Boards May Need To Reevaluate Their Idea Of Acceptable Risk

Risk management is a key responsibility of any corporate board, but specifically, how boards determine the level of acceptable risk that is right for their company appears to be gaining importance. Executives at many companies are feeling pressure to improve revenues in the current high inflation, high-interest rate environment. Some companies are posting record earnings as the major stock exchanges continue setting records—so investors ask, why isn’t my company? Corporate board members might want to reevaluate the risk assumptions they’ve already made about their business plans and determine whether those risks are still acceptable once future changes in market conditions and anticipated interest rate cuts by the Federal Reserve are factored in.

Hertz Corporation CEO Stephen Scherr recently stepped down after the company’s decision to build the largest electric vehicle rental fleet in North America backfired. CNN.com reports that after purchasing 60,000 EVs from Tesla and two other car makers, the price for electric vehicles unexpectedly dropped and customer demand to rent EVs fell far short of expectations. In January, Hertz announced plans to sell 20,000 of the EVs it purchased to begin reversing the failed strategy, but it had to accept less than projected for each vehicle, resulting in the company taking a $245 million charge against its earnings. Perhaps the company wanted to accelerate a quick turnaround after emerging from bankruptcy in 2020. Unfortunately, betting on EVs did not work out well.

What was intended to be a bold move intended to capitalize on the popularity of EVs with car buyers, turned out to be a risky miscalculation. Electric car buyers and car renters didn’t embrace electric vehicles with the same enthusiasm. While EV sales were trending up, EV rentals were not. Additionally, the “unthinkable” happened when EV automakers decided to cut prices to sustain sales levels, which hurt the resale value of the EVs that Hertz purchased.

There is risk in every business strategy, but corporate boards may need to consider exploring more thoroughly the level of risk their company is exposed to if it follows a particular business strategy. Boards are being held to a higher standard regarding these matters. To do this, directors might need to:

Determine what the board considers acceptable risk. The board may need to come to agreement on certain lines the company should not cross when attempting to create sustainable growth. For example, some companies use Bitcoin as a financial hedge against investments in stocks, even though it has proven to be a very volatile investment vehicle. How much exposure to Bitcoin would your board find acceptable? What is the acceptable risk when gaging customer demand for a particular product—do you build inventory ahead of demand or use a “supply on demand” model? These small nuances could have a major impact on the company. Once the board members are in agreement, they can articulate their risk considerations to the CEO and management team.

Prepare for the worst-case scenario. While no one wants to highlight potential flaws in a business strategy, refusing to entertain the idea that things may not go as planned is not acceptable. If the worst-case scenario for a strategy could inflict irreparable harm to investors and the company, it may not be worth the risk. Does the board and management have a crisis management plan in place should the worst-case scenario unfold? How would the company communicate its recovery efforts to shareholders and the financial markets?

Maintain succession plans for both CEO and board members. There will be disagreements about how much risk is appropriate when operating any company, and because of that someone may be forced to leave. According to news reports, Hertz has had four CEOs in the last five years. At some point, shareholders may hold the Hertz board accountable for the CEO turnover. The board can reduce the likelihood of that happening by recruiting directors who are sensitive to making decisions within “acceptable risk” that will mitigate losses for investors. Perhaps those board members will select a CEO who will do the same.