Welcome to BoardExpert

This blog is intended to be a governance resource and source of current governance commentary, offered by a corporate governance academic engaged in research, teaching and other ongoing academic activities. There is a very public element to the governance field, and it is hoped that this blog will contribute to the public discussion of current governance issues. It is also hoped that it will address a need in the governance field by presenting a holistic online approach to the topic. There is a rapid rate of change in the field of governance (public, private, government and not-for-profit entities) and developments in internet technology move swiftly. This governance gateway offers resources for a broad variety of stakeholders including: [...more]

UBS’s $2B fraud: Teachable moments for risk management, corporate governance & banking regulation

Sep 20

Posted in Legislation, Risk Governance and Combined Assurance | Comments Off on UBS’s $2B fraud: Teachable moments for risk management, corporate governance & banking regulation |

After the 2008 financial crisis, I wrote to Professor John Hull, a derivatives expert at University of Toronto’s Rotman School, and asked whether the boards of investment banks should have directors with derivatives expertise on them. His response was “There is no question in my mind that a large financial institution should have on its board people (perhaps 2 or 3) who understand derivatives and other complex financial products. They should also receive stress test results. One of the problems is that, although stress tests are carried out, their results are often ignored by senior management.”

We now are witnessing a stunning 2B alleged fraud by a 31 year-old so-called “rogue” trader – one Kweku Adoboli – at the Delta One desk (read: ETFs – Exchange-Traded Fund and index related trading) of UBS, who had intimate back-office booking knowledge of how trades are reconciled with counterparties. This is a teachable moment, namely that the risk management, corporate governance and banking reforms to date have been wholly inadequate. The 2008 crisis can occur again and “Too Big to Fail” has not been addressed.

We need to admit that most – if not the vast majority – of corporate directors simply do not understand complex derivative products, and we are demanding too much of them when we expect that they do. If we want directors to understand derivatives, they need to be chosen differently. A current or former CEO may not understand. And there is evidence that CEOs do not make better directors. A common refrain from directors I interview of large complex institutions is “Richard I don’t understand.” And these are very senior business people. In the words of one Chief Risk Officer of a bank, “Directors cannot possibly understand.”

Derivatives experts exist. They have narrow subject-matter expertise. What are the odds this type of person would be asked to serve on an investment bank board, pushing back on management all the time, when management and directors themselves select one another under the current system, rather than directors being selected by shareholders? The derivatives expert may not be asked because “they haven’t run anything.” As we move towards expert and diverse boards, these types of individuals need to populate boards to make them more effective.

Next, the trader, Mr. Adoboli, is not simply a “rogue” as UBS maintains. He is an employee operating within a system of deficient internal controls. The bank, the management and regulators are at fault.

Surveys and studies indicate that risk management is presently inadequate. There needs to be a significant restructuring of risk and assurance of risk. Risk management is a cost, and money spent on internal controls to mitigate risk does not contribute to the bottom line. CEOs resist, boards don’t understand, and regulators need to regulate.

The BP disaster resulted from flawed risk management according to expert reports. NewsCorp phone hacking is flawed risk management. The Canadian corporate governance guidelines on (National Policy 58-201) mentions the word “risk” twice in its entire set of guidelines, and the risk management provision is twenty-one words in length (section 3.4 c). Many governance codes addressing risk are similarly sparse and written at high levels, with rare exception. Without proper regulation, as a “stick,” boards have little to point to in insisting on robust risk management and internal controls.

When a CEO or CFO attests to a board of directors that the internal controls over risks are adequate, that attestation should be subject to external review, especially for operational risks such as environmental compliance, information technology, bribery, or complex derivatives – whatever it is that can materially affect – and if unchecked bring down – a company.

Internal controls exist – authorization of transactions, electronic safeguards, segregation of duties, control limits, and prevention of manual override. They cost money to implement and are often perceived by management as a “drag” on profit-making.

The rigor of internal controls over financial reporting for S-Ox needs to apply to all major business risks, not just financial. Companies will resist because of cost and distraction, so policy choices needs to be made. Are we willing to live with trusting a CEO?

More needs to be done as well in the governance context. Here is advice to the chairs of investment banks, in light of UBS:

The chair of the compensation committee should retain an independent compensation consultant to study the compensation for each material risk-taker, and report to the chair on how their remuneration is incenting adverse risk-taking. The compensation consultant must tailor risk-adjustment advice to suit that bank, and comply fully with all Basel Committee on Banking Supervision reports and recommendations. (Any blowback by management that we need to pay our people and traders this way or they will move to a competitor should be met by requests for empirical evidence, which, according to Ken Feinberg, the former US pay czar, does not exist.)

The chair of the audit committee of the investment bank should instruct internal audit to complete a thorough review of the design and effectiveness of internal controls over all trading activities, and report directly to the chair. The chair should approve the budget, resources and work plan. If the head of internal audit is not up to the task, the chair should fire him or her and find someone who is. If necessary, external assurance providers —not the external auditor— should be retained by the chair as well, and report directly to the committee not management.

Next, the chairs of these two committees, together with the board chair should meet with the CEO and CFO to inform them of the above two studies, and direct them to cooperate fully with all requests for information. Directors need to direct more, if and when required.

How many chairs have the fortitude to do this, I wonder? If directors are there to control management, then they must have the statutory authority and resources to do so.

Lastly, regulators need to regulate if and when required. Specifically, all regulators should separate, permanently, global wholesale/investment banking’s proprietary trading from retail banking. Otherwise taxpayers will be on the hook for a very dangerous industry, akin to “casino gambling” by critics. It is totally unacceptable that one person, reputed to have “bet $10bn,” can cause this much damage. If you multiply it, with contagion, the investment banking system is broke and dangerous. Regulators need to address this issue. It has been three years since the financial crisis. In the words of Martin Wolf, a member of the UK’s Independent Commission on Banking, “No sane country can allow taxpayers to stand behind such risks.”

