Thank you for your invitation to speak here tonight. I thought I might comment tonight on the big story in international markets, the volatility of world stockmarkets and its implications for regulatory policy.
Slide 1 shows the growth of the US S&P 500 stock index over the course of the last 12 years. As you can see from 1996 to its peak in March 2000 it doubled. This had all the hallmarks of a bubble. And the events since then have the hallmarks of a correction.
In mid July 2002 the S&P 500 was down 48 per cent from its peak.
Compare this with the growth in the ASX200 index. The ASX200 was much more steady and incremental in growth - no bubble and no bust. But remember back to 2000. Most people saw our market's `conservative' growth as an indication of some kind of failure - we were an old economy rather than a new one, we had missed the ICT boom, etc. etc. At that time I argued we were a new economy not because we manufactured ICT but because we used it. And better than putting all our eggs in the tech basket was to have a rounded economy that was broadly based and could withstand shocks.
If the Australian stock market had the same sector weights (including IT) as the S&P, our stock market would have recorded a 32 per cent fall in value rather than the 3 per cent fall that has occurred from March 2000.
Slide 2 shows that over the last three or so years, the Australian share market has performed extremely well compared to other markets. The Reserve Bank reports in its latest Statement of Monetary Policy, that the UK and Canadian markets fell by more than 30 per cent and the US and Japanese markets fell by around 40 per cent since March 2000. Our performance in comparison leaves our stock market as one of the best performers in the world over the last couple of years.
Slide 3 shows why we can call the US sharemarket result a bubble. It compares the S&P index with underlying corporate profits based on tax returns. Interestingly, this is a measure of profits that companies do not have an incentive to overstate - they are profits filed for the purpose of tax.
Slide 4 shows how on an `as reported' profits basis stock prices rose all out of proportion with P/E ratios reaching unprecedented levels.
Going back to the comparison of corporate profits and share prices [slide 3], it is not hard to see why managers were motivated to fix remuneration to share prices rather than underlying profits. During the Tech boom the fact that a company made low or no profit was almost a badge of honour. In Tech companies there was often another reason to pay executives in shares or options - sometimes there was no cash.
One of the advantages of a market is that it allows profitable businesses to prosper and non profitable ones to fail. As a consequence capital gets allocated to the more profitable ones. This shows up at the level of the firm - capital is allocated to produce the goods and services that people want to buy. And the price signals of all those consumers buying goods and services for value allocates capital as between alternative uses.
At the national economic level, this success in efficient resource allocation shows up in higher productivity growth and more robust GDP growth. This is not to say there are no occasions to intervene in a market - plainly there are. But over time markets allocate limited resources better than the alternative mechanisms such as State ownership and State control.
Australia's GDP growth has remained strong during the Asian crisis, and the recent US recession. The latest National Accounts data confirms that Australia continues to be one of the strongest growing economies in the industrialised world. Growth was 4.2 per cent in the year to the March quarter. Low inflation, low interest rates and a competitive exchange rate have provided a sound environment for business growth.
This is an exceptional performance when compared against many of our trading partners. For example, in 2001 the US grew by only 0.3 per cent and the European Union by 1.5 per cent. Closer to home Japan, our largest export market, contracted by 0.5 per cent.
Australia's market sector labour productivity grew by 3 per cent per annum over the second half of the 1990s, compared to just 0.8 per cent per annum in the second half of the 1980s.
In a framework of strongly competitive markets, good corporate governance and sound reporting help ensure that scarce equity and debt are allocated to firms that can make the most productive and profitable use of them.
As we saw in the US in the late 1990s, it may be possible for a short period for prices to run away from fundamentals.
But in the longer term, corporate fundamentals will always assert themselves in the markets for debt and equity: Does the firm have good profits and cash flows? Does it compare well to competing firms in its sector and the broader economy? Is it well governed, with good board oversight of its strategic direction? Are the company's directors and management honest in their dealings? Does the company fully and promptly disclose relevant information, which enables investors to make informed decisions?
Good accounting, auditing and corporate governance help markets answer those vital questions, and allocate scarce capital to those who can make the most productive use of it.
These factors are all essential to well functioning markets, which are among the foundations of a strong economy.
