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Discussion notes for Corporate Secretary Think Tank Canada Panel, 2 October 2013: Panel: Shareholder Activism, 9:30-10:45am
There have been a number of activist situations in Canada recently, including CP, Agrium, Telus, BlackBerry, Tim Hortons and others. Is your board a siting duck or otherwise vulnerable? Here is what the red flags are for defective governance, below.
The following reflects, in no particular order: (i) my work in advising regulators (e.g., OSFI, OSC, AGCO, FiCom, others) in respect of governance; (ii) interviews with 40 activists, private equity leaders, members of the NACD 100, and top 100 CEO listing in 2013; (iii) my advisory work in two activist situations above (both advising the activist in the first, and board under attack in the second); (iv) my work with governance enhancements in companies that have been accused of fraud, bribery, corruption, stock manipulation and otherwise (ten in total); and (v) my advising and assessing award-winning boards (nine in total), who have strengthened their governance. The data collection has included individual director interviews and observing the board in action. For the full paper, published in the International Journal of Disclosure and Governance, November 2013, Special Issue: Enhancing the Effectiveness of the 21st Century Board of Directors: Part II, edited by myself, please contact me and I will email it to you.
Governance red flags, for activist attack and board bulletproofing, especially board composition, leadership, value creation and compensation, include the following, in no particular order
1. Captured, owned directors (trips, gifts, friends, company office, interlocks, school together, jobs for kids, donations, Directors economically dependent on fees): not objectively independent and/or owned in the boardroom, and Board refuses to have heightened independence standards or address the foregoing;
2. Directors with reputational, adverse publicity, integrity, independence, other board performance, egregious action or failure baggage, or inadequate experience and track record, and Board does not cure the distraction or adverse inference (i.e., promptly remove the Director);
3. No or little industry (market / geography, customer, supply chain) expertise on Board, and Board incapable of providing strategic control and direction to Management;
4. Legacy, pedigree, over-boarded (>2), over-tenured (>9 years), or otherwise ‘zombie’ Directors without new blood, diversity and renewal. Evidence is: busy boards with busy directors (>2 boards) “consistent and convincing” worse long-term performance and oversight (Stanford researchers); >9 years directorship reduces firm value (“board tenure has an inverted U-shape relation firm value” – Huang, July 2013); and gamed majority voting returns ‘zombie’ director to board. Global regulatory director tenure converging on 9-10 years (UK, India, Australia, Hong Kong, Singapore, other). Management-beholden, cozy, over-tenured, or legacy service providers (law, audit, compensation): no renewal or freedom to be adverse: regulators now addressing;
5. Management who unduly influence independent oversight functions (internal audit, chief risk officer, chief compliance officer, chief actuary, or equivalents) or external assurance advisors (external audit, governance lawyer, compensation consultant, search firm) from Board or Committee oversight, by preselecting, starving or otherwise unduly influencing. Regulators are becoming clear these functions are to be independent of senior and operational Management, and accountable to the Board and/or relevant Committee directly;
6. Weak, legacy, not independent, not effective, or unskilled Chair (Board or Committee): specifically, a Chair owned by Management or a dominant Shareholder, or both, or who does not understand obligations, capital markets, lacks leadership, credibility, cannot implement strict management accountability standards, and lacks subject matter or industry expertise; A Chair who should not be Chair, in other words;
7. A Board Chair who cannot lead value creation: An activist Board does the following:
- Board, led by Chair, sets standards for vigorous value creation process, establishes ambitious value creation criteria, and leads Management to develop optimal value creation plan;
- Deep dives and due diligence by all Directors into company, business model, industry and markets to understand value drivers, innovation opportunities and associated risks;
- Board approves plan and its milestones, monitors progress regularly, calling for prompt corrective action to ensure goals are met, including increased goals as new unplanned/unanticipated opportunities arise;
- Value maximization plan clearly and simply spells out key timelines, milestones, targets, and individuals accountable for each key plan component and specific results;
- Reporting format and information flow provides frequent, timely and accurate information to Board on plan progress and any variances;
- Board addresses plan variances quickly and directly: Management provides concrete responses on how shortfall will be corrected, by whom and when;
- Chair adopts a primary role in foregoing;
- Maintenance of ‘day to day’ management by CEO and rest of executive team;
- Highly engaged level of functioning by Board and a shift in primary focus towards value creation; and
- Robust debate and review of plan execution is primary board meeting agenda item; and at least one presentation each board meeting from key personnel below the senior level, on that particular individual’s role in the value maximization plan and a full discussion of progress to date in that regard.
