion focused around three key themes:

• What are the common elements/reasons for the actual or perceived successes at cost reduction with improved quality?
• What works to align incentives among market participants – insurers, hospitals, physicians, employers, and consumers – to accomplish greater cost savings while enhancing quality of care and of life?
• What are the impediments or challenges to achieving greater gains at the local or national level?

Meg Guerin-Calvert: The most frequently cited examples of institutions that have achieved success in cost reduction and improvement of quality of care include some of the nation’s largest and most highly integrated private healthcare organizations. Some of these organizations provide the full spectrum of inpatient and outpatient care and others are more specialized. Kaiser, for example, may be the most fully integrated of the examples mentioned – within this single organization there are physicians, clinics, hospitals and insurance, with fully managed inpatient and outpatient care. It’s also noteworthy that these entities coexist and compete with other organizational forms in the provision of physician services, insurance and hospital care, demonstrating that the healthcare marketplace supports a variety
of entities.

There are several common themes from these examples. First, most of these organizations are very large for their locality or region. This suggests that even as a single firm these organizations are able to get relatively complete information on the local population, its healthcare needs and characteristics, as well as on providers.

Second, these highly integrated organizations can use this access to develop and implement solutions to identify higher costs, to reward improved quality and cost reduction, and to induce providers and patients to take preventive care steps so as to reduce more costly inpatient or outpatient care. A common element of cost reduction successes are organizations that have made use of their own data and information on procedures, outcomes and costs, and then developed systematic and comprehensive analyses both internally, and relative to external standards, to identify the sources of variation and to develop solutions. They have developed metrics, and can track and implement them.

Third, the gains from improvements and cost reductions can be internalized by the organization, and thereby create greater incentives to invest in activities such as improved IT and electronic records.

Fourth, these are largely examples of private organizations, not public or government-funded ones, which have relied on market mechanisms to accomplish their goals. These include a variety of contractual arrangements with many different healthcare market participants.

Charles Overstreet: The most common element in achieving cost reductions is how readily any cost reduction can be measured. Cost reduction success stories are often best illustrated by how the reductions were tallied up. That is to say, whether the reduction or improvement is large or small and how easy it is to track. Many reductions have to do with the overall change in the actual outlay of cash. Supplies, hourly wage, medicines, devices, etc. all have a cost. If we can identify these costs, reduce these costs and then track the reduction, we have a success story.

But cost reduction is often illustrated in more complex scenarios where there may be many variables or components that are being improved (or are perceived to have been improved). The key to success in these more complex scenarios is not in just tracking individual component improvements, but in developing and tracking simple overall statistics of improvement. One classic example is the great strides in improving cost and quality in cardiac surgery. Over the past several years we have seen many improvements in this area of medicine. Why? Yes, medical science has advanced and we have improved medicines, techniques and other factors. But I would argue that one of the major reasons for the improvement in quality and cost in this area is the ease with which one can actually gauge and track improvements.

Some simple statistics that are easily tracked are the real contributing factors of the improvement in this area – Length of Stay (LOS) and Cost per Case. These two statistics are easily calculated and they complement each other. Moreover, most would agree that a reduction in the LOS of a hospital stay is an improvement in clinical quality, and agree that a reduction in Cost per Case is also a success. Both metrics do not allow for much argument or difference of interpretation – ‘they are what they are.’

Martin Cohen: Historically, hospitals and physicians have addressed cost reduction through enhanced management of labor and non-labor (i.e. medical supplies, cost of implants, cost of contract services, etc) costs. Also, in the early ’80s (with the introduction of DRG’s) and the late ’80s and early ’90s (with the expansion of HMOs) significant improvement was achieved in reducing clinical costs, through better management of the clinical care process. However, much is left to accomplish in this area.

Although hospitals and physicians must (and will) continue to look for ways to reduce labor and non-labor costs, in order to reduce the cost of care in a meaningful way it is essential to continue enhancing clinical care processes through better coordination and management of care delivery. On a day-to-day basis that would call for better coordination of preventive, diagnostic or therapeutic modalities provided by patients’ primary care and specialty physicians. In an acute inpatient setting, this would entail not only coordination of care among the physicians but also the nursing, diagnostic and other professional staff providing care in the hospital.

