The current global economic crisis has shown that companies face risks more complex and dangerous than in prior decades. Undue risk-taking has been one of the main causes of the breakdown of the financial markets. While the current focus of the public debate is on the banking industry and on financial instruments, boards of other companies should be equally aware of the importance of these issues and must conduct a comprehensive review of their companies' risk profile including financial, currency, liquidity, compliance, litigation and reputational risks. While it is essential for companies to incur certain business risks in order to be successful, and extreme risk-avoidance strategies would be counterproductive, it is evident that they must pay greater attention to risk management.
As long as the credit crisis continues and it is unclear whether financing can be secured for ordinary operations without a particular risk profile, it is paramount that the directors pay special attention to financial instruments, financing in general and liquidity levels. Appropriate stress testing procedures must be implemented to measure potential effects of liquidity issues stemming from the business, as well as from further potential disruptions in the financial markets. Increased attention should be paid to the hedging of currency and operational risks including the potential insolvency of business partners.
As regards the supervisory board which, due to Germany's two-tier governance system, consists of non-executive directors only (including labour representatives) and is not involved in the management of the company but is in charge of the appointment and oversight of the executive directors, the non-executive directors must satisfy themselves, in a thorough review, that proper processes are implemented for risk management and that an appropriate risk culture has been developed throughout the company.
A major prerequisite of any well-functioning risk management process is transparency and an orderly flow of the information that is required to recognise and to evaluate material risks. The supervisory board should have the executive directors periodically report about the company's risk management systems.
While most companies have focused increasingly on compliance issues over the last years, compliance will continue to be a major issue in 2009. From a credibility point of view, to be able to conduct their business and to obtain financing, it is essential for the companies that they can demonstrate that appropriate programmes have been put in place in order to ensure compliance. This will be particularly important for companies in industries which have a negative track record with regard to issues like bribery, corruption, accounts manipulation, cartel violations or other unethical or illegal acts. In a globalised economy, programmes to ensure fair treatment of workers and human rights in all parts of the world will also gain further importance.
Again, this is an issue to which the supervisory board should pay increased attention and have the executive directors periodically report to them on the status.
The steady increase of lawsuits filed against former and current executive and non-executive directors alleging a breach of their fiduciary duties shows the importance of proper policies for risk management, compliance and of the implementation of efficient structures and programmes. While observers offer different views as to whether the current scope of such litigation is appropriate, directors should be aware that a decrease in litigation cannot be expected in the current climate.
It will be for the courts to develop reasonable standards of liability which do not undermine the business judgement rule and do not exaggerate the duties and liabilities of the directors. While directors should be liable for personal involvement in non-compliance and the intentional failure to implement appropriate control, reporting or information systems, there is a dangerous tendency to base cases on a breach of fiduciary duty for failure to exercise control and to uncover non-compliance. Intentional disregard of "red flags" must be clearly distinguished from cases in which directors have not been personally involved but are tried on the basis that they should have taken measures to prevent wrongdoings that were difficult to detect. It would be helpful if the Supreme Court would soon have the opportunity to rule how the business judgement rule should be applied in such situations.
Directors should expect that there will be further scrutiny and public discussion of executive compensation. This applies both to the structure of compensation packages and to the total amounts of the overall payments which are widely considered excessive, in particular if companies incur losses, reduce their workforce or seek government bailout in the current crisis.
The bailout offered by the federal government to financial institutions includes certain restrictions on the compensation of the directors. However, there are political demands to cap the compensation for all companies regardless of such a bailout situation. While such proposals have little chance to become law at the moment, the directors of major companies should actively engage in the debate and demonstrate and explain that their compensation levels are justified. Otherwise, the proposals, most of which are unreasonable, could find additional political supporters.
The compensation packages should be restructured to ensure that they do not incentivise excessive risk taking and that the currently depressed share prices do not provide an opportunity to achieve inappropriate compensation levels through stock options and similar compensation plans. In any event, full transparency will be necessary in order to silence the critics.
On the other hand, supervisory boards must be careful not to lose sight of the fact that an attractive compensation is necessary to attract the top executives, which is essential in the long-term interests of the company, its shareholders and its other stakeholders. Boards should also ensure that the directors are protected by D&O insurance providing the fullest coverage available.
As the supervisory board (Aufsichtsrat) and the executive board (Vorstand) are separated in the German corporate governance system, German companies do not face the issue whether the positions of CEO and chairman of the board should be separated. For the same reason, there is a lesser need for independent committees.
Another governance issue may become more prominent in the coming years: While it has been standard and quite successful practice in many companies that the retiring CEO would become chairman of the supervisory board, there has been a number of recent cases showing that the representation of former executive directors in the supervisory board may be a material conflict issue, in particular if the former CEO becomes chairman of the supervisory board. Many observers argue that such a scenario may be harmful and in particular makes the discovery of non-compliance and other violations more difficult. While there are some examples in which the transition worked very well, it is possible that shareholder activists and major institutional investors will refocus on this governance issue in 2009.
Although financing for major transactions is difficult to obtain, the depressed share prices of many public companies may pose a takeover threat. Strategic buyers which manage the crisis better than others may pursue acquisition targets which appear to be vulnerable.
Potential targets should carefully review anti-takeover devices and monitor their shareholder base. In the current situation in which many shareholders may be forced or tempted to accept a premium over a depressed share price, although the mid- or long-term expectations would be much better, it is even more important than usual for the companies to be well prepared.
While many hedge funds face substantial problems of their own, it is possible that such activist shareholders will mount significant attacks on public companies in the upcoming year. The "roller coaster" development of share prices which we have experienced recently offers unique opportunities to activist investors with a short-term interest. Therefore, pressure to implement measures enhancing short-term performance or gains, including divestitures, facility closures, lay-offs and special dividends should be expected. Therefore, it is paramount to convince major institutional investors that the company has a reasonable long-term business plan and professional management which will deliver long-term results.
The notification requirements for the acquisition of shares and other securities providing an influence on voting rights have been tightened by the recently enacted Risikobegrenzungsgesetz, in particular with respect to funds acting in concert.