Governance Blog

Should governance lawyers be independent?

Dec 20

Posted in Independence and Role Clarity, Shareholder Accountability | Comments Off on Should governance lawyers be independent?

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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.

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What boards and individual directors can learn from Toronto Mayor Rob Ford and managing conflicts of interest

Nov 29

Posted in Ethical Leadership, Citizenship and Integrity | Comments Off on What boards and individual directors can learn from Toronto Mayor Rob Ford and managing conflicts of interest

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What is the lesson here for boards of directors and individual directors and officers? Avoid conflicts of interest at all times, but if and when they do occur, the test is perception and process. Every board should have a conflict of interest statement that applies to officers and directors, and to a control person or significant shareholder if applicable. It should cover identification and resolving of the conflict. If you are in doubt as to whether you have a conflict, you must disclose and cannot influence or take part in a decision, transaction, arrangement or otherwise in which you: can be perceived to have an interest, direct or indirect; cannot be seen to be impartial from an outsider point of view; or receive a benefit not shared by other shareholders. If you do take part in the decision, or do not disclose the potential conflict, or attempt to influence the vote, you risk detailed legal scrutiny after the fact to show your conduct was improper and did not conform to best practice. Records of the matter should be kept, a special committee may need to be formed composed only of directors who are seen to be independent in all ways from the matter and the director or officer or shareholder with the conflict, and expert independent advice should be sought. These best practices will protect the board as well as yourself and your reputation that you acted prudently, exercised your duty of care, were transparent, and acted only in the best interest of the company and all shareholders.

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Mayor of Toronto Rob Ford’s Errors

Nov 28

Posted in Uncategorized | Comments Off on Mayor of Toronto Rob Ford’s Errors

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Rob Ford apologized yesterday, but that should have occurred months if not years ago when the letterhead to solicit donations was used. He said he did not benefit from the conflict of interest. This is not only incorrect, but also not relevant. Conflicts of interest are based on perception, not what the recipient thinks.

Ford made several strategic errors. Here they are:

He did not take advice, legal or otherwise, the judgment confirms. This is remarkable. The Municipal Conflict of Interest Act is a “sledgehammer,” according to Professor David Mullan and former Integrity Commissioner. I agree. There should be graduated penalties commensurate with infractions, rather than declaring the seat vacant. A lawyer could have predicted that this conflict would end up putting a stranglehold on Ford and removing him from office. Ford was not even familiar with the above Act, he acknowledged under cross-examination. He was also alleged by the Integrity Commissioner to be in violation of the Code of Conduct at Articles IV, VI and VIII, and by requesting forgiveness of the donations, the Lobbyists’ Code of Conduct. Justice Hackland found Ford had a “dismissive and confrontational attitude” towards the Code.
Ford did not act on the advice he did get. He was instructed, immediately preceding a vote, not to vote on a motion in which he had a pecuniary interest. Ford refused, and not only spoke to the motion, but also voted on it. This was a fatal flaw. It is entirely correct that Ford ought to have had the opportunity to speak as a matter of procedural fairness, as his lawyers argued in the judgment, but that was not what the Act read. (The Act really does need to change to enable a person alleged to be in conflict to speak to the issue in an open forum.)
Ford stubbornly refused to acknowledge the case against him. And it was a silly, amateurish case that should have been avoided. Ford should have known better. Soliciting donations using government stationary implies the communication is official and carries credibility on which the requesting party is trading. It opens the door to expectations by lobbyists of favorable treatment resulting from the donation. This, precisely, is what the Act seeks to penalize. The recipients or cause – or even the quantum ($3,150.00) – is not the issue. Indeed the more deserving the cause, the greater the likelihood is that the conflict will be acute and unrecognized.

The Integrity Commissioner’s report, which Justice Hackman referred to as “excellent,” reads:

“In fairness to Councillor Ford, it is common for a person who has blurred their roles to have difficulty “seeing” the problem at the beginning. It often takes others to point out the problem, especially in a case where the goal (fundraising for football programs for youth) is laudable. The validity of the charitable cause is not the point. The more attractive the cause or charity, the greater the danger that other important questions will be overlooked, including who is being asked to donate, how are they being asked, who is doing the asking, and is it reasonable to conclude that a person being asked for money will take into account the position of the person asking for the donation.”

