Dr Neil Béchervaise

NB Consulting (Australasia) Pty Ltd

Corporate governance, managerial malfeasance and incentive compensation schemes: The case of HIH Insurance in Australia

The Global Business & Finance Research Conference, London, England

14-18 July, 2003

Dr Scott Bourke
and
Dr Neil E. BŽchervaise
Adjunct Professor
Australian Graduate School of Entrepreneurship
Swinburne University of Technology

Dr Scott Bourke is a Director and Principal of the consulting firm, Cree & Bourke Associates Consulting. A lawyer, organisational consultant and corporate adviser, his doctoral research examines power relationships and the role of communication in transformational change.

Key Words: Corporate governance, managerial compensation, management, shareholder risk, malfeasance Corporate governance , managerial malfeasance and incentive compensation schemes.

Abstract

Recent US and Australian corporate performance failures provide some evidence of managerial malfeasance. One possible motivation for managerial malfeasance derives from incentive based compensation contracts. However, the alignment of shareholder and managerial returns is a pillar of the Anglo-American model of corporate governance under which, it is argued, board monitoring and incentive compensation arrangements are the primary methods of reducing the potential for excessive managerial risk taking and malfeasance.

Doubts have been increasingly sounded in the literature about the theoretical and empirical validity of incentive compensation arrangements and their capacity to align shareholder and managerial returns. Dramatic corporate failures and substantial pay-outs to departing executives, apparently regardless of performance, have further fueled the debate in the popular media and among minor-shareholder lobby groups.

Nevertheless, current proposals for reform of the Anglo-American based Australian corporate governance regime continues to focus almost exclusively on monitoring mechanisms, righteous indignation demands for increasingly punitive action against perceived perpetrators of the malfeasance. Scant consideration has yet been given to improving the transparency of corporate governance mechanisms such as incentive compensation schemes.

This paper argues that the paradigm-perpetuated hegemony of the Anglo-American model and the laissez faire approach to the structuring of managerial incentive compensation contracts derives from a normative pragmatism that stems from the dominance of market-based economic theory. To transcend normative pragmatism, it is argued, requires much more than increasing transparency.

Introduction

Corporate governance is a "system by which corporations are directed and controlledÓ (OECD 2000). A corporate governance regime should be designed to legally and commercially regulate, inter alia, the activities of an organization's managers to preclude acts of malfeasance. Where malfeasance occurs, it becomes important to consider the contribution of both systemic and corporate level factors to better understand the reason for the failure. Where corporate collapses show signs of commonality and pervasiveness, as they have, for example, in the United States and Australia recently, it increases the likelihood that a country's corporate governance regime should share a greater proportion of the blame.

Following on from the spate high profile corporate performance failures post Enron in both Australia and the United States (USA), recommendations for reform of the existing corporate governance systems have been quite narrow in their focus. They have largely concentrated on issues of transparency and monitoring. Examples include calls for greater general commercial and financial information through regulated disclosure, increasing board independence, increasing audit independence and mandating improvements in audit standards.

What is more interesting, even perplexing, is the possibility that managerial compensation arrangements have compromised or undermined the governance of the firms in question. This possibility appears to have been given scant attention, which is surprising given the reality that Òorganizations are simply legal fictions, which serve as a nexus for a set of contracting relationships among individualsÓ (Jensen and Meckling, 1976:p305).

This paper proposes that a predominant organisational conflict of interest - between shareholders and management - and the way it has traditionally been addressed in Australia and the USA, particularly, through incentive compensation schemes should be a primary issue of concern in any corporate governance discussion.

The paper argues that, despite its contrary intentions, the Anglo-American model of corporate governance, in seeking to align managerial and shareholder interests (Jensen & Meckling, 1976) legitimises incentive compensation arrangements that may not, and possibly cannot, promote effective governance in the best interest of all stakeholders. Further, the complex and often unpublished structuring of these compensation arrangements provide the opportunity and, in the face of declining shareholder value, even the encouragement for senior executives to engage in malfeasance. In turbulent economic periods, senior executives may be motivated to create the illusion of performance through a variety of unethical, unprincipled, legally questionable and even overtly illegal means to maintain their own vested interests.

The financial collapse in March 2001 of HIH Insurance Limited (HIH), a major Australian public company, provides a preliminary case study for discussion of this argument. Rather than casting HIH, et al, as isolated examples of managerial corruption and errant behaviour by senior executives, however, this paper proposes recent corporate performance failures like HIH and Enron as symptomatic of a much deeper and more fundamental crisis in the Anglo-American model of corporate governance. The argument is developed in five sections.

