Executive Summary:
HIH corp. was going through a major crisis and directors tried to manipulate the market and tried several last ditch efforts to avoid the crisis, but because of several reasons crashed and resulted into a loss of billions of dollars of small investors and resulted into various businesses shutting shop to avoid litigation because their insurance provider had collapsed, thus resulting in many more billions of combined loss of the stake holders. The resulting evolution in corporate governance principles governing corporate have made disclosures and managing companies by directors more effective and legal reforms like CLERP 9 and many changes in directors duties and the way courts see the actions of directors have undergone a change. The directors who were responsible were punished and rightly so as to set a deterrent for other directors managing corporate of dire consequences if they fail to effectively install proper corporate governance principles in their companies.
Introduction:
In the recent history all over the world there have been many corporate collapses all around the world. The most famous of these corporate collapses were of Enron Corporation in US, One Tel and HIH insurance in Australia. The company taken for this case study is HIH insurance this case is famous as ASIC v Adler. The three directors of HIH Insurance Ltd were found to have breached section 180(1). Until its collapse HIH insurance Ltd was the second largest general insurance company. ASIC instituted proceedings against three directors of HIH insurance Ltd these directors were Rodney Adler, Raymond Williams and Dominic Fodera. ASIC alleged these three directors for breaching directors’ duties including the breach of the duty of care in section 180(1). Adler was non-executive director of HIH and it was found by court that he was also an officer of a subsidiary of HIH, HIH Casualty & General Insurance Co Ltd (HIHC). Fodera was executive director and finance director of HIH and HIHC. Williams was chief executive officer of HIH and a director in both HIH and HIHC. The breach of directors duties by these directors lead to collapse of HIH. This was the biggest corporate collapse in the history of Australia. Collapse of this corporation proves that there were some loop holes in the system and there was need to improve the whole system. In this essay first I have discussed the meaning of corporate governance and its importance then the brief introduction of case, the description of directors’ duties that were breached remedies available in general. At the end there are few recommendations for the possible reforms that should be introduced in the future so that these types of collapse don’t happen again.
What is corporate governance?
Corporate governance is concerned with the way in which companies are directed and controlled. In corporate governance the corporate charter, bylaws, formal policy, and the rule of law define the relationship between all the stake holders in a company. These stake holders are the shareholders, directors, and management of the company. Corporate Governance includes the laws and customs affecting that direction, as well as the goals for which it is governed. This system of corporate governance is implemented on behalf of stakeholders to reduce agency cost and information asymmetry. The main function of corporate is to monitor whether outcomes are in accordance with plans.
In brief we can say that corporate governance is the procedure by which companies are directed and controlled. It promotes companies’ compliance with codes and an investment technique based on active ownership
The rationale of putting into operation and formulating the good corporate governance practice is to make certain that companies are directed and controlled in a way that most competently defends and supports the benefit of its participants. It has been argued that. “It is the divergence of interests of the various stakeholders in companies which makes the corporate governance debate crucial. Good corporate governance should be about protecting and balancing the interests of stakeholders by setting up the appropriate mechanisms to align these divergent interests where possible and to ensure adequate monitoring of management.”
Currently the ASX Listing Rules have adopted “comply or explain” approach to corporate governance. As per this approach now the companies are supposed to adopt each of the recommended corporate governance structures and practices set out in a good practice guide published by the ASX Corporate Governance Council and give an explanation in the company’s annual report if the company has not adopted one or more of those recommended practices.
The collapse of HIH had a profound impact on ASX and the corporate governance received a renewed attention in 2002. At this point of time the government of Australia and ASX announced a number of new initiatives to strengthen the corporate governance in Australia. The corporate governance council was formed by ASX in august 2002. Main purpose of this Corporate Governance Council is to formulate policy on the key corporate governance issues like composition of board and independence of directors, competency of directors, remuneration, related party transactions, integrity of reporting including consideration of audit committees, risk management and codes of ethics for senior management, and shareholder participation.
Overview of CLERP 9
Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure) Act 2003. This Act is also known as (CLERP 9) after the collapse of HIH there was a need for corporate law reform the federal government enacted this bill on 30th June 2004. This act contains a number of reforms to the corporations act 2001.Reform enclosed in the CLERP 9 discussion paper. The recommendations enclosed in the report of HIH royal Commission released in April 2003 are also taken care of and considered in CLERP 9 Act.
