Risk Rap

Rapping About a World at Risk

Healing the Breach: An Essay on Sound Practices for Fund Managers

…“the “money-management business” (with its plethora of mutual funds, investment counseling firms, and hedge funds) has so many practitioners who’ve grown up in an era where it’s all been about marketing and not risk management,…” “If 2004 goes bad, it will go really bad “ Bill Fleckenstein Contrarian Chronicle

This candid remark is an astonishing observation. The assertion that money management is more about marketing then risk management is a bit disconcerting. The most recent Security Exchange Commission’s (SEC) announcement concerning its investigations of brokerage firms for receiving commission payment premium’s by asset management firms for directing investors into purchases of preferred mutual funds is the latest example of how this statement is a tragic reality for investment product consumers.

We live in the era of radical capitalism. It is characterized by fierce political pronouncements of the sanctity of laissez-faire principles and the ultra aggressive pursuit of free markets, resulting in the increased rationalization of the market mechanism into our culture and daily lives. For many readers this statement is not surprising or profound. Marketing is king, and if you have any doubts about it, try locating a music station in New York City that is not wed to a Top 40 play list or Talk Radio format.

However, as this Milton Friedman vision of utopia continues its inexorable march of rationalization, a strange alchemy is taking place. As businesses damn the torpedoes to pursue markets, ethical business practices and sound corporate governance principles are being sacrificed at the alter of EBITDA, ROE, P/E’s and the Holy of Holies those sacred stock options. The ironic twist to all this is that these aggressive business practices defended on the grounds that they enhance shareholders value are actually seriously eroding the values of brands, profit margins and market capitalizations. Ask a shareholder of Enron, Parmalat or WorldCom about the clever corporate stewardship of these company’s former management teams and you’ll get a resounding thumbs down.

But there is something deeper going on here. When investors entrust their money to an investment manager, they may be attracted to the sizzle (remember past performance is not indicative of anything) but what they want is still the steak. Investors want an investment manager that can understand their investment goals and risk tolerance and provide them with an investment vehicle that can balance that risk tolerance with the capability of realizing an expected return. The act of giving a manager discretionary power over an individuals retirement fund, a union’s pension portfolio, a family office or child’s educational financing vehicle is a tremendous act of faith that requires an extraordinary degree of confidence in the manager’s ability to provide an acceptable return, but to also be a trusted fiduciary that has the requisite operational support and controls in place that will safeguard and honestly seek to grow and protect an investors capital.

Mr. Fleckenstein’s assertion that risk management has taken a back seat to marketing and product placement is unfortunately an accurate assertion. The financial services industry is unique in the sense that it is the loam of all capitalist constructs. Yet as a business, financial services companies are no different from any other economic enterprise. All companies create products and differentiate themselves through the value proposition incorporated into their product. Intrinsic to the product creation process is a determination of the type of materials that will form its composition. A conscious decision is made as to how the product will be positioned and marketed, its performance metrics determined, customer service resources required to support the product as consumers use it and how it will be distributed. Once those variables have been determined, a profit margin is added and a value proposition to potential customers is conveyed. The value proposition that is communicated to consumers comes to be known and identified as the product brand. An investment product is designed to essentially address current and future financing requirements and the risk profile of the consumer are central to the design and purpose of the product. That is why this bifurcation is so dangerous. It undermines the inherent purpose of the investment product and should more truthfully be marketed as a product that enriches the commission merchant that may over a specified period of time garner a return for the investor. Think about all the Enron employees who had their 401k’s invested entirely in Enron stock.

This is probably the most significant point and primal differentiator of companies that manufacture financial products with that of companies that manufacture consumer durables. Financial products facilitate the flow of capital through the markets. It feeds the invisible hand that guides and directs all economic activity. If the flow of financial products is impeded, or abates due to consumers lack of confidence, a consumer driven economy like that of the United States will suffer greatly. Foreign governments and institutions buy US Government bills, bonds and notes because of the well-earned confidence they have in Uncle Sam’s stable currency and it’s ability to pay it’s debt and provide a fair return to all note holders. However if that confidence goes away, Uncle Sam will have to curtail its deficit spending, raise taxes on its people and enter into other messy measures to remain economically viable. Confidence is a lovely thing both for nations and companies and once that confidence is lost it is a difficult, if not an impossible thing to regain. Confidence is the basis of risk management. Credit risk and rates of return, the key variables of risk management, all start with the certainty of confidence.

