Key Issues: Applied Corporate Governance

The demise of HIH: corporate governance lessons
The business decisions that led to the collapse The failures of management that led to poor business decision-making The clear causal link between corporate governance and mismanagement

By Phillip Lipton, Associate Professor Corporate Law, RMIT

influenced strongly by senior management and from which senior management benefits significantly, to that of an ASX listed company run primarily in the interests of shareholders.

This remained true for the remainder of the company’s life.

The fateful business disasters
Commissioner Owen identified four disastrous business ventures which were critical to the ultimate collapse of HIH. These instances of poor decision-making were caused by and reflect a poor corporate governance culture. • The UK operations were established in 1993. HIH board minutes did not disclose any board consideration of whether the establishment of operations in the UK was compatible with the broader strategy of the company and there was no evidence of board participation in any business plan. Poor quality management information and inadequate accounting systems impaired the Australian management’s ability to monitor and control the UK operations effectively. The resultant losses in the UK were estimated at $1.7 billion. • The acquisition of a US business was accepted by the board without analysis of management’s assertion that entry into the US market would be profitable. No due diligence was carried out and there appeared to be a complete failure to appreciate the level of risk involved. Losses attributable to the US acquisition were estimated at $620 million. • The board meeting convened to discuss the acquisition of FAI was not called until earlier on the very day of the meeting with five of 12 directors not present. Of the seven directors present, four participated by video conferencing. It was resolved at this board meeting that the takeover should proceed. The directors did not appear to have had the benefit of board papers, including the report prepared by HIH’s financial advisers. Adler,
KEEPING GOOD COMPANIES 273

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he collapse of the HIH group resulted in a deficiency of up to $5.3 billion, making it Australia’s largest corporate failure. The ensuing Royal Commission report released in April 2003 provides a rare detailed dissection of a spectacular corporate implosion and a very useful case study from which corporate governance lessons may be learnt. This is particularly so because HIH was not an unusual case of major fraud or embezzlement. The failures identified by Commissioner Owen were by and large failures stemming from mismanagement. Most breaches of the law were designed to cover up the consequential increasing financial difficulties which were engulfing HIH. Most of the multi-billion dollar deficit arose because claims arising from previously insured events were far greater than the provisions which had been made. Payments of these claims came out of present income and this created an unsustainable situation. This underreserving was the main cause of HIH’s failure and, according to Commissioner Owen, the reason for this major under-reserving and failure to properly price risks was mismanagement and poor business decisionmaking and execution. This was largely due to poor corporate governance. The failure of corporate governance could be seen as part of the corporate culture which was central to poor decision-making. In 1995 an independent due diligence report described HIH as a:
company which has not yet made a complete transition from an entrepreneurially run company JUNE 2003

