5. The Refco Scandal
In October, two months after an initial public offering that valued the company at more than half a billion dollars, derivatives broker Refco’s share price lost about two-thirds of its value before the New York Stock Exchange called a halt to trading. The collapse was triggered when the company announced that chief executive Philip Bennett has been asked to take an immediate leave of absence and to pay back $430 billion in debt that had apparently been concealed for seven years before the IPO. Refco said it believed the money was owed by a third-party, but it turned out to be owed by a company Bennett controlled.
A few days later, the U.S. Attorney’s office in New York charged the former CEO with one count of criminal securities fraud. According to prosecutors, Bennett engaged in a series of transactions at the end of recent fiscal quarters, designed to disguise the debt owed to Refco by a private entity he controlled.
Refco closed down business nits that helped investors trade stocks, bonds, and foreign currencies, leaving only its core futures brokerage operation and filed for Chapter 11 protection on October 17.
But the company’s advisors faced a daunting public relations challenge too, as investors began to ask how those advisors could have scrutinized the company’s books without finding the alleged fraud. Meanwhile, many wondered how institutional investors could have bought into the IPO despite warning signs in the prospectus.
Buried in the boilerplate discussion of various risks to its business disclosed in the prospectus Refco filed with the Securities & Exchange Commission on July 25—two weeks before the IPO—was a paragraph indicating that the company’s accountants at Grant Thornton had found two “significant deficiencies” in its internal controls.
The Chicago-based accounting firm reported that Refco’s finance department did not have the resources to prepare financial statements “that are fully compliant with all S.E.C. reporting guidelines on a timely basis” and that the company lacked a formal process for closing its books at the end of each quarter.
Among the advisors caught up in the crisis were Grant Thornton, private equity firm Thomas H. Lee Partners, and Wall Street investment banks Goldman Sachs, Credit Suisse First Boston and Banc of America Securities.
“While our professional consideration is still underway, it appears to be a purposeful deception that required participation by senior management, hidden well enough to also evade numerous other detailed financial inspections performed by many of the most well-respected financial institutions in the country,” said Grant Thornton, which was the subject of an inquiry by the Public Company Accounting Oversight Board.
Goldman was hired in the wake of the crisis to help the company raise fresh capital—a decision that caused some consternation. “To me, that was a desperate attempt to slather themselves in respectability that wasn’t terribly well thought through,” said Michael Greenberger, a law professor at the University of Maryland and a former regulator with the Commodity Futures Trading Commission. “Goldman has its own problems here.”
Writing in The New York Times, meanwhile, Grethen Morgenson opined that “scariest of all may be the fact that supposedly savvy institutional investors who are fiduciaries—TIAA-CREF and Oppenheimer Funds, for example—bought Refco’s shares in spite of the hair-raising risk factors detailed in the prospectus….This is the way investors live now: a financial services company’s inability to prepare its own financial statements does not preclude financial institutions from buying its stock.”
Others predictably wanted to know why the relevant regulators had not spotted the problems. The Wall Street Journal editorialized that “all those new laws, rules and regulators that Congress created after the WorldCom and Enron failures weren’t able to detect, much less prevent, what is alleged to have been fraudulent behavior. Sarbanes-Oxley, which was supposed to protect investors from nefarious CEOs, didn’t deter former Refco chief Phillip Bennett from allegedly disguising that an entity he controlled owed Refco hundreds of millions of dollars.”
For public relations practitioners, the speed at which the ripples from the crisis spread out to engulf advisors and investors provided a valuable lesson, says Peter Hirsch, who head the global corporate affairs practice at Porter Novelli.
“Perhaps it’s my imagination,” Hirsch says, “but I was impressed by how quickly the Refco story unfolded. The pace with which major business media ‘followed the money’ in examining all of the various business relationships underlying Enron or Parmalat was significantly slower. There has been a learning process based on a succession of crises that has increased the page-loading speed of the media.
“What this suggests, of course, is that the window of response for companies even two or three layers removed from the immediate crisis has shrunk considerably. This development will force organizations to examine the risks to which their business partners are exposed, not just their own risks, much more carefully in their risk communications planning.”
4. Time Warner Under Fire
In 2004, Eliot Spitzer was the boogeyman of American business, as the New York attorney general pursued a series of prosecutions against the dubious legal practices of financial services companies and others. But in 2005, an even scarier villain emerged: the hedge fund manager.
