Rosemary Howard

We have all had at least one bad experience with dialing through to an Australian firm’s call centre. A long wait. Finally an operator. Answering lots of questions the firm already has in their database. Getting disconnected as they transfer you to another division, and then having to start all over again.

We often assume that these experiences are with outsourced, offshored call centres in India or the Philippines. But this is not always the case.

Sometimes offshored call centres can provide superior customer service (and at lower costs) to Australian call centres, and provide better data analytics.

When we think about the offshoring of Australian financial institution jobs, what questions should we ask?

The first I suggest is why is an organisation thinking of doing it. If the answer is as simple as cost due to Australia’s high wage structure and high dollar, then one probably needs to ask more.

As revenues are harder to come by, there is no question that Australian financial institutions (like all Australian firms) need to manage costs more carefully.

However, the outsourcing or offshoring of call centre and IT jobs should be a more strategic decision.

All firms – including Australian financial institutions – need to consider their long term strategy and therefore how they operate in that context. They need to reflect on the key trends of our time, namely globalisation and digitisation.

In the constrained post-GFC world, Australian financial institutions cannot grow sufficiently to meet investor expectations without the support of offshore markets, particularly in the Asia Pacific region. This insight is reflected in the Government’s recent Asian Century white paper.

As companies consider the optimal destinations for the demand side of their business, they need to also think about where to best locate supply side functions.

This raises the question: what supply side functions are best located in Australia, and what are the sources of our national competitive advantage?

With the finance sector, the GFC has demonstrated we have some real competitive strengths. These include the strength of our banks, our financial regulatory system, our universities and our superannuation system. Given this, what jobs are best located here versus offshore?

There is no question that on face value at least, lower paid roles such as call centre and IT processing can be delivered more cheaply offshore. India and the Philippines come to mind and even our nearest neighbour, New Zealand, guarantees at least a 25-30% cost savings based on wages and overheads.

But then some strategic questions need to be asked. Can these roles be performed to a high standard offshore? Will customer satisfaction data be readily available to drive innovation? Are there hidden costs or risks from having functions offshore? What is happening to wage relativities given wages are rising faster in China and India?

Australian organisations often send offshore the functions that may not be working for them. But you cannot offshore what you cannot manage well yourself.

Organisations also need to consider that by offshoring, they may throttle their employment pipeline of younger workers. Up to half of call centre employees in Australian financial organisations are university-qualified and may likely be suited to progressing to higher level positions in the firm.

If offshoring is strategically right (not just short-term cost cutting), and the whys have been thought through, then it can work. In fact some specialist offshore firms who focus on call centre management or IT processing can offer superior services to some available in Australia or delivered in house.

Outsourcing particularly offshore requires a high level of partnering between the Australian firm and the outsourcer, and this requires the right supplier.

Proactive communication is needed with all stakeholders so as not to tarnish the brand, reputation and image of the Australian firm with customers and employees alike, and affected employees need to be given every chance to be supported and move to a different role.

But there is no question outsourcing often fails and is followed by a period of insourcing and onshoring – we are seeing this happening at present with many US and UK firms.

Many would argue that more regulation is required to stop jobs going offshore.

Australia now ranks 96th in the World Competitive Index in terms of regulatory barriers to business performance, down from a ranking in the 60’s. We also rate more poorly than we should for strategic, people and sales management.

Australia’s focus needs to be on developing high value-adding jobs. That’s why we should only regulate where necessary but educate and develop wherever possible. I am a strong advocate for the ongoing development of those in leadership positions to enable optimal strategic and people management decisions to be made.

To optimise our firms’ performance, business and government need to work collaboratively together. We need to work harder at improving in the areas of management practice, active stakeholder communication, long-term strategy, sales, marketing, innovation and creativity.

Better educated and developed leaders will ensure that the right strategic decisions are made and the right jobs stay onshore.

Rosemary Howard is the former Executive Director and Conjoint Professor of Executive Education at the Australian Graduate School of Management. This opinion piece was previously published on The Conversation under “Impact of offshoring jobs from Australian financial institutions“.

Dale Boccabella

The essence of the legal relationship known as a trust is the separation of legal ownership of assets from beneficial ownership of those assets. The trustee is the legal owner and beneficiaries are beneficial owners. Because of this separation, the law imposes strict obligations on trustees: for instance, the trustee must act in good faith and for the benefit of beneficiaries.

However, for many families, the discretionary trust largely owes its existence to suspicion of — and mistrust of — those associated with the trust creator’s family and/or parties dealing with the trust. Structuring the discretionary trust to deal with these suspicions and mistrust is a major pre-occupation of financial planners, accountants and lawyers that advise on and arrange for the creation of discretionary trusts.