Agenda items almost entirely involved matters brought forward by management. Other board members did not contribute to the agenda. This lack of ‘psychological independence’ meant that the board was highly inclined to accept what it was told without proper questioning and waive rules and guidelines. The chair failed to ensure that all important matters were put on the agenda and it was not controlled by management. donations. It involved the sale of HIH’s profitable retail insurance businesses acquired from FAI in the joint venture. The chair must take responsibility for taking the lead in securing full disclosure by all directors. The result was an immediate cash flow crisis which hastened the end of HIH. representing FAI. Management was not held accountable or subject to questioning. Within 10 weeks of the start of the joint venture. The joint venture agreement involved a major strategic change for the company. rather matters came forward at the discretion of the chief executive. This was instrumental in the development of a lack of accountability by senior management to the board and a lack of independence within the board. He dominated the company and was instrumental in bringing friends and associates on to the board. gifts and payments to staff. Estimated losses arising from the FAI takeover were $590 million. An important aspect of poor corporate governance and mismanagement was the failure of risk identification and risk management. for the efficient organisation and conduct of the board’s function and to ensure that all appropriate matters are raised for discussion. The ineffective chairman The chairman of HIH. The approach of the board and senior management to the CEO was ‘unduly deferential’. The chair has an important responsibility to identify and resolve conflicts of interest and cannot just rely on directors to make disclosure and assume there is no conflict of interest in the absence of disclosure. Usually there were four meetings of the board per year plus an annual budget meeting. The takeover therefore proceeded even though it was not possible to make a considered assessment of FAI’s worth. As pointed out by Austin J in ASIC v KEEPING GOOD COMPANIES . The board received little information apart from the quarterly financial reviews and some individual transactions and was reliant on management to highlight areas of concern. 274 JUNE 2003 Beware the dominant chief executive! Ray Williams was chief executive from the beginning of the business until he resigned in October 2000. • The Allianz joint venture came into operation in January 2001. Williams continued to act with the same authority as before. refused to allow a due diligence to be undertaken and there was a general lack of knowledge about FAI and its financial position. This indicates a board that was only concerned with past financial performance and was not involved in discussing the path ahead. No one in management or on the board analysed the likely cash flow implications before HIH entered into the joint venture. The directors were incapable of appreciating the risks involved and consequently could not ask the right questions before the agreement was entered into. This failing is obviously particularly critical in the insurance industry. it resolved to proceed after a 75 minute meeting. This indicated that the board acted largely as a rubber stamp with little independent involvement in the company. The chair had no major involvement in the process of determining the information which went to the board. The chair has general responsibility to oversee the functioning of the board. clearly failed in a number of respects to carry out his role properly. Geoffrey Cohen.Applied Corporate Governance cont. Personal and company funds were intermingled and not disclosed to the board. As a dominant CEO. HIH relied on publicly available information which did not disclose considerable underreserving of FAI’s insurance business. yet the board knew nothing of it or several other restructuring proposals developed by management. The decision to proceed with the takeover was hastily taken after scant consideration and with insufficient preparatory and investigative work. This left the nonexecutive directors highly dependent on management for their information. Even after stepping aside as chief executive. The information before the board lacked any careful analysis of its implications and effect on cash flow. Williams had no clearly defined limits on his authority in areas such as investments. HIH was placed in provisional liquidation. The board did not have a clear policy on matters reserved to itself. The directors totally failed to consider the risks posed by the takeover. At the board meeting called to consider the restructure proposal. In fact it was clear to Commissioner Owen that the directors had no idea what the strategy of the company was. Therefore there was no independent assessment of performance even while financial results deteriorated. The board agenda largely became pro forma and not ‘a living tool for organising and shaping consideration and review’. The failure of the chairman to discharge his responsibilities can be illustrated by his failing to bring the CEO to account when he by-passed the board in a key transaction. The board appeared unconcerned about this.