There are several key elements required to bring about improved coordination and management of the clinical care processes including (1) improved access and transparency of patient medical information (electronic medical records), (2) the development and implementation of best practices with respect to clinical treatment protocols, (3) the need to better track and monitor clinical quality outcome measures and finally (4) the need to align the economic incentives for hospitals and physicians. Each of these is an essential component necessary to improve the effectiveness and efficiency of clinical care processes and all must be addressed.

Charles Overstreet: One of the reasons why reductions/improvements on a broader and deeper scale get bogged down, or do not reach their full potential, is that we get sidetracked in arguing over the metrics of reduction/improvement, or we cannot develop sound and systematic metrics of measurement. In my example of the cardiac surgery improvements, we can quickly get into a debate over measuring other factors of reduction/improvement when we get into more complex measures such as outcomes, readmission rates, volume of diagnostic procedures, etc. These types of factors are important and need to be measured, but we do not have a recognized commonality of ‘how to keep score.’ Thus I would assert that greater reductions/improvements in overall healthcare will require a common (and agreed-upon) method for measuring the change.

Martin Cohen: Although there have been attempts to address the essential elements I described earlier, they have not been addressed in a comprehensive way and accordingly have met with varying degrees of success. For example, the establishment and growth of HMOs have provided a significant reduction in the cost of care. However, these reductions in cost have been primarily driven from the economic incentives provided to providers and reduced access to services. Absenting the transparency of medical information, development of clinical pathways and better tracking and monitoring of meaningful clinical quality measures, this method of reducing costs has a limited upside and is certainly not grounded in clinical effectiveness.

On the other hand, substantial work has been done in the development of electronic medical records, development and tracking of quality measures and establishment of enhanced clinical protocols/pathways. But until providers, both physicians and hospitals, are reimbursed for services in a manner that provides aligned economic incentives, and until quality becomes a component of how providers are paid, history has proven that behaviors are not likely to change and significant cost reduction impact will not likely be achieved.

In order to achieve the real efficiencies available through enhanced coordination and management of care, the Federal Government, through modifications to the Medicare system of reimbursing physicians and hospitals, will have to lead the way.

Meg Guerin-Calvert: The examples of individual organizations are the most dramatic and perhaps most informative, but may obscure other sources of gains in the management and reduction of costs. During the 1990s and early 2000s, there was substantial consolidation of hospitals, the vast majority of which raised no antitrust concerns and which resulted in substantial and well-documented efficiencies. In addition, efforts on the health insurance and provider sides have focused on mechanisms to create incentives for improved preventive care, pay for performance, and metrics. 

Celia Hall: The United Kingdom’s National Health Service (NHS), which oversees the delivery of healthcare to all UK citizens, has pursued some noteworthy reforms that deserve more attention as the United States looks for opportunities to control costs and preserve quality.

One initiative has been to break up the organization into smaller, more flexible and more autonomous units such as NHS foundation trusts covering both hospital and primary care. These are self-governing organizations that run hospitals and provide healthcare to the general public but are able to raise their own capital and save and invest any savings they generate. They work to nationally agreed standards, in order to provide consistent standards of care across the country. Hospitals can only obtain and maintain foundation trust status if they are able to prove and show good financial control and governance.

The foundation trusts are similar to medium-sized businesses, and there is a belief that it will be easier for these locally focused organizations to contain costs and cut waste. According to the independent regulator of NHS foundation trusts, the trusts spent £22.7 billion in 2008/09 and generated a retained surplus of £269 million. While this is a tiny amount compared to total spending, each of the 122 trusts in England is under an obligation to make efficiency savings every year or face loss of their foundation trust status.

Edward Reilly: We can also look to employers as innovators in developing ways to reduce healthcare costs while improving quality of life for their employees and families. For example, Coca-Cola has taken very innovative steps to control costs, by focusing on behavioral changes, and incentivizing people to live a healthy lifestyle. By next year, it is going to cover 100% of the cost of preventive screening for its employees. The program is projected to save an average of $300 in healthcare costs per employee per year, and reduce the company’s healthcare costs by 8%, annually.

Another example is the tremendous transformation we have observed at Walmart. It is counseling employees on how to take advantage of government healthcare options. And it is very active in promoting wellness programs, taking a more progressive approach, while putting more responsibility on employees.
Some may be surprised by the fact that one of the elements we’re seeing in our ongoing public opinion research is that employees perceive employers to be a primary steward of their interests.

