Dr Richard Leblanc

“The Board Chair is owned by the CEO,” directors told me after I was called in by the regulator to assess the board. The Chair owned a condo next to the CEO and was a close personal friend. I have not assessed a board when there was not at least one director, and oftentimes, after governance failure, several directors who are viewed as non-independent by their fellow directors, even though these directors are independent by regulatory standards.

Academics have never been able to show that independent directors strengthen company performance for one major reason: true independence is not being measured from the outside, and can readily be undermined by clever, self-serving management and directors themselves by allowing it to occur. Bright-line independence tests or rules can be out-smarted, and many fail to capture the underlying conflicts of interests.

In my research involving shareholder activists, activists tell me how they investigate director backgrounds to show the compromising of independence. Activists’ inherent presumption is that each director is non-independent to begin with. They are put in place by management or other directors, not shareholders.

Here are the ways directorial independence is compromised, before or after a director begins to serve: a close social or personal relationship with another director or member of management; serving on another board or in another business relationship with a director; excessive tenure on the board; excessive director pay or expenses; an office at the company for the director; the use of secretarial staff; gifts such as cigars; vacations with other directors, a significant shareholder, or management; jobs or contracts for acquaintances or referrals of the director; lunches, dinners, entertainment or sporting events with a small group of directors and management (rather than collective board dinners); informal collaborating in a decision by a board or committee chair with management in advance of the meeting; boards or committees not hiring independent advisors but are beholden exclusively on management; directors taking advantage of a corporate opportunity, resource or perquisite with full knowledge (or not) of other directors; or having a bias towards a particular stakeholder in board deliberations (including a significant shareholder).

There exists pressure on Canadian directors to allow their independence to become diluted, directors tell me, and to be collegial in this dilution. I have interviewed some of the top board chairs in Canada, and one of their major concerns was the “slippery slope” of directorial independence. I have found that directors can become less independent, but I have never found them to become more independent. Boards, in theory at least, should decide what degree, if any, of independence slippage (see all of the above real examples) they are willing to tolerate.

If one or more directors has their independence compromised, particularly a board or a committee chair, then governance failure can and does occur. Conflict-seeking directors are toxic to a board and should be removed. Directors know which director(s) has lost their independence. By the time I arrive, I am confirming what they already know and failed to act upon. A trained outside expert can readily observe captured directors during board meetings, interviews and customized questions.

Why is There a Director Independence Dis-connect?

If director independence is compromised and regulatory standards fail to detect this, then the regulators have failed. It should not be possible, if regulators are doing their job, to have a director who is not independent, inside the boardroom, and at the same time that director complies with independence guidelines outside the boardroom.

What is the Standard for Independence of Public Company Directors in Canada?

Directorial independence in Canada is presently a subjective standard (what directors believe), rather than an objective one (what is reasonable to believe). This means that if directors collectively believe that a director does not have a “material” relationship that can reasonably be “expected” to “interfere” with that director’s independent judgment, then that is the end of the analysis. The absence of an objective, reasonable or perceived point of view is anomalous when it comes to overseeing conflicts of interest in the workplace, so why should boards be any different? What should matter is what is reasonable, not what a director or a board believes. This subjective view can be unreasonable.

How Can Director Independence Be Strengthened?

Director independence is important because independent directors control management. It is important to get independence right – in theory at least – but also in practice if directors are to possess independence of mind coming onto the board and maintain it once they are on.

Here are some reforms I recommend and use to address director and board independence:

• Regulatory reform should occur so independence of directors espoused by regulators equates with actual independence inside boardrooms. An objective, reasonable person standard should be used.

• Boards should enact a robust conflict of interest policy, for directors, not drafted by management, and this policy should be disclosed to shareholders.

• Independent advisors should facilitate an annual peer review of director independence, as is done in the United Kingdom. The review process should be disclosed and acted upon.

• Codes of conduct should be drafted (not by management) to apply to a board of directors. Boards should not be using the company code because director independence issues are not captured.

• Boards (and if not, regulators) should impose reasonable term limits on director tenure, beyond which the director is not regarded as independent, as is done in several countries.

• Boards should require the confidential disclosure of directorial perceived conflicts (including assets and financial information relevant to the company’s business) to the audit committee, including that of family and affiliates of the director.

• Audit committees should review and recommend to the board perceived conflicts of interest by directors, and should create a special committee of independent directors who are independent of the matter and the director, if and when required, with independent advisors retained by the audit or special committee.

