- Should lawyers expressly encourage clients to consider the organisation's values when considering their advice?
- Directors and senior executives must put in a serious effort to understand the culture of their organisation.
- Legislative change to the financial services provisions of the Corporations Act have introduced a new test that applies to all dishonesty offences.
See also: What are we Learning From Royal Commissions and Inquiries?
The requirements that focus attention on the director role are complex and weighty. Under this burden, stewardship that demonstrates understanding and embraces culture will improve efficiency and effectiveness. But, what is the influence of law on the nebulous nature of culture, can legal frameworks provide guidance for directors as they work with culture?
Recent commentary on the underlying causes of numerous corporate scandals has focused on culture as a governance tool, difficult though it is to specifically identify culture in a manner that avoids platitudes. Nevertheless, an urgent search for explanations and solutions becomes even more necessary when companies, and the people who work within them, systemically act in a way that breaches normative values, or worse act criminally.
The Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry ('royal commission'), recommended that organisations, as often as reasonably possible, take proper steps to assess the entity's culture and its governance, identify any problems that appear and deal with those problems in a manner that regularly determines whether any changes made have been effective. While the regulators call for boards to have greater accountability for culture, how can directors properly identify their organisation's culture?
The relationship of law with culture
Directors and senior executives must put in a serious effort to understand the culture of their organisation. In a pessimistic piece that questions whether current directors could ever effectively address these challenges, Graham Samuel noted:
"Cultural change needs to be driven internally by the board and management, with limited reliance on consultants. If a board and CEO do not know what culture is needed to be imbued in their organisation, perhaps they should be considering their suitability for leadership of the organisation."
Given the size of many institutions, analysing and changing culture will require a lot of effort.
Commissioner Robert Hayne described culture as the "shared values and norms that shape behaviours and mindsets" within an organisation, describing it as 'what people do when no-one is watching' and what might be called, essentially, 'internalised' or 'instinctive' application of shared values and norms, that seems to both reflect and constitute the culture of an entity, either driving or discouraging misconduct (see APRA's Risk Culture October 2016 Information Paper).
Professor Jennifer Hill provides an interesting review of relevant definitions in her recent article Legal personhood and liability for flawed corporate cultures.
Legal responses may be well-meaning, but they are often too blunt to assist. The law's relationship to culture is as complex as the concept itself. Commissioner Hayne noted that culture cannot be prescribed or legislated, but it can be assessed (See Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry - Volume 1, p375). In essence, the royal commissioner urged that to preserve and enhance a reputation...the enterprise must do more than not break the law. It must seek to do 'the right thing'.
Hayne adopted the Treasury's question:
"What more can be done to achieve effective leadership, good governance and appropriate culture within financial services firms so that firms 'obey the law, do not mislead or deceive, are fair, provide fit for purpose service with care and skill, and act in the best interests of their clients."
Robert Fitzgerald asks whether lawyers are the best people to advise on what is fair. Perhaps they are not. He asks, will lawyers start to give advice not only about what the client can do, but also what is the right thing to do. On more than one occasion Hayne asked participants in the royal commission, "When did you think this was the right thing to do?". Should lawyers expressly encourage clients to take into account the entity's values when considering their advice? Some lawyers have argued that imposing requirements such as this is taking things too far.
It is axiomatic that the primary cultural responsibility for an organisation lies with its directors, and the mechanisms of governance they operate through the CEO and other managers (See Final Report Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry p4).
While directors understand strategy, do they understand culture? The aphorism 'culture eats strategy for breakfast' evokes a discussion on the nature of good leadership that inspires, rather than commands.
"A company's culture must be a strategic asset. The board should have a strong pulse on how executive, mid-level and lower-level management demonstrate and communicate the company's values."
Klemash asks whether the board has the right metrics to understand the 'tone at the top, mood in the middle and buzz at the bottom'.
