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Archive for the ‘Global Corporate Governance’ Category

Regulators turning up anti-bribery heat on corporate boards: But will practices change?

Russia is one of the most corrupt nations in the world (see a recent anti-corruption story on Russia by the New York Times). It ranks 143rd of all 182 countries on Transparency International’s corruption perception index, with a score of 2.4. Canada ranks the 10th least corrupt country in the world with a score of 8.7. New Zealand is the least corrupt country globally, ranking first with an overall score of 9.5. The US ranks 24th and the UK 16th, with scores of 7.1 and 7.8 respectively. See the “Full Table and Rankings,” where countries can be searched via the table. Lower rankings and higher scores mean the country is perceived as being less corrupt.

Prime Minister Harper visited China, India and Brazil to enhance trade with these countries, which are also some of the most corrupt nations in the world, ranking in at 95th, 75th and 73rd respectively. Libya, which involved the alleged Montreal-based SNC Lavalin bribes of some $56 million, comes in at 168. Within these countries, the governments themselves are the net beneficiaries of much of the corruption, so these politicians are far from motivated to impose reform.

Is it realistic to expect that Anglo-American nations, such as the US, UK and Canada, can impose “Western” will on the very way business is done, and has been done, in some countries for centuries? And if things will not or perhaps cannot change, should home country boards of directors be held responsible for systemic local corruption that may be beyond their control?

Regulators are taking corruption and the role of boards and senior management very seriously. The Securities and Exchange Commission and Department of Justice recently released 130 pages of guidance (see the PDF and other coverage here and here) on the Foreign Corrupt Practices Act (“FCPA”). The US has had the FCPA since 1977. Enforcement and penalties have gone up dramatically in recent years. The UK Bribery Act, from 2010, has some of the most stringent bribery laws in the world. In Canada, we have The Corruption of Foreign Officials Act (since 1999) and the recent guideline from the OSC for issuers operating in emerging markets (see the PDF).

Emerging economies are future markets for Canadian companies. The Prime Minister has a vision for Canada to be an energy supplier superpower. For this to happen, Canada will shift its trade to markets with 100s of millions or billions of consumers and much higher growth rates than our current major trade partner, the US, which could be coping with austerity due to its debt for years to come. Harper was in India last week to boost trade.

What is clear is that there is an enormous disconnect between the home country regulations now being imposed, and host country actual practices on the ground.

What should boards that have operations in emerging market jurisdictions do? Six things. First, if you are doing business in such a market, you need a director with extensive on-the-ground experience at the board table, who can tell you and management what the hotspots are. You should move a board meeting to the jurisdiction once a year so directors can get a first hand look. Second, boards must make it crystal clear to management that if the company is not going to bribe, management must walk away from certain business. And the board must support this and not have incentives that promote bribery. Third, the internal controls over financial reporting must be as strong in the emerging market as it is in the home market. Investment and resource commitments need to be made. Fourth, boards must have their own experts to scrutinize off-balance sheet and related-party transactions and complex structures; validate and assure internal controls; and provide foreign language document translation. Fifth, local auditors should have the same oversight, scrutiny, and as necessary direct contact with the audit committee that the home auditors have. Lastly, there needs to be zero tolerance by the board communicated to each employee and supplier. The UK is even banning facilitating payments, which are regarded as a “tip,” as these may be bribes in disguise.

Companies and politicians are feeling the pain, including on Canadian shores. The Wal-Mart bribery probe has widened beyond Mexico to include China, Brazil and India. The RCMP is investigating the SNC Lavalin bribery allegations, on which I advised a law firm suing the company. I blogged about Sino-Forest, a case of alleged Chinese fraud by a Canadian-listed company. In Quebec, the corruption inquiry has cost the Mayors of Montreal and Laval their jobs and this is only the beginning. There are allegations of kickbacks in cash that may reach other more senior politicians. And Ontario is not immune either. A senior Canadian director remarked that Ontario has a reputation for being “the best place to carry out a stock fraud in the industrialized world.”

Clearly, more work needs to be done. Canada’s corruption ranking on Transparency International may go down in 2012 instead of up.

New financial services governance guidelines for Canada: Analysis & summary

The proposed OSFI corporate governance guidelines have been criticized for blurring the line between the board and management and for adopting a ‘one sized fits all’ approach. This is hardly surprising, and is the criticism to many governance regulations over the last twenty years, along with cost, as boards have become more active.

