Jenny Buchan

The Australian government is moving to introduce a new Franchising Code of Conduct as part of wide-ranging reforms to how franchising arrangements are regulated, claiming it will be fairer for small operators and cut red tape. Whether that will happen is far from certain.

The proposed changes will only apply to franchise agreements signed from the start of 2015. The biggest changes are the introduction of a specific duty of “good faith”, and the requirement for franchisors to give prospective franchisees an “information statement”.

These changes are accompanied by legislation that will give the regulator, the Australian Competition and Consumer Commission, the ability to impose financial penalties on franchisors that breach the code, whereas it wasn’t able to before.

But the changes would leave some of the fundamental problems affecting the relationship between franchisors and franchisees – namely knowledge and power imbalances – unfixed.

Knowledge and power imbalances are the Achilles heel of franchise relationships. A franchisor builds a business, creates a blueprint of it, and licences franchisees to replicate it using the blueprint. With power over the content of the agreements comes scope for abuse. Franchisees sign the agreements with little ability to negotiate changes.

The first Franchising Code of Conduct in 1998 attempted to bring balance to franchise relationships. It mandated pre-contract disclosure, specific rights such as a cooling off period for franchisees and established a dispute-resolution system based on mediation.

However, eight more franchising reviews have been conducted since the code was introduced, suggesting it has not achieved its objective of raising standards of conduct in franchising.

The current proposals have come out of the 2013 Wein Review. It made recommendations in eight broad areas: disclosure, franchisor failure, transparency of financial information, good faith, the end of a franchise agreement, dispute resolution, enforcement and “other matters”.

Most recommendations weathered the subsequent change of government.

The most significant change, Wein’s recommendation for a “good faith” clause, has been adopted. But a party to a franchise agreement does not have to act in good faith if this would get in the way of their legitimate commercial interests.

This means, for instance, that if a franchisor’s duty to its own shareholders is best met by selling the franchisor’s business to a property developer who wants the franchisor’s sites (even though this would mean the franchisees lose their businesses), the franchisees’ rights become secondary. This will only create a false sense of security for franchisees.

Another major change, the proposed information statement, is intended to address knowledge imbalances by providing franchisees with more information. But the change will only require a generic information statement, which assumes all franchise networks are the same, and that franchisees can already conduct adequate due diligence.

This overlooks the fact that every franchise is structured differently. Even within the same network different franchisees can be exposed to different risks.

A prospective franchisee, attempting to conduct due diligence, will still meet numerous impediments. Neither a franchisor’s disclosure documents nor its franchise agreements are on a public data base. This means potential franchisees cannot compare the offering before them with what is usually offered for franchisees in the same network, or with the franchise agreements of comparable businesses.

This is even worse if a franchisor operates through a trust, because the franchisee cannot discover who is behind the trust. And because dispute resolution processes are confidential, it is difficult to identify problems in the network.

Franchising has changed since 1998. Franchisors used to establish a successful business before franchising it. Now, according to the Franchising Australia Survey 2012, one-third of franchisors have operated their business for less than 12 months when they start selling franchises.

How can a business operating for less than 12 months be described as successful? And franchisors now exist within networks of, say, 40 related entities. Any due diligence on the franchisor is not indicative of how sound the franchisor’s related entities are.

The franchisor may itself be a “$2” company. If it is not performing well it can be placed in administration and restructured by shedding franchisees. The code should require disclosure of a full organisation chart showing how the franchisor fits into the group.

Perhaps the worst of the overlooked opportunities for reform is that of franchise failure. The franchisor retains the right to terminate the franchise agreement if the franchisee enters administration, but no reciprocal right exists for the more vulnerable party – the franchisees.

The government has returned the complex challenges that franchisor failure presents to the “too hard” basket. This is a missed opportunity to alleviate the knowledge and power imbalances that make life for franchisees that much more difficult.

Jenny Buchan is an associate professor in the school of taxation and business law at the Australian School of Business. A version of this post appeared on The Conversation.

http://theconversation.com/new-franchising-law-no-code-for-fairness-25154

Justin O’Brien

Australia cannot ignore the Singaporean investigation into attempts to manipulate key financial benchmarks. 

The investigation by the Monetary Authority of Singapore into the attempted manipulation of key financial benchmarks has profound implications. Notwithstanding the fact that no evidence of actual success has been proffered, Singapore has moved quickly and decisively to change the domestic and international regulatory battleground.