Initially, the paper outlines the facts and circumstances surrounding the collapse of HIH Insurance Limited, which is proving to be the equivalent for Australian corporate governance that Enron was for the United States (US). The thesis is proposed that the corporate governance failure at HIH, in which managerial malfeasance has been identified as a significant driver, was the real or principal reason - though not the only one - for the company collapse.

Following Zingales (2000), the paper then explores the essential relationship that exists between the Anglo-American model and the economic theory of managerial-incentive-based compensation schemes that derive from Jensen & Meckling's (1976) theory of the firm and agency theory (Fama & Jensen 1983). From this basis, managerial malfeasance is identified as a consequence of the misalignment of managerial and shareholder interests.

A review of emerging literature supporting the economic theories of managerial incentive compensation highlights the theoretical limitations and lack of empirical validity associated with such schemes and this analysis is used to contest the integrity of proposed reforms to the existing Australian corporate governance regime.

In closing, following Turnbull (2000), the paper invokes the sociological perspectives of Kuhn (1970) and critiques deriving from a market based ideology (Lazonick and O'Sullivan 2001) to explain the resilience of the Anglo-American model in the face of mounting evidence w

The collapse of HIH Insurance Limited (HIH)

HIH Insurance Limited was the principle holding company for an Australian based insurance services group that was, up until its financial collapse and insolvency in March 2001, Australia's second largest general insurance provider. The $AUD5.3b collapse of HIH , which actually predated Enron's bankruptcy in the USA by more than six months, sent shockwaves through the Australian business community.

A Royal Commission was established to inquire into and investigate the factors that caused the failure of HIH. Its findings summarised the immediate consequences of the collapse of the HIH as Òprofound in terms of the hardship which [it] occasioned to policyholders and others affected by [it]. The repercussions of the collapse are continuing and will likely continue for some years to comeÓ .

The business history and chronology of events leading up to the insolvency of HIH are well documented in material posted to the website of the HIH Royal Commission and, notwithstanding that the findings of the Commission have yet to be handed down, the final submissions of the counsel assisting, Wayne Martin QC, are as comprehensive and objective an assessment of the circumstances that led to the collapse of HIH as are presently available. Among others, they include:

a. Reason/s for the HIH collapse

Large-scale corporate collapses are almost invariably complex affairs to analyse for a wide variety of reasons including the availability of widely accepted accounts of those events leading up to the collapse. Conflicting witness accounts and the availability of crucial evidence are practical manifestations of this problem. In consequence, it is problematic to attempt to draw strong conclusions on the specific acts or acts that caused the particular collapse under consideration.

More generic or tentative conclusions, unhelpful as they often are, tend to be more common. And so it is with HIH. Royal Commission counsel, Wayne Martin QC's overall conclusion was Òclear beyond all argumentÓ that HIH failed as an insurer because it Òconsistently provided cover to policyholders in return for premiums which were not properly priced to cover the risks being assumedÓ. HIH through its Board and management operated on, Martin asserts, the basis of Òa fundamentally flawed business methodologyÓ.

As Martin goes on to acknowledge, there is nothing revelatory in this assessment. With some variation, most businesses fail because they can't generate a profit: it is in many respects a statement of the obvious. Clearly of greater interest are the circumstances surrounding the myriad decisions that led HIH's management and Board to negligently underestimate and underprice the insurance risks they were creating exposure to.

In addition to this "under-provisioning", Martin identifies three other aspects of HIH's business that contributed substantively to its failure. They were the Òunprofitably of the group's business in the United Kingdom É the un-profitability of the group's business in the United States and É HIH's acquisition of FAI Insurance LimitedÓ.

Martin then highlights the importance of corporate governance at HIH and, it is argued, in any large public corporation, as fundamental to reducing the Òthe likelihood of collapseÓ. Those governance mechanisms include the Òsenior management, the board of directors, the auditors, the professional advisors in the form of actuaries, lawyers and financial advisors, and the prudential regulatorÓ.

This paper focuses only on the governance failures of senior management whom, Martin concludes (a) intentionally Òmisled and lied to the company's auditors from time to timeÓ, (b) engaged in acts of Òcorporate expenditure and executive self-indulgenceÓ that were imprudent if not self-interested and (c) engaged in accounting, audit and reinsurance practices that suggest substantial breaches of the law.

In common with the case of Enron, Martin's findings suggest HIH's management engaged in intentional and systematic under-provisioning of the group's liabilities with the objective of overstating the listed entity's reported profitability and its net asset position.