Ken Henry, then chairman of NAB, speaking at the royal commission questioned whether the board can 'ensure' a particular culture, said:
"We have said consistently to APRA the word 'ensure' is a bit strong. It's really difficult for a board to be held accountable for ensuring anything, just as it's rather difficult to hold APRA to that - to that standard of ensuring an appropriate risk culture'. He said that the board 'has the principal role to play in respect of the development of the culture of the organisation' but that 'ensure is a bit of a strict standard."
He added, "Model, lead, encourage, those words are...more obvious than 'ensure'".
What are the implications for directors?
Will the law itself require change? And to what extent should boards take into account the interests of their customers when assessing what is in the best interests of the company? This raises a much larger debate about how directors should satisfy their obligations. That debate raises questions of whether directors' duties should be seen as public duties.
Dr Henry also thought the question of whether customers or shareholders should have priority "goes to the state of capitalism", adding, "the capitalist model is that businesses have no responsibility other than to maximise profits to shareholders".
Perhaps, more pointedly, it goes to the question of how directors' duties should be regulated. He added that NAB had decided that instead of a business purpose "to maximise shareholder returns subject to customer tolerance and subject to regulatory tolerance", it should be "about maximising the outcomes for customers subject to financial viability". While there is no doubt that attitudes towards the construct of directors' duties are evolving, it may take legislative change to underpin attitudes such as this.
There are tentative moves to widen the scope of matters directors should take into account when fulfilling their duty to the company they direct. So-called 'constituency statutes' apply in many European jurisdictions and states in the United States. In the United Kingdom the 'enlightened shareholder model' of s 172 of the UK Companies Act 2006, specifically endorses non-shareholder considerations to be considered by directors, without displacing entirely the obligations to shareholders.
Some think no change is required to Australian law, while others note there is no need for a break from the current legal position that directors' duties are owed to the company, and take a more open approach, referring to the principal directors' duty (see s 180 of the Corporations Act 2001), which is 'a hybrid provision, with legal elements both public and private'.
The United States Business Roundtable issued its updated Statement on the Purpose of a Corporation on August 19, 2019, which while confirming this the free-market system, marked a departure from the previously endorsed philosophy of Milton Friedman that emphasised the maximisation of profit as the "one social responsibility of business".
The Roundtable now emphasises a focus on customer value, employee well-being, dealing fairly and ethically and enhancing diversity and inclusion in committing to generating long-term value for shareholders.
The royal commission's findings are relevant for culture and governance across all industries for several reasons, particularly because financial services should drive the dominant paradigms of good governance, relying as they do on trust and stability to attract business. The regulations designed to keep governance and culture in check in financial services have many similar features in other regimes, including rules about disclosure and licensing to regulators with similar criminal prosecution powers.
Dimity Kingsford Smith, Professor in the Faculty of Law at the University of New South Wales, was a member of the independent advisory panel of experts in the administration of law and regulatory enforcement that examined APRA's enforcement strategies and infrastructure, and how it interacted with APRA's core supervisory approach.
The Review recommended, among other things, a stronger level of co-ordination for enforcement between APRA and ASIC so they share information and take coordinated action while holding entities and individuals to account. Following the royal commission, both organisations will have greater levels of funding and monitoring with newly bolstered statutory powers to revise and create additional penalties to better effect enforcement powers, extending the Banking Executive Accountability Regime (BEAR) to other regulated industries.
The issue of fairness
Speaking recently in a public forum on the state of financial regulation in Australia, Professor Kingsford Smith made particular reference to a case involving Westpac that highlights the issue of fairness in financial services culture and which offers a subtle example of how an organisation can act improperly.
Involving Westpac Securities and ASIC, the matter was overshadowed somewhat by the royal commission because both were heard around the same time. But the decision, by Her Honour Justice Gleeson, was an important one as it looked at a normative requirement and general obligation of financial services licensees to ensure financial services are provided "efficiently, honestly and fairly".
The case concerned Westpac contacting customers offering a free service to search for super accounts they might hold with other providers. This contact was followed up by telephone calls from the bank's Super Activation Team offering to roll over the funds from the newly located external accounts to the customer's BT accounts. The Super Activation Team asked customers what they were looking for, what they saw as important and what they cared about, in a super fund.
