Our Reflections on this report

Any update from our firm in relation tocorporate governance and HIH would not becomplete without an acknowledgment from usof our involvement in two aspects of HIHsaffairs the payment to us of $1,000,000 on14 March 2001 and the consultancyagreement we previously had with Mr CharlesAbbott, a former partner of the firm, whichincluded a commission entitlement.

As a firm, we are reflecting on theseexperiences and the Commissioners Reportmore generally and we are seeking to learnfrom them. It has much to say to directors,managers and advisers about the importanceof integrity in all our business dealings. Wecommend the report to you.

John AtkinManaging PartnerBlake Dawson Waldron

(full letter on page 2)

BLAKE DAWSON WALDRONL A W Y E R S

May 2003

Corporate Governance Update

HIH Royal Commission Report

IntroductionOn 15 March 2001 provisional liquidators wereappointed to the HIH Insurance Group. Theestimated $3.6 to $5.3 billion collapse of HIH isreported to be the largest corporate failure inAustralian history. The magnitude of the collapsehas been felt across Australian society, including inindustries reliant upon public liability andprofessional indemnity insurance, the residentialbuilding market, and insurance markets.

The Royal CommissionThe Federal Government appointed the HonJustice Neville Owen in August 2001 toinvestigate the failure of HIH. The key emphasisof the HIH Royal Commissions inquiry was toascertain the reasons for and the circumstancessurrounding the failure of HIH. The terms ofreference also included an inquiry intoundesirable corporate governance practices.On 17 April 2003, the Federal Governmentreleased the long awaited report of the HIHRoyal Commission (Royal Commission), TheFailure of HIH Insurance (Report).

"I found myself asking rhetorically: did anyone stand back and ask themselvesthe simple question is this right?"Hon Justice Neville Owen

The Report is the culmination of almost 20months work and incorporates oral and writtenevidence from more than 100 witnesses during220 sitting days. Justice Owen identified 56instances of potential civil or criminal lawbreaches. The Report makes a number ofrecommendations in relation to these potentialbreaches, including recommendations that actionbe taken against certain principals and executivesof HIH.

In addition, Justice Owen has made over 60policy recommendations covering areas includingfinancial reporting, accounting standards(including AASB 1023), auditor independence(and rotation), ASX Listing Rule amendments andamendments to the Corporations Act concerningclarifying (ie extending) the responsibilities andduties of middle management.

In releasing the Report, the Treasurer indicatedthat Justice Owens recommendations will beconsidered when the CLERP 9 legislation isprepared. However, the extent to which the CLERP9 legislation picks up the recommendations will besomething to monitor. It is expected that this

legislation will be introduced into Parliament in thesecond half of 2003.

The ReportThe Report focuses upon the corporate collapse ofHIH and its lessons. It examines the consequencesof directors and executives failing to act ethically, togive full disclosure both internally and to themarket, to apply rigour to decision making, to takepersonal responsibility for the standard of corporatedecisions, and to act independently. It providesnumerous examples of inappropriate use ofcorporate resources, extravagance, conflicts ofinterest and dishonesty.

Reasons for failure where doesresponsibility lie?Justice Owen concluded that the HIH case wasnot a case where wholesale fraud orembezzlement abounded. He concluded thatthere were 6 primary reasons for the failure:

1. the money was never there there wasfailure to provide adequately for future

2 BLAKE DAWSON WALDRON

Dear Clients and Professional Colleagues

Our Reflections

Any update from our firm in relation to corporategovernance and HIH would not be completewithout an acknowledgment from us of ourinvolvement in two aspects of HIHs affairs thepayment to us of $1,000,000 on 14 March 2001and the consultancy agreement we previously hadwith Mr Charles Abbott, a former partner of thefirm, which included a commission entitlement.

In his report, the Honourable Justice Owen(Commissioner) makes a number of very powerfulobservations on the importance not just of theform but rather the substance of corporategovernance and the importance of a strong senseof integrity on the part of both company officersand advisers. We agree with his observations andwould add that a key part of any sense of integrityincludes being honest enough to admit when youhave made a mistake.

Last year we carried out our own investigationinto the receipt by us of the $1,000,000payment. Following that investigation, wedecided it was not appropriate for us to retainthose monies and we repaid both the$1,000,000 and two other payments we hadreceived shortly before the appointment of theprovisional liquidators, together with interest.

