G’day. Our columnists are getting into gear – today Jack Robertson makes his 2003 debut with Time for a question change on Iraq (jack20), a piece debunking Jim Nolan’s defence of war on Iraq on human rights grounds in Take a risk for human rights: Back Bush, webdiary17Jan.

Harry Heidelberg was inspired by HIH: Will Costello be nailed? (webdiaryJan17)to write two columns. His corporate eye view of the perils of outsourcing is at Outsource, then backsource at Harry20Jan). He goes to town on bad corporate behaviour in HIH: Time to stop the rot for good (Harry20Jan).

Michael (last name withheld) in Sydney, another financial type, blames the incentive-based pay which has mushroomed since deregulation for much of the sleaze:

“Having worked in stockbroking, investment banking and now for a large multinational (whew, there’s a list !), it seems to me that since the deregulation of financial industries around the world, starting in the late 1970s in the US and making its way here in the 1980s, the world of commerce has been engaged in a project to both increase the percent of employees remuneration driven by incentives and to push this methodology throughout as many levels in the organisation as possible.

What started as bonuses for bankers is increasingly becoming, in some shape or form, a feature of many people’s pay structure.

At the risk of a gross generalisation, the theory as taught in most business schools is about getting the employees to think like owners by “giving” them a stake in the economic outcomes of the firm. This then engenders greater commitment, productivity and performance and all’s right with the world.

In practice, I have very serious doubts about some of the unintended consequences of this approach. Let’s just put to the side the most egregious examples from recent corporate collapses. They’re far too obvious. What are some of the other problems of this path we seem to be heading down somewhat unquestioningly ?

Firstly, the design of incentive based remuneration systems is very difficult to get right. Problem is, if you give someone an explicit incentive, they may very well follow it to the letter. For example – bonuses based on current year performance can create dysfunctional short term behaviour, like the profit banking Harry Heidelberg discussed.

Secondly, what should be the measures? Accounting profits? “Economic” profits? Cash? There’s a whole world of literature out there on what metrics to use. Use the wrong one, or the wrong combination and it can backfire.

Thirdly, if people are rewarded on the basis of getting the deal done, the audit signed or the case won, we have seen all too clearly that sometimes the result can come a too high a price. Which might not be a problem for you if you’ve banked your bonus and moved on, right?

Finally there’s the issue of how to incorporate subjective judgments about performance in incentive pay. Another example from my experience was a bonus system largely decided upon the fees generated by the employee and the recommendation of the head of the business unit. There were no guidelines about how these recommendations were to be made. Consequently, the bonus system, which could account for anything from half to a multiple of salary (depending on seniority) became a black box. This did not make for a particularly healthy culture – intensely competitive politics, patronage, no co-operation etc.

But my biggest problem with the whole concept is that the underlying Pavlovian premise is people respond best to money and that all you have to do is provide a steady stream of cash based on the right targets and all will be well. As you noted in your speech, this goes to the monetisation of all values. If it can’t be quantified in cash terms, then we question its worth and importance.

So what has all this to do with ethics? In many professional services firms and large corporations, the structures in place to reward people often take no account of any concepts of ethical or fair dealing. That’s not to say that ethics isn’t a core value of the firm. “We value honesty and ethical dealing above all else” etc….

If anyone gets caught, of course they’ll be sacked, but is it any wonder that the actions (ie pay systems) speak louder than the corporate vision statement rhetoric? I firmly believe that unless there is some moderation (let alone reversal) in the magnitude and extent of incentive based pay, or at the very least a rethink of methodologies, governmental or societal responses will have great difficulty getting past incentive systems that can at best make it easy to ignore, and at worst actively work against, ethical behaviours.

And we’re spreading this approach throughout the economy. Hmmm. Not too sure about that.

Australian Financial Review legal reporter Chris Merritt wrote a disturbing piece about HIH on Saturday, opining that the perpetrators of the bankruptcy of one of our largest insurers would get away with it. “Those who had been expecting the nation’s governments to launch a crackdown of the insurance industry and its professional advisers are too late. Instead of a crackdown, state and federal governments are already implementing the exact reverse,” he wrote.