So employers have an even more critical role to play in communicating with employees what can be done to better manage costs to the business, and what individuals can do to change their behavior in ways that will help to reduce healthcare costs. The human resources departments in particular are playing valuable roles when employees interact with an insurance company – educator, explainer and advocate.

Our research shows that people are willing to make sacrifices to keep their employer-provided health insurance. Indeed, a recent FTI survey found that 70% of all respondents are willing to take a pay cut to keep the healthcare insurance currently provided by their employer. The same survey found that while 29% of those surveyed blame employers for rising health insurance premiums, five other groups were identified more frequently as the source of such increases (health insurance companies, hospitals/medical facilities, lawyers, government, and consumers/employees).

Charles Overstreet: In continuing my theme on the need for common measurement, I think that measurement and tracking are essential for aligning incentives for all those participating in the healthcare marketplace. Reduction in the costs to consumers must be balanced with the real or perceived loss of revenue from the perspective of the provider.

The promise of truly managed care allowed for some of this balance. Payments for care were to be placed in a pool and used as needed by a patient population. Through responsible management of that care and a focus on ‘health maintenance,’ the total outlays from the pool were to be reduced. When the year was over, whatever was left in the pool was shared between payer, provider and beneficiary, and thus, all of those involved had aligned incentives. This is the simplest way to initiate and sustain real reductions and improvements.

Meg Guerin-Calvert: Even where there is sound measurement and metrics, there still needs to be sufficiently broad data (both cross-sectional and time-series) to be able to conduct a sound empirical assessment of the variation in costs and quality, while controlling for the wealth of factors that can affect both. As Charles notes, there are often many factors that explain a given result, meaning that empirical analyses must be sufficiently sophisticated to deal with the complexity.

A hallmark of the FTI professionals working in the healthcare area is knowledge of healthcare data, extensive experience with empirical analyses at the most disaggregated and detailed level, and a thorough understanding of the approaches and mechanisms used to improve costs and quality – whether for firms in financial distress, those seeking process improvement, others via merger, or in the development of new ventures.

Celia Hall: There are similar challenges in the United Kingdom, which is battling the problems of an insatiable demand for healthcare, little incentive to use the service responsibly and an ageing demographic. In the UK, two generations have got used to the idea of free healthcare and the NHS is very much seen as a sacred cow. There is little incentive for politicians to tackle the cost issues head-on so any changes will be a case of evolution rather than revolution.

Similarly, small hospitals in medium-sized towns are very inefficient. It is impractical for these hospitals to provide every single service or expertise that can be provided by larger regional hospitals. But there are huge political constraints, particularly for local representatives, in addressing this.

Another issue in the UK is that in trying to reduce costs, implementing comprehensive reforms can prove to be quite costly. There have been well-publicized delays and cost overruns on a central IT operation for the National Health System. The IT was designed to link 30,000 GPs and 300 hospitals to a central system and contain information on 50 million patients. It was projected to save more than £1 billion a year. But it is now four years behind schedule and it may also end up costing four or five times the original £6.2 billion budget.

Edward Reilly: As a result of the healthcare reform debate, irrespective of the final resolution, there will be greater scrutiny on healthcare providers and the cost and effectiveness of what is being delivered. Although not directly included in health reform, the Government has set aside billions of dollars for comparative effectiveness trials to look at the relative benefits of various treatments for the same indication or diagnosis. For example, a trial would look to compare rehab therapy to surgery for a specific orthopedic procedure, review the outcomes and assess the relative benefits. The tools are available today to design and implement patient registries, studies and technologies for evaluating real world outcomes for safety, effectiveness, quality and value.
 
Meg Guerin-Calvert: As my colleagues in this roundtable have indicated, achieving clear gains in costs and quality depends on developing and assessing sound empirical evidence, which must then be connected to effect changes in performance, whether by physicians, hospitals, insurers, employers or patients or some combination of them. That involves organizational structures, including some internal to firms, and others that require coordination across otherwise independent players. I can envision that such extensive empirical analyses could be conducted by individual health systems, by insurers, by physician groups, as well as by combinations of such entities. While there are opportunities for substantial cost savings at the individual provider or insurer level, there are likely to be even greater potential gains from finding the means to develop sufficient data to conduct sound studies by multiple entities in an area and to implement the results across firms and markets. That is a challenge because it requires development of contractual arrangements to accomplish data-gathering, development of the empirical analyses, and then implementing solutions for cost reduction and alignment of incentives.