A discretionary trust is a trust, much like a fixed trust. However, unlike a fixed trust, no beneficiary (or potential beneficiary) obtains an income or capital distribution/allocation unless the trustee exercises the discretion they have in favour of a beneficiary. And generally, the size of the distribution is also at the complete discretion of the trustee. This means that even if a beneficiary has been assured of income and capital distributions by the promoter or controller of a trust, or has a legitimate expectation of getting a distribution, that assurance or expectation is worth little should the trustee not make a distribution to them. In legal terms, a potential beneficiary of a discretionary trust only has a right to be considered for distributions.

And while it sounds strange, assets and property held in a discretionary trust are not beneficially owned by anyone. While discretionary trust assets are legally owned by the trustee, the trustee does not beneficially own the assets. The trustee must, however, manage and safeguard the assets for the general body of potential beneficiaries, but no beneficiary can demand an asset or income from the trustee.

Suspicion and mistrust can be manifested in a number of ways and at various levels.

Resentment or suspicion can flourish when the trustee makes “unequal allocations” of income between beneficiaries and/or the allocations made do not meet expectations of all beneficiaries. The same point can be made in regard to capital distributions from the trust fund, although capital distributions are usually deferred towards the end of the life of the trust.

The seeds of mistrust (or the need for protection) are also manifest in the area of the office of “appointer”. Most modern discretionary trusts will have an appointer or even joint appointers. An appointer will have the power to remove a trustee and appoint a new trustee. Appointers are usually the promoter or the controller of the trust. While it is prudent to have an appointer who can deal quickly with a trustee who is breaching their obligations, the appointer can also use their power to remove a trustee should the trustee make “unsatisfactory” allocations of income (or capital) where there is no breach of trust.

Mistrust can also fester in a more recent addition to the actors associated with the modern discretionary trust: the so-called “guardian” or “protector”. The role of this person is to provide an extra check on the otherwise wide powers of the trustee. This person can be given the power to veto certain trustee distribution decisions. This is important because the removal of a trustee by an appointer after the trustee has made an unsatisfactory allocation of income (or capital) will not prevent the allocation from being valid. In other words, the guardian or protector can provide protection against a circumstance that an appointer may not be able to protect against.

Mistrust also stems from the nature of potential beneficiaries’ interests. As noted earlier, beneficiaries of a discretionary trust do not beneficially (or legally) own the trust’s assets before the trustee makes an allocation to them. This means that a creditor of the potential beneficiary cannot get access to the assets in the discretionary trust to help satisfy a debt owed to them by the beneficiary. This also means the trustee in bankruptcy of a beneficiary usually cannot access assets in a discretionary trust.

Another concern is relationship breakdown. The assets held in a discretionary trust will not automatically be included in the property of the potential beneficiary. However, family law legislation also does not automatically rule out the property held in a discretionary trust from being counted as “property of the marriage” for the purpose of the property division on relationship breakdown. Whether or not the trust’s assets form part of property of the marriage will largely depend on whether the trust is the alter ego of the beneficiary. In spite of these contentious, case-by-case rules, there appears to be a perception that housing assets in a discretionary trust provides a safeguard against “gold-diggers”.

Furthermore, the legal principle that permits creditors of a trust (lenders, suppliers of goods on credit) to access the assets of beneficiaries of the trust in certain circumstances does not apply in a discretionary trust situation. This means that those providing credit to a discretionary trust are very likely to want guarantees for repayment of their debt.

Another area of mistrust is the “spendthrift children”. In short, if instead of “housing” or “parking” assets in a discretionary trust, the assets were distributed immediately to children, there is always the risk that some of the children may spend the funds on “wasteful things”.

Furthermore, by housing assets in a discretionary trust, there is a much greater safeguard (virtually guaranteed) that the children will not realise the assets to switch to another investment or another asset class. Apparently, this is one of the attractions of the discretionary trust to farming families as it provides greater assurance that the farm will not be transferred outside the family.

Even from this brief outline, it is clear that distrust is not a stranger to a discretionary trust.

Dale Boccabella is an Associate Professor of Taxation Law at the Australian School of Business. This opinion piece was previously published on The Conversation under “Beware the pitfalls of the discretionary family trust“.

Anil Hargovan

Fortescue Metals Chairman Andrew Forrest can breathe a huge sigh of relief after winning his High Court appeal against a Federal Court finding that might have seen him banned as a company director.

The Australian Securities and Investments Commission (ASIC) suffered loss in more ways than one. Apart from the financial sting, where costs were awarded against ASIC, the regulator also suffered from reputation loss arising from the way in which it ran the case.

The unanimous judgement was highly critical of the manner in which ASIC framed its case and has sent a clear and sharp message to the corporate regulator for the need for greater transparency when formulating claims against defendants.

In 2011, the Full Federal Court overturned the decision of the trial judge and held that (then-CEO) Forrest had breached his duty of care and diligence by allowing Fortescue to make misleading statements that it had entered into “binding contracts” with several Chinese companies for the development of critical mining infrastructure.

When news broke in the media that such agreements struck in the framework agreement were not binding, the Full Federal Court also upheld ASIC’s claim that the company had breached the continuous disclosure laws by failing to disclose this to the market.

