Irrational exuberance and corporate regulation Cover Story

  • Date:01 Jun 2005
  • Type:CompanyDirectorMagazine
The first and often only reaction from governments to abhorrent corporate behaviour - however isolated the incident - is to enact new legislation and give the regulators more power. But has this rush to legislative judgment gone too far and become a threat to the economy and an unforeseen cost burden to consumers? John Arbouw reports

Irrational exuberance and corporate regulation

The first and often only reaction from governments to abhorrent corporate behaviour - however isolated the incident - is to enact new legislation and give the regulators more power. But has this rush to legislative judgment gone too far and become a threat to the economy and an unforeseen cost burden to consumers? John Arbouw reports

When US Federal Reserve Board chairman Alan Greenspan addressed the American Institute in 1996 he coined the phrase "irrational exuberance" to describe the then trend to pump up asset values and create an asset bubble that could "impair the real economy, its production, jobs and price stability."

Almost 10 years later, irrational exuberance and its effects could be used to describe the ever-increasing use of legislation and corporate regulation used to redress a few isolated incidents of corporate wrongdoing.

In the same year Greenspan made his speech the US Congress passed regulatory reform laws intended to slow down the proliferation of government regulations, yet by 2001 more than 14,000 new regulatory laws had been passed. The US Congressional Office of Management and Budget estimated the annual cost at around $US38 billion a year between 1992 and 2002.

In Australia in that same year, there was much discussion about corporate law reform and in March 1997, the Treasurer announced the Corporate Law Economic Reform Program (CLERP) involving a fundamental review of key areas of regulation which affect business and financial activity.

The broad objective of CLERP was to ensure that business regulation was consistent with promoting a strong and vibrant economy and providing a framework which assists business in adapting to change.

Last July the ninth manifestation of CLERP came into law. Nowhere in the CLERP principles does it say a cost benefit analysis was conducted to gauge the impact of compliance.

According to a recent survey of US financial executives, the cost of complying with Sarbanes-Oxley for a typical company is around $4.6 million plus an additional 38 percent each year for future audits.

In Australia, a recent Access Economics/BCA report says federal and state governments added 33,000 in new laws, rules and regulations in 2003. Two-thirds of all Acts passed by the Federal Government related to business.

Regulation at federal and state levels is growing at around 10 percent a year - more than twice the rate of Australia's economic growth, says the report.

On a state level, NSW produces on average 300 pages of new laws, rules, regulations and by-laws every week. Queensland added 8700 pages of new laws and rules in 2003. Victoria has 69 business regulators controlling 26,000 pages of regulation.

According to the report, the Federal Government now passes 350 pages of new laws every week it sits and half of all legislation passed by the government since Federation has occurred in the past 14 years.

And the cost of this exuberance is estimated at 8 percent of GDP. The OECD estimates that the compliance cost of regulation for small and medium-sized Australian businesses in 1998 was more than $17 billion. In 2001-02, the Federal Government spent $4.5 billion on the administrative costs of Commonwealth regulatory bodies.

Even one piece of legislation can have significant costs, says the report. Westpac estimates, for example, that proposed legislation on antimony laundering will cost the bank up to $25 million over three years. Even though the legislation has not yet been passed, the bank has already spent more than $7 million in anticipation of the new regulation.

And it isn't only Australian taxpayers and consumers who ultimately pay the price of this exuberance.

"Governments are increasingly introducing laws that mean a company director or executive is deemed to be individually liable for an offence when their company is found liable for that offence, effectively reversing the onus of proof and overturning the precept that an individual is innocent until proven guilty," says the report.

"The arguments usually put for such provisions are that it is too hard for regulators to properly investigate and prosecute alleged breaches of the law and that directors and senior executives are capable of looking after themselves when facing such prosecutions. In reality, it means that company directors and executives are having their rights to be treated equally before the law eroded."

This exuberance may be well-intentioned and politically expedient, but companies are becoming increasingly hesitant to take sensible business risks, the cost of compliance has increased significantly, especially for smaller companies, and ultimately the Australian consumer is punished through increased prices for goods and all of us in lower superannuation returns.

"A strong economy can only shield Australia from the worst impacts of regulation for a limited time - it will directly affect growth by tying up too many resources in ultimately unproductive activities," former ASX chairman Richard Humphry says in the report.

The latest example of irrational exuberance is the new set of corporate governance regulations put forward by APRA for deposit-taking institutions (ADIs), general insurers, life insurers and authorised non-operating holding companies (NOHCs).

APRA has been under severe criticism for not preventing HIH - and its set of corporate governance rules aims to capture the high ground with some of the provisions at odds with the ASX's corporate governance guidelines.

