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Canada’s Corporate Governance Guidelines Are Out of Date, Part 2

Following up from last week’s blog, I argued that Canada’s corporate governance guidelines were out of date because of: 1. Lack of principles and practices; 2. Lack of focus on risk management; 3. Lack of independence of mind; 4. Lack of industry expertise; and 5. Lack of shareholder engagement, here are reasons 6-10 that our Guidelines need an update:

6. Lack of shareholder engagement: The words “investor” and “shareholder” are mentioned once each, in a perfunctory manner, within the 2005 Guideline. Shareholders own the company and regulators and investors are explicitly providing context now: for investor input on director selection; for engagement and dialogue between investors and directors; and for the use of technology in shareholder communication and annual meetings. The foregoing are all absent from the Guidelines. Canada has still not adopted “say on pay,” which has also been a catalyst for shareholder engagement. The US, UK, Australia, Germany, France and other European countries either have say-on-pay or are moving rapidly in this direction. Canada is a laggard.

7. Lack of focus on strategy and value creation. “Strategy” is mentioned only once within the entire Guidelines, and that is that the board should approve a strategic planning process, and approve, at least annually, a strategic plan. It is hardly surprising that many boards short-change strategy at the expense of compliance. This requirement of once a year essentially marginalizes a board in its strategic role. When I interview top directors who add value strategically, the strategic oversight and involvement by boards are much more focused and engaged. There are strategic best practices here that would enhance the performance and value creation that a proper board can make. Regulators drafting this guidance should have experience creating listed company value.

8. Lack of focus on sustainability: The word “environment” or “sustainability” is not mentioned at all in the 2005 Guidelines, a noticeable omission. Australia’s emphasis on economic, environmental and social sustainability risks, within its Corporate Governance Principles and Recommendations, is second to none, as is South Africa’s focus on “integrated sustainability reporting” within King III. This omission is especially noticeable given investor focus on the environmental, social and corporate responsibility. The lack of environmental stewardship and response to climate change is also a broader issue. Canada is also a laggard here.

9. Lack of compensation guidance: The regulatory movement from short-term, quantitative, financial metrics, to risk-adjusted, long-term, qualitative, non-financial metrics for executives is absent from the Guidelines, as is guidance on non-executive remuneration. Investors, regulators and good boards are focusing on leading performance metrics that reflect the entire business model and value chain (most of which is non-financial), and that are longer-term in nature.

10. Lack of focus on the chair of the board: Lastly, but far from least, the position of the board chair has undergone a metamorphosis since 2005. There is no guidance at all offered on the role, responsibility and attributes of an independent chair, within the Guideline. Other codes offer extensive guidance on skill-sets and responsibilities that and on which the chair should possess and execute. Without this regulatory guidance, a chair (and committee chairs) can be bullied or unduly influenced by dominating reporting management such that they are rendered ineffective, albeit formally independent. More guidance is needed. Chair position descriptions should not be drafted by management lawyers or management-retained lawyers.

Conclusion

Does Canada improperly have a false sense of governance superiority? Perhaps so. But in this rapidly changing field, if you rest, you are left behind. Nine years is sufficient rest.

There are arguments (i) by industry and advisors to management that corporate governance in Canada is not broken so does not need to be fixed; and (ii) by regulators who complain of scarce resources and how difficult it is with fragmented securities commissions and the diversity of Canadian companies. I have never been persuaded by these arguments.

To address the second argument, what is required is leadership and political will. Premier Kathleen Wynne’s and the OSC’s Maureen Jenson’s emphasis on gender diversity have resulted in nine jurisdictions collaborating and endorsing recent changes to the disclosure of gender diversity, term limits, and measureable objectives, for example. To address the variety of Canadian companies, South Africa’s King III Code applies to all types of companies (public, private, state and non-profits). The issue is one of drafting.

To address the first argument, namely the arguments by industry, regulators should be conscious of undue influence by reporting management and service providers, whose internal power, business model, or commercial interests may be disrupted by governance rejuvenation. The primary consideration for policy renewal should be evidence-based policy and international consistency with best practices. Regulators should also guard against potential conflicts of interest and regulatory capture, by themselves, including those individuals within regulators who intend to return to private industry, or who have other close association with regulated companies. Regulators should also guard against those provincial regulators who oppose reform on the basis of extraneous and non-relevant considerations, such as a desire to maintain turf.

Richard Leblanc is an Associate Professor, Law, Governance & Ethics, at York University. He can be reached at rleblanc@yorku.ca.

