Every CEO’s Nightmare

It took 17 years of dedicated work to build Knight Capital Group (KCG) into one of the leading trading houses on Wall Street. It all nearly ended in less than one hour.

What happened to Knight on the morning of Aug. 1 is every chief executive’s nightmare: A simple human error, easily spotted with hindsight but nearly impossible to predict in advance, threatened to end the firm. The details vary from industry to industry, but in the big picture, what happened at Knight could happen at any business.

At Knight, some new trading software contained a flaw that became apparent only after the software was activated when the New York Stock Exchange opened that day. The errant software sent Knight on a buying spree, snapping up 150 different stocks at a total cost of around $7 billion, all in the first hour of trading.

Under stock exchange rules, Knight would have been required to pay for those shares three days later. There was no way it could pay, since the trades were unintentional and had no source of funds behind them. The only alternatives were to try to have the trades canceled, or to sell the newly acquired shares the same day.

Knight tried to get the trades canceled. Securities and Exchange Commission Chairman Mary Schapiro refused to allow this for most of the stocks in question, and this seems to have been the right decision. Rules were established after the “flash crash” of May 2010 to govern when trades should be canceled. Knight’s buying binge did not drive up the price of the purchased stocks by more than 30 percent, the cancellation threshold, except for six stocks. Those transactions were reversed. In the other cases, the trades stood.

This was very bad news for Knight but was only fair to its trading partners, who sold their shares to Knight’s computers in good faith. Knight’s trades were not like those of the flash crash, when stocks of some of the world’s largest companies suddenly began trading for as little as a penny, and no buyer could credibly claim the transaction price reflected the correct market value.

Once it was clear that the trades would stand, Knight had no choice but to sell off the stocks it had bought. Just as the morning’s buying rampage had driven up the price of those shares, a massive sale into the market would likely have forced down the price, possibly to a point so low that Knight would not have been able to cover the losses. Goldman Sachs stepped in to buy Knight’s entire unwanted position at a price that cost Knight $440 million – a staggering blow, but one the firm might be able to absorb. And if Knight failed, the only injured party, apart from Knight’s shareholders (including Goldman), would have been Goldman Sachs (GS) itself.

Disposing of the accidentally purchased shares was only the first step in Knight CEO Thomas Joyce’s battle to save his company. The trades had sapped the firm’s capital, which would have forced it to greatly cut back its business, or maybe to stop operating altogether, without a cash infusion. And as word spread about the software debacle, customers were liable to abandon the company if they did not trust its financial and operational capacities.

If the trading disaster alone did not earn Knight a place in future business school case studies, what followed in the next four days certainly did. First, Joyce secured a line of credit for his company, to assure customers that it had the resources to stay in business. Then, over the weekend that followed the trading disaster, he put together a deal to sell most of the company’s equity to a group of outside investors. This restored the firm’s financial strength at a big price to the original shareholders, who saw most of their equity value wiped out. But apart from the firm’s owners, nobody associated with Knight, and no taxpayers or other third parties, were damaged financially. The new investors may have made a good investment in the long run.

Managing a business is the art of addressing unlimited opportunities with limited resources, while avoiding threats and managing risk. The head of every company, no matter how large or small, should to make the enterprise stable and resilient so that it can weather short-term shocks while in pursuit of long-term goals. Nearly all of us do.

The keys to risk management are diversification and redundancy. You don’t want your business to be overly dependent on a single employee (including yourself), supplier, customer or product. You can spread out geographically to mitigate natural disasters. You want have backup computers, backup generators and backup equipment in case something vital breaks down. You plan for disasters, and you test your plans.

But you can’t plan around the fact that your business requires humans, and humans inevitably make mistakes. Yes, you can have quality assurance, multiple levels of review, excellent hiring and training practices. These things will help you avoid many problems, but they will not allow you to avoid all problems all the time. Even the best people err, and even the best error-trapping systems miss some mistakes. The flaws will usually be clear only in hindsight.

So I, and many other business leaders, felt great empathy for Joyce and his team when their professional world was turned upside down. A lot of people in his industry reached out to see if they could help. A lot of customers gave Knight Capital the benefit of the doubt and enough time to put itself back together.

“Thank you for standing by us,” Knight wrote in a full-page advertisement in The Wall Street Journal last week. “At Knight Capital Group, our gratitude extends to the financial services industry, clients, valued stakeholders and employees. Not only did you believe in the important role we play in the capital markets – you helped pull us through. We are now moving ahead with as much resolve as ever to deliver on your trust and confidence.”

Don’t mention it. We may not like to think about it, but it could happen to anyone.

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