Rethinking what it means to be an “independent” director

Sep 13

Posted in Independence and Role Clarity | Comments Off on Rethinking what it means to be an “independent” director |

I remember an institutional shareholder speaking at a corporate governance conference and proclaiming that what boards of directors need most is “unconflicted directors giving unconflicted advice.”  “Unconflicted” directors – otherwise known as “independent” directors without ties to the company or its management – are thought to be disinterested and more effective at monitoring management and operating in the best interests of the company overall.

Assessing whether directors are conflicted, however, occurs differently compared to that of senior management and other employees.

In directors’ cases, the assessment of conflicts is done by the board, inside the boardroom. Directors assess whether they have “material relationships” that could be “reasonably expected” to interfere with their “independent judgment.”

There is no reason why the review of independence of directors should not be subject to an objective standard of reasonableness, as it is for managers and other employees, to accompany the subjective view of individual directors.

For management and employees, conflicts of interest are subject to senior management or board of directors review (typically under a Code of Conduct). The perception of a conflict is as important – if not more important – than whether the manager believes he or she is conflicted.

A good conflict policy focuses not only on the subjective view of the manager or employee, but an objective “reasonable perception” viewpoint as well. A manager could believe that he or she is not conflicted, but when a relationship is viewed through an objective lens, the perception of a conflict may exist.

Directors may be subjectively of a view that a director or group of directors may not be conflicted, but that view may not be objectively reasonable. Further, social connections among directors, and between the directors and the CEO, may not be reflected in formal independence standards, or even detected. We saw this recently in News Corp whose directors had social and personal connections to Rupert Murdoch. Lucy Marcus and Nell Minow have done very effective jobs scrutinizing the statutory independence of News Corp directors, who have direct ties company management and the controlling shareholder. Media stories and scrutiny breeds skepticism and undermines the credibility of good boards.

My own research suggests that formal independence standards may not equate with independence of mind within a boardroom. A CEO may try to “capture” a director through gifts, trips, vacations, charitable contributions, jobs for his or her children, and other forms of social favoritism (documented in my research). Long serving or “interlocked” directors, or directors with affiliations to service providers, may also not have independence of mind.

Directors may quite simply be the CEO’s friends.

A few weeks ago at a research symposium I attended at University of Texas, a paper was presented that addressed the pre-existing social connections with the CEO that independent directors had. The finding by Professor Huijing Fu were that these social connections between the CEO and directors compromised the board’s ability to monitor.

Boards are afforded considerable latitude in terms of how they assess their own conflicts of interest, and perhaps this shortcoming should be addressed. Directors may have vested interests in having narrow, limited, subjective categorical standards of independence. Lawyers may as well, in providing assurance to clients.

The review of conflicts of interest is crucial, as corporate governance effectiveness – including oversight of transactions between insiders by a subset of independent directors – is underpinned in large measure by whether directors – including the Board Chair – are independent or not. Proxy advisory and rating agencies tend to assess director independence by the outputs or decisions a board takes. Perhaps independence should be scrutinized earlier on, before decisions are taken or even before directors come to the boardroom.

It is time to rethink how the independence of directors is assessed.

 

Fraud and Corruption Allegations at Sino-Forest Corp – Lessons for Chinese and Indian Companies in Meeting Western Corporate Governance Practices

Aug 30

Posted in Global Corporate Governance | Comments Off on Fraud and Corruption Allegations at Sino-Forest Corp – Lessons for Chinese and Indian Companies in Meeting Western Corporate Governance Practices |

China and India collectively represent a market of 2.5 billion people with GDP growth rates hovering around 9%. Clearly they are lucrative markets for Anglo-American companies. These countries are, however, two of the most corrupt nations in the world, ranking 78th and 87th, respectively, according to Transparency International’s corruption index. Canada, the UK and US rank 6th, 20th and 22nd. If Chinese and Indian companies seek access to public money from western capital markets, to integrate more fully within the global economy, they must reform their corporate governance and accounting practices.

It is not enough to rationalize Chinese and Indian companies at present as “investor risks.” Market regulators, representing the public interest whose mandate it is to protect investors, have an obligation to require compliance with listing standards and act when this is not the case.

Boards of directors of companies listed on Canadian, American and British stock exchanges have an obligation to be independent and effective. Directors should be judicious when accepting directorships of Indian and Chinese companies, as they could very easily become ensnared in alleged violations of the Corruption of Foreign Public Officials Act, the Foreign Corrupt Practices Act, or the new UK Bribery Act.

The Ontario Securities Commission recently ordered senior executives of Sino-Forest Corp. to resign. Subsequently, the Chair and CEO of Sino Forest resigned amid an internal review of fraud allegations. The Securities and Exchange Commission recently established a task force to address abuses by Chinese companies accessing US markets through “reverse mergers.” Twenty-five NYSE listed Chinese companies have disclosed accounting discrepancies or have seen their auditors resign, shares have been halted in more than twenty Chinese companies, and five Chinese companies have been delisted.

The Satyam case in India represents a high-water mark for fraud and defective corporate governance in India. We will see how the alleged fraud at Sino Forest and several other Chinese companies play out.

In Sino Forest’s case, independent investor-led research firm Muddy Waters has accused the company of “massively exaggerating its assets,” of having “a convoluted structure whereby it runs most of its revenues through ‘authorized intermediaries,’” and of having capital-raising tantamount to a “multi-billion dollar ponzi scheme,” with “substantial theft,” in the firm’s words.

These allegations, if proven, occurred on a Canadian stock exchange, tainting Canada’s reputation. Canadian director, Spencer Lanthier, at a celebratory dinner honoring Canadian directors, recently remarked publicly, “This city, this province, this country has a reputation of being the best location to carry out white collar crime, corporate fraud, in the industrialized world.”