Although, as noted earlier, the Royal Commission has not yet handed down its findings, Martin's preliminary submissions identify corporate governance failure as the primary cause of HIH's collapse. The various governance failures he chronicles in detail made it possible for senior executives to develop Òa fundamentally flawed business modelÓ and then perpetuate the myth of success and performance from the business model through malfeasance.

b. Senior executive compensation and its relationship to the financial performance of HIH

In the context of incentive compensation schemes and their alignment of shareholder and managerial interests, the circumstances of HIH's managerial compensation arrangements and its financial performance warrant examination in relation to its collapse. Over the course of the financial period 1995 - 2000, HIH's official consolidated group financial statements showed profitability (before extra-ordinary items) as ranging from approximately $AUD50-90m per annum. In the following year, HIH declared one of the largest losses in Australian corporate history at the time of $AUD5.3b. Martin observes that HIH's official financial accounts substantially overstated the profitability and net asset position of the company over the period.

Against this background, the history, quantum and structure of senior executive remuneration arrangements at HIH appear incongruous. In 1992, as HIH was about to become a listed public company, then Managing Director Mr Ray Williams received a $4.7 million lump-sum payment authorised by the Board. In submissions to the Royal Commission, Mr Williams testified that this payment was designed to compensate him for an unexpected fall in his salary package after the company floated. In other evidence tendered to the Commission, it was revealed that in 1995 a $1 million 'golden hello' payment was made to a new finance director Mr Dominic Fodera.

Although the precise terms of contractual incentive compensation arrangements have not been revealed, it is clear that over the period 1995-2000 and before, Mr Williams, Mr Fedora and other senior executives and directors of HIH received significant 'at-risk' bonus payments and other 'soft dollar' fringe benefits from the company in addition to the 'at-risk' payments, substantial 'no-risk' base compensation (salary and benefits) packages for both the directors and senior executives that were widely recognised to have been at the upper end of the range for comparable executive salaries.

Corporate governance, corporate failure and managerial malfeasance

The case of HIH, Enron and many of the other recent corporate collapses provides the strong suggestion that these executive remuneration schemes have generated significant misalignment between the interests of management and shareholders. It is this misalignment that carries with it the motive for excessive risk taking and malfeasance on the part of senior executives and directors. To the extent that governance reform does not address the need for a better understanding of these schemes, their rationale and their governance consequences, it will arguably not address the real cause of malfeasance based corporate governance failure that has led to the later corporate collapses.

The resolution of the conflicts of interest generally assumed to exist between management and shareholders (at least in economic theory) are the primary rationale for corporate governance. The foundational work of Bearle & Means (1932), the Theory of the Firm (Jensen & Meckling, 1976) and Agency Theory (Fama & Jensen, 1983), each acknowledge and deal with the issue of agency risk in the corporate context.

Collectively, these theories are pivotal to and provide the basis for the Anglo-American model (Zingales 2000). The later two theories actually mandate, inter alia, the adoption of incentive based compensation contracts to reduce the prospect of managements engaging in behaviour, both inappropriate risk taking and malfeasance, that is inconsistent with shareholder interests (Jensen & Meckling 1976, Fama & Jensen 1983, Eisenhardt 1989).

Turnbull (1993:p4) observed that Òno agreed definitions or boundaries for defining or investigating corporate governanceÓ have, as yet, been established. This is not altogether surprising; the concept of corporate governance has been established as determinedly social and cultural in character (eg Trompenaars and Hampden-Turner, 2002). Nevertheless, the term itself is relatively new to the commercial lexicon (Zingales 1997), though questions concerning issues of contemporary corporate governance have dated from Berle & Means (1932). The lack of consensus on a definition of corporate governance (Turnbull 2000) isn't surprising given the complexity of the phenomenon and the range of perspectives, economic through to sociological, from which it has been conceptualised. Economists tend to frame corporate governance narrowly as Òthe complex set of constraints that shape the ex post bargaining over the quasi rents generated in the course of a relationshipÓ (Zingales 2000). Other disciplines offer broader perspectives.

Turnbull (2000), by way of example, defines corporate governance as "the influences affecting the processes for appointing those who decide how operational control is exercised to produce goods and services and all external influences affecting operations or the controllers". The OECD has framed corporate governance as "the distribution of rights and responsibilities among different participants in the corporation, the board, managers, shareholders and other stakeholders" . Preferring the exhaustive process of international trans-disciplinary consultation leading to its formulation and efforts to reconcile disparate economic and sociological conceptions of corporate governance , this paper presumes the OECD definition.

It is acknowledged that corporations can fail for a variety of reasons ranging from honest but inept or negligent managerial decision-making to excessive risk taking and, les frequently, to circumstances beyond managerial control (Moldoveanu and Martin 2001, references). Malfeasance, in this context, becomes "a wrongful act that the actor had no right to do; improper and illegal professional misconduct" .