However, before the findings of the Full Court were remitted to the trial judge to assess civil penalties for breach of the Corporations Act (which included the prospect of being banned from being a director, as well as financial penalties), Forrest appealed to the High Court.

In rejecting ASIC’s claim that the public statement was misleading, the High Court emphasised the need for ASIC to identify the intended audience and to ask: what would they have understood?

Applying this test, the High Court found that the intended audience of investors and members of the business community would not have understood the agreement to be binding in a legal sense. According to the High Court, “it would be extreme or fanciful” for the target audience to have understood that the contracts were capable of being enforced by an Australian court if the parties later disagreed.

Of all the competing meanings of the phrase “a binding contract”, as used in the context of this case, the High Court took the view that it simply conveyed to the intended audience what the parties to the framework agreement had done and said they had done.

In preferring this narrow meaning, the High Court found that there was no evidence led at trial to show support for a broader meaning, for example, that a court will grant relief should the agreement be breached.

Concerned that the decision might be seen as falling short of protecting the investing public, the High Court was at pains to point out that the result in this type of cases are determined by the particular facts and evidence.

As a result, the High Court cautioned that this case does not establish a broad proposition to the effect that any public statement that Company A has made a contract with Company B necessarily conveys to its audience a message only about what the contractual document contains. The effect of the message conveyed is, ultimately, dependent on a close and careful analysis of the facts.

There are at least two key messages highlighted in today’s judgement. First, the value of this judgement as a precedent for corporate management to navigate its way through the investor protection provisions of the Corporation Act is limited, due to its narrow focus.

Based on the High Court’s finding on the core issue of misleading or deceptive conduct in favour of the defendants, the court did not focus on other significant issues such as the use of the business judgement defence – that the decision was made in good faith and with the best interests of the company – as a defence for breaching directors’ duty of care and diligence.

Nor did the result in this case warrant an examination of the directors’ obligations under the continuous disclosure laws.

It is understandable, but regrettable, that the High Court did not offer guidance on such important issues of major concern to the corporate community.

Second is the clear and sharp message sent to ASIC that its litigation strategy was defective for two main reasons.

One, ASIC failed to clearly specify the basis of the alleged misrepresentation (for example, whether it was fraudulent or negligent), resulting in confusion and potential unfairness to the defendant.

Second, in piling one alternative claim on top of another, ASIC was found to have taken this strategy to litigation to new heights which was condemned.

Such an approach was considered by the High Court to be “planting a forest of forensic contingencies” and unacceptable to achieve a fair trial.

In so doing, the High Court upheld the notion and reminded ASIC that no person ought to be put to loss without having a proper opportunity of meeting the case alleged against them.

Such critical remarks offer comfort to potential defendants facing allegations of breach of law by regulatory agencies.

Anil Hargovan is an Associate Professor at the Australian School of Taxation & Business Law at the Australian School of Business. This opinion piece was previously published on The Conversation under Sharp message to ASIC as Forrest wins High Court appeal.

Peter Swan

Common sense suggests company boards are best composed of directors who hold shares in the business because any poor performance is effectively ‘skin in the game’ as a cost to the director as well as to shareholders. Director’s interests align with shareholders. Directors who mismanage pay a severe price. Evidence also implies this is the case.

During the global financial crisis when the ASX200 index tumbled nearly 40%, incentivised boards suffered fewer relative stock price falls. Yet this advantage can be lost if a company’s board has too many outside directors or if the board members are too compliant to the chief executive. They fail to ask the tough questions. The size of boards is also an issue. Having executive board members who share ownership directly benefits firm performance and lowers CEO pay – but less so when ownership is combined with large boards. It seems when a firm performs poorly, too many independent directors can impede critical action – such as firing an underperforming CEO. A ‘smallish’ board of five or six highly incentivised directors, with a low proportion of outside directors who are prepared to monitor and not just advise management, is optimal, according to my research done in conjunction with Serkan Honaine.

Poor governance can squander a firm’s wealth and our study into how well the interests of independent board members and shareholders are aligned in larger Australian companies suggests large boards of eight-plus members can be very destructive for shareholder value. The average market-to-book ratio of companies with smaller boards of seven or less directors is 50% higher than those with eight or more, and nearly 40% higher when debt-financed assets are included.Our research based on an analysis 284 major Australian listed companies over the decade to 2010 shows that if businesses with large boards behaved like firms with fewer directors, they would improve their performance substantially. Reducing the size of the average large board (nine directors) of Australia’s top 200 firms in 2010, to the size of the average small board (six directors), could boost an individual company’s performance by as much as 50%.

In all likelihood, a large board indicates that management is in control with little effective supervision by shareholder representatives. Naturally, management is reluctant to give up its privileges and drastically reduce board size despite huge cost savings. Poor board monitoring and weak decision-making is collectively costing shareholders hundreds of millions of dollars. Part of the solution is to replace large boards with smaller boards that do not try to usurp the role of management by micromanaging and to focus on the important task of hiring and firing the CEO.