• An anonymous procedure for reporting on directors who do not disclose potential conflicts should exist, to the audit or special committee.

• The governance committee should recommend independent board and committee chairs, and the board chair should be selected by confidential ballot without the CEO being present or unduly influencial.

• For significant shareholder boards, independent directors should be chosen by and from minority shareholders, so a portion of directors are independent of the significant shareholder, commensurate with the significant shareholder’s portion of common shares.

• For widely held boards, shareholders should select a portion of directors so directors are independent of each other and management.

• Boards should disclose the origination of each director, namely how that director came to be recommended for election by shareholders.

• Boards (and if not, regulators) should diversify themselves so directors do not come from the same homogenous pool and are independent from one another.

Dr. Richard Leblanc, Editor of The Handbook of Board Governance (Wiley, 2016), can be reached at rleblanc@yorku.ca.

Jamie Dimon and Lloyd Blankfein (Chairs and CEOs of J.P. Morgan and Goldman Sachs, respectively) should be relieved of their Board Chair responsibilities.

Here is why.

Consider how two hypothetical – but typical – board meetings play out: the first occurs with a Chair and CEO role combined in one person, with another director as a “Lead Director,” and another board meeting occurs with Chair and CEO roles separated into two people.

In the first board meeting, when one person occupies both the Chair and CEO roles, there is a very high concentration of power. Another director independent of management acts as a “lead” director and the counterpoint. The Lead Director may sit next to the Chair and CEO in the boardroom, but the Lead Director does not chair the actual board meeting. Nor do lead directors have final say when push comes to shove over the board agenda. Nor do they establish the information flow the board receives, as good chairs do.

The Lead Director has influence, but the Board Chair has actual authority. What gets discussed, when and how, is the purview of the chairperson of any board. The most important role a Board Chair has is to control the discussion, who speaks and in what order, and how decisions get made (or not). These meeting levers shape outcomes. If the person controlling the discussion, the information and the agenda (i.e., the chair) has a vested interest in the outcome and is the same person (i.e., the CEO), there is an inherent bias in all decisions. The board’s fundamental oversight role in controlling management is compromised.

When I observe the second type of board meetings — with non-executive, independent Chairs and separate CEOs (i.e., two separate people), the dynamics are very different. The board meeting is almost “bi-polar” in nature. There is a natural counterpoint when debate happens because the CEO is separated out of the critical proposal and approval parts of the discourse. Power is more flat. Directors feel free to speak up because the chair is one of them (independent). It is hardly surprising to see the lead director role marginalized by a strong personality who controls a board meeting. CEOs have very strong personalities. Directors are more likely to weigh in and exercise independence if they aren’t blocked by their chair.

At one point, Canadian bank boards argued – unsuccessfully – and of course their CEO and Chair incumbents were the primary proponents, that good governance could include the fundamental conflict of a combined Chair and CEO role. “Good” governance, the argument goes, could include having exclusively independent committees, an effective lead director, and an effective reporting and assurance structure. Proponents for maintaining the Chair and CEO roles also argued whether to split of not “depends on the personalities,” somehow implying an effective chair who has a good working relationship with a CEO could not be found. The real resistance to splitting the roles were the egos and hubris of the incumbents, and a captured board beholden to them.

Shareholders and regulators prevailed in Canada, the UK, Australia and New Zealand, where non-executive chairs are the norm. In the most recent set of governance reforms of 2013, for example, Canada’s financial institution regulator stated that the role of the Chair should be separate from the CEO, as this separation “is critical in maintaining the Board’s independence, as well as its ability to execute its mandate effectively.” Back in 2003, OSFI (Canada’s financial institution regulator) stated that both a non-executive chair versus a lead director could achieve board independence. The choice was up to the board, OSFI stated. Regulators have since progressed, advising that the roles can and should be split, for all federally regulated financial institutions, for the sake of good governance.

Having a non-executive chair separated from the CEO role (two different people) won’t guarantee success or prevent failure. Academics cannot prove a systemic relationship between board leadership and performance because chair effectiveness is so difficult to measure. But this can be posited: if the chair is effective, there is a much greater likelihood of better governance than relying on the effectiveness of a lead director. I have yet to see an effective lead director who approaches how effective a separate chair can be. A lead director role is institutionally more passive. Ask yourself if Jamie Dimon had to answer to a separate no-nonsense Chair who understood banking and risk whether the J.P. Morgan Chase’s risk meltdown would have occurred. (See the Senate report here.) The roles of a Lead Director and Board Chair are different. More and more American corporations are moving towards effective, non-executive chairs. Banks should not be dragging their feet.