 

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Canada’s Corporate Governance Guidelines Are Out of Date

In my teaching, research and consulting, I no longer use “NP-58201 Corporate Governance Guidelines,” June 17, 2005 (“Guidelines”), that apply to publicly traded companies in Canada, as an example of exemplary corporate governance. I regard them as stale and dated. I cannot think of another developed country that has not updated its governance guidelines in almost 10 years. There have been more changes to governance since the financial crisis of 2008 than in a generation. And we are only about half way through all of them. Canadian regulators – including all provinces and territories – need to keep up, and step up.

Here are the deficiencies to the Guidelines as I see them:

1. Lack of principles and practices: Our Guidelines are four pages long. The UK’s new Code (September 2014) is thirty-six pages. Australia’s Principles and Recommendations (March 2014) are forty-four. South Africa’s “King III” (2009) is sixty-six pages, to pick only three examples. Quantity is not necessarily quality, but by having such succinct guidelines, the opportunity to set out (i) best practices that (ii) achieve the objective of principles is gone. It is comply or explain against a perfunctory unitary guideline, which can be – and is – gamed by reporting management. There should be more robust guidance, where the regulator explains various ways good governance can occur, from which listed companies can pick and choose according to their circumstances.

2. Lack of focus on risk management: Take risk for example. The Canadian Guidelines simply state that the board should identify principal risks and ensure appropriate systems are in place to manage these risks. I have no idea what this actually means, nor may directors. Risk management oversight now involves an explicit risk appetite framework, internal controls to mitigate, technology, limitations, and assurance provided directly to the board and committees by independent risk, compliance, and internal audit functions. None of these practices, which are very much addressed by other regulators, appear in the 2005 Guidelines. Consequently, many public companies have immature risk management, especially in addressing non-financial risks such as cyber security, operations, terrorism and reputation. Regulatory inaction has an effect. Even a forward-thinking director may be blocked by intransigent management to devote greater resources to mitigating risk because of inadequate regulation.

3. Lack of independence of mind: In Canada, a board can subjectively believe a director to be independent, but this belief need not be independently validated, nor tied to any objective or reasonable standard. Nowhere else can a conflict of interest lack a perceptual foundation. As a result, directors tell me how colleagues are compromised by an office, perks, vacations, gifts, jobs for friends, social relatedness, relations to major shareholders, excessive pay, excessive tenure, interlocks, and other forms of capture. If a director or chair is captured, they are owned by management and totally ineffective. If there is a difference between regulatory independence and the independence of mind of directors, the fault lies with the regulation. Regulators should implement an objective standard of director independence, not a subjective one.

4. Lack of industry expertise: It was admitted in open forum that the original 1994 committee did little research. Sufficient industry expertise on boards is glaringly absent from the Guidelines, and consequently in many boardrooms. We are suffering from an independence legacy, perpetuated by entrenched directors, and unsupported by academic research. For example, in Australia, two academics claim has cost their country’s decline in shareholder value between 30 and 50 billion Australian dollars (“Does “Board Independence” Destroy Corporate Value,” by Peter L. Swan and David Forsberg).

Fraud, meltdowns and underperformance such as Nortel, RIM and CP all had a paucity of industry experts on their boards, including, most recently, Tesco in the UK. JP Morgan at the time of the risk management failure did not have a single independent director with banking experience. Prior to Bill Ackman’s involvement in CP, not a single independent director had rail experience. I recently assessed a similar board and not a single director had the necessary industry experience. The Guidelines should require relevant industry expertise on boards. I recommended this to OSFI when I was retained by them to examine their earlier guidelines, and this is now the law for all federally regulated financial institutions, along with risk expertise being present on boards.

5. Lack of financial literacy and internal audit: There is no requirement to be financially literate to sit, initially, on an audit committee of a Canadian public company. This presumes someone can acquire financial literacy as opposed to having it to begin with. There is also no requirement to have an internal audit function for a Canadian public company. This should also change so audit committee members hit the ground running, and there should be a comply or explain approach to internal audit. In many compliance failures, there is a defective or non-existent internal audit function, with a weak audit committee lacking recent and relevant expertise. Regulators are now moving towards “independent coordinated assurance,” which means that reporting to, and functional oversight by, the board and committees are fulfilled by internal and external personnel who are independent of senior and operating management, including, most importantly, an effective and independent internal audit function.

Join me next week where I will talk about 6-10, including: lack of shareholder engagement; lack of focus on strategy and value creation; lack of focus on sustainability; lack of compensation guidance; and lack of focus on the chair of the board.

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The Corporate Governance Game Changer That Needs to Come To Canada

I teach my students and counsel board clients that shareholders elect directors; directors appoint managers; directors are accountable to shareholders; and managers are accountable to directors. This is largely theoretical.

