The Changing Role of the Audit Committee: Applying the Lessons

1. The Changing Role of the Audit Committee: Applying the Lessons Presented by Andrea St. Rose & Associates Bay Gardens Hotel – July 17, 2009 Andrea St. Rose & Associates

2. The Changing Role of the Audit Committee: Applying the Lessons Agenda 1. Global Overview of the Financial Crisis 2. Current Issues and Risks – What Regional Audit Committees Should Know 3. Setting the Agenda for future Success in the Caribbean 4. Restructuring the Corporate Framework to Strengthen the Audit Committee

3. The Changing Role of the Audit Committee: Applying the Lessons Agenda 5. Implementing Audit Committee Fundamentals & Best Practice 6. Question and Answers

4. Global Overview of the Financial Crisis

5. Global over view of the Crisis Structure 1.The Making of a Financial Crisis 2. The Global Experience 3. Our Caribbean Experience – Jamaica, Trinidad, Antigua

6. The Making of a Financial Crisis • Generally preceded by asset price bubbles and economic booms. • In many instances there are regulatory lapses. • Usually accompanied by Greed. • Corporate governance is usually weak • Risk Management Policies are usually weak or absent.

7. The Making of a Financial Crisis What we know for sure: • Economies experience both upswings and downturns. • During upswings companies tend to believe that the good times will never end. • When profits are increasing – entities tend to turn a blind eye to the attendant risks. • Above average returns tend to be accompanied by above average risk taking. • We have learnt nothing from past experiences – e.g. The Great Depression of the 1930’s

8. THE MAKING OF A FINANCIAL CRISIS • If we know for sure that upswings are generally followed by downswings – then why is it that most companies are unable to weather the storm when it makes “landfall”? • We prepare for hurricanes but not for the financial tsunamis.

9. The Making of a Financial Crisis The Current Financial Crisis: • The Sub prime fiasco: • It is believed that the current financial crisis began brewing sometime during mid 2007. • Prior to 2007, the US environment experienced high liquidity levels – • With such high liquidity levels, financial institutions in the US, responded to a general Govt push encouraging home ownership. • Financial institutions offered adjustable rate mortgage loans to individuals who were unable to comfortably afford the repayment of those loans. • Those risky loans were pooled and sold as investments – repayment of which were secured by the cash flows from the underlying mortgages.

10. The Making of a Financial Crisis The Current Financial Crisis: • The Sub prime fiasco: • In the face of rising oil prices and higher cost of living, homeowners suffered cash flow problems. • As persons gained an understanding of the financial environment, confidence levels began to fall – accompanied by a fall in demand for housing • The sub prime mortgage owners found themselves in difficulty and were unable to make the monthly repayments – which sometimes increased due to interest rate adjustments - hence they defaulted. • The underlying cash flows were no longer available to service the mortgage backed securities – the underlying securities became worthless.

11. The Making of a Financial Crisis The Current Financial Crisis: • The Subprime fiasco: • The result was increasing losses for those institutions that had invested in those securities, coupled with reduced liquidity. • Stock prices began falling and equity holders suffered huge losses. • Investors began loosing confidence in the Financial System – Asset prices were falling in values and investors wanted their monies back. Some institutions folded up while some with greater public interest were bailed out by Governments/Central Banks. • As some institutions folded up employment rose and reached record levels in the USA.

12. The Making of a Financial Crisis The Current Financial Crisis: • The Subprime fiasco: • Given the global network overseas institutions that had invested heavily in those risky securities also suffered losses and so the dominos came falling down.

13. The Making of a Financial Crisis There were some “Smart” ones … or so it seemed. The Collateralised Debt Obligations: • Some smart people recognising the risks involved considered that the boom could not survive for long and took insurance to cover the possibility of default – akin to betting that the entity would fail. • When the entities defaulted, the security holders demanded payment from the insurance companies. • Given the extent of the defaults, the insurance companies came under pressure and some like AIG had to be bailed out by the US Govt.

