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Where governance went wrong - globally and in New Zealand

Jane Diplock AO Chairman, Securities Commission New Zealand & Executive Committee, IOSCO

Victoria University - and Corporate and Public Governance Conference

Wellington
27 November 2008

Good evening to you all. It is a special pleasure to be participating in this conference on corporate and public governance and I welcome the opportunity to talk to you all. We are experiencing unprecedented times. The immense challenges which those working in the financial markets face are important to us all. The impact of the global financial crisis is far-reaching and touches the lives of most people. Repercussions have already spread to the real economies and a number of countries, including New Zealand, are in recession. It will therefore not only fall on those in the finance sector itself to contribute towards solutions for a better future. The effort required is a collective one.

Today's topic is corporate governance. This is important because it goes to the heart of investor confidence in our capital markets. Investors are likely to have more confidence in markets when companies have high standards of corporate governance. A dramatic reduction in investor confidence has been a feature of the current crisis. Now more than ever, with the meltdown in the world's financial markets and widespread repercussions, it is relevant to review and discuss matters that impact on the protection of investors. It is also vital in today's globalizing capital markets to keep a global perspective on issues and developments.

I commend Victoria University for their initiative in organizing this conference which provides a very useful dialogue on some particularly pertinent issues, in these very unusual times.

This evening I plan to discuss corporate governance issues against the backdrop of the current global market turmoil. I will review recent developments from both New Zealand and global perspectives.

Global financial crisis

Taking a moment first to just recap quickly what we have seen play out across the global financial markets over the last year:

You will recall that from mid June 2007 onwards, it became apparent that many institutional investors were exposed to potentially large losses through their investment in residential mortgage-backed securities (RMBSs), collateralised debt obligations (CDOs) and other forms of securitised and structured financial products linked to US sub-prime mortgages. Uncertainty over the extent of those losses and how they would flow through complex lending chains pushed certain institutions and hedge funds into a liquidity crisis. Their urgent responses sent shockwaves through debt and equity markets in the US and elsewhere.

From the beginning of the crisis there has been a flurry of work from across the full spectrum of the international global financial regulatory framework. Work has been undertaken by financial services regulators, organizations such as the International Organisation of Securities Commissions (IOSCO), the Financial Stability Forum, as well as other self regulatory and finance industry organizations, in attempts to find solutions to the problems which arose.

Political leaders have addressed the challenges arising from this crisis, with state-supported bank bail-out packages, fiscal-stimulus packages worldwide, co-ordinated reduction in interest rates, and the recent special G20 and APEC summits to address the crisis. The latest developments being the second US rescue plan of $800 billion and the bail out of Citigroup.

Rescue measures are still being implemented and solutions being sought as we speak. But one thing is clear - a lack of corporate governance has played a role in contributing to the problems.

The New Zealand experience

Looking at the New Zealand situation, as you know, while the turmoil here was initially largely the result of domestic concerns, after August 2007 when the sub-prime effects were being felt in the US and UK, credit to all banks began to be constrained. Inter-bank lending reduced. Few New Zealanders were directly exposed to the securitized products which caused turmoil in other parts of the world, however it was the reduction in liquidity that more generally affected this market. This, combined with declining economic conditions and a falling New Zealand property market, influenced the markets in New Zealand. Ultimately rescue actions taken in other markets would impact on New Zealand, leading to the introduction of the government deposit guarantee scheme.

We did have our own crisis in one segment of the capital market, with the collapse of a number of finance companies from early 2007. While this represents in dollar terms, a limited part of the capital market, the failures in this sector damaged confidence of the investors affected and had an impact on investor confidence more broadly. I will discuss the finance company failures in more detail shortly.

The crisis and corporate governance

Turning now to the theme of corporate governance, the topic of this conference:

As Charlie McCreevy, European Commissioner for Internal Market and Services noted at a recent conference on challenges for corporate governance in the EU:

"The current financial crisis has pushed systems of corporate and internal governance across the global financial system to the limit. As we know, these systems have unfortunately been found wanting"

In examining our own problems in New Zealand with failed finance companies, we have certainly seen that a lack of good corporate governance has been a contributor. We have not been alone in this. Considering international developments we see a common thread - a failure of good corporate governance. Good corporate governance remains a key underpinning of successful capital markets globally. Whether corporate governance systems have been rules-based or principles-based has not been material, we have seen failures in New Zealand and globally, across the board.

