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Archive for the ‘Independence and Role Clarity’ Category

American Banks Should Split the Chair and CEO Roles

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.

Should governance lawyers be independent?

Most boards need professional advisors, such as auditors, compensation consultants and lawyers. After Enron and WorldCom frauds of 2002, regulators stepped in to ensure that auditors were hired by – and accountable to – the audit committee of the board, on behalf of shareholders, and not hired by or unduly influenced by the CFO as they once were. After the financial crisis of 2008, regulators stepped in (in 2012) to ensure that compensation consultants were hired by the compensation committee of the board and not hired by or unduly influenced by the CEO or other management. What about lawyers? Should lawyers who act for management also advise the board of directors? I don’t think so.

Now there are strict independence requirements for both auditors and compensation consultants. Their primary client is the board of directors and ultimately shareholders, whom the board is there to represent. It is entirely probable that if you do your job properly as an auditor or compensation consultant, that you will make recommendations that management will not like. You are there to act on behalf of the board and shareholders, not management. You cannot have dual masters and fulfill your fiduciary duties to only one as a professional. Indeed, auditors and compensation consultants cannot provide any additional services to management without the express consent from the board or a committee of the board. This authority is – or should be – rarely granted now.

Lawyers are equally important in the field of corporate governance. They interpret and apply legislation and offer advice to a variety of constituencies – shareholders, directors, managers and other stakeholders – who have interdependent and even adverse interests in the well being of the corporation and the competition for scarce resources. If the above reasoning is correct, so far as auditors and compensation consultants is concerned, strict independence should also apply to lawyers.

What this means is that a lawyer (or even a law firm) who has acted, or currently acts, or seeks to act, for management, should be prohibited from also acting for the board. This independence requirement is not practiced currently. There are numerous lawyers and law firms who act for both management and boards. Because most fees originate from management work, the consequences of this is a pro-management bias exhibited by lawyers who have drafted protection and entrenchment mechanisms for management such as poison pills, dual class shares, restrictions on meetings and voting, and staggered boards. Lawyers then resist pro-shareholder governance reform such as majority voting, say on pay and proxy access.

When interests between management and shareholders become adverse, even through the regular course of events, it is important for boards to have their own set of lawyers who are independent from management and seen as objective and willing to act in the interests of directors, not management, and ultimately shareholders. Management lawyers frequently exhibit an anti-shareholder bias, using words such as “attack,” “dissident,” and “proxy fight.” See here for example: Dealing With Activist Hedge Funds. Shareholders suffer when the board retains advisors who are beholden to management.

Some services this new set of “governance-only lawyers” could offer include:

  • Drafting board guidelines, committee charters and position descriptions for the board [if drafted by management lawyers, as they are now, these policies are often pro forma, management friendly, and restrict the board unnecessarily];
  • Board and committee reviews of effectiveness [typically these reviews are done by management or management lawyers currently];
  • Advising the board on activist shareholders, institutional shareholders and overall shareholder engagement [these governance lawyers would have a shareholder not a management mindset];
  • Reviewing and opining on the annual proxy circular, on behalf of the board [typically the board does not have the time to do a detailed review];
  • Review of the strategic planning process and value creation by management, on behalf of the board [again, with a shareholder mindset];
  • Negotiating and drafting the CEO contract and its terms, on behalf of the board and shareholders [typically a management lawyer drafts the agreement];
  • Assessments of risk management and oversight functions, on behalf of the board [again, the assessment would be independent of management and lawyers would work with independent auditors as necessary];
  • Ongoing coaching and development and review of implementation of policies, on behalf of the board.

All of the above activities and services are currently offered by management lawyers primarily from the point of view of management, not the board and not shareholders. This needs to change. The lawyers involved should fall into line (or camps), just like the auditors and compensation consultants have. There is room for governance lawyers who are unambiguously there to act only for directors, on behalf of shareholders.

Canadian Pacific is a Teachable Governance Moment

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.

 

There needs to be greater scrutiny of director independence – what it means and who decides

This will get legal and technical very quickly in the first few paragraphs, but please bear with me. Director independence is an important area and worth blogging about.

Currently, if a director has no direct or indirect “material” relationship with the company, that director will be independent. Whether a relationship is “material” is a relationship that could, in the view of the board of directors, be reasonably expected to interfere with the exercise of that director’s independent judgment.

A board determining director independence is a subjective view, i.e., the view is based on the board’s judgment. The board’s judgment need not be objectively reasonable, which is otherwise known as a “reasonable person” standard. Also, there may not be a line of analysis that could reasonably lead a board from the factors it considered to the conclusion it reached.

After the 2008 financial crisis, the Ontario Securities Commission (OSC) attempted to introduce a reasonable person standard for director independence, by stating that boards should “have regard to all relevant circumstances” in their analysis, and that a director should not have a relationship with the company or its management that could be “reasonably perceived” to interfere with that director’s independent judgment.

These amendments were strenuously resisted on grounds it would limit the director pool, and that outsiders lacked the collective experience and specific knowledge of the director in question.

The OSC has yet to address this issue of director independence.

