Refer to the attached article (In Moodle), The Demise of HIH: Corporate Governance

Lessons, could you explain how HIH went collapsed? Why auditors lost their

independence? What could they have done to avoid the circumstances of not losing their

independence?

The demise of HIH:

corporate governance

lessons

JUNE 2003 KEEPING GOOD COMPANIES 273

Key Issues: Applied Corporate Governance

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

The 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

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,

The demise of HIH:

corporate governance

lessons

JUNE 2003 KEEPING GOOD COMPANIES 273

Key Issues: Applied Corporate Governance

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

274 JUNE 2003 KEEPING GOOD COMPANIES

Applied Corporate Governance cont.

representing FAI, refused to allow

a due diligence to be undertaken

and there was a general lack of

knowledge about FAI and its

financial position. The takeover

therefore proceeded even though

it was not possible to make a

considered assessment of FAI's

worth. HIH relied on publicly

available information which did

not disclose considerable underreserving

of FAI's insurance

business. The decision to proceed

with the takeover was hastily

taken after scant consideration

and with insufficient preparatory

and investigative work. The

directors totally failed to consider

the risks posed by the takeover.

Estimated losses arising from the

FAI takeover were $590 million.

The Allianz joint venture came

into operation in January 2001. It

involved the sale of HIH's

profitable retail insurance

businesses acquired from FAI in

the joint venture. The result was

an immediate cash flow crisis

which hastened the end of HIH.

No one in management or on the

board analysed the likely cash

flow implications before HIH

entered into the joint venture.

The joint venture agreement

involved a major strategic change

for the company, yet the board

knew nothing of it or several

other restructuring proposals

developed by management. The

board appeared unconcerned

about this. At the board meeting

called to consider the restructure

proposal, it resolved to proceed

after a 75 minute meeting. The

information before the board

lacked any careful analysis of its

implications and effect on cash

flow. The directors were incapable

of appreciating the risks involved

and consequently could not ask

the right questions before the

agreement was entered into.

Within 10 weeks of the start of

the joint venture, HIH was placed

in provisional liquidation.

Beware the dominant

chief executive!

Ray Williams was chief executive

from the beginning of the business

until he resigned in October 2000.

He dominated the company and was

instrumental in bringing friends and

associates on to the board. 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.

Therefore there was no independent

assessment of performance even

while financial results deteriorated.

The approach of the board and

senior management to the CEO was

'unduly deferential'. 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. As a dominant CEO,

Williams had no clearly defined

limits on his authority in areas such

as investments, donations, gifts and

payments to staff. Personal and

company funds were intermingled

and not disclosed to the board. The

board did not have a clear policy on

matters reserved to itself, rather

matters came forward at the

discretion of the chief executive.

Even after stepping aside as chief

executive, Williams continued to act

with the same authority as before.

Management was not held

accountable or subject to

questioning. An important aspect of

poor corporate governance and

mismanagement was the failure of

risk identification and risk

management. This failing is

obviously particularly critical in the

insurance industry.

The ineffective

chairman

The chairman of HIH, Geoffrey

Cohen, clearly failed in a number of

respects to carry out his role

properly. The chair has general

responsibility to oversee the

functioning of the board, for the

efficient organisation and conduct of

the board's function and to ensure

that all appropriate matters are raised

for discussion. The board agenda

largely became pro forma and not 'a

living tool for organising and

shaping consideration and review'.

Other board members did not

contribute to the agenda. Agenda

items almost entirely involved

matters brought forward by

management. The chair had no

major involvement in the process of

determining the information which

went to the board. This left the nonexecutive

directors highly dependent

on management for their

information. This indicated that the

board acted largely as a rubber stamp

with little independent involvement

in the company. The chair failed to

ensure that all important matters

were put on the agenda and it was

not controlled by management.

Usually there were four meetings

of the board per year plus an annual

budget meeting. 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. This indicates a

board that was only concerned with

past financial performance and was

not involved in discussing the path

ahead. In fact it was clear to

Commissioner Owen that the

directors had no idea what the

strategy of the company was.

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.

The chair must take responsibility for

taking the lead in securing full

disclosure by all directors.

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. As

pointed out by Austin J in ASIC v

JUNE 2003 KEEPING GOOD COMPANIES 275

Applied Corporate Governance cont.

Rich [2003] NSWSC 85, 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. 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. This again reflects the

recurrent theme of a board held

captive by a dominant CEO.

The board that did not

ask questions

The Royal Commission report

clearly considered that the board did

not properly carry out its role. This is

not surprising considering the

dominant role played by Ray

Williams as CEO and the ineffective

role of the chair. There was little if

any documentation or analysis of

future direction or strategy. While

management is best able to propose

strategy, it is part of the role of the

board to understand, test and

endorse the company's strategy. This

meant that the board was unable to

monitor management performance

and proposals by reference to

endorsed strategy. Where a board

functions properly, any deviation in

practice should be challenged and

explained. The board must regularly

test and review the strategy's

appropriateness and monitor and

assess whether the strategy is being

achieved and, if so, to what extent.