Brief over view of the case:
Adler was controller of Pacific Eagle Equity Pty Ltd (PEE). This company received ten million dollars from HIHC on 15th June 2000. PPE was the trustee of Australian Equities Unit Trust (AEUT). Adler Corporation was the controller of AEUT. This company Adler Corporation was associated with Adler. AEUT then issued units to HHIC at a price ten million dollars. And after purchasing these units HIHC was entitled to receive 90% of the AEUT’s distributable income. Out of this ten million dollars four million were used by PPE for the purchase on the stock market of shares in HIH. Mr. Rodney Adler the non executive director of HIH and officer of HIHC informed a journalist when the prices for HIH shares were falling due to rumors in the market, that he was investing his own family money into HIH shares. So the stock market was not aware that the money used to purchase HIH shares was of HIH itself. The purpose of this was to increase the share prices of HIH shares. Over next three months after the purchase of shares PEE sold the shares of HIH at a loss of over two million dollars. Out of remaining $6 million $3.86 million were used by PEE to purchase shares of unlisted technology and communication companies. These shares were purchased from Adler Corp at the original price that Adler Corp paid for these shares. At the time when these purchases were made the stock market for technology and communication stocks had collapsed in mid April 2000. These purchases were done without any independent analysis of the market value of shares. PEE lost all $3.86 million on these investments. And finally PEE gave three unsecured loans totaling $2.04 million. These loans were given without proper documentation to companies associated with Adler Corporation and Adler.
Decision on the case:
Each of the transactions in the above case was taken separately by Santow J. The transactions like payment of $ 10 million by HIHC to PEE and further use of a portion of these funds by PEE for purchasing shares in HIH. After considering these the court held that section 180(1) had been breached by Adler. Santow J held that a reasonably careful and diligent director or officer of HIH or HIHC in the position of Adler would not have caused or procured the payment of $ 10 million by HIHC to PEE. This money was used for different purposes $ 4 million was used to purchase the shares of HIH to raise the value of shares of HIH. Moreover this information was not known to other directors of HIH other then Williams and Fodera. And this event was not even considered by the investment committee of HIH. Due to this payment of $10 million dollars by HIHC to PEE the court also held that Adler had breached section 181 of duty to act in good faith and for a proper purpose and section 182 the duty not to improperly use his position as a director
The court held that Williams had breached section 180(1). Williams had failed to put in place proper protection measures like independent appraisal of the investment by way of proper due diligence and moreover he did not even ensured that the investment was approved by the investment committee of HIH or the board of directors. For approval of such investments HIH had its own protection measures and Williams did not made it certain that HIH had complied with its protection measures. The court held that Williams had breached section 182 because he had used his position to gain advantage for Adler and Cause disadvantage to HIH and HIC.
It was held by court that Fodera had also breached section 180 because he had done nothing to get the investment proposal approved by the investment committee of HIH or Board of directors.
The court held that Adler had breached his duty of care contained in section 180(1) this was held in relation to the transaction where a portion of $ 10 million was invested in three technology and communication companies. It was apparent at the time when PEE acquired these shares from Alder the technology and communication companies were facing problems with their cash flow and raising new capital and the future of all the companies was doubtful and all of them were high risk investments. The court also held that Adler had breached sections 181,182, and 183 that is the duty not to make improper use of information gained as an officer.
On 14th April 2005 Rodney Adler was sentenced for four and a half years of imprisonment . This jail sentence came after Adler pleaded guilty on 16th February 2005 to four criminal charges these charges were
1.two counts of disseminating information knowing it was false
2.one count of obtaining money by false or misleading statements
3.one count of being intentionally dishonest and failing to discharge his duties as a director in good faith and in the best interests of the company
Recommendations for possible reforms:
Considering the recommendation of the Report of the Royal commission many of the recommendations should be implemented to improve corporate governance the Federal government has implemented many of these reforms.
The Report of the HIH Royal Commission was released by the Federal Treasurer on 16 April 2003. Some of the recommendations of the Royal Commission relating to corporate governance are reflected in the CLERP 9 Act.
The report recommended improving the disclosure of directors’ remuneration . This recommendation was accepted by the government and the corporations Act is amended through CLERP 9 and now the companies are required to include a dedicated Remunerations Report as Part of the annual directors’ report. Remuneration details of all directors and top executives must be present in the remunerations report. And this will be subject to non binding approval by shareholders. This is an important step and will help in controlling irregularities. When HIH was about to collapse many of its directors had received big pay cheque
The report suggested amending the definition of ‘officer’ and their duties. This recommendation was referred to the companies and markets Advisory Committee for review. There is a need to redefine these terms as directors and officers owe different duties to company.
