David Mayhew: Knighthoods and crony capitalism

Doug Graham's reputation built during his political career was a major factor in his appointment at Lombard. Photo / Paul Estcourt
Doug Graham's reputation built during his political career was a major factor in his appointment at Lombard. Photo / Paul Estcourt

To strip or not to strip the man of his knighthood is the question many pundits have put to John Key after the conviction of Sir Doug Graham in the Lombard Finance company prosecution. Another question that has not been asked of the PM is whether Graham's case shows that crony capitalism is alive and well in New Zealand at a level equal to that in the UK of another (now former) knight, Fred Goodwin.

Goodwin, the former chief executive officer of the Royal Bank of Scotland, was knighted in 2004 for his "services to banking". Normally removal of an honour is the result of criminal conviction or being struck off by the person's regulator.

In Goodwin's case neither had occurred. Rather he was stripped of his title this year because of the scale and severity of the consequences of his actions. The global financial crisis overwhelmed RBS in October 2008, resulting in capital injections of taxpayers' money totalling £45.5 billion ($87.3 billion).

As the dominant decision maker at RBS at the time, widespread concern about Goodwin's decisions meant that retention of a knighthood for "services to banking" could not be sustained.

It was also said that Goodwin had brought the honours system into disrepute.

But the real scandal, and where crony capitalism came into play, was that he was knighted in the first place, well before his contribution was tested over time.

The term, crony capitalism, is used to describe an economy where success is based on close relationships between businessmen and government. Awarding honours can be an example of this - between 1999 and 2006, the UK Labour Government ennobled no fewer than 10 bank bosses.

Other examples in Britain include, "rocketing executive pay, bankers' bonuses, shameless tax avoidance and cosy relations between politicians, press barons and business leaders", to quote Conservative MP David Davis (in Prospect, March 2012). In Davis' view, crony capitalism inflicts huge damage to the UK economy, industry and society.

What about crony capitalism in New Zealand?

Graham was knighted in 1999 for services to the justice sector and Treaty of Waitangi settlements. His reputation built during his political career would have been a major factor in his appointment as a director of Lombard. It would also have been a major source of comfort to investors, not least because as an independent director and chairman of the board he was responsible for effective corporate governance taking into account their interests.

It is here that he and the other directors failed. The key finding of the judge was that there was a material discrepancy between the liquidity squeeze confronting Lombard in December 2007 and the more confident comments conveyed in the offer documents. Graham was aware of the implications of tight liquidity conditions for the company, which he described in an email in mid-November 2007 as "sailing very close to the wind now".

The same email identified that "the next two or three months will be critical". But Graham argued in court that it was not necessary to tell the investors of that assessment. Rather, he said, investors relied on the directors to make commercial judgments and would decide to invest on the basis of the commercial decision-making ability attributed to the directors.

Matters of detail such as reliability of projections on loan repayments (on which adequate levels of liquidity was dependent) need not be mentioned.

The flaw in this reasoning, as the judge noted, was that the decision to invest was for the investors to make on the basis of being adequately informed on material matters, not simply in reliance on the quality of judgment of those who would become the custodians of their investments. That concept underpins the disclosure-based regime on which law and regulation in investments are based.

The crucial point is that there is an inherent conflict of interest, between the directors who naturally wish to see a continuation of the company's business and investors who wish to assess the risk of their investment and act accordingly.

Good corporate governance recognises this conflict and manages it appropriately: not an easy task, but that is where the quality of the directors comes into play.

The irony of Graham's position in the trial is that it puts his reputation front and centre of the investors' reliance on the directors. That is, of course, what fuels the current debate about his knighthood: that he allowed his reputation to be associated with a product which was ultimately mis-sold.

Which brings us back to crony capitalism: too many of the great and the good have been seduced into lending their names as independent directors to businesses without fully understanding the vital role demanded of them in the corporate governance of the business.

The very fact of the finance company prosecutions (Five Star, Nathans, Bridgecorp, Lombard and more to come) must have brought home the risks this entails to all directors.

More generally, there needs to be a proper understanding that a healthy economy depends on the complementary and balanced roles of government and the marketplace (as argued in the US context by Jeffrey Sachs in The Price of Civilization, Economics and Ethics after the Fall, published in 2011).

Undoubtedly, the finance company debacle has scarred the New Zealand financial markets and therefore the economy.

The challenge is to identify other areas where unacceptable risks may be developing and to act before they crystallise causing damage to the economy and the country.

Whatever one makes of the Graham case, perhaps the knighthood debate is a red herring.

It would be a great shame if his work during the 1990s in progressing Treaty of Waitangi settlements for the benefit of all New Zealanders is tarnished by removing the honour bestowed on him by the country.

The greater issue that has emerged from the finance companies cases is the dangers of government and markets getting too cosy, and if there is to be an enduring lesson for New Zealand, then attacking crony capitalism is a good place to start.

David Mayhew is a barrister in London. In 2010/11 he was the Commissioner for Financial Advisers and a member of the Securities Commission.

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