9. CEO and other management information/personnel funneling, channel blocking, and starving of the Board; a weak Chair who does not cure; buy-in to “nose in fingers out” drinking of the Kool-Aid promulgated by Management and even director associations (see item 8 above), without an activist Director who can move the room;
10. Lack of executive/in camera sessions without any Management (including General Counsel / Corporate Secretary) in the room (i.e., executive sessions of and with: the Board; each Committee; each independent oversight function (see item 6); each external assurance provider (item 6); and key Shareholders, without Management);
11. Lack of regular meetings with Directors and major long-term Shareholders, and Board Chair directing counsel not to interfere; and failure of Board to understand/appreciate, or be misinformed about, shareholder base, and their concerns, behaviors, styles and preferences, including dissident activity by insurgents and activists: no early warning system or rapid response, experienced fight team, and being caught flat-footed;
12. Not listening to, or acting upon, advisory, precatory or withhold proposals, resolutions, votes, the will of shareholders, or listening to advisors, or having conflicted advisors, and curing the underlying issue(s) promptly;
13. Lack of value creation plan, with focus on innovation or strategy by the Board, or a separate board Committee if the Board cannot or will not (see item 8 above for what this looks like);
14. Lack of confidence in Directors by investors: A board incapable or unwilling to direct, control or replace underperforming, ineffective or inefficient Management;
15. An arrogant, insulated, bloated, complacent, non-introspective, defensive, clubby or otherwise inexperienced board that is in denial, not in charge, has lost objectivity, is not credible, does not have a sense of urgency, cannot be relied upon, and/or has become entrenched;
16. A governance analysis by a Board that is not at least equal to that of the activist, who bases theirs on public (not inside) information;
17. Directors who are ‘paid for showing up’ (per meeting, per committee, flat fee, etc., or excessively paid) without incentive link from their pay (cash and equity) to individual performance and/or achieving company value creation hurdles; and spending Directors’ own money on stock, vs. being awarded stock for attendance (current);
18. Boilerplate, inadequate, complex or gamed disclosure;
19. Failure to appreciate the sophistication, resources, screening, homework, PR, signaling, persuasive ability, staying power and resolve of an activist to go the distance;
20. A Board allowing Management to become emotional and attack the activist, rather than focus on the value creation plan, the issue(s), and communicating this to Shareholders to win support, or compromise, or resolve with the activist (as the case may be);
21. A Board itself becoming defensive to reasonable governance enhancements or significant reform: going dark, lawyering up, engaging in window dressing, di minimis action, and/or siding with Management at the expense of the Company and Shareholders (as the case may be), thinking the issue will go away; or acting in the best interests of company as pretext for perceived self interest;
22. Entrenchment: Non reasonable pills, staggered, dual, super, restrictions, thresholds, advance notice, bylaws, etc., devised by incumbent Management counsel, approved by Board, and perceived to hide, block or frustrate fluid market for corporate control and/or director removal;
23. Advocacy and funding of trade associations, advisors, lobbyists to resist governance reform (using Shareholder money by self-serving Management is the view of some activists);
24. Inadequate attention to validating (and on occasion misrepresenting) each Director’s expertise: in other words, linking the strategy and value creation plan of the Company to each Director’s separate competencies;
25. Not countering the expertise and track record of each incumbent Director on the Management slate vs. each prospective Director on the dissident slate, removing any weak Director on Management slate where necessary: in other words, not countering the activist two part concerns that: (i) change is necessary, and (ii) the activist Director slate can more effectively address the change;
26. Management hubris, herding, empire building, going beyond pure play, poor capital deployment or cash oversight, asset or supply chain mismanagement, deficient operating, financial or strategic performance, or running out of options, and Board not owing the best ideas for unlocking of shareholder value before the activist does, with the Board being perceived as “enthusiastic amateurs” (large institutional shareholder CEO, from interviews);
27. Over-reliance on inflated peers and hyper benchmarking, (salary-disguised, non stretch bonuses, LTIP not performance-based (PSUs)), and 17% of CEO pay unrelated to performance rather than structural result of year-over-year above-median peer group pay (Elson and Ferrere, August 2012);
28. Excessive compensation equity to management: mixed relationship to performance, tendency to manipulate, and a Board moving goalposts;
29. Lack of proper independent governance treatment and disclosure of waste, conflicts of interest, related party transactions, complex structures, use of corporate opportunity, and extraction of Shareholder money to founder, family or insider, and sleepy Board;
30. Lack of integration of academic research: Recent disclosure in reference to 1994 Dey guidelines: “We did virtually no research.”; and
31. Board or retained management advisors that subscribes to the myth, or do not confront the evidence, that hedge fund interventions do not create long term positive operating performance and value for all shareholders, when systemic study shows they do (Bebchuk, July, 2013: analysis of 2000 interventions over 1994-2007 studied @ 5 year periods).
