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.