When the project ended, $640 million had been rolled over into BT super accounts from January 2013 to September 2016. But, according to ASIC, the conversations with customers that drove the accumulation of these funds had crossed the fine line between personal and general advice.
Westpac argued the customer contact calls were a 'naked exercise' in marketing, and that customers would have known this, and not been misled into thinking that the bank was acting in their best interests.
Her Honour, Justice Gleeson, found that Westpac had breached its ethical obligations because, among other things, the bank did not explain that a prudent person might want to consider the loss of benefits from the other funds, including the potential loss of insurance policies and did not explain its own interest in consolidating the funds.
The decision is important for organisational culture because it goes to the actions of frontline staff and to the subtle manner in which a 'fairness norm' that should be an aspect of organisational culture was offended by what was, otherwise, a technically sufficient level of compliance. Westpac was found not to have acted in an efficient, honest and fair manner.
Legislative change to the financial services provisions of the Corporations Act 2001 has increased civil penalties and criminal sanctions for dishonesty in the course of carrying on a financial services business in relation to a financial product now carries a penalty of imprisonment for up to 15 years.
Perhaps more significantly, the changes have introduced a new test that applies to all dishonesty offences under the Corporations Act. The amendments insert a definition of 'dishonest' into s 9 of the Corporations Act to mean "dishonest according to the standards of ordinary people".
The impact on directors of organisations not involved in financial services should not be underestimated. The changes include amendments to s 184 of the Corporations Act, which imposes criminal liability on directors of any company for certain breaches of directors' duties. Previously, criminal liability was imposed where a director was "intentionally dishonest", but the reference to intention has now been removed.
The royal commission went beyond issues of dishonesty by requiring directors to consider the concept of fairness. Professor Kingsford Smith defines fairness as a mutuality of value and equality of treatment, and identifies a lack of mutuality, currently, in a sector supposedly built on trust and confidence. She foresees that fairness requirements in other regulatory regimes will pick up on this idea over time and warns that the new test of dishonesty will have a profound effect for boards in all sectors of the economy.
A final word on the interaction of culture within organisations and the law, and the legislative framework that generates and underpins it, might best be summed up in recent comments by Commissioner Hayne. In a speech to the University of Melbourne's Law School in late July about the predominance, recently, of royal commissions investigating industry sectors for misconduct he said "Trust in all sorts of institutions, governmental and private has been damaged or destroyed", leaving the question of regulation in the public interest and its impinging interaction on the culture of enterprise in organisations open for further development, requiring ever more attention from directors.
Directorial Q&A with Jonathan Casson
What key messages do think the various inquiries have sent directors?
Undoubtedly the key message is that business as usual is not acceptable. A renewed focus on ensuring diverse and appropriately skilled boards is essential. Understanding an organisation's culture, and moulding the culture to reflect the stated values and ethics of the organisation is clearly a board obligation.
What do you think the big focuses will be in 2020 in light of these inquiries’ finding?
Taking on board and implementing the re-focused policies described earlier this year by the United States Business Roundtable (Statement on the Purpose of a Corporation) and the impact of principle 3 in the ASX Corporate Governance Principles and Recommendations (effective 1 January 2020). Also, directors will need to jealously guard the ethical and cultural health of their organisation, without becoming overwhelmed.
In light of the findings, what top questions should directors be asking themselves in 2020?
In light of the findings, directors should ask themselves not only if the proposed action is legal, but if it is ethical and the right thing to do, and whether it supports the company's values. In answering this they should consider long-term impacts as well as short-term wins.
What changes could we expect boards to be making in 2020 as a result of these inquiries?
Boards should be conscious of the stronger level of cooperation for enforcement between APRA and ASIC, and their new policy of "why not litigate?". There should be an increased focus on an entity's ethical obligations, especially but not only in the financial sector, and an awareness of the changes in the Corporations Act 2001 regarding criminal liability, and the definition of 'dishonest'.
An edited version of this piece was originally published in Volume 71 - Number 8 of the Governance Institute of Australia's Governance Directions Journal.