Chris notes that even if prosecutions of a few of the 1000 possible breaches of law identified by counsel assisting were launched, it would break the bank of the regulatory authorities. The big boys twist the legal system every which way, at enormous expense, to save themselves, and Peter Costello has given corporate regulator ASIC a mere $5 million extra to do the job. Even if Costello gave more money, the regulator would still only do targetted prosecutions, Chris said.

What’s more, ripped off consumers will find it harder to launch civil proceedings for damages because since the HIH collapse state and federal governments have begun changing the law to make it harder to sue company directors and professional advisers, including watering down the tests for professional negligence!! Looks like accountants and lawyers here are nearly as powerful as the US lobby groups who’ve been so successful in feathering their nests and limiting their accountability. NSW – home to the workers friend Bob Carr – has been first off the mark in legislating to protect professionals against consequences for their negligence. The others have yet to act, so there’s still time to knock off the rort elsewhere.

In announcing these drastic curtailments of liability for negligence, says Merritt, Governments “failed to recognise the dual nature of the law of negligence, which simultaneously operates as a system of compensation and as a system for enforcing community standards by punishing wrongdoers.”

“By watering down its effectiveness as a compensation system, the nation’s governments have also watered down its effectiveness as a system for enforcing community standards.”

Harry wants all the alleged perpetrators dealt with as a lesson to companies and the professions. I agree. Peter Costello, as architect of APRA, the disastrously failed regulator for the insurance industry, has a duty to fix up his own mess. He should do at least five things:

* Give ASIC enough funds to prosecute ALL cases where there is ANY chances of success, and instruct ASIC to do so. Let’s have an end to prosecution of all poor miscreants and selective prosecution of the winners of our society who do the wrong thing. That’s the best stick, by far, to ensure more businesspeople and their professional advisers think twice before breaking the rules. It would be money very well spent.

* Tell ASIC to publish a list of ALL adverse findings against all affected players – including professional lawyers, accountants and actuaries accused on unprofessional conduct – and publish regular updates of where they’re at on each.

* Tell ASIC to detail every legal ploy that every prosecuted player uses to delay proceedings and to recommend legal changes to cut off all possible technical means for corporate players to evade responsibility for their actions.

* Write to all professional bodies of the accountants, lawyers and actuaries involved and demand details of what action, if any, is being taken to discipline and if necessary expel errant practitioners. Two of Australia’s top legal firms, Blake Dawson Waldron and Minter Ellison, are implicated in this scandal, and it’s time to end the closed doors, only-if-we-feel-like-it responses from professional associations with the job of encouraging and enforcing ethical behaviour in their ranks.

* Convene a meeting of state governments to draft comprehensive laws to clean up and reform the associations of all professionals with ethical responsibilities. In the meantime, tell professional bodies to come up with their own reforms pronto.

I outlined one model in my piece Ethics overboard: How to promote integrity in the moment of choice (webdiary14Jan):

What I’m thinking of is framework legislation, to cover all jobs with ethical duties. It could require all professions to have an ethical oversight body comprised of a chairperson and directors agreed to by consensus between the profession’s leaders and consumer groups, and if consensus cannot be reached, by election. Membership of the professional body would be compulsory to work, and members of the oversight body would have legal protection against defamation and the like.

The group or individuals on it would give advisory opinions to members in a bind. These would be regularly published in a pro-forma way. If a professional accidentally breached an ethical duty, apologies could be lodged, and published. The body would look at complaints it judged worthy of consideration or those it found out about independently, in open session. It would seek the views of members. It would publish reasons.

Except for extremely serious matters, like a psychiatrist sleeping with a patient, there would be no penalty or a reprimand on proof of a first breach. What I’d be looking for is an ongoing conversation, a genuine engagement, for the profession, not a penal system. Because the system is not penal, the person under investigation would be required to speak for him or herself.