14. THE GLOBAL EXPERIENCE CASE STUDIES – A look at some failed institutions

15. Merrill Lynch & Co. In 2005 CEO of Merrill Lynch pointed out: • “We’ve got the right people in place as well as good risk management and control.” E. Stanley O’Neal, CEO, 2005 Source on Merrill Lynch & Co.: G. Morgenson, New York Times, November 9, 2008. Prepared by: Timur Gok

16. The Global Experience Merrill Lynch & Co. • In 2007 and the first two quarters of 2008, Merrill had lost about a quarter of the profits it had made in its 36 years as a listed company (after-tax losses of $14b and $52b of write-downs). Financial Times, August 28, 2008 Prepared by: Timur Gok

17. Merrill Lynch & Co. • Ahmass L. Fakahany was vice chairman and chief administrative officer • He was responsible for the firm’s market and credit risk management as well as corporate governance and internal controls • “Weakened Merrill’s risk management unit by removing longstanding employees who “walked the floor” talking with traders”. Prepared by: Timur Gok

18. Merrill Lynch & Co. • Another key figure was Osman Semerci, who ran Merrill’s bond unit • Former employees described him as an “intimidating” manager “who would chastise traders and other money makers who told risk management officials what they were doing” • “There was no dissent. So information never really traveled.” Prepared by: Timur Gok

19. Merrill Lynch & Co. • “The risk in Merrill’s business model became viral after AIG stopped insuring the highest quality portions of the firm’s CDO’s against default” Prepared by: Timur Gok

20. Merrill Lynch & Co. Source: Wall Street Journal (April 18, 2008).

21. The Global Experience In 2007 Citigroup CEO indicated: Citigroup • “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Chuck Prince, Former CEO, Citigroup Financial Times, July 9, 2007 Prepared by: Timur Gok

22. Lehman Brothers • Madelyn Antoncic, managing director of Lehman’s management committee and the firm’s chief risk officer, was sidelined because of her unease with the huge bets the bank was taking • “There was risk management, but the prevailing atmosphere was for fast growth and special fast-track treatment for what we now know were toxic deals.” Prepared by: Timur Gok

23. UBS • “Used to Be Smart” • The shareholder report gave three broad reasons for what went wrong: • “The investment-banking arm's preoccupation with growth; • “Reliance of the control team on flawed measures of risk. • The culture of the bank.” Source: The Economist, April 24, 2008. Prepared by: Timur Gok

24. HBOS • HBOS dismissed Paul Moore, head of group regulatory risk between 2002 and 2005, for raising concerns about risks • “They were not inclined to listen to a different view… I was one person speaking out with experience who did see, in a generic sense, the writing on the wall.” Prepared by: Timur Gok

25. The Decision Making Process

26. The Global Experience Shocked!!!!! • "Those of us who have looked to the self-interest of lending institutions to protect shareholders' equity, myself especially, are in a state of shocked disbelief.“ Alan Greenspan Prepared by: Timur Gok

27. The Global Experience Lahde Capital ( USA) • In October 2008, Andrew Lahde, founder of California’s Lahde Capital, a hedge fund, quit the business. One of his funds had made a return 870 percent last year. • In his farewell letter, he attacked the “idiots” running the banks who were willing to take the other side of his bets. Prepared by: Timur Gok

28. A.I.G. • The bail-out of AIG cost US taxpayers $182.5 billion so far • Between 1968 and 2005, Maurice “Hank” Greenberg had been the CEO of AIG • “A bullying, omnipotent ruler—[a boss] who did not so much build a company as tailor it to his character and render it incapable of being run by anyone else.” Source on AIG and AIG FP: M. Lewis, Vanity Fair, August 2009. Prepared by: Timur Gok

29. A.I.G. Financial Products • Founded in 1987 • “By 2001, was generating $300 million a year, or 15 percent of AIG’s profits.” • AIG FP employees kept 30 to 35 percent of the profits that they generated (the typical hedge fund keeps 20 percent) Prepared by: Timur Gok

30. A.I.G. Financial Products • In 2001, Hank Greenberg—and the AIG board—appointed Joe Cassano as the company’s third CEO • Presumably, Greenberg “saw in him a pale imitation of his tyrannical self and felt he could control him” Prepared by: Timur Gok

31. A.I.G. Financial Products • Under Cassano’s leadership, “AIG FP became a dictatorship” • “The way you dealt with Joe was to start everything by saying, ‘You’re right, Joe’.” • “Valued loyalty and obedience above all”. Prepared by: Timur Gok

32. A.I.G. Financial Products • No one questioned it when AIG FP was insuring billions of dollars worth of subprime mortgages • Not only that, but along the line, Cassano had agreed to triggers that required the firm to post collateral if it were to lose its AAA credit rating • The company unraveled when the housing bubble burst Prepared by: Timur Gok

33. OUR CARIBBEAN EXPERIENCE • A Look at what has happened – The Caribbean

34. OUR CARIBBEAN EXPERIENCE • Jamaican Financial Crisis ( late 1990’s) • Trinidad – Clico Financial • Antigua - Stanford International/ Bank of Antigua

35. Jamaican Financial Crisis • Followed the bust of an asset price bubble. • There existed a relatively high interest rate environment. • Significant increase in non performing loans when property prices fell. • Dominated by a high level of related party transactions. • Legislative environment was relatively laxed.