Following Moldoveanu and Martin (2001), this paper focuses on Òfailures of managerial integrity (lies, fabrications, embezzlement and self-dealing) that reveal Òwilful behaviours of the part of managersÓ that substantively adversely impact Òthe value of the firm's assetsÓ (Moldoveanu and Martin 2001: p2). HIH provides a case study example of insolvency that clearly falls within this definition. Enron is another.

The Anglo-American model and corporate failure

Across the juncture of the 20th and 21st centuries, comparative corporate governance research has become a substantial academic and governmental interest with culture being strongly identified as an explanatory mechanism for complex organisational behaviour (Turnbull 2000, Maruyama 1991, Morrison 1991 and Hampden-Turner and Trompenaars, 2002). Licht, Goldsmith and Shwartz (2001) provide further evidence of the importance of culture in a countries model of corporate governance. Culture alone, however, provides only limited access to the economic and sociological assumptions underpinning the corporate governance paradigms with which most large organisations are managed.

Over the course of the past forty years, a comparative body of academic research and thinking has constructed and defined three essentially distinct models of corporate governance: the Anglo-American or US model, the European or German model (JŸrgens, et al, 2000) and the Japanese model (Gilson 2000, Hamilton 2000). In the wake of HIH, Enron and other corporate collapses and failures such as Global Crossing, Tyco and WorldCom, the adequacy of the Anglo-American corporate governance regimes that operate in US, Australia and the UK (Turnbull 2000, Cheffins 2001, Hamilton 2000) has been called into question.

Investigations into these corporate collapses and other related scandals have resulted in recommendations for corporate governance reform in these countries that are broadly similar . They centre around improving corporate transparency through better disclosure, increasing board and auditor independence and generating uniformity of accounting standards (see for example McKinsey 2002).

The role of incentive compensation schemes as motivation for excessive risk taking and managerial malfeasance is in our opinion given inadequate attention both in the analyses of recent corporate failures and in these reform recommendations. Preliminary evidence from HIH, Enron and many of the other corporate collapses strongly suggests that managerial malfeasance was at least involved in a contributory capacity.

Once plausible motivation for managerial malfeasance stems from excessive incentive compensation schemes that exacerbate rather than reduce the misalignment of managerial and shareholders interests. These schemes often present the possibility of extra-ordinary compensation for senior executives and directors. It could be argued that these incentives provide the motivation to engage in malfeasance in circumstances where it is unlikely that, even through excessive but legal risk taking, it is not possible to achieve the performance hurdles required for the senior executives to receive their performance linked compensation.

At least in economic theories of the firm, conflicts of interest are presumed to exist between the interests of management and the 'providers of finance', which includes (references). It is the resolution of these 'agency' conflicts that represents the primary rationale for corporate governance under economic conceptions of the firm (Sheilfer & Vishny 1995).

Bearle & Means (1932), Jensen & Meckling (1976) and Fama & Jensen (1983) all acknowledge, either explicitly or implicitly, the issue of agency risk in firm level inter-relationships that arises through the separation of the firm's ownership and its management or control. Such concerns with the problems of agency probably date from Adam Smith. Collectively these theories are constitutive of the 'Anglo-American' model of corporate governance (Zingales 1997).

Agency theory (Fama & Jensen 1983, Eisenhardt 1985, Ross 1973) and its emphasis on the resolution of managerial / shareholder conflicts, is central to the modern Anglo-American conception of both the firm and firm governance. Agency theory recognises, even mandates, inter alia the adoption of incentive based compensation contracts as one mechanism to reduce the prospect of managements engaging in excessive risk taking and malfeasance, both of which are inconsistent with shareholder interests (Fama & Jensen 1983, Eishenhardt 1985, references). The other mechanism that reduces agency risk is monitoring (Eisenhardt 1989). The principal role of directors and other 'third party' agents such as auditors and accountants is to monitor the firm's management (references).

Establishing some key linkages

a. The Anglo-American model of corporate governance

'The Modern Corporation and Private Property' (Berle and Means, 1934) is generally accepted as providing the theoretical foundation underpinning the modern US centric conception of 'the firm as public corporation' (Milstein 2002, Hamilton 2000, Gilson 2000). In conjunction with Jensen and Meckling's Theory of the Firm (1976), and extended by Fama and Jensen's (1983) work on Agency Theory, Berle and Means (1934) basic theory on the separation of 'ownership and control' in firms continues to provide the foundation on which Anglo- American governance systems are based (Hamilton 2000, references). In fact, as Jensen & Meckling (1973) have pointed out, the general problem of agency cannot be dissociated from issues surrounding the Òseparation of ownership and controlÓ in the modern diffuse ownership corporation.