We have also carried out our own investigationinto the consultancy arrangement we had withMr Abbott. That arrangement was entered into

in 1990 at the time of Mr Abbotts retirement asa partner. While, as the Commissioner notes, ourconsultancy agreement with Mr Abbott hadbeen disclosed to HIH, and to its shareholdersthrough HIHs Annual Report, we accept theCommissioners criticism that the commissionelement was inappropriate and note his findingthat Mr Abbotts disclosure of it was insufficient.Our consultancy arrangement with Mr Abbottwas terminated in 2001.

Following these investigations we have nowreviewed our policy on consultancyarrangements generally to ensure that there areno such arrangements which would give rise to aconflict of that nature, irrespective of thedisclosures that may be made.

As a firm, we are reflecting on these experiencesand the Commissioners Report more generallyand we are seeking to learn from them. It hasmuch to say to directors, managers and advisersabout the importance of integrity in all ourbusiness dealings. We commend the report toyou.

Yours sincerely

John AtkinManaging PartnerBlake Dawson Waldron

claims through chronic under-reserving orunder-provisioning;

2. mismanagement lack of attention todetail, a lack of accountability forperformance, and a lack of integrity in thecompanys internal processes and systems;

3. the ill fated commitment in 1996 to re-enterthe US market;

4. the unwise acquisition of FAI insurances in1998;

5. poor decision making including the sale ofthe most profitable lines of business; and

6. the corporate culture the culture thatdeveloped was inimical to sound managementpractices.

Corporate mismanagement

The Report concluded that mismanagement atHIH included:

a lack of attention to detail at all levels fromthe board down;

a lack of accountability for performance;

a lack of integrity in the companys internalprocessing systems;

the use of incorrect accounting in relation tocertain reinsurance transactions;

the accounting treatment of certain intangibleand other assets which made the balancesheet appear stronger then it was;

generally aggressive accounting; and

an overly complicated corporate structure.

These factors, could be said to have manifestedthemselves in a number of poor, and ultimatelyfatal, business decisions. Again, HIH was not a caseabout wholesale fraud, but essentially involved ill-informed decisions being made to address flawsthat were appearing in the edifice that was HIH.

Specifically, Justice Owen highlighted that:

the HIH board failed in its decisions on majortransactions and acquisitions, because thesedecisions were made without due deliberationor analysis foremost among these was theacquisition of FAI Insurances in 1998;

the audit committee did not give sufficientdetached consideration to audit issues and thatthe committee was too close to the board asevidenced by the influence that the chiefexecutive officer exercised in deliberations andfunctioning of the audit committee; and

the HIH board failed to appreciate theimportance of HIHs single biggest liability itsprovision for outstanding claims.

Some lessons to be learnt substance over formThere are many lessons for company directors andmanagers and some of these are examined below.

The Report contains a number of sections oncorporate governance. The Commission definedcorporate governance as "the framework of rules,relationships, systems and processes within and bywhich authority is exercised and controlled incorporations". The importance of corporategovernance substance over form is a key themeof the Report. It should be remembered that HIHhad a stated corporate governance framework,consisting of those matters that are typicallyincluded in a corporate governance framework.

The Report acknowledges that corporategovernance is an evolving concept, and corporategovernance practices must necessarily bemoulded to the circumstances of the particularentity. Justice Owen is adamant that a "one sizefits all" approach is not desirable. Corporategovernance has at its heart accountability andstewardship and the effective management ofrisk. It is reliant upon people with integrity whoexercise an independence of judgment.

Accountability through a clear strategy,written objectives and performance objectives

1. Identify and articulate strategyIn his Report, Justice Owen identified the failureof HIH to formulate an adequate managementstrategy as a serious deficiency. This wasdemonstrated by the boards, and individualdirectors, inability to articulate the companysstrategy both before the collapse of HIH andwhen giving evidence to the Commission. Thelack of any analysis of the future strategy of thecompany made assessment of business decisionsand review of the performance of HIH andmanagement difficult.

Boards must consider and develop companystrategy. This is more than just developing adocument filled with buzz-words. It requiresfirst, a detailed understanding of the companysbusiness and its business, regulatory andcompetitive environment. Next comes detailedplanning, resulting in the development ofmeaningful performance indicators whichencourage behaviour which furthers thestrategy. A common method of achieving this isthrough a designated periodic (usually yearly orhalf-yearly) strategy meeting or strategyweekend in which information flows both toand from board members and senior executives.

2. Monitor and review performanceThere was no clear framework from whichperformance of HIH could be judged. Inmonitoring performance, the board of HIHneeded to measure management proposals by

BLAKE DAWSON WALDRON 3

reference to endorsed strategy, with anydeviation in practice being understood andchallenged.

