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An Inefficient Deregulatory Initiative: The Australian Class Order Deed of Cross Guarantee

Sandra van der Laan

Modern globalised society is becoming increasingly complex, both socially and economically. To maintain commercial 'order' it is necessary for governments, their regulatory agencies as well as other quasi-legislative bodies, like the accounting profession and (say) the securities exchanges, to intervene through legislation and various administrative regimes. What follows examines the efficiency of regulatory intervention in the form of an administrative set of arrangements (a specific Class Order Deed of Cross Guarantee, DXG) administered by Australia's national corporate regulator (currently the Australian Securities and Investments Commission, ASIC). The analysis is limited to Australia as the DXG is uniquely Australian.

Government and administrative intervention in the market (or economic regulation) through implicit or explicit legislative and administrative controls serves to constrain and shape economic activity. Most theories advanced to explain economic regulation examine regulation through the prism of satisfying the 'public interest' or that it has been captured by interest groups advancing their own agenda. More recently, moving away from traditional approaches, some theories explain regulation as being shaped by institutional arrangements and the resulting regulatory processes and outcomes occur in a particular regulatory space (Hancher and Moran, 1989) which enables an examination of the consequences of the regulation. This perspective underpins the following examination of a voluntarily-adopted Australian financial reporting provision that emerges as a result of an ASIC Class Order, namely the DXG. The DXG is an example of what is described below as discretionary regulation. The regulation can be adopted or not at management's discretion, however, there are potential costs from adoption.

Audited financial reports of corporations provided for 'users' of financial information are highly regulated. The primary objective - 'in the public interest' - of requiring audited financial reporting is to communicate to interested parties verified relevant and reliable information about a reporting entity to enable efficient and effective allocation of scarce resources. Under the DXG only certain economic group accounting information is made available to the market. This presents an interesting regulatory development simultaneously requiring additional mandatory disclosure in summary form, closed-group accounts, but also allowing for non-disclosure of individual corporate financial information which is a form of redacted disclosure (Verrecchia and Weber, 2006). A different notion of redacted disclosure is adopted in what follows as it is more descriptive of the DXG regime.

The DXG arose from a regulatory initiative originally introduced in 1986 under the then national regulator, the National Companies and Securities Commission (NCSC). The regulation was claimed, by the NCSC Chairman, Henry Bosch, to reduce the regulatory burden for companies and - it promoted the uniquely Australian phenomenon - the closed group. Administrative arrangements creating the closed group which provide accounting and auditing relief to wholly-owned subsidiaries have a number of conditions to be met. Critical to obtaining relief is that companies must enter into cross guarantee arrangements in respect of the individual closed-group companies' debts. This regulation brings to the fore the fundamental objectives of accounting and auditing for corporate entities. It also highlights inconsistencies in Australia's Corporations Law, in particular, relating to the capital boundary issue. Specifically, concerns exist as to efficacy of the notion of the corporate 'veil' as it applies in the corporate group context. As a side issue, it highlights the difficulties of achieving real International Financial Reporting Standards (IFRS) convergence when legal nuances are in play across different jurisdictions.

The analysis reveals the primary persistent objective of the DXG regime (outlined at its introduction) is to reduce regulatory compliance costs for wholly-owned subsidiaries. Whether this has been (or is currently being) achieved has not been tested, but merely assumed and accepted. This, notwithstanding the Class Order giving rise to the DXG regime has been in existence (in various forms in Australia only) for a quarter of a century. Its introduction, persistence, continued refinement and expansion suggest that there must be something beneficial to some parties about the regime. To this end, empirical evidence is provided on some of the 'purported' benefits associated with the DXG. It will enable, amongst other things, an assessment of whether Henry Bosch's original justifications and support for implementing the arrangements were, and remain valid.

A further assumption supporting the introduction and persistence of the DXG is the claim that providing separate audited financial reports for wholly-owned subsidiaries does not provide the market with an increased amount of meaningful information, given that this information is subject to consolidation with the parent entity. However, under the current regime, what results is a limited set of financial reports for what amounts to a new form of accounting entity, a closed group. Creditors are argued to be 'protected' against their loss of the company specific information from their debtor subsidiaries by the covenants of the DXG allowing access to the assets of closed group on liquidation.

Similar to consolidated groups, a closed group arguably is an entity for financial reporting purposes that is defined by, and only acknowledged in, an accounting context. Therefore, initially an overview is provided of the nature, characteristics and incidence of closed groups. This establishes the basis for exploring in detail the two central propositions of the implementation of such a regulatory intervention. First, does providing relief for wholly-owned subsidiaries from administrative (accounting and compliance) and auditing requirements result in audit cost savings for the corporate group. The accounting and compliance costs are not considered, but it is argued are likely to be immaterial. And second, in practice, whether creditors are protected by the cross guarantee arrangements under the DXG which crystallise on liquidation. This analysis rests on a Kaldor-Hicks' notion of regulatory efficiency. It evaluates regulation on the basis of whether the 'harm' inflicted on third parties (in this case, creditors) is less than the amount that transactors are better off. If it is, then the regulation is considered efficient.

In essence, the analysis evaluates of the consequences of the DXG regime with reference to economic concepts and assumptions in terms of costs versus benefits of the two primary observable rationalisations for the implementation of the regulatory intervention. Therefore part of the analysis takes the form of an examination (albeit preliminary) of audit fees in order to determine if the anticipated benefits flowing from the regime in the form of reduced audit fees have been achieved. One of the conclusions of this thesis is that more detailed analyses of this aspect are required.

The covenants of the DXG that crystallise on liquidation are then evaluated in terms of the potential cost of the guarantee arrangements. The costs of creditor protection are approximated. They are empirically evaluated through a series of case studies in order to determine if creditors of closed-group companies are protected though the ability to access the assets of other closed-group companies on liquidation.

Overall, the preliminary and partial analysis fails to provide evidence of any 'net' benefits from the DXG regime. Specifically, unintended consequences are indentified - additional benefits are found for the primary and secondary parties, and unforseen costs are identified for third parties, namely creditors (including employees) and shareholders. As such, the regulatory intervention does not satisfy the requirements of economic efficiency. The evidence adduced here, while partial, suggests that the continued provision of financial reporting and auditing relief to wholly-owned subsidiaries in the corporate group context through the current cross-guaranteeing arrangements should be revisited. Further research is required, but at present there is scant evidence to support the claim the regime is meeting its intended objectives.


Professor Graeme Dean, Professor Stewart Jones and Dr Demetris Christodoulou.