Risk Scenario

Babes in Lawsuit Land

A risk manager's improper reporting catches the SEC's attention.
By: | August 30, 2012
Risk Scenarios are created by Risk & Insurance editors along with leading industry partners. The hypothetical, yet realistic stories, showcase emerging risks that can result in significant losses if not properly addressed.

Disclaimer: The events depicted in this scenario are fictitious. Any similarity to any corporation or person, living or dead, is merely coincidental.

Part One

Paul Ferranzo took a deep breath and surveyed the fairway of the Par Four 16th as it banked left and around the stand of maple trees that blocked a player’s view of much of the green. He was strongly tempted to intentionally hook the ball and try to cut 25 yards off of his second shot if he could.

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A Tiger Swallowtail butterfly chose that moment to visit the hydrangea bushes next to the ball-washing machine that flanked the tee. Paul tried to blank the butterfly out of his mind. He had $500 on this game and his opponent, who was also his insurance broker, was standing about 25 feet away.

The broker was ostensibly staring at the face of his iPhone, reading a text message, maybe. But if Ferranzo knew him like he thought he did, he knew the broker was secretly wishing Paul would shank one.

“Screw it,” he said to himself. “I’m going to bend this baby.”

Paul settled his feet, dropped his head, drew the head of the driver back and swung through, letting the club face linger on the ball just a millisecond longer than he normally would. He brought his head up just in time to see the ball begin to descend from the peak of the drive. The ball took a nice, midsummer grassy bounce, heading left, just where Paul had wanted it to.

“Holy crap!,” his broker said with a real edge in his voice.

“Wasn’t that great a shot,” Paul said, turning to see his broker still staring at his iPhone.

The broker looked up with concern in his eyes. Then cast a quick glance to where he last saw the golf ball.

“Not that. Don’t you have a distribution center near Lincoln?”

Paul felt ice water enter his bloodstream.

“Yeah, why?”

“Two tornadoes touched down in Lincoln, or just outside of Lincoln, about an hour ago. Big ones, one an F3, the other an F4,” the broker said.

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“Can you drive?” Paul said, motioning to the golf cart. The broker nodded and headed briskly to the cart, sheathing his driver in his golf bag with practiced alacrity.

By the time they got to the club house, Paul, the risk manager for the Beamish Babe retail line, had learned that the company’s distribution center near Lincoln had been torn that very day into unproductive pieces.

Game over. Game on.

The supply chain implications of the loss of the distribution center were sobering, to say the least. Paul had a feeling the implications were big. He really couldn’t say just how big. It would probably be days before the company knew the full extent of this.

In the back of his mind was the company’s 10K for 2011, which it had published a scant three months ago. The work Paul and the company’s finance committee had put into that report was beyond anything they had ever taken on. But that was the atmosphere these days, with the SEC demanding more and more detail on risk exposures from publicly traded companies.

This supply chain loss loomed large. Paul now worried that the company’s reporting in this area might have been inadequate.

“Who knows,” he said to himself as he drove home for what was probably not going to be a very good night’s sleep. “Who knows what the SEC will make of this,” he said.

“Or the shareholders.”

Part Two

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Beamish Babe was publicly traded and had built up its business by being lightning quick to market with the latest style trends. It had stayed on top, even in this tough economy, because management had been aggressive, almost merciless in cost cutting. They’d had to be, it was a jungle out there these days.

That cost cutting, and what it had meant to risk management, was now gnawing at Paul Ferranzo’s belly.

In the past fiscal year, Paul had faithfully carried out the Board of Director’s orders, as carried to him by the CEO, that he exhaustively research and report on the company’s material risks, be they credit, financial, property, operational or reputation; the whole range. His work included interviewing regional vice presidents, members of the treasury, and the company’s corporate communications team, on the whole menu of the company’s risks.

Paul had turned in a report on those risks, which had become the backbone of the Risk Factors section of the company’s 10K.

Paul had done what he could, but there was only so much he could control.

The CFO had his own agenda, as did the procurement arm. After Paul filed his report, with the publication date of the 10K still two months away, procurement had sold to the CFO the idea of cutting down the company’s number of Midwestern distribution centers from two to one.

They would keep Lincoln, shut down Little Rock and then sell that distribution center. No less a company than Apple itself wanted to buy the building and the land.

The CFO loved this move. It represented a $20 million one-shot swing and $7 million annually in savings going forward.

But now look what had happened. The tornadoes had punched out Beamish’s sole Midwestern distribution center.

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Early news coverage was taking things in the wrong direction, fast. The mayor of Lincoln was quoted on CNN decrying the number of jobs the tornado had wiped out.

The mayor had pulled a tax increment financing deal together to land the Beamish Babe distribution center and he couldn’t control himself, he painted the loss of the distribution center as a regional economic disaster.

The vice president of the Beamish Babe distribution center stood next to the mayor at the site of the loss, they were friendly after all, and corporate communications had been too slow to foresee all the possible angles and warn him away from the television cameras and the microphones.

“Don’t say anything,” Paul said out loud as he watched the coverage with the CFO. “Don’t say anything.”

But just then a television reporter swung her microphone over to the vice president.

“This is a total loss, I don’t know how we come back from this,” the Beamish vice president said.

Paul and the CFO each gave the other a look that said, “Oh well, there goes that.”

The comments from the vice president and the mayor’s emotional statements had to get the SEC’s attention.