The experience of successful healthcare organizations shows that in a market-oriented healthcare system, the market can function to achieve substantial cost savings, where it can replicate by contractual arrangements what integrated firms have been able to develop internally. However, increased coordination can lead to a reduction in competition. And so antitrust authorities will need to provide greater guidance about the standards by which any new types of arrangements between and among participants will be evaluated, because existing guidelines suggest that many of these arrangements fall outside of recognized safety zones. For example, would antitrust issues arise if hospitals and physicians, hospitals and plans, or smaller independent plans within a region, pool data and information on claims or procedures, collectively fund empirical research on the sources of cost increases, and then implement initiatives to change behaviors so as to reduce costs?

The essence of the proxy reform proposal is to allow shareholders who own at least 1% of a company’s shares to have their board nominees included in corporate proxy materials. This would apply to companies with a market capitalization exceeding $700 million. A 3% stake would be required for shareholders of midsize companies and a 5% stake for shareholders of smaller companies.

After releasing a detailed proposal in early June, the SEC received more than 500 sets of comments.  The intensity of the response is not a surprise. As one attorney told The Wall Street Journal, ‘It’s the biggest change relating to corporate governance ever proposed by the SEC. Period. It gives activists the ultimate vehicle to express dissatisfaction with a board, the ability to replace board members at the company’s expense.’

The all-out lobbying battle in Washington has pitted the Business Roundtable, U.S. Chamber of Commerce and National Investor Relations Institute against investor groups such as the Council of Institutional Investors and institutional-investing giant Capital Research & Management Co., as well as some large unions. All agree the present proxy system is too complex, but some argue the SEC isn’t attacking the root of the problem, and instead is approaching reform in a piecemeal fashion that doesn’t take into account how the interrelated parts need to work together.

Critics of the SEC proposal argue more time is needed to ensure the technology is in place to support this new style of proxy voting, and to ensure that corporate issuers aren’t hampered with excessive costs of materials printing, mailing and proxy solicitation firm engagement to get out the retail vote.

The real issue behind the proxy access rules is that it has the potential to simplify shareholder activism and reduce the costs associated with it. Lower turnout and support for board members this proxy season paves the way for bad press, hostile shareholders and heightened activism levels at target companies. The SEC’s proposed rules put few limits on shareholder activists who will find it easier to advance their narrow interests at the expense of the broader shareholder goals.

The New York Stock Exchange’s Rule 452, approved in July, provides a preview of how the proxy reform would work in practice, were it to be enacted. It is likely to cause short-term problems since it eliminates ‘Broker Discretionary Voting’ without providing an easy way for retail shareholders to vote. While the intention of removing brokers’ ability to cast votes for shareholders who don’t return voting material unless instructed to do so may be fine, the consequences could have major adverse impacts in practice. Without new technology to lower the cost for retail shareholders to vote, the rule will likely translate into lower voter participation rates. Board members may appear to get much less support than in the past, making them appear to have lost shareholder confidence when, in reality, there were simply fewer voters. This may have the unforeseen consequence of exacerbating the voting impact of the better coordinated activist or opposition group.

It remains an open question as to whether the SEC will approve changes to the proxy process. If it does, it could lead to a shake-up in corporate boardrooms. What’s not clear is whether the shake-up will be for better, or for worse.

Indeed, there are many reasons why companies end up in poor health: flawed business models, strategic gaffes, poor execution, emerging competitors and weak management, to name a few. When it comes to turning around an unhealthy company, however, there is a single formula that works. The field of turnaround management has attracted a wide range of practitioners and philosophies over the years. We believe that some approaches are not only ineffective, but actually serve to stifle recovery. This article will describe a proven framework for operational turnaround management that can help to ensure sustainable long-term profitability and market leadership.

The Balance Sheet is Not the Place to Start

Thousands of companies are in the midst of financial distress every day, even in the best of economic climates. But restructuring and operational turnarounds tend to attract the most attention during periods of economic contraction. Underlying problems in core business models are exacerbated during these periods, and bankruptcies surge, as recent experience has demonstrated. Moreover, projections of corporate debt maturities and defaults over the next few years (see Debt Maturity: The Next Wave on page 8) suggest that we may see a record number of restructurings before this cycle ends.

The effects of the recent global credit crisis notwithstanding, the majority of distressed companies historically have faced challenges well beyond the balance sheet. The problem is that so many management teams in turnaround mode focus primarily on access to capital. This finance-first approach is short-sighted at best, fatal at worst. Recapitalization is helpful for shoring up finances quickly, but it does little to guarantee long-term cash flows and operational sustainability.