Yes, from an investment performance point of view 2003 was a terrific year. All major equity indices were up. Thanks in large part to a federal tax rebate program the US economy grew by 8% during the 3rd quarter, prompting Mr. Greenspan to proclaim with a certain degree of confidence that the recession had ended. Yet from corporate governance, business confidence point of view, 2003 business news makes the turn of the century robber barons look like acolytes of Mother Teresa. To restore confidence investment managers need to develop a Sound Practice program that will repair the breech and bridge the bifurcation of marketing and risk management within the investment management enterprise. Lets turn our focus on how and why this bifurcation must be bridged.

Sound Practices Builds Confidence

The explosive growth of the global hedge fund industry and the important role it plays in providing market liquidity and as an alternative asset class for high net worth investors and institutions is increasingly placing the industry in the global spotlight and many regulators, interest groups and institutional consumers are demanding greater transparency and advocating increased oversight and government regulation.

The Long Term Capital Management debacle, George Soros’s unilateral assault on and profitable dismantling of the Pre-Euro Exchange Rate Mechanism, numerous hedge fund blow-ups through poor management controls or outright fraud, and the most recent disclosure of the widespread collusion of hedge fund arbitrageurs and mutual fund managers to conduct market timing trading, is seriously eroding investor confidence in financial institutions. This is creating a political climate favorable to enhanced regulation and oversight of financial institutions. The recent investigative actions of New York State Attorney General Elliot Spitzer, and the appointment of William H. Donaldson to head the SEC are clearly political responses to the crisis in corporate governance and regulatory malfeasance.

At last count, there are approximately 20,000 companies engaged in investment management within the United States. Some investment companies are regulated by the SEC, some by the Commodities Futures Trading Commission (CFTC), some by the National Association of Securities Dealers (NASD), some conform to best practices required by custodial counter-parties, and some are guided solely by the good conscience of the fund manager.

In this rapidly expanding market, managers are seeking to differentiate themselves and attract investors assets through slick marketing campaigns, presentations, road shows, and shameless boasts about a mangers progeny, experience and past performance. Attestations of operational readiness and management’s commitment to ethical corporate governance is usually covered with a statement that lists the prime broker, the accounting firm for auditing and the administrator for transfer agency and shareholder communications. The manager believes that by listing the service providers (corporate brands) they convey a message to the investor that they are operationally sound and have the operational controls in place to satisfy all contingencies. Unfortunately, these service providers are retained for a very specific purpose and taken in aggregate do not amount to the implementation of a unified sound risk management program. Indeed, Arthur Anderson was a leading provider of services to the alternative investment management market and reliance on this brand to infer regulatory compliance or adherence to sound operational practices was clearly a miscalculation.

In the day-to-day operation of the business the tension between regulatory compliance and entrepreneurial zeal is usually resolved in favor of doing the transaction. When we asked an executing broker working a large sale transaction for a first time hedge fund customer if the hedge fund identity had been properly documented and verified in conformance with the rules of the USA PATRIOT Act he stated, “They’ll never answer these questions and if we ask they’ll simply go to another broker to work the order. We’ll take the hit to do the deal.” Yes this broker made a calculated decision based on the potential that the hedge fund was not entering into this transaction to launder money through the capital market system or was a front for terrorist financing. He was probably right, and earned his firm a nice commission for working the 100,000-share block at $.05 per share. But what if he was wrong? Was the premium commission rate a fair return for a ruined reputation, a million dollar fine, the revocation of your industry license, a lifelong ban from the industry, or even a prison sentence?

What are Sound Practices?

Sound Practices are a set of standards and operational controls that mitigate numerous risk factors in the investment management enterprise. Sound Practices address the investment process, its decision and operational support functions, capital introduction, compliance requirements, business continuity, fund strategies and investor communications within a set of defined expense ratios.

