The sin of omission

It isn’t the thing you do, dear, Its the thing you leave undone — Margaret E. Sangster Greed and hubris are reliable suspects in determining the causes behind almost all corporate collapses.

It is an easy explanation to make and fits the assumption that we are all prone to human weakness. But as John Arbouw reports, the real crime may have more to do with the manner in which boards and management interact and the sin of omission.

The BBC television series Silent Witness features a coroner who keeps examining a corpse to search for evidence of a crime. The drama often revolves around the coroner rejecting obvious explanations and the determination to seek answers. The corporate coroners in the US and Australia face a similar task in determining the causes of recent corporate collapses or inappropriate corporate behaviour. The investigations into the collapse of One.Tel and HIH are current examples. The danger is that these investigations will draw only the obvious conclusion that a corporate crime has or has not been committed. If there is evidence of crime and people are charged, the tendency is for the case to be closed. What will not be immediately obvious is whether the recent corporate collapses are symptomatic of a deeper malaise in the manner in which boards and management operate. Recently, the chief financial officer of Harris Scarfe pleaded guilty to 30 fraud offences involving $22 million worth of false transactions over several years. In his defence he maintained that he was acting under instructions from the managing director and the executive chairman, both of whom deny the allegation.

The case is not one of theft, only deception. It appears that the auditors, the audit committee, the board and the managing director somehow allowed $22 million worth of transactions to go missing in action without anyone noticing. The One.Tel and HIH sagas thus far tell similar stories of a disconnect between management and the board. However, the emphasis in the investigations and certainly in the newspaper and television reporting of the corporate collapses is to establish the emotive link between victim (shareholders, creditors, employees) and the perpetrators (CEO, auditors, accountants and/or relevant directors). Corporate crime or wrongdoing is being reduced to a case of purse snatching. The blame game makes good reading or television, but does little towards finding a more comprehensive reason of what went wrong and how this can be prevented. There are accusations that the accounting profession is at fault. Critics say a true and fair picture of accounts complying with accounting standards is all very well – but what if this fails to give a true assessment of the financial health of the company?

It isn't only compliance with accounting standards that are being questioned. The Ramsay Report into auditor independence recommends the separation of auditing and consulting work. The Enron case is a classic example where the provision of both auditing and consulting work by the same firm creates problems. Ironically, the true and fair test of accounts originated in the early 1990s following the corporate cowboy abuses of the 1980s. The obvious conclusion is that no standard or corporate regulation will stop any individual determined to abuse the system. But are the standards or lack of them at fault or is it something else? Are we going to treat corporate crime in the same manner as crime in the community? Do we need more corporate cops and tougher laws, or is there something else that is wrong? What is becoming clear is that boards and directors are under huge pressure because they face a growing range of aggrieved groups and individuals who threaten to make them personally liable if things go wrong. At issue is the relationship of trust between boards and management and the over-reliance on boardroom solidarity to the point that there is not enough people asking the tough questions. It has long been accepted that corporate governance is not a tick-the-box exercise, but what about the financial affairs of the company?

Being a director should not have to be an act of faith in the goodwill and honesty of management or the accuracy of the financial reports presented. And this is not an issue restricted to large publicly listed companies. If there is a corporate corpse or patient on the gurney then somewhere along the line the board and individual directors haven't asked the right questions. It is bringing a new dimension to risk management. Keith Skinner, chief operating officer of Deloitte Australia, and Giam Swiegers, managing partner of Deloitte's Financial Advisory Services, have between them nearly 50 years of experience in insolvency and corporate restructuring. They have examined a number of corporate corpses over the years and looked at the evidence leading to failure and the conclusion is almost always the same: the particular board did not ask the right questions and ignored the red flag warning signals. "It is amazing how many times boards do not question on an ongoing basis whether the resources are sufficient to meet the strategy," says Skinner. "Management accounts are an historical record of what happened in the past, they do not tell you what you need to go forward.

"If I were a director, I would be looking for forward cash flows and forecast balance sheets and profit/loss cash flow and balance sheets that all match and are linked to the organisation's plans and strategies. One on it own doesn't tell you the whole picture ... a fatal mistake that is often made. "I have come across companies that have good looking P/L and cash flow but no forecast balance sheet. If you actually do one you will see from the sales and the collection of things that there are negative debtors." While Skinner doesn't say so, the above scenario is certainly reminiscent of what happened at One.Tel where the cash flow dried up because the company hadn't put a proper billing system in place. But who is to blame in those circumstances, the board for not asking for the right financial information or management for not providing it? While there is no question that it is the responsibility of management to provide the information, the failure to do so is not necessarily a corporate crime – but it is certainly a sin of omission.