The OSFI guidelines have not changed in almost 10 years. In full disclosure, I was asked by OSFI to a) conduct a review and assessment of OSFI’s 2003 Corporate Governance Guideline and the Board Assessment Criteria against other international financial regulatory practices and recent developments or recommendations, and b) provide suggestions for future revisions after taking into consideration current global governance developments, including those related to financial institutions.

I reviewed 57 codes in total for OSFI, carefully tracking developments globally since the financial crisis. There are four major changes (among others) since the 2003 guidelines as follows:

1.         Boards of federally-regulated financial institutions (FRFIs) will need to have risk and relevant financial industry expertise represented in their board. This is entirely reasonable and codifies what good boards already do in their competency matrix approach that I recommended to the OSC in 2005. The notion that a board such as JPMorgan should have no independent directors with banking experience, for example, can have dire consequences when approving complex products and risks that directors do not understand for want of expertise. OSFI is not being overly prescriptive, only saying it desires “reasonable representation” of risk and financial industry expertise, leaving it to FRFIs to define and determine. It is not unreasonable to have risk and industry expertise on the board of a financial institution.

2.         Second, independent third parties should be retained to assess the board, risk management and oversight functions. This does not mean the board is “managing,” but rather the board gets to see an objective view other than from management. Management is conflicted in assuring its own work and the board should not be beholden to this. The board should be free at any time to commission an independent review of any material risks or internal controls. This puts the heat on management, as a third party will be reviewing at some point. If management is doing its job, it should welcome this input. This proposal can be criticized for “offloading” oversight to outsiders, but with 100s of FRFIs that carry deposits and insurance of Canadians, independent reviews from time to time are a fail safe.

3.         Third, the board may need to have a dedicated risk committee and reporting function (e.g., CRO); and should approve a risk appetite framework (RAF) with cascading tolerance limits and implementation. This puts the heat on boards to know and understand the risks of their institution, and on management to translate that into thresholds complied with throughout the organization. OSFI set out at pages 19-20 of the draft guideline guidance on what the RAF should contain with areas and examples of best practices. It is not unreasonable for the board to approve risk, but with examples of what this actually entails. The OSC 2005 guideline (NP 58-201) is now out of date because risk is only a few lines: namely that the board should identify the principal risks and ensure implementation of appropriate systems to manage these risks – which is vague at best and wholly inadequate at worst.

4.         Lastly, the CFO, head of internal audit and appointed actuary (for insurance companies) should have a direct reporting line to the audit committee; and the audit committee should approve the external audit fees and scope. Not only is this best practice, internationally, but I would also add, as OSFI similarly goes on to write, that the audit committee should have private sessions with the internal audit, external audit and appointed actuary at every audit committee meeting. The audit committee should also approve the internal audit work plan, budget, independence, person and compensation.

Overall the draft OSFI guidelines are proportionate, pragmatic and reflect leading practices (e.g., G30, Walker and OECD reports and Basel principles). Canada has a very well regulated financial services sector, that some say is the envy of the world. These new corporate governance guidelines will help ensure that this fiscal prudence and stewardship continues.

Quebec Premiere Charest’s Proposed Anti-Takeover Law is Misguided

Premiere Jean Charest, who is in the midst of an election campaign that he is losing, is promising a law that would give stakeholders at Quebec companies – such as employees, management, suppliers and local communities – superiority over the interests of shareholders. This potential law is misguided and would entrench ineffective boards, management teams and firms, to the detriment of shareholders, investment and the Quebec economy overall. See here also.

When a similar law PA-SB 1310 was enacted in Pennsylvania – to preserve local employment, disgorge profits and ward off unsolicited take-overs – stock prices declined by $4B in the six-month period between the announcement and enactment of the law, according to a study by researchers Szewczyk and Tsetsekos. Pennsylvanian companies that chose to opt out of some or all of the law experienced “significant positive stock price returns,” while Pennsylvania companies that adopted the law performed “significantly worse” than firms outside Pennsylvania, according to Stanford researchers Larcker and Tayan.

While many US states have enacted so-called “stakeholder statutes,” these laws enable – although do not require – boards to consider the interests of stakeholders other than shareholders in their deliberations. These laws are largely permissive in nature in other words, and good boards always consider stakeholder interests in any event. The Canadian Supreme Court has spoken on how to do this. Pennsylvania’s law is not only mandatory – obligating certain stakeholders to be considered – but also places the interests of non-shareholders above those of shareholders, as Quebec’s proposed law intends to do. Indeed, under Charest’s proposal, shareholders, remarkably, may not even have a vote on a proposed takeover. Our high court has stated, in BCE Inc. v. 1976 Debentureholders, that a board has a duty to treat stakeholders affected by corporate actions equitably and fairly, and that there is “no principle that one set of interests should prevail over another” (page 9). Charest’s proposal, if it unfairly treats shareholders (and prima facie this is almost certainly the case if it denies them a vote), may be challenged on the basis of its constitutionality.

