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Governance drifts off course in sea of collapse

AUTHOR: Lachlan Colquhoun   DATE: 30.11.02   ISSUE 3, 2002

Well before the Enron collapse, the demise of Arthur Andersen and the excesses of HIH, the philo­sophical father of the market economy, Adam Smith, anticipated the problem of corporate governance in volume 2 of his Wealth of Nations, published in 1776.

“The directors of such ‘joint-stock’ companies, however, being the managers rather of other people’s money than their own, it cannot be expected that they should watch over it with the same anxious vigilance with which the partners in a private partnership frequently watch over their own,” Smith wrote.

“Negligence and confusion always prevail, more or less, in the management of the affairs of such a company.”

Smith’s words are indeed prophetic, because negligence and confusion is a good summary for the events of the past two years.

The US accounting scandals and the behaviour of the boards of Australian firms such as HIH and One.Tel have created the perception of a crisis in corporate govern­ance which has produced a flurry of responses, both in Australia and overseas.

In the US, the recent Sarbanes-Oxley Act passed by Congress commits the country even more strongly to its black letter law approach, while both the New York Stock Exchange and NASDAQ have issued principles of governance reform.

In Australia, the Australian Stock Exchange has created a new Corporate Governance Council, partly under pressure from ASIC chairman David Knott. Prime minister John Howard, listening to the public mood, says: “People think something has gone wrong and I think some people have been getting away with murder in corporate excess.”

Corporate governance, of course, is a lot more complex than executives abusing their expense accounts or receiving overly­generous or undisclosed options packages.

At its core, corporate governance is about the legal and organisational structures which determine the way in which a company is managed, and from that flows just about everything else – from a firm’s acquisition strategy to its human resources policy.

Ownership and control
MBA students at the AGSM grappled with the issues of corporate governance at the first Integrative Program on the subject, presented recently by professors Chris Adam and Lex Donaldson.

The program began by looking at why corporate governance has become such a pressing, practical problem, tracing its history from the early days of capitalism when the owner managed the firm, to the creation of joint stock companies in the 19th century – which began the separation between the shareholder-owner and the hired manager, and remains at the core of the modern dilemma.

Add to that ‘stakeholder’ theory – where employees, suppliers and the community at large also have a stake in the operation of the corporation – and there is a plethora of usually competing interests to juggle.

“Most of the analysis starts with the so­called ‘agency theory’ where the manager is an agent and the outside owner is the principal,” says Donaldson.

“Much of the worry is about a large corporation where most of the owners are these dispersed shareholders who own but don’t control, and there are these managers on the inside who control but don’t really own.”

Response to these concerns has been two-fold: balance the interests of the managers on the board with non-executive, independent directors who represent the shareholders, and attempt to align the interests of the managers with that of the company through performance-linked remuneration like share options.

The rationale, says Donaldson, was to make the managers more like owners and so stem management excesses. But the options themselves are now seen as management excesses.

The public backlash against management excesses, particularly the cost of options, has thrown more focus back on the role of independent board members who are presumably there to keep executives in check. But does stacking the board with non-executive members actually improve corporate governance, and does it improve the operation of the company and safeguard shareholder’s interests?

“I’ve always believed that the best model is one in which there are no executives on the board because if you merge the interests of management and the board you don’t get sufficient arm’s length,” says Frank Conroy, former Westpac chief executive and now a non-executive director of several companies, including St. George Bank and Santos.

As a guest speaker on the corporate governance program, he said independent non-executive directors brought a “broad­based spread of knowledge” to companies which might otherwise be “mono-cultural” and closed off in their thinking.

“I have always believed that directors should be far more assertive in their questioning of management and absolutely unforgiving if they find that management hasn’t presented relevant and necessary information,” he says.

Directors under fire
Donaldson says some research challenges the view that the non-executive board is the best model: “Researchers have looked at that and some have found evidence supporting the view that there should be more independent board members, but there have also been studies¹ that have found exactly the opposite.

“One study² found evidence of higher company performance where the CEO was also the chairman of the board. In another study³ – which looked at Australian examples – the more outside directors there were on the board the worse the returns to shareholders,” says Donaldson.

“That latter finding was particularly evident in cases where the outside directors had connections with other businesses and economic entities, and that pattern really goes against conventional wisdom that powerful and experienced outsiders on the board are the way to go.

“This is a concern that has been expressed about some members of the Coles Myer board over the years and still is now. It is a perceived conflict of interest when a director also has other interests, such as being a supplier or is linked to a competitor,” says Donaldson.

Does this then mean that the professional director who serves on half a dozen boards or more is a part of the problem too?

AGSM research⁴ has shown that having more external directors with links to external entities can actually reduce the performance of a company.This points to the failure of the well-entrenched ‘cooptation theory’ that presumes benefits will flow from experienced business people recruited to multiple boards.

Cooptation theory has been criticised recently to the extent that the AGSM has coined a new term, ‘dys-cooptation’,to explain why the theory hasn’t succeeded in practice.

The complex web of relations between the board of insurance company FAI, its eventual parent HIH and failed telco One.Tel is a case in point. Rodney Adler’s contro­versial role as the vendor of FAI and then a member of the HIH board is the subject of further study at the AGSM.

“Non-executive directors are there to mediate between owners and managers, but we have to ask if it is really working as intended,” says Adam.

