The HIH Legacy: Corporate Governance and Shareholder Value

Article by Michael Mills and Grant Marjoribanks with assistance from Christine Robertson, Philippa Stone and Don Harding

HIH Royal Commission Report released
The HIH Royal Commission recently provided its answer as to why HIH collapsed and who was responsible.

While the media has focused on the Commission's findings of potential wrongdoing by certain individuals and proceedings that may follow, its findings regarding corporate governance are likely to prove to be of most enduring importance to companies and their directors and executives. The Commission emphasised that it would be a mistake to dismiss HIH as simply a corporate aberration.

The implications of corporate governance for shareholder value
One consequence of the Commission's report is that it will almost certainly reinforce investors' perception that 'undesirable corporate governance' equals 'investment risk'.

The practical consequence for those charged with maximising shareholder value is that suggestions of financial impropriety or otherwise undesirable corporate governance practices can have a profound impact on market value. However, avoiding or responding to corporate governance criticisms is not straightforward. The application, and often the content, of the standards is not clear and in many instances the final arbiter will be market opinion.

The Commission suggested that good governance processes are likely to create an environment that is conducive to success, but emphasised that good corporate governance is a matter of substance not form.

Broad areas the Commission considered warranted attention were:

• the need for truly independent judgment at Board level
• periodic testing of the practical effectiveness of governance models
• greater disclosure in relation to the way a company is run (Report, 1xi ).

Undesirable corporate governance: what does it mean?
The criticism of 'undesirable corporate governance' was a constant refrain of Counsel Assisting the Commission.

Yet the Commission faced a dilemma in its report – could it conclude that systems or practices did not comply with desirable corporate governance standards when the existence or content of those standards might be thought to have been unclear at the time?

The Commission sought to address this dilemma by asking: 'What would those who have an interest in the company's success sensibly expect of those responsible for putting the relevant corporate governance practice into effect?'. The Commission's view was that if the way in which the practice was or was not carried out fell materially short of that sensible expectation, then it would be undesirable.

This approach led the Commission into making many findings of 'undesirable corporate governance' in circumstances where it stopped short of finding that a breach of the law might have been involved, including findings that:

• the Board of HIH was compromised by the influence of senior management, and failed to subject management proposals to sufficient scrutiny
• the absence of strategic discussions at Board level affected its ability to operate as an effective check on management
• there was a culture where senior management failed to bring important facts to the Board's attention
• the Board failed to monitor systematically the performance of management and generally failed to hold executives to account in the interests of the company
• the Board failed to ensure that the agenda for the Board was controlled by the Board rather than management
• the Board was involved in a systemic failure in stewardship of the Group's assets, including executive remuneration, termination payments and 'inappropriate corporate excess'
• the Board failed to implement mechanisms to identify and resolve conflicts.

Pitfalls to avoid
Directors and executives and those who advise them now have some guidance in terms of the recently released ASX Corporate Governance Council's Principles of Good Corporate Governance and Best Practice Recommendations. The ASX Guidelines are in some instances stated broadly and are not prescriptive, reflecting the Council's view that 'one size does not fit all' in the Australian market.

The Commission endorsed that approach:
I think that any attempt to impose governance systems or structures that are overly prescriptive or specific is fraught with danger. By its very nature corporate governance is not something where 'one size fits all'.

Further, while the Commissioner considered the move to corporate governance guidelines and benchmarks worthwhile, he noted that the effectiveness of such models is limited. Cautioning against being seduced by the corporate governance 'mantra', the Commissioner observed that the key to good corporate governance lies in substance not form.

How to ensure you are engaging in best practice
Boards wanting to focus on substance, not form, would do well to heed the following key lessons:

• Directors and senior executives are not going to be able to adopt a 'tick the box' approach to corporate governance issues, or simply delegate them to middle management or rely wholly on external consultants.
• Corporate governance issues will require a deliberate and responsible evaluation of what are necessary and appropriate structures and processes to adopt by those who have a close appreciation of the dictates of the individual circumstances of the company, namely the directors and senior executives.
• Such an evaluation would be assisted nevertheless by an understanding of contemporary corporate governance thinking both in Australia and overseas, and of the relevant lessons to be drawn from the experience of collapses such as that of HIH. Some of the Commission's suggested lessons from the HIH experience are:

• These issues require companies to be proactive rather than reactive. As the arbiter of judgement on a company's corporate governance will often be market opinion, companies need to be able to respond to criticism in a way which is perceived to be considered and well-reasoned.

As the Commission concluded:
There is also a danger that strict adherence to a published best practice model will lead to its becoming as blunt an instrument for the achievement of the aspirational aims of corporate governance as legislation can be. It would be unfortunate and counterproductive if users of the annual report and financial statements of companies were themselves to adopt the 'tick the box' approach and not acknowledge the existence of reasoned exceptions to a recommended best practice. Market participants need to embrace the corporate best practice model in the spirit in which it is put forward and to acknowledge that adherence is but a means to a goal.

The Commission's reference to the need to acknowledge the existence of reasoned exceptions to a recommended best practice is important. It should provide comfort to companies who have good reason for adopting a different approach to that suggested by the ASX Guidelines. It is important that the ASX Guidelines are not treated by the market and regulators as rules without tolerance for departure where there is justification for doing so.

Insurance implications
The bulk of the Commission's recommendations understandably relate to the general insurance industry and its future regulation.

In short, given the criticism of regulators for failing to detect the problems within both FAI and HIH, heightened regulation and closer scrutiny of insurers will follow with various benefits and implications for the insurance industry and corporate insureds. In particular:

• increased reporting obligations on insurers will result in greater transparency and enhance the ability of corporate insureds to evaluate the financial position and integrity of insurers
• increased regulatory scrutiny will likely lead to higher compliance costs for insurers which, in turn, are likely to increase the cost of insurance
• the existence of, and adherence to, satisfactory risk management programs, including satisfactory corporate governance structures and processes, may become an important factor in assessing price and terms for specific classes of corporate insurance cover, including directors' and officers' liability cover.