What’s the difference between Sound Practices and Regulatory Compliance?

If we accept the definition that compliance is a set of externally imposed rules required to insure that counter-parties of a transaction and the rules governing the transaction meet acceptable minimum standards to facilitate an ethical and efficient exchange of value; I think we come pretty close to the meaning and nature of compliance and the purpose of the functions required to support it.

In the United States, depending upon the type of products a financial services firm offers, there may be or may not be a governmental agency or Special Regulatory Organization (SRO) that is charged with compliance oversight and enforcement of its business practices. The Office of the Comptroller of the Currency (OCC) is charged with the responsibility to oversee compliance with regulatory statutes for savings and loans, thrifts and banks. For broker/dealers the NASD is the SRO oversight body. For mutual fund companies and publicly listed companies, the SEC is the regulator. Future Commission Merchants are regulated by the CFTC; and hedge funds, -sometimes referred to as an Unregistered Investment Company (UIC)- at present escape any formalized regulatory oversight body.

Each regulatory body has its own set of compliance rules, guidelines and enforcement mandates. One can imagine the overlap and confusion that occurs when a bank owns a broker dealer, which owns an asset management firm, that offers mutual funds and off shore hedge fund products to institutional, retail and high net worth investors. The maze of regulators and the differing and sometimes contradictory regulatory requirements creates a reactionary and possibly antagonistic response to regulatory examinations and demands. At the very least, compliance is a significant cost of doing business and adds little to the intrinsic value of the product offered by the institution. The added expense of compliance deals with the structural aspects of the market, not the intrinsic value of the product. This is a dangerous bifurcation in its own right. A financial product, (specie for the capital markets) requires a denigration of value to assure a controlled velocity through a regulated market structure.

For companies that view regulatory compliance as a necessary evil that tempers entrepreneurial pursuits and whose function is an added cost of doing business; these organizations will develop a best practice culture that is inherently restrictive. This type of corporate response to regulatory or best practices initiatives will always be overwhelmingly reactive and places the enterprise at great operational and regulatory risk.

Sound Practices are different. Sound practices are a set of internally (organically) developed operating principles that inform the values of ethical corporate governance, is enforced by internal management and seeks to become invisible as it ingrains itself into the operational and business culture of the firm. Sound practices must be viewed as fundamental to a firm’s value proposition, organically grown and endemic to the corporate culture and proactively conveyed to the market as a premium brand.

The internal development or organic growth of best practices as a central desire and objective of the corporate enterprise is revealed as central to product brand and the value proposition offered in the market. This positions the firm and its products as a premium brand. The business benefits of a sound practice program are enhanced margins, product performance and the attraction of quality clients and vendor relationships. More importantly it differentiates the firm in a crowded market because its quality brand is perceived by the market as endemic to the firm’s corporate culture and as such is inherently superior to something that is externally imposed by some governmental or regulatory body. On a macro-economic level the socialist or state capitalist experiments in highly regulated planned economies are the logical extreme and true antithesis of a sound practice culture.

Within the hedge fund industry in the United States the concept of Sound Practices first surfaced in an industry study entitled Sound Practices for Hedge Funds. The study was an industry response to the Clinton Administration’s request to examine the lessons learned from the Long Term Capital Management implosion and recommend basic guidelines to avoid similar disastrous occurrences in the future. The paper was a breakthrough on a number of fronts, placing the science of risk management and the utilization of risk measurement tools at the center of the investment management enterprise. Though the study was a political response to a catastrophic market event, the real purpose of the study was to temper the drive to regulate the hedge fund industry. In essence, the authors of the study asserted that regulatory oversight is not needed if hedge funds implement and maintain a sound practices program. Sound practices will allow investment companies to remain unregulated and will assure that the industry is fully capable of self-policing through the creation of practice standards. Indeed, any regulation or governmental oversight will further drive the industry offshore to more discreet and tax friendly domiciles and could potentially drain capital and liquidity from the US capital markets.