In his first piece for Webdiary, Harry Heidelberg detailed an horrific example of the laxness of many professional bodies these days:

Don’t believe existing bodies when they say they have it covered. I belong to one which has a members ethical counselling service. A mate of mine went to them in dire need of advice earlier this year and they were hopeless. They offered no help at all. The whole thing is window dressing crap. When you really need them, they won’t be there for you.

This mate of mine had to resign from his job to get out of his ethical dilemma and endure three months of frightening unemployment. Some people may treat this lightly but I think it is outrageous that a well known professional body has a so-called ethical counselling service that failed so abysmally. Sure, it may be an isolated case but it should never happen. In the case of my mate it was serious stuff. His employer was on the verge of bankruptcy and hadn’t paid “group tax” (ie the pay as you earn tax deducted from employees) in nearly a year. No one cared for him. He’s a good guy and no one cared or listened. He could only trash himself to survive and sleep at night. From My ethics, Harry10Sep2002.

Harry’s example was replicated during HIH. The Herald’s Elizabeth Sexton laid bare the inaction of the accountants’ professional body and the collapse of peer group pressure as a means of ensuring ethical pressure in a great piece in Saturday’s paper called Unheard voices of warning at HIH. I’ve republished her piece at the end of this entry. (Conflict of interest, the most basic professional no-no, is now broken at will by directors and professionals, as the HIH inquiry shows. crikey.com.au’s editor Stephen Mayne lists the worst of them, together with other corporate examples, in his list of ‘conflicted service providers’ at crikey.)

After Liz Sexton’s piece, a brilliant expose of the culpability of Peter Costello for the APRA mess and a compelling case why either he or the APRA board he appointed should resign or be sacked. Christopher Sheil’s piece, which appeared in the Australian Financial Review last Friday, also makes the old point governments never remember – if you want to deregulate markets you’ve got to have very tough, very well resourced regulators to keep the players honest. “Light touch” regulation in a deregulated environment always ends in tears. Always.

As Webdiarist Jozef Imrich writes:

What we’re dealing with here is not a shortage of regulation, but rather a deficit of morality and ethics in the rooms of the corporate executives. We have laws in place that require full and honest disclosure of assets and liabilities. These executives chose to either bend or break those laws, and they should be paying a heavy price for it.

The scandal has helped to show us once again that not only is government regulation necessary, but stronger government oversight is a must.

I suspect that those with high ethical standards who get appointed to the positions of government oversight bodies will ultimately prove most fruitful to the public interest. Each nation needs characters who are above the board, literally and metaphorically. Experienced and fearless operators, like former NSW auditor Tony Harris, ought to be placed in a position of power where they can enforce stronger government oversight.

I bet my life on the fact that people dedicated to public service would make CEOs responsible and liable for the accuracy of the financial statements of their company.

Without a stronger government oversight, the prosecution will continue to kick in only after we have caught corporate executives doing something wrong.

If there’s any justice in politics, Costello should be nailed on this one. A mea culpa is the least he can do. That, and a bloody good Costello blueprint for nailing the culprits and cleaning up the supervision of ethics in our professions.

Harry advises that the annual general meeting of the Davos forum will be on the topic “Building trust’. The preamble: “During the past year trust has broken down throughout society. The Annual Meeting will provide a platform for leaders to address the challenge of restoring confidence and building trust.” The meeting begins on January 23 in Davos, Switzerland. For details, and “trust survey results” go to weforum.

***

Unheard voices of warning at HIH

by Elizabeth Sexton, SMH, 20/01/2003

“When Jeff Simpson was wrestling with his conscience in mid-2000, three of his mates in the insurance industry were worried about him. “Their continual advice to me was ‘Be careful, Simmo, are you sure you know what you are doing?’,” he says.

Mr Simpson, who had resigned from his job as a middle-ranking accountant at HIH a year earlier, was considering alerting the Australian Prudential Regulation Authority to some of HIH’s dodgy financial habits.

His friends, also ex-HIH, were not anxious about the strength of his case, but they suggested he use rubber gloves to post the document to APRA. “I didn’t think they were joking,” Mr Simpson told the HIH Royal Commission 10 days ago.

Still, he found the nerve to contact APRA, although unfortunately the regulators could not see what was staring them in the face. At least he tried.