Richard W. Leblanc, PhD
Additional notes for Corporate Secretary Think Tank Canada Panel, 2 October 2013, on Gender Diversity on Boards
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Additional notes for Corporate Secretary Think Tank Canada Panel, 2 October 2013
Panel: Gender Diversity on Boards, 1:45-3:00pm
The following reflects, in no particular order, (i) my work in advising regulators (e.g., OSFI, OSC, AGCO, FiCom, others) in respect of governance (including diversity and director competencies); (ii) interviews with male and female directors concerning diversity; (iii) my advice and assessment of award winning boards known for leading diversity practices; (iv) my work with governance reforms in recommending women to all male boards, and improving director recruitment, assessment and retirement practices. The data collection has included individual director interviews and observing the board in action.
Diversity red flags include, in no particular order:
- Self interest by over-boarded and/or over-tenured male (and on occasion, female) Directors who wiggle or refuse to go, buttressed by unsubstantiated anecdotal belief or myth, such as CEOs make better Directors, women are not “qualified,” or there are not enough qualified women Directors to be found, typically within their own networks, etc.;
- Applying industry “experience” to prospective directors and not to incumbent Directors: Blocks women, and regulator has never used word “experience” to my knowledge;
- “CEO” preference, where CEO has never been used by a regulator, nor is this title determinative of director performance, nor is it a competency or a skill: Use “enterprise leadership” or “leadership” instead;
- A preference for CEO directors is not evidence-based, including the views of directors themselves: CEOs are seen as dominant, poor listeners, and stretched, and 80% of directors do not believe active CEOs are better directors than non-CEOs: “Are Current CEOs the Best Board Members? CGRP-18,” Stanford University, 2011). Directors who are retired CEOs are not seen as better than average board members by a majority of other directors (ibid.);
- Perversion of the competency matrix requirement (NP 58-201 3.12-14), focusing on “experience,” when the regulators (including whom I have advised) use “expertise” (OSFI) and “competency” and “skills” (OSC/CSA); Expertise (my view, not in regulation) = SKEET (skills, knowledge, education, experience and training), meaning experience is but one way to acquire expertise. Competency can be defined as: a cluster of related knowledge, attitudes and skills that affect a major part of one’s job; that correlates to performance; that can be measured against standards; and can be improved via training and development (S. Parry, “Just What is a Competency,” June 1998). Expertise and competency are broad concepts, in other words;
- Larger issue permitting self dealing and preference: There is opaqueness and regulatory temperance as to what it means to be “qualified” to be a Director, even on a public company board in Canada. The requirements are minimalist: You do not even need to be financially literate, at least initially, even to serve on an audit committee: You need to be over 18, not bankrupt, and not insane (and found to be such by a court). There are no requirements for continuing education or a code of conduct, unlike other fiduciaries;
- Academic evidence is that busy boards (a majority of busy directors on three or more boards) contribute to worse long-term performance and oversight, and that over-tenured directors (beyond nine years) diminish firm value [see my Activist panel notes and references];
- Evidence is women augment male director attendance; gender diverse boards allocate more time to monitoring; and “CEO turnover is more sensitive to stock return performance with a greater proportion of women on boards” – in other words, gender diverse boards are more likely to fire a non-performing CEO (Adams and Ferreira, 2008). Note also busy boards (see above) are less likely to fire non-performing CEOs (Fich and Shivdasani, 2006). Keep in mind: The choice of CEO is the most important decision a board makes and has the greatest affect on company performance;
- Not recruiting first time directors: Focus on board “experience” (rather than governance expertise) blocks women, whereas 80% of directors serve on only one board and no empirical evidence confirms multiple directorships contribute to performance and oversight (indeed the evidence is the opposite);
- Recruiting Directors previously known to the board may be at variance with the Board’s ability to push back (constructively challenge) against each other and Management
