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A rebuttal to Terence Corcoran’s “OSFI and the bureaucratization of corporate governance”

Terence Corcoran launched a scathing attack against recent regulatory announcements by the Office of Superintendent of Financial Institutions (OSFI) and the Ontario Securities Commission (OSC) on assessing and interviewing directors, and strengthening gender diversity, respectively.

OSFI announced, in a draft advisory, that it intended to ask for curricula vitae of, and interview, certain directors and senior management, who include oversight functions. The Ontario Securities Commission, in a request for comment, has proposed disclosure amendments that include addressing term limits; the representation of women on boards and in executive officer appointments; and internal targets that companies could set to achieve greater gender diversity.

Mr. Corcoran calls OSFI’s announcement a “bureaucratization” of governance; contends that the OSC will “force” women directors onto boards in a “social policy agenda”; and calls an academic study “Junk Science,” while accusing the study’s authors of “manipulating” their data: a very serious charge. All these contentions warrant a counterpoint.

Currently, financial institution and public company directors are self-selected by themselves or, worse yet, management. Shareholders may not propose their choice of, or remove incumbent, directors. They press for this right, otherwise known as “proxy access,” (e.g., shareholders who own 3% of common shares for three years can propose up to 25% of a board’s directors in an uncontested election), but boards resist. Company management has challenged proxy access in court, and has won.

Therefore, there is no third party oversight or validation of director skills, qualifications and selection. This reality enables self-interest, entrenchment, recruitment on the basis of personal relationships, discrimination, and directors who do not possess requisite expertise and background.

My own research and work with boards suggests directors can and often are conflicted through gifts, donations, offices, vacations, jobs for acquaintances, prior friendships, and other perks that management gives them. I have observed and assessed bank directors who tell me they do not understand acronyms that are being discussed. One director, emblematic of many, told me, “we don’t understand derivatives.” I have witnessed directors: arrive unprepared for meetings; fall asleep at meetings; who have “not made a single contribution in years” (according to other directors); and who do not do “any of this” (proper risk management). In one instance, a female director was proposed to a largely male OSFI regulated board, and a male director remarked “she’s attractive … since she likes skiing and sailing, she’ll be a good board member.” In another, a director asked “You want us to appoint a lady to our board?” A board chair once told me “There are only twenty women in Canada who are board ready.” (The qualification to be a director is often minimal: over 18, not bankrupt, and not insane.)

I also regularly conduct reviews of significant companies where directors are lacking in relevant industry and risk expertise. This is not true of all boards.

In short, how directors are selected, and what their qualifications are, are largely shielded from scrutiny. Investors are left to rely on fuzzy short bios, and assertions that a proper recruitment process based solely on merit has occurred.

OSFI enacted significant changes to governance, requiring: boards to have directors with risk and financial industry expertise; an explicit risk appetite framework; and oversight functions (including internal audit) reporting directly to them.

I know of at least one bank, one utility, and one university (and these were the only three organizations I checked) where the Internal Audit function reports to the CEO or CFO, which is wrong.

Corporate governance involves a legacy of “independent” directors, opaque selection, and deficient reporting, assurance and internal controls. Interviews, CV checks, and greater disclosure, which shareholders should be doing, can put the heat on boards to clean much of this up. Regulators have shown internationally that they are prepared to conduct interviews and enact competency matrixes in the absence of shareholder oversight. If boards wish to forestall regulation, the answer is to improve their practices and disclosure consistent with best practice, which now includes diversification.

Indeed, Canada is late to this global board diversity movement. The majority of peer countries around the world have already enacted diversity legislation, in many cases in a much more intrusive approach than the balanced and proportionate approach the OSC is suggesting. Mr. Corcoran states the OSC is going to “force” companies to appoint more women. This in my view is not correct because companies with no or few women on their boards are free to describe why this is the case, and why this should continue.

This is not a bureaucratization of governance, but a prudent assurance of systemically important financial institutions. Interviews are wise because simple questions, such as “To whom do you report?” “How did you come to be selected?” and “What relationships do you have with directors or management?” address what CVs can hide.

Shareholders can tell when they meet with a director whether that director is “camera ready,” and OSFI will be able to as well. If a director is camera ready, and possesses all the requisite qualifications to be fit and proper, they should have nothing to worry about. Indeed, good directors should welcome the interview.

Lastly, Mr. Corcoran derides academic studies. This past summer, a primary drafter of guidelines that had a profound effect on governance and director selection in Canada remarked publicly, “We did virtually no research.” This is unfortunate because academics bring something to the table. They adopt an independent, evidence-based approach. I have numerous studies underscoring the positive effects women on boards have. There are studies suggesting CEOs do not make better directors; tenure beyond 9 years diminishes shareholder value; and busy boards with over-boarded directors result in diminished board oversight and performance. People should not be afraid of, or deride, academic studies. On the contrary, they should welcome and learn from them.

Academic studies should be more widely consulted, not less. My own LinkedIn group, Boards and Advisors, has almost 10,000 members, attesting to the benefits of academic, practitioner – and journalist – interaction.