Here is the reality: Shareholders: (i) cannot select directors; (ii) cannot communicate with directors; and (iii) cannot remove directors, by law, without great cost and difficulty. Therefore, directors are largely homogenous groups who are selected by themselves, or, worse yet, management.

Addressing the foregoing is the one piece of reform that will change corporate governance and performance for the better. The rest is, as they say, window dressing.

I have encouraged institutional investors and regulators to consider advocating what is known as “proxy access.” This means that a shareholder, or a group of shareholders, who (i) own a modest, minimum threshold of shares (say 3%, although the percentage could be higher or lower, or floating, depending on the size of the company); (ii) for a period of time (say 3 years, although the time period could be shorter); (iii) can select up to 25% of proposed directors, of the total board size, in an uncontested election (meaning a change of control is not desired by the shareholders) in a given year.

When shareholders “select” their nominees for the board, these directors would be alongside, in the management proxy circular, in alphabetical order, with profile parity (short bios and areas of competency), the management slate of directors. Management would be obliged to include shareholder-nominated directors, at a cost to the company, not shareholders, if the above ownership and time requirements are met. There would be no costly proxy battles or dissident slates. There would be no undue influence by management to marginalize shareholder-nominated directors within or outside of the proxy. Rules of the road will be set.

Then, shareholders get to decide, as they should, on the best directors from among the management-proposed and the shareholder-proposed directors. Ideally, the selection should be as blind or neutral as possible. The focus should be solely on the qualifications, competencies and track record of the proposed directors for election at that company. May the best directors win, as should be the case in any election, versus a slate of management-nominated directors, which is the case now. Under this new regime, there will be winners and losers. The practical effect may be that legacy or unqualified directors may withdraw from this scrutiny, as Canadian Pacific directors did at the time of shareholder Pershing Square’s involvement. This is not an undesired outcome and creates a market for the most qualified directors to rise to the top.

When proxy access was proposed by the Securities and Exchange Commission (SEC) in the US, management and lawyers who work for management used shareholder money to fight proxy access proposed under Dodd Frank, and won in the US Court of Appeals, on the basis of an inadequate cost benefit analysis. (Canadian investors and regulators should learn from this experience.) Proxy access now is left to companies on a one-off basis, rather than being system wide. Meaningful proxy access has only occurred at a small number of companies as a result. The SEC should revisit proxy access. Industry Canada is currently looking at implementing proxy access at the 5% level for all federally incorporated companies.

Opponents to proxy access argue that shareholders selecting directors will propose special purpose directors or directors who lack the background or experience. The evidence is the opposite. Shareholders are better at proposing directors who have the shareholder track record and industry expertise that the current board lacks. Recall Canadian Pacific, where not a single director possessed rail experience prior to shareholder involvement. There are other examples at Hess, Office Depot, Darden, Bob Evans, Abercrombie and Occidental Petroleum (see Field Experience Helps Win Board Seats), where shareholder-advocated directors were either better than incumbent ones, or caused the renewal of management-advocated ones. A director qualification dispute is welcome and will focus the lens on competencies of directors, including industry expertise, which is a good thing. Ann C. Mule and Charles Elson report in “Directors and Boards” that “One study concludes that more powerful CEOs tend to avoid independent expert directors.”

Herein lies the real resistance to proxy access: Management does not want it, and, the record shows, will fight vigorously to resist it. Management-retained advocates hired to oppose proxy access should disclose whom their client is. Directors however, when deciding to support proxy access, or not, should not be beholden to management, nor their advisors, nor act out of self-interest in entrenching themselves, but should be guided only by the best interests of the company, including its shareholders. There is evidence that the market values strong proxy access positively, leading to an increase in shareholder wealth. If a director possesses the independence of mind, and the competency and skills to serve on the board, they should welcome proxy access. It will mean that the under performing directors on the board will be ferreted out, and current directors can avoid this uncomfortable task. Shareholders and the new competitive market for corporate directors will do it for them.

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Advice to Boards: Renew Your Directors or Shareholders May Do It For You

Here is a top 10 list reflecting forty recent director and executive interviews and ongoing advice and assessment provided to activist investors and boards.

Infuse your board with a shareholder mindset and directors with value creation track records

“Too many service providers” … “with no industry experience” … “who have not run anything” and “who lack value creation experience” go silent when tough business decisions need to be made, directors say. They “cannot provide the hard core insights to the management team” other than “be careful.” They default to process, “flavors of the day,” and recency, rather than leading substance and strategy. Directors and executives describe such formally independent but experientially lacking directors as “immature,” “provincial,” and “naïve.” Management is more critical: They “lack depth” and “contribute nothing.” Trying to get them off the board, in the words of one director, is like “pulling teeth.”