The Anglo-American model remains, as Berle & Means (1934) observed, an insider-out market based construct predicated on the absence of a dominant shareholder, in contrast to the European bank centred model (Turnbull 2000). At its simplest, the Anglo-American model is concerned with Òthe relationships among the professional managers of a publicly held corporation, its board of directors and its shareholdersÓ (Hamilton 2000). It reflects a collection of theories that are essentially economic in origin but legal in manifestation (Westphal and Zajac 1998).

The literature supports the view that the Anglo-American or Òoutsider/arm's-lengthÓ (Cheffins 2001) model reflects the corporate governance regime that regulates the US and Australian systems of commerce (Dunlop 1999, Hamilton 2000, Turnbull 2000). The OECD's analysis also supports this conclusion. The similarities between the US and Australian governance regimes are quite obvious. Australia's system of corporate governance is not unlike the US system in its basic structure: it Òconsists of a 'matrix' of legislation, accounting standards which have the force of law, Australian Stock Exchange (ASX) Listing Rules and voluntary self-regulatory codes of practiceÓ.

The fact that the Australian and US systems of corporate governance are quite similar is not surprising. As Cheffins (2001:p3) notes, Australian Òpolicymakers and academics have drawn upon work done in the US and the UK when they have analysed key corporate governance issues, such as the functioning of the board of directors and the structure of executive payÓ.

Leaving aside issues around the dispersion of share ownership (Cheffins 2001), there are compelling legal and capital market-based arguments to support the proposition that the Australian and US models or systems of corporate governance have common foundations. Our analysis of the Anglo-American model therefore has equal application in and relevance for both countries systems of governance.

b. Shareholder value, agency and the Anglo-American model

The economic 'theory of the firm' (Jensen & Meckling 1976) and its later variations and extensions (eg. Agency Theory cf. Fama & Jensen 1983, Jensen 1994) ascribes certain roles, rights, responsibilities and entitlements to inter alia the providers of equity capital, managers and the board of directors. We will deal with them and their firm level inter-relationships under these theories in that order.

Shareholders as providers of equity (as distinct from debt) capital are the firm's owners and enjoy a residual entitlement to the assets of firm (Jensen & Meckling 1976, Jensen and Smith 1985). Shareholders have a legally pre-eminent, but non-contractual, residual claim on the corporation's assets because they hold its equity. All other interested corporate stakeholders or constituencies in contrast have at best a limited contractual relationship with the corporation.

The need for managers and, in turn, for directorial boards arises primarily because of perceived legal risks associated with the separation of Òownership and controlÓ (Berle & Means 1932, Jensen and Smith 1985). An agency relationship arises in the corporate context between managers and (through the board) shareholders. The agency relationship is defined by Òa contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision-making authority to the agentÓ (Jensen & Meckling 1976).

Here shareholders (as principals) through a delegation to the board establish a contract that specifies the work to be undertaken by the managers (as agents) who then perform the contractually specified work (Eisenhardt 1985). Managers, as the agents of shareholders (who are the principals), are therefore charged with applying the assets of the corporation to further the exclusive interests of shareholders.

The main function of a board (and other third party agents on behalf of the board) is to monitor the firm's management to ensure that it complies with its contractual undertakings (references). The role of the board involves ratifying and monitoring the organization's decisions of the CEO and other senior executives and hiring, firing and compensating those same senior executives (Jensen and Smith 1985).

We have referred earlier to the centrality of agency conflicts in understanding corporate governance. In whose interest the board should act is a separate but related corporate governance issue (Zingales 1997). Under Australian statutory and common law, directors at all times must act and make decisions in the best interests of the corporation 'as a whole'. This means effectively that the board must act in the interests of shareholders and only in very limited circumstances (such as the verge of insolvency or bankruptcy) take account of the interests of other stakeholders (e.g. creditors in the insolvency example).

Under the economic theory of the firm, it is clear that the board's role is to act in the exclusive best interests of shareholders (Zingales 1997, Hamilton 2000). It follows therefore that a fundamental principle of the corporate agency relationship must be that the agent (management) should at all times act in the best interests of the principle (shareholders) (Fama and Jensen 1983, Jensen and Smith 1985).

c. Agency, Incentives and the Anglo-American model

In all agency situations, there are Ògood reason(s) to believe that the agent will not always act in the best interests of the principalÓ (Jensen & Meckling 1976). The problems of agency and corporate governance overlap here because managers will not act in the best interests of shareholders unless the governance system motivates them to do so through its system of rewards (references, Zingales 1997, Aglietta, 2000).

Under situations involving incomplete information and uncertainty concerning future events and outcomes, two primary agency problems are posed: moral hazard and adverse selection (Eisehhardt 1989). Adverse selection refers to the problematic nature of agent recruitment and evaluation: how the principal can assess the agent's competency to perform the assigned task. Moral hazard refers to the difficulty principal's face in ascertaining if their agent has applied maximum effort in furtherance of the contractual objective (Eisenhardt 1989).

