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A rebuttal to Terence Corcoran’s “OSFI and the bureaucratization of corporate governance”

Terence Corcoran launched a scathing attack against recent regulatory announcements by the Office of Superintendent of Financial Institutions (OSFI) and the Ontario Securities Commission (OSC) on assessing and interviewing directors, and strengthening gender diversity, respectively.

OSFI announced, in a draft advisory, that it intended to ask for curricula vitae of, and interview, certain directors and senior management, who include oversight functions. The Ontario Securities Commission, in a request for comment, has proposed disclosure amendments that include addressing term limits; the representation of women on boards and in executive officer appointments; and internal targets that companies could set to achieve greater gender diversity.

Mr. Corcoran calls OSFI’s announcement a “bureaucratization” of governance; contends that the OSC will “force” women directors onto boards in a “social policy agenda”; and calls an academic study “Junk Science,” while accusing the study’s authors of “manipulating” their data: a very serious charge. All these contentions warrant a counterpoint.

Currently, financial institution and public company directors are self-selected by themselves or, worse yet, management. Shareholders may not propose their choice of, or remove incumbent, directors. They press for this right, otherwise known as “proxy access,” (e.g., shareholders who own 3% of common shares for three years can propose up to 25% of a board’s directors in an uncontested election), but boards resist. Company management has challenged proxy access in court, and has won.

Therefore, there is no third party oversight or validation of director skills, qualifications and selection. This reality enables self-interest, entrenchment, recruitment on the basis of personal relationships, discrimination, and directors who do not possess requisite expertise and background.

My own research and work with boards suggests directors can and often are conflicted through gifts, donations, offices, vacations, jobs for acquaintances, prior friendships, and other perks that management gives them. I have observed and assessed bank directors who tell me they do not understand acronyms that are being discussed. One director, emblematic of many, told me, “we don’t understand derivatives.” I have witnessed directors: arrive unprepared for meetings; fall asleep at meetings; who have “not made a single contribution in years” (according to other directors); and who do not do “any of this” (proper risk management). In one instance, a female director was proposed to a largely male OSFI regulated board, and a male director remarked “she’s attractive … since she likes skiing and sailing, she’ll be a good board member.” In another, a director asked “You want us to appoint a lady to our board?” A board chair once told me “There are only twenty women in Canada who are board ready.” (The qualification to be a director is often minimal: over 18, not bankrupt, and not insane.)

I also regularly conduct reviews of significant companies where directors are lacking in relevant industry and risk expertise. This is not true of all boards.

In short, how directors are selected, and what their qualifications are, are largely shielded from scrutiny. Investors are left to rely on fuzzy short bios, and assertions that a proper recruitment process based solely on merit has occurred.

OSFI enacted significant changes to governance, requiring: boards to have directors with risk and financial industry expertise; an explicit risk appetite framework; and oversight functions (including internal audit) reporting directly to them.

I know of at least one bank, one utility, and one university (and these were the only three organizations I checked) where the Internal Audit function reports to the CEO or CFO, which is wrong.

Corporate governance involves a legacy of “independent” directors, opaque selection, and deficient reporting, assurance and internal controls. Interviews, CV checks, and greater disclosure, which shareholders should be doing, can put the heat on boards to clean much of this up. Regulators have shown internationally that they are prepared to conduct interviews and enact competency matrixes in the absence of shareholder oversight. If boards wish to forestall regulation, the answer is to improve their practices and disclosure consistent with best practice, which now includes diversification.

Indeed, Canada is late to this global board diversity movement. The majority of peer countries around the world have already enacted diversity legislation, in many cases in a much more intrusive approach than the balanced and proportionate approach the OSC is suggesting. Mr. Corcoran states the OSC is going to “force” companies to appoint more women. This in my view is not correct because companies with no or few women on their boards are free to describe why this is the case, and why this should continue.

This is not a bureaucratization of governance, but a prudent assurance of systemically important financial institutions. Interviews are wise because simple questions, such as “To whom do you report?” “How did you come to be selected?” and “What relationships do you have with directors or management?” address what CVs can hide.

Shareholders can tell when they meet with a director whether that director is “camera ready,” and OSFI will be able to as well. If a director is camera ready, and possesses all the requisite qualifications to be fit and proper, they should have nothing to worry about. Indeed, good directors should welcome the interview.