The commission has revealed other similar episodes in the sorry history of HIH and FAI that were capable of restoring our faith in human nature, but they can probably be counted on the fingers of one hand.

An overwhelming impression from last week’s closing submissions is the number of people who knew the place was rotten but did not tell. In a sense, their stories are more disturbing than the much shorter list of those accused of premeditated fraud.

How did a series of otherwise honest Sydneysiders working in two of the least glamorous fields imaginable – insurance and accounting – end up with their faces on the front pages and their names on lists of potential targets for court action?

The short answer is that they turned a blind eye.

It’s not hard to imagine why. With mortgages and school fees to pay, it is a big call to stick your neck out against your employer.

Despite his initial approach to APRA, Mr Simpson eventually got cold feet. He was worried that he was “perhaps in breach of confidentiality if I went further with this sort of thing or it would upset too many people or it might mean somebody trying to sue me”.

It is hard to criticise him for being discouraged, though, given APRA’s reaction and what he described as a “don’t go there” response from the Institute of Chartered Accountants the previous year. (In a black twist, the person the institute nominated to listen to Mr Simpson’s story in 1999 was named in the closing submissions as a central player in an accounting fraud in 1998.)

The potential for financial pressure to stop people rocking the boat did not apply only to employees. The commission heard that an “unhealthy” 50 to 80 per cent of the fee income of external actuary David Slee came from HIH. For the accounting firm Arthur Andersen, HIH was the biggest single Sydney audit client.

A counsel assisting, Richard White, SC, said this week the willingness of the auditors to call things as they saw them was compromised by constant pressure on the audit division from other parts of the firm to lift “underperformance” when it came to profit contribution.

There was extensive evidence that both the actuary and the auditors were well aware of HIH’s parlous state.

Mr White criticised Mr Slee this week for “optimistic assumptions and inadequate methodologies” in assessing how much money HIH needed to set aside to meet future policyholder claims. But, though his analysis was allegedly weak, Mr Slee was still alarmed and his reports to the board carried increasingly strident warnings of the dire risks facing the company. What a pity none of the non-executive directors ever read them.

The commission also unearthed a 2000 e-mail from an employee of the Australian Government Actuary to an APRA staff member, reporting Mr Slee had told him that, if Canberra made the insurance regulations tougher, it would “blow his major client out of the water”.

The audit certificate included in the HIH annual report was signed for five years running by an Andersen partner, Alan Davies. In early 1999, he told directors he would qualify his “true and fair” declaration if HIH did not change its ways.

Concerned by an utterly blank response, he arranged a lunch meeting with two non-executive directors. One of them, Neville Head, told the commission about the “angry” reaction from HIH’s chief executive, Ray Williams, that the meeting took place without his knowledge, which included the comment that “there appear to be people working against me”.

Andersen quietly shifted Mr Davies off the HIH account a few months later. Overall, the auditors failed in their duty to scrutinise the integrity of the published accounts, a counsel assisting, Wayne Martin, QC, said on Monday. “In virtually every instance of controversy, (Andersen) ultimately yielded to management’s view of the accounting treatment to be adopted, which invariably had the effect of overstating profitability and understating liabilities,” Mr Martin said.

Mr Martin described the evidence given about the reasons for shifting Mr Davies as “tortuous”, but concluded that it appeared linked to Mr Williams’ reaction to the lunch. Mr Williams did not go so far as changing audit firms, however. That would have been very much out of character for a man who counted his business relationships in decades.

Mr Slee first dealt with Mr Williams in 1970 and started as HIH actuary in 1980. Andersen audited HIH’s books continuously from 1971. Three of its former audit partners accepted invitations to join the HIH board. One of them, Geoff Cohen, chaired HIH from its 1992 stockmarket float until its March 2001 collapse. Sydney QC Bob Stitt, who served the same board term, had appeared regularly as the company’s barrister since 1971.

Loyalty was the highest praise Mr Williams could bestow on staff. Those who understood “the Heath Way” (HIH originally stood for Heath International Holdings) and stuck around could expect some of the lavish treatment for which HIH is now infamous.

