Guest Blog – “The Cautionary Tale of HIH: ‘Independent’ Directors as Lemons”

The second stage conference for the book project critically comparing and assessing “Independent Directors in Asia” is hosted by co-editor A/Prof Dan Puchniak at the National University of Singapore Law Faculty over 26-27 February 2015. In addition to comprehensive reports from different countries in the region, including one co-authored by myself and Sydney Law School colleague Fady Aoun regarding Australia), the project will include a chapter comparing significant case studies from various jurisdictions, based on short (1000-word) contributions from experts in various jurisdictions. Below is the (unfootnoted) text of Mr Aoun’s contribution on a very significant corporate collapse in Australia in 2001.

Written by: Fady Aoun (Sydney Law School)
Much has been said and much ink has been spilled over the failure of HIH Insurance Ltd (‘HIH’) in 2001, arguably Australia’s worst corporate collapse. Billions of dollars of wealth were destroyed, some of HIH’s directors and senior management team were thrown into gaol, and there were enormous social and economic impacts on various stakeholders (especially employees) and HIH insurance policy holders. Justice Neville Owen’s three-volume Royal Commission report [2003] catalogued a cascading series of disastrous operational decisions, fraught business expansion, chronic under-provisioning, ineffective auditing and limp regulatory oversight. These problems were all caused, and compounded by, poor corporate governance structures. In this connection, the ‘shambling journey towards oblivion’, wrote Justice Owen, had deep roots.
Many used HIH’s demise as a clarion call to improve auditor independence, extend corporate liability to senior managers, and, of course, improve corporate governance. However, this brief case study merely draws attention to the endemic dysfunctionality of HIH’s board and, in particular, the inefficacy of its pusillanimous non-executive directors. Put bluntly, when viewed through the lens of effective corporate governance, the (notionally) majority ‘independent’ board of then Australia’s second largest insurer (but leading general insurance company) showed itself to be a ‘lemon’.
Yet it is illusory to say that the majority of the board was independent (in the sense used in this book). Closer examination exposes the truth. A snapshot of HIH’s board at 30 June 1999 reveals a board of 13 directors, five of whom were executive directors. Of the eight non-executive directors, the bulk were compromised: four — Charles Abbott, Rodney Adler, Geoffrey Cohen and Robert Stitt — were inside directors; and two — Justin Gardener and Michael Payne — could be charitably characterised as outside directors. Thus, there were only two independent non-executive directors: Alexander Gorrie and Neville Head. Justice Owen thought that these directors had met Derek Higgs’ criteria of ‘independence’, before noting that they had both resigned by the end of 1999.
Although HIH was then without independent directors until its collapse in 2001, Gorrie and Head’s efforts to improve corporate governance structures, as we will see, proved futile/ineffective. That HIH’s corporate culture ‘was inimical to sound management practices’ is undeniable. As the Royal Commission’s Report further explained:
The problematic aspects of the corporate culture of HIH — which led directly to the poor decision-making — can be summarised succinctly. There was blind faith in a leadership that was ill equipped for the task. There was insufficient ability and independence of mind in and associated with the organisation to see what had to be done and what had to be stopped or avoided. Risks were not properly identified and managed. Unpleasant information was hidden, filtered or sanitised. And there was a lack of sceptical questioning and analysis when and where it mattered.
This short quote not only encapsulates the serious flaws in management practices, but also highlights the anaemic contribution by the non-executive directors to HIH’s governance. These interconnected problems deserve further unpacking, for they reveal three major lessons that may be drawn from HIH’s failure.
Firstly, the dangers of a dictatorial CEO, coupled with a weak board, are apparent here. Ray Williams, described as a ‘dominant personality’ and unrivalled in terms of ‘authority and influence’, treated the company he co-founded as his personal fiefdom. He did not tolerate dissent. Moreover, even though Williams spearheaded a series of disastrous business decisions, some of which even lacked fundamental due diligence, he remained ‘unchallenged’.
A second and related problem was the ineffective monitoring by the board. Executive directors, and senior management, were not kept in check. To the contrary, the board appeared captured by senior management. The evidence strongly suggested that there never an instance where the board ‘rejected or materially changed’ management proposals. This was no doubt due to board’s reluctance to oppose such proposals, given that Williams sponsored them all. With the benefit of hindsight, Gorrie conceded that managerial pressure over board deliberations compromised its independence.
It is true there were instances where non-executive directors raised governance concerns. But those efforts were too little, too late. In two separate letters in May 1999, Gardener (to Williams) and Head (to Cohen) aired concerns about managerial control over board agenda and HIH’s corporate governance procedures (especially the adequacy of discussion over ‘critical issues’ and the quality of board papers) respectively. Neither Gardener’s or Head’s concerns, or suggested improvements, were taken seriously. They were not circulated at a formal board meeting, but rather were briefly canvassed at a specially convened meeting of non-executive directors called by Williams. The other non-executive directors (Head was abroad) predictably fell into line. Much responsibility for these corporate governance failures was sheeted home to Geoffrey Cohen, said to be an ‘ineffective chairman’. In particular, Justice Owen found that Cohen’s responsibility here was to ensure the board proper considered Gardener’s memo as well as to act on Head’s ‘astute and well-reasoned’ concerns.
The third lesson to be drawn from HIH’s failure relates to its poor business ethics, and its conflicts of interest management system. In short, there was no such system. Once more, the unfortunate star here is the chairman. (Cohen appears to have adopted a cavalier attitude to conflict of interest management. For instance, somewhat inexplicably, he denied a conflict of interest arose via his position as chairman of HIH audit committee and his personal consultancy agreement with Andersen.) Cohen was also singled out as having a special responsibility to ensure the identification, ventilation, and resolution of possible conflicts of interest. Cohen’s ‘abdication’ of responsibility in this respect, Justice Owen found, proved a ‘grave impediment to the proper functioning of the board’. But the Royal Commission was also careful to point out that the chairman was not solely to blame: ‘the board should have also ensured that proper procedures were in place’. The independent directors, in particular, shirked their responsibilities here.
While there was a ‘semblance of standard corporate governance mechanisms at work’, HIH’s failure is a stark reminder of the likely outcome the coupling of poor corporate governance structures with disastrous (mis)management. Even though HIH was fundamentally flawed on so many levels, the independent directors still ought to have done more.

Author: Luke Nottage

Prof Luke Nottage (BCA, LLB, PhD VUW, LLM LLD Kyoto) is founding co-director of the Australian Network for Japanese Law (ANJeL), Associate Director (Japan) of the Centre for Asian and Pacific Law at the University of Sydney (CAPLUS), and Professor of Comparative and Transnational Business Law at Sydney Law School. He specialises in international dispute resolution, foreign investment law, contract and consumer (product safety) law.