The report recommended broadening the membership of Australian accounting standards board (AASB). The government accepted this recommendation and took the relevant steps for the same so that non accountants get membership of AASB. As suggested by Capture theory that the regulated will try to control regulator there is a need for non accountants to be member of AASB the regulatory body.
The report recommended that Australian involvement in the development of international accounting standards should be increased. More over it also recommends that Australia’s standards should be stricter then the international accounting standards with respect to disclosure requirements. And these standards should be consistent with the international framework. It is difficult to make sure that disclosure requirements in Australia are stricter then international standards because it may not be always practical to do so.
The HIH report suggested that members of accounting bodies should consult independent advisers or the Urgent Issues Group when there is disagreement with company management about the interpretation or application of accounting standards. This is necessary because it will stop regularities in corporate governance.
Amendment of AASB 1023 was also recommended to correct deficiencies relating to insurance.
The report also recommended various auditing reforms these reforms are necessary to enhance the independence of auditors. Few of the recommendations are presented below.
Developing a standard for the independence of auditors. Under the CLERP 9 Act, auditors are now required to provide to their clients a written declaration that the auditor has complied with the auditor independence requirements and any applicable codes of professional conduct. The new liability framework is designed to encourage a ‘culture of compliance’ by making it an offence to breach the independence requirements and placing liability on all members of an audit firm and all directors of audit companies.
Amending corporations Act to require annual audit statement. Auditors are now required to disclose all details of their non-audit services in a statement in the annual report.
Compel restrictions on retired auditors so that they cannot become directors of former clients. The report recommended that only after a period of 4 years a retired partner of an audit firm could become a director of a can occupy a senior management position. In CLREP 9 government imposed a restriction of 2 years instead of 4 years as recommended by report.
The OECD Principles of corporate governance are international benchmark for policy makers, investors, corporations and other stake holders worldwide. These principles have developed the corporate governance program and they offer precise direction for legislative and regulatory initiatives in both OECD and non OECD countries.
The Australian Prudential Regulation Authority (APRA) is the prudential regulator of the financial services industry. It oversees banks, credit unions, building societies, general insurance and reinsurance companies, life insurance, friendly societies, and most members of the superannuation industry. APRA is funded largely by the industries that it supervises. After collapse of HIH APRA disqualified many directors of HIH from holding post of directors or senior manager in a general insurer
Various researches have been conducted in the direction of corporate mismanagement and how the investors should be informed as to their investments soundness, this has been incorporated now and various analysts like standards and poor have now a corporate governance criteria on which they analyse corporate by getting them to fill out data for them, but a debate is going on in this direction as to how will it be decided that these measures will be cost effective and to what size of a corporate will the criteria be effectively measuring, though being a very good evaluation criteria CGSS( corporate governance scoring systems) still lack in implementation because of non decision about their effectiveness. This system can be recommended if the company’s annual turnover is more then $ 100 millions.
Directors’ duties
As a common rule directors of a company owe duties to the company and not to individual members, creditors or others. Duties of a director are fiduciary in nature. They involve a relationship of trust and so they are suppose to act in the best interest of the company . Directors’ duties fall under two broad categories as statutory duties and General Law duties. Statutory duties are imposed by ASIC and General Law duties are imposed by company . These duties can be further classified into
Duty to act with reasonable care, skill and diligence S 180
Section 180(1) of corporations act states that a director or other officer of company must use hispower and discharge hisduties as a reasonable person would do. General Law and statute law are both source of this duty this duty can also arise out of a contract between director or other officer and the company. The minimum standards of this duty are specified in Daniels V AWA Ltd (1995) . The measure of care, skill and diligence will be different in each case and will depend upon circumstances. But generally it requires that the director must have a basic understanding of the business of the company and use the diligence of a reasonable person in that position.
Duty to act in good faith and in the interest of the company
This duty is imposed by S 181 of corporation act. It is also imposed by general law. This duty requires directors to act in good faith (honestly) and in the best interest of the company. (Greenhalg v Arderne Cinemas Ltd) .