Hedge funds—less-regulated high-risk investment funds for wealthy, sophisticated investors—are becoming increasingly activist, often demanding immediate action from management to unlock short-term value, and frequently doing so publicly through the media.
“I think that we’ve only scratched the surface on the pressure by hedge fund activist investors on companies to make changes in their business in order to increase the current price of their stock,” says Martin Lipton, takeover lawyer and partner at the Wall Street law firm of Wachtell Lipton Rosen & Katz. “We have a group of activist hedge funds now… I think it’s a terrible thing for corporate America. I think what we’re seeing is a replay of the attempt to drive American business to short-term results instead of long-term values. And ultimately it’s a tremendous threat to the vitality of our economy.”
In August, billionaire investor Carl Icahn, who made his name as a corporate raider in the 1980s, told Time Warner chief executive Richard Parsons that he and three other hedge fund investors—Franklin Mutual, Jana Partners and SAC Capital—had accumulated a $2.2 billion stake in the company, about 3 percent of the company’s stock.
Days later, Icahn publicly urged Time Warner to split off its cable business and buy back at least $20 billion worth of its stock, claiming management has not done enough for shareholders. Icahn said that management has done “a commendable job managing each of their various businesses,” but criticized the company’s leadership for having “not proposed measures which would enhance value” for shareholders.
Says Al Tortorella, who heads the crisis group at Ogilvy Public Relations Worldwide, “The long line of corporate buccaneers that have forever plagued Time Warner/AOL, may finally watch Carl Icahn define what the company will ultimately become. With all that has happened to this iconic organization over the years, how much more of a crisis can it be?”
There is no doubt that Time Warner has underperformed in recent years. When Parsons took the CEO’s job in May of 2002, shares in the company opened at $18.85. When Icahn made his first public criticism of the company, shares were priced around $17—and they gained about 10 percent in value after Icahn’s goals were announced.
Parsons and the Time Warner management had already begun moving in the direction Icahn was pushing for. The company had announced a $5 billion share buyback plan—later doubled to appease the critics—and said it would spin off about 20 percent of its cable business when its acquisition of cable operator Adelphia was completed. But Icahn was far from satisfied. And he became even less satisfied after the company announced a wide-ranging pact with Google.
In a letter to the company’s board, Icahn told Time Warner directors they “may be on the verge of making a disastrous decision.”
At the heart of the dispute was whether Time Warner’s financial resources were better directed toward activities other than buying back the company’s own shares. Buying back more stock would immediately increase the value of the shares, but it would also mean that the money would not be available for buying or building longer-term businesses that could increase the long-term value of the company.
Most neutral observers seemed to believe that Icahn was over-reaching, with some even accusing him of good old-fashioned 80s-style “greenmail”—pay is off with a short-term increase in the share price and we’ll go away and bother someone else. Others believed there was more at stake that one company’s strategy.
“If Time Warner gets blown up, then no public media company CEO who’s not in a control situation will ever feel comfortable making the right long-term strategic and investment decisions, because he’ll always believe that there’s another greenmailer just a phone call or headline away,” wrote Leo Hindery, managing partner of InterMedia Partners, a media-industry private investment firm.
For corporate communications professionals, however, the message is clear: hedge funds are growing more active and more vocal, and companies better understand how to respond.
“Icahn’s Time Warner campaign is emblematic of a significant sea change in the capital markets, the return of corporate raiders as ‘white hat’ crusaders for shareholder value,” says Rich Blewitt of Weber Shandwick’s crisis management unit Rowan & Blewitt. “The lesson? As the 2006 proxy season gets underway, look for a lot more of the same from impatient shareholders of underperforming companies.”
3. Leadership Turmoil at Morgan Stanley
On Monday June 13, embattled Morgan Stanley chief executive Philip Purcell finally bowed to the inevitable and announced his retirement, three months after the resignation of two top executives in protest at his leadership. Their departure dragged a dispute between the CEO and a group of dissident shareholders and former employees into the public spotlight.
“It has become clear that in light of the continuing personal attacks on me, and the unprecedented level of negative attention our firm—and each of you—has had to endure, that this is the best thing I can do for you, our clients and our shareholders,” Purcell said in the letter to employees that was later released by the company.