Global perspectives

Looking at the international picture, if we examine what went wrong we do find a number of instances where corporate governance has been lacking.

We have seen conflicts of interest arising in the valuation of securities. The credit rating agencies are seen as having played a major role in this, as McCreevy put it, "by greatly underestimating the credit risk of structured credit products". Certainly credit rating agencies have attracted significant attention during the crisis with questions raised about the integrity of the processes they used and the reliability of the ratings for complex financial instruments. What is most controversial and unacceptable is the fact that they helped design these financial instruments and then rated them. IOSCO, in updating its Code of Conduct for Credit Rating Agencies, suggested refinements to enhance the quality and integrity of rating processes, avoid conflicts of interest, and clarify the responsibilities of CRAs to the investing public and to securities issuers. Going beyond that, there are now calls, among them from the G20, for some form of public oversight regime to oversee and monitor compliance of CRAs with such codes of conduct. The European Commission is proposing a registration and rather detailed oversight regime with measures under development.

Another matter that the crisis has highlighted is the issue of excessive remuneration drivers leading to profligate lending by mortgage brokers and others. Remuneration structures in financial institutions and the incentive programmes in place are now being examined under the microscope of the global financial credit crisis. As McCreevy put it "compensation incentives should not only focus on short term gains but overall shareholder interest and long-term, firm-wide, profitability". This also links into the questions of ineffective audit committees, or the lack of audit committees, an evident feature of the financial sector landscape.

As the world's regulators grapple with understanding the underlying facts that led to the crisis more and more fingers point towards the lack of risk assessment and control. Managing risks is and should be a key part of the governance of any organisation. Analysis by IOSCO makes it clear that, as I mentioned earlier, the market turmoil stems in part from widespread use of new forms of asset-backed securities and of sub-prime mortgage derivatives, which were used to transfer credit risk. Institutions failed to ensure that they were diversifying risk as intended through their investment in these instruments. IOSCO found that this was due to inadequate internal controls and risk modelling capability and an inability to really understand exposure from these types of vehicles.

Related to this is the issue of boards properly understanding and valuing assets (and the associated risks). The multi-billion dollar losses sustained by the monoline insurers are testament to this. Traditionally these insurers simply covered municipal bonds, which rarely defaulted and had relatively predictable risks. Hence they almost always enjoyed a triple-A rating and this automatically applied to any products that they chose to insure. With the property market lending boom they diversified into mortgage-backed securities, (such as CDOs and CDSs) without properly understanding and valuing the underlying assets and associated risks. This meant that they did not charge adequate premiums nor maintain adequate reserves, ultimately leading to massive irrecoverable losses.

So we see other examples of where poor corporate governance has contributed to the turmoil we face today. There has been the failure of boards of directors and management to transparently disclose the true nature of their products and the risks associated with them. We have also seen flagrant breaches of accounting standards. IOSCO's task force on the sub-prime crisis looked closely at the implications of institutions, investment banks and regulators relying on mark to model or as some have described it mark to myth, rather than to the market, especially at times of illiquidity in markets for those securities. There have been signs of poor governance in respect to matters of capitalisation and liquidity management.

Finance company failures

Turning to the New Zealand experience, while the market conditions, namely the products and the market participants, were not the same as on the international stage, some similar themes have played out.

While the beginning of the collapse of finance companies in this country in 2006 and early 2007 was a decidedly local problem, later the credit crisis undoubtedly added to some finance company problems. Looking at these finance company collapses there are a range of aspects where good governance was lacking. As you will appreciate with investigations underway I cannot be specific but I would like to share with you some general themes evident in the troubled finance companies.

These have included the failure to ensure that disclosure and financial reporting were accurate, particularly as related to party lending and/or asset quality.

We have seen some fairly heroic valuations in a declining market. While directors are entitled to receive and rely on expert advice, I don't believe they should do so blindly. Directors need to critically assess valuations and other external reports and exercise common sense and good judgement.