Lastly, Mr. Corcoran derides academic studies. This past summer, a primary drafter of guidelines that had a profound effect on governance and director selection in Canada remarked publicly, “We did virtually no research.” This is unfortunate because academics bring something to the table. They adopt an independent, evidence-based approach. I have numerous studies underscoring the positive effects women on boards have. There are studies suggesting CEOs do not make better directors; tenure beyond 9 years diminishes shareholder value; and busy boards with over-boarded directors result in diminished board oversight and performance. People should not be afraid of, or deride, academic studies. On the contrary, they should welcome and learn from them.

Academic studies should be more widely consulted, not less. My own LinkedIn group, Boards and Advisors, has almost 10,000 members, attesting to the benefits of academic, practitioner – and journalist – interaction.

Richard Leblanc is an Associate Professor, Law, Governance & Ethics, at York University. He also teaches corporate governance at Harvard University, and regularly advises boards and regulators. His views are his own. Disclosure: Professor Leblanc has advised, and has been retained by, OSFI and the OSC.

Richard Leblanc: Ten reasons that pay governance is broken

Executive pay is always in the news. Just last week an executive of Yahoo walked away with what was said to be a 100M parachute. I was interviewed by CBC radio on upcoming sunshine laws that are going to be enacted in Alberta. Last month, Ontario Power Generation fired three executives after an auditor general’s report on excessive compensation. The Premier of Ontario has vowed to crack down on excessive public sector executive compensation.

Do politicians have a track record of properly addressing compensation? I don’t believe so. Here are ten reasons that the governance of executive pay is broken, starting with politicians.

Politicians. Politicians have been the single greatest driver of increasing executive pay. Transparency or “sunshine” laws that politicians enact enable executives to utilize the pay of other executives to exert upwards pressure and threaten to leave, which is difficult to counteract. Transparency is good, but transparency without any guidance towards pay setting results in pay spiraling upwards. There is not a single jurisdiction that introduced pay transparency where pay has gone down. There was a time where executive pay was written within an envelope in a top desk drawer, and the focus in pay negotiations was on what the executive can do for the company, not what everyone else was earning.

Pay consultants. Pay consultants use this pay data and sell it back to the company in the form of “peer benchmarking,” which consultants have cleverly invented, which is now the predominant way to set pay. This means executive pay is driven by cherry-picked larger companies at the 75th or 90th percentile, resulting in a baked-in pay increase to the executive irrespective of performance.

Lack of professional standards. Lawyers and accountants can lose their license if they breach their fiduciary duty to their clients. They (we) have professional standards and rule-books addressing the duty of care, conflicts of interest, fee arrangements, continuing education, and just about everything you can think of to ensure the client is well served. Compensation consultants have no such obligations. Anyone can put out a shingle and call him or herself a pay consultant, and they do. You can sit on a compensation committee without any compensation expertise whatsoever. The requirement to be a director is shockingly low. In many cases, you need only to be over 18, not bankrupt and not insane. Maybe it is time to raise the bar for compensation consultants and compensation committee members. When advisors have standards, and pay-settors have expertise, they will make better decision.

Unnecessary complexity. Ask any director how much did his or her CEO “earn” last year, and see if you get a consistent answer. You likely won’t. It’s a simple question that deserves a simple answer. Pay depends on whom you ask and can’t even be defined. Is it “intended,” “realized” or “realizable”? We now have multiple “vehicles” for getting all types of pay to executives, with multiple valuations and performance periods. It becomes impossible to understand, value, and compare pay to performance. Therefore, mistakes and self-interest are possible. Pay needs to be radically simplified. Complexity deliberately frustrates and obfuscates basic analysis.

Captured pay-settors. Even if a compensation committee has formally independent directors, this does not reflect social relationships, the use of company resources by the directors, interlocks, excessive tenure, over-boardedness, reciprocity, favors, exorbitant pay to directors, vacations, gifts, donations, jobs for directors’ children, and a host of other factors that my research and work with boards uncovers. The compensation committee is then an arm of management.