Morgan Stanley was the most active issue on the New York Stock Exchange that day, its shares up $1.06 to $50.94, an indication of just how resoundingly Purcell’s foes—led by former chairman S. Parker Gilbert and known as the Group of Eight—had won the bruising public relations battle that was waged over the preceding months.
Morgan Stanley’s share price was down about 39 percent since 2000, and the bank was reeling from an unexpected legal blow, after a Florida jury awarded billionaire investor Ronald Perelman a total of $1.45 billion in damages after finding the firm defrauded Perelman when he sold camping-equipment maker Coleman to a Morgan Stanley client, appliance maker Sunbeam. But the dissidents were apparently most concerned about Purcell’s supposed neglect of the firm’s traditional and most profitable investment banking business.
On March 3, the dissidents had written to the board requesting that Purcell be replaced. On March 29, Purcell—apparently feeling the heat—announced that he was replacing president Stephan Newhouse, a 26-year veteran, with two of the CEO’s closest allies within the organization: Zoe Cruz and Steve Crawford. Two days later, the Group of Eight published a full-page ad in The Wall Street Journal, taking the dispute public.
In April, Joe Perella—head of the firm’s investment banking division—announced that he was leaving. Purcell remained defiant and the board, which some say was “packed” with Purcell allies, continued to support him. At a meeting on May 1, the board rejected the notion of splitting the firm in two—effectively selling off the retail business—and publicly reaffirmed its commitment to sticking with the embattled chief executive.
There were more executive departures, but a surprise second-quarter profit warning proved to be the final straw. The firm said it would report profits 15 percent to 20 percent lower than last year’s second quarter and blamed poor market conditions for the shortfall. Purcell said he would step down.
The reaction inside the company was captured in by an unidentified employee quoted by CNN/Money: “Ding, dong the witch is dead.”
Purcell’s departure alone is unlikely to end the bank’s problems, which include a struggling Discover credit card business, weak results at its Dean Witter brokerage, and a tough fixed-income trading environment. But the appointment of former president John Mack to replace Purcell
One clear lesson for communications people was that well-organized critics are increasingly sophisticated about public relations. The Group of Eight had retained Edelman, and waged a relentless campaign through the media.
Another lesson is that it is extremely difficult for an embattled chief executive to survive after he has lost the support of employees. The constant rumblings of dissatisfaction within the firm, gleefully leaked to the media by disgruntled employees, simply compounded the message from outsiders that Morgan Stanley was in turmoil.
“Throughout the six months before his departure Purcell engaged in more and more entrenched behavior, including attempting to pack his board,” says Helio Fred Garcia, a crisis management counselor and principal at Logos Consulting. “It was inevitable that he’d have to leave, and he hurt himself and the franchise by leaving too late. Mack has done an admirable job in keeping the firm together, and it turned in positive financial performance for the year.”
2. Merck’s Continuing Vioxx Crisis
Last year, Vioxx was number one on our list of the biggest crises, and this year the impact of Merck’s decision to keep its blockbuster painkiller on the market even after it learned about potentially dangerous side-effects continued to be felt, as the first Vioxx lawsuits came to trial.
The FDA approved Vioxx in 1999 for arthritis pain and certain other kinds of pain in adults. Later it was approved as a treatment for rheumatoid arthritis in adults and, more recently, for rheumatoid arthritis in children. But concerns about the drug’s safety arose almost immediately after approval. In 2000, the the New England Journal of Medicine published the results of a Merck trial called Vigor, which suggested that patients taking the drug were four times more likely to have a heart attack or stroke than patients taking an alternative painkiller.
In 2004, Merck was conducting its own trial intended to determine whether Vioxx could prevent a recurrence of precancerous growths in the colon. Instead, the trial showed that people taking a low dose of the drug for more than 18 months were twice as likely to have a heart attack or stroke as patients taking a placebo. The company consulted about two dozen outside experts in several medical specialties. While some rheumatologists advised Merck to keep Vioxx on the market and add a warning label, other doctors urged Merck take the pill off the market completely.
Merck directors met a few days later and on September 30 the company announced that it was withdrawing the product. Initially, at least, the company scored high marks from public relations experts. It didn’t wait for the FDA to order Vioxx off the market but undertook a global recall on its own initiative, and was forthright in all its public announcements.