Risk Aversion and Big Boards

Larger boards appear to substantially drag on overall firm performance through a variety of mechanisms, such as reducing non-executive director (NED) incentive pay and raising base pay for outside directors. Such actions encourage a board, dominated by outside directors who have no incentives, to entrench poorly performing CEOs. Large boards are also more cautious because they can have more difficulty reaching a collective decision. This constrained risk-taking results in slow responses to new circumstances and slower release of new information. The resulting reduced stock price volatility appears harmful to shareholder value.

Bigger boards, dominated by outsiders unlikely to be informed of company affairs, have a tendency to keep growing. Large, externally dominated boards appoint more and more directors like themselves with little or no regard for the wishes of shareholders, who are then hit twice. Shareholders not only pay for the salaries of surplus directors but also suffer performance decline into the bargain.

Our research measured performance by comparing companies’ market values to book values. (The market-to-book ratio attempts to identify undervalued or overvalued securities by taking the market value and dividing it by book value. As a rule, the more the ratio exceeds 1, the better the performance while those below 1 are considered undervalued or poorly performing.)

We find that, based on 2010 values, property group Westfield and National Australia Bank (NAB) had below-average market-to-book ratios of 1.34 and 1.39, respectively, and 13 board members each. Publisher Fairfax Media, with 11 board members, carried a very depressed ratio of 0.58, which is well below 1 (and far lower still in 2012). National airline Qantas had 10 members on its board and its value ratio was less than 1 (at 0.83) with its ratio continuing to deteriorate.

Investment and financial services provider Macquarie Group had 10 members with a ratio of 1.03. In contrast, with only five directors on their boards, investment fund Platinum Asset Management and high technology company, Silex Systems, had ratios of 11.7 and 9, respectively.

Meanwhile travel brand group, Wotif, and electronics retailer JB Hi-Fi, each with six directors, had ratios of 13.2 and 7, respectively.

Challenging Independent Director Dominance

In theory, Australian boards appear to be wide open to influence by outside directors. Unlike the US corporate landscape, no chief executive was chairman of a big Australian publicly listed company board. As a result, non-executive directors have a greater ability to intervene in a firm’s activities.

Shareholders have greater power too. Only 40% of Australian shareholders vote at company meetings on proposals from the directors – half the rate of the US. So large shareholders of Australian companies may not need as much stock to maintain control and can make critical decisions, which puts the onus on independent directors to apply greater scrutiny.

We suggest the findings on the harmful effects of outside directors’ dominance and large boards are directly contrary to the views held by regulators, which have been shaped by big corporate collapses. Virtually every country in the world has mandated a majority of independent directors based on little more than what may be simply a coincidence: the failed US energy company, Enron, happened to have a majority of executives on their board.

We challenge the trend for corporate governance councils around the world to introduce policies for a majority of independent directors on boards. Full-time executives, especially those with shares providing skin in the game, know a great deal more about the company and where it is heading than do outside directors. Moreover, typically they stand to lose a great deal more than do part-time directors if the company fails. This may include their jobs and livelihood.

Part-time, outside directors typically have little background in the industry. If the company fails, they may lose their director’s pay that in some cases is little more than a sinecure for turning up to board meetings. If prominent in the community, they may also suffer reputational loss.

We also question the regulators’ decision – in Australia and other countries – to make share ownership a barrier to independence. The Australian Securities Exchange’s (ASX) listing rules require the majority of directors to be ‘independent’, which is defined as not being a substantial shareholder (by holding less than 5% of stock in the company) or not having worked in an executive capacity for the company or another group member for at least three years. This seems counter intuitive because large shareholders have the most to lose from bad managers. They therefore have an economic incentive to gather information and actively monitor the chief executive.

If protecting shareholder interests is the task non-executive directors are facing, then surely alignment with, and not independence from, shareholders is ideal. The New York Stock Exchange (NYSE) and NASDAQ listing rules adopt a neutral stance: stock ownership per se is not a barrier to independence, and they set the barrier at 10% of stock for directors taking on an audit committee role because of the Sarbanes Oxley Act.

It would seem that regulators, in their quest to free management of burdensome shareholder concerns, have taken Australia way out of the mainstream at a huge cost to investors and forno apparent reason other than to appease the privileged managerial class at the big end of town.

Regulators’ Response

The ASX does not see this as a burning issue. When the ASX Corporate Governance Council recently reviewed its Corporate Governance Principles, roundtable discussions were held throughout the country with representatives of directors, management, institutional and retail shareholders, proxy advisers and others with an interest in how corporate governance practices are developing, no change was recommended.

The council chair, Malcolm Starr, said the consensus view was to leave well alone because the present system was working well. He acknowledged the viewpoint that it was counter intuitive to limit non-executive directors’ shareholdings because ownership should encourage better monitoring of company management. Yet there was another opinion that complete independence (through no shareholdings in a company) was the better way to go, Starr insisted.

