Striking the balance between damaging dissolute disclosures and close cryptic cover-ups is less a matter of legislating than of moral fibre. By Leon Gettler
“It’s no accident that we put strength of character first. Like any successful company, we must have directors who start with what is right, who do not have hidden agendas and who strive to make judgments about what is best for the company, and not about what is best for themselves or some other constituency.”
– Enron chief executive, Kenneth Lay
As chairman of the board and chief executive since 1986, Lay was expected to embody these principles and ensure that Enron did the same. History tells otherwise. Since he gave that address at a 1999 conference sponsored by the Centre for Business Ethics, the energy trader that was once America’s seventh-largest company has become its biggest bankruptcy; a mess of paper shuffling, false reporting and insider trading.
Thousands of Enron workers and shareholders lost their savings. But executives, including Lay, made sure they cashed in $US1.1 billion ($2.15 billion) in stock before the crash. Regulatory filings show that Lay sold about $US20 million of stock last August when he was told by Enron executive vice-president and whistleblower Sherron Watkins that the company’s off-balance-sheet activities threatened its survival. While he was selling, he was advising staff to hold on to stock. In an online forum last September, he spruiked the company’s shares as an incredible bargain.
Australia is not exempt from cover-ups and poor public information: there are suggestions that it may be worse here because of poor standards of disclosure compared to what some see as a more open framework in the United States. This is one reason why the collapse of HIH and the revelations now coming out of the royal commission have sent shock waves through the community.
At the time of going to press, the commission had heard evidence alleging that FAI had engaged in a sham reinsurance deal to inflate its profit before it was taken over by HIH in 1998. Justice Neville Owen has been told of the use of such terms as “renting the balance sheet”, “avoiding external awareness” and “this agreement is in the bottom drawer”. All choice terms that were aimed at hiding the truth about the balance sheet. More alarmingly, evidence has also emerged suggesting that the problems run deeper than HIH. During the hearing, a former executive of the reinsurer GeneralCologne Re named three other companies that he believed had negotiated sham arrangements. Their names were recorded but circulation of the list was restricted to commission staff and the Australian Prudential Regulation Authority.
The extraordinary events surrounding Enron and HIH go beyond business leaders’ personalities. They also reflect the failure of safeguards to protect investors and employees. Auditors, lawyers, directors, finance analysts, regulators, credit rating agencies, media and politicians have not escaped blame. But, reduced to its essence, these catastrophes were a question of character and human frailty, sometimes of Dostoyevskian proportions.
Disclosure is well and good. But as the ex-chief of the National Companies and Securities Commission, Henry Bosch, says, it also presents a moral dilemma for managers and executives hired to maximise profit and shareholder value. Now chairman of Transparency International, Bosch says: “A strong counter-influence stems from their desire for commercial confidentiality. They would all be aware that competitors are listening to what they tell the market. There is a tension in all companies about this. Indeed, it is in the interests of shareholders who wish to see their companies prosper that competitors not be given too much of a break. It is always necessary for companies to strike a balance.”
Concerns about transparency and disclosure in Australia continue to grow. When National Australia Bank announced the $3.6-billion HomeSide disaster, shareholders went for the jugular. A report by the US law firm Wachtell, Lipton, Rosen & Katz cleared NAB chief executive Frank Cicutto and other executives of any wrongdoing in relation to the losses. The bank put most of the blame on three HomeSide executives, who had since been fired. It also blamed external market forces such as falling US interest rates. But that did not stop one of its biggest shareholders describing the bank’s handling of the debacle as arrogant, particularly in the amount of information it released to the market.
The head of equities at Perpetual Investments, Peter Morgan, told The Australian Financial Review: “A prudent chairman would have gone round to the major shareholders and put it out there as to what was actually going on. Rather, we have again got this situation, which seems to be popular in Australia, where you treat shareholders with disdain.”
Looking back with wisdom
After every corporate disaster, everyone is wiser in hindsight. Whistleblowers are discouraged in most corporate cultures, and becoming a naysayer is never a great career move. Just two years ago, the then Enron treasurer, Jeffrey McMahon, found himself in trouble when he raised questions with chief executive Jeff Skilling about the propriety of some of the group’s partnerships. Here was the problem, he later told investigators: he could not represent Enron’s interests while he was negotiating a partnership agreement with his boss.
