Merrill board: Too late to the game

(Fortune) -- Merrill Lynch's board of directors was instrumental in removing Stanley O'Neal from the CEO and chairman posts after the brokerage reported $7.9 billion of bond losses in its third quarter.

But the board may have missed earlier opportunities to keep O'Neal in check. Several board members, including Alberto Cribiore, now the company's interim chairman, sat on committees that were supposed to help prevent Merrill from taking the sort of outsized risks that led to the losses.

Ousted Merrill Lynch CEO Stanley O'Neal.

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While board members from outside Merrill probably won't end up taking as much blame as O'Neal and other senior Merrill executives for the losses, the board's role is coming under scrutiny. That's because two board committees had the power to step in and object as Merrill became dangerously overexposed to collateralized debt obligations - the complex debt securities that were the source for most of the third quarter losses and which, according to analysts, could produce another $4 billion of losses in the fourth quarter.

For instance, Merrill's finance committee, which includes Cribiore and Chubb CEO John Finnegan, is charged with regularly reviewing "credit, market and liquidity risks" at the company, according to Merrill's 2006 annual report.

Company documents also show that the audit committee, chaired by board member Anne Reese, a former chief financial officer of ITT Corp., has a very instrumental role in overseeing risk management at Merrill (Charts, Fortune 500). The firm's 2006 proxy statement says that the audit committee "oversees management's policies and processes for managing the major categories of risk affecting us, including operational, legal and reputation risk."

After the 2001 Enron scandal, regulators and lawmakers went to considerable lengths to strengthen corporate governance, including measures to beef up the oversight powers of committees that contain independent directors and report to the board. However, Merrill's shocking losses indicate that this relatively new system of checks and balances, centered at the board, failed to spot the risk-related problems that were brewing at the brokerage.

"The events at Merrill are a perfect example that boards can miss very significant risks," says Patrick McGurn, of ISS Governance Services, a firm that advises shareholders on corporate governance issues.

When sent questions for Cribiore, Merrill Lynch declined to comment. Charles Rossotti, an adviser to the Carlyle Group who chairs Merrill's finance committee and also sits on the audit committee, declined to comment. Chubb's Finnegan didn't comment. Reese, who is also on the finance committee, didn't respond to a request for comment.

Publicly-filed Merrill documents show that the company, like other banks, has built internal governance structures that are designed to govern the amount of risk that it takes on.

The presence of the audit and finance committees in these structures is critical because both committees allow people outside the firm to have oversight of management decisions. In addition, both committees are supposed to have members who have the expertise to properly assess the often complex information provided by management. For example, Merrill says that Reese and Rossotti are "audit committee financial experts," as defined by Securities and Exchange Commission rules on who can be designated an expert for that committee.

One of the big questions that will be asked about the conduct of Merrill's board is whether company management gave board members the information they would have needed to make a proper judgment on whether the brokerage was taking on too much risk.

As with all oversight bodies, board members can only make informed decisions if they have enough information. However, a diligent board member would ask for more information if he or she felt that they didn't have sufficient data. In fact, the Sarbanes-Oxley Act, whose main aim was to improve corporate governance after the Enron scandal, gives audit committees the power to engage independent advisers to help it carry out its duties.

Little has been revealed to suggest that Merrill's board took substantial and effective steps to help Merrill avoid losses on subprime mortgages and CDOs.

The New York Times reported that management informed the board of the firm's exposure to subprime mortgages business in April and CDOs in July.

Since CDOs typically contained subprime mortgages, a diligent board member would have understood that stress in subprime would immediately hurt the CDO market.

More importantly, for a long time before that April meeting, the board should have spotted that Merrill was becoming overexposed to CDOs. This summer, as the credit crunch began to bite, Merrill's exposure to CDOs was $40 billion, up massively from just over $1 billion 18 months earlier.

That growth should have been an immediate red flag to the audit and finance committees, because it had the power to severely damage Merrill's balance sheet.

Merrill packaged CDOs and always aimed to sell most of them quickly to investors. Because CDOs never traded in liquid markets, there was always a danger that a bank would be stuck with them if it couldn't find sufficient buyers in a market downturn. To guard against this risk, a bank would try to avoid ever having too many CDOs on its books or it would take out insurance against losses on CDOs with financial instruments called derivatives.

If Merrill's audit and finance committees judged that the overall net increase in CDO exposure was not a big risk, they would have been reaching a very unorthodox conclusion, from a risk management point of view. The fact that other banks did not got get stuck with such large CDO holdings suggests they managed the risks of this product much more effectively.

At some point, the board had to act, though.

Merrill's third quarter earnings on Oct. 24 must have been a very uncomfortable moment for members of the audit and finance committees. That's because the $7.9 billion of losses on junk mortgages and CDOs was $3.4 billion higher than the company predicted three weeks earlier.

On a conference call to discuss third quarter earnings, Merrill's CFO Jeff Edwards explained that the bank reported the higher loss number because it had made a more conservative assessment of what its troubled assets were worth.

It may transpire that board members played a role in reaching that more conservative assessment. However, the real trigger may have been the installation of new, more conservative managers to oversee the fixed income business, which would have included CDOs and subprime mortgages, and risk management. In the first week of October, David Sobotka took over from Osman Semerci as head of fixed income. And in September, Ed Moriarty took on the new post of head of risk management.

At any rate, the board had to do something when the higher loss number came out - and the swiftness with which it dispensed with O'Neal suggests that its patience had run out.

"Merrill's board may have felt burned in trusting management's assessment of risk," says McGurn of ISS Governance Services.

In turn, Merrill shareholders could end up feeling very burned for having trusted the board.