Many Chinese and Indian companies have a small number of significant shareholders, typically company shareholders or management. In China’s case, “Guanxi” is prevalent, which means personalized networks of influence, or entrenched conflicts of interest and opaqueness, with law on the books but not enforced. The importance of an independent and effective board of directors cannot be overstated.

I have been asked for advice by corporate directors who have been approached to sit on boards of companies traded on North American stock exchanges with the majority of their activities or assets within India or China. Here is what I recommend, as a starting position for any director asked to serve on the board of such a company, all of which should be in writing and agreed to, prior to the director joining the board:

  1. The company must be audited by a licensed and properly qualified and staffed accounting firm that includes Anglo-American trained accountants who speak Mandarin (for Chinese companies). The accounting firm itself should be independently and annually assessed and have no adverse examinations. All quality assurance recommendations should be implemented by the accounting firm, including coordinated assurance cooperation by audit stakeholders such as vendors, banks, government entities, and other creditors, suppliers and customers.
  2. The company must comply with all corporate governance standards and there must be independent (e.g., Anglo-American) assurance of this compliance.
  3. The CFO and finance department of the company must be properly qualified and trained, have the necessary authority, and work at the headquarters of the company. The CFO must report directly to, and be assessed by, the Audit Committee.
  4. An internal audit function must exist, and this function must report directly to the Audit Committee at every meeting. The Audit Committee must approve the work-plan, qualifications, selection and compensation of the head of internal audit.
  5. The board of directors must have a majority of directors who are independent of management and the significant shareholder, if one exists. Half of the independent directors should have industry experience, including in China or India.
  6. Independent directors must have the authority to replace the CEO if necessary, even if resisted by the significant shareholder, particularly if the CEO is the significant shareholder.
  7. Independent directors should have authority to approve all related party transactions. Related parties should not vote and not be in the room when the transaction is discussed. The code of conduct should be written in Mandarin and all employees and key suppliers should sign off annually. Compliance should be independently assured and reported directly to the Audit Committee. Follow up directives from the Audit Committee must be implemented. The Audit Committee must have access to resources and advisors to fulfill its obligations. A proper whistle-blowing procedure should also exist, with external reporting to, and clarification provided by, an independent service provider.
  8. Director insurance and indemnification must be externally reviewed and adequate so the independent director is protected. Provisions to fund special committees and independent advisors should be provided, under the control of independent directors.
  9. Independent directors must have the authority to require external assurance for any material business risk and/or internal controls, including corruption risk.
  10. The chair of the board must be an independent director with leadership and industry experience sitting on listed Anglo-American company boards.
  11. The chair of the Audit Committee must be an independent financial expert with experience sitting on listed Anglo-American company audit committees.
  12. The Board must meet at least once a year in China (or India). Independent directors should meet with local management and personnel without senior management present. All recommendations must be acted upon and with a progress report provided to independent directors.

Boards of directors of companies traded on western stock exchanges must oversee effective internal controls over corruption, financial reporting and reputation risk.

The above points are a starting position and minimum thresholds to protect an independent director and afford necessary authority to fulfill his or her obligations.

 

Canada’s Absence from the Global Movement Towards Diverse Boards of Directors

Aug 22

Posted in Diversity, Women on Boards | Comments Off on Canada’s Absence from the Global Movement Towards Diverse Boards of Directors |

On Monday August 21st, I am delivering the opening keynote address to the annual Canadian Society of Corporate Secretaries conference in Quebec City. (See my PDF slide deck with embedded links here). It is beneficial that the conference is being held in Quebec City this year. In Quebec, Premier Charest mandated into law in 2007 that by December 2011, boards of directors of all Quebec enterprises need to be comprised of an equal number of men and women, and that the cultural make-up of boards reflect more the ethnic diversity of Quebec.

Quebec City academic Marie Marie-Soleil Tremblay was also a part of a working group of eight Canadians who addressed board diversity in a submission that was recently made to the European Commission, which is contemplating introducing initiatives to make boards of directors within European Union countries more diverse. (See the group’s report here and the European Union “Green Paper” on proposed corporate governance reforms here (PDF). The questions on board and gender diversity are 5 and 6.) I plan to draw on our group’s submission in my address. The diversification of Canadian boards will be my opening topic. I also plan to show this video provided to me by Catalyst in the US.

With the exception of the Province of Quebec, Canada has been noticeably absent from the global boardroom diversity movement. Major initiatives by market regulators – ranging from disclosure of diversity plans, to self-imposed objectives, to full-fledged board quotas – in the US, UK, Australia and a number of European countries are well underway. At a the 2011 Institute of Corporate Directors Fellowship Awards Gala, Spencer Lanthier, who was one of four Canadian directors honored, called boardroom diversity “the number one issue in corporate governance right now” and that boards should just “get on with it.”

It is difficult without some form of government leadership (e.g., disclosure of diversity plans in a “comply or explain” manner), similar to that of other countries, to expect corporate boards to “get on with it,” given that boards are of a limited size and bringing on a woman by necessity might require removing a man. Both women and men tell me in confidential interviews that the system is presently “stuck.” The figures in Canada for women on boards have hovered around 8-14%, depending on the survey, and have been stagnant for many years, with only small upticks. Australia recently reported, after the Australian Stock Exchange required companies to state diversity objectives and progress towards meeting them, a whopping 600% increase in women being appointed to corporate boards in just two years. Now women comprise 30% of all new director appointments. The figure used to be 7.5%.