Non-executive directors were blamed for failing to understand the Failure to grasp the concept of conflicts of interest ‘Avoidance of conflicts goes directly to the integrity of the board’s processes’. It was a damning indictment of the board that the directors were unable to identify the strategic directions of the company. Some board members remained present even when their private interests were at issue in a way that might come into conflict with the interests of the company. if so. This lack of understanding meant the directors were unable to identify and deal with looming problems before it was too late. Even if the right questions were asked.. outstanding claims provisioning. The board must regularly test and review the strategy’s appropriateness and monitor and assess whether the strategy is being achieved and. to what extent. report clearly considered that the board did not properly carry out its role. an interest was disclosed but little further information given so the board could not properly decide whether it was in the company’s interests for the transaction to proceed. This resulted in investment decisions being made which were opportunistic and lacking in direction. This meant that the board was unable to monitor management performance and proposals by reference to endorsed strategy. There was little if any documentation or analysis of future direction or strategy. This is not surprising considering the dominant role played by Ray Williams as CEO and the ineffective role of the chair. these reports never came before the board or audit committee nor was an actuary invited to a meeting to answer questions on how the figures were arrived at. This purchase of HIH shares was designed to give the stock market the false impression that Adler was supporting HIH’s falling share 275 The . a subsidiary of HIH provided an unsecured $10 million loan to an entity controlled by Adler. test and endorse the company’s strategy. Where a board functions properly. Ray Williams as CEO never clearly expressed to the board his plan for dealing with a difficult competitive commercial environment. This loan was used in the following transactions: • about $4 million was used to buy HIH shares on the stock market. However. any deviation in practice should be challenged and explained. the chairman’s responsibilities include the general performance of the board and the flow of information to the board on matters such as key transactions. The board did not have appropriate procedures in place to readily identify and resolve such issues. A long-term strategy or plan was never formally submitted to the board for critical analysis. This is crucial to the financial health of an insurer and was the most critical part of HIH’s financial statements.Applied Corporate Governance cont. it is a matter for the board as a whole to recognise conflicts of interest as a problem and install a proper system for dealing with such issues.. This is primarily the responsibility of the chairman. JUNE 2003 KEEPING GOOD COMPANIES . The crucial question of determining the amount of reserves was set in reliance on actuaries’ reports. The inability of all parties concerned to understand the concept of conflicts of interest was illustrated in the case of ASIC v Adler [2002] NSWSC 171. the board would have been unable to assess the responses. At the time Adler was also a non-executive director of HIH and. Rich [2003] NSWSC 85. However. The board was heavily dependent upon the recommendations of senior management and there were few occasions when proposals put forward by management were appropriately tested by the board. The board did not grasp the concept of conflicts of interest and its critical importance in corporate governance. through a controlled company. Related-party transactions were entered into where a director failed to declare an interest in the transaction because the director considered the interest to be wellknown. This again reflects the recurrent theme of a board held captive by a dominant CEO. In other cases. a substantial shareholder. While management is best able to propose strategy. The failure to understand strategy led to a failure to appreciate the risks involved and the board then could not ask the right questions to ensure the strategy was properly executed. This dysfunction led to the major failures of operations in the UK and US and the FAI acquisition which were ultimately crucial in the collapse of HIH. In June 2000. it is part of the role of the board to understand. Concerns about governance were raised by two nonexecutive directors who expressed concern to the chairman that the board was not properly involved in important strategic matters and was dealing only with matters brought by management. The chair did not bring these important concerns to the board because the CEO indicated that he did not wish this matter to be raised. The board that did not ask questions The Royal Commission report clearly considered that the board did not properly carry out its role.