Ray Williams as CEO never clearly

expressed to the board his plan for

dealing with a difficult competitive

commercial environment. It was a

damning indictment of the board

that the directors were unable to

identify the strategic directions of

the company. A long-term strategy or

plan was never formally submitted to

the board for critical analysis. This

resulted in investment decisions

being made which were

opportunistic and lacking in

direction. 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. Even if the right

questions were asked, the board

would have been unable to assess the

responses. 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.

Non-executive directors were

blamed for failing to understand the

outstanding claims provisioning.

This is crucial to the financial health

of an insurer and was the most

critical part of HIH's financial

statements. This lack of

understanding meant the directors

were unable to identify and deal

with looming problems before it was

too late.

The crucial question of

determining the amount of reserves

was set in reliance on actuaries'

reports. However, 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.

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.

Failure to grasp the

concept of conflicts of

interest

'Avoidance of conflicts goes

directly to the integrity of the

board's processes'.

The board did not grasp the

concept of conflicts of interest and

its critical importance in corporate

governance. 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.

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.

In other cases, 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.

The board did not have

appropriate procedures in place to

readily identify and resolve such

issues. This is primarily the

responsibility of the chairman.

However, 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.

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. In June 2000, a

subsidiary of HIH provided an

unsecured $10 million loan to an

entity controlled by Adler. At the

time Adler was also a non-executive

director of HIH and, through a

controlled company, a substantial

shareholder. This loan was used in

the following transactions:

about $4 million was used to buy

HIH shares on the stock market.

This purchase of HIH shares was

designed to give the stock market

the false impression that Adler

was supporting HIH's falling share

The ... report clearly

considered that the

board did not properly

carry out its role.

276 JUNE 2003 KEEPING GOOD COMPANIES

Applied Corporate Governance cont.

price by personally buying its

shares. The shares were later sold

at a $2 million loss.

nearly $4 million was used to

purchase various unlisted shares

in technology and

communications companies from

Adler-controlled interests. 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. A total

loss was made on these

investments.

$2 million was lent to Adler and

associated interests. These loans

were unsecured and not

documented.

These transactions were not

referred to the board or investment

committee established by the board

to oversee the HIH investment

portfolio. Adler was a member of this

committee. The investment

committee had responsibility for

making, 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, approving

investment authorities and reporting

all decisions and recommendations

to the board. 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.

Ad hoc executive

remuneration

Remuneration reviews for senior

executives were ostensibly

determined by the board's human

resources committee which met

annually. The committee's terms of

reference required it to review the

remuneration of various officers and

senior employees. In fact, all

decisions about remuneration and

performance were made by Williams

who, although not a member of the

committee, attended all meetings by

invitation. The committee did not

make proposals on its own initiative

nor did it ever reject a proposal put

by Williams.

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. With the

removal of objective benchmarks

against which performance could be

measured, performance evaluation

and determinations of remuneration

and bonuses were carried out at the

sole discretion of Williams.

Williams' own performance

appraisal was carried out by the

chairman without proper process or

detailed review. Increases in his

salary were approved without advice

or regard to performance.

Unusual accounting

transactions

The board must be satisfied that

the accounts were derived from

systems likely to produce accurate

accounts. Internal financial controls

were inadequate because there was

consistent failure to meet budgetary

targets. This was not discussed by the

board. Budgetary control as a

strategic planning tool was therefore

ineffective.

HIH management regularly used

one-off end of year transactions that

affected profits to disguise poor

underlying performance. Whether

the use of such aggressive accounting

practices was appropriate was not

considered by the board or audit

committee.

Ineffective audit

committee

The audit committee's terms of

reference and minutes indicated that

the audit committee was almost

entirely concerned with matters

directly concerning the accounts and

the figures. There was no concern

with risk management and internal

control. The audit committee should

be comprised of only non-executive

directors. The HIH audit committee

was regularly attended by all

directors including executive

directors. The non-executive

directors rarely met with the auditors

in the absence of management to

discuss contentious matters or areas

of concern.

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. Such meetings should

occur regularly so that the board can

consider the issues carefully. The

audit committee could not and did

not ask the right questions.

Compromised auditor

independence

Auditor independence and the

appearance of independence are

fundamental to an effective audit.

The independence of HIH's auditor,

Andersens, 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.

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

current over-emphasis on corporate

governance is misconceived and

ultimately counterproductive.

According to this view, the causes of

corporate failure and mistakes are

poor strategy and flawed business

plans and not poor governance. 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. I suggest that the

HIH Royal Commission report shows

this view to be based on an entirely

erroneous conception of what

constitutes corporate governance.

Commissioner Owen considered that

there was a clear causal link between

poor corporate governance and

mismanagement. Viewed in this

light, corporate governance is much

more than compliance with an arid

set of guidelines just for the sake of

appearing to comply. 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. It influences how the

objectives of the company are set and

achieved, how risk is monitored and

assessed, and how performance is

optimised.

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, without regard to its real

import. If that happens, 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.

HIH had a corporate governance

model and it was stated in the

annual report. The problem was that

the board did not periodically assess

the effectiveness of the company's

corporate governance practices.

There were relatively few clearly

defined and recorded policies and

guidelines. Where they did exist they

were ignored. It is evident that it is

these elements which are crucial to

good corporate governance practice.

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.

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.

JUNE