The Australian Institute of Company Directors agrees. “Non-executive (or independent) directors are seen as ‘custodians of the governance process. While they govern an organisation on behalf of the shareholders or members by whom they are elected, their role is to act in the long-term interests of the company, not shareholders per se, and certainly not particular shareholders,” says spokesman Steve Burrell.

We say independence is undermined by other factors – such as by the old boys’ network that traditionally has appointed directors in the first place. In theory, outside directors should confront management and champion shareholder concerns, but in practice, their motivation is suggested to be more about behaving in ways that will bring more lucrative directorships.

Non-executive directors who are often appointed through friends on the board would be more partial to showing allegiance to their friends and overlook activities by management to expropriate the wealth of shareholders. Directors who do ask questions of management are likely to be either ignored or ostracised. They face the prospect of being denied the right to stand for reelection.

Paper independence aside, high levels of fixed compensation for attending scheduled meetings, along with the barriers to equity ownership provide for little incentive for non-executive directors to exert the extra effort that would add value to the firm. Likewise, the low level of variable forms of compensation to non-executive directors provides little incentive for them to seek and endorse strategies that add value to a company, as the non-executive directors would receive little in the way of the fruits for their labour.

Yet there could still be an incentive for non-executive directors, who may be motivated to perform their role more effectively by both the lure of new directorships from other boards and the financial incentive of being a corporate insider.

Why board size counts

We show that company performance diminishes with reduced monitoring of management by directors, while future firm performance increases when executive and non-executive directors own shares in the company – but not when the board is big. Weak monitoring by large boards, in combination with a high proportion of non-executive members who do not effectively own or take responsibility for decisions – the ‘free rider’ problem – was also found, particularly when boards consisted largely of non-executive directors without shares in the company.

A standard justification for large boards may be the need for these knowledgeable or well-connected outside directors to act as advisers – particularly in big complex companies. Yet it has been long believed that companies with larger boards suffer in performance because of their difficulty reaching consensus on decisions.

Greg Medcraft, the new chairman of the Australian Securities & Investments Commission (ASIC), has warned boards they will be held to account. “For instance, in the Centro case, Mr Medcraft has said publicly that ASIC acted where it believed directors’ behaviour did not meet the expectations of the law,” emphasises an ASIC spokesman. The Federal Court recently found directors of the Centro property group breached their duties when they failed to notice multi-billion dollar errors in the property group’s accounts.

Medcraft, who was appointed in May 2011 for a five-year term, says directors play an important role and they must not uncritically adopt the work of management on major issues for which they are responsible. “The key elements of the financial position of the company are things that directors should understand,” he says.

Conclusions

Our findings are a challenge to the ASX and ASIC, which discourage outside directors from owning shares in companies they hold board roles on for fear it undermines their independence. Ownership can be a tool to help align shareholder and manager interests and is linked to a firm’s positive performance. It is only likely to be fully effective if the board size is restricted to no more than about five or six. If management needs advice then it should simply hire consultants, not create large unwieldy structures made up of so-called ‘advisors’ kowtowing to management.

Before accepting a board role, a prospective director needs to signal his believe in the board’s monitoring role either by substantial personal shareholdings or taking his pay in the form of escrowed shares during his tenure. He may also need to negotiate funds set aside to assist board members in their monitoring role as boards need access to resources independent of day- to-day managerial control, especially when dissatisfied with the CEO’s performance.

Professor Peter Swan AM FASSA is a Professor of Finance, Australian School of Business, The University of New South Wales. This opinion piece was previously published on the ASA Magazine.

The  Reserve Bank of Australia (RBA) has cut its cash rate by 25 basis points to 3.25 per cent in response to a weakening outlook for global economic growth. I feel the decision by the RBA to cut interest rates may boost underperforming sectors of the economy.

Professor Fariborz Moshirian

Plans for the Eurozone’s rescue fund are to go ahead, following a ruling by the German Constitutional Court at Karlsruhe. This was a much anticipated landmark ruling watched around the world, delivering a momentous decision with far-reaching implications for the euro’s future. It means Europe can finally sign the European Stability Mechanism (ESM) and fiscal pact.

The German Bundesverfassungsgericht Constitutional Court overturned a number of legal challenges aimed at preventing two crucial economy boosting tools into law.

The ESM was set to replace the temporary European Financial Stability Facility (EFSF) and should have been in place by the beginning of July. However it needed Germany’s share of the rescue money to function and that was really held up pending the court ruling.

The European Stability Mechanism is a fund backed by the 17 countries that use the euro, with those members paying 80 billion euro up front, and pledging 620 billion euro as a backup. Its purpose is to support countries that have got into financial trouble and just can’t borrow money on the normal money markets. The 700 billion would enable the fund to sell highly rated bonds.”

It is designed to come to the aid of debt-stricken countries such as Spain and Italy. The court’s rejection of thousands of injunctions from Germans objecting to participation in the European Stability Mechanism will help smooth the way for the Eurozone to attempt to contain the debt crisis.