And when an economy uses its resources more productively, the total welfare of the community is lifted.
So we want our markets to function well; to build a stronger economy, to benefit the community.
In any year there will be thousands of business failures.
They will fail not necessarily because they are run by bad people. Or because any law was broken. Or because of executive greed. They might fail because they produce goods or services which people don't want to buy, or don't want to buy at that firm's price when it is available cheaper elsewhere. They might fail because of management inexperience, or because they were under-capitalised and never had a chance. They may fail because of external factors which were not forseen or could not be counteracted.
A company's failure can be a very personal blow to its investors, its directors, its management and its employees but it does not necessarily mean someone has broken the law. Effective corporate regulation and effective corporate governance does not and should not mean that corporate failures will be eliminated.
What it means is that investors, management, employees and customers can be confident that corporate activity is transparent and open, that corporate laws are followed, and that any failure to follow the law will be pursued by a vigorous corporate watchdog and enforced by an independent judiciary.
Australia vs USA
Under this Government, Australia now has the highest rate of share ownership in the world. We welcome the fact that so many more Australians have a stake in Australian companies. But this widespread share ownership has not eliminated the risk inherent in investments. It does make corporate regulation more important, so that risks of theft, fraud, concealment are eliminated or at least minimised to the extent possible.
These are not just issues for Australia. Globally there is a focus on disclosure and transparency. Recent corporate collapses in the United States serve to remind us of the serious costs of regulatory failure and corporate wrongdoing. Investors lose money, employees lose jobs, great companies can be destroyed. Confidence is shaken.
The Government wants to ensure that Australia's regime of corporate regulation protects the legitimate interests of all market participants, including the individual owners of shares as well as companies.
This Government commenced the overhaul of Corporations law with its Corporate Law Economic Reform Program in 1996 because we recognised that bad regulation has a real economic cost, while good regulation can increase the overall wealth of the community.
Previously, as part of CLERP, the Government restructured Australia's accounting standard setting process to strengthen the independent standard setter and balance the influence of the accounting bodies with broader stakeholder input.
We require disclosure of options.
The Corporations Act 2001 requires that details of the options granted as part of the remuneration of directors and the five most highly remunerated officers of a company be disclosed in the annual directors' report.
- For listed companies, the requirement is to disclose `details of the nature and amount' of these options. This would normally be taken to include their value.
However, to put the matter beyond doubt, the AASB has included in a proposed accounting standard on "Director, Executive and Related Party Disclosures" a requirement that disclosing entities disclose as remuneration:
- The value of equity-based compensation benefits based on their net fair value at vesting date (a valuation methodology is also specified); and
- Information on the terms and conditions of grants of equity compensation and other bonuses in the year of grant and in subsequent years until fully vested; this includes the price at which options may be exercised and the performance criteria that must be met in order for them to vest.
The AASB issued an exposure draft of this standard on 31 May 2002.
On many levels, Australia's corporate regulation and corporate culture compares favourably with the United States.
Our accounting standards promote substance over form - the "true and fair" requirement - whereas the US tends to rely on detailed provisions - the "black letter law" approach - which can encourage circumvention and loopholes.
To give you an example, the US Financial Accounting Standards Board has a standard governing accounting for financial derivatives and hedging - a standard that has been cited in relation to the collapse of Enron.
This standard, based on a simple principle but with myriad qualifications, exemptions and exceptions, now runs to over 800 pages. And it is still a work in progress.
A culture that says "show me where it says I can't do this" is more susceptible to sharp practice and unethical decision-making than one which favours compliance with broad principles of accurate reporting.
The Australian Accounting Standards Board has announced that it will issue future international standards at the same time as they are issued by the International Accounting Standards Board.
- This follows the announcement by the Financial Reporting Council on 3 July 2002 of its support for the adoption by Australia of international accounting standards from 1 January 2005.
- The IASB expects to issue its exposure draft on Accounting for Share-Based Payments in October 2002 which will require expense recognition of equity-based remuneration, including share options. The IASB expects to issue a final standard towards the end of 2003 to apply as a final standard to accounting periods beginning on or after 1 January 2004.
Disclosure of information to markets is another important difference.