There is no reason women should not comprise a similar percentage of all board appointments in Canada. In the aftermath of the financial crisis, which includes scathing reports (here and here (PDF)) documenting governance and regulatory breakdowns, governments want to make sure that boards can be as strong as they possibly can be. There is academic evidence that women make better monitors within boardrooms and that men even enhance their performance when women come on to boards. (See my article in English, here, and in French, here.) There is also a case to be made that group-think (which means groups agreeing too much by virtue of similar background and social pressure to conform) is counteracted with greater diversity, in all forms (women, visible minorities, Aboriginal Peoples and people with disabilities). Beyond the academic case however, the business case is that having diverse boards ensures access to a broader talent pool of Canadian directors, as Canada increasingly sees China, India and Brazil as trader partners and our companies need to compete in the global marketplace.

The case against gender diverse boards is that many or most women are not former CEOs and do not have broad-based, business experience, with direct responsibility for profit and loss, which is helpful experience for boards. Yet there is scant academic evidence that CEOs make better directors. Moreover, enterprise leadership includes not-for-profit, professional firms, and divisional leadership within companies, as well as “up-and-comers” in the executive suites, such as CFOs and COOs. Competency matrixes (required for boards under National Policy 58-201 Corporate Governance Guidelines, section 3.12) now include skills such as social media/technology, sustainability, human resources, and public policy, where women are particularly strong. Expatriates with international experience (in India and Asia) who know the players and the markets are of enormous assistance to management teams when they sit on boards.

It is also not the case that diverse directors cannot be found, or the pool is too small, which is another argument against diverse boards. My LinkedIn® Group, Board Advisors, for example, includes 460 members. My profile alone has over 800 connections that include practicing directors and prospective directors at the top of their game. I am interviewing over 100 directors for my research and half of them I expect will be female and many will be visible minorities. There is a rich network of very well qualified directors out there for board positions. Search firms and nominating committees of boards would be well advised to look harder, and more creatively. The world has changed and prospective directors cannot simply be found at private clubs like they used to. Canada has incredibly talented directors, and we need to use all the available talent we can.

The benefits for board diversity is are enormous. Boards need to get on with it, yes, but so do our government and regulatory leaders in providing that extra “nudge.” Having companies disclosure diversity plans, for the board, senior management and the company as a whole, is a needed first step.

 

CEO Succession Planning – The Number One Job of the Board, But Poorly Done

Aug 14

Posted in Board-CEO Relations, CEO Succession Planning | Comments Off on CEO Succession Planning – The Number One Job of the Board, But Poorly Done |

I received a call from a board chair the other day. He wanted to see pay arrangements for his company’s C-suite executives to confirm that potential CEO successors heading business units were properly compensated. He felt entitled to this information but wanted to check with me first.

I said that the board should see any compensation of any individual within the company, as the board deems appropriate, to ensure that individuals are not taking inappropriate risks, based on new regulations (PDF, at page 8093). I have written about implementing risk-adjusted compensation.

That the board had not seen, much less approved, the pay and leadership development of potential CEO successors is a risk. TSX boards are responsible for succession planning under the regulations. If potential CEO successors are not compensated properly, they may be retention risks. Leadership development blockages may exist, but the board has no way of knowing this without a viable plan.

CEO succession planning is poorly carried out in many boards because CEOs drag their feet and ineffective boards accept this. The choice of CEO is the most important decision a board makes. Leadership can make or break an organization.

The reasons for poor CEO succession planning are simple. The current CEO is conflicted and so is the board. CEOs are conflicted because they are planning to replace themselves, which no one wants to do. Boards are conflicted because they are assessing their own work, namely their decision to hire the CEO in the first place.

Problems and solutions for poor CEO succession planning

Here are some of the telltale problems, solutions and red flags for poor CEO succession planning:

Problem: Dominant CEOs refuse to plan or unduly influence the process

Solution: The board should own CEO succession planning, not the CEO. The current CEO’s views are important but should not over-ride. If a CEO is not being helpful, CEO succession planning should form part of incentive compensation, with specific objectives. CEO succession planning should start the day the new CEO is hired.

Red flags:

  • Chair and CEO roles held by the same person (see my recent paper on separate chairs);
  • a CEO who is a founder;
  • large pay gaps between the CEO and direct reports;
  • limited board exposure to high potential talent;
  • limited management bench strength; and
  • other signs of CEO entrenchment.

Problem: Boards of directors do not make CEO succession planning a priority

Solution: The board should have a private session without the CEO to discuss and assign the leadership and scope of CEO succession planning. A robust CEO and leadership development plan from management should be requested. A board committee of independent directors should oversee the identification of executives matched to paths and time-frames, and make recommendations to the board.

Red flags:

  • A board that is not independent;
  • low director turnover;
  • minimal external benchmarking; and
  • lack of knowledge and information.

Problem: CEO succession planning relies on informality rather than concrete plans

Solution: The next CEO profile and development leadership ladders for near, mid and long-term high potential talent, both internal and external, should be documented. Boards should understand the availability, quality, action plans, and special compensation arrangements for candidates. The board should provide input on, approve, and regularly discuss the CEO succession plan.

Red flags:

  • Plans are seen as personal rather than good governance;
  • limited resources and advisors for the board;
  • limited proxy disclosure of CEO succession planning; and
  • lack of even immediate successors.

No one is irreplaceable or will live forever

Directors often tell me when I ask about their biggest mistake that they waited too long to replace a CEO. Poor succession planning can adversely affect the morale and performance of any organization.

Organizations change and strategies change. Generally, people don’t, so the skills of a CEO and even directors may be outdated or not suited for the organization as it evolves.

CEO tenures have gotten much shorter.

You can’t replace someone without a viable alternative.  It becomes a lot easier for a board to “pull the trigger” when proper succession planning is done.  If there is dissatisfaction with CEO succession planning, that is the fault of the board.

Why CEOs earn 400 Times Average Employee Salaries

Aug 9

Posted in CEO, Organizational Performance and Compensation, Performance and Evaluation | Comments Off on Why CEOs earn 400 Times Average Employee Salaries |

I attended an American Bar Association seminar last week by telephone that was very informative. It was a presentation by an American colleague, Professor Charles Elson, and his graduate student, Craig Ferrere, on executive pay and the use of peer groups.