There have been instances of too few directors, even sole directors, and times when there were no independent directors on the boards of these companies. In some cases independent directors failed to ensure they were adequately informed or took insufficient interest in the business. Some directors were swayed by persuasive management and did not exercise independent judgement.

Sometimes we have seen an ineffective (or no) audit committee. We have seen situations of companies which were poorly capitalised; which had no liquidity buffer for a downturn. We have also seen the poor handling of growth or expansion of the business. There has been an evident failure to recognise or act on warning signs in a timely manner.

We are not saying that finance company failures have been solely due to poor governance. But in our view, this has been a contributing factor in many cases.

Securities Commission actions

I would like to mention here that the Commission has been extremely energetic in pursuing those who appear to have breached the law in relation to these companies and has cooperated with other regulators to an unprecedented degree. We are determined to ensure that those whose actions have led to investor losses and to the ensuing loss of confidence in the market are brought to account. Where companies had offer documents registered or advertisements distributed after October 2006 the Commission has the powers to take civil actions. We can apply to the court for pecuniary penalty orders and in some circumstances orders to compensate investors. The Commission can also take criminal proceedings. In fact, we have investigations that are well advanced and you can expect some announcements in the near future.

I would like to make the point here that no regulatory framework can or should prevent failures. Where there is a poor business model no regulatory framework will save a business. Similarly where there is poor corporate governance, poor risk assessment or poor capital or liquidity management, businesses will fail. Good governance is the key to a successful, well managed corporate.

One of the key messages then, we should take away from periods of turbulence, past and present, is that the most effective way to minimize damage from market turmoil is to put in place a world-class financial sector and responsible corporate governance.

International research shows that fundamental aspects of corporate governance can play a key role in corporate performance. At the Securities Commission we have seen many examples which support this theory. Most cases of corporate failure and breaches of securities law are, in the Commission's view, at least partly attributable to a failure of governance at some point. The failed finance company scenario is just one example of this.

Securities Commission Principles

I'm sure many of you are aware that the Securities Commission published a set of Principles to give guidance to the market in February 2004, entitled Corporate Governance in New Zealand-Principles and Guidelines. The intention was to contribute to high standards of corporate governance in New Zealand, to be achieved when directors and boards adapt and implement the Principles through their structures, processes, and actions, and demonstrate this in their public reporting and disclosure.

The Commission's corporate governance Principles are intended to apply to entities of all types, not merely issuers or listed companies, and by no means limited to the private sector. They are not part of the law.

Breaches of the Principles of good corporate governance do not of themselves always constitute a breach of the law, as the laws relating to this field are specifically addressed in the Companies and Securities legislation. However, poor corporate governance does very often directly or indirectly result in situations where the law is found to be breached. Indicators of poor corporate governance include directors not having adequate control of a company, not putting in place adequate systems to control the company, or failing to keep an adequate eye on executives and staff.

Directors need to be as informed as they can be about their roles and responsibilities and ensure they have effective systems in place to control and guide the company. This is important as it not only affects the performance of the company but also the potential personal liability of the directors. At this point I should also note that there is no distinction in the law between executive and non-executive directors. Their responsibilities are identical.

In 2005 and 2006 the Commission reviewed corporate governance disclosures of issuers in their annual reports. Reviews revealed that while corporate governance disclosures by issuers were improving there was nevertheless significant scope for improvement. In particular, disclosures on how entities manage their shareholder and stakeholder relationships were very limited.

Therefore as part of its financial reporting surveillance programme, the Commission is about to undertake a fresh review of corporate governance disclosures and will report on this in due course.

Regulatory response

Our investigations with finance companies shed light on mis-selling of financial products and poor adviser conduct illustrating the need for there to be a regulated framework in this arena.

The Financial Advisors Act, passed in September, is an important reform for retail investors and consumers. It aims to ensure that quality financial information and advice is provided to the public and also to assist New Zealanders to make the most of their investments. The new law will require financial advisers to meet standards for competence, professional conduct, and disclosure and make them accountable for the quality of advice they give to clients. A key focus for the Commission will be to bring this new regime into operation as early as possible. This will help to restore investor confidence and mean investors will be able to obtain sound financial guidance when the two year Government deposit guarantee scheme is lifted in late 2010.

