How a single mouse click can destroy a company

Guest Post by Scot Justice, CPA:

Corporate Risk Appetite in a World Where a Mouse Click Can Cause a Company to Fail

On August 1, an electronic trading software upgrade malfunction caused Knight Capital Group to lose $440 million in approximately half an hour.  As the story developed, it became evident that this was truly an accident. Unfortunately, Knight Capital’s software upgrade didn’t have an off switch and it took thirty minutes to turn the trading program off.

This short time period resulted in severe consequences for the company and its shareholders. Knight Capital’s market capitalization dropped significantly as its stock price fell from a trading range of $12-14 to $2-3 (http://finance.yahoo.com/q/bc?s=KCG+Basic+Chart) and in order to continue operations Knight Capital had to accept a $400 million bailout from other Wall Street firms (http://www.reuters.com/article/2012/08/06/us-knightcapital-rescue-idUSBRE8750HF20120806).

With the prevalence of high-speed electronic trading, the odds are high that Knight Capital won’t be the last firm to suffer the adverse effects from trading software failures. When you take into consideration the high risk taking environment on Wall Street that caused the financial meltdown of 2008, it is vital for financial services company’s boards and executives to assess and manage the risk associated with their operations. It is also important for these firms to communicate to employees the risk appetite that is appropriate for them to have as they perform their jobs.

Earlier this year, the Committee of Sponsoring Organizations of the Treadway Committee (COSO) published a thought paper entitled Enterprise Risk Management – Understanding and Communicating Risk Appetite that took COSO’s integrated framework for internal controls and risk management a step further by recommending that corporate leaders be intentional in determining their firm’s risk appetite. (http://www.coso.org/documents/ERM-Understanding%20%20Communicating%20Risk%20Appetite-WEB_FINAL_r9.pdf )

This COSO paper defines risk appetite as “the amount of risk, on a broad level, an organization is willing to accept in pursuit of value” (p. 1). Within this context, an organization’s risk appetite is set by the tone of those at the top in a manner similar to the tone at the top that is often associated with corporate ethical behavior. This means that those entrusted with corporate governance must be deliberate in determining and communicating the formal risk appetite to employees and corporate stakeholders.

For the sake of argument, let’s say that the Forbes article “Knight Capital Is Just Another Example Of Poor Risk Management” is correct when it reports that Knight Capital pursued profits at the expense of risk management and this caused employees to push risk boundaries in order to maximize profits (http://www.forbes.com/sites/greatspeculations/2012/08/03/knight-capital-is-another-example-of-poor-risk-management/).  It is logical to infer that the high-risk/high-reward appetite tone set by the top at Knight Capital caused mid- and lower-level managers to believe that making high risk choices during the software upgrade implementation was acceptable if doing so would lead to a competitive and profitable advantage over the trading software used by competitors.

If Knight Capital’s executives and board had established a more appropriate risk appetite tone, it is likely that the question “what will we do if something goes wrong when we execute this software” would have been considered during the planning stages of the software upgrade implementation. Taking the time to seriously address this risk management question would have undoubtedly been less costly than $440 million.

by Scot Justice, President, CPA for Small Business, LLC, Kennesaw State University – DBA Student. Scot’s Virtual CFO blog is here.

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About Mark P. Holtzman

Chair of Accounting Department at Seton Hall University. PhD from The University of Texas at Austin. Worked at Deloitte's New York Office. BSBA from Hofstra University.

One comment

  1. I teach 100+ fraud/auditing/ethics classes every year. Plus I have the only speakers bureau in the U.S. for white collar criminals at http://www.TheProsAndTheCons.com. Knight is a great example of how little amounts are material. Auditors make the mistake of thinking that little numbers are automatically little. Not the way it works. A number doesn’t have to be big to be material. 30 minutes of trading is immaterial to 24 hours. So what’s the big deal? Little numbers are material if the EFFECT of the little number is material. If little number weren’t material companies wouldn’t care if the EPS rounds Up or Down. Or a nonprofit executive director would not order the controller to classify administrative cost as program costs to reduce admin from 20.2% to 19.8%. .4% is an immaterial change. So why? Answer….A potential donor won’t give if the admin rate exceeds 20%. Make sense?

    Gary Zeune CPA
    http://www.TheProsAndTheCons.com
    gzfraud@gmail.com

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