Background to Executive Compensation Reforms

Dodd-Frank (which is a significant piece of legislation in the US) is requiring that compensation committees that approve executive pay be composed of independent directors and that compensation consultants, when retained, also be independent. Sarbanes-Oxley (a similar piece of legislation enacted after WorldCom and Enron) adopted a similar approach mandating independent audit committee members and independent external auditors.

Dodd-Frank also will require (in regulation yet to come by the Securities and Exchange Commission in Washington) the disclosure, for each listed US company, of a ratio comparing CEO pay to that of the median (meaning, middle) pay of an employee of the company, and greater demonstration of pay-to-performance linkages. Dodd-Frank has also mandated that pay plans be put up for an advisory (meaning, non-mandatory) shareholder vote at least once every three years, otherwise known as “say-on-pay” votes.  The vast majority of say-on-pay votes have been approved.

Skeptics argue, however, that making compensation committees more independent, and mandating greater pay disclosure for shareholder approval, will not constrain pay, but may actually compound the problem, otherwise known as “the law of unintended consequences.” This means that with greater and greater pay disclosure, CEOs become competitive and greedy, saying to compensation committees, in effect, that they are worth more than another CEO, for example, and exert greater upward negotiating pressure on the committee.

Having a more independent compensation committee members may not, in and of itself, be adequate to respond to this pressure in the competition for executive talent. Nor will say-on-pay votes, as shareholders want the best CEO leading the company so that they will maximize their investment.

The skeptics may have been largely correct over the years, given that even with many of the above reforms beginning to be enacted and the global recession, CEO pay has continued to rise, at a 10-20 percent level.

The Structural Reason CEO Pay Continues To Rise Despite Reforms

A very important reason CEO pay continues to rise in spite of all these reforms over the years is related to the “Lake Wobegon” effect, which is a natural human tendency to overestimate one’s capabilities, and this means that the water continues to rise for all CEOs.

A problem is the way pay is actually calculated and compared.

Executive pay is calculated by comparing executive pay within similar companies, otherwise known as “peer groups.”  When the pay is compared, compensation committees decide whether they should pay their CEO at 50th, 75th or 90th %’ile when compared to the peer group. The peer group is a basket of companies that is very important, and executives will cherry-pick or favor certain companies that may not entirely compare to their company in terms of size, complexity or industry. Companies are compared using peer groups of similar companies, in other words, not individuals.

In addition, the vast majority of compensation committees will select either the 50th, 75th or 90th percentile for their CEO, for the simple reason that they do not want to signal to the market that their CEO, whom they have chosen, ranks in the 25th percentile, for example, or even below the 50th.

The implication of peer groups and percentile selection, combined, which constitute the primary tool of comparing and setting pay, therefore means that CEOs have a “built-in” increase of between 10 and 20% every year (or an average of 17%), which is compounded each year. This increase results from repeatedly choosing 50th, 75th or 90th percentile comparison of peer groups of companies rather than individuals.

The difficulty with peer groups is that they are predicated on the characteristics of the company, rather than the individual. Performance metrics of companies are compared and then the individual pay is “back-doored” based on the company’s performance. In addition, if a company within a peer group has a very successful year, all CEOs who use that company within their peer groupings will benefit regardless of their performance, which is unjust enrichment.

There are no widely accepted individual performance metrics, to complement or counter-act the systemic bias of peer groups and percentile rankings.  Imagine if you will that there was a CEO ranking based on a metric that was shown to correlate to corporate performance, and among individual CEOs so CEOs could be compared, such as “stewardship of assets,” for example.  CEOs could be ranked within an index, say Fortune 500, for Fortune 50, much the same way that mutual fund managers or even hockey players are (the number of goals, assists, etc.) are compared, over a 5 year period to counter act the effect of an anomalously good or bad year.

Professor Elson and his graduate student are working on a such a metric and index.  If they successful, this will begin to address the structural bias inherent in setting CEO pay.

Audit Committee and Risk Management Oversight Questions for Boards

Aug 7

Posted in Audit Committee, Risk Governance and Combined Assurance | Comments Off on Audit Committee and Risk Management Oversight Questions for Boards |

Many of the questions below are based on hypothetical and disguised but plausible scenarios that I researched, or upon which I directly advised.

Let’s say a worker is responsible for maintenance of a machine, but because of time pressures, cuts corners and does not address fatigue (or wear and tear) in the machine, and no one oversees this person’s omission. The machine fails and affects the failure of other machines nearby. The company is in an industry where, if that machine fails, 300+ customers will likely die.

Or let’s say it is another machine where, if it is not treated properly, the company’s product can be poisonous. Or another machine where, if procedures are inadequate or not followed, property destruction and death can result. Or another process in an institution, where if internal controls are inadequate or not implemented, millions of dollars of losses can result.

Aside from senior management, is it fair to hold the board responsible for the above failures in risk management and internal controls, in the above hypotheticals? Is it fair to hold the committee chair or committee overseeing this risk responsible, in part?

I am not sure. It would depend on the actions (or inactions) vis-à-vis best practices and legal tests. One thing I can say however, is that I have had the good fortune of interviewing and seeing how one or two excellent board or committee chairs, or directors on a board, can completely reform and turn around risk management of an entire large, complex organization by pressing management and holding them accountable. This is a pleasure to watch and see, how effective a strong board and strong directors can be. This is how boards should be.

I recently interviewed directors and senior management of an important organization, along with nine leading Canadian directors and audit committee chairs. Here are some questions that address the above scenarios and incorporate learning I have developed from my research and assessing audit committees.

  1. Risk Management Coverage and Assurance Mapping

    Is each material financial and non-financial risk (no more than 12-15) covered (via explicit mapping) through identification, treatment, independent assurance and upward reporting? Do board guidelines and committee charters cover off all material risks so none slip through the cracks?