Operational Risk Mitigation

As previously stated, developing and adhering to a set of best practices principals and guidelines will add intrinsic value to product and corporate brand. The purveyors of Business Performance Management (BPM) solutions routinely boast the claim that publicly listed companies that practice BPM have P/E ratios that trade at a 15% premium to industry peers who have not implemented a BPM strategy. The question whether BPM is a silver bullet to enhance market value or whether BPM practitioners are leading companies dedicated to implementing programs and mechanisms to build shareholder value are irrelevant. What is important is that BPM practitioners are implementing processes and tools to understand and isolate operational risk to create product delivery and decision support mechanisms that build intrinsic product and corporate brand value. Thus at its heart, BPM practitioners seek to heal the bifurcation of marketing and operational risk management and firmly establish and display the synthesis as central to the value proposition a company delivers to its clients.

Operational risk factors in the investment management complex are numerous. They include valuation practices, system infrastructure, business continuity contingencies, vendor and service provider dependencies, risk management tools, risk management function segregation and asset gathering or capital introduction and investment acceptance principles. All of these risk factors are significant and each one on its own could threaten the ongoing viability of the enterprise. Each risk factor must be addressed in detail with a comprehensive programmatic approach to develop and implement processes and controls to enhance best practices to support the function and mitigate the risk factor associated with the business process. The Basel Capital Accord (Basel ll) proposes the introduction of a capital charge related to the operational risks of financial institutions. Basel II defines operational risk as “the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events.”

As an example, poor record keeping or an honest miscalculation on a corporate action treatment or security valuation can be forgiven. After all, the restatement of earnings -even during the Sarbanes Oxley Era- in corporate America is common. Laundering money for criminal enterprises, or heaven forbid, financing terrorism goes way past lax controls. In the eyes of the law it is criminal, in the eye’s of regulatory authorities it’s a serious offence, and a heavy fine and asset forfeiture is possible. If this occurs, in the mind of the consumer the fund manager is guilty of two counts of treason. The first count of treason the fund manger is guilty of is against his country. The second count the fund manager is guilty of is the betrayal of a sacred fiduciary duty. A hedge fund manager would probably never recover from this type of avoidable catastrophic risk event.

Fund managers need not look at compliance with the USA Patriot Act as another cumbersome compliance requirement that will be expensive to address. The belief that compliance will antagonize or annoy potential clients and may in fact drive them to a competitor whose controls are not as stringent and whose compliance laxity facilitates transactions by making it easier for investors to place assets with the competitor may hold some truth. But shouldn’t a fund manager avoid those types of clients anyway?

Compliance with The USA Patriot Act requires that investment companies conduct due diligence and maintain and administer a Customer Identification Program (CIP). Investment companies should view compliance with the Act as an opportunity to develop a Know Your Customer (KYC) capability that enhances and enriches the client relationship with the firm. When fund managers make KYC the cornerstone of their product development initiatives marketing will then truly serve the risk management requirements of clients.

The process of conducting the KYC due diligence exercise results in a more in-depth understanding of the customer. As managers are verifying customer identification information they will routinely uncover residential, employment and family histories that give them a better perspective on the client’s needs, their appetite for risk, other fiduciary relationships the client has and the source of the clients wealth. The regulatory objective of the KYC process is to verify the clients identity and to make sure they are not a money launderer or terrorist. The sound practice objective of the KYC process is to cover the regulatory requirements and more importantly to gain insights and understandings into their personal and business motivations. Armed with this understanding the manager can design or offer an investment product that will address the client’s risk management requirement. Client’s will appreciate the fact that managers are conducting this due diligence to insure that their funds will not be commingled with money launderers or terrorists, and that the firm is taking appropriate steps to insure that they transact business with reputable clients whose ethical and moral standards are similar to their own high standards.

As clients experience the KYC discovery process, they will begin to understand that the firm is committed to delivering a qualitatively superior value proposition. The client experience will help them to understand that the marketing focus of the firm is to acquire trusted customers and the depth and quality of client relationships are established to understand client needs and requirements. The client will also gain the assurance that regulatory risk and the potential for large fines and asset forfeitures are minimized due to the care the firm has exercised in determining that its clients are the right type of clientele and that the firm’s management has created operational controls and processes to prevent the risk of money laundering within the investment management enterprise.