Duty to use power for proper purpose S 181
According to section 181 of corporations act directors are suppose to exercise their power for power purpose. The court will adopt two step analyses to determine weather a director has used his power for proper purpose or not [Howard Smith Ltd V Ampol Petroleum Ltd] . First court will determine which power was used? And second it will determine what actual purpose behind the use of power was?
Duty to avoid conflict of interest
– requirement to disclose certain interests; ss 191-196
Under section 191 of corporations act a director is supposed to give notice to other director and disclose his material and personal interests in a matter that relates to the other affairs of the company unless there is an exemption.
– duty not to misuse information or position ss 182,183
Section 182 and 183 forbids directors from using their position and information available to them because of their position improperly. Both of the sections are civil penalty provisions. [Grove v Flavel]
Conclusion
The case of HIH needs to be seen in perspective and the agency theory best explains the debacle due to directors breaches, the directors are after all human beings who have various aspirations, and there is a conflict of interest with their fiduciary duties, because some directors are founders of that Corporate and have had great pains to make the company so big, so they tend to think that they can overcome the crisis which they face, because managing a big corporate entity is always filled with some crisis or the other and the directors have managed by steering the company through these crisis. It is a very tough decision to take the company through bankruptcy, as all directors know that in the life of the corporate it has faced similar situations many times, and their decision to continue operating has many times got the company out of any mess. Thus this thin line of discriminating when they wont be able to make the company come out of the present crisis is very difficult. But as outside interests have to be considered which are often of the unwary small investors investing their hard earned savings into such companies, governments intervention through regulators is expected, and these regulators would frame policies by first facing situations like HIH which was a big learning example of its kind and has made regulators change and ask for more disclosures and more intervention, which is not wrong, because just like law which is constantly evolving the laws to force better corporate governance are evolving and will evolve either from government or from industry itself.
References
(2002) 41 ACSR 72; 20 ACLC 576
This definition was adopted by the Committee on the Financial Aspects of Corporate Governance (known as the “Cadbury Committee”) in its Report, (1992), [2.5]
Ramsay,I., Hoad,R., “Disclosures! Corporate Governance in Practice” Company Director ,Vol 14 No 2, March 1998.pp11, 17.
Principles of Good Corporate Governance and Best Practice Recommendations (2003).
http://www.asic.gov.au/asic/asic_pub.nsf/byheadline/05-94+Ray+Williams+sentenced+to+four-and-a-half+years’+jail?openDocument as on 19th June
http://www.asic.gov.au/asic/asic_pub.nsf/byheadline/05-+Rodney+Adler+pleads+guilty?openDocument as on 19th June
http://www.hihroyalcom.gov.au/finalreport/Front%20Matter,%20critical%20assessment%20and%20summary.HTML#_Toc37086538
http://www.oecd.org/about/0,2337,en_2649_201185_1_1_1_1_1,00.html
http://www.apra.gov.au/media-releases/05_13.cfm as on 20th June
Harahan, P., Ramsay, I., & Stapledon, G. (2004). Commercial applications of company law (5th ed.).Sydney: CCH Australia limited
Ibid p 244
Ibid p 244
(1995) 13 ACLC 614; 16 ACSR 607.
Hanrahan, et al, p250
Ford,H., Austin, I.R.,(2003)Ramsay Ford’s principles of corporations law (11th ed.) Butterworth’s Australia, p325
(1951) Ch 286 at 291
[1974] AC 821; [1974] CLC 40-101
Hanrahan, et al, p 283
Ford, et al, p 404
Hanrahan, et al, p 310
[1986] 4 ACLC 654 at 662
Other books
Lipton, P., & Herzberg, A.(2003). Understanding company law (11th ed.). Australia: Lawbook Co.
Lipton, Herzberg, Von Nessen,.( 2002) .Essential Corporations Legislations; Thompson Law Book Co.
Westfield,M.,(2003).HIH:The inside story of Australia’s biggest corporate collapse,John Wiley & sons Austrlia,Ltd.
Journals
CORPORATE GOVERNANCE SCORING SYSTEMS: WHAT DO THEY TELL US?; Pernilla Linden, Zoltan Matolcsy. Australian Accounting Review. Melbourne: Mar 2004.Vol.14, Iss. 1; pg. 9, 8 pgs.
TRUE AND FAIR – AN IMAGINARY VIEW; Mark Leibler. Australian Accounting Review. Melbourne: Nov 2003.Vol.13, Iss. 3; pg. 61.