But however exemplary the company’s management of the recall might have been, it did not insulate the stock against the strong reaction of the market. Merck lost $28 billion in value—about 27 percent of its market capitalization—in the immediate aftermath of the announcement. Critics quickly focused on the biggest question facing any company that finds itself in this kind of crisis: what did Merck know and when did the company know it? The fact that critics had raised serious questions about the safety of Vioxx almost since its introduction put the company in a difficult position.
“Merck did everything right years too late,” said Fred Garcia. “Companies can be forgiven even if people are hurt, but they won’t be forgiven if they’re seen not to care that people have been hurt. The central issue in this case isn’t whether they should have recalled the product or whether they handled the announcement well or poorly. To their credit they acted with good speed when they decided to pull the product. The central issue is what Merck knew—or should have known because others were trying to tell them—and when they knew or should have known it.”
Those questions became central as the first Vioxx lawsuits came to trial.
So far, Merck has won one state case, in New Jersey, and lost another, in Texas. The first federal case ended in a hung jury last month.
But the next round of trials could be influenced by an editorial published in the New England Journal of Medicine, accusing Merck of concealing information about three heart attacks among Vioxx patients in the study the journal published in November 2000. Merck says those deaths occurred after the study’s cut-off date for side effects, but journal editors say such data is routinely added until publication.
Those allegations, along with testimony from a Stanford University medical professor who says thee company sought to stifle academic discourse by attempting to discredit Vioxx critics, could make life even more uncomfortable for Merck over the next few months.
“Vioxx was the Mount St. Helens of healthcare, with continuing eruptions that have altered the landscape of the pharmaceutical business,” says Tim Barritt, who heads the crisis practice at Ketchum. “With mixed results for Merck in litigation companies will need to look hard at the long term business implications for any potential blockbuster. A risk management plan around pharmaceutical product withdrawals is clearly a must-have for manufacturers moving forward.”
At the same time, he says, Vioxx was the catalyst for a series of voluntary reforms that changed the face of pharmaceutical marketing.
Meanwhile, Merck still faces some difficult questions. “With thousands of Vioxx lawsuits still pending, the news that critical information was not included in the Vioxx study published in the New England Journal of Medicine raises broad questions about the veracity of medical studies, publication policies, and how that information is used in the marketplace,” says Barritt. “Pharmaceutical companies will likely face increased skepticism around study data, and will need to present thorough evidence and documentation on drug safety.
“Progressive companies will need to constantly demonstrate actions that support responsible research and marketing practices if they want to move beyond the shadow of Vioxx.”
Garcia agrees: “Vioxx has led to lots of companies recognizing the need to disclose early and to validate concerns carefully, to demonstrate situational awareness and self-awareness, which Merck seemed to lack. Others are learning from Merck’s mistakes, and working to prevent themselves from falling into the same trap.”
1. Guidant Corporation
On May 24, the front page of The New York Times included a damning headline: “Maker of Heart Device Kept Flaw from Doctors.” The company in question was Guidant Corporation, and the allegation was that it had known for three years of a problem that could cause a defibrillators, implanted in approximately 24,000 people, to short-circuit malfunction.
The problem came to light after the death of a 21-year-old college student from Minnesota whose defibrillator short-circuited. Guidant officials told his doctors that it was aware of 25 other cases in which that particular brand of defibrillator had malfunctioned. The company had changed its manufacturing processes three years earlier, but a senior company executive told the Times the company “had not seen a compelling reason to issue an alert to physicians about the defibrillators because the failure rate was very low and replacing the devices might pose greater patient risks.”
In making the decision to say nothing to physicians and patients, however, Guidant took the decision about risk out of their hands. Rather than allowing them to decide on a case-by-case basis whether the risk of removal was greater than the risk of malfunction, it made that decision for them. In so doing, it violated the principle that people have a right to “informed consent” when they are being put at risk.
The company’s failure to share the information drew fierce criticism. “At the end of the day, you have to come down on the side of full disclosure,” said Dr. David Cannom, director of cardiology at Good Samaritan Hospital in Los Angeles.
The company made the wrong decision, and it was inevitable that in this age of transparency the decision would eventually become public knowledge, igniting the suspicion that it was made for cynical financial reasons—a suspicion the company vehemently denies. That raises the question of what role the Guidant public relations team played in that decision. There are three possibilities.
The first is that they were never informed of the problem, either because Guidant didn’t believe PR people had any worthwhile insight into an issue that had the potential to significantly impact the company’s reputation, or because it knew what its PR people would say and had already decided it would ignore their advice, caring less about its long-term reputation than its quarterly revenues.