The regulatory change is based on very loose principles articulated by the International Organization of Securities Commissions earlier this year. The decision is a considerable victory for IOSCO, which is chaired by Greg Medcraft of the Australian Securities and Investments Commission. Its articulation of global principles, although purposively vague, was designed to demonstrate both the timeliness and efficacy of international coordination. In fleshing out these principles in a radical redesign, Singapore is providing a much needed route map to navigate two pressing hazards.

The first of these is how to handle the investigation and enforcement process. The MAS action has foreclosed individual investigation and the piecemeal erosion of trust associated with periodic disclosure of individual institution misconduct. Instead it opted for a comprehensive settlement. The second and potentially more significant navigational aid is how the settlement forcibly enlists the industry in protecting the integrity of the rate-setting process.

The benchmarks are conceived as a public good that industry has an obligation rather than an interest in protecting. Cleverly, the MAS has forced ‘skin in the game’ by demanding individual banks increase the level of reserves deposited with the central bank.  Under the terms of the settlement, released on Friday, the banks implicated have to deposit additional reserves in Singapore for a period of one year, during which they will not receive any interest.

The exact amount depends on the degree of complicity in the scandal, with the highest imposed on ING, RBS and UBS (S$1-1.2 billion each). What is also clear, however, is that the MAS does not trust the capacity of any of the banks to clean this mess up without external supervision. The banks are required ‘to report their progress to MAS on a quarterly basis, and conduct independent reviews to ensure the robustness of their remedial measures.’ Self-certification, therefore, is deemed in itself inadequate.

The Association of Banks in Singapore is to be stripped of its capacity to self-regulate the benchmarks. Manipulation or attempted manipulation is to be made specific civil and criminal offence. At the same time, the authorities have made it clear that ongoing integrity can only be vouchsafed by a significant change in practice. The MAS has managed to force the industry to institute an effective early-warning system linked to blacklisting those directly implicated (if not charged with wrongdoing). It notes that ‘the industry will put in place measures to facilitate reference checks, so that an institution would be made aware if a potential hire had been implicated in attempts to inappropriately influence benchmarks.’ 

In taking such robust enforcement action, Singapore is guarding itself against the possibility that any future civil or criminal proceedings in the United States will seek to quarantine guilt to subsidiaries operating in Asian markets. Its integrated approach also has the capacity to break the impasse within the IOSCO taskforce set up to evaluate how benchmarks can be refined. The United Kingdom continues to insist Libor and its facsimiles can be reformed; the United States by contrast wants it replaced by observed rates. These too, however, run the risk of being manipulated.

It goes without saying that the primary focus of the MAS investigation will be the main British Banks implicated, including RBS and Barclays. It is, however, also significant that US banks have been censured formally. The involvement of two major Australian banks – ANZ and Macquarie – in the scandal also raises serious questions about the efficacy of oversight here in Australia.

Because ANZ and Macquarie were in the bottom range (S$110-300m) they failed to make initial international media reports. Although Macquarie itself does not itself submit to the Association of Banks in Singapore benchmark rate, it too is found to have ‘deficiencies in governance, risk management, internal control and surveillance systems.’ Along with the other banks censured it must adopt measures to address deficiencies and appoint an independent party to ensure the robustness of remedial measures.

With the MAS action, the manipulation of financial benchmark scandal has gone global. Australia, the lucky country, has for once not been saved by the tyranny of distance. In today’s globalized marketplace, it is too obviously implicated for regulatory agencies here in Australia to ignore.

Professor Justin O’Brien is director of the Centre for Law, Markets and Regulation at UNSW  Law.

His most recent research paper on Libor has just ben published by Edmond J Safra Center for Ethics at Harvard university. It is available for download at http://ssrn.com/abstract=2277172

A shorter version of this article was previously published in The Australian Financial Review.

Peter Swan

On Thursday the Gillard Government launched Phase 2 of their High Speed Rail study that was produced as part of a political agreement with the Greens.

The very optimistically projected cost is $114 billion for 1,800 kms of rail to link Melbourne to Brisbane via Canberra and Sydney. Approximately 8% of the route requires exceedingly expensive tunneling, giving huge scope for costs to blow out.

The projected (internal) financial return is 0.8% compared with a minimum of 15% to be considered for a commercial project. Hence it could never be financially viable and is likely to require on-going subsidies even if the Government provided the entire capital cost.

