The failure of HIH
HIH collapsed with liabilities exceeding assets by some A$5.3 billion. Thousands of jobs were lost. Policy-holders and creditors face a wait of up to 10 years before receiving what the liquidator has predicted will be a 10 to 20 cent in the dollar payment1.
In Australia, the HIH Royal Commission inquiry, conducted by Justice Owen, held the principal cause of HIH’s failure to be “under-reserving” – the failure of HIH management to adequately provide for future insurance claims2: “Under-reserving combined with a litany of other shortcomings to lead to financial disaster”.
These shortcomings included:
- a lack of attention to detail
- a lack of accountability for performance;
- a lack of sceptical questioning and analysis, and
- lack of any real corporate governance model combined with seriously flawed internal processes and systems.
To these Royal Commission findings were added, by the New South Wales courts, findings of dishonesty and a
near-total want of care and diligence by directors Rodney Adler and Ray Williams.
As a result of their conduct, both directors were barred from corporate involvement for lengthy periods and ordered to pay to the liquidator of HIH more than A$8m in damages. In Adler’s case, to add to his woes, criminal charges have now been brought by the Australian Securities and Investments Commission, ASIC.3
“Corporate governance” is the framework of rules, relationships, systems and processes by which authority within a corporation is exercised. The cornerstones of any governance framework are openness, integrity and accountability.
The management of HIH was categorised by a failure of those processes. While the collapse created great headline news, with "behind-the-scenes" stories of corporate greed, last-minute payments, secret deals between mates and the false boosting of profits, Justice Owen held that this was “not a case where wholesale fraud or embezzlement abounded”, but rather a case where the gross mismanagement of the company ultimately brought about its downfall4.
For example, Rodney Adler dishonestly “borrowed” A$10m from HIH. While this transaction was a factor in the company’s failure, this dishonesty – and other dubious decisions – would have been identified earlier had HIH followed sound governance practices.
The recent collapse of UK public metals company TransTec provides another sorry example of the same thing, this time damaging the public reputation of Labour MP and former Paymaster-General Geoffrey Robinson, who was involved.
TransTec expanded quickly, with a major customer contract and a new factory in Ireland. What managers failed to tell the board, though, was that the factory never functioned properly and had led to an out-of-court settlement with the major customer. Unknown to the board, the terms of that settlement drained TransTec of much needed financial resources, which proved fatal.
In the enquiry which followed the collapse, the Department of Trade and Industry found that the company’s fatal expansion decisions had been the result of a complete lack of effective supervision by non-executive directors and auditors. In essence the board, according to the enquiry report, was “dysfunctional” and “passive”.
The stories of HIH and TransTec do not make pleasant reading. They reinforce why courts in some jurisdictions are increasingly taking the view that directors with expertise, or who receive warning signals, cannot sit back and passively rely on management reports and policy manuals.
For example, HIH seemed to have a corporate governance model. Its investment policies were clear and conservative, and it had an investment committee (amongst others) responsible for assessing and approving all major company investments. Yet those policies were not enough by themselves to stop the disaster from occurring.
The company’s policies or guidelines were not all clearly defined and documented, and did not deal with all issues essential to the proper running of such a large organisation. And, according to Justice Owen, where clear and complete policies did exist they were often ignored.
While no system of corporate governance can ensure immunity from financial ruin, good governance practices which are followed can focus those in charge on the purpose of their corporate activity and can help to identify problems early.5
Primary governance responsibility lies with the board of directors, which is appointed by, and accountable to, shareholders.
While it is neither desirable nor practicable for the board of a large corporation to involve itself in matters of day-to-day management, the board is ultimately responsible for the performance of the corporation. A breakdown in the provision of information from management, if unremedied, reflects poorly on the corporate governance of the company. Directors have a responsibility to request more information where it is necessary to fulfil their duties.
The HIH and TransTec boards were heavily dependent on the advice of senior management. However, the principle of accountability requires directors to test and question what management gives them. Passive acceptance, especially where there are expert directors faced with signs of trouble, is not an option.