The Australian Tax Office has also entered the corporate governance space with the suggestion that companies should conduct a corporate governance style tax audit to see whether they are in compliance.

Australia has signed up to the International Financial Services Reform, but while the future potential benefits are touted as easier access to foreign capital markets, the real and present cost will be borne by small to medium sized companies caught in the IFRS net.

Another example of exuberance is the suggestion by Deputy Prime Minister John Anderson last month that the ACCC should be in charge of the nation's ports. This is unlikely to go much further because the ACCC is already defensive over suggestions that its role in monitoring the business of infrastructure supply has led to the infrastructure crisis currently facing the nation.

However, the ACCC is still determined to achieve its goal of having tougher laws for price fixing.

The Senate is now considering legislation that will mean directors and senior executives lose their legal protection and could be forced to pay fines of up to $500,000 out of their own pockets and that they will also have trouble getting their legal expenses indemnified by the company.

Judges will also have the power to ban senior officers and directors from being a director or managing a company in the event of proven offence.

Little wonder that the fear of further regulation and the loathing associated with time wasting compliance is becoming widespread.

In a survey of AICD members last month, directors were asked to name the issues that "kept them awake at night" and the number one issue was the weight of regulation and effectively managing the pressures of compliance.

And this isn't only a corporate problem as members nominated the risk to personal reputation as a major nightly eye-opener. As one member put it "there is a growing gap between what we actually do as directors and what the courts, government and the press expect us to do".

AICD chairman Don Mercer pointed to this growing expectation gap in his opening address to the Company Directors Conference last month. The recent judgment in the Greaves case that a chairman of a company lives by a different set of rules and therefore should face increased liability to that of other directors is a prime example.

"The court appears to have imposed executive responsibilities on a non-executive chairman who works, as non-executives do, in a part-time capacity," Mercer said.

"If executive responsibilities are to rest on a chairman (which is at odds with the ASX corporate governance rules calling for an independent director to fill the role), then we are looking at a fundamental changes to the structure of boards and the emergence in Australia of the executive chairman."

And the trend for more and more legislation and regulation will almost certainly continue as society keeps demanding predictable security in the face of an open future. Whether it is in the school playground, on the supermarket shelf or an investment in a listed company, society seems determined to want a risk free condition of interaction.

At one time there was an insurance clause that exempted natural disasters because they were "acts of God". God has not only deserted the insurance industry but the psyche of the individual as the blame game is played out in every aspect of human endeavour.

The French expression c'est la vie (that's life) has long since been replaced by who is responsible.

The not unexpected result is that the natural and justified risk of doing business and creating wealth is becoming frustratingly tempered with a fear of failure and the cost to personal reputations.

The empty boardroom (see October Company Director) is in danger of becoming a reality as experienced directors opt for safer havens on private equity firms and those directors that do stay become increasingly risk averse - to the detriment of corporate performance and a strong economy.

Is corporate regulation killing the company?

By John Arbouw

Following a survey of members to determine "What keeps them awake at night?" the AICD organised a private session of chairmen and senior directors from the Top 100 companies at the Company Directors Conference in Perth facilitated by Harvard professor Jonathan West.

At another of the conference forums, Wesfarmers chairman Trevor Eastwood, ASX director Cathy Walter and AICD's Law Committee chairman Professor Bob Baxt discussed "Is Corporate Regulation killing the company?" The two sessions encapsulated many of the views held by all Australian directors in terms of the effects of regulation.

The survey results were quite conclusive as to director worries, with respondents expressing concern over the increasing regulation and the pressures of managing this. Directors also nominated the risk to personal reputation that comes with increased regulation.

According to one of the respondents: "The threat of criminal High Court actions has profoundly changed the risk/return characteristics of being a director".

What also keeps directors awake is the fear of not knowing everything that goes on in the company. As one director put it "the ability of a director to dig deeply into a large corporation is limited. There is an expectation that non-executive directors should know everything. That is crazy."

Members also expressed concern over the lack of understanding in the public domain over what boards actually do; and managing the expectations of courts, governments and the media.

One result from this is that boards are increasingly being asked to be responsible for a broader range of activities, a lot of which they don't have actual control over.

One example pointed out by Helen Nugent AICD corporate governance committee member and chairman of Swiss Re (Australia) and Funds SA as well as a director of Macquarie Bank, Origin Energy, Carter Holt Harvey and Unitab in the session with Top 100 directors is the move by the ATO to make directors responsible for tax policy within the company.

She also pointed out that legislation currently before states such as NSW in terms of the Workplace Fatalities Bill threaten to put increased liabilities on directors for events that are often beyond their control.