Can the project be justified in cost-benefit terms? Certainly, the Report claims that there is a positive benefit/cost ratio at low discount rates with the benefits roughly equal to the costs with a 7% discount rate.

These benefits consist of consumer and producer surplus. It is my belief that these benefits are likely to be vanishingly small in practice with the costs far outweighing the benefits.

These benefits are assumed to arise largely from time savings due to better access and egress compared with airports such as Tullamarine. A high-speed rail connection between Tullamarine and the City could be built for less than $114 billion with considerable time and convenience savings. There might even be some spare change.

Such assumed time savings also presumably drive the 55% of passengers who are assumed to switch from air to rail and the 19% induced passenger increase.

It is hard to imagine that the 23% of passengers that are assumed to switch from cars will gain sizeable subsidiary benefits to motivate a switch. In fact, many who currently drive will face car-rental and other out-of-pocket costs that are likely to be sizeable.

In my view, these passenger estimates are likely to be even more upward-biased than the pie-in-the-sky estimates that led many toll-road providers to the bankruptcy in both Sydney and Brisbane. Projected toll-road/tunnel usage exceeded the reality, typically by 100% or more.

At least one would think that private providers taking and equity stake would be cautious in accepting ludicrous estimates of traffic projections. Governments looking for juicy election bribes have no such hip-pocket concerns. All of these failed projections tended to give excessive weight to traveler time-saver benefits.

The first question to ask is what is a high-speed rail network? It is largely duplication of air passenger routes provided for ‘free’ by nature. Unlike air-routes high-speed rail is exceedingly capital intensive with an exceedingly long gestation period.

The Report projects that cash-flow will be positive for the first time around 2060, about 45 years after commencement. Once of the few routes that is commercially viable is in major Japanese city pairings with population density about 1,000 times higher than major pairings in Australia.

Even Japanese bullet trains received a bailout in 1987 and Taiwan’s line needed rescuing only two years after commencement. In China the high-speed network is highly problematic with severe speed limitations imposed on some lines. One line was even reduced to 45 kms an hour. Even in much denser Europe, only a few city pairs are financially viable.

There is no indication that any success will be achieved in North America. The Californian line that commenced in 2008 had spent $630 million within three years without constructing even one kilometer of track.

Thus the benefits of high-speed rail are largely illusory, especially in Australia with its exceptionally low population density and existing network of relatively efficient airports. Removal of curfews could greatly improve airport efficiency, especially in Sydney. Unfortunately, the costs are not illusory and are likely to be massively understated in the Report.

There have been quite few very-fast train schemes in Australia, mostly centering on the Sydney-Canberra-Melbourne corridor.

The first one was proposed by the then head of the CSIRO who carried the appropriate handle of ‘Wilde’. Hence the ‘Wilde scheme’, of which the latest incarnation from the Gillard Government is yet another example of an exceedingly white elephant.

It is also well timed as a tempting election bribe where it joins the Gonski Report into school funding, the National Disability Scheme and numerous other unfunded projects.

Professor Peter Swan is the Professor of Finance at the Australian School of Business.

From the Knowledge@Wharton today blog.

A strong wave of investments has flowed into Europe over the last couple of months, offering some observers hope that it’s a precursor of a sustained economic recovery and an end to the long-standing euro crisis. On the surface, it appears to be good news, particularly given that the eurozone recently slipped back into recession. But despite the injection of more than $135 billion in private investment towards the end of 2012, the latest economic indicators offer more cause for pessimism than optimism.

The split between what financial markets and the economic fundamentals are telegraphing about the future is confusing many observers. On the financial side, equity and bond markets, buttressed by the moves of the European Central Bank (ECB) in the fall to support government debt markets, have seen two very positive developments. One development is falling government bond interest rates, which is key because that makes it easier for some of the more desperately strapped governments to finance their large debts. The second development is rising equity markets. That suggests some companies may become more optimistic and could start to hire new workers in countries that have devastating unemployment rates.

As for why the stock markets are doing so well while real economies are doing so badly: “I think that quantitative easing is a big part of the explanation,” says Wharton finance professor Franklin Allen. “[Central banks] are buying up huge amounts of debt securities globally, and at least part of the money is going into equities and driving their prices up.”

Wharton management professor Mauro Guillen notes that bond markets have improved significantly in the eurozone because Spain and Italy have had de facto bailouts. “A bailout is needed if there is a problem with selling government bonds at an affordable interest rate. From this point of view, the ECB’s action in the summer to support the euro at all costs has made a difference. The risk premiums have come down – the ECB has been buying Italian and Spanish debt. So, in a way, they have already been rescuing Italy and Spain without going through a formal bailout.”