In the market for corporate control, accountability to everyone is accountability to no one. From an investor’s perspective, shareholder rights plans, staggered boards, dual class shares and restrictions on shareholders to call meetings and vote on corporate changes by written consent are all efforts to entrench ineffective management and firms, and enable the extraction of private wealth by insiders, to the detriment of other shareholders.

Politicians should not be in the business of picking winners and losers as they do not have the competence to do this. Government is not governance. Nor do judges have this ability to second-guess managers and boards. There is a well enshrined “business judgment rule” holding that a judge may not second-guess corporate judgment providing proper process occurred. A law like what is being proposed by Charest, which is essentially a bias against shareholders, immunizes a firm from competition, in essence saying a board can “just say no” to a takeover, full stop. Takeovers – even Rona by US’s Lowe’s Cos. Inc. – occur because of weaknesses and inefficiencies in the marketplace. (I was in a Rona store the other day and walked out when I could not find someone to help me.) If a firm cannot compete on the basis of price, quality or service, it should be taken over or replaced by a firm and a management team who can.

The Supreme Court was clear in the BCE case that the duty is owed from the board to the corporation, but that a stakeholder cannot be unfairly treated. Stakeholders include shareholders, who cannot contract with the company like other stakeholders can. While the high court did not endorse shareholder wealth maximization, it certainly did not invalidate it either. Once shareholder wealth maximization is vitiated, as this Quebec law would do, shareholders will simply invest their money elsewhere, where their rights and vote are respected, as they did in Pennsylvania. Quebec will lose.

Politicians should be more concerned with creating the fiscal and economic climate to attract jobs and investment, not enacting protective barriers that will have the opposite effect in a global world.

 

The Battle for CP ~ Welcome to the Great (and Cozy) White North, Mr. Ackman

By now, you may have heard that Canadian Pacific CEO Fred Green, Chairman John Cleghorn, and four other CP directors have resigned or will not stand for re-election, to make way for Pershing Square’s Bill Ackman and a new slate of CP directors – and a new approach to corporate governance in Canada.

The Pershing Square bid is the perfect storm for what is wrong with Canadian corporate governance: (i) the lack of attention to strategy; (ii) the lack of shareholder accountability; and (iii) the lack of directors with domain expertise. It represents a tipping point for any board in the way it does – or should do – business in Canada.

Lack of Attention to Strategy

The “Dey” Guidelines are now almost 20 years old. They are outdated. Much has changed in corporate governance. Canada needs revised and updated guidelines to the 2005 National Policy, which incorporated many of the Dey guidelines. The Dey guidelines from 1994 contain six words on strategy: “adoption of a strategic planning process,” which is inherently ambiguous. The 2005 National Policy is not much better, adding that the board must approve a strategic plan at least annually. (Emphasis added).

This approach to strategy is wholly inadequate, and the consequences are obvious. In an Institute of Corporate Directors session I facilitated of ninety-four directors last week, when a question on the board’s role in strategy was asked, two panelists deadpanned “we do it in a superficial way” and “it doesn’t happen.” Boards have become obsessed with compliance at the expense of value creation for the company and shareholders.

The research – from Ernst and Young, Egon Zehnder and McKinsey for example – confirm that a more engaged board under a private equity governance model will outperform their public company peers, by a factor of three to one. This outperformance under a Bill Ackman model cannot be ignored by public companies. For academics who desire to show a more causal link between governance and performance, as do I, it should not be ignored either.

The deep dives and due diligence conducted by Pershing Square – over 100 pages in total – should be conducted by boards if they are doing their job, and wish to keep hedge funds from knocking at their door. But there is code like “nose in fingers out” or “micro management” used by Canadian CEOs and directors themselves that keeps directors from performing their strategic role.

The evidence of CP is a case example: Seven COOs and CFOs were replaced in the last five years; CP has consistently underperformed across its peers, including its Operating Ratio; and yet CEO Fred Green met 17 of 18 objectives set by the CP board. And the board moved those targets, resulting in the cost of management as a percentage doubling.

Public company boards need to be much more engaged in strategy, and demanding of management. As reported in the Journal of Applied Corporate Finance, value may be “left on the table” ~ which would invite sophisticated investors like Bill Ackman to come in.