Furthermore, subscription and redemption releases are facilitated due to proper controls in place with administrators and custodial institutions. This places enhanced liquidity at a fund manager’s disposal allowing the manager to practice effective cash management techniques that position the manager to take advantage of investment opportunities that may arise. This raises the possibility of developing a more effective collateral management capability that will tighten spreads on haircuts and dramatically reduce financing expenses. The credit rating of the firm would improve allowing lenders to further reduce financing rates to capture the funds business in a competitive credit and financing market. The reduction in the cost of capital can dramatically affect investment performance and the marketers can truly boast of a source of alpha that is directly attributable to operational sound practice processes.

Having proper procedures and business processes in place with administrators and custodian institutions will also facilitate the transfer of shareholder data to accountants for tax and audit purposes. This will expedite the delivery of tax and performance information to shareholders, generating savings in preparation fees and lessening the possibility of costly restatements. This will reduce and maintain fund expense ratios to absolute minimums. Marketers can clearly demonstrate that the fund managers are good stewards and are as concerned with minimization of business expenses as well as investment performance and high watermarks.

Increased transparency and the opportunity to dramatically enhance shareholder communications and reporting will be a strong attraction to many investors. Indeed, many institutional investors demand a level of transparency, communication protocols, and reporting tools that would have been unthinkable only a short while ago. As sophisticated institutional participation grows within the industry, the implementation of a sound practice program will be the only way hedge fund products can incorporate the necessary value proposition that addresses their risk management profiles and requirements. Sound practices and the compliance function become significant differentiators and powerful marketing tools. At last, the bifurcation is healed.

James Wolfensohn, President of the World Bank has been quoted as saying, “Corporate governance is about promoting corporate fairness, transparency and accountability.” Sound Practices is a necessary prerequisite for effective and ethical corporate governance. Fund managers must accept it’s precepts and sell side institutions and other industry participants and service providers must demand compliance, disclosure, ethical trading principals, honest research, operational integrity and a full commitment to its implementation and adherence. Effective corporate governance practices will restore the faith of the investing public in the global financial services industry and maintain the rationality of the world’s capital markets. It will also please investors to see realized enhanced returns on investment portfolios and help fund managers to fully participate and enjoy the benefits of a thriving hedge fund practice.

Originally written January 5, 2004, the article is significant because it raises concerns about financial services product marketing practices that still need to be addressed six and half years later.

You Tube Music Video: Mike Oldfield, Tubular Bells

Risk: regulatory, consumer confidence, sound practices

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June 7, 2010 Posted by | AML, banking, Basel II, credit crisis, hedge funds, investments, marketing, operations, private equity, product, product liability, regulatory, reputational risk, risk management, sound practices | , , , , , , , , , , , , , , , , , , , , | 1 Comment

PCA Goes To The Lonesome Valley

PCA RIP

PCA RIP

On Monday came the not surprising news that Peanut Corporation of America (PCA) has filed for bankruptcy.

The practice of selling food additives laced with salmonella bacteria makes it difficult to win back the trust of customers that had been so grievously violated.

PCA’s actions to knowingly ship contaminated products that have resulted in nine deaths and have sickened 637 people in 44 states. PCA’s salmonella laced peanut paste has contaminated 2,226 processed food products. A full list of recalled products can be found on the FDA website. These potentially criminal acts by PCA’s management has demolished the PCA corporate brand making it impossible to continue as a going concern.

The Chapter 7 bankruptcy filing will liquidate the company. This strategy will protect the PCA shareholders in the privately held firm from the significant legal liability that this event has created. It does not however protect PCA’s company management and accomplices that knowingly shipped contaminated products from potential criminal prosecution. Criminal persecution of those involved should be pursued and if anyone is found guilty punishment must be severe.PCA released its contaminated product into a large and extensive supply chain. Many leading brand food processing manufacturers that use PCA’s peanut paste as an ingredient in their packaged goods products have suffered severe reputational damage to their product and company brands. Though PCA’s corporate liability may be mitigated with the bankruptcy filing, aggrieved consumers will continue to have have legal recource by filing suits against the major consumer product companies that are still in business. This could make for a record breaking class action product liability suit.