We have seen the failure of this approach most notably in the retail sector, where there are repeated declarations of bankruptcy – known as ‘Chapter 22’ and ‘Chapter 33’ scenarios. Many retailers are prone to multiple bankruptcies because their turnarounds are often little more than feats of short-term financial re-engineering. From an operational standpoint, most distressed retailers overly focus on a ‘four wall’ cash flow analysis. The allure of such an analysis is its simplicity: keep stores that contribute positive cash to overhead and close cash-flow-negative stores. The result is often a slimmed-down operation and a smaller footprint that’s still riddled with shortcomings. Unless management addresses competitive advantages (or the lack thereof), the smaller chain continues to see declining operational performance. It’s akin to treating symptoms.

Sustainable Turnarounds Focus on the Income Statement

Most failing companies have a fundamental problem in their core business, which is why the only way to execute a successful operational turnaround is to focus on the core, not, as we call it, the clouds. The first instinct of many managers when commencing a turnaround strategy is to cut costs. Costs should and will be scrutinized and there will always be areas of inefficiency and waste. However, from a long-term perspective, a company cannot cut its way to an operational turnaround. While cost-cutting can help to achieve a cash-neutral or cash-positive position in the short term, it won’t solve deeper structural problems facing the core business.

A more dangerous instinct is for managers to try to supplement the core business by launching new products and/or entering new markets. The theory is that the revenue and cash flow from successful new businesses will help to fund the turnaround of the core. This is illogical. Growth on top of a flawed business simply produces a larger flaw. For a struggling ice cream chain, introducing a new flavor will never repair the underlying business problem. Instead, managers must identify and capitalize on the company’s distinct competitive advantage. This advantage, if one exists, will serve as a life raft to strengthen core operations over time.

The initial phase of a turnaround is day-to-day implementation toward defining the end-game. It involves a combination of short-term and long-term decision-making, which must be executed quickly and communicated clearly. We’ve found that maximum interaction with staff during this phase leads to maximum performance outcomes. Ride along on repair calls. Have lunch with the admin pool. Go on sales calls. Such interactions help the turnaround team to frame the discussion about the competitive advantages.

Like many turnaround advisors, I learned my most important lesson early on in my career: many companies cannot be turned around. Despite natural optimism and good intentions, management teams cannot will an operational turnaround to happen. The most brilliant turnaround team cannot turn a market laggard into a market leader. The company’s assets and advantages must be evaluated with brutal candor; only then can management determine with confidence whether a turnaround is feasible or if the company’s best course of action is liquidation. If there is no clear competitive advantage on which to build a realistic plan, then an operational turnaround is not feasible. And if a turnaround is not feasible, recognizing this fact quickly is the most important strategic decision for preventing further losses.

If a competitive advantage does exist, then it must quickly become management’s platform for future profitability. The most effective way to harness this advantage is to make it the core of the end-game, which is management’s vision of the company’s future state once it has achieved sustainable long-term health. The end-game must be driven by the market opportunity inherent in the company’s competitive advantage. An end-game must be as specific as possible and must be driven by markets, not finances. A return to profitability is not an end-game; it is a tool required to achieve the end-game.

Cultural Change is the Ultimate Factor in Turnaround Success

Achieving the end-game will often take years and will depend on the wisdom of hundreds of decisions along the way. After nearly three decades in this field, I’ve learned that one element in the turnaround process is more important than any other: employee behavior. In fact, we’ve developed a Golden Rule of operational turnarounds (see below).

Culture is all-powerful in turnaround situations, and what fuels culture are the incentives for staff to behave in a certain way. What’s more, culture has little to do with the balance sheet, but has everything to do with the income statement. The key is to focus employee behavior – through proper incentives – on the activities that will most rapidly enhance the income statement, which of course will depend on the nature of your business problem. If done properly, these new behaviors can reduce or eliminate negative cash flow, which is a necessary precursor to long-term health.

Every unhealthy company struggles with counter-productive internal behaviors, even if these same behaviors at one time enabled the company’s growth. As shown in Figure 1, negative behaviors do not appear overnight. They typically become entrenched in the culture of the organization over many years. And when they are exacerbating the core business problem, the first job of the turnaround specialist is to identify them.