The directors also had a responsibility to ensurethat management proposals were beingfollowed through. HIH's UK business was thesubject of constant regular internal audit reportsfor some time however, little was done toensure that the proposals for improvement wereimplemented and followed through.

3. Directors must take a sufficient level ofresponsibilityJustice Owen made the point in his Report thatit was a constant refrain from the directors thatthey relied and were entitled to rely onmanagement and external advisers and shouldnot be held responsible for any deficiencies inthe information that they obtained. In JusticeOwens view, it was incumbent on the directorsof HIH to put in place systems sufficient forthem to be able to determine whether or notthe information provided to them wasreasonably reliable.

Conducting inquiries into whether informationprovided by management or delegates isreliable, is not only good corporate governance,but can be important in establishing a defenceunder section 189 of the Corporations Act. Inthe context of assessing whether a director hasbreached a duty, section 189 provides that adirector's reliance is reasonable if, among otherthings, the director believes on reasonablegrounds that the person who provides theinformation is reliable and competent and thedirector has made an independent assessmentof the information.

Active monitoring can be crucial for this point.Knowledge of the information gatheringprocess and assumptions on which informationand reports provided to the board are based is agood starting point. This, together withknowledge of the business itself, should enablea director first to tell if the information is ofcredible quality and then to make sensibleinferences from the information as to theperformance of the business.

Clear lines of responsibility, reporting andauthority

4. Positioning for proactivenessA clear lesson from the HIH experience is thatall directors must ensure that they are placedin a position whereby they can questionmanagement properly, review theperformance of the company and monitor theeffectiveness and implementation of thecompanys strategy.

Independent and non-executive directors shouldconsider whether they should be meeting with

senior employees without the presence ofexecutive directors. The Report details a numberof instances whereby the non-executivedirectors were kept in the dark concerningtransactions involving HIH. For example, some ofthe non-executive directors of HIH only learnt ofthe acquisition by HIH of Sphere Drake'sinsurance business in the UK in January 1997upon reading about it in the newspapers.

5. Define and enforce limits on authorityIn the case of HIH it should also be noted thatthe defined limits on the authority of the chiefexecutive officer and other senior managerswere non-existent or were routinely flouted.The failure to clearly set and enforce the limitsof executive and management authority wasseen a number of times in the HIH tale.Examples range from the seemingly benign, asdemonstrated in the instances of uncontrolledphilanthropic largesse, to the criticallyimportant, in the way management wentabout writing new business.

HIH's entry into film finance insurance is a clearexample of the importance of setting andenforcing operational limits of authority. TheUK branch's entry into this previouslyunexplored market came about as a result ofone of the UK underwriting staff writing filmfinance policies outside of set limits. When thepractice became known, a large amount ofbusiness had been written in an area whichHIH had no intention to enter into. The resultwas entry into a new underwriting area forwhich management lacked both anappropriate understanding of the risks and theability to accurately price those risks.

In any organisation, people should knowwhere they stand and what activities they arepermitted to undertake. They should also knowwhen their superiors need to be involved inconsidering a decision, noting that the board,ultimately, has responsibility for the direction ofthe company.

6. Corporate structureThe way the HIH group was organised made itdifficult for the board to monitor the activitiesof the overall group. For instance:

the non-executive directors, who wouldotherwise be playing a monitoring role, werenot directors of the entity which was licensedas an insurer; and

the business was administered on a portfoliobasis rather than on a company-by-companybasis and administered by subsidiaries whichwere separate from the licensed insurer.

Therefore a situation existed where onesubsidiary was taking care of the interests of anumber of companies in the HIH group all of

4 BLAKE DAWSON WALDRON

which potentially had different risk profiles anddivergent interests to protect. For instance HIH(Liability) Pty Ltd looked after HIH, C&G, CIC andFAI General among others.

Company groups are commonly structured fortaxation or liability minimisation purposes. Boardsshould consider, however, whether over emphasison these factors is detrimental to the goodgovernance of companies in the relevant group. Agoal should be to have a corporate structure thatencourages good governance behaviour.

Monitoring of management

7. Board must assert itself and fulfil its roleIt is clear in the case of HIH, that managementoperated without regard to the board and itsrole in monitoring the companys operations.Rather, it seemed that management regardedthe board as a hurdle to be overcome or anobstacle to be circumvented, rather than aresource to improve corporate performance.

The board has a fundamental role in ensuringthat management performs adequately, inaccordance with the defined strategy of thecompany. The roles of management and theboard are not necessarily inconsistent. Conflictsbetween the two can be avoided throughproperly documented procedures and effectivecommunication.