  2. Whistle blowing and Code Compliance

    Employees may now go directly to regulators without utilizing the company’s internal investigation procedures, and participate in a monetary reward. Does the company code of conduct have fair, impartial, credible investigation procedures that employees trust and actually use? Does effective oversight occur of ethical reporting by the Audit Committee

  3. Internal Audit

    Does the Audit Committee approve the appointment, compensation, work-plan, independence and accountability of this function? If not, why not? This person should report directly to the Audit Committee.

  4. IT Governance

    Is IT risk and opportunity management adequately overseen by the board (or a committee), including over IT investment, cloud computing, social media, security of information, privacy, business interruption and crisis planning? Does management (and the board) have competencies in these areas?

  5. Stress and Scenario Testing

    Is the capital structure, quality of earnings and revenue tested under various adverse conditions (including regulatory, competitor and contagion), such as “what if” or “when”?

  6. Audit Committee Bench Strength

    Does the Audit Committee have the competence and courage to understand and constructively challenge the basis and rationale for management’s estimates, assumptions, judgments and forecasts, both in terms of potential manipulation by management, and the fairness, balance and quality of financial disclosure?

  7. Chair Reporting to the full Board

    Does the Audit Committee Chair (and other committee chairs overseeing non-financial risk) submit a written report that enables non-committee members to understand the deliberations, recommendations and reporting, and ask questions and receive satisfactory answers?

  8. Auditor and Financial Management Bench Strength

    Does the board have confidence in the quality of finance and risk management, and external and internal audit (including integrity, competence, responsiveness and reporting)? The board should oversee all of these positions, subject to shareholder approval for the external auditor.

  9. Internal Controls over Non-Financial Reporting

    This area may be a weakness for many boards. Has the regime for financial reporting and assurance been adopted for the most important non-financial reporting risks of the organization (e.g., operations, compliance, environmental, social, reputation)? Has the effectiveness of the design and implementation of internal controls been tested on and reported to the board or relevant committee, for these areas? Boards should press management for this reporting and obtain independent (outside) assurance for risks of concern, to put the heat on management.

  10. Undue Influence / Reliance, Integrity and Fraud Risk

    Are there any pockets within the organization or executives who may have the opportunity, pressure or incentive to take inappropriate risks, or engage in potential fraud, that may be exacerbated during an economic downturn? As two audit committee directors said, the systems must be “person-proofed” and run on “auto pilot.” Can the board demonstrate that it has taken reasonable steps to satisfy itself that executive officers possess integrity? (The board is responsible for satisfying itself that executive officers have integrity under NP 58-201.)

Conclusion

Back to our original hypothetical scenarios. Directors have said to me, “we missed it,” or that you cannot protect yourself against a “rogue” or someone who is intent on committing fraud. I am not sure these answers are entirely satisfactory.

It seems to me that if the above steps are followed, and a culture of risk management and tone-at-the top is set by the board, there is a much lesser likelihood that “we missed it” will occur.

Corporate Governance in the European Union: Emerging Developments, Part 2

Aug 6

Posted in European Corporate Governance | Comments Off on Corporate Governance in the European Union: Emerging Developments, Part 2 |

(Continued from Part 1.)

Shareholders:

  1. Are there any EU legal rules that are contributing to inappropriate short-termism among investors? If so, how could these rules be changed to prevent such behaviour? (Short-termism could occur via asset manager relationships resulting from increased intermediation, automated and high-frequency trading and shorter retention periods, or “regulatory bias” (Green Paper wording) that could cause mispricing, herd behavior and increased volatility.)
  2. Are there measures to be undertaken in regards to the incentives and performance evaluation of asset managers (e.g., fees and commissions based on short term, relative performance), who manage long-term institutional shareholder portfolios, with a view to better aligning interests of asset managers with those of long-term institutional investors?
  3. Should EU law promote more effective monitoring by institutional investors (i.e., asset owners) over asset managers (i.e., agents of institutional investors) with regard to strategies, costs, trading and the extent to which asset managers engage with investee companies, with a view to greater transparency of fiduciary duties by asset managers, greater monitoring of activities that are beneficial for the long term interests of institutional investors, and more active stewardship of investee companies by asset managers?
  4. Should EU rules require a certain independence of the governing bodies of asset managers, or are other measures (e.g., legislation) needed to strengthen the disclosure and management of conflicts of interest?
  5. What is the best way for the EU to facilitate shareholder cooperation? (Shareholder cooperation means the ability of institutional investors, in particular those with diversified portfolios, to engage with one another successfully, without being in contravention of EU laws on “acting in concert,” which could hinder shareholder cooperation. Shareholder cooperation may be facilitated by setting up shareholder fora, for example, or an EU proxy solicitation system whereby companies set up a specific function on their website enabling shareholders to post information on certain agenda items and seek proxies from other shareholders.)Shareholder cooperation is part of shareholder engagement. Shareholder engagement means “actively monitoring companies, engaging in a dialogue with the company’s board, and using shareholder rights, including voting and cooperation with other shareholders, if need be to improve the governance of the investee company in the interests of long-term value creation” (from the Green Paper).
  6. Should the transparency of proxy advisors be enhanced (e.g., with regard to analytical methods, conflicts of interest, and whether and how a code of conduct is applied)? If so, how?
  7. Are legislative restrictions on proxy advisors necessary (e.g., to restrict the providing of consulting services to investee companies)?
  8. Should a mechanism (technical and/or legal) be in place to facilitate the identification of shareholders by issuers, in order to facilitate dialogue on corporate governance? If so, would this mechanism benefit cooperation between investors? If so, what would be the details of such a mechanism (e.g., the objectives to be pursued, preferred instrument, frequency and cost)?
  9. Should minority shareholders be accorded additional rights to represent their interests within companies with a controlling or dominant shareholder? (A controlling shareholder (the predominant governance ownership model in European companies) can be defined (by the author, as it is undefined in the Green Paper) as a shareholder with the ability, either in fact or law, to exercise a majority of the votes for the election of the board of directors. A significant shareholder could be an individual, a group of individuals (e.g., a family, a voting trust, etc.), or a corporation.)The word “rights” and “represent,” above, can be interpreted to mean something more than simply augmenting the influence of minority shareholders, and stems from difficulties identified in the Green Paper that minority shareholders have in protecting their interests in companies with a significant shareholder and a within a “comply or explain” regime. Certain Member States for example have reserved the appointment of some board seats to minority shareholders.
  10. Do minority shareholders need greater protection against related-party transactions? If so, what measures should be taken? (A related party transaction is defined (by the author, using concepts from a corporate governance proposals from the Canadian Securities Administrators in December, 2008) to be a conflict of interest between the related party (e.g., a control person, a significant shareholder, an officer, or a director of the corporation) and the corporation itself. If (in the author’s view) the board of directors does not take all appropriate action in light of the conflict, or shareholders (all shareholders, including minority) do not have full knowledge of, and the opportunity to approve, a significant related party transaction, the result could be self-dealing and appropriation of monies or opportunities by the related party at the expense of the corporation and/or minority shareholders. The Green Paper uses the terms “protection against potential abuse” in describing the extraction of benefits by controlling shareholders and/or boards to the detriment of minority shareholders. Examples of a related party transaction may be a contract, arrangement or transaction entered into between the company and a significant shareholder or control person; or a contract or decision that will benefit an officer or director.
  11. Should measures be taken at the EU level to promote share ownership by employees?