The problem of adverse selection is addressed, to some extent, through diligence. Incentive compensation schemes, in addition to internal and external monitoring, have been proposed as a mechanism that can align shareholder and managerial interests and address the risk of moral hazard. On the premise that 'fixed-wage' contracts may not be the optimal method of aligning the divergent interests of principal and agent (Jensen & Meckling 1976), a significant literature has developed around the agent-based incentive compensation schemes and their capacity to serve this purpose (Prendergast 1999, Murphy 1999, Mehran 1995). Incentive compensation schemes are in theory designed to induce and motivate the agent to act in the best interests of the principal and overcome the problems of agent self-interest (Fama and Jensen 1983). The term encompasses a fairly broad range of incentive mechanisms including Òpiece rates, options, discretionary bonuses, promotions, profit sharing, efficiency wages and deferred compensationÓ (Prendergast 1999).

Testing the economic theory of managerial incentives

Considerable reliance is placed on agency theory to explain how incentive compensation schemes should work, and vice-versa, to achieve alignment between managerial and shareholder interests (Abowd and Kaplan 1999). It is therefore not surprising that the role of incentive compensation schemes in aligning managerial and shareholder interests has been the focus of extensive academic research and commentary in economics (Abowd and Kaplan 1999, Murphy 1999, Prendergast 1999, Mehran 1995) and organisational science (Westphal and Zajac 1998, Milstein 2002).

Studies frequently cited as in support of the proposition that incentive compensation schemes align shareholder and managerial interests include Jensen and Murphy (1990), Aggrawal and Samwick (1999) and Hall & Liebman (1998).

Jensen and Murphy (1990) assessed salaries and bonuses against corporate performance for 2,505 CEOs in 1,400 US public corporations over the period 1974-1988. In framing their conclusions as being at odds with the conventional wisdom regarding CEO compensation prevalent at the time, Jensen and Murphy (1990) observed that CEO compensation did not reflect changes in corporate performance. However, they did add the limitation to their findings that the independence of pay and performance was a function of the absence of aggressive 'pay for performance' systems in the surveyed corporations.

In contrast, Hall and Liebman (1997), employing a 15-year panel data set of CEO compensation in large US public firms and a variety of pay-to-performance measures that includes changes in the value of CEO stock and stock option holdings, found that CEO compensation was highly responsive to firm performance.

Introducing an alternative variable, Aggrawal and Samwick (1999) seek to explain the failure of previous studies to find convincing evidence of a relationship between high-powered incentives and relative performance evaluation by reference to strategic interactions between firms. Their results suggest evidence that CEO compensation tends to be responsive to rival firm performance and to increase with increasing competition in the firm's industry sector.

A weak relationship between managerial compensation and shareholder performance includes Core, Guay and Larcker (2002), Talmor and Wallace 2001, Elayan, Lau & Meyer (2001), Abowd and Kaplan (1999), Himmelberg and Hubbard (2002) and Andjelkovic, Boyle and McNoe (2001).

Analysing cross-sectional variation in New Zealand executive compensation during the first year of public disclosure Andjelkovic, Boyle and McNoe (2001) find no evidence of a positive relationship between pay and performance, regardless of firm size, risk, leverage or board structure. Himmelberg and Hubbard (2002) observe that the empirical evidence supporting relative performance evaluation is at best mixed. Citing Antle and Smith (1986) and Bertrand and Mullainthan (1999) they suggest the empirical research is consistent with CEOs being rewarded for luck and that Òthe rise in CEO compensation in the aggregate good times is evidence of pure rent extractionÓ (Himmelberg and Hubbard 2002:p1).

In the face of this, at best inconclusive display of empirical evidence, it is difficult to substantiate an argument in favour of incentive compensation schemes linking managerial and shareholder returns. In fact, the weight of empirical research appears to support the opposite conclusion. The position is best summarised, perhaps, by Westphal and Zajac (1998), Òresearch on executive compensation has led many observers to conclude that traditional management incentive practices are inadequate to reduce agency costs significantlyÓ.