If a director is conflicted or his or her independence is compromised, the board should not be the sole arbiter of this. Directors are a small group, subject to group dynamics and peer pressure, and should not be immune from external scrutiny of perceived conflicts or of compromising of independence that incorporate best practices. Conflicts of interest are handled within an organization by people independent of the decision.

Take two good examples of how director independence could be better scrutinized, from an objective point of view: (i) director tenure and (ii) director relationship to a significant shareholder or control person.

Director Tenure

There is a reasonable belief that exceeding a certain number of years on a board promotes greater closeness to management and less objectivity in performing an oversight role of management. The UK for example has a “nine year rule” for all its listed companies, beyond which a director’s continued independence is called into question. There is also a reasonable view that board renewal and diversity of skill sets is a good thing, in that a younger director with a more relevant skill set need not be blocked by a senior director who refuses to retire.

When the UK rule is applied to Canada, several directors fail. Of five chartered banks, for example, thirty (30) directors exceed nine years with several directors on bank boards for almost 20 and up to 25 years. Directorship should not be a lifetime appointment. These directors need to let go and make room for the next generation of directors.

The debate on whether long-serving directors are reasonably perceived to be independent from management, and if so, how, and how the views of their fellow directors have been canvassed, is one worth having, juxtaposed with objective views of scholars, rating agencies, diversity candidates and shareholders on this topic. The UK incorporates both the subjective and objective views.

Director Independence from a Significant Shareholders or a Control Person

Right now a control person or significant shareholder is not disqualified from being independent.

It is equally reasonable that an appropriate proportion (subjectively and objectively defended) of a board be comprised of directors who are independent –subjectively and objectively– from both management and a significant shareholder or control person, if either exists. Numerous Canadian companies have a significant shareholder or control person. (A significant shareholder or control person could own a majority of voting shares and control the directors’ appointment to a board.)

It may also be reasonable to consider the control person or significant shareholder’s nature and degree of involvement or influence over management for purposes of assessing independence.

A related party (insider) transaction can occur such that directors elected by and from the non-significant shareholder or control person may also be reasonable, to oversee such transactions.

Will the debate occur?

Long-serving directors and significant shareholders or control persons have vested interests and their view is worth hearing. It should not be the case however that the debate does not occur or other views are excluded from an unbiased assessment of director independence, what this means and who decides.  It is important to get director independence right as much of corporate governance effectiveness hinges on the independence and ultimate effectiveness of directors.

Board Leadership ~ No One Sized Fits All Approach

There is a lot of prescriptive dogma about board leadership, from academics, rating agencies and shareholder groups, espousing a board chair separate from the CEO, even though the academic evidence is that having a separate, independent board chair does not necessarily result in a better board or even shareholder performance.

The prescription permeates into guidelines and codes for Canada, the UK, Australia, New Zealand and South Africa, where independent chairs are called for. The Americans however have largely incorporated a different approach, in the concept of a lead director.

A lead director is the independent counterpoint to a board that has a combined Chair and CEO role vested in the same person, or has an executive Chair role (e.g., a founder or major shareholder). A very good guidebook was recently released by the National Association of Corporate Directors outlining the responsibilities and important characteristics of Lead Directors. Some 2/3 of NACD members surveyed responded that they have the position of Lead Director, and 90% of respondents believed that effective Lead Directors enhance board effectiveness. I recently moderated a Lead Director panel in Dallas, Texas to discuss the report.

What matters in terms of board leadership is not whether a board of directors is led by an independent Chair or an independent Lead Director, per se, but the effectiveness of that person in that role at that time. And specifically: the leadership skills and personal attributes of the person, and the relationship with the CEO and other directors. Researchers, if they have any hope of drawing causal relations between boards and performance, should focus more on the behaviors and skills of board leaders and other directors, inside the boardroom. Companies in turn should be comfortable with designing – and defending – a leadership structure that works for them, given the individuals involved and circumstances and ownership of the company.

How can either a board chair or a lead director be ineffective? By being captured by the CEO (losing independence); by not being able to run meetings effectively (board meetings or executive sessions); by being too dominant or weak; by not understanding the industry; by not investing the time to fulfill the job description; by not ensuring proper agendas and information flow; and, most importantly, by not having the right leadership skills. Some attributes of a successful chair or lead director, other than independence of mind and leadership, include integrity, teamwork, consensus-building, constructive challenge and mentoring and development.

It is also a myth that a lead director is necessarily less effective than a non-executive chair simply because the board chair conducts board meetings and the lead director does not. A competent lead director can have a significant effect on a meeting even without chairing it. A separate board chair can be over-ridden by a dominant CEO or other directors even if that person is chairing a meeting but cannot do so effectively. Some of the least effective meetings I have observed had non-executive chairs leading them. See my recent paper (PDF) with Katharina Pick here.

Board leadership is an art. Not all – or even many – directors are cut out to lead a board. The qualities and selection of that individual – next to the selection of CEO – is probably the most important decision a board can make. Any dysfunctional board will likely have an ineffective independent board leader, whether that person is chair or lead director.

The focus should be on the skills, attributes, selection, effectiveness and assessment of the person, not the structure, or one particular model over another.


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