Unfortunately this tragic occurrence could have been prevented. PCA’s actions demonstrate a disturbing ambivalence toward effective sound corporate governance practices. Companies that willingly sacrifice risk management and ethical business practices for the sake of short term profits consistently undermine corporate sustainability. All may not result in a dramatic corporate implosion like PCA. But ultimately the song of corporate liquidations remains the same. Unemployment for workers, aggrieved consumers, community desertion, tortured consciences and and in some instances criminal prosecution.

RIP PCA.

You Tube Video: Fairfield Four, Lonesome Valley

Risk: corporate goverance, ethics, risk management, legal

February 18, 2009 Posted by | associations, compliance, manufacturing, Peanut Corporation of America, product liability, supply chain, sustainability | , , , , , | Leave a comment

For the Want of a Nail: Lennar Homes

for the want of a nail

for the want of a nail

Community developer Lennar Homes lawsuit against drywall manufacturers reminds me of the old Mother Goose nursery rhyme, “for the want of a nail.” The rhyme begins with a nail that was not available to affix a shoe to the hoof of a horse. The loss of the nail loses the shoe, which loses the horse, which loses the rider, which loses the battle, which loses the war, which loses the king which loses the kingdom. For the want of a nail is an instructive tale of how seemingly insignificant or minute events can create consequences that escalate into a catastrophic incident that impacts and endangers many.

The Lennar lawsuit is yet another egregious example of supply chain contamination that has recently come to light. The discovery of toxic substances within drywall manufactured in China and used in the construction of Florida homes has prompted the lawsuit against manufacturers and a number of installation subcontractors that purchased the contaminated drywall on behalf of Lennar.

Lennar’s lawsuit alleges that subcontractors it employed to install dry wall, substituted high quality domestic brands with the less expensive contaminated drywall. The subcontractors imported the contaminated drywall from China to save on costs of materials in an attempt to boost profits for their contracted work. The drywall was discovered to contain toxic substances after a number of homeowners began to complain of foul odors, product deterioration and in some cases sickness due to exposure to the contaminated product.

It is believed that the Chinese drywall was found to contain a quantity of dry ash which was used as a filler substance in the manufacturing process. Dry ash is a waste by product of coal fired power plants that are so prevalent in China. The dry ash is known to contain concentrations of heavy metals that are considered dangerous to humans.

This event is certainly unwelcome news for the beleaguered construction and real estate industries. Particularly so in deeply distressed markets like southern Florida. It has heightened the risk profile of all parties involved and could spell catastrophic consequences for some of the involved manufacturers, homeowners, and contractors. This event can also impact the profitability of banks that may be forced to write off non-performing mortgages and construction loans sold to affected homeowners and contractors. Insurance companies may be required to pay off clams for product liability and homeowner policies. Municipalities are also at risk due to this event. Tax ratables and property values are threatened due to property abandonment and the suspicion that toxins have been introduced into the community.

This risk event will require the drywall manufacturers to face severe legal liability. It will impact profitability due to the financial stress of remediation expenses. Most significantly these types of events do severe damage to the company brand and reputation. A great deal of company and product branding is about trust. This types of events compromise the trust of brand consumers. Once that trust is violated it is very difficult to win it back.

Lennar violated its customers trust by allowing its supply chain to be contaminated. This violation of trust will result in financial loss and may create a long term health risk for Lennars customers and their families.

The municipalities that welcomed Lennar with the anticipation that development will serve the citizens of their communities have now been scarred by an ecological hazard. This will continue to haunt the reputation of these towns for many years because it threatens the value of both contaminated and non contaminated homes.