Last July, Mario Draghi, the ECB president, said his institution would do “whatever it takes” to avoid countries leaving the eurozone. Some countries wanted to exit in order to be able to create their own home currency, which they could then devalue to spark exports and get out from under crushing debt. The bank said it would ensure with financial underwriting that Italy and Spain could issue as much new debt as needed in order to finance the strict deficit-reduction programs now underway.

Ordinarily, the positive developments seen recently in financial markets might be viewed as leading indicators pointing to better days ahead. But these are not ordinary times. The problem is that these developments come against a worsening economic performance and not a stabilizing outlook. The best recent example is Italy, which takes on outsized importance given that it is probably too big for the eurozone to bail out if that were required, particularly after the huge bailout measures directed at Greece, Portugal, Spain and Ireland. Here are some notable recent economic indicators for Italy:

• The Bank of Italy now forecasts a continuation, through much of this year, of the recession that started late in 2011. This month it cut its GDP growth forecast for 2013 from -0.2% to -1.0%.
• Industrial production dropped by 7.6% in November compared with a year earlier, and was down 1% from the previous month.
• In the first 11 months of 2012, production declined 6.6% below the 11-month period in 2011.
• Demand for fuel fell for the January-November 2012 period by 12% compared with 2011.
• This year will mark the 15th year in a row that Italy has recorded a decline in industrial production.

For Spain, Europe’s fourth-largest economy, the story is similarly grim. Unemployment hit a new record at 26%, and youth unemployment – which is decimating an entire generation of workers’ chances at securing good careers – is now above 55%. Industrial production slumped 1.8% in the final quarter of 2012 from the same 2011 period. The economic contraction in Spain (as in Italy) is a direct result of strict austerity policies. The Spanish government is slashing government spending in order to reach eurozone-imposed, deficit-reduction goals. Spain’s budget deficit ratio, which was 9.4% of GDP in 2011, dropped to 6.3% in 2012, and the aim is to hit 4.5% this year and 2.8% in 2014.

The data for Spain and Italy highlight the problems. “The financial markets are signalling a bright outlook, but the reality in terms of growth currently is far from that,” says Allen. Eurozone growth forecasts call for recession for the next six months to a year, then a switch over to growth. “The problem is that these growth forecasts have been drastically wrong. Greece is the classic example. When they started with the bailout program, the projections were that there would be a similar trajectory. That, of course, is not what happened, and we have had five years of contraction.”

Italy could “well get into a downward spiral like Greece,” Allen says. The ECB’s Fiscal Compact Treaty, as in the case with Spain, will be a long-term drag on growth because it requires Italy to slash its debt by more than 3% of GDP for many years. As the country’s economy and thus revenues shrink, it then has to cut even more, “and this will be problematic. The recent problems and the bailout of Monte di Pascua di Siena [an Italian bank] illustrate there are a lot pitfalls along the way as the economy starts shrinking. Italy hasn’t grown significantly for a long time. It’s not clear what policies will create growth.”

The austerity policies being vigorously pursued in much of the eurozone increasingly are being questioned, including by the International Monetary Fund (IMF), which recently acknowledged in this Working, titled “Growth Forecast Errors and Fiscal Multipliers,” that too much austerity can damage GDP growth during a debt-deflation recession such as we have now by a factor of two or three times more than previously thought.

This is a huge concession and suggests that the current approach of using austerity for debt reduction may be self-defeating. In its most recent update of its World Economic Outlook, released January 23, the IMF forecast that while the world economy overall was likely to grow by about 2% this year, the “euro area continues to pose a large downside risk to the global outlook,” as does “excessive near-term fiscal consolidation in the United States.”

Guillen agrees that austerity policies have outlived their usefulness. “Germany seems fixated on this idea [of austerity]. They are balancing their own budget, although the markets are not demanding that. In the periphery, austerity means a prolonged recession and high unemployment for a longer period of time. I’ve said many times there is a middle-of-the-road solution that doesn’t negate the need for fiscal rebalancing while avoiding a long slump.” Germany should raise wages, which would stimulate troubled euro economies; the ECB should raise its inflation target, which would help to alleviate debt burdens more generally; and the surplus economies should engage in fiscal stimulus.