And it is not the case that Ford did not benefit.

The Integrity Commissioner goes on to write,

“Where there is an element of personal advantage (in this case, the publication of the Councillor’s good works, even beyond what they had actually achieved), it is important not to let the fact that it is “all for a good cause” justify using improper methods for financing that cause. People who are in positions of power and influence must make sure their private fundraising does not rely on the metaphorical “muscle” of perceived or actual influence in obtaining donations.”

This is the heart of the case against Ford. Justice Hackland wrote that Ford ignored the law, did not secure professional advice, and this amounted to “willful blindness.”

Regardless of one’s politics, this case was not well handled by Ford. His legal team is expected to apply for a stay of the judgment and file an appeal.

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Governance at the Salvation Army

Nov 27

Posted in Not-for-profit Boards | 1 Comment »

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The Salvation Army recently dismissed Mr. David Rennie, its executive director of its toy warehouse in Toronto, where there was an alleged “massive” theft of $2M in children’s toys. This amount of toys, which were recently located, along with Mr. Rennie surrendering to police, cannot be carried out under one’s arm. It likely involved inadequate internal controls over the segregation of duties, over the safeguarding of assets, and over restricted areas. Perhaps paper rather than IT controls were being used (still not uncommon), which is more capable of manual override.

A qualified audit opinion was offered by the Salvation Army’s external auditors, KPMG, over the last three years (see here and here). According to Stanford researchers, the external audit process (see slide 10) should include fraud evaluation, a review of opportunities for fraud, and an examination of incentives for fraud. Auditors should use “professional skepticism,” but it is not the explicit objective of the audit to identify fraud (slide 9).

It is unclear, judging from the Salvation Army website, whether the Governing Council of the Salvation Army has adequate independence from management or financial expertise (see page 31 here), where independence or financial background is not mentioned). There is an advisory board, but there is no indication that the Salvation Army has a proper, functioning board of directors, that oversees risk and controls. Advisory committees advise, but cannot direct.

Theft happens when there is opportunity, incentives and lack of internal controls. A board, or lack thereof, controls and approves all of these factors – and in particular, controls. I was in Calgary after the XL Foods crisis, lecturing to a room full of directors on beef association boards in Alberta. “Do you approve the internal controls over food safety?” I asked? Not many hands went up. “Do you take tours of the plant, seeing the line, and talking to workers? Do you have an internal audit function that tests the design and effectiveness of internal controls, and reports directly to you?” Again, not many hands went up.

A proper board will want to see validation over the internal controls over all material risks – in the form of real time risk registers with individual accountability and mitigating actions. Material risks are not just financial, but non-financial. This includes operational controls, such as the line in a meat plant, or the warehouse with toys in it. I did a review of a diverse, complex NFP operation last week where documented risk management and operational control oversight by the board was inadequate. I am recommending 45 governance enhancements including a compliance committee of the board and proper risk oversight. I am designing a not for profit and governmental governance accountability course within York University’s Masters of Financial Accountability (MFAc) degree program this January given the importance of not for profit organizations to the economy, and the presence of governmental corruption.

Internal controls basically constrain management. No one likes to be controlled and there is an obvious aversion to management controlling itself or dedicating resources for this. In not-for-profits and charities especially, there are stretched resources, volunteers, and a tendency to trust people. However, fraudsters exploit these areas of vulnerabilities. Controls need to be person-proofed and require a diligent board with authority and competency to require adequate reporting, controls and follow up. Sadly, this was not the case at the Salvation Army and the board (or lack thereof) is at fault. Donations may suffer but more importantly, so may children at this time of year.

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

Nov 19

Posted in Audit Committee, Ethical Leadership, Citizenship and Integrity, Financial Reporting, Global Corporate Governance, Integrated Reporting and Accountability, Risk Governance and Combined Assurance | Comments Off on Regulators turning up anti-bribery heat on corporate boards: But will practices change?

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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 143^rd of all 182 countries on Transparency International’s corruption perception index, with a score of 2.4. Canada ranks the 10^thleast 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 24^th and the UK 16^th, 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 95^th, 75^th and 73^rd 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.

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Should governance lawyers be independent?

What boards and individual directors can learn from Toronto Mayor Rob Ford and managing conflicts of interest

Mayor of Toronto Rob Ford’s Errors

Governance at the Salvation Army

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