Cyclical Forces And The Crises of 2010

Devastating news about Johnson & Johnson, Toyota, BP, and Goldman Sachs – to name just a few – dominated headlines as much in 2010 as lousy economic news.   But it’s hardly a coincidence that crises have been more prevalent in the wake the dramatic economic contraction we’ve faced.

Recession certainly exposes the financially weak and the criminal.  In 2002 and 2003, Enron, WorldCom, and others collapsed amid accounting scandals.  This time around, Bernie Madoff was the first of a handful of Ponzi scheme managers to face perp walks.  And Lehman Brothers and AIG were revealed to be the weakest players in their respective markets as the dominos fell after the mortgage market collapsed.

But 2010 has been perilous for businesses across all sectors, including some of the best run companies in business, and that’s typical of recession and post-recession years.  Consider some cyclical elements that make crises more likely in the aftermath of economic downturns:

Internal – Belt-tightening:

• Layoffs – Workforce reductions leave companies with fewer people to do the work, stretching those who are left behind, sometimes to the point where they simply can’t pay attention to everything all the time.  Further, the stress of insecurity can fatigue employees (even in companies that haven’t done layoffs), who then seek to avoid extra responsibilities whenever possible.  These factors conspire to increase the potential that something will be missed and make it more likely employees will try to avoid responsibility for fixing little things that could spiral into full-blown crises.
• Capex Investment Cuts – As plant becomes antiquated, management’s inclined to stretch it as far as possible before approving funds for upgrades.  Sometimes the gamble works, but other times, it can lead to breakdowns in significant parts of the operation.
• Operating Cost Reductions – As CFOs pare funding for daily operations, it becomes more likely that crucial departments, such as quality assurance, get shortchanged.  Managers’ decisions about where to cut budgets are never fun, and ultimately some cuts need to be made.  But, each cut produces a corresponding change in the risks the company faces.  Unfortunately, risk management and crisis preparedness may also face cuts, making it less likely the company can detect changes in its risk profile and respond effectively to crises.
• Supply Chain Price Pressure – Procurement departments use their market power to force supplier prices down as much as possible, exacerbating the pressures on vendors and suppliers.

External – Police Actions, Politics, and Shakedowns:

• Government Activism – Government officials and regulators turn activist, policing some real problems and exploiting populist sentiments to win political favor with frustrated voters.  In the process, they often demonize business and politicize crises that occur.
• Legal Attacks – Trial lawyers search for opportunities to preach revenge to dissatisfied, frustrated, and angry customers, shareholders, local communities, and former employees.  Sometimes these attacks are justified, but other times they’re just corporate shakedowns designed to play on the emotions of potential plaintiffs and extort money from companies using the threat of severe adverse publicity.

The Dangers of Cautious Expansion

Unfortunately, cautious expansion can be just as dangerous, if not more.  Increasing volume without adding staff, increasing operating budgets, restarting capex investment, and bolstering quality assurance only adds stress to systems that are already working at or beyond capacity.  As that stress increases, it’s only logical that a weak link in the chain will break eventually, plunging the company into crisis.

It’s also worth noting that expansion pressures on smaller, less-scalable businesses in a company’s supply chain can increase stress on their systems exponentially, and the company that manages the final product brand generally ends up responsible in the eyes of customers for any crises that occur.

Management decisions designed to handle to business cycle pressures create dramatic changes in company risk profiles.  If companies limit their investments in risk management, they limit their abilities to detect these shifts and take appropriate actions to mitigate or transfer risks.  If they limit their investments in crisis preparedness, they also limit their abilities to prepare crisis management plans for risks that must be tolerated.

Since Sarbanes-Oxley passed in 2002, CEOs have been required to sign off annually on company controls, which many experts believe include risk management and crisis preparedness.  But this is the first full recession we’ve experienced under SOX, and laws may be interpreted differently across the business landscape.  As the economy starts to churn in the year ahead, managers would do well to ensure they fully understand how their decisions change the risks inherent in their businesses.  And, boards of directors should protect shareholders by demanding regular reports on risk management and crisis preparedness within the businesses they oversee.  In doing so, they may make 2011 a better year than 2010.