It is like a schoolboy bringing home a report card he has prepared himself that shows that, although he has to work harder in some subjects, the overall picture looks good. The problem is that the report card only provides a selected happy snap of the situation. However, the parents are so relieved that on the basis of the report card things appear to be going well that they pat the child on the head and tell him to work harder. "I have been shocked by the number of times that I have seen boards operating without cash flow numbers that are linked to the P/L," says Giam Swiegers. He says it is the responsibility of the board and all directors to ensure that they are receiving the correct financial information. What both Skinner and Swiegers are saying is that the issue of insufficient financial information is a risk management issue that is the responsibility of the entire board. They maintain that while a board has various risk management strategies in place, the risk of insufficient financial information provided by management should receive the same emphasis as regulatory or legal risk.

"We are making a case that a comprehensive risk management program is absolutely essential for every board," says Swiegers. This becomes even more critical if you have a diverse portfolio. You need a risk strategy program for each of the business elements. "I don't see how you can delegate that to a sub-committee of the board. The board as a whole should be responsible because isn't that what they test the corporate strategy against." Keith Skinner tells the story of a global company involved in a restructuring that didn't have any short-to-medium-term cash flow forecasts. It broke its banking convenants and the board became aware of that only belatedly. "There are numerous instances that I have come across where companies have breached financial convenants with their bank and the board doesn't know and is only advised of this after the fact," says Skinner. "The biggest omission in cases of corporate failure in my experience is the inability of companies to reliably forecast cashflow to ensure availability of funds and to stay within the financial covenants. When this occurs the board loses control of the situation and limits the options that are available."

While it is easy to point to failures both Skinner and Swiegers insist that many boards are doing the right thing. They say that complexity of the director role should not be underestimated. What is also at issue is the traditional demarcation lines between board and management functions and the mix of the board. It is very hard for a director with financial services experience to judge the non-financial performance of a manufacturing company. He or she ultimately has to rely on the relevant expertise of other directors to breach the shortfall or bring in independent advice. "A lot of directors that Keith and I have been speaking to are taking a good hard look around the board table to see the levels of skills and expertise that is available," says Swiegers. "The global business environment has become so complex and multi-faceted that it provides a challenge for boards. Even in our own business there is much greater demand for higher levels of expertise. We have to bring in outside expertise as well." The increasing complexity and fast pace of the global business environment isn't only an issue for boards and directors. Faced with public outrage and shareholder losses, governments are also being forced into action.

The problem is that a lack of regulation wasn't the main reason why companies ended up in the corporate morgue and more regulation will create as many problems as it is supposed to solve. Both Swiegers and Skinner say that the ultimate sanction is the market itself where investors punish the share price and this is far more damaging and effective than more rules. "I don't believe that management sets out to deliberately deceive a board," says Swiegers. "But at the same time there are a lot of disconnects between management and boards and you have to ask what happened. "The one warning I give people is that no one gets cheated or conned except by someone they trust. The moment you as a director feel comfortable that is precisely the time you should be asking why you are comfortable and if this is correct. "Every time I have investigated something that has gone wrong the first thing I hear is that I never suspected that."

Swiegers and Skinner say boards should be alert to any red flags. These could include:

• is management often wrong and constantly reviewing and changing forecasts?

• do you believe the managers explanation for various forecasts? Have you asked auditors or independent experts to audit these?

• does the board have the deep industry expertise to evaluate management's comments relating to under-performing entities?

• constant shocks and fire-fighting.

• is the internal audit producing useful reports and are they focusing on risks?

• does the board rely exclusively on its information from the CEO?

And some of the reasons companies end up in the corporate morgue is due to:

• shareholders pressing management to do even better

• aggressive acquisitions-moving from core competence

• moving into markets without understanding

• boards are less likely to push management to test whether their judgement was commercially sound if they have been successful in the past

• fast growing companies seldom present directors with sensitivity analysis-especially to things like foreign exchange and interest rate risk

• aggressive bonus schemes for management often encourages risky decisions.

Did the board consider what behaviours they may be encouraging and how will they monitor this? In their current role Skinner and Swiegers are in the business of preventive corporate medicine. It is better to fix a company than pick over the remains of the corporate corpse to determine the cause of death. In the BBC TV series, the silent witness is the corpse itself. In the corporate world, HIH, One.Tel and Enron are a body of evidence for the investigators. The question is whether there has been a corporate murder and a corporate crime leading to the conviction of responsible parties or whether it is part of a systemic fault in the way boards and management interact. There is no doubt that in all the instances of corporate collapses there has been a great deal of unacceptable behaviour by a number of individuals. But what is becoming clearer is that the real cause of the problem is the age-old sin of omission.

Disclaimer

The purpose of this database is to provide a full-text record of all articles that have appeared in the CDJ since February 1997. It is aimed to assist in the research and reference process. The database has a full-text index and will enable articles to be easily retrieved.It should be noted that information contained in this database is in pre-publication format only - IT IS NOT THE FINAL PRINTED VERSION OF THE CDJ - therefore there might be slight discrepancies between the contents of this database and the printed CDJ.