As part of asserting its role, the board must avoidbeing deferential towards, or intimidated by, the

chief executive officer or other executives. Achief executive officer who is given free reign,with the board merely acquiescing to theproposals put forward, can lead to results whichmay not be favourable to the company as awhole. Justice Owen commented specifically onthe reluctance of some on the board to act toreprimand the chief executive officer in instanceswhere the board was cut out of the loop ondecisions concerning significant transactionsinvolving HIH.

Due process

8. Monitor and resolve conflicts of interestJustice Owen noted in the Report that, atboard level there was a clear failure torecognise, address and resolve conflicts ofinterest of individual directors. There weresimilar problems associated with related partytransactions. These problems arose because theboard did not adequately focus on the criticalissues of conflict of interest and related partytransactions. Further, the board did not haveprocedures to enable it readily to identify andresolve such issues. Justice Owen noted thatthe company chairman had primaryresponsibility in this area.

In addition to written procedures and ensuringthat all directors are trained in conflictidentification and management, directors shouldbe pro-active in bringing potential conflicts outin the open. As Justice Owen stated:

BLAKE DAWSON WALDRON 5

Better Governance Practices Ensure there are proper procedures for board meetings, including making the meeting

agenda a live working document and ensuring that the agenda is controlled by the boardnot management.

Implement adequate procedures for identifying and, if necessary, resolving conflicts ofinterest.

Review the role and influence of senior executives in relation to the board.

Ensure that the chairman acts independently from senior executives.

Encourage questioning and challenging by the board of the information provided to it bymanagement.

Ensure that there is proper and independent analysis by the board of all decisions onsignificant proposals.

Facilitate an effective audit committee independent from management, which meets withthe auditors in the absence of management.

In relation to assessing salary increases for senior executives seek independent advice andensure clear performance criteria exist to guarantee the salary increase is a true and fairreflection of each executives performance.

Empower the chairman to satisfy himself or herself that the supply of information to theboard is appropriate to enable the board to properly undertake its function.

Promote a culture where management has a responsibility to bring matters of concern to theboards attention.

"The board and in particular the chairmanshould have taken the lead in ensuring thatall situations which might involve or give riseto a conflict of interest were fully disclosedand ventilated so that none of the otherdirectors could be under anymisapprehension concerning the relevantcircumstances."

9. Active company chairman and a livingagendaJustice Owen found that the use of astandard form agenda for board meetingswhich was prepared essentially by themanagement of HIH, limited the scope ofissues addressed by the board. Justice Owencommented that the agenda became a proforma and was not a living tool fororganising and shaping consideration andreview of the current issues facing HIH.Because of this, the information flow to theboard was controlled by management andthe board did not have appropriate checksand balances in place to minimise the riskthat it was being misled.

The board and the chairman and notmanagement need to drive the agenda. Thisensures that a proper review of whethermanagement is acting in the best interests ofthe company as a whole, is not subverted. Toenable a chairman to do this, he or she musthave a good understanding of theperformance of the company, its strategy andthe developments that the executives areseeking to implement.

10. Issues must be given real considerationJustice Owen observed in his Report that thefact that debate occurred in a board meetingdoes not necessarily mean that the requisitelevel of independence and rigour of analysisthat is required of a board, was practised.

The Audit Function

11.A separate and independent AuditCommittee is importantThe constitution of the HIH audit committeedetracted from its ability to function effectively.The audit committee did not operateindependently and in reality acted as anextension of the board. Executive directors ofHIH often attended audit committee meetings,regardless of whether they were formallyappointed to it. In the period leading up to itsbeing placed in provisional liquidation, HIH hadfour executive directors and two other directorswho had recently been in senior managementroles. The attendance of executive directorsundermined one of the roles of the auditcommittee being the ability to operateindependently of management.

However, the audit committee must be morethan nominally independent. It must be active,have a written charter that is followed andplay an active role in considering the accountsand the manner in which current and futureactivities will be accounted.

12.The role of external auditorsJustice Owen also made a number ofcomments on the conduct and role of externalauditors. In Justice Owens view externalauditors play a vital role in the financialreporting process, particularly in relation tocompanies where the financial position andperformance is a matter of national economicsignificance.

A properly conducted audit should enable usersof the financial reports of a company to relyupon the accounts with a degree of confidence.Justice Owen, however, did not got as far to saythat if a company becomes insolvent it isindicative of wrongdoing on the part of theexternal auditor.

Justice Owen made a number ofrecommendations in relation to auditorindependence. These are set out in the tableon page 7.