The second is that PR people were informed of the problem, and agreed with other executives that there was no need to inform either the medical community or the company’s customers.
The third is that PR people were informed, gave good advice, and were ignored.
Whichever of those three possibilities is true, the implication is that Guidant did not take the public relations implications of its decision seriously. That proved to be a disastrous mistake, because the Times story sent the company into a tailspin, scuttling a planned acquisition by Johnson & Johnson and triggering investigations by the Justice Department and the Food & Drug Adminisration.
The company is the subject of a takeover battle between J&J and Boston Scientific, although its value is considerably lower than it was when J&J made its initial bid—and could fall even lower after another New York Times piece, earlier this month, which suggests some company executives had urged full disclosure in January of 2005.
Says Helio Fred Garcia, “Guidant fell into the classic trap of not bundling all the bad news at once and getting it out there. People interpreted Guidant in the Merck frame: it knew about potentially fatal problems for years, and took insufficient remedial action. When J&J played hardball and slashed $4 billion off the purchase price, Guidant saw the tangible cost of ineffective crisis management, of letting bad news dribble over time rather than making one large and complete disclosure up front.”
Even in a year dominated by government catastrophes like Hurricane Katrina, it’s clear that corporations have not insulted themselves against crisis.
“Corporate leaders carry an obligation to learn the lessons from Katrina and to put into practice these and other learnings from 9/11, the Asian tsunamis, the Northeastern blackout and other recent disasters,” says Larry Kamer, president of North America at Manning Selvage & Lee. “Crisis preparedness is more than good insurance; it’s one of the most important acts of corporate responsibility a company can implement.”
The events of September 11,2001, carried a similar warning, but 18 months after the attacks security firm Guardsmark reported that half of U.S. companies surveyed still did not have backup facilities at remote sites, did not search visitors’ bags, and did not conduct emergency drills. “Katrina has once again rung the alarm bell,” says Kamer, “but companies seem to be hitting the snooze button for a second time.”
SunGard, which specializes in business contingency and remote site planning, says only 50 percent of Fortune 1000 companies have formal disaster recovery plans. Disaster-Resource.com says only 30 to 50 percent of companies ever test such plans.
“Companies without tested plans, following a catastrophic disaster, experience much higher failure rates over time than those that do,” says Kamer. “And there’s good evidence to suggest that crisis preparedness is linked with fewer fluctuations in stock price and a more durable reputation.”
According to crisis management expert James Lukszewski, Katrina—and in particular the media’s coverage of the disaster—taught several lessons for public relations people:
First, “rely on yourself to get accurate information out. Prepare to communicate directly with those who matter to you…. Monitor the news aggressively, then correct and clarify all errors and fabrications on your Web site for immediate electronic distribution to those who need to know…. Correct everybody, including yourself when you give out erroneous information.
And “record every interview…. Transcribe the interviews and confrontations, place both on the Web so those interested can make up their own minds, rather than basing their judgment on the 16 words some editor chooses to use.”
There is a clear payoff for companies that learn these lessons.
Says Fred Garcia: “Effective crisis response isn’t just a matter of protecting reputation. It also allows a company to get on with business faster and more effectively than if it delays its response. More important, effective crisis response has direct impact on a company’s productivity, demand for its product, stock price, and other quantitative measures of success.”
He points at the work of two Oxford University researchers, Rory Knight and Deborah Pretty, who studied the stock price performance of prominent publicly-traded corporations that had suffered significant crises. They calculated each company’s stock price performance attributable to the crisis—stripping out market movements and other factors unrelated to the crisis that might have affected the stock price—and found companies that mishandled crises saw their stock price plummet an average of 10 percent in the first weeks after a crisis, and continue to slide for a year, ending the year after the crisis an average of 15 percent below their pre-crisis prices.
Companies with effective crisis response, on the other hand, saw their stock fall an average of just 5 percent in the weeks following a crisis. More significant, those companies saw their stock price recover quickly, and remain above their pre-crisis price thereafter, closing an average of 7 percent above their pre-crisis price one year after the crisis.
“In other words,” says Garcia, “the tangible difference between effective and ineffective crisis response was, on average, 22 percent of a company’s market capitalization. The most important determinant of a company’s ability to recover and increase its market capitalization after a crisis is the management team’s response.”