Paul was uneasy but had no time to waste. He wasn’t cc’d on every e-mail but word was getting around that stores in the Midwest and the West were clawing at each other’s eyes for product, putting in orders for inventory that just wasn’t there.

The company was mobilizing to try to shift inventory from the East Coast, but who wanted to under-supply New York, Boston and Miami? Those cats needed to get fed. Procurement could have fun with itself now, Paul thought to himself bitterly.

A review of his notes from his interview with the Midwest regional vice president made Paul more than uneasy. With the business and contingent business interruptions that were piling up now, they had vastly under-reported their possible losses in that area.

The models they’d used just weren’t accurate enough to have predicted a strike this bad.

Paul watched a pair of high school girls dressed in Beamish Babe sweatpants, with the letters “BMB” printed on the back, walk past his office building on their way to the local coffee shop.

“Enjoy them while supplies last, girls,” he said out loud, shaking his head and turning his face back to his computer monitor.

Part Three

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It was a few months until the day came when Paul looked up to see Ray Sachs, the CEO of the company, standing in his doorway. Ray, who preferred casual dress, was wearing his ubiquitous designer polo shirt and jeans. In his hands was a two-page letter.

“You got a second?” Ray said.

Like he wouldn’t say yes.

“Sure, Paul said.

Ray stepped into Paul’s office and closed the door.

As he sat down in front of Paul, Ray threw the two-page letter on Paul’s desk.

It was a Wells notice from the United States Securities and Exchange Commission. The letter said that the SEC had begun an investigation into shareholder allegations that Beamish Babe had substantially misrepresented its material risks in its 2011 10K.

“This is on you,” Ray said.

“I know,” Paul said.

Ray had another letter in an envelope in the back pocket of his jeans.

It was Paul’s letter of resignation.

It wasn’t like the supply chain interruptions from the tornadoes that struck Lincoln in June of 2012 had devastated the company because they hadn’t. In terms of what fell to the company’s bottom line, the supply chain issues stemming from the loss of the distribution center had resulted in revenue losses. But it was hard to pin down in exact numbers to what degree.

Company-wide revenues for the first quarter were off 8 percent, though. Net income was off 25 percent. Retail analysts for the investment banks hadn’t seen that coming and the stock price plummeted 15 percent in one day.

In its first quarter release to investors, the company’s corporate communications team gamely tried to spread the blame for the company’s reductions in net income and revenue, but successful shareholder lawsuits have been built on lesser losses and Beamish Babe was just not going to get off Scott-free on this one.

The SEC concluded that the board of directors of Beamish Babe breached its fiduciary responsibilities by accepting and turning in a report to the SEC that underreported its Midwestern property risks and its risks to its supply chain. The SEC used its subpeona powers to order copies of Pauls’ notes from his interviews with his regional vice president.

Those notes clearly showed that Paul and the vice president had relied too much on inconclusive models and had failed to take into account the impacts of possible supply chain interruptions.

For his documented part in failing to fully comprehend and report the risks to the company’s supply chain, the regional vice president was fired.

But Beamish Babe now had problems that firing someone couldn’t fix.

Attorneys for the shareholders picked up the SEC report and threw it at the company’s D&O and E&O policies like a big spear.

The company’s D&O and E&O policies responded, but Beamish Babe’s total cost of risk would never again look the same.

Summary

Paul Ferranzo, the risk manager for a large retailer, does a diligent job of documenting his company’s risks in its annual report to the U. S. Securities and Exchange Commission. But Ferranzo ends up losing his job when a sequence of events undermines his company’s best reporting efforts, leading to an SEC investigation.

1. Link procurement and operations to risk management: Many companies struggle when it comes to creating linkage between their risk management departments and other key areas like procurement and operations. When it comes to business and supply-chain interruptions, there is simply too much at risk for risk management to be kept out of the loop when it comes to strategic business decision making like the location of a warehouse, supplier or distribution center.

2. Manage your message: Press accounts and other forms of media exposure, including social media exposure, can have an inordinate amount of influence on the mind sets of shareholders and regulators. Companies should have a crisis-response plan in place that is well-understood by all key players. That response plan should include a strategy for limiting negative media exposure. Beamish Babe should never have let one of its officials near a politician in front of a television camera during a crisis.

3. The SEC means business: In 2010, the SEC broadened is subpoena powers and made them permanent. Instead of working forward and letting business decisions strike the risk managers desk without any foresight, companies need to work backward, in a sense, and operate with the assumption that business decisions that create possible risk exposures will have to be reported on a quarterly basis. Before making a decision, publicly traded companies need to ask themselves, “What exposures will this create that I should report?”

4. Don’t over-rely on catastrophe models: More and more companies are realizing that they must take a hybrid approach to using models in managing risk. The major losses due to tornadoes in the United States in 2011 were a wake-up call for everyone. Models that concentrate mainly on wind storms in Texas, Louisiana and Florida will be of limited use to a company that has key operations in Oklahoma or Kansas. The model hasn’t been made that can predict the kind of tornado and flood damage we saw in 2011.

5. Build a proactive board of directors: Risk committees should include active board members who aren’t afraid to challenge the assumptions and actions of senior management. To ensure that accurate annual and quarterly reports are filed, board members need to have full transparency into and involvement with enterprise risk management. It takes a number of sets of eyes in many cases to adequately assess and report a risk.

Dan Reynolds is editor-in-chief of Risk & Insurance. He can be reached at [email protected]

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The R&I Editorial Team can be reached at [email protected]