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Thursday, November 10, 2011

A Board Complicit in MF Global's Bets, and Its Demise -

A Board Complicit in MF Global's Bets, and Its Demise

The easy explanation for MF Global's downfall is that it was killed by Jon S. Corzine's risky trading bets. Yet MF Global was torpedoed not only by Mr. Corzine but by its board.

The board at MF Global is highly sophisticated and experienced. It includes two former senior executives from HSBC, the former chief financial officer of the Aon Corporation and a top member of the private equity firm J. C. Flowers & Company.

Under this board's watch, MF Global invested in European sovereign debt using short-term financing. When ratings agencies and investors became spooked by the European debt exposure, the financing dried up and a classic run on the bank soon ensued. Bankruptcy followed.

On paper, these highly qualified directors should have realized that Mr. Corzine and MF Global were taking undue risks. After all, it was short-term financing that brought down Lehman Brothers and Bear Stearns. There is even a board member who appears to specialize in this type of financing and risk management: Robert S. Sloan, a managing partner of a company that focuses on in global collateral management and counterparty risk management

This is also not a case of willful blindness. The board appears to have been thoroughly aware of these trades and discussed them. The existence of these trades was also disclosed by MF Global in its public filings, though perhaps not thoroughly. By the available indications, MF Global directors approved these trades.

The question is, why? How could this experienced board have been so foolish, particularly when several directors appear to have expertise on this matter?

There is some thought that the MF Global board failed to stop these trades because it was in awe of Mr. Corzine and his Goldman Sachs pedigree. The "Corzine as Wizard of Oz" argument, however, seems too glib given the sophistication of the board. These directors were simply too experienced to be fooled by Mr. Corzine or to be lulled into blind obedience.

A better explanation may be that boards are inherently unable to do the job we want of them: to oversee the company and counteract the influence of its chief executive.

Directors are part-time members of a corporation. The ability of even the most sophisticated directors to understand the business better than management is unlikely.

The result is that when a chief executive says that a course of action is the right one to take, directors are highly unlikely to challenge this action because they too believe it. Directors want to get along and move the company forward. These dynamics are incredibly powerful and can take hold for even the most sophisticated boards.

Many recent books and articles about the financial crisis and Bear Stearns, Merrill Lynch, Lehman and the American International Group portray boards that were not particularly good at supervising risk at their companies. Instead traders and executives were given free rein to take tremendously risky bets that brought the house down.

If MF Global is different, it is because the board appears to have been very involved in the trades. In the other cases, it appears that the boards had little clue about the risks. In other words, the directors of MF Global were engaged and knew of these risks. They were not duped by Mr. Corzine or anyone else. But they lacked the ability or desire to really challenge him. Not because he was from Goldman's cloth, but because he was management.

MF Global even promoted its risk management in its filings, stating that its approach to risk "involves a strong governance structure that clearly defines responsibilities, delegated authorities for risk control as well as risk-taking and documented policies designed to identify, measure, control and mitigate risk."

This disclosure establishes that the board had ultimate responsibility for the firm's risk management. Yet, the collapse of MF Global shows that boards are too often unable to deal with risk even when they are aware of it.

So what can we do about this?

Perhaps it is time to recognize that it is not just boards, but the investing culture that needs to change. A place like MF Global, where one person can make such a significant decision, is bound to explode.

But while individual decisions need to be checked, asking boards to do this work appears to be foolhardy. They just lack the skills, the depth and are not there on a day-to-day basis.

Boards instead need to take responsibility to create a culture that serves to check risk effectively. The MF Global board appears to have failed at this task. What now appears to be a blindingly obvious failure of risk management should have been caught before it even got to the board. By the time the board was deciding on the validity of these trades, it was already over — months before the actual collapse.

If we are going to get boards to take even this responsibility, we need to get serious about accountability.

I think it is also questionable whether a more rigorous compensation scheme would have deterred Mr. Corzine. He appeared to have the self-confidence of the gods, a quality not unknown among Goldman traders. Goldman at least recognizes the potential for such hubris and has in place strong risk management.

This doesn't mean that executives shouldn't forfeit compensation when they blow up their company. We also need accountability at the board level. If the board members were to be penalized for their failures through forfeiture of their own compensation, perhaps directors would have focused on creating a stronger risk management culture, one that appears absent at MF Global.

In the absence of accountability, there needs to be regulation that recognizes that boards cannot stop undue risk. Regulators need to create a system and culture that forestalls it.

Above all, we need to ask hard questions about why boards have repeatedly failed to prevent the implosion of their financial institutions. Otherwise, we will waste another crisis.

Steven M. Davidoff, writing as The Deal Professor, is a commentator for DealBook on the world of mergers and acquisitions.

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