How Boards Can Prepare for Unplanned Catastrophic Events

Seymour Burchman and Blair Jones are Managing Directors at Semler Brossy Consulting Group, LLC. This post is based on their Semler Brossy memorandum.

Corporate boards have a fiduciary responsibility to manage risk, especially against major events that could overwhelm an organization and devastate shareholders’ investments. The Covid-19 pandemic has forced new attention on board’s responsibilities.

It’s tempting to call this pandemic a black swan, a calamity so unexpected that companies could not have prepared for it. But experts have been predicting global pandemics for years, and in January 2020, the World Economic Forum’s Global Risks Report cited infectious diseases as a potential threat. And few companies included a global pandemic in their high risk categories.

Indeed, it’s better to see the pandemic as a “black elephant”—a term derived from a cross between a black swan and the “elephant in the room.” Coined by the investor and environmentalist Adam Sweidan, it describes a looming disaster that’s clearly visible, yet no one wants to address it.

The 2008 financial crisis may have been the first such black elephant, with warnings ignored by most companies and policymakers.  But we’re likely to suffer more from such events, such as cyberattacks, breakdowns in algorithmic-driven security trading, and weather disasters due to climate change. With markets and businesses now deeply interconnected across the globe, disruptions in one place can spread rapidly and deeply.

Boards have a special responsibility for building the necessary resilience in this environment.In the past, the short-term focus of capital markets often pushed directors away from resilience. Any airline that tried to build up a substantial cash reserve in the 2010s, for example, would have been pummeled by investors demanding dividends or stock buybacks. Many airlines did eventually invest in long-term customer and supplier connections.  But we now know they needed a bigger frame for resilience.

As former Gen. Stanley McChrystal has pointed out, the economy in recent decades aggressively pursued the efficient use of assets. Through debt leveraging, extreme outsourcing, and attenuated supply chains, companies became vulnerable to disruption in far-flung places. Yet investors sought returns ever more strongly, discouraging executives who might have wanted to play it safe.

Boards need to step up their game here.  The companies that thrive in the future will have resilience built into their systems, and they’ll have a ready playbook for getting through black elephants. This article guides directors in getting there, through governance, leadership development, and compensation programs.

Resilience through Governance

Boards have several ways to promote resilience and watch for potential black elephants. They can encourage stress tests in comprehensive risk reviews. They can press management on the worst-case scenarios for each black elephant, including when the threat becomes existential for the company. They can then suggest “war games” to develop principles for effective responses—with lessons brought back to the board for assessment and discussion.

Operationally, they can encourage management to fortify the company’s defenses, both physical (such as against flooding and hurricanes) and digital. The pandemic has served as an unfortunate trial-by-fire for many kinds of defenses. Boards can encourage resilience in supply chains with reshoring or repositioning, simplification, and redundancies.

They can also promote technological solutions to minimize disruption, from automation and 3D printers to flexible IT systems. They can expand the options for remote work, supported by robust, secure videoconferencing and other technologies. As the needs of the business change, they can promote organizational resilience with apprenticeship or retraining programs for employees.

Resilience Through Leadership Development

Board-driven conversations and exercises around black elephants can happen only with interested and effective leadership. Developing leaders with the organizational and business acumen to think creatively and proactively about the future should be a board priority. As management brings talent planning discussions to the board, directors should decide whether there are agile leaders in the pipeline who will respond to threats promptly and decisively.  They should look for leaders who:

  1. Operate from a set of clear values, making tradeoffs that build commitment and goodwill for the long term. These are inclusive leaders who act and communicate transparently—sharing the principles by which decisions are made, never seeking to blame, and telling bad news as well as the good.
  2. Have a holistic view of the company that extends well beyond their functional silos.
  3. Pull the organization together around a North Star purpose, promoting collaboration across the organization, and empowering local decision-making to respond to unique local customers, suppliers, and circumstances.
  4. Act decisively when speed counts, while learning from suboptimal decisions and pivoting as necessary.
  5. Are intellectually curious, noticing the small things that make a difference and seeing new possibilities when the old ways no longer work. They don’t rest on their laurels, as they know the world will keep changing.

Boards can use the succession planning process to get clear on who these leaders are and ensure they hone their skills. For example, they could deploy them on multidisciplinary initiatives to explore growth possibilities.

Resilience Through Compensation

Boards can also contribute by redesigning compensation programs. The challenge is two-fold. First, boards must explain to investors that the firm’s sustainability depends on investments for resilience, even at the cost of short-term cash. Without support from investors, boards will get nowhere.

As they build this support, boards can design incentives to boost resilience while maintaining accountability.  Companies still need executives focused on maximizing value, and resilience should not be an excuse for losing sight of profitable growth over the long term.

Some of that resilience will come from better balancing the needs of all stakeholders. Companies will still want executive incentives to align with investors, but also capture the needs of other stakeholders. This balancing will help ensure, as was the case with the current pandemic, that corporate leaders consider their local communities (through providing needed goods and services), ensure that suppliers starved for cash do not go out of business, and share the pain with front line employees.

This expanded focus on stakeholders translates into measures that can be hard to quantify. It likely means increased weighting on long-term incentives, perhaps extending beyond the standard three-year programs. Boards could add a scorecard that evaluates contributions to stakeholders and modifies incentives based on strategic and financial outcomes. A food and beverage company, for example, might measure progress on sustainable sourcing, responsible packaging, and diversity and inclusion initiatives. Larger ownership requirements for executive stock ownership could overlay these solutions.

If a black elephant event overwhelms these compensation plans, companies will need to use after-the-fact judgment and discretion. Directors can work now to devise rules to govern those adjustments. Here are some principles to ensure fairness:

  • Make adjustments symmetrical—if boards adjust awards upwards for unexpected factors that hurt results, then they should also adjust downwards for factors that boost results.
  • Maintain pay/performance relationships to the extent possible.
  • Ensure full transparency, both internally and externally, through clear communication with stakeholders, especially investors and executives.
  • Consider how the actions taken will provide precedents or affect the company long after the black elephant event.

Resilience takes years to build up, so boards should prepare for a long-term program rather than a big quick initiative.  For now, directors are busy dealing with the current crisis. But in time, they can use the pandemic as a springboard to making their company ready for the next black elephant.

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