I have reviewed public and private plans by activist shareholders and private equity firms and there is no comparison to the often “superficial” (to use a word from above) approach to strategy typically taken by public company boards. There is absolute clarity under private equity what management is held responsible for, and variances to be reported in advance to – and understood by – the board. Boards of this caliber are much more engaged and focused on shareholder value. No stone is left unturned.

Lack of Attention to Shareholders

Second, many public boards in Canada do not meet directly with shareholders, or if they do, it is behind closed doors – the “cozy” Canadian way. Bill Ackman did not accept this and was unwilling to compromise or go away. This cozy environment has to change, including shareholders asserting themselves much more. And lawyers cannot unduly influence this communication.

Most importantly, Canadian shareholders should have proxy access, or the right to nominate directors of their choosing and put those directors on to the proxy circular, which is another American development that makes sense. It should not take Pershing Square, a 14% shareholder of CP, CP’s largest, a long, protracted, expensive proxy battle to implement governance change. Vote counting, majority voting, plurality voting, etc., are window dressing. Shareholders should have the right to nominate directors to boards and fire directors who do not perform, with ease and transparency. The threshold should be low, or even based on the company’s largest shareholders.

In addition, Canadian directors need to have a % of their net wealth at stake in the boards on which they sit, for true shareholder accountability and alignment. This does not mean directors receiving shares for board service, but actually issuing a check from their savings. The CP board owned 0.2% of stock and it was given to them, not bought. If one director, had $100M of his or her own wealth invested, the CEO would be replaced, Pershing Square said.

Lack of Attention to Domain Expertise

Lastly, the entire board of CP, other than the CEO, did not have rail experience prior to Pershing Square’s involvement. This is a direct consequence of the Dey guidelines from 1994, even though the research does not support independent directors and firm performance. The reason is that if directors do not understand the business, or industry, they are under-engaged in strategy and even their ability to monitor is compromised. They don’t understand. Look at the board of JPMorgan, which lost $2B last week. Other than the CEO, not even a single director has banking experience. If a director does not have experience in the sector, they cannot identify the risks.

Pershing Square’s directors have been selected on the basis of railroad expertise, restructuring expertise, shareholder representation, entrepreneurial culture and a culture of equity ownership and shareholder value creation. What a breath of fresh air. Boards would be wise to take a page from the Bill Ackman playbook, or shareholders should themselves.

And, most of the above Pershing Square directors are from Canada. The notion that we have a talent shortage is a myth. If the board’s desire is for a “CEO,” then there may be a shortage, but the evidence from Stanford University is that CEOs do not make better directors. There is plenty of talent in Canada, and boards need to reach into the C-suite and into shareholder communities. And they need to diversify to mitigate groupthink. The directors exist. My own database contains hundreds.

The Need For New Guidelines

Shareholder accountability, strategic engagement, and director experience and skills, all point to shortcomings that are non-existent or short-changed in the Canadian corporate governance landscape. This is exactly what Bill Ackman brings to the table. Welcome to Canada, Mr. Ackman.

The Boardroom of the Future: Changes that will reshape corporate governance

A global “mega-cap” company recently asked me to submit a briefing on how a boardroom of the future will look. This is an abridged summary of my report.

Democratization of governance

Your shareholders will nominate and elect your directors by electronic voting directly on your website. They will base their vote on the accomplishments of each director and track record of acting in the best interests of shareholders and the company overall.

Electronic registries and meetings will be the primary basis upon which shareholders select directors to your board. Director competencies will be fully disclosed.

Diversification of boardrooms

Your board will be 40% to 50% women and have far fewer CEOs on it in the next five to seven years. Your directors will be independent experts within their relevant strategic domains, will be quick studies, and will have access to the best learning of the company. They will request an Office of the Board be established. Board tenure will not exceed 9 years.

Corporate reporting

Reporting to shareholders will be fully integrated and online. Non-financial risks and internal controls will be independently assured. All reporting will be accessible, complete, accurate and independently validated.

Technology

Your board will be paperless and directors will have access to any piece of information they need to oversee and advise management. Technology will be used to attract and communicate with international directors. Risk appetite frameworks, established by the board, will translate into clear incentives and constraints using integrated firm-wide information systems.

Executive compensation

Executive compensation will be established by shareholder-directors. Professional standards will be imposed on any consultants retained by these directors. All compensation will be fully risk-adjusted and linked to performance. Current models and methods will change significantly.

Office of the Board

An Office of the Board will be established. It will house independent staff and resources available and accountable to the board and paid by the company.

 

Regulation of corporate governance

The unprecedented intrusion into the governance of companies will continue until most or all of the above reforms are implemented.

Conclusion

The above changes are significant and will fundamentally change the way directors are selected and how boards control management.


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