The issue is one of fudging the role of the board and the role of management. The primary responsibility of boards is one of oversight but increasingly there is the assumption in government, the judiciary and the community that this should also involve executive responsibilities and therefore increased liabilities.

Nowhere was this more evident than in the Greaves case which provides the as yet untested precedent value that a chairman has more responsibilities and therefore more liabilities than other directors.

As AICD chairman and chairman, Australia Pacific Airports and Orica, Don Mercer pointed out the findings against Greaves blur this traditional line between the role of the non-executive directors and chairman and executive duties.

"This confusion as to what levels of responsibility exist for chairmen, under what circumstances, may well backfire in the future," he said. (The full speech is on the AICD website).

As AICD Queensland president and non-executive chairman of the national board of Corrs Chambers Westgarth, chairman of Suncorp Metway and a director of CSR, TABcorp Holdings and Australian Magnesium Corporation John Story put it: "We have a collective responsibility as a board. We can't simply sit on our hands and say that was the chairman's fault if something goes wrong."

The view that irrational exuberance in terms of more and more legislation is a cyclical phenomenon due in part to the recent corporate disasters was challenged by former NSW Olympics minister Michael Knight, who is currently the chairman of Sydney Gas, the publicly listed entity intent on developing gas resources in the Sydney Basin.

"I would argue that something has changed permanently," Knight says. "Rene Rivkin dying or Rodney Adler in jail doesn't mean that all this is over or goes away in a year or two. Now that share ownership has become a mainstream matter there has been a permanent change in community interest in what happens in business.

"The media reports everything as a passion play in terms of good people and bad people and politicians responding to that are not as a group terribly sophisticated about the detail of policy but they are pretty good at sniffing the winds of community resentment."

The result of this passion play is a loss of trust from the community and this is not helped as Telstra director Charles Macek pointed out "when the community see people paid a large amount of money and they have done a bad job".

According to one director, it has become a case of risk management in that society wants to pass on the consequence of risk onto directors and the answer is to manage this risk.

"This is already happening," he said. "If you compare the directors of today with the situation 30 years ago we now have much better procedures and processes in place. We need to engage with shareholders more and get the message out."

According to former AICD chairman John Ralph (now a life member of the AICD), we need to get a community of interest who all have a stake in how well companies operate.

"Profit is not a dirty word," Ralph says. "If the corporate system is not operating well, then there won't be the money available to fund retirement and health. It isn't only directors who have a stake in how well companies operate. If you put legislative hurdles in the way that cause companies not to operate optimally and repress that activity then everybody loses not only directors."

At the conference forum "Is Corporate Regulation killing the company?" many of the same themes discussed at the session with the top directors also came up.

Wesfarmers chairman Trevor Eastwood, who has been a director for 35 years and has served on the boards of around 20 public companies, says one of the drivers of the proliferation of new legislation is the involvement of the community in the affairs of business through both direct and indirect share ownership through superannuation.

"This is the group that most strongly feels government ought to be able to legislate to reduce investment risk," he says. "There has been too great a shift in non-executive directors being made accountable for areas that were previously management's responsibility. The increased level of compliance directors must involve themselves with has changed the nature of the role - and increased regulation is also having an effect on the selection of directors.

"There will be more professional directors who in addition to legal or accounting qualifications will also have specialised knowledge on corporate governance.

"The challenge for our legislators and regulators is to develop a better understanding of the corporate world and how boards work so unnecessary legislation can be avoided."

Cathy Walter began her presentation by posing such questions as "do we as directors get the legislation we deserve and can we turn this increased legislation into an asset?"

"One of the ways we can best equip ourselves to limit the regulation phase is to see the warning signs and change our behaviour in response to emerging environmental shifts and community attitudes," Walter said.

Walter also made the point that part of the Australian regulatory regime particularly in terms of audit independence was a response to US regulation and the perceived need to align the two regimes if most favoured trading nation status was desired.

While directors prefer a self-regulation regime based on principles Walter made the point that any principles regime will also rely on an ethical based profession.

"How can we change the regulation we get? From time to time we hear discussions that directors should be regarded as professionals and members of a profession. Indeed, the AICD training courses represent a laudable attempt to lift the standard of directorship on a whole.

"You will remember that the professions for a long period were self-regulating in acknowledgement of their strong internal discipline. However over time the ability of the professions of law and accounting to regulate themselves has become more constrained.

"So what would it take to be more like professionals? Directors could think about regulating their conduct in response to ethical standards in a way that might make specific laws and regulation unnecessary," she said.

"Directors could think about their own sense of what is right and proper conduct. Recent literature has drawn attention to the downside of what is called creative compliance that's to say compliance with the technical provisions but not its spirit.