The drywall installation contractors face a high probability of bankruptcy and potential criminal prosecution. This event will fire a deepening distrust of Chinese manufactured products. It will certainly add stress to the delicate political balance of the highly codependent China USA trade relationship. Instigating calls for more protectionism and “Buy America” mantra by American based manufacturers. The prospect of added strain with China is particularly delicate due to China’s important roll in financing government spending through its large purchases of US government bonds. All because some subcontractors wanted to realize a little more profit margin. For the want of a nail indeed.

The unfortunate realization is that this risk could have been prevented. Master contractors need to put in place service and supply level agreements that prohibit the use of substituted materials. Master contractors need to manage supply chains by insisting that all materials used by subcontractors meet quality specifications and are sourced from trusted and thoroughly vetted providers. Adherence to international product quality and testing standards must be ascertained before those are accepted into the supply chain. This is just one aspect of ascertaining weather a supplier meets acceptance criteria into a company supply chain.

The Profit|Optimizer helps manufacturers, developers, contractors and lenders conduct a risk assessment of their supply chain. It is something that many businesses often take for granted yet holds the potential to become one of the most dangerous risks to the financial health and stability of the business enterprise.

Sum2 sells nails. The Profit|Optimizer helps business nail down risks that can deconstruct your business. It is a great set of tools to build profits and construct a healthy sustainable business.

Next time you read Mother Goose “for the want of a nail” to a child remind them to pay particular attention to its sage advise. It may be the first lesson in effective risk management that they will receive.

You Tube Music Video: Peter Paul and Mary, If I Had A Hammer

Risk: supply chain, product liability, reputation risk, ecological

February 7, 2009 Posted by | disaster planning, ecological, manufacturing, product liability, reputation, supply chain | , , , , , , , | Leave a comment

Kashi’s Kismet

salmonella

salmonella

Last night as I was researching the Peanut Corporation of America’s (PCA) peanut paste recall, my wife received an urgent telephone call from our local supermarket. The caller informed us that the Kashi products we purchased were subject to recall. I was a bit astonished by the call for several reasons. The first being notified of the unhappy news that a premium brand product that I so enjoy has the potential to kill me or make me very ill due to Salmonella bacteria. It goes without saying that it was a most bracing experience. I was also a bit bemused about the ability of my local supermarket to track me down to inform me that my favorite breakfast cereal might endanger me. At the very least letting me know that this is no breakfast for champions.

Though this is a positive example of how consumer product data mining and customer tracking business intelligence is employed; the realization that your breakfast eating habits are tucked away in some giant relational database remains a bit unnerving. But that is a different subject for another day.

After checking with the Kashi website the cereal products I purchased were not listed on the recall list. Kashi website lists granola bars and cookies as its only products that are subject to recall. As a committed consumer of the brand I remember when I purchased the cereal a free granola bar was included in the package for product promotional purposes. When I returned home I eagerly consumed the free granola bars. I am happy to report that I have not fallen ill. I’ll have to go back to the supermarket and ask if the non contaminated cereal I still have in my cupboard remains subject to the recall. An interesting product bundling dilemma.

The mechanics and execution of the product recall seems to be effective. The sophisticated use of data mining technologies and the ability of the manufacturer to contact a retail consumer through a digital trail that includes customer loyalty cards, credit card, and product bar codes is pretty impressive.

What is of concern about Kashi and other processed food manufacturers that are dependent on an expanded and complex supply chain is their failure to uncover the risk associated with the supplier. In this case PCA. It is alleged that PCA had a leaky roof that played a role in contaminating the peanut paste. A simple walk through of the facility may have uncovered this risk factor. Certainly if a company fails to perform the most basic facilities maintenance functions (like a leaky roof) odds are that the company has other issues and businesses functions that it is not addressing. This is the cockroach theory. Where you see one there are usually many others. A simple walk through may have revealed that all was not kosher at PCA.

Supply chain risk is becoming more prominent as manufacturers and service providers aggregate components and ingredients from numerous providers to deliver a finished product or service to end user consumers. The implementation of a sound practice program that addresses risk associated with supply chains is a key ingredient for a sustainable business enterprise.