- “Boards with more directors that didn’t have prior relationships with other directors tend to address affective conflict more quickly than boards where directors had prior relationships. I believe this is because of the deleterious impact on extra-boardroom relationships – directors with prior relationships don’t address affective conflict because they don’t want their behavior “corrections” to impact the prior business dealings (or relationship) they have outside the boardroom.” (SCharas, PhD candidate, email to the author, whom the author is supervising (disclosure));
- In other words, men may be “conflict-averse” (which perpetuates boardroom groupthink and management capture) because there is a greater cost due to relationships (social, economic, political, religious, other etc.) outside of the boardroom, because these Directors, in turn, were recruited because of this relationship and personal knowledge;
- “A prior study published in the HBR has found that teams that have women on them out-perform those that don’t for overall team effectiveness.” (ibid., Solange Charas, email to the author, 28 September, 2013) (http://hbr.org/2011/06/defend-your-research-what-makes-a-team-smarter-more-women/).
- Lack of robust independent director assessment, with consequences and direct link to re-nomination: perpetuates non/under performing Directors and frustrates renewal:
- Blockage of third party reviews of board and director effectiveness, by Manager or a Director: Regulators now are requiring regular third party (objective) reviews;
- Boilerplate one sentence disclosure of board effectiveness review;
- Lack of Canadian political leadership (until very recently in Ontario): Canada (other than Quebec) is late to boardroom diversification;
- Lack of agreement among provinces and stalling of corporate governance guideline development, including director recruitment, expertise and tenure (Canada is one of the few industrial countries that has not updated listed company requirements until before the financial crisis – NP 58-201);
- Use of largely binary regulatory guidelines [NP 58-201] governing director recruitment, rather than principles and practices that achieve the objectives of the principles [OSC proposal in 2008]: Leading practices are omitted, and undue deference / influence to those with vested interest in the status quo [read: conflicted], including stakeholders, who may be a vocal minority in the public debate or on a Board;
- Gamed or otherwise defective director bios (puffery, positions, roles occupied over a career), rather than disclosure of specific competencies and skills, at board and committee level, underscored by how and when the competency and skill was acquired, and how each competency contributes directly to the value creation plan and oversight of the company and its Management;
- Defining diversity expansively / downward to include almost anything (e.g., perspective, thought, viewpoint): Blocks women;
- Trade associations, funded by memberships, beholden to status quo members: undue deference to those with vested interests: Blocks women;
- Gaming of retirement age (69, 70, 72, now 75) and resistance to term and directorship limits by self-interested Directors;
- Resistance to competency matrix disclosure and transparent director nomination and selection practices: inadequate regulatory guidance;
- Undue influence of Management on the competency matrix (design and administration), whereas Nomination Committee must be independent (including its work);
- Pro forma management friendly governance documents proffered by management counsel or developed by Management (conflict in either case) vs. the Board or Committee or independent counsel, accountable to the Board, not Management;
- Gamed or defective director competency matrix (matrix not disclosed; competencies ill-defined, or unbalanced; scale ill-defined; no third party check): permitting fuzziness and back-dooring of preselected candidates, often known to one Director [see above study and “Friends Don’t Let Friends Join Their Board” by Amanda Gerut, Sept 30, 2013 (proprietary – see AgendaWeek.com);
- Pre-ranking and not interviewing prospective Directors; Not disclosing origination of a Director (how he or she came to be known to the Board);
- Not consulting with major long-term Shareholders on prospective Directors, and institutional shareholders, further, and perhaps more importantly, not having a roster of qualified directors and advancing proxy access;
- Search firm who also assists Management (executive search – conflict), or reporting to a particular Director (as opposed to a Committee), or not behaviorally validating Directors through rigorous processes: No code of conduct or industry practices for director search firms; and
- Matrix analysis by corporate secretary or general counsel who do not possess independence or expertise to do so.