Italy’s current economic indicators, which help clarify what is happening in the eurozone more generally, are “very worrying,” says Allen. “It’s not clear they are on a sustainable path. They may well follow Greece. If that happens … the EU can’t bail them out.” So while it is possible that the ECB “may start monetizing the debt, this will require a large increase in their balance sheet. Not only will they effectively need to finance the Italian government but also the Italian banks. The other options will be to default or to leave the eurozone or both. None of these outcomes is good. ”

Many observers now think the ECB ultimately will weaken the euro considerably in order to stimulate the economy, Allen says. But such measures involve big risks. “We don’t know the possible long-term effects of these kinds of policies. My own view is still that the eurozone needs an exit mechanism for extreme problems. They avoided setting it up with Greece because they could fudge the numbers. But this was a mistake because if Italy has to leave, there will probably be significant contagion.”

If it is true, as more and more observers believe, that austerity now is causing more problems in Europe than it is solving, why can’t Europe’s leaders see that?

Politics and pride are preventing a clear view, says Allen. “The systems they have put in place haven’t worked, and they don’t want to admit this. They may muddle through. But the human cost is tremendous. Unemployment will probably go up significantly in Italy going forward. It is already unacceptably high in Spain and Greece, particularly youth unemployment.”

These societies are already undergoing tremendous social unrest under today’s stark economic conditions. How long can Europe go before there is a major political or economic breakdown, something far worse than we’ve observed so far? “We will see how much people will take,” Allen says. “The extreme parties are losing votes at the moment. But if growth doesn’t happen soon, this could change quickly.”

This post was previously posted in Knowledge@Wharton Today Blog: Europe’s Fundamentals Sink Despite Investment Surge

Rosemary Howard

Not the big end of town, but not small either, Australia’s  mid-market (defined by companies with revenue of $10-$250mil)  makes up just 1.4 percent of Australian businesses yet contributes more than a third (37 per cent) of Australian business revenue, contributes 21 per cent of deposit and borrowings and employs one in five Australians (23 per cent).

These businesses contribute around $425 billion in added value, compared to large and small businesses – which contribute $393 billion and $373 billion respectively.

The mid-market is the fastest growing sector in our economy, yet it often flies under the radar. By focusing on this sector, we can support its growth — not only here but into Asia, which is where the growth lies.

Recently, the Australian Government released the “Asian Century” whitepaper which addresses how to ride the wave of Asia’s continual growth. This is about government investment in education, infrastructure, workplace change and assisting companies find bigger markets for 2020+.

For mid-market businesses in Australia, the Asian Century whitepaper signifies the need to network and be open to the world, particularly to Asia. Geographically, Australia is intrinsically linked to Asia and we are in an enviable position given the tremendous growth of China and the Asian tigers.

Australia is now at a very important point in its history.  The world is changing dramatically and a strong Asia focus is required.  This applies at the general economic and society level as well as at the company level.

Let’s have confidence and stay positive.

Leadership. Innovation. Collaboration. Openness. Investment.

These areas are critical to the future of Australia’s mid-market sector.

Rosemary Howard is the Executive Director and Conjoint Professor of Executive Education at the Australian Graduate School of Management.

Rosemary has over 30 years experience in senior management with executive leadership positions in public and private sectors. Prior to joining AGSM, Rosemary was CEO at TelstraClear and inaugural Managing Director, Telstra Wholesale. Previously, Rosemary was Executive Director, NSW Department of State Government.

Rosemary holds a Bachelor of Science from Sydney University, Masters of Science and Society from UNSW and Graduate Diploma of Management from AGSM.  In 2003, she was awarded an Australian Government Centenary Medal for ‘Service to Australian Society in Business Leadership’.

Tim Harcourt | The Airport Economist

When you are punting on this year’s Melbourne Cup, have a bit of sympathy for Australian export businesses who have to make their big bets on international markets in the Asian region. Like a good punter Australian exporters have to look at the horse, the jockey, the state of the track, and of course, the odds. And it is not just a flutter for them but a major business decision that will affect their livelihood as well as the well being of those whom are dependent on their business as well.

To help the average race goer understand the nuances of exporting, the following export ‘form guide’ has been produced. 

Horse number one is Great Samurai, representing the Japanese market. It’s a long standing champion, has been written off by some, but still very capable and strong and has helped others develop in the East Asian stable yards through outward investment.

Secondly, there’s New Dynasty, representing China. This dynamic new colt has surprised seasoned punters with his ability to maintain a fast pace, year after year.