This and other recent reforms are helping bring New Zealand's regulatory framework into equivalence with other jurisdictions, and with what is considered international best practice.

Balance in solutions

New Zealand of course is not alone in seeking solutions to restore confidence to the markets. As I alluded to earlier, there is an unprecedented and intense effort across all levels of the global financial markets architecture, including regulators, and related global organizations, self-regulatory organizations, politicians, and industry.

A robust response is certainly required if we are to restore investor and business confidence. We need to explore appropriate interventions to stimulate the market and yet allow innovation which is a precursor to growth. It is a delicate balancing act.

As Prime Minister John Key noted in his address at the CEO Summit at the APEC meeting last weekend:

"Reforming the global financial system will require a balancing act between on the one hand, moving away from largely unregulated environment of today, and ensuring we do not completely undermine financial markets".

We need to be wary of a knee jerk response to over-regulate. Other non-regulatory interventions and solutions may be equally as effective. It is important a balance is struck.

What is important for New Zealand is being able to attract capital from both home and offshore. In this regard the Commission is working proactively with the NZX and the Capital Market Development Taskforce to seek solutions that assist New Zealand companies raising capital more quickly and cheaply, and to bolster the New Zealand capital markets to increase the depth and liquidity of those markets.

Global approaches to the crisis

But coming back to the pressing matters confronting us from a global perspective:

What has become more evident than ever is that coordinated approaches are vital in today's globalised capital markets. Again John Key noted in his recent address to the APEC meeting that one of the factors that rest on the world's ability to put the crisis behind us relates to "how prepared we are to accept the interconnected nature of the global economy and as such how much we are prepared to join forces to combat the global financial crisis."

This was very much the spirit in which the G20 leaders came together in November to address and find solutions for the crisis.

This is also where IOSCO plays such a significant role. The Commission has been a member of IOSCO, the recognized international standards setter for securities regulation, for over 20 years. IOSCO promotes the full implementation of its 30 Principles of securities regulation in all member states and facilitates cross border exchange of information and cooperation, through its Multilateral Memorandum of Understanding (MMOU). I have the privilege to Chair its Executive Committee, the governing body of the organization.

IOSCO is undertaking considerable work aimed at addressing the current financial crisis. Earlier this year, in May, it published its report on the sub-prime crisis, the culmination of urgent work requested by the Financial Stability Forum late last year. Just yesterday we announced further work that would be urgently undertaken through the establishment of three task forces to address the market abuse evident in this crisis. The task forces will review includes issues around short selling including to aim to eliminate the gaps in various regulatory approaches to naked short selling. There will be an examination of ways to introduce greater transparency and oversight to unregulated market segments, such as over the counter markets for derivatives and other structured products. The third task force will examine areas surrounding unregulated entities such as hedge funds, including the development of recommended regulatory approaches to mitigate risks associated with their trading and traditional opacity.

The task forces are working urgently to present their reports to the next IOSCO meeting in February and then to the G20 meeting in the European spring of 2009.

So we see that while much of the visible recent rescue focus has been from a political level and with a prudential perspective in propping up the banking systems around the world, the conduct regulators are also playing a critical part in addressing the weaknesses in the regulatory frameworks to avoid such problems arising in future. After every crisis there tends to be a call for tough, and even prescriptive rules to be put in place. The Sarbanes Oxley Act introduced in the US in the aftermath of Enron is an example of this. It is important that leaders find the correct balance between over- and under-regulation. Regulation should not only protect the interests of investors and ultimately all citizens but should also foster economic growth and innovation. It is also the correct time for regulators to move from a short-term crisis resolving model to finding long term sustainable solutions.

In this context there has been talk of a global super regulator. To my mind this is a quixotic quest. In the future far more important will be a network of mutual recognition arrangements around the world.

To conclude, I would agree that the system has failed investors. We must now build on lessons learnt from this crisis. Part of the answer will be in addressing certain standards to ensure an alignment between corporate behaviour and the interest of the investor. We must acknowledge that our rules have been found wanting. We must however be mindful of striking the right balance as we address this. In all this work what is clear is that better corporate governance would have helped. Good corporate governance going forward will certainly be a major contributor to getting our capital markets back on track.

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