Adam is also a company director, and has sat on the board of ORIX Australia – the local subsidiary of the Japanese company – since late 1999. The Australian board has nine members – three from the Japanese parent company, three non-executive Australian directors and three local executive directors.

“Because the Australian business, which includes operations in New Zealand, has a single owner, some of the communication aspects of corporate governance are simplified,” says Adam.

“For example, the annual general meeting is held with a very well-informed shareholder because there is almost daily communication of decisions or advice from the Australian company to its parent in Japan.

“On the other hand, we have complexities of accounting practices and funds management, because of the US listing, when demands for information disclosure differ from both Australian and Japanese practices.

“We tend to follow whichever practice is most demanding in terms of disclosure – this is most often the US structure,” he says.

In addition to the regular board meetings held every second month, Adam says the ORIX board undertakes the appropriate governance subcommittee activities such as holding quarterly meetings of the audit committee (comprising non-executive directors) and annual meetings of the remuneration committee (also comprising non-executive directors).

“We believe it is very important for good governance that the expected arm’s length processes of conformance review and strategic oversight are actively conducted by the ORIX board,” says Adam.

Donaldson points out that in Australia some of the more notorious examples of corporate excess have been in companies where the CEO is also the founding entrepreneur, such as Bond Corp, One.Tel and HIH.

Although they were among some of our largest corporations, these companies had not evolved very much beyond the owner-manager stage when they ran into the problems that destroyed them, along with the wealth of the shareholders. Just because a company is big doesn’t mean that its approach to corporate governance is mature.

“When you look into some of those cases the CEO is not some sort of profes­sional manager who owns little or nothing, he’s often a founding entrepreneur who owns a considerable amount of the company,” says Donaldson.

“So it’s a misdiagnosis to say the problem is purely and simply the separation of ownership and control.”

After participating in the corporate governance program, MBA student Robin Durham is now doing a further study of corporate governance on the HIH case, alongside Donaldson and another student, Mark Baragwanath.

The aim of the study is to dig through material such as transcripts from the current Royal Commission to determine to what extent good corporate governance could have made a difference in preventing the $5 billion collapse.

Governing competing interests
One of the main principles, according to Donaldson, is to: “focus on the company rather than one group of people”.

“People say that the director has a fiduciary responsibility and they translate that to saying that the directors should put the interests of the shareholders first. But when this has come before some of the courts in the US, the courts have taken a very different view and said that the real respon­sibility of a director is primarily to the company, and the shareholders come second,” he says.

“So it’s the company as an ongoing entity which should be the focus, because if it does well then the shareholders will do well over the long term, and I have a lot of sympathy for that view.”

Adam’s view is that best practice: “has to be closely linked to the legal structure of the organisation.

“I don’t think companies should be free agents to choose which way they want to go here,” he says.

“I think part of the issue is that we run the risk of having boards focus too much on conforming. I’m a little reluctant to make every single company toe a specific line, which might be appropriate for large mature public companies with dozens of internal accountants, but would kill a start-up,” says Adam.

How much regulation?
While the US has traditionally taken a rules­based approach, as evidenced by the Sarbanes-Oxley reforms, Australia has favoured a principle-based approach which relies on companies doing the right thing.

Adam, for one, believes that the global rules will eventually converge towards the US model, but he is unsure whether that will result in best practice.

Donaldson says: “I don’t really think the trend towards more disclosure, for example, will work. I think it’s really weak and watery.

“People tend to favour more disclosure and believe that if companies’ annual reports provide more information then that’s the answer, but it clearly isn’t.

“For example, knowing that the head of a company was getting as much money as he was wouldn’t tell you he was manipu­lating accounts and that the auditors were helping him,” says Donaldson.

“It’s a question of raising directors’ awareness of their responsibilities, and I think that is actually a better course to follow,” adds Adam.

“The Australian Institute of Company Directors has done an excellent job over the years in building up an awareness, a body of material that can be made available for use, but I think we could do a little more in the way of encouraging. I hesitate to say licensing, but I’m thinking of something in that direction where directors have to do a course and have some continuing education over time,” says Adam.

Lex Donaldson agrees, but points out that even within professional bodies trying hard to do the right thing there are biases which can obscure the agenda.

“Directors’ groups talk about the importance of the non-executive director, whereas professional management groups highlight the importance of executives, and it all gets a little difficult,” he says.

“Its not wrong for them to do that but I think the best thing is to have dialogue among all the different groups.

“That’s the process I’m involved with in my work here at the AGSM, and I think that’s really the best we can hope for at the moment.”

*Lachlan Colquhoun is a freelance writer

FOOTNOTES
1 Lex Donaldson and James H. Davis, ‘Stewardship theory or agency theory: CEO governance and shareholder returns’, Australian Journal of Management, vol. 16, no. 1, pp. 49–64, Sydney, 1991; and Melinda Muth and Lex Donaldson: ‘Stewardship Theory and Board Structure: A Contingency Approach’, Corporate Governance: An International Review, vol. 6, no. 1, pp. 2–28, January 1998.

2 Lex Donaldson and James H. Davis: ‘Stewardship theory or agency theory: CEO governance and shareholder returns’, Australian Journal of Management, vol. 16, no. 1, pp. 49–64, Sydney, 1991.

3 Melinda Muth and Lex Donaldson: ‘Stewardship theory and board structure: a contingency approach’, Corporate Governance: An International Review, vol. 6, no. 1, pp. 2–28, January 1998.

4 ibid.