Richard W. Leblanc, PhD
The US Securities and Exchange Commission announced this week that public companies will be required to disclose the ratio of the annual total compensation paid to their CEO against compensation of that of the median worker, in the form of a ratio (e.g., 200 to one). See the proposed rule, here. One consultant estimated in a guest lecture for me that ratios could be as high as 1,000 to one. (See a list of eight companies apparently with this ratio, here.)
Other compensation consultants and lawyers have commented on the new CEO to median worker pay ratio. Advisors warn about the “law of unintended consequences” in this ratio, and how societal wealth disparity should not be laid on the doorstep of companies.
Let me fault the law of unintended consequences and wealth disparity at the doorstep not of companies but of the advisors themselves.
What happens with disclosure of pay data is revenue streams for pay advisors to boards. “Peer groups” and “benchmarking” – which is how most public company CEOs are paid – are inventions of compensation consultants. So are stock options. These concepts did not exist prior to Congress mandating greater pay disclosure.
“Peer groups” is a basket of similar or larger companies compared to one company, and “benchmarking” is a decision to pay a CEO at the 50th, 75th or 90th percentile of other CEOs. It is not in any executive’s interest to be paid compared to CEOs at smaller or less complex companies, nor to be paid as a ‘below average’ CEO, even though by definition 50% of CEOs must be below average.
This one issue – benchmarking against peer groups – has been responsible for CEO pay increases more than any other. Other academics have found that using benchmarked peer data in the above fashion results in a 17% structural year-over-year increase in CEO pay, that is unrelated to the CEO’s actual performance. This structural advantage, compounded annually, has caused the wealth disparity between CEOs and the average worker.
The pay consultants may be grinning behind closed doors because the above pay ratio will provide further built-in annuities for their firms beyond peer benchmarking and say on pay. What I predict is that compensation consultants and lawyers will do the following:
(i) Assist companies in determining and interpreting their ratio (revenue stream number one);
(ii) Sell the data back to companies to compare and explain ratios among their peers on an industry-by-industry basis, because average worker compensation for Bank of America will be different than that of Apple, for example (revenue stream number two); and
(iii) Sell the data to labor groups to assist them in collective bargaining (revenue stream number three).
What happens with disclosure and data sales back to the company is that people see what others are making and their competitive rivalry creates upwards pressure on all pay. The pay consultants’ business model is predicated on comparables and this exacerbates upwards pressure because data is now provided to justify approval by boards. Thus, the law of unintended consequences is perpetuated by the very people benefitting from it: executives and pay consultants.
Boards seem powerless because the entire industry is predicated on a flawed method of paying CEOs. Downward discretion is met by threats to leave, which is also a myth. Having independent compensation committee members and independent compensation consultants, which was also recently mandated, doesn’t change the way CEOs are actually paid.
Therefore, what should a compensation committee do to prepare for the onslaught of pay ratios to come? Three things.
First, don’t let the ratio, the CEO, or the workers drive pay in either direction. Focus on governance and the actual performance within the company, not beyond it. An anomalous ratio could indicate CEO entrenchment or lack of succession, or worker retention, morale, or productivity issues.
Second, resist being overwhelmed by pay data and complexity. You are elected by shareholders to exercise your business judgment and discretion. I have interviewed numerous compensation committee members who are overwhelmed and intimidated by the glossy reports, the expertise of advisors, and the sheer complexity of how pay has morphed. Have a sense of self and the heft and confidence – and competence – to simplify, understand, and push back when you need to. You are driving the bus. Be fearless and do the right thing, as one director recently said.
Third, appreciate the vested interests of pay advisors. You are not obligated to have them. If you ask a barber if you need a haircut, you know what the answer will be. Consultants, when or if needed, work for you, the compensation committee, or at least should do so. Be very willing to oversee metrics and data that are customized to suit your organization and no one else’s.