directly concerning the accounts and the figures.Applied Corporate Governance cont. Increases in his salary were approved without advice or regard to performance. decisions about remuneration and performance were made by Williams who. Internal financial controls were inadequate because there was consistent failure to meet budgetary targets. HIH management regularly used one-off end of year transactions that affected profits to disguise poor underlying performance. These loans were unsecured and not documented. price by personally buying its shares. attended all meetings by invitation. The shares were later sold at a $2 million loss. In fact. There was no concern with risk management and internal control. A total loss was made on these investments. • nearly $4 million was used to purchase various unlisted shares in technology and communications companies from Adler-controlled interests. One of its investment guidelines related to unlisted investments which were not to be undertaken without prior approval of the managing director or finance director and then ratification by the investment committee. all 276 JUNE 2003 Conclusion There is a commonly held view in boardrooms that was widely expressed in the aftermath of the release of the ASX Corporate Governance Council’s Principles of good corporate governance and best practice recommendations that the Ineffective audit committee The audit committee’s terms of reference and minutes indicated that the audit committee was almost entirely concerned with matters KEEPING GOOD COMPANIES . managing and controlling investments made or to be made by HIH and its subsidiaries subject to the control and direction of the board. Its terms of reference included considering and approving investment guidelines. A requirement that senior officers be reviewed against key position objectives was removed from the committee’s terms of reference at the request of the CEO. Compromised auditor independence Auditor independence and the appearance of independence are fundamental to an effective audit. Unusual accounting transactions The board must be satisfied that the accounts were derived from systems likely to produce accurate accounts. The non-executive directors rarely met with the auditors in the absence of management to discuss contentious matters or areas of concern. Adler was a member of this committee. was compromised in several respects: • the HIH board had three former Andersens partners • one Andersen partner was the chair of the board and continued receiving fees under a consultancy agreement • a partner was removed from the audit team after meeting with non-executive directors in the absence of management • Andersens derived significant fees from non-audit work which gave rise to a conflict of interest with their audit obligations. approving investment authorities and reporting all decisions and recommendations to the board. Ad hoc executive remuneration Remuneration reviews for senior executives were ostensibly determined by the board’s human resources committee which met annually. The independence of HIH’s auditor. The investment committee had responsibility for making. This was not discussed by the board. The committee did not make proposals on its own initiative nor did it ever reject a proposal put by Williams. These shares were purchased at cost even though the stock market for such investments had collapsed and no independent assessment of their value was made. although not a member of the committee. The HIH audit committee was regularly attended by all directors including executive directors. With the removal of objective benchmarks against which performance could be measured. Williams’ own performance appraisal was carried out by the chairman without proper process or detailed review. Such meetings should occur regularly so that the board can consider the issues carefully. performance evaluation and determinations of remuneration and bonuses were carried out at the sole discretion of Williams. • $2 million was lent to Adler and associated interests. The audit committee should be comprised of only non-executive directors. Budgetary control as a strategic planning tool was therefore ineffective. The committee’s terms of reference required it to review the remuneration of various officers and senior employees. Andersens. The audit committee could not and did not ask the right questions. These transactions were not referred to the board or investment committee established by the board to oversee the HIH investment portfolio. Whether the use of such aggressive accounting practices was appropriate was not considered by the board or audit committee. It is necessary for such meetings to take place so as to enable the board to determine whether it can safely rely upon what management is telling it.

how risk is monitored and assessed. As stated in the ASX Corporate Governance Council’s Principles of good corporate governance and best practice recommendations: Corporate governance is the system by which companies are directed and managed. without regard to its real import. There were relatively few clearly defined and recorded policies and guidelines. current over-emphasis on corporate governance is misconceived and ultimately counterproductive. annual report.Applied Corporate Governance cont. Commissioner Owen considered that there was a clear causal link between poor corporate governance and mismanagement. The problem was that the board did not periodically assess the effectiveness of the company’s corporate governance practices. According to this view. If that happens. However they provide a comprehensive template for boards to improve their performance and enable them to ensure that they operate effectively and add value and do not fall ineptly into the poor corporate governance practices unearthed by the HIH Royal Commission. the tendency will be for those who pay regard to it to develop a ‘tick in the box’ mentality … the expression ‘corporate governance’ embraces not only the models or systems themselves but also the practices by which that exercise and control of authority is in fact effected. Commissioner Owen distinguished between the adoption of a model of corporate governance and its practice in the following terms: There is a danger it [corporate governance] will be recited as a mantra. HIH had a corporate governance model and it was stated in the JUNE 2003 KEEPING GOOD COMPANIES 277 . Where they did exist they were ignored. It influences how the objectives of the company are set and achieved. corporate governance is much more than compliance with an arid set of guidelines just for the sake of appearing to comply. Viewed in this light. It is evident that it is these elements which are crucial to good corporate governance practice. I suggest that the HIH Royal Commission report shows this view to be based on an entirely erroneous conception of what constitutes corporate governance. and how performance is optimised. It is further suggested that the adoption of the Best practice recommendations will lead to a time-wasting and distracting conformance and tickthe-box mentality. The ASX Corporate Governance Council’s recommendations are numerous and detailed and will force many boards to spend long hours in restructuring the way they do things. the causes of corporate failure and mistakes are poor strategy and flawed business plans and not poor governance.

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