During an economic downturn, directors need to maintain focus on a company's fundamentals: its business, management, and liquidity.
In times of economic uncertainty, directors may be surprised by how quickly their company’s fortunes can change. The company may find itself in a difficult situation without any management mistakes. It is crucial in situations like these that directors remember that even in the most difficult of times, the fundamentals of the directorship continue to apply: Directors are responsible for overseeing the company’s business.
While most directors understand and know, like the Boy Scout slogans, it is worth repeating the basics: It is the director’s responsibility to oversee the company’s operations and it is the day-to-day running of the company. In times of market uncertainty, there are generally three main areas that directors need to focus on: the health of the business, the quality and depth of management (including succession planning), and the liquidity of the company.
Review the company's business model
Paying careful attention to the overall health of the company is central to a director’s responsibility. In adapting to changing economic conditions, directors should assess the resilience of the company’s business model. For example, the collapse of the U.S. subprime mortgage market in 2007 caused significant losses—some predictable, many unforeseeable—to many companies in a variety of industries, and financial losses can occur without warning.
However, if a company's management can be aware of the potential risks arising from changing market conditions and is willing to adapt the company's business model and strategy to these changes, they can minimize losses if a crisis occurs or, even better, prevent a potential crisis.
Likewise, as economic conditions change, it is important for boards to ensure that the company has a management team that is capable and ready to take the heat off the crisis. The capabilities and qualities of management need to be assessed in terms of experience, expertise, commitment, leadership, and depth. Furthermore, boards need to ensure that their CEO understands that he has the support of the entire board for the company’s strategic direction if economic conditions worsen, or that the director needs to raise his concerns if there are any differences of opinion about the company’s strategic direction.
A key part of this process is ensuring that the board is regularly briefed directly by the CEO so that the entire management team has confidence in strategic decisions. This is also a key part of the board’s succession planning process. These issues should be discussed throughout the CEO’s tenure by including them on the agenda at every board meeting.
Company Care
Once directors are satisfied that the CEO’s business model and strategy are sound, and that the current management team is capable of effectively managing the company’s current state, they still need to be sure they understand the key factors that shape the company’s performance. Directors need to understand how the company’s revenue stream is likely to respond to changing conditions in the economy and in their industry.
For example, directors need to have a comprehensive understanding of the company’s customer base and whether it is changing in a positive direction. Directors also need to have a comprehensive understanding of the company’s operating costs, including labor and goods sold as well as goods in progress, and administrative costs. Directors should have an overview of the company’s market and financial position so that they can make appropriate management decisions about potential risks in operations depending on different economic conditions.
Board members need to focus their attention on the company’s liquidity. This is especially important in today’s market environment. A clear understanding of the company’s cash flows and credit arrangements is critical. Directors need to be aware of whether the company’s business has seasonal cash needs and ensure that during the company’s peak cash needs, the company has access to sufficient capital to meet the needs of the business. Management needs to understand what happens if cash flows are not as strong as anticipated. And directors should ask themselves, if an industry declines during a peak cash need period, how severely will the company’s liquidity be affected?
Liquidity is a key consideration in the mergers and acquisitions context. The failure of its bid to acquire footwear retailer Genesco to a much smaller competitor, Finish Line, is a cautionary tale. Finish Line attempted to acquire Genesco in a highly financed deal. The deal had no financing conditions, but Finish Line’s financial commitment was contingent on the solvency of the merged entity. While the strategic transaction seemed certain to close when it was exposed, that has long since ceased to be the case, as the sudden decline in the industry has put the solvency of the merged entity in doubt.
In the context of mergers and acquisitions, directors should be careful to examine liquidity and solvency risks, particularly in highly leveraged transactions – where the financial performance is at risk – and consider the impact on the company if the transaction is exposed or not successfully completed.
Directors should always be concerned about succession planning, and the challenging economic environment only heightens its importance. If a company experiences a downturn and the CEO (or another key member of management) resigns without a clear, capable successor, the board and the company will struggle to effectively address the challenges facing the company.
Make informed decisions
Automatic reporting and information systems are the enemy of liability. The level of discretion required of directors varies depending on the particular situation facing the company. Directors need to be aware of market conditions and think carefully about how trends and events affect the company’s strategy and business performance. As long as directors act on a well-informed, confident basis, and in a manner that makes them believe that the company’s best interests are at stake, their business decisions will receive legal protection.
Directors actively seek information to be fully informed – this is the core tenet of corporate care. To be fully informed, directors must take due care to obtain relevant information, and to give serious thought and consideration before making a decision. A lack of care for the company – whether through deliberate decision-making without full information and careful consideration or through systematic disregard of a known risk – will not satisfy the requirement for a director to act honestly and on a fully informed basis.
It is the responsibility of directors to demand that they be provided with the information they need to make informed decisions, and it is the responsibility of the management team to provide adequate information to the directors. In turn, directors are entitled to rely on board members and other experts in the decision-making process. Furthermore, directors should not hesitate to seek advice from experts to determine whether the information provided to them is sufficient to make a decision.
Liability Insurance
In today's highly litigious environment, companies need to ensure that they have appropriate and up-to-date compensation arrangements in place for board members and that they have adequate officers' and directors' liability insurance.
These arrangements should be reviewed regularly to ensure that directors are adequately insured against personal liability for their actions as directors. Although officers and directors liability insurance is increasingly expensive, it is comprehensive in most cases and should be purchased by companies. The limitations and exclusions in the insurance package should be carefully reviewed so that directors understand what they are covered for and what they are not.
In addition, directors should consider the impact of the company's bankruptcy within the scope of the insurance coverage.
Proactive management
Management is a proactive pursuit. Directors should periodically satisfy themselves that the company is pursuing the right strategic direction, that its business and liquidity are stable, and that management is prepared to deal with unexpected events in the industry and the economy. If there are no signs of an impending downturn in a company, there is no need to hold extraordinary board meetings or seek outside advice simply because economic conditions are uncertain.
Directors may request information from board meetings and provide feedback to the CEO or other board members as appropriate. In a constantly changing business environment, directors need to be proactive in the performance of their management responsibilities.
David A. Katz