The present turmoil in Europe may continue for some time to come, however I think major economies should avoid sinking into recession as long as European policymakers intensify their efforts to address the Eurozone crisis.

Professor Fariborz Moshirian is the Director of the Institute of Global Finance at the Australian School of Business.

Les Hems | CSI Blog

In April last year I wrote in The Conversation about an innovative financial investment mechanism called Social Impact Bonds, that was designed to address some of society’s wicked problems by engaging government agencies, not-for-profit organisations, private investors and financial institutions.

At that time only one of these SIBs was operating in the United Kingdom. After what seems to have been a long pause, the increasing levels of interest and rhetoric have turned into some tangible products, including here in Australia.

In the last weeks two new SIBs have been launched in the United States – one in New York and the other in Massachusetts. Meanwhile in NSW, three SIB propositions are now under negotiation.

The most interesting aspect of these new initiatives is how the basic SIB concept developed in the UK has been adapted in different jurisdictions.

As I have explained in my previous story, the way a SIB works is by a bond-issuing organisation raising capital from investors, based on a contract with government, to deliver improved social outcomes that generate future government costs savings.

As well as repaying the principal, investors are paid a reward if the agreed outcomes are achieved.

The growing interest in SIBs is driven by a number of factors. Firstly, Governments are developing long-term outcomes focused “payment by results” or “payment for success” mechanisms to replace inefficient and ineffective mechanisms such as contracts, fee-for-service or grant-in-aid mechanisms.

Secondly, not-for-profit organisations are increasingly focused on delivering long-term social impact. However, many not-for-profit organisations are “permanently failing” – with demand for services outstripping supply, they are under-capitalised, use a short term revenue funding model, and rarely use debt finance.

Thirdly, investors of all shapes and sizes are increasingly seeking to achieve an appropriate balance between commercial returns and the social and environmental value created.

There is now a shift from ethical and socially responsible investing – based on screening out investments associated with social and environmental damage – to social impact investing where commercial returns are blended with the creation of social and/or environmental value.

This shift chimes with Professors Michael Porter and Mark Kramer’s vision of creating shared value.

SIBs offer the potential to harness these three drivers and re-engineer the traditional relationships between government agencies, not-for-profit (NFP) organisations and investors to create social benefit

Given this positive analysis it might have been safe to assume that first UK SIB focusing on recidivism would be rapidly replicated in other jurisdictions and across other policy fields.

However, the UK experience showed it takes a long time to develop a SIB proposition and measuring success is not only complex, but absolutely essential in order to find a point where all partners will agree to proceed.

The first UK SIB is reportedly progressing well and is on schedule to deliver the target outcomes.

But it’s most striking attribute is that it is an “all-at-risk” investment; where the failure to achieve the target reduction in recidivism leads not only to investors losing the reward payment for use of their capital, but also losing the principal.

Government has therefore achieved a complete transfer of risk to the private investor – although it has to be acknowledged that it is difficult to assess risk in such an innovative mechanism.

It is therefore unsurprising that all the investors in this innovative mechanism are philanthropic institutions – trusts and foundations – which can rationalise the downside risk as a donation as well as a failed investment.

Trusts and foundations traditionally use the financial returns on their investments to provide grants with the goal of achieving social value. The SIB mechanism offers them a mechanism to also use their corpus to achieve social value. However, if accessing commercial investment capital is a SIB goal, then arguably the UK SIB has failed.

The deal was formulated by a specialist intermediary – Social Finance; they hold the contract with government to deliver the agreed outcomes and are responsible for the ongoing management of the SIB.

Social Finance sub-contract the delivery of the intervention programs to a number of not-for-profit organisations. Finally, the reward payment and repayment of the investors’ capital will come from an innovation fund rather than the mainstream service delivery budgets.

The New York SIB is also in the field of recidivism, but with some significant adaptations to the original UK SIB, particularly around the nature of the risk sharing and the involvement of a commercial investor.

For instance, in the NY SIB, the prime investor is investment bank Goldman Sachs, along with with Bloomberg Philanthropies – the charity of New York major Michael Bloomberg – which is providing a credit guarantee that limits losses to a quarter of the invested capital. A further adaptation is a research centre – the MDRC – is coordinating the delivery of the recidivism program.

In Massachusetts, two “payment-for-success” based initiatives are under development which relate to recidivism and homelessness.

At this stage it is not clear what structures may be used, but it is interesting to note that the process is being driven by government and is following a traditional procurement process.

This is also the case with the Social Benefit Bond (aka Social Impact Bond) trial in NSW.

Three proponents are now involved in a negotiation process and while the full details aren’t known, at least one proposition includes two mainstream financial institutions, another involves a specialist intermediary, and all three have on-board very large not-for-profit organisations.

An overarching conclusion is that in these early stages, social impact bond propositions will need more “trials” to better understand stakeholder behaviour as well as how to optimise incentives.

In these early stages the costs of the measurement and research must also be borne outside of the SIB mechanism, or else transaction costs will undermine their financial viability.