Still, there is nothing like a series of collapses to inspire the sort of soul-searching that was summed up by Commonwealth Bank chief executive David Murray earlier this year when he said boards of directors needed to have a conscience. “They have to ask themselves every day whether they are pursuing a standard of behavior that they would expect in ordinary life to be regarded as the best way of doing things. Across the totality of the business sector, we have to pick up our act; either in the way we behave or in the way the community perceives us.”
Murray had good reason to be concerned. Enron’s shockwaves have rattled the foundations of global markets. Stocks have fallen after rumors of dodgy accounting, sending companies around the world into damage control. Groups like Apple Computer, for instance, have adopted changes in their audit policies to prohibit their auditors from providing non-financial consulting services. This is to remove potential conflict of interest. The Danish brewer Carlsberg has replaced its chief financial officer to limit the damage from embarrassing insider trading. Denmark’s Financial Supervisory Authority was called in when Carlsberg’s shares dropped sharply after analysts were told that its 2002 earnings had been too optimistic.
None of this is surprising. Finance, accountancy and transparency are raw material for Wall Street, which is why investors always bail out of stocks at the first hint of impropriety or lack of disclosure.
There is evidence that many Australian companies are less than enthused about transparency and disclosure. A 1999 study by the Centre for Corporate Law and Securities Regulation at the University of Melbourne revealed that eight out of every nine companies queried by the Australian Stock Exchange over unusual share-price movements had to reveal previously undisclosed information to shareholders. The findings suggest that many companies are failing the Australian Stock Exchange rules for continuous disclosure. Even after being queried, some businesses seemed to have trouble answering the questions adequately or providing enough information. The businesses most often queried were the small telcos; miscellaneous industrials; high-technology and computer, and office services businesses; exploration companies; and health-care and biotechnology businesses. More than 80% of these had a market capitalisation of less than $100 million.
The findings highlighted shortcomings in the continuous-disclosure rules and fuelled suspicions that insider trading was going on. In 16% of cases, companies released pertinent information to the market in conjunction with their response. Most of the revelations concerned operations, divestments or acquisitions, and agreements.
Additional research from the centre shows that governance issues might reflect more systemic problems. One study found that Australia’s most powerful shareholders, the institutional investors, did not use their voting influence over some of the nation’s biggest companies. It showed that when institutions did flex their muscles, it was usually to throw their weight behind boards of directors. The centre’s director, Professor Ian Ramsay, said Australia’s framework for disclosure was sound. Still, there were alarming gaps.
Apart from non-disclosure, there was also a distinct lack of meaningful disclosure. Companies met requirements according to the letter but not to the spirit. Ramsay said many companies went through the motions of preparing disclosure statements without doing any meaningful analysis of their corporate governance and the issues that it raised. The centre found, for example, that 25% of companies did not discuss criteria for board membership or whether the chairman was executive or non-executive. A similar number did not reveal whether directors were able to obtain independent advice. It also found that 65% did not discuss procedures for reviewing the performance of managers and directors.
Ramsay said disclosure issues could create problems for the market and for business leaders of the future: “I wonder how long this can continue before we have a credibility problem. The evidence is mounting that we do have some endemic non-compliance, and it can’t go on.” He said Australia’s defamation laws presented another problem. In the US, the plaintiff has to show malice on the part of the person or organisation sued, providing the plaintiff is a public figure. There is no such test in Australia, and critics claim this restricts freedom of speech: “Defamation can affect the information that comes out of companies and what we say about companies. The US is more open because there is more critical scrutiny of companies.”
Apart from the regulatory issues, there are potential constraints on disclosure through the concentration of ownership and consolidation. Banks and fund managers are taking over financial planners, and investment houses cut deals while employing analysts who are supposed to provide independent scrutiny of those deals. The size and structure of the Australian economy means this is pronounced. Ramsay said: “We have big firms offering a multitude of services. Some of those services have disclosure as their core objective. We need to know whether there are any conflicts that will limit disclosure. Concentration offers efficiencies; but it is not always that conducive to open disclosure.”
These concerns need to be put in context. Australia is well regarded internationally for its transparency and corporate governance. Bosch points out that there is more disclosure now than in the 1980s. Bosch also believes that the Australian Stock Exchange requirements for continuous disclosure ensure that businesses can be more transparent here than in the US, where they are required to file reports only each quarter.
