Dr Richard Leblanc

It is exceedingly rare for a director to be removed from a board. Only 2% of directors who step down are dismissed or not reelected, according to Stanford researchers. The vast majority of directors are re-elected and continue serving, in other words. Some directors serve on boards for up to twenty or twenty-five years. About a year ago, I counted 30 directors who served on Canada’s five bank boards for more than 9 years. Nine years is the upper limit for independence now in the UK.

A board does not have the power to remove another director, even if that director is performing poorly. If the director digs in and refuses to step down, that director must be replaced at the annual meeting. It is rare for shareholders to remove a director at the meeting if he or she is re-nominated. Only 93 directors failed to win majority support, out of a total universe of some 50,000 directors, as of recent figures.

Shareholders have limited rights to propose or remove directors. A special resolution is needed, if shareholders can demonstrate cause, to remove a director, for example. HP, Yahoo, RIM, Chesapeake Energy and Bank of America – which have lost a combined $353B of shareholder value, are good examples of the difficulty of director removal.

The effect of the above entrenchment mechanisms is that shareholders are essentially shut out of the corporate governance process. They can neither propose nor remove directors without great difficulty and expense. Protracted proxy battles need to occur to force the issue. This is a structural and systemic problem with governance.

The board really polices itself but shareholders should have a greater say, through at a minimum majority voting and not having staggered boards. Approximately half of public companies have staggered boards, which may insulate or entrench management. Each director should come up for election each year and be required to obtain a majority of all votes cast to continue on.

Second, performance of directors should be much more public so shareholders can make a more informed decision when they vote. The UK is the best here (disclosure of director performance) but much more can be done, in the US and Canada for example.

Third, a tenure limit of 10-12 years at the long end makes sense. The UK, Hong Kong and Singapore have a 9-year limit. There should be an outer limit as this would help turnover, diversity and limit entrenchment. Ten years is a good number to retain institutional memory but not have a life-time appointment. The Ontario Securities Commission (OSC) in Canada should give serious consideration to the effect of prolonged tenure on independence.

Fourth, the tenure of directors should be linked by the nominating committee to the peer review. Canada started peer review of directors in 2005 and was one of the leaders here. Now other countries are following but the next step is linking the results of the peer review to continued tenure. Boards know who the non-performers are but they should receive guidance from the OSC that it is good to link peer review to re-nomination. The OSC should also consider this, as it would address non-performance. Also, the board knows the board best.

Retirement age, if needed, could be 72-75 as the population is growing older, but boards may not need retirement ages if they have all of the above. And the research doesn’t support age and effectiveness. You can be 63 and ineffective and 74 and very effective.

So, greater performance information, majority voting, no staggered boards, a greater say by shareholders, a tenure upper limit of 10 years, and linking re-nomination to peer review, are all practices that would enhance governance transparency, quality and accountability.

 

Shareholder activism at CP Rail, Yahoo, Research in Motion, Chesapeake Energy and BMC Software continues, trying to prevent the destruction of billions of dollars of shareholder value. Shareholders rejected Citigroup’s, Aviva’s, Knight Capital’s, FirstMerit’s and Cairn Energy’s executive pay packages. Activists and hedge funds such as Bill Ackman at Pershing Square, Dan Loeb of Third Point Capital, Vic Alboini at Jaguar Financial Corp., Paul Singer at Elliot Management and Carl Icahn reveal defects in the current corporate governance system. What do they all have in common? And are boards listening?

I wrote in an earlier blog that Canada’s current governance guidelines from 1994 and 2005 are outdated. They, as well as other guidelines, underemphasize value creation, shareholder accountability and competencies of boards. My LinkedIn group, Boards and Advisors, drawing on the above shareholder activist cases, the success of private equity governance, and experiences within our group, developed over several dozen posts and other writings a ten point model of reform for public company boards. The model can be downloaded here, and will be summarized below. Boards would be wise to take note in creating value for shareholders.

1. Value Creation and Maximization: The board, led by the Chair, should set the standards for a vigorous value creation process, establish ambitious value creation criteria, and lead management to develop an optimal value creation plan. The board should approve the plan and its milestones, monitor progress regularly, and call for prompt corrective action to ensure goals are met, including increased goals as new unplanned/unanticipated opportunities arise.

2. Hold Management to Account: Reporting format and information flow should provide frequent, timely and accurate information to the Board on plan progress and any variances. Boards will need to be smaller and meet more frequently. Management must provide concrete responses on how shortfalls will be corrected, by whom and when.

3. Pay for Performance (and only performance): The Board should establish value creation plan execution to simple, straight-forward performance metrics so there is no ambiguity, as to management and shareholders, between management wealth creation and the performance and increase in equity value of company. Pay should be straight-forward: with a concrete timeframe; with substantial but reasonable/proportional-to-performance reward to the CEO; with a long term period; with high hurdles (e.g., earnings growth %, revenue growth %, return on equity %); and with one of the targets relating to performance of company to greater market. The CEO should receive a portion of grant for performance below target, but a high threshold should be in place below which CEO receives nothing.

4. Ethic of Personal Responsibility: Directors should put themselves and their personal interests and resources at risk for the ultimate good of company and collective interest of all shareholders. Conflicts of interest and related party transactions should be managed transparently and rigorously.

5. Active Investing in the Boardroom: Each Director should purchase shares directly from personal funds commensurate with his or her savings capacity. Shareholders or their designated appointees should be represented on the Board.

6. Selecting the Right Chair: The Chair should be selected, with shareholder approval, on the basis of mindset, leadership, an understanding of value creation process and the capital markets, the ability to view things holistically, an ethic of accepting personal responsibility, industry experience, and no desire for the CEO role. The Chair, next to CEO, is probably the most important decision a board makes.

 

 

7. Selecting the Right Directors: “Independence” of Directors should have an objective as well as a subjective basis (e.g., not just judged from board’s perspective, but from reasonable person standard). Directors should be selected and assessed on basis of industry experience and track record, value creation process experience and mindset, shareholder representation and a culture of equity ownership, entrepreneurial culture, and specific functional skills.

8. Board Engagement: A robust debate and review of plan execution should be a primary board meeting agenda item. Regular and robust communication between the Board and executive team, including open communication below the senior management level, in large part should not focus on “oversight” but on engaging others in the organization in regard to their role in the company’s business and value maximization plan.

9. Shareholder Accountability: Regular director-shareholder contact (in person and electronic) should occur absent management. Each director should be elected each year by a majority of votes cast. Shareholder nomination of directors, with thresholds and holding periods, should occur to enable nomination and recall of Directors by key long-term Shareholders.

10. Monitoring and Compliance: Independent assurance should be provided to the Board over all material risks and internal controls. All risks, not just financial, should be identified and assured.

When you look at each of the situations that shareholder activists involve themselves in, every one of the above 10 reforms have been inadequate by all of the boards collectively of the above companies. Further, a private equity form of governance, on which the above is based, has been shown to result in three times the enterprise value of public company peers.

There are numerous other public companies that are similar to the most acute identified above.

Governance reform will not be solved by more regulation focusing on compliance or trying to prevent failure. Governance reform needs to be shareholder-driven and focus on success.