13.The role of internal auditorsAs Justice Owen observed, the purpose ofinternal audit is to provide an objectiveassessment of a companys performance andthe effectiveness of its systems of internalcontrol. An effective internal audit functioncan help a company avoid unjustifiable risks.

It is clear from the Report that in the case ofHIH, internal audit reports received bymanagement were not presented directly tothe audit committee or the full board. Instead,the material was being provided throughmanagement and only a summary prepared bymanagement was ultimately provided to theaudit committee. In one instance in relation toan unfavourable audit report, an executivedirector instructed the secretary for it to betaken off the audit committee agenda and itwas removed from the board packs.

In addition, the board often did not activelyfollow through on whether therecommendations arising from the internalauditor's report was being effectivelyimplemented. The operations of HIH's UKoperations had been the subject of internal auditreview for a significant period with internal auditreports or summaries being regularly presentedto the board. Notwithstanding the deterioratingposition being evidenced by the series of reports,the board failed to ensure that the measuresdesigned to bring about change were effective.

6 BLAKE DAWSON WALDRON

The lesson here is that the internal auditorsshould report directly to the audit committee(or the full board) so that management doesnot have an opportunity to delay or sanitiseunfavourable reports or bury anythinginconvenient. The board also has aresponsibility to ensure that defects identifiedby the internal auditor are addressed so as toavoid future calamity.

In conclusionThe Report of the Royal Commission providesmany lessons for those who are involved in therunning of companies, and their advisers. One ofthe next steps will be to monitor the extent towhich the recommendations made by JusticeOwen are adopted by the government.

BLAKE DAWSON WALDRON 7

Key RecommendationsSome of the key recommendations madeby Justice Owen include:

directors' remuneration disclosure reviewing the Corporations Actrequirements, accounting standards andthe Listing Rules relating to directors'remuneration to ensure that they"achieve clear and comprehensivedisclosure of all remuneration or otherbenefits paid to directors in whateverform".

statutory duties of management amending the Corporations Act toprovide that some of the statutorydirectors' duties are imposed on a"functional" basis that is, duties shouldbe imposed on all persons performingfunctions for and on behalf ofcorporations, whether employees orcontractors.

audit independence and employeeassociations to promote theindependence of auditors:

there should be a mandatory period of4 years between an audit partnerresigning from an audit firm andbecoming a director or taking up asenior management position with aformer client;

there should be a mandatory 2 yearperiod between a former partner whowas not directly involved in the auditof a client becoming a director or seniormanager of that client; and

there should be no more than oneformer partner of an audit firm, at anytime, being a director or seniormanager of a client.

auditor rotation the requirement forrotation of the lead engagement partnerand review partner proposed in CLERP 9should be extended to key senior auditpersonnel.

continuous disclosure amending ListingRule 3.1 to require that price sensitiveannouncements must have the approval

of either the board or a delegate of theboard subject to ratification by the board,prior to their release.

blacklisting of analysts amending theListing Rules to prohibit the "blacklisting"by companies of analysts who publishunfavourable reports concerning thecompany.

Listing Rule 11.1 amending Listing Rule11.1 so that it applies to any significantchange in the business or assets of alisted company, whether by way ofacquisition, disposal, amalgamation orotherwise, with "significant change" tobe defined to encompass financial andgeographic factors as well as the natureand scale of a company's business.(Listing Rule 11.1 requires a company tonotify ASX of a proposed significantchange to the nature or scale of itsactivities. Once notified, ASX can requirethat a company seek shareholderapproval for the proposed transaction.)

International Accounting Standards inadopting International AccountingStandards, Australia should reserve theright to require more stringent standardsthat are not inconsistent with therelevant international standards,including disclosure requirements.

APRA a number of recommendations inrespect of APRA, including:

removing ASIC and RBA involvement inthe supervision of APRA;

creating an APRA executive responsiblefor the management and operation ofAPRA; and

adopting procedures to ensure thatstaff and management continuallyquestion their assumptions, views andconclusions about the financial viabilityof supervised entities, particularly onthe receipt of new information aboutan entity.

Sydney (02) 9258 6000Melbourne (03) 9679 3000Brisbane (07) 3259 7000

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Where applicable, liability limited by the Solicitors Scheme, approved under the Professional Standards Act 1994 (NSW).This publication is intended only to provide a summary of the subject matter covered. It does not purport to be comprehensive or to render

legal advice. No reader should act on the basis of any matter contained in this publication without first obtaining specific professional advice.

2003 Blake Dawson Waldron

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