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The Board Bungled It

FOR ONE PRE-EMINENT FINANCIAL organization to lose its CEO is a misfortune, but for two prominent companies to lose their CEOs begins to look like carelessness. When Citigroup’s Charles O. Prince III and Merrill Lynch & Co.’s E. Stanley O’Neal stepped down under pressure in the face of mounting losses and billions of dollars in …

FOR ONE PRE-EMINENT FINANCIAL organization to lose its CEO is a misfortune, but for two prominent companies to lose their CEOs begins to look like carelessness. When Citigroup’s Charles O. Prince III and Merrill Lynch & Co.’s E. Stanley O’Neal stepped down under pressure in the face of mounting losses and billions of dollars in write downs, most observers viewed the episode as boards of directors vigilantly sacking incompetent CEOs in the face of the subprime mortgage fallout. We beg to differ. The real blunder was the board’s bungling of enterprise risk followed by a succession fumble when it became apparent that neither company had any bench strength on its senior team-an elementary governance error. In financial markets, it is well established that the efficacy of trading and investment strategies is limited by definition and that backwards testing cannot prove that investment systems work. In his seminal work Fooled By Randomness, the statistician and derivatives trader turned- philosopher Nassim Nicholas Taleb made a compelling case that one should be prepared for the unexpected, especially when making large bets as Citi and Merrill Lynch were doing. The recent turnover of CEOs Prince and O’Neal raises questions about the role played by their respective boards in the debacle. Was it really a case of the CEOs not doing their jobs, or of the boards not digging deep enough together with the CEO and the senior team to get their arms around the nature and complexity of the exposure?

It is the role of the board to stay apprised and be diligent in assessing enterprise risk, those risks that are large enough to cause serious harm to the health of the enterprise. In a large financial company those risks are regular, and firms have risk management functions that are looking over the firm’s risks everyday. Both Citi and Merrill made very large bets on the mortgage market with the full knowledge of their respective boards. It was initially a very profitable service offering. What board wouldn’t be paying close attention to an activity that’s throwing off large amounts of revenue? The board has a responsibility to understand those risks and be responsible for subsequent losses. To say they did not understand the risk due to complexity or inadequate review is unacceptable. Boards should have independent risk assessments in order to understand if the enterprise is taking on undue risk.

As Taleb might observe, the debacles in financial markets (remember Long-Term Capital Management and Bear Stearns’ recent fund blowups) are black swan-like events, outliers that most people don’t expect-most folks expect swans to be white because that’s what their experience tells them. But the fact is, repeated observations of white swans doesn’t prove that black swans don’t exist. Any risk assessment should take into account that the historical absence of a major downside doesn’t mean it’s unlikely to occur. The risks taken on by Citi and Merrill were too large even for them and should not have occurred. Their boards should have made sure of it.

So if these debacles are not just about CEOs having gone wild, why make the change if blood is also on the boards’ hands as well? Shouldn’t the heads of other financial services companies that have had mortgage losses also roll? More likely, Citi and Merrill made changes for other reasons-reasons that were building over time. What is perplexing is that these boards had no succession plan in place. Companies of this stature should have been prepared. This is Governance 101.

What is the moral here? This recent CEO turnover is not about making a bet and having it go wrong. This happens all the time. It is more about exposing weakness in the board oversight process and the resulting havoc that can occur. Citi and Merrill will hopefully also get serious about succession planning, and perhaps the industry will improve its enterprise risk assessment process. It is not acceptable for the board and CEO to be fooled by randomness. Random occurs too often. 

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