Monitoring and Implementation of Corporate Governance Codes:

  1. Should companies departing from corporate governance codes be required to provide detailed explanations for such departures, and describe alternative solutions employed? (Under a “comply or explain” regime, adopted by many countries and widely endorsed for its flexibility, it is permitted for companies to depart or diverge from the corporate governance code recommendations, providing that there is adequate disclosure to explain the rationale for the departure, and how the practices or actions taken achieve the objective of the principle or recommendation, for example – hence “comply or explain”. The issue has been the adequacy of disclosure, both for the “comply” and “explain” planks of the regime.)
  2. Should monitoring bodies (e.g., securities regulators and stock exchanges) be authorized to assess the informational quality of corporate governance compliance statements, and require more detailed explanations as necessary? If so, how should this be done, and what exactly should be their role?

Conclusion:

In response to the commentary, the European Commission will take next steps, with any future legislative or non-legislative changes to be accompanied by extensive impact analysis. The Green Paper is instructive because it provides Member States, the European Parliament, and other countries and legislative bodies an indication of what corporate governance reforms, many of which are significant and go beyond other global developments, may be emerging within Europe in the coming months.

For interested readers, a group of Canadians responded to 23 of the 25 questions, here (PDF). This group consisted of a mixture of academics and practitioners, was self-organizing, possessed expertise across a range of governance topics in order to address as many of the Green Paper questions as possible, and offered examples and experience from the Canadian setting and group’s work wherever possible.

Corporate Governance in the European Union: Emerging Developments, Part 1

Aug 5

Posted in European Corporate Governance | Comments Off on Corporate Governance in the European Union: Emerging Developments, Part 1 |

The European Commission is proposing a series of corporate governance reforms for EU member countries.  As the reform’s “Green Paper” (as it is called) sets out in its introduction, the G20 Finance Ministers and Central Bank Governors emphasized in late 2009 that actions should be taken to ensure sustainable growth and to build a strong international financial system.  Corporate governance is seen as a means to prevent excessive risk taking and undue influence on the short term, in this regard.  The purpose of the EU’s corporate governance Green Paper is to respond to the G20’s edict, under the auspices of the European Commission’s Corporate Governance and Financial Crime Unit, and propose wide-ranging and long-awaited corporate governance reforms within European Member States.

There are 25 corporate governance proposals in total, under four general categories: (i) General; (ii) Boards of Directors; (iii) Shareholders; and (iv) Monitoring and Implementation of Corporate Governance Codes.  The full text of the proposals is available online, in downloadable PDF format, at the European Commission’s website here (PDF).

The proposals are comprehensive and are a major step forward.  Proposals address the governance of small and mid-cap companies (SMEs) and unlisted companies (as well as listed companies); the separation of chair and CEO; board diversity; external board evaluations; having boards be responsible for risk appetite, and potentially overseeing disclosure of “societal risks”; disclosure of director remuneration (executive and non-executive) for shareholder advisory votes; the governance of asset managers and proxy advisors (including addressing conflicts of interest); greater shareholder engagement; strengthening the rights of minority shareholders; employee stock ownership; and possibly strengthening authority to monitoring bodies (e.g., securities regulators and stock exchanges) to assess information quality of listed companies’ compliance (or explanations of non-compliance) with governance code provisions.

The overall tone and direction of the EU’s governance proposals are significant because they not only reflect several reforms already undertaken in other countries, but go beyond many of these in a prescriptive way, particularly those involving proxy advisors, asset managers, institutional shareholders, the relationship between controlling and minority shareholders, and the role of regulators in overseeing the informational adequacy of company disclosure within the voluntary “comply or explain” regime more effectively.

The 25 proposals are as paraphrased as follows (the first 12 of 25 proposals are in this Part; with the next 13 to 25 and conclusion to follow in Part 2):

General Questions:

  1. Should the EU take into account a company’s size when instituting governance reforms?  (For example, there could be a separate code for SMEs, or a certain size threshold, above which corporate governance measures would apply.)
  2. Should governance measures be instituted for unlisted companies?  Or should they apply only to listed companies?