A real-world example will help to illustrate our recommended approach to operational turnarounds. In 2000, I was CEO of a leading company in the time-share market, with 89 resort properties in eight countries and $500 million in annual revenue. A key growth driver for the company was its mortgage origination business, which loaned customers 90% of the $10,000 unit purchase price. A majority of these subprime mortgages were securitized and sold to Wall Street, thus removing significant risk from the balance sheet. However, some of the mortgages remained on its books. When defaults on the mortgages held by the company accelerated, its ability to tap the secondary market dried up and this sudden lack of liquidity forced it into bankruptcy. When I became CEO of the company, I worked with management through four key stages of the turnaround process, forcing honest reflections and tough decisions. This process generally doesn’t make a lot of friends, but sticking to these phases will invariably optimize any company’s outcome.

Assess Existing Behaviors

Nobody likes working for a weakened company. But it’s the entrenched behaviors of these same employees, often starting with the CEO, which usually have weakened the company in the first place. And they usually know it. That’s why employees often open up to the turnaround team, offering their own diagnoses and sometimes already knowing the solution. As implied in Figure 1, the turnaround team’s first priority is to understand the existing behaviors and their impact on performance decline. Then they must take a step back and evaluate the incentives that are in place to motivate and reward these behaviors. Is the culture driven too much by the sales function? Too little? Are employees rewarded for retaining or expanding customer relationships? Are they given the tools to do so? How are collaboration and cross-selling rewarded? How are acquisitions integrated culturally? Has management communicated a vision and strategy for the future? How does the company reward employees for helping to achieve that strategy?

At the time-share company, the corporate culture was driven entirely by sales. Built by acquisitions, these acquisitions were poorly integrated. Customer experience and retention were not a priority. An exclusive behavioral focus was on revenue growth. Sales representatives, who were paid entirely on commission, earned 20% of each $10,000 sale. At the same time, the time-share company provided most customers with mortgages for 90% of the purchase price, or $9,000. With no credit standards in place, these subprime mortgages came home to roost as high defaults (in the same way as we have seen over the past two years in the U.S. housing market). Without the ability to securitize the loan, even before taking into account overhead and marketing expenses, every sale immediately ate into the company’s cash flow, setting it up for a death spiral toward liquidation.

Define the Competitive Advantage

A turnaround lives or dies on the basis of a company’s ability to define its competitive advantage, which necessarily forms the core of the turnaround strategy. So, what is a competitive advantage exactly? Above all else, this stage is an exercise in market assessment. What distinct advantage or niche does the company own in the market? Why do customers choose the company over its peers? Most importantly, the results of the competitive advantage must be clearly reflected on the income statement; if historical sales patterns and/or cash flows can’t demonstrate that the advantage is real, then it isn’t.

Examples of competitive advantage may include:
• A presence in more lucrative geographies than any competitor
• A reputation for customer service and support unmatched in the industry
• Exclusive licensing deals with important partners or distributors
• An unrivaled R&D capability and reputation for innovation
• A respected brand that generates greater customer loyalty than that of competitors

Once the competitive advantage is defined, it will become the foundation of the company’s turnaround strategy. The competitive advantage will quickly come to define the company’s success, both today and in the future. This means that management’s end-game must be defined in competitive terms and then communicated aggressively both internally and externally.

Every decision throughout the turnaround process will be measured against its effect on the end-game, which is why it must be as specific and realistic as possible. Years ago, I asked a client to describe his end-game, to which he replied, ‘To get bigger.’ Such a response is not entirely uncommon. Unfortunately, such a vague notion is not only reckless, but can be extremely damaging to the turnaround process. On the contrary, end-games must be market-driven and specific, such as to become the number one or number two player in market A, or to be the largest provider to vertical market B, or to have physical presence in our 10 most important geographical markets. Such objectives are not only realistic and measurable, they are infinitely more inspiring to employees who know the company’s competitive position better than anyone.

In the case of the time-share company, rudimentary market analysis revealed that the company’s international footprint of properties was its key differentiator and unique advantage in the marketplace; not a single U.S.-based competitor offered customers such a breadth of international options. Moreover, the European operation was the only profitable part of the business at the time. Yet these were the assets that management was planning to sell to raise cash to continue funding the non-profitable part of the business. Such a transaction, which was ultimately canceled, would have all but guaranteed the infeasibility of a turnaround and the liquidation of all of the company’s remaining assets.