Ramsay suggests that the disclosure issue has made many business leaders defensive. At the heart of the problem lies a natural reluctance to admit a mistake. Former Telstra chief executive Frank Blount, in his book Managing In Australia, which he wrote with former Westpac chief Bob Joss, says: “Mistakes were really viewed as a sign of weakness, so they were never acknowledged.” Blount was referring to the lack of communication between managers and staff, but his words point to a conservatism that extends beyond the Australian workplace. It goes to the heart of the challenge to our management class. It is a question of character.
The character of integrity
by David James
Richard McCormick, chairman of the International Chamber of Commerce and a director of Wells Fargo bank, United Airlines and United Technologies, says that after the collapse of the B2B commodities company Enron in the United States, he will be a lot more careful. “I won’t accept that because I don’t understand something, it will be all right. I am not someone who has trouble speaking up, but I will, like many directors, be more vigilant.
“I cannot believe some of those things [in Enron] were allowed to occur. I have read many articles on it in The Wall Street Journal and the like, and I still can’t work out what exactly happened. But I do not think there is really a need for extra legislation; all directors are going to be a lot more careful.”
McCormick is wrestling with the problem that routinely besets assessments of character. Most observers thought Enron to be an exemplary company. Even The Economist gushed: “Spend long enough around top Enron people and you feel you are in the midst of some sort of evangelical cult. In a sense, you are. Mr Lay, with his ‘passion for markets’, is the cult’s guru. His disciples are Enron’s managers, an intelligent, aggressive group of youngish professionals, all of whom ‘get it’.”
After the collapse, the magazine adopted a very different tone, discovering a parallel between Lay and an earlier business villain who helped to provoke the regulatory surge of the 1930s. It said Samuel Insull had turned a modest energy company called Middle West Utilities into the hub of a vast financial empire made up of companies with interlocking boards. “His empire collapsed amid accusations of stock fraud and crooked accounting; congressional hearings followed, together with ringing promises that such a thing would never be allowed to happen again.”
It is a typical pattern. It is easy to assume that those who succeed do so with a reasonable level of integrity. Successful leaders may cut corners, but they are allowed more leeway because they see the world in a different way. Hence, the disillusionment when they fail, and the intense recriminations.
Ken Parry, associate professor at the Centre for the Study of Leadership at Victoria University in Wellington, says the relationship between leadership and integrity has been tested. Writing in The Heart and Soul of Leadership (the latest book in the AIM Management Today series), Parry cites a 1999 study by the centre of more than 1300 managers showing that when managers displayed “transformational” qualities (being a role model, inspiring and showing vision), or “developmental exchange” leadership traits (showing attention and providing constructive rewards), they were thought to have integrity. But, if they were concentrated on “corrective avoidance” methods (monitoring for errors, waiting until problems arose or being laissez faire), they were thought to have low integrity.
“Can we train for integrity?” asks Parry. “No. Can we test people for integrity prior to selection? No. What we can do is to train people to be better transformational leaders, confident that they will be perceived to be ethical by their troops.”
Parry says his research has shown that more than 6% of managers who are above average in leadership ability are perceived to be below average in integrity. “Approximately one in 20 people are aberrant self-promoters, a mild form of the organisational psychopath. The remainder act ethically.”
Ray Elliott, director of the Organisational Enhancement Consultancy, also in The Heart and Soul of Leadership, writes: “For all the weaknesses of our national identity, our national strength lies in our capacity to tolerate and generally embrace differences of character, ethnicity, race and religious belief.”
Elliott believes that if there is a “prevalent ideology” in Australia, it is secular humanism. This suggests that integrity in Australia is not considered to be exemplified by an unqualified commitment to moral principles. It is more likely to be expressed in terms of pluralistic tolerance and the pursuit of mutual self-interest. It is only when this turns into pure self-interest on the part of the leader that recriminations follow.
Enlightened self-interest is never likely to be sufficient. Being consistently ethical usually requires some form of sacrifice. Personal integrity differs from the pursuit of leadership quality in one important way. Unlike leadership ability, it is not relevant whether it is innate or learned. Integrity is a matter of free will; it is not seen to be something acquired or genetic. And that is finally the best lesson about leadership character: it is about personal choice, not something to be studied in a laboratory.