"The best protection from future regulation is to ensure directors do not settle for creative compliance and resist any concept of what can we get away with and instead focus on personal beliefs of what is right and what is wrong.

"I am not suggesting that the majority of directors do not bring this dimension to their decision making but rather that we need to constantly focus on these ideals so that our collective action doesn't endanger the regulatory outcome we would prefer."

In his presentation Professor Baxt acknowledged that Australia had achieved some competitive advantage from the manner in which it had adopted corporate regulation, but that there are still some major problems that need to be addressed.

"There is a trite observation in the law that you are innocent until proven guilty," Baxt said. "Unfortunately that observation applies less and less both in the Corporations Act and more regrettably in a range of state and federal statutes.

"The presumption has been is that it is too hard for the regulator to establish that any particular breach of the law has occurred and so what we will do is switch the onus as occurred with Ms Corby who had to prove her innocence rather the Indonesian court proving her guilty.

"The principles of corporate and other regulations in this country is premised on cost benefit analysis being established to ensure that the legislation put forward by governments merits passage by Parliament.

"I would challenge you to produce a sensible example of this cost benefit analysis being undertaken in recent years in relation to some of the changes we have seen in the various areas of regulation."

Baxt says we need to be more demanding of government in the way it introduces and passes laws.

"The way the process works at the moment is that a law is passed, extra money is allocated to ACCC or ASIC and the government says go and chase the people breaking the law. Governments take the position don't blame us ladies and gentlemen of the community, blame the people in those companies that are breaking the law.

"The fact is that there are very few people that break the law in a manner that is so heinous that it requires the introduction of legislation that reverses the onus of proof or the strict liability regime."

According to Baxt, every time we pass legislation such as financial services regulation the cost to the community is quite horrendous.

"Everyone thinks the costs of this something for the corporations subject to the legislation - it is not. The regulators have to get up to speed in this area and they are still struggling."

So is corporate regulation killing the company?

The dominant view to emerge from the session is the metaphor of the boiling frog. If you place a frog in cold water and turn up the heat, the frog will not notice the incremental changes until it is too late.

Corporate Australia and company directors are now feeling the heat.

The way forward

The sessions at the AICD conference weren't only about identifying the problem. There were also sensible suggestions as to what can be done.

These issues call for a multi-faceted response from AICD and its members along the following lines:

Manage a measured and active response to the recent cases.

This can be done by:

  • research to assess the (limited) precedent value of the cases (eg specific facts such as consent judgment, evidence of inadequate financial information provided to the board, particular and atypical catastrophic circumstances etc)
  • promote awareness of these issue and their consequences among directors, the media, politicians and the community generally eg public forums, media articles, dialogue with politicians
  • closely monitor future legal proceedings bearing on this issue and participate where appropriate eg by supporting - and possibly promoting - test cases, providing AICD members to give expert evidence, engaging in media debate around cases
Actively debate the limits of the riskless society principle:
  • emphasise the trade-off between entrepreneurial innovation and risk. Society must accept that, in some cases, the risk of entity failure is a consequence of promoting innovation and entrepreneurship
  • emphasise the differences between entity failure due to:
- normal factors of capitalism eg market forces,

economic cycles

- fraud

- negligence, incompetence or mismanagement.

Emphasise that different consequences at law and in societal expectations must apply to directors in each case (ie entity failure should not automatically equal director's liability).

Focus on performance

Society long ago moved from a trust to a performance model for assessing its professionals eg lawyers, doctors and directors.

Try to rebuild trust but recognise that the ultimate test (defence) is performance. To that end, continue the trend of (particularly) the last 30 years to lift the standards and performance of directors via:

  • improved methods for the selection of directors eg educating boards, board and director evaluation, providing tools such as the AICD database, use of specialist recruitment firms, accreditation systems for candidates
  • lifting the skills of directors, eg training and development, introduce mandatory CLE
  • possibly consider some method of self regulation
Lobby government along with other relevant interest groups
  • explore the 'coalition of interests with strange bedfellows' concept (ie the BCTR model)
  • target key groups of influence eg parliamentary counsel, politicians, superannuation and other major investor groups, the media
  • counterbalance the usual "passion play" response of the media
Minimise risk

Minimise the risk wherever possible using the means available eg

  • continuous disclosure to the market
  • full and open engagement with entity executives
  • use lawyers, accountants and other experts, where appropriate, to advise
  • actively participate in debate to define good practice
  • co-operation with regulators and Government
  • early use of administrators and other insolvency practitioners, director resignation etc where appropriate.

The editor acknowledges the contribution of Mallesons Stephen Jacques chairman Frank Zipfinger to the summary of the way forward


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