Boards of Directors:

  1. Should the duties and responsibilities of the Chair and CEO be clearly divided?
  2. Should the recruitment policies of directors (including the board chair) be more explicit about the profile of directors, to ensure that boards have the right skills (e.g., competencies and other attributes)?  Should these policies also ensure that the board is suitably diverse?
  3. Should companies be required to disclose whether or not they have a diversity policy (e.g., to apply to the board, senior management and the organization), and if so, should the objectives and progress of the policy also be disclosed?
  4. Should companies be required to ensure a greater gender balance on boards (e.g., through disclosure of objectives and progress, through quotas, or through other mechanisms)?  If so, how should this be done?
  5. Should the number of mandates that a non-executive director (NED) holds be limited? If so, how should this be done?  (This limitation may include consideration of various types of directorships, whether the NED also occupies an executive position, and whether leadership positions are also occupied (e.g., chair).)
  6. Should listed companies be encouraged to conduct externally facilitated board evaluations regularly (e.g., “every three years”)?  If so, how should this be done? (Given that the UK Code (2010) recommends a similar time frame for externally facilitated board evaluations (“at least every three years”), this may be a move towards standardizing board evaluations, and frequency may be a potential variable, too.)
  7. Should disclosure of an organization’s board remuneration policy and its implementation, and the remuneration of executive and non-executive directors be mandatory?
  8. Should the remuneration policy and report on its implementation be put to shareholders for an advisory vote? (This proposal would constitute a European version of ‘say-on-pay’.)
  9. Should the board approve and take responsibility for a company’s risk appetite and report this appetite to shareholders?  Should this disclosure include societal risks (such as risks related to climate change, the environment, health, safety, human rights, etc.)?
  10. Should a board take reasonable steps to ensure that the company’s risk-management arrangements are effective and aligned with its risk profile?

Ten Suggestions to Reform Executive Compensation Oversight

Aug 1

Posted in CEO, Organizational Performance and Compensation | Comments Off on Ten Suggestions to Reform Executive Compensation Oversight |

I recently served as a compensation consultant asked by board and compensation committee chairs to recommend changes to a CEO’s compensation package. I was clear with the CEO that my client was the chairs, not the CEO, and my task was to embed best practices into the CEO’s compensation plan.

Here are the principles and touch points I employed. They do not necessarily flow from the above example, but also incorporate lessons learned over the years. The requirements for compensation committees are changing now, with guidance and codes arising from the BCBS, the FSB, the SEC (pdf) and the CSA (pdf).

1. Engage in CEO succession planning

Nothing handcuffs a compensation committee more, and gives an incumbent CEO greater bargaining power during pay negotiations, than the lack of immediate successors, internal or external. CEOs resist succession planning because it is not in their interest. The board should insist on regular, robust reporting on CEO succession plans, and do market checks. The board should own this process, not the CEO.

2. Ensure committee members understand the business.

The compensation committee is vulnerable to self-interested CEOs favoring certain metrics, or adjustments that result in enhanced bonus and equity. Members therefore must adequately understand the business and performance metrics that drive strategy and affect behavior to be the counter point.  Many compensation committees are not up to this task, in my view.

4. Have backbone and ensure no undue influence by the CEO.

A CEO may subtly co-opt and manage a compensation committee so it is composed of “friendlies,” who are sympathetic to the CEO, and resist full board involvement. Committee members need to have independence of mind, no personal relations with the CEO, and not be long serving. In two separate stock-option backdating cases I advised on, I recommended that the CEO not be in the room when compensation is discussed, and that a female director be recruited to sit on the committee.

5. Recruit a female director to sit on or chair the compensation committee.

If you think your compensation committee needs greater independence and expertise, bring on a female compensation consultant with 20 years experience who has done 50 compensation plans, including ones in your industry, with no ties to management, and then watch how things change for the better.

6. Use balanced performance metrics and stretch goals to drive behavior.

If a CEO is not listening to the board, or emphasizing certain things at the expense of others, change the compensation package. In my example, I recommended, modified and defined metrics in leadership, strategy, risk and financial, and customer, shareholder and board relations. The weightings, threshold and targets should be challenging and documented. There should be a balance between quantitative, formulaic, short-term metrics and qualitative, judgmental and longer-term ones.

7. Implement risk-adjusted compensation.

Compensation consultants are still promulgating the metrics that got us into the financial disaster. Risk-adjusted metrics and after the fact adjustments are however being requested by regulators. See my recent article (pdf) on this. Insist on tailored, adjustments to account for risk and compensation materializing before bonuses are awarded and equity vests. Compensation committees should have approval over pay of each risk-taker in the organization.

8. When hiring a consultant, ensure independence and knowledge of best practices.

Similar to non-audit related services, I would not hire a compensation consultant who works for a firm that provides non-committee related services to management. If a compensation consultant is doing his or her job properly, the CEO and senior management is likely not their biggest fan. Interests could even be adverse. Negotiation of terms, etc., should occur between the consultant and chairs. Chairs need to step up and inform CEOs of this new normal.

9. In linking performance and pay, document the “hows” and “whys”.

Regulators, shareholders and other stakeholders want to see how and why the committee and board made the decisions it did, in clear non-legal language. This does two things. It forces organizations to be transparent and accountable externally. Second, internally, it imposes rigor and diligence on the committee’s deliberations, reporting and assurance processes.

10. Involve key shareholders and chairs in compensation dialogue, without the CEO.

It used to be that CEOs did not want to leave the room during executive sessions. Now they are reluctant to leave the room during dialogue with shareholders. There should be a mechanism for the chair of the board and/or chair of the compensation committee to have direct exposure to, and hear views from, significant shareholders. The CEO should not interfere.

Conclusion

If a compensation committee does all or most of the above, there should be likelihood that shareholders will endorse a pay-for-performance plan.

« Older Entries Newer Entries »

Back to top