36. Jamaican Financial Crisis • The first Group to come under pressure was the Caldon Finance Group. • The result was contagion and a run on other financial institutions • The Government stepped in and formed Finsac to manage the sale of toxic assets. • The situation was brought under control relatively quickly.

37. CL Financial Group • The group controlled assets in at least 28 companies located in the region and throughout the world. • Its insurance arm are the main insurance companies in the Eastern Caribbean – Clico and British American Insurance Company. • In 2004 it was alleged that the Group had entered into certain high risk ventures

38. CL Financial Group • Concern was raised by investors in respect of the impact of falling real estate prices and a decline in the price of methanol on the Groups overall financial situation. • In early 2009 CIB faced liquidity challenges and a subsequent run on the Bank.

39. CL Financial Group • The Financial difficulties had to do with: • Excessive related party transactions which carry significant contagion risks. • An aggressive high interest rate resource mobilisation strategy to finance an equally high risk investment – much of which were illiquid – in T’dad and abroad. • Very high leveraging of the Group’s assets which constrained the potential amount of cash that could be raised from asset sales.

40. CL Financial • The Central Bank later announced that the Min of Finance took over control of the assets and liabilities of CLICO, CIB and CMMB.

41. BANK OF ANTIGUA/STANDFORD INT’L BANK • In 2009 it is alleged that certain companies of the Stanford Group were involved in a Ponzi scheme. • This was apparently triggered by a review into the high interest rate policy of certain companies in the Group following the Madoff investigation. • One Caribbean interest , SIB, an offshore Bank, was specially named. • The result was a loss of confidence and a subsequent run on Bank of Antigua Ltd, a related company. • The Central Bank stepped in and took temporary control of Bank of Antigua.

42. Current Issues & Risks What Regional Audit Committees Should Know

43. Current Issues and Risk Structure 1.A breakdown of Risk controls vs. Financial Reporting Controls 2. What we already know 3. Role of Audit Committee in Risk Management

44. Current Issues & Risks • Risk Controls Vs Financial Reporting Controls • The current Global Financial crisis is not about “cooking the books” or not consolidating risky SPVs. • It is about companies pursuing risky strategic activities – Boards and Senior management. • Unlike controls over financial reporting which has been legislated ( Sarbanes Oxley Act), excess risk taking i.e. greed has not been legislated. (Compliance with SOX could not stop the current crisis)

45. Current Issues & Risks What do we already know: • The Audit Committee plays a major role in the oversight of Risk Management. • Internal auditors are required to evaluate and make recommendations for improving risk management processes. • The toxic Mortgage Backed Securities were purchased by sophisticated institutional investors.

46. Current Issues & Risks Role of the Audit Committee in Risk Management • To provide effective oversight members of the audit committee are to have an in depth knowledge about the business, the major risks that it faces and the control environment within which the organisation operates. • This means that Audit Committee should obtain some level of training with respect to Risk Management – otherwise they may not be in a position to effectively dispense their oversight obligations.

47. Current Issues & Risks Role of the Audit Committee in Risk Management • The case studies on the failed institutions pointed to lapses in risk management. • As an audit committee member can you confirm the following:? • The overall risk management strategy of the organisation has been well articulated. • You fully understand the business and its exposures to significant risks. • You have a good understanding of the products offered and the level of risks attached to same. • A risk management culture is instilled throughout the organisation.

48. Current Issues & Risks Role of the Audit Committee in Risk Management • Number of audit committee members present. • Number of internal auditors present • No of persons who have received training in Business Risk and Controls / Risk Management.

49. Setting the Agenda for future success in the Caribbean Emphasis on controlling risk exposures

50. Setting the Agenda for future success in the Caribbean • In Setting the agenda for future successit is critical that risk issues are prioritize – the keys risks should be a top agenda item. • An understanding of risks should focus not only on the downside risks but also on the upside risks. • Focusing on the downward risks while ignoring upside risks results in the erosion of shareholder value.