Short termism. Most pay metrics are short term and financial. This means the executive is being unduly enriched and is trading on the effects of his actions that materialize years down the road, or not. Pay metrics should be matched to the actual effects of performance over time, and the value chain of the company. It is impossible to align pay to performance with only short-term financial metrics. Long term, non-financial metrics must be used, and pay-settors should have the spine and competency to insist on it. (Or regulators eventually will.)

Heads I win, tails you lose, or no downside for risky behaviour. Pay needs to incorporate risk-taking. We know that risk management in many companies is immature, so how can the downside of a decision possibly be incorporated into pay? If it is not, there is no or limited downside for executives to swing for the fences. Pay metrics and awards should account explicitly for risk. Most do not. This is not an insignificant point, as risk-taking compensation fueled the financial crisis. Regulators are addressing compensation and risk, but not fast enough.

Undue influence of Management. One highly paid CEO said to me once, “I will outgun any compensation committee.” If pay is truly a free market decision between owners and executives, the power, expertise and participation of shareholders must equal that of executives. Pay committees will need surgery for this to occur, starting with shareholders determining who is on their pay committee. That way, pay committees are the agents of their owners, not management.

Directors not listening to Shareholders. Directors assume that they know what shareholders want but this is folly. Surveys reveal a wide divide between shareholders and directors on executive pay. Directors need to meet directly with shareholders without executives present. Most don’t.

Lack of oversight and accountability. In the public sector in Ontario, there have been several governance scandals, including Ontario Power Generation, eHealth, Ontario Lottery and Gaming Corporation, and Ornge, that have included compensation and spending. What this reveals is defective oversight. Governance is not government. Ministers oversee 100s of agencies, boards and commissions operating in major sectors of the economy. Without independently assured oversight, and directors chosen exclusively on merit and not pre-existing relationships, often to the Minister or party in power, these scandals will continue. Premier Kathleen Wynne would be well served to address this lack of accountability and good governance. Saskatchewan has an excellent upward reporting model involving corporate secretaries and use of governance tools I helped create that apply to all crown companies.

One of my colleagues recently said to me, on the outlook of corporate governance in 2014: “Seems like a stand pat year with lots of tinkering but nothing profound happening.” With pay governance to improve, we might need some profoundness and not as much tinkering.

Richard Leblanc: Ten Corporate Governance Trends for 2014

1.         Active owners focused on performance. Expect pressure by activists and institutions for boards to control under-performing management to continue unabated. Boards incapable or unwilling to rein in inefficiencies, improper capital allocation, asset mismanagement, or operational improvements will be targets. Directors whose skills do not support value creation; and ossification, complacency and atrophy more broadly, will also be targets.

2.         Shareholder accountability: Expect greater direct communication between boards and major shareholders, with “listening” mode and restricted management access continuing. Look also for pressure on asset owners themselves, by investee companies, for engagement transparency, protocols and disclosure. Expect proxy access demands by investors to continue; management and retained advisor resistance to it; and potential regulation enabling it in the future.

3.         Regulation. Continued widespread regulation targeting boards will continue. Industry Canada is contemplating governance reforms in 2014 or beyond. In the US, pay for performance, clawbacks, pay ratios, and proxy advisory regulations are likely in 2014.

4.         Director and auditor entrenchment. Expect pressure for board renewal and auditor rotation to continue in 2014. This will take the form of tenure limits, caps on directorships, diversity legislation, director and auditor evaluation, and mandatory requests for audit tender. Expect continued resistance by incumbent directors and the big 4, but expect also shareholder pressure and regulation to overcome.

5.         Cybercrime and other operational and reputation risks. Expect lawsuits targeting boards for data breach and investor loss at Adobe, Skype, Target, Neiman Marcus and Snapchat that precipitate governance enhancements. Expect greater risk regulation and spends for financial service companies and non-banks. Many boards and management have immature risk management, deficient – or at times non-existent – controls over IT, operational, and reputation risks. Look for efforts by good boards to have risk expertise on the board; internal oversight functions and third party reviews reporting to the board; and assurance over the entire risk appetite framework. Expect lawsuits and increasing regulation for the laggards.

6.         Focus on longer-term value creation. Expect asset owners to exert pressure on directors and asset managers to develop long-term metrics commensurate with the product and risk cycle of the company. Pay metrics such as health, innovation, culture, R and D, etc. will drive long-term investment. Look for “integrated” reporting and metric maturity in 2014 and 2015, making it easier for corporate boards to direct long-term non-financial incentive pay and investment.