Richard Leblanc is an Associate Professor, Law, Governance & Ethics, at York University. He also teaches corporate governance at Harvard University, and regularly advises boards and regulators. His views are his own. Disclosure: Professor Leblanc has advised, and has been retained by, OSFI and the OSC.

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Richard Leblanc: Ten reasons that pay governance is broken

Executive pay is always in the news. Just last week an executive of Yahoo walked away with what was said to be a 100M parachute. I was interviewed by CBC radio on upcoming sunshine laws that are going to be enacted in Alberta. Last month, Ontario Power Generation fired three executives after an auditor general’s report on excessive compensation. The Premier of Ontario has vowed to crack down on excessive public sector executive compensation.

Do politicians have a track record of properly addressing compensation? I don’t believe so. Here are ten reasons that the governance of executive pay is broken, starting with politicians.

Politicians. Politicians have been the single greatest driver of increasing executive pay. Transparency or “sunshine” laws that politicians enact enable executives to utilize the pay of other executives to exert upwards pressure and threaten to leave, which is difficult to counteract. Transparency is good, but transparency without any guidance towards pay setting results in pay spiraling upwards. There is not a single jurisdiction that introduced pay transparency where pay has gone down. There was a time where executive pay was written within an envelope in a top desk drawer, and the focus in pay negotiations was on what the executive can do for the company, not what everyone else was earning.

Pay consultants. Pay consultants use this pay data and sell it back to the company in the form of “peer benchmarking,” which consultants have cleverly invented, which is now the predominant way to set pay. This means executive pay is driven by cherry-picked larger companies at the 75th or 90th percentile, resulting in a baked-in pay increase to the executive irrespective of performance.

Lack of professional standards. Lawyers and accountants can lose their license if they breach their fiduciary duty to their clients. They (we) have professional standards and rule-books addressing the duty of care, conflicts of interest, fee arrangements, continuing education, and just about everything you can think of to ensure the client is well served. Compensation consultants have no such obligations. Anyone can put out a shingle and call him or herself a pay consultant, and they do. You can sit on a compensation committee without any compensation expertise whatsoever. The requirement to be a director is shockingly low. In many cases, you need only to be over 18, not bankrupt and not insane. Maybe it is time to raise the bar for compensation consultants and compensation committee members. When advisors have standards, and pay-settors have expertise, they will make better decision.

Unnecessary complexity. Ask any director how much did his or her CEO “earn” last year, and see if you get a consistent answer. You likely won’t. It’s a simple question that deserves a simple answer. Pay depends on whom you ask and can’t even be defined. Is it “intended,” “realized” or “realizable”? We now have multiple “vehicles” for getting all types of pay to executives, with multiple valuations and performance periods. It becomes impossible to understand, value, and compare pay to performance. Therefore, mistakes and self-interest are possible. Pay needs to be radically simplified. Complexity deliberately frustrates and obfuscates basic analysis.

Captured pay-settors. Even if a compensation committee has formally independent directors, this does not reflect social relationships, the use of company resources by the directors, interlocks, excessive tenure, over-boardedness, reciprocity, favors, exorbitant pay to directors, vacations, gifts, donations, jobs for directors’ children, and a host of other factors that my research and work with boards uncovers. The compensation committee is then an arm of management.

Short termism. Most pay metrics are short term and financial. This means the executive is being unduly enriched and is trading on the effects of his actions that materialize years down the road, or not. Pay metrics should be matched to the actual effects of performance over time, and the value chain of the company. It is impossible to align pay to performance with only short-term financial metrics. Long term, non-financial metrics must be used, and pay-settors should have the spine and competency to insist on it. (Or regulators eventually will.)

Heads I win, tails you lose, or no downside for risky behaviour. Pay needs to incorporate risk-taking. We know that risk management in many companies is immature, so how can the downside of a decision possibly be incorporated into pay? If it is not, there is no or limited downside for executives to swing for the fences. Pay metrics and awards should account explicitly for risk. Most do not. This is not an insignificant point, as risk-taking compensation fueled the financial crisis. Regulators are addressing compensation and risk, but not fast enough.

Undue influence of Management. One highly paid CEO said to me once, “I will outgun any compensation committee.” If pay is truly a free market decision between owners and executives, the power, expertise and participation of shareholders must equal that of executives. Pay committees will need surgery for this to occur, starting with shareholders determining who is on their pay committee. That way, pay committees are the agents of their owners, not management.

Directors not listening to Shareholders. Directors assume that they know what shareholders want but this is folly. Surveys reveal a wide divide between shareholders and directors on executive pay. Directors need to meet directly with shareholders without executives present. Most don’t.

Lack of oversight and accountability. In the public sector in Ontario, there have been several governance scandals, including Ontario Power Generation, eHealth, Ontario Lottery and Gaming Corporation, and Ornge, that have included compensation and spending. What this reveals is defective oversight. Governance is not government. Ministers oversee 100s of agencies, boards and commissions operating in major sectors of the economy. Without independently assured oversight, and directors chosen exclusively on merit and not pre-existing relationships, often to the Minister or party in power, these scandals will continue. Premier Kathleen Wynne would be well served to address this lack of accountability and good governance. Saskatchewan has an excellent upward reporting model involving corporate secretaries and use of governance tools I helped create that apply to all crown companies.