Define the Required Behaviors

The next stage can cause a turnaround specialist to become extremely unpopular, as it’s during this period that changes are made and sacrifices are required. Compliant with our Golden Rule mentioned earlier, new standards and incentives are introduced to change human behavior – a daunting exercise even in the best of circumstances. The first priority is to fix the cash-negative problem through short-term strategies, which may include:

• Centralizing operations to maximize cost efficiencies
• Decentralizing operations to promote greater revenue growth
• Closing certain business segments that are beyond repair
• Securing new contract terms with customers and vendors
• Introducing new metrics for staff productivity and performance

Since these short-term fixes will change incentives and require new behaviors, there is likely to be an onset of employee fallout. Embrace these departures! They are a sign that the message and end-game are clear. Headcount reduction is usually inevitable during a restructuring process and the most successful form is natural attrition. As behavioral standards suddenly change, certain staff will come to realize that they will no longer thrive in the new environment. And this is good.

From our experience, sales talent falls into one of two orientations – and skill sets – within an organization. We call these hunters and herders. As shown in Figure 2, hunters are oriented toward customer acquisition and see their mission as helping the company maximize revenue growth, while herders are oriented toward customer retention and see their mission as helping the company maximize efficiency and profitability.

These categories apply not only to the sales team. Typically, one orientation is more likely to leave the company based on the end goal. It is management’s job to change the incentives in a way that ensures the wrong type of talent is departing and that the talent required is staying.

In the time-share company’s situation, its short-term survival required a dramatic shift in behavior from revenue-at-any-cost to profitability-at-any-cost. The first step was to centralize control of the sales and mortgage origination processes, control for which previously was scattered across a variety of managers and locations. All contracts would require central approval. Credit standards would be dramatically tightened. The historical 10% down payment requirement was scrapped and we reset the goal of down payments to an average of 30%. These new standards proved highly disruptive to the company’s sales-driven culture, but were essential to guarantee at least a cash-neutral position in the immediate future. Using our formula, we changed sales compensation from being based on total contract value, to being based on total amount of the down payment. We achieved our target of 30% down payments and were cash neutral in just over a month.

Implementation

Consistent communication is critical throughout the turnaround. Management must make sure all decisions – even the ugly ones – are designed to leverage the company’s competitive advantage and achieve the end-game. A world-class communication infrastructure is essential here. The management team, particularly the CEO, should always be accessible for questions. (See sidebar on page 23.) Employees don’t have to like management’s decisions, but they need to understand them. During turnarounds, lack of information is always worse than having negative information. This is why management must be quick in disclosing bad news as well as good news. And if management doesn’t have the answer to a question, it shouldn’t be afraid to say so.

So when is the turnaround complete? There’s no magic formula for deciding when the company is on a path to long-term growth, but in our experience, the board and management team will know it when they see it. The results of improved performance will be evident on the income statement. Staff turnover will have subsided. New behaviors will have been institutionalized. And sustainability and growth will be the new words of the day.

At the time-share company, management made the long-term decision to kill bad revenue; in other words, it needed to reduce sales volume and revenue in favor of sustainable profitability. And that’s exactly what happened. Within two years, revenue fell from $500 million to $280 million, but the company was profitable again. Overhead expenses were shaved, but many costs – sales and marketing, for example – were appropriately right-sized for a leaner, smaller organization. In 2007, seven years after its brush with total liquidation, the time-share company was sold to its new owners for $700 million, a 35% premium to its stock price. In announcing the deal, the new owner cited the time-share company’s international properties as a strategic complement to its own U.S.-focused portfolio. 

Conclusion

Successful turnarounds have many elements. Financial engineering is often hailed as a cure-all, but in our experience, even the best-capitalized company will ultimately fail if its core business model is flawed and its internal culture and behaviors continue to support that model. The four phases of turnaround management described here represent a proven framework for any management team struggling to repair fundamental problems in its core business. Turning around any company is often difficult, disruptive and sometimes unpleasant. However, through proper strategic planning and consistent decision-making, even the sickest of companies can hope for a recovery and a long, prosperous life.

Greg Rayburn is Senior Managing Director at FTI Consulting in the Corporate Finance/Restructuring Segment and Head of FTI Palladium Partners, the firm’s interim management practice. He has 25 years of experience in operational turnaround management, serving as interim Chief Executive Officer at companies across a wide variety of sectors.