In the UK there are a range of institutions and funding sources, including BIG Lottery, NESTA and Big Society Capital. In the US, President Obama established a fund of US $100 million to develop “payment for success” mechanisms.

But in Australia there are no similar sources of funding to support measurement, research and development. If SIBs are to become more widely used here, this is a significant gap that has to be remedied.

This article was previously posted on The Conversation and on the CSI Blog under: Will social impact investing finally pay dividends?

Professor Peter Swan

The bribery scandal and apparent cover-up revealed in yesterday’s ABC’s 7:30 Report and The Age that is now engulfing the Governor of the Reserve Bank of Australia (RBA), Glenn Stevens, his former deputy, Rick Battellino, now retired, and the RBA Board had its origins in one of Australia’s great technology success stories. This was the invention of plastic (polymer) bank notes in the 1980s. Having successfully protected its property rights despite fears of reverse engineering by overseas note printing interests, the RBA and two offshoots, Note Printing Australia (NPA) and Securency International, involved in polymer note printing and marketing, have been accused of covering up the scandal that involved payment of large bribes (secret commissions) to politicians and officials in a number of Asian countries.

When senior RBA officials were given a detailed memo providing details of the bribery scandal as early as 2007, the matter was not taken to the Australian Federal Police and there seems to have been no public acknowledgement of the problem until press reports raised the issue about two years later.

Although this is the second major bribery scandal involving exports to foreign governments, the kick-backs on the sale of wheat to Saddam Hussein of Iraq by the Australian Wheat Board being the first, this appears to be the first that has sparked a major police investigation and large-scale prosecution of officials involved. Corrupt payment of bribes is illegal in Australia, even to foreign officials and politicians, even though it is an accepted part of doing business in many parts of the world. In fact, many would regard it as a necessary cost of doing business and way to promote Australia’s exports.

As is usually the case, the bribery and corruption pales into insignificance relative to punishment metered out to those who cover-up. Richard Nixon was forced to resign, not for hiring the ‘plumbers’ in the first place but rather for his failed cover-up attempt.

The involvement of the most senior officials of the RBA and possibly the Board in the cover-up, even if they were unaware of large-scale bribery prior to 2007 in the bank-note offshoots, is an exceedingly damaging development for an organisation that until recently has retained a reputation for integrity and exceptionally good monetary policy in recent years.

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There is an ongoing investigation into the Bank of England’s oversight of the rigging of the LIBOR interbank rate by Barclays and other British banks at a time when the Bank of England was facing the prospect of further massive public bailouts of the banks. Mr Bob Diamond, Barclay’s CEO who was forced to resign because of the scandal, explained to a senior Bank of England official at the time that “not all banks were providing [LIBOR] quotes at the level that represented real transactions.”

By this he meant that a number of banks including Barclays were deliberately understating their borrowing costs to make it appear they were more solvent than they really were. Lack of response from Bank of England officials, who claim not to have interpreted the conversation in this light, was taken by Barclays as implicit acknowledgement and support by the Bank of England for LIBOR rigging.

In the case of the US Federal Reserve, lax monetary policy and their success in bringing the cash rate down to close to 1% after the bursting of the internet bubble and 9/11 has been blamed for exacerbating the credit crisis that led to the GFC. Certainly, FED oversight over the lead-up to the GFC and the US NINJA loans scandal was weak. It has only recently been revealed that RBA and other Australian regulators were almost equally lax in allowing Australian banks and mortgage providers to push huge numbers of ‘low-doc’ loans on impecunious investors who had little or no prospect of repaying. Banks and mortgage providers seem to have secretly filled out forms to make it appear that borrowers were in a far more financially sound position than they were in reality.

The plastic banknote bribery scandal and cover-up places the largely very distinguished business people making up the RBA Board in an exceedingly difficult position. Did they know of, or should they have known what was going on at the time of the presumably secret 2007 Memo or even earlier?

In the CENTRO case, the court found that non-executive directors cannot uncritically accept advice from either management or auditors. Directors must take ultimate responsibility for company affairs. Of course, unlike CENTRO, the RBA is not a listed company with shareholders. It is the Federal Treasurer and Government that appoints directors to the RBA Board and thus should play an important role in its oversight. The Treasurer also appoints the Governor of the RBA. I should imagine that the Governor is accountable to the Treasurer, the Government, and perhaps ultimately to Parliament.

It is tragic that the scandal and apparent cover-up has damaged the reputation of the Governor, senior officials, board members and the RBA as a whole, despite the high regard for its conduct of monetary policy. The best we can hope for now is a quick end to the cover-up, if there really was one, and a speedy resolution of this very sordid affair. The successful setting of monetary policy is very much dependent on the reputation of the RBA. This needs to be repaired as quickly as possible.

Professor Peter Swan is the Professor of Finance at the Australian School of Business. This article first appeared in the Australian Financial Review.