Putting off confronting an unpleasant truth might be an understandable human trait, but, in the case of HIH, it made the final outcome much worse than it needed to be.”

***

Competition push needs safeguards

by Christopher Sheil, AFR, 17/01/2003

Christopher Sheil is a visiting fellow in the School of History, UNSW

The HIH debacle has lessons for the structure of other regulators, as Christopher Sheil explains.

Only the federal Treasurer, Peter Costello, can save the board of the Australian Prudential Regulation Authority.

The fallout from the HIH Royal Commission may also set back the Howard government’s plans for a national electricity lawmaker, and should trigger a basic rethink of prevailing approaches to regulation.

But before we jump ahead, let’s look at APRA. Under the authority’s legislation, the board has the responsibility for determining APRA’s policies (“including goals, priorities, strategies and administrative policies”) and for ensuring the body’s functions are performed “properly, efficiently and effectively”.

In light of this charter, the survival of the board beggars belief, given that the senior counsel assisting the royal commission has not only charged that APRA “missed every one of the available opportunities to identify and react to the looming financial problems of the HIH group”. He has also claimed that the body “lacked the resources and the requisite culture to undertake any effective form of regulation” and “wasn’t well served by its senior officers”.

With criticisms as sweeping as the board’s responsibilities are broad, even in the event that the royal commission’s final report proves half as damning, APRA’s bosses should still be well on their way.

Of course, Costello can save the board, by taking the responsibility for APRA’s failure and resigning himself. Fat chance. Yet there is a case to be made. After all, APRA is wholly Costello’s creation.

The Treasurer established the now beleaguered regulator in 1998, following the recommendations of the financial system inquiry (the Wallis inquiry) he instigated in June 1996.

The Wallis inquiry’s main thrust was to separate the Reserve Bank of Australia’s responsibility for economic policy from the task of supervising bank prudential standards, which was devolved and amalgamated with other supervisory responsibilities including responsibility for insurance funds within the new APRA.

Back then, Costello boasted that his new competition-based supervisory system would cut costs by reducing regulation in favour of a level national playing field, thereby inducing investment and benefiting consumers.

The whole system, he frequently puffed, was “leading edge in world terms”.

How far away those heady 1998 days seem. This week, counsel assisting the royal commission observed that in “hindsight, there was never any realistic prospect that [APRA] would adequately perform its regulatory responsibilities with respect to HIH”. This week, Costello hasn’t uttered a word.

More broadly, the APRA debacle also spells trouble for the long-mooted national electricity regulatory authority, which is one of the Howard government’s headline objectives for 2003.

As with the Treasurer before him, Industry Minister Ian Macfarlane has been trumpeting the case for the national regulator, promising benefits from separating policy from regulatory responsibilities and by “reducing government intervention and control” in favour of enhanced competition on a level national playing field.

Macfarlane is already puffing about the way his proposed national regulatory scheme will pronounce Australia “open for business”.

And just like Costello and the financial sector, Macfarlane is in grave danger of overlooking the distinctive features of electricity markets, which mean that increased competition will always demand more, not less, supervision.

The need for more regulation under conditions of intensified competition follows from two ready observations. The first is that electricity like compulsory insurance products contains many public goods and essential service characteristics, in addition to embodying natural monopoly elements.

These market characteristics are quite remote from the abstract model of perfect competition that underpins the assumptions upon which Costello’s past and Macfarlane’s envisaged regulatory reforms are based.

Most pertinently, when public goods, or monopoly, or near-monopoly features are present, governments can never escape the consequences of major market failures, as the HIH collapse amply demonstrates.

In turn, this automatically means that, unless governments flagrantly wish to widen their exposure to market failure, measures to increase competition in these kinds of industries must always be accompanied by more regulation.

This insight is scarcely novel. Unlike Australia’s economic rationalists, Adam Smith knew that regulations designed to protect the public interest always have to be strengthened with increased competition, for this will always oblige businessmen to “be more liberal in their dealings with their customers, lest their rivals should carry them away”.