Remove over-tenured directors and ensure committee chair rotation

Long-serving legacy directors and committee chairs are described as “tired” and “complacent” by fellow directors who have been there “much too long,” and block renewal efforts when “they are the most conflicted.” Research suggests that directors beyond nine years diminish shareholder value. Tough discussions are occurring in boardrooms. Conflicted directors should leave the room during the discussion, directors say. Long-serving directors are loath to give directorships up, arguing they are different. Fellow directors and investors are increasingly unpersuaded by self-interest.

Conduct an independent performance review

One answer, according to head of corporate governance at CalSTRS Anne Sheehan who served on a recent panel discussion with me, is to have independent director performance reviews, with expectations set at the outset, and link the results to renewal. Don’t rely on retirement age as a performance proxy. Directors and regulators are mandating independent reviews. Blockage by self-serving chairs and directors are increasingly falling onto deaf ears. The review should have consequences, which means removing directors who have outlived their usefulness. “Rigorous evaluation,” consistently is a theme in my interviews. If a board blocks independent critical review, or does not act on the results, investors will step into the gap, and it will be far more consequential, costly and adverse.

Engage directly with investors on board performance and composition

What investors want to see now is recent, relevant, validated industry experience contributing directly to the company’s value creation chain, by each and every director. If a board cannot lead a value creation model that is endorsed by major investors, including capital and asset allocation and performance, and what each director’s contribution is to that, the board is vulnerable. Few boards have conducted this internal review with the rigor that an activist does. Camera-ready boards are having structured meetings with long-term shareholders to listen, learn and act. Boards ignore investors at their peril.

Address director origination and its impact on independence

Assume that investors will ferret out any and all conflicts, including friendships. If a director has previous or current relationships, to each other or to management, they lack independence and will not ask tough questions, new research suggests, unlike directors who are recruited primarily on the basis of merit who are unknown previously to the board. These directors are “owned” is the common refrain. Current examples include reciprocity, favours and capture. These directors cannot push back as the cost is too great. They are part of management. Therefore, boards need to rid themselves of these directors and discontinue recruiting based on prior relationships.

Diversify your board to add value

Make sure your board is diverse, and underpinned by the skill sets needed. Many companies do not have board diversity policies. Defensive, perfunctory policies are not useful. The best policies are prescriptive, have measureable objectives, and define diversity, with increasing numbers that a board holds itself responsible for meeting and on which progress is reported. There are measureable objectives for gender, age, ethnicity that align with the company, its business, its industry, and the markets in which it operates.

Focus on company performance over governance box-ticking

Governance has been a cottage industry dominated by self-serving professional advisors and associations, many directors and investors have told me. The pendulum as swung so far, such that investor performance is either entirely absent or an afterthought rather than the primary focus. “You can tick all the governance boxes, and underperform your peers,” one director states. So-called governance awarded companies have even been rife with corruption. Conversely, you can have many governance boxes unticked and perform for investors. Good boards do not let the governance tail wag the performance dog. Investors want performance, not governance accolades. We know that governance rating agencies and proxy advisory firms have metrics that lack prescriptive validity. We see award-winning companies who have failed in their performance, subsequently being attacked by activists with share price appreciation soon following. Activists are unimpressed, and, increasingly, the governance community is questioning its own focus and priorities. One award winning company with a director who has seen the activist light remarked that his board could be “10 times stronger.”

Conduct a thorough transparent director competency review, and act on the results

The director competency matrix belongs to investors and directors, not management. A matrix can be back-doored and manipulated, resulting in a complacent board. An inclusive, dynamic, objective, peer-to-peer, validated matrix review will generate development opportunities, remove directors who are lacking, and generate desired skills in the next directors. Regulators are calling for curriculum vitaes, interviews, and want to see each director is fit for purpose. Boards are wise to ensure that matrix design and administration is expert, free from management control, and reflects investor input.

Focus on softer director attributes

Skills I have recently developed for directors include: integrity, teamwork, communication and commitment. If only one director does not possess these, a board can be poisoned. These attributes can and should be recruited for and validated. A director who is lacking and cannot improve should be promptly replaced. The best boards are embarking on this review.

Display leadership and integrity

Lastly, ultimately, board renewal is about leadership and integrity. The Board Chair position is rapidly maturing. Directors who dig in and entrench are placing their own interests ahead of those of the company, resulting in grave disquiet. This is an integrity issue. Entrenched directors should do the right thing when it is time to go. Activism has become mainstream and shareholders may have much greater power in the future than they do now to propose effective and remove ineffective directors, if directors do not do it themselves.

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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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