Australia has an effective continuous disclosure regime, where significant information must be disclosed to the market as and when it is known, rather than the US system which focuses on quarterly reporting.
In addition, the presence of non-executive directors on boards appears to be a more common element of corporate culture in Australia than in America.
This distinction is most often seen in relation to the roles of Chief Executive Officer and Chairman. In America, the combined role of "Chairman and CEO" is far more prevalent. The practice most Australian public companies follow is to have an independent director as Chairman rather than the CEO. This is the preferred approach recommended in our guidelines for recommended corporate governance practice.
Improvements
We have room to improve and we are doing so in a number of areas.
The Government commissioned Professor Ian Ramsay to review the question of the independence of company auditors and we will issue our response to his recommendations in our CLERP 9 paper to be released shortly. But that report was written before more recent developments and therefore could not respond to them.
- Final implementation of reforms in the audit area will take account of any recommendations of the HIH Royal commission, work currently being undertaken by the Joint Committee of Public Accounts and Audit, and developments overseas, particularly in the United States in response to the collapse of Enron and WorldCom.
CLERP 9 will also contain proposals in the areas of audit standard setting, analyst independence, shareholder participation, continuous disclosure and enforcement issues.
ASIC, while having stated that it does not believe that Enron/WorldCom type accounting abuses represent a material risk in Australia, has established a task force to review the financial reports of selected listed companies and report on compliance with accounting standards.
In addition to action by government and its agencies, non-government organisations have a key role to play in maintaining proper standards of corporate governance.
The Australian Stock Exchange plays a key role in the continuous disclosure framework, but also in shaping Australia's corporate culture. The Government welcomes the recent initiative by the ASX to establish a corporate governance council and its announcement that it will enhance Listing Rule requirements regarding disclosure of compliance with standards.
Enforcement
Part of the test of the effectiveness of a law is its enforcement. By this standard, Australia's corporate law and its system of enforcement rates very highly.
Over the past two years, ASIC has successfully prosecuted a number of high-profile corporate officers.
- Former Harris Scarfe CFO, Alan Hodgson, was gaoled for 6 years;
- Following HIH's collapse, Rodney Adler was banned from company management for 20 years, fined and ordered to co-pay compensation in the amount of $7 million;
- Ray Williams was banned from company management for 10 years, fined and ordered to co-pay $7 million compensation; and
- Nicholas Whitlam was banned from acting as a director of any company for 5 years and ordered to pay penalties of $20,000.
Many of these people are appealing.
Looking at the last 3 years, action taken by the Australian Securities and Investments Commission has resulted in the gaoling of 69 corporate criminals for a maximum of 229 years.
Today, ASIC has 111 defendents before the courts facing criminal charges and 20 facing civil proceedings.
We have made also made it easier for ASIC to enforce our laws by significantly boosting ASIC's funding.
In the May Budget, the Government committed to boosting ASIC's funding by more than $90 million over four years, to maintain its enforcement capability and undertake ongoing work to implement and administer the recent CLERP reform in the financial sector.
By contrast, Labor's election policy was to boost ASIC's funding by only $6 million over 4 years; $84 million less than was delivered by this government.
There has been a very recent suggestion about increasing penalties for corporate offenders. Increasing maximum legal penalties achieves nothing unless prosecutions are brought and secured. Look at the failure of the `Skase Chase'.
However, laws and enforcement do not tell the whole story.
Governments aim to incorporate regulatory flexibility and avoid prescriptive approaches as far as possible. We have attempted to take a longer-term view in our regulation, so that changes in technology, business practice and community expectations can be successfully incorporated into regulation in an evolutionary manner.
But this approach cannot be sustained unless business also accepts responsibility for maintaining confidence in business practices.
Regulation is vital, but if `sharp' practice becomes morally acceptable, if peer standards do not reinforce standards, our laws will not be sufficient in themselves.
And business leaders such as yourselves have a central role in reinforcing and upholding standards. Without those standards, a great restraining force is lost.
Conclusion
Our economy is strong but not immune from international developments. We have come a long way with tax reform, reform of corporate governance, balancing our Budget, repaying $62 billion of Labor debt and labour market reform. But if we want to withstand these continuing challenges there is more to do. Our work is not yet finished.