The future strategy of a company is an integral part of corporate governance, being the base against which all proposals and decisions should be tested prior to endorsement.
While, generally speaking, it is for management rather than the board to propose and document the company’s strategy, it is the board’s responsibility to understand, test and endorse the strategy. In monitoring the company’s performance, the HIH board failed to measure management proposals against the endorsed strategy, and to challenge or require explanations for any deviation in practice.
Corporate governance further requires the board to set clearly defined delegations of authority and to have a well-understood policy on matters that are reserved to the chief executive. This does not appear to have been the case at HIH, where Chief Executive Ray Williams had many discretions in areas of investments, corporate donations, and staff gifts.
One of the interesting asides in the HIH saga was the large amount of money paid to charities and political parties. Generally, these discretionary payments should be undertaken in a transparent and justifiable way, with full regard to the interests of the shareholders. There is nothing inherently wrong with a board making this kind of payment, but it requires deliberation and documentation by the board as to how and why it is good for the company.
Executive expenditure must be supervised and disclosed, with ultimate accountability resting with the board. No one should be in a position of self-authorisation of expenditure without a process for subsequent disclosure and review.
Conflicts of interest
Corporate governance is also relevant in the area of conflicts of interest. Avoidance of conflicts goes directly to the integrity of the board’s processes.
Directors are obliged to avoid situations where their personal interests might conflict with their duties to protect and advance the interests of the company. Conflict of interest situations within HIH were not recognised or adequately dealt with, with some directors being present in board meetings when, on an objective view, their private interests were clearly at issue.
The board, and in particular the chairman, should ensure that all situations which might involve or give rise to a conflict of interest are fully disclosed, so that no director is under any misapprehension regarding the relevant circumstances.
At HIH, Ray Williams knew of the profound conflict in which Rodney Adler’s constant financial requests had placed him, but chose to approve the requests anyway. Such a want of probity is very difficult for any board to guard against. But proper reporting and auditing procedures should at least make early detection, and mitigation of harm, possible.
Current opinion suggests that it is desirable to have a majority of independent directors on a public company board. They would bring a broader perspective and exercise independent judgement regarding the company’s strategy and performance.
Some commentators6 have criticised Justice Owen’s findings, which almost completely exonerated the non-executive directors of HIH, ignoring the implications arising from the recent Australian case, ASIC v Rich7. ASIC v Rich suggested that all directors are under a continuing obligation to keep themselves informed about the activities and financial status of the company, casting doubt on the presumption that non-executive directors are entitled to assume that they are being kept fully informed.8
Probably the best view is that non-executive directors with special talents (legal, accounting or business), or who have reason to question the company’s affairs, must take steps to inform themselves about all relevant matters. Certainly, in the TransTec and Rich cases the failure to do so counted against the non-executive directors involved.
Legislative change in Australia
In reaction to HIH and similar sagas in Australia, there has been a raft of statutory changes encased in the Corporate Law Economic Reform Programme (CLERP9) and other recent reform packages. These changes include:
- requiring disclosure of the packages of top 10 executives
- allowing shareholders to discuss and have a non-binding vote on those packages at the AGMincreasing fines for failing to disclose material issues
- disqualifying directors who are involved in insolvent companies for up to 20 years
- requiring the boards of all Australian companies to pass annual solvency resolutions
- more strictly separating auditors from company operations and imposing lengthy time periods before accountants can join their client companies; and
- requiring certification of accounts by the CFO and CEO.
The rules are far-reaching and will have an impact on New Zealanders doing business with Australia. This is particularly so given the NZ-Australia policy of Closer Economic Relations and the trend towards legal harmonisation between the two countries. You cannot help but wonder that instead of this complexity there should be a simple rule that companies should apply a little common sense.
The collapses of HIH and TransTec affected many lives and could, arguably, have been avoided. Accountability and disclosure, central to any corporate governance model, can ensure that those likely to be affected are aware of any failings much earlier in the game, and may prevent the widespread distress, loss, uncertainty and cost caused by these crashes. Put simply, with apologies to Tennyson, when managers make proposals the board’s role is to reason why.