Evaluating 'independent' advice

BY ROSS GITTINS

Third parties can suffer when businesses pay outsiders to assess them.

It's simply this: in the modern, mercenary world, paying someone to give you "independent" advice is a contradiction in terms. The conflict of interest is obvious.

If someone's paying you to give them advice, the temptation to give them the advice they want to hear so as to ensure you retain their business is overwhelming. The problem arises when the law requires companies to pay to obtain advice for the benefit of other parties who aren't paying for that advice and have no direct relationship with the provider of the advice.

The most glaring example is the role of the credit rating agencies, whose failure to provide genuinely independent advice contributed greatly to the financial crisis. They gave AAA credit ratings to sliced-and-diced mortgage-backed securities that were actually quite risky (because they included the mortgages of sub-prime borrowers) and ended up worth a fraction of their face value.

How could such amazing dereliction happen? It happened because it's left to the company that issues the securities to pay the rating agencies to award the rating that potential investors rely upon when deciding whether to buy the securities.

It seems clear that in an environment where everyone in the financial markets was getting in for their cut, the rating agencies yielded to the temptation to grant unjustified ratings to insistent customers.

They had no contractual relationship with the intended users of their supposedly independent ratings, but an all too real commercial relationship with the issuer buying the rating.

When you think about it, you realise the commercial world has many examples of the law requiring companies to buy "independent" advice for the benefit of shareholders, investors, other creditors and other "stakeholders".

Next most obvious is the requirement that public companies have their financial accounts externally audited. No doubt in time we'll see loads of litigation against auditors who gave their clients unqualified audit reports right up to the time they collapsed.

Then there are the supposedly independent expert reports provided for company prospectuses. There are the reports of remuneration consultants that directors use in judging the (invariable) inadequacy of executive salaries, which they often claim as independent advice.

There's even company directors themselves. In theory, they represent the interests of the shareholders, protecting them from the self-interest of executives.

But they have no real relationship with the amorphous mass of shareholders. Rather, all their contact is with the executives who, in reality, often appoint them - and probably often organise the advice on which the directors' own remuneration is determined.

It's remarkable how little public discussion there is of this patently obvious problem: that advice one party buys for the benefit of other, absent parties can't be independent of the interests of the party wielding the cheque book.

But it's not hard to guess why there's so much reluctance to face up to this anomalous arrangement: the obvious solution to the problem is unattractive to all sides.

It's clear the party that pays for the independent advice - the party that has the commercial relationship with the provider of the advice - must itself be independent of the party whose affairs are being reported on.

And it's obvious who the independent payer must be: the Government (or some government agency). Governments could recoup the cost of obtaining the advice by levying a fee on the party being reported on (which is already responsible for bearing that cost under the present arrangements).

You can imagine how much enthusiasm there'd be for such a reform among either the reported-on or the reporters. Let the government get directly involved? Never.

And in the present anti- government environment it's hard to imagine the politician who'd be keen to expand the role of the public sector in such a way.

So it looks likely that, by tacit consent of the vested interests, we'll go on pretending that independent advice can be bought, and continue to provide shareholders, investors and others with false security.

But it's interesting to ponder how such a practice could have built up in the first place. How could it have been imagined that independence could be paid for?

I think it could have been imagined in a former, less mercenary era, when "professionalism" meant something very different.

Today, to be professional means either to be paid rather than amateur, or it means being highly competent at your job.

In the old days, it meant putting the interests of your client ahead of your own interests. What a quaint notion. Who today would delude themselves that they didn't care all that much about what was in it for them?

In the old days it wouldn't have been so hard to believe that auditors and credit raters were capable of keeping the interests of shareholders and other investors ahead of their desire to preserve a harmonious relationship with their client.

What changed? We all became a lot more money- hungry.

Why have we become more mercenary? I believe it's an unintended consequence of micro-economic reform, or "neo-liberalism". We deregulated and privatised in an effort to increase competition in markets, thereby inducing greater economic efficiency.

It's worked a treat. Competition is more intense in most markets, the economy is more efficient and as a community we're a lot more prosperous.

But in turning up the competitive heat we got people more focused on the monetary prizes and crowded out non- commercial motives and norms of accepted behaviour such as true professionalism. One day we'll have to face up to the consequences of our reduced emphasis on ethical behaviour.

* Ross Gittins is the Sydney Morning Herald's economics editor.

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