The fight for Canadian Pacific Railway (CP) by activist investor Pershing Square demonstrates several shortcomings in the public company governance model and what can be learned from private equity. CP and RIM are significantly underperforming Canadian companies. There are numerous others. The question is where is the board?

The current corporate governance model is largely focused on compliance, not on value-creation. Most regulations short shrift the board’s strategic and value creation role. Canadian guidelines address strategic planning in one sentence, at 3.4 (b). The NYSE rules do not contain the word “strategy.” Educational programs are overwhelmed by auditors, lawyers and pay consultants. Boards have become bureaucratic traffic cops and the trend is continuing after 2008. How would codes and educational programs look if they were drafted and taught by long-term active investors?

Regulators in large measure are to blame. They overemphasize structural board independence at the expense of industry knowledge and shareholder mindset. The separation of chair and CEO and having a plethora of independent directors accomplishes little unless there is a clear understanding of roles. Most chair and director position descriptions are little more than high-level one or two page compliance documents written by lawyers designed to keep directors at bay. Directors are selected for independence and profile because that’s what the regulators want. Yet scholars know research does not support independent directors and the creation of shareholder value. What is missing? What can we learn from activist investors and private equity?

Here are some facts about CP according to Pershing Square’s materials and presentation:

• All directors own < 1% of stock and it was given to them, not bought;
• Four COOs and three CFOs have been replaced in the last five years;
• CP has consistently underperformed across industry peers, yet the CEO met 17 of 18 objectives set by the board;
• The cost of management as a percentage has doubled;
• There has been a moving of targets by the board, and these targets have been meaningfully lower than CN’s;
• There has been a lack of rail experience on the board, shareholder representation or equity ownership; [CP did not have any railroad expertise to drive the value creation process on the board (other than the CEO) until Bill Ackman first launched his activist efforts]
• If one director had $100M of his or her own wealth invested, the CEO would be replaced, Pershing Square said;

Deep dives such as the above by sophisticated activists such as Den Loeb and Bill Ackman need to be undertaken by boards themselves. This dive need not be overly complex. Look at Ironfire Capital’s analysis of the New York Times. How many boards have the skills to do this, I wonder? The approach Bill Ackman brings is not exclusive in its applicability to under-performers. The fundamental question is how many companies are under-performing relative to their potential, just not to the extreme extent of CP? And does this speak to a more robust corporate governance model on a wider scale?

We can learn from private equity and the nature of board engagement and shareholder value creation. According to experienced chair and activist investor, Henry Wolfe, “Numerous studies have been done of the performance and value creation results of private equity portfolio companies compared to their public company peers. At least in all that I have seen, the studies clearly demonstrate that private equity companies significantly outperform.” Wolfe goes on to say, “The implications of these comparative results for public companies is or at least should be staggering to those who serve on or advise public company boards. Adding fuel to this point Ernst & Young and other studies, including by McKinsey, found that the primary driving force for this out-performance was the PE Corporate Governance Model.” See the following link to an Egon Zehnder Private Capital Thought Leadership article regarding the work they did to learn more about a McKinsey study on Private Equity.

Michael Jensen at Harvard from his panel role in the 2007 Morgan Stanley Roundtable on Private Equity and its Import for Public Companies, said “In fact, my sense is that the due diligence process that the buyout firms go through in vetting and pricing a deal causes those principals and their managers to learn more about the business than has ever been known since it was a public company.”

This should not be the case if the public governance model worked. A key disconnect is director-shareholder accountability, which is not the case in private equity.

The nexus between public company boards and shareholders who own the company is limited at best, and this affects motivation and accountability. Boards continue to entrench themselves through staggered elections, at the expense of shareholder value. Most boards do not actually engage with shareholders directly other than at a perfunctory annual meeting. Shareholders cannot even propose directors in the proxy circular. A recent proposal by a group of Canadian investors is recommending (see the “Roxborough Initiative”) not only that shareholders select but also that shareholders – not management – compensate directors. This would address incentives and accountability. Director performance reviews should also be shared with shareholders and shareholders should have a say on board chairs. We are a long way from this type of meaningful board-shareholder accountability.

It is time to push the envelope and rethink the current model of corporate governance, in terms of how directors are selected, directors’ fundamental understanding of the business and the value creation process, the role of the non-executive chair, and director accountability to shareholders.