Professor Fariborz Moshirian

Tensions remain in Europe as details of exactly how the European Central Bank will stabilise the bloc’s bond markets, now there are possible plans for a new wave of bond purchases aimed at helping to calm the euro zone’s turmoil, and optimism the European Central Bank (ECB) will provide more help to euro zone nations under pressure from the markets.

For the euro, the biggest uncertainty is whether the debt-laden governments of Spain and Italy will take up the ECB’s hinted offer that they seek financial aid from European bailout funds as a precondition for the ECB buying their bonds. Such assistance would likely come with strict controls over fiscal and economic policy.

For the euro zone to find its way through this crisis, any intervention in the bond markets needs to be combined with a bolder overhaul of the system itself. However investors are so worried that the slightest sign of a problem means they rush into safe-haven assets. Right now the EU needs a detailed plan to build a banking union and to mutualise some debt.

The markets are however very nervous. There are still many challenges facing Greece and Spain. The ECB has so far not taken enough action to stabilise the bond markets, and details of how it will do this and how effective it will be remain unclear. There are ongoing concerns about the potential for opposition from Germany – the euro zone’s largest country and paymaster – to any large-scale bond-buying program.

Professor Fariborz Moshirian is the Director of the Institute of Global Finance at the Australian School of Business.

Professor Peter Swan

The prospective entry of the London-based LCH Clearnet to break ASX’s monopoly of clearing house activities is great news for Australian investors and brokers alike. It seems likely that the bid to break the ASX monopoly will be approved by the Australian Securities and Investments Commission (ASIC) and the Australian Treasurer (see Bianca Hartge-Hazelman’s AFR story). The clearing and settlement process for derivatives, cash and shares is a crucial component of trading activity. Clearing provides the critical assurance that trades will settle, removing the counterparty risk via a third-party guarantee in exchange for a fee.

Incumbency of the clearing and settlement process, like incumbency in terms of the trading mechanism, confers considerable advantage to the Australian Securities Exchange (ASX). The much heralded entry of Chi-X, providing competition in trading, has resulted in negligible loss of market share to ASX. This is testimony to ASX’s preparedness for Chi-X entry, reflected in lower fees and revamping of ASX’s trading system, as well as natural monopoly advantages.

In contrast, entry into the London market imposed serious market share losses to the London Stock Exchange (LSE) even though the incumbent’s loss of profits was far less than its market share loss with competition increasing the overall size of the market.

Clearing and settlement, as embodied in the ASX CHESS system, probably has some natural monopoly elements, although not as much as in the trading system. Hence, entry of competitive clearing house providers is unlikely to lead to any catastrophic loss of ASX market share in the short-run but will put considerable downward pressure on ASX fees in a business segment generating 15% or more of ASX revenue. Lower fees will encourage greater trading volume and liquidity.

As the ASX loses more statutory protection against entry in different areas of its business, it is going to be forced to become more innovative and competitive if it is to survive as other than a target for predators.

Its business model in recent years has been to give in to major brokers demanding less transparency and openness. Thus, in November 2005, the ASX decided to conceal broker identities in the limit order book, making it far harder for traders to find suitable counter-parties. I believe that such opacity is one of the reasons that some brokers describe the current ASX market as ‘dead’ with much less willingness for parties to trade.

Similarly, in the area of corporate governance recommendation for listed companies, the ASX has looked after the bid end of town via promotion of the rather strange idea that companies should be run with boards dominated by a majority of ‘independent’ non-executive directors (NEDs).

In practise, this means that companies are ‘monitored’ by part-timers largely ignorant of company affairs and typically recruited from outside the industry with little if any ‘skin in the game’ or alignment with shareholders. No wonder the performance of many large companies with large boards (Rio is an example) has been exceedingly poor in recent years.

Under the ASX’s non-binding governance rules, Gina Rinehart would not qualify as an ‘independent’ director if she were to join the Fairfax board as she owns more than 5% of the stock. Whatever one thinks of Gina Rinehart, rules that discourage incentivised board members are a national disgrace.

Within the top ASX 200 companies, firms with above average sized boards have on average a 50% lower market to book ratio than do firms with below average sized boards. Hence, it would seem that management is far less constrained and need not act in shareholder interests when boards are large and consist of part-timers with only weak alignment with shareholders.

The raison d’etre of the ASX board in recent years has been to try to sell itself to the highest bidder, even when that bidder, the Singapore Stock Exchange, has a dismal record in comparison with its peers, rather than trying to improve its own performance.

Clearing and settlement, and in particular, the ASX dominance of this activity, is one of those issues that led the Foreign Investment Review Board to reject the Singapore bid last year. I am sceptical that one or two entrants into clearing activity would of itself lead to a change of heart by the regulator. However, if there were to be thriving competition in clearing and settlement, together with a lot more competition in trading, and an overseas bid without close foreign government ties (unlike the Singapore bid), then the regulator is likely to be much more forthcoming.

Professor Peter Swan is the Professor of Finance at the Australian School of Business. This article first appeared in the Australian Financial Review.