Thirdly, Passionate Tradition, representing Korea. This little known but powerful galloper with an industrious approach has revealed new appeal to punters in recent years.

Fourthly, there’s Fragrant Harbour, representing Hong Kong. Known for slipstreaming the colt from China but also an attractive performer in her own right.

Fifthly, there’s Little Dragon, representing Taiwan. She is occasionally overshadowed by her new high profile cousin, New Dynasty, but she’s a tidy performer who has rewarded loyal supporters well over many seasons.

Next is The ASEAN Emissary, representing Vietnam. This is the dark horse of the East Asian field that has put together a string of good seasons in recent years and seems set for even better days ahead.

Next is Taj Mahal, representing India. An up and comer who is twinned sometime unfairly with New Dynasty, but is coming into his own thanks to ongoing reform of stable practices.

Finally there’s Archipelago, representing Indonesia. Had question marks a while ago but had now start challenging the field and becomes am up and coming favourite amongst Aussie punters.

Racegoers should also consider a few newcomers amongst the emerging markets including Arabian Nights from Abu Dhabi in the United Arab Emirates, Samba Fever from Brazil and even a roughy like Genghis Khan from Mongolia, Burmese Days from Myanmar or Boratnomics from Kazakhstan might be good for a place.

So there you have it, your own export form guide for Asia. Fortunately, back in the real world, exporting is clearly not all about luck as much as skill and strategy. It requires good research, innovation, flexibility and good knowledge of your prospective market. And most importantly, the evidence shows that it does pay off. According to economic research, exporters are, on average, faster growing, more profitable and more productive than non-exporters. Exporters also pay better wages; provide better employment conditions and higher quality jobs than non-exporters. In short, exporting is a good bet for both large and small players in the international trade game but you’ve got to be a stayer in the Asian Century.

Tim Harcourt is the JW Nevile Fellow in Economics and an adjunct professor in International Business Strategy, at the Australian School of Business, the University of New South Wales (UNSW) & author of The Airport Economist:  www.theairporteconomist.com.

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.

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?

Vic Edwards

Read virtually any newspaper at the moment, and you’ll be told how China could be about to witness a sharp economic contraction, which could impact on Australia’s AAA credit rating.

New figures show China’s export demand has moderated and orders in construction and real estate have contracted. That has compounded fears China is mirroring a slowdown in the global economy.

Many commentators have indicated that China will have a hard economic landing. My view is that this is wrong, and China is more likely to have a soft or cushioned landing provided that the USA does not slip into a steep recession or depression.

A sharp slowdown in China would cause problems in Australia because of its large exports in minerals, pushing Australia’s current account into deficit.

The ratings agency Standard & Poor’s has warned that Australia’s AAA credit rating could be at risk – and losing ­Australia’s top sovereign debt rating would threaten banks ability to borrow offshore. These concerns have seen the Australian dollar falling almost one US cent, and the ASX trading below 4,000.

I attended the Fitch Ratings Credit Forum, and found its assessment of China’s future outlook was much more pessimistic than my view. I am optimistic about the future for China, and while the rate of growth may slow down, any threat to Australia’s credit rating is unlikely to come from the booming Middle Kingdom.

The Chinese purchasing managers’ index fell to 55.2 in May from 56.1 in April, according to new figures from the China Federation of Logistics and Purchasing. A reading above 50 still indicates expansion.

On my visits to China over the past few weeks it has become clear that China is successfully making the transition from an export oriented nation to one that is much more based on domestic consumption. Certainly, this will cause a drop in its growth rate from 11% per annum to around 8%, but this is still a favourable outcome.

The change to a domestic economy is one that is good for Australia, with China still importing many raw materials. A factor not accounted for in most of the recent analytics of China is the fact that the enormous effort in developing infrastructure has been greatly misinterpreted. Western analysts and some of the investment banks have pointed to what seems to be excess capacity in having empty office blocks and highways leading to nowhere.

However the massive construction projects that are going on in the second tier cities such as Qingdao, Tianjin, Changsha and Chengdu are pulling people back from Beijing and Shanghai and providing a future base for decentralisation. New very fast trains are now permitting rapid and cheap transport. This is a real plus for China’s future. It will decongest the cities of Beijing and Shanghai and lead to future growth and development of the poorer western regions. Throughout my latest visit, I have seen that the investment in infrastructure is paying off.

Vic Edwards is a Visiting Fellow in Banking and Finance at the Australian School of Business.