Researchers and commentators have established a wide range of explanations for the lack of evident linkage between organisational performance and managerial incentives. These range from concerns with the limitations of agency theory (eg. Hall and Liebman 1997, Westphal and Zajac 1998, Abowd and Kaplan 1999) to proposals for alternative theories of corporate agency (eg. stewardship theory cf. Donaldson & Davis 1991). For example, the concern exists that agency theory does not deal effectively with risk and, in particular, the risk aversion of CEOs (Hall & Leibman 1997), the 'risk paradox' in this context arising from: the economic and behavioral literatures on executive compensation [which] suggest that, ceteris paribus,

chief executive officers will prefer a pay package with a small pay-for-performance component (Zajac and Westphal, 1994). From a normative agency theory perspective, CEOs, as risk-averse agents, prefer less risk in their compensation contracts (Harris and Raviv, 1979), and incentives add uncertainty to a CEO's compensation (Beatty and Zajac, 1994). Westphal and Zajac (1998:p2)

Proposals for corporate governance reform in Anglo-American regimes

The Australian community should not be asked to bear any significant risk of repetition of a collapse of this magnitude. No doubt this is the reason why the government appointed this Commission to inquire into the reasons for and circumstances surrounding that collapse so that steps can be taken to reduce the likelihood of a recurrence of those reasons or those circumstances.

Following the collapse of HIH in mid 2001, concern has heightened over the adequacy of the existing Australian corporate governance system and, in particular, its capacity to protect against a repetition of the HIH failure. In response to these concerns, the Commonwealth Government has signalled its intention to contemplate reforms similar in principle to those being considered in the US following the failure of Enron.

Key governance areas being examined as part of the reform agenda in Australia concentrate on matters of technical regulatory disclosure and increasing the independence of directors, auditors and investment bankers or 'agents of agents' as Turnbull (2000) refers to them . There is established doubt that incentive based compensation schemes can produce alignment between the interests of senior executives and shareholders. In this climate, the apparently increased incidence of excessive risk taking and even managerial malfeasance appears as a consequence of misalignment between shareholder interests and managerial self-interest when downward market pressures are applied. This raises a number of implications for reform of the Anglo-American model based governance regimes operational in the US and Australia.

It becomes clear that to reduce the risk of managerial malfeasance, governance reforms need to directly target - and desirably reduce - the extent of misalignment between managerial incentives and shareholder interests. The assumption that shareholder and managerial interests can be aligned through contractual arrangements is not only important to the validity of the Theory of the Firm and Agency Theory, it is also critical to the integrity of the Anglo-American model. The need for transparency in setting, tracking and, potentially, adjusting those arrangements is integral to the maintenance of effective corporate governance.

Full disclosure of senior executive contracts and the nature and structure of any incentive compensation schemes is pivotal to ensure that, ex ante, shareholders are aware of and can assess the risks of malfeasance that might arise through misalignment.

Media reporting on the rapid escalation in base rates and performance pay achieved by CEOs relative to ordinary employees (Ruthven 2003, Mintzberg et al 2002) exemplifies a significant historical shift in the public perception that corporations, directors, shareholders and corporate performance are beyond general comprehension. The extent of minority shareholder ownership since "The Gold Cadillac" supports an argument that the separation of interest between shareholders and management, upon which the theory of the firm (Jensen and Meckling 1976) is predicated and for which boards are responsible, has broken down.

Our analysis casts some doubt on the prospect that current proposals for reform of Anglo-American governance regimes can be expected to reduce the likelihood of managerial malfeasance on the scale of Enron and HIH recurring. The possibility that the Anglo-American model of corporate governance possesses an inherent 'self-correction' mechanism as Milstein (2002) has suggested, is difficult to support. To the contrary, the weight of logic and evidence favours the opposite conclusion.

As Turnbull (2000) has noted:

Even in Anglo countries with a well-developed system of property rights, law and regulatory agencies, major failures in corporate control frequently occur. These failures commonly occur with clean audit reports which has created an academic literature on the Òaudit expectation gapÓ (Guthrie 1992, Guthrie & Turnbull 1995, Walker 1991a, 1991b). As responses to major failures, committees of inquiry are established (Cadbury 1992, Bosch 1995) and codes of Òbest practiceÓ recommended as a political palliative and attempt to patch up an inherently flawed system. However, all such codes for unitary boards are Òmisguided, misleading and so misnamed.

Current proposals for governance reform seem to be attacking the symptoms (eg. audit malpractice) rather than the real cause (managerial malfeasance motivated by excessive compensation schemes) of corporate performance failures such as Enron and HIH. In consequence, it is highly unlikely that they can achieve the purpose for which they have been designed and were intended.

By way of international comparison, there is a view in the US that the Sarbanes-Oxley reforms have focused far too heavily on audit and independence issues, with too little emphasis on executive compensation. Warren Buffett, in his annual Berkshire Hathaway review for 2002, has pointed out the limitations of "independence" per se of directors and audit rules. He has called for directors with ownership interests, to renegotiate CEO compensation to make it more sensible.

The causes of recent problems such as Enron in the US have yet to be formally resolved in the US legal system. However, academic writers who attribute the Enron collapse primarily to independence and audit issues acknowledge that Enron's compensation policies focused employee attention on earnings and stock price, with a resultant short-term focus contributing to Enron's problems.