One of my colleagues recently said to me, on the outlook of corporate governance in 2014: “Seems like a stand pat year with lots of tinkering but nothing profound happening.” With pay governance to improve, we might need some profoundness and not as much tinkering.

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Richard Leblanc: Ten Corporate Governance Trends for 2014

1.         Active owners focused on performance. Expect pressure by activists and institutions for boards to control under-performing management to continue unabated. Boards incapable or unwilling to rein in inefficiencies, improper capital allocation, asset mismanagement, or operational improvements will be targets. Directors whose skills do not support value creation; and ossification, complacency and atrophy more broadly, will also be targets.

2.         Shareholder accountability: Expect greater direct communication between boards and major shareholders, with “listening” mode and restricted management access continuing. Look also for pressure on asset owners themselves, by investee companies, for engagement transparency, protocols and disclosure. Expect proxy access demands by investors to continue; management and retained advisor resistance to it; and potential regulation enabling it in the future.

3.         Regulation. Continued widespread regulation targeting boards will continue. Industry Canada is contemplating governance reforms in 2014 or beyond. In the US, pay for performance, clawbacks, pay ratios, and proxy advisory regulations are likely in 2014.

4.         Director and auditor entrenchment. Expect pressure for board renewal and auditor rotation to continue in 2014. This will take the form of tenure limits, caps on directorships, diversity legislation, director and auditor evaluation, and mandatory requests for audit tender. Expect continued resistance by incumbent directors and the big 4, but expect also shareholder pressure and regulation to overcome.

5.         Cybercrime and other operational and reputation risks. Expect lawsuits targeting boards for data breach and investor loss at Adobe, Skype, Target, Neiman Marcus and Snapchat that precipitate governance enhancements. Expect greater risk regulation and spends for financial service companies and non-banks. Many boards and management have immature risk management, deficient – or at times non-existent – controls over IT, operational, and reputation risks. Look for efforts by good boards to have risk expertise on the board; internal oversight functions and third party reviews reporting to the board; and assurance over the entire risk appetite framework. Expect lawsuits and increasing regulation for the laggards.

6.         Focus on longer-term value creation. Expect asset owners to exert pressure on directors and asset managers to develop long-term metrics commensurate with the product and risk cycle of the company. Pay metrics such as health, innovation, culture, R and D, etc. will drive long-term investment. Look for “integrated” reporting and metric maturity in 2014 and 2015, making it easier for corporate boards to direct long-term non-financial incentive pay and investment.

7.         Focus on the Board Chair. Expect greater movement to non-executive Chairs from Lead Directors in the US, and Chair position maturity in other Anglo-American countries. Look for rigorous roles and responsibilities of board chairs developing, beyond formal independence, including driving value creation and company performance for investors.

8.         Greater clarity on pay for performance. Look for guidance by the SEC, including on realizable pay. Expect movement from short term, quantitative, financial pay metrics to long term, non-financial, qualitative, multi-year return metrics, and pay that adjusts for risk and performance over the longer term, with greater discretion to compensation committees and boards – and if necessary shareholders.

9.         Tightening up of independence standards. Look for boards to tighten up independent standards over lawyers, compensation consultants, auditors, and themselves, to arrive at “non-conflicted directors getting non-conflicted advice.” Look for scrutiny over soft management influence and capture over all of the above. Expect continued regulation if or when boards resist.

10.       Greater focus on culture, whistleblowing, tone in the middle, and anti corruption. Expect good boards to go beyond the CEO to scrutinize compensation of “risk takers” anywhere in the organization; share the hiring, firing and compensation decisions for risk, internal audit, compliance and the CFO; and receive assurance and reporting over all material risks and controls. CEOs (or any operating or senior management) who block or are not transparent should be regarded as red flags.

Richard Leblanc is a governance lawyer, academic, speaker and independent advisor to leading boards of directors. He can be reached at rleblanc@yorku.ca or followed on Twitter @drrleblanc.

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Gender diversity on boards: My discussion notes

I have been asked to serve on a panel in Toronto next week, 20 October, and in NYC on November 12, 2013, to discuss gender diversity on boards.

Here are my discussion notes for both panels if readers are interested: https://dl.dropboxusercontent.com/u/79214614/Richard%20LeblancTorNYCGenderDiversityNotesOctNov13.docx

The links to both panels are here:

https://111213newyork.eventbrite.com/

https://www.wxnetwork.com/board-diversity-a-time-for-women-to-lead/

Richard Leblanc

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Social media trends and listening for boards

I was asked to give brief talks on social media trends and the board’s role in “listening” at an NACD conference. Here are my notes, as well as a reading list, if group members are interested:

https://dl.dropboxusercontent.com/u/79214614/NACD%20Richard%20LeblancNACDDiscussNotes14Oct13.docx

https://dl.dropboxusercontent.com/u/79214614/NACD%20SM%20lab%20possible%20readingsv2.docx

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