The Profit|Optimizer devotes a section to supply chain risk. All process manufacturers must require suppliers to conduct a thorough risk assessment of processes and functions as outlined in the Profit|Optimizer. The Profit|Optimizer also includes a section on facilities risk. The risk assessment tools offered by the Profit|Optimizer would have uncovered the dangerous risk factors at PCA and may have prevented the fatal and costly release of contaminated products.

The kismet of commercial enterprises like Kashi will continue to be bright so long as the mantra of sound risk management is practiced with more vigilance. In doing so the health and well being of its loyal customers will flower as will the value of its product brands and the sustainability of the business.

You Tube Video: Vince Guaraldi, The Peanuts Theme

Risk: reputation, brand, product liability

February 4, 2009 Posted by | manufacturing, product liability, reputation, risk management, supply chain | , , , , , , , , , , | Leave a comment

Peanut Corporation of America

A salmonella breakout that has been traced to peanut products marketed by the Peanut Corporation of America (PCA) is an unfortunate and severe example of a company with poor risk management, weak corporate governance controls and questionable ethical business practices. In most instances poor risk management and corporate governance violations primarily victimizes the company that fails to institute them. In the case of the PCA, unsound business practices has unleashed a deadly viral bacteria into a vast consumer market. Since its outbreak in October the salmonella infection is believed to have claimed the lives of 8 people and has sickened over 500. PCA violations will also cast a long shadow on the vibrant US peanut growers and processing industry.

A brief examination of some of the public disclosures that have come to light concerning the PCA speaks of a telling breakdown in sound risk management practices. These disclosures also hints at potential instances of fraud to cover up lax controls and compliance violations cited by FDA and State of Georgia food safety examiners.

The PCA had been cited for violations and lax operational controls during past inspections by regulatory agencies. Inspectors found evidence of roach infestation and mold in the production and storage facilities. Inspections also revealed that product quality had been compromised due to a degraded manufacturing process and improper maintenance of the operating facility. After bringing this to the attention of company management PCA executives sought out food testing companies that would provide results to indicate that product quality met federal safety standards and were safe to ship.

Utilizing industry standard risk analysis tools like the Profit|Optimizer would have revealed several breaches in sound risk management practices at PCA. Lax operational controls, poor facilities and the evasion of corporate governance practices will likely put PCA out of business due to the damage its actions have done to company product brands and reputation.

Problems and risks associated with process manufacturers like PCA add layers of complexity to determine product risk due to its role as a supplier in an intricate and expanded supply chain for processed consumer food products. The melamine contamination of Chinese milk products and the mortgage backed securities market crisis provide examples of how product liability and consumer risk is leveraged due supply chain complexity. The pervasiveness of products that use the peanut paste manufactured by PCA is very similar in many respects. Cookies, ice cream, crackers and other products are subject to recall. Some of the companies affected by PCA’s contaminated products include premium consumer product and brand marketing companies like Kellogg, General Mills, Jenny Craig, Nuti-System and Trader Joes.

Severe product liability events like this unfortunately also cast aspersions on an entire industry. Associations like the American Peanut Council are most concerned that the poor manufacturing practices and product quality standards exhibited by PCA will reflect on how consumers view the industry as a whole. It is a valid concern for the industry association and it must demonstrate to the regulators and consumers that its membership is committed to sound manufacturing practices, product quality and corporate governance excellence. This is not a PR problem. Nor is it a problem born from an industries anathema to regulatory control or a problem unleashed by some renegade industry member. Industries and their representative associations must also help address sound risk management and corporate governance excellence as a cultural issue that is endemic to its membership. Then industry excellence becomes synonymous with product quality and consumer satisfaction.

In all the FDA uncovered 10 violations and has published its report and carries a full listing of recalled products and other resources on the FDA website.

You Tube Video: Dizzy Gillespie’s Big Band, Salt Peanuts

Risk: product, operations, regulatory, reputation

January 29, 2009 Posted by | associations, manufacturing, operations, Peanut Corporation of America, product liability, regulatory, reputation, risk management, supply chain | , , , , , , , , , , , , | Leave a comment