A major corporate governance case that has been recently formally resolved in the US legal system is the one brought by the US Securities & Exchange Commission against Albert Dunlap, the CEO, other executives and the auditors (Arthur Andersen) of Sunbeam. The SEC's case was that improper accounting techniques were used to inflate Sunbeam's earnings. The settlement states that Dunlap did not receive performance-based bonuses during the relevant period. However, it is worth noting that Dunlap once famously stated that "I'm a superstar in my field, much like Michael Jordan in basketball and Bruce Springsteen in rock 'n 'roll" to justify his apparently excessive compensation payments.

In Australia, pending the report of the HIH Royal Commission, the Federal Government has confirmed that it will enhance disclosure of executive remuneration and otherwise press on with its CLERP 9 reforms to address audit independence. However, the Federal Opposition has gone further, suggesting that tax deductibility should be denied to "excessive executive golden handshakes". The latter measure, if applied, would go some way to inhibiting excessive CEO compensation, and addressing ongoing concerns about the focus of these reforms. More recently, the board of AMP Insurance, having dismissed its CEO following a significant miscalculation involving British Insurer, Pearl, is risking a court challenge to limit his termination payment in efforts to contain shareholder anger and further decline in its stock value.

A way forward

Well-substantiated concerns with the fallibilities and theoretical weaknesses of the Anglo-American model of corporate governance and the economic-legalistic theories on which it is premised have been voiced variously since the 1930s. In the Australian context, Turnbull (2000) laments that,

faith by political ideologues in replicating the dominant, but flawed US governance model has so far been little inhibited by scholarly research, empirical evidence or the competitive success of other approaches (models). Turnbull (2000:p11)

The problematic nature of having recognition of these serious questions being addressed in a broader public debate around corporate governance reform in Australia is attributed to the problems of 'normal science'

This denial of reality can be explained by the observation of Kuhn in considering research into what he described as Ònormal scienceÓ. Kuhn (1970: 24) observed that this type of research does not "call forth new sorts of phenomena: indeed those that will not fit the box are often not seen at all. (Turnbull, 2000:p12)

Kuhn's concern with normative pragmatism in scientific inquiry was preceded by the somewhat similar concern of J M Keynes who had noted in his 'General Theory of Employment, Interest and Money' (1936) that Òworldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionallyÓ. To question the philosophical and ideological orthodoxy that applies in the context of the corporate governance debate is still to tread the path of greater resistance (Gupta, Pike, Roos & Burgman, 2003). Moreover, the Anglo-American model of governance, as has been previously noted, is inextricably tied to the hegemony of the market-based economic thinking (Lazonick and O'Sullivan 2001). To question the fallibility of the Anglo-American model of corporate governance is to risk calling into question the integrity of the market economy that is at the heart of our way of life.

So how do we move forward? Is it possible to overcome a normative pragmatism that maintains the uncritical acceptance and flawed reform of the Anglo-American model of governance in the US and Australia? How do we approach the reform of corporate governance in the wake of HIH and Enron?

Managerial and directorial transparency is clearly a necessary condition, though it has been shown as insufficient to overcome normative pragmatism in the past. Corporate performance failures of the 1980's brought changes to the corporate governance systems of Australia and the US that increased corporate disclosure (Turnbull 2001). Nevertheless, pervasive malfeasance recurred in the recessive period of the late 1990s.

The unchallenged assumptions that underpin the mental models of senior executives, directors, regulators and institutional investors in relation to the theory and practice of corporate governance need to be exposed, explored and opened up to the possibility of constructive contest and corrigibility. Few would regard such an exercise - with its unpalatable intention of reforming the Anglo-American model - as anything but a complex and problematic affair.

As Gilson observes in relation to the problematic nature of targeted solutions to inherently systemic, pervasive and interconnected problems:

A complementary system is difficult to change piecemeal; like leverage, complementarity has an ominous downside. When external economic changes counsel altering one institutional attribute, the change may cause the productivity of the entire system to decline dramatically because other attributes were selected to make good use of the now altered attribute. (Gilson, 2000:p9)

If, however, we are to produce a system of governance in Australia that we are confident will reduce the risk of future corporate collapses of the magnitude of HIH, a more expansive debate is required. This debate must involve a greater critical consideration of the role of incentive compensation schemes as a principle mechanism of corporate governance. Perhaps it must also include a reassessment of the risk levels accepted by shareholders, both in terms of their faith in corporate governance and of their expectation of return on investment.

Selected references

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Westphal, J.D. and Zajac, E.J. 1998. "Symbolic Management of Stockholders: Corporate Governance Reforms and Shareholder Reactions". Administrative Science Quarterly, Volume 43 at pp. 127-153.

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