Corporate governance - a chink in the chain

The recent spate of corporate collapses has produced extreme nervousness in financial markets. Pundits have likened the situation to that in 1929 and the US President has been led to speak out in support of the enforcement of higher standards of corporate governance. Ironically this occurs at a time when companies as never before have been engaged in the production of ethical paraphernalia - codes of ethical conduct, social audits, environmental audits.

The collapse of Enron (paradigm of ethical management in textbooks) and WorldCom (brave 'new economy' company) support the cynical conviction that the production of all this ethical bumpf is nothing more nor less than part of a marketing strategy. Unenforceable company codes of conduct will never be effective in a competitive market place. The benefits of cheating - for those who do not get caught - will always dominate the strategy of ethically proper behaviour. As one old-timer said to me: "The line between a knighthood and a jail sentence is a very fine one." In fiercely competitive modern markets this is true a fortiori.

The market is nervous not simply because companies have failed, nor even that they have attempted to present themselves as solvent long after the point of insolvency. What is particularly threatening in the current crisis is that auditors have effectively colluded with corporations to deceive investors.

We have all heard the joke about the CEO who calls his accountant in to his office and asks: "What is two plus two?" The accountant nervously closes the door, lowers the blinds and asks in whispered tones: "What do you want it to be?" The modern corporation is an effective autarchy in which the CEO has virtually untrammelled power, at least until the company gets into such trouble that he is fired. His successor immediately assumes similar powers, which he uses to fire his predecessor's key supporters and external advisors, to replace them by people and advisory groups loyal to himself. Is it surprising that accountants and auditors are easily suborned?

Much attention has been focussed on the Andersen Group. However the level of nervousness in the market far exceeds what would be appropriate if the investment community saw Andersen's practices as falling clearly outside the norms of accepted auditing practice. What the investment community suspects, of course, is that Andersen's behaviour is not so very different from the behaviour of its competitors. It is this fact that has produced the current crisis of confidence.

While George Bush is promising to take steps to ensure that corporations produce accurate reports concerning their financial status on the Australian scene Professor Allen Fels is seeking to have the penalties imposed on corporate wrongdoers increased. One part of Fels's strategy is to increase the financial penalties imposed on businesses, the other to increase those penalties faced by individual directors.

Given the current crisis facing the capitalist system such moves may appear attractive. But the purpose of business regulation is not solely or even primarily to prevent wrongdoing. In a globalised economy companies, countries and individuals compete for scarce resources in a myriad of ways. The Australian regulatory framework is effectively in competition with the regulatory framework as is exists in Singapore, the USA, China and Nigeria. Similarly our tax system competes with tax systems of other nations.

What Australia needs is a competitive regulatory environment. While serious corporate wrong-doing must clearly be discouraged it has to be recognised that too much regulation can be as bad as too little. Far better to have a dynamic economy where some misdemeanours go unpunished than a stagnant one where every wrong-doer is brought to justice.

Of course none of this answers specifically what would constitute an optimal level of corporate regulation within Australia. What we do know however is that corporate failure is already treated far more seriously here than in the United States and Australian company directors already face more serious consequences for misconduct than their peers in most other nations. If we want to keep our regulatory framework internationally competitive the answer must lie somewhere other than in raising penalties for misconduct.

An alternative to harsher penalties is to look for ways of increasing the probability of earlier detection of financial crises. A model for this already exists in the life insurance industry. Within each life insurance company there is the position of Appointed Actuary. The Appointed Actuary has the legal responsibility (as does the auditor) of reporting to the regulator (in this case APRA) on the company's financial state of health. The model seems to have worked tolerably well in preventing corporate collapse within the life industry and has recently been extended to General Insurance, unfortunately after several horses have bolted.

My proposal is that this model be extended to listed companies generally. This would require the Chief Financial Officer having the same kind of legal obligation to report to the relevant regulator as the Appointed Actuary has in the insurance industry. As well as raising the probability of early detection, this reform would have the additional benefit of reducing the untrammelled power of the CEO.

Auditors could be subject to similar controls. One of the partners in Audit firms could be required to have the responsibility of reporting to APRA in respect of the veracity of the audits done by the partnership.

My proposal effectively puts a 'chink in the chain of command.' CEOs may not like it, but it is the CEO's overwhelming power that has been the problem in many of the recent scandals. There is a good reason for separation of powers in any system of governance, and my proposal codifies this in the case of listed companies in Australia. This proposal would be more effective - involving as it does additional checks and balances - than ASIC's new regulation (effective from August 15) that Chairmen must personally sign off on the accounts. Any CEO worth his salt is perfectly capable of controlling the information flow to the non-executive directors (including the Chairman) on his board. It is well nigh impossible to hoodwink one's CFO in respect of the relevant matters. Good governance involves a separation of powers and the latter requires breaking the chain of command at the right point and in the right way.

There will always be some business failures within a dynamic economy. The challenge of regulation is to prevent excessive corporate wrongdoing. The sure sign that it is excessive is when, as is currently the case, confidence in the markets takes a serious tumble. To restore confidence investors will need to be first and foremost reassured that the financial reports of companies are indeed an accurate assessment of the company's financial state of health. The simple reform proposed here would do much to improve the honesty of Australian Company reports without imposing a further competitive disadvantage on Australia's Companies in a fiercely competitive global economy.