7.         Focus on the Board Chair. Expect greater movement to non-executive Chairs from Lead Directors in the US, and Chair position maturity in other Anglo-American countries. Look for rigorous roles and responsibilities of board chairs developing, beyond formal independence, including driving value creation and company performance for investors.

8.         Greater clarity on pay for performance. Look for guidance by the SEC, including on realizable pay. Expect movement from short term, quantitative, financial pay metrics to long term, non-financial, qualitative, multi-year return metrics, and pay that adjusts for risk and performance over the longer term, with greater discretion to compensation committees and boards – and if necessary shareholders.

9.         Tightening up of independence standards. Look for boards to tighten up independent standards over lawyers, compensation consultants, auditors, and themselves, to arrive at “non-conflicted directors getting non-conflicted advice.” Look for scrutiny over soft management influence and capture over all of the above. Expect continued regulation if or when boards resist.

10.       Greater focus on culture, whistleblowing, tone in the middle, and anti corruption. Expect good boards to go beyond the CEO to scrutinize compensation of “risk takers” anywhere in the organization; share the hiring, firing and compensation decisions for risk, internal audit, compliance and the CFO; and receive assurance and reporting over all material risks and controls. CEOs (or any operating or senior management) who block or are not transparent should be regarded as red flags.

Richard Leblanc is a governance lawyer, academic, speaker and independent advisor to leading boards of directors. He can be reached at rleblanc@yorku.ca or followed on Twitter @drrleblanc.

Gender diversity on boards: My discussion notes

I have been asked to serve on a panel in Toronto next week, 20 October, and in NYC on November 12, 2013, to discuss gender diversity on boards.

Here are my discussion notes for both panels if readers are interested: https://dl.dropboxusercontent.com/u/79214614/Richard%20LeblancTorNYCGenderDiversityNotesOctNov13.docx

The links to both panels are here:

https://111213newyork.eventbrite.com/

https://www.wxnetwork.com/board-diversity-a-time-for-women-to-lead/

Richard Leblanc

Social media trends and listening for boards

I was asked to give brief talks on social media trends and the board’s role in “listening” at an NACD conference. Here are my notes, as well as a reading list, if group members are interested:

https://dl.dropboxusercontent.com/u/79214614/NACD%20Richard%20LeblancNACDDiscussNotes14Oct13.docx

https://dl.dropboxusercontent.com/u/79214614/NACD%20SM%20lab%20possible%20readingsv2.docx

My submission on gender diversity to the Ontario Securities Commission

There was a consultation paper put out by the Ontario Securities Commission, Canada’s largest securities regulator. See the paper here, which calls for responses on page 20, and deadline was extended to Oct 4, 2013.

Here is my letter in Word, here.

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.

Methodology

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

Additional notes for Corporate Secretary Think Tank Canada Panel, 2 October 2013

Panel: Gender Diversity on Boards, 1:45-3:00pm

Methodology

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:

  1. 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.;
  2.  Applying industry “experience” to prospective directors and not to incumbent Directors: Blocks women, and regulator has never used word “experience” to my knowledge;
  3.  “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;
  4. 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.);
  5. 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;
  6. 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;
  7. 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];
  8. 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;
  9. 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);
  10. 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
  11. “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));
  12. 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;
  13. “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/).
  14. Lack of robust independent director assessment, with consequences and direct link to re-nomination: perpetuates non/under performing Directors and frustrates renewal:
  15. Blockage of third party reviews of board and director effectiveness, by Manager or a Director: Regulators now are requiring regular third party (objective) reviews;
  16. Boilerplate one sentence disclosure of board effectiveness review;
  17. Lack of Canadian political leadership (until very recently in Ontario): Canada (other than Quebec) is late to boardroom diversification;
  18. 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);
  19. 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;
  20. 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;
  21. Defining diversity expansively / downward to include almost anything (e.g., perspective, thought, viewpoint): Blocks women;
  22. Trade associations, funded by memberships, beholden to status quo members: undue deference to those with vested interests: Blocks women;
  23. Gaming of retirement age (69, 70, 72, now 75) and resistance to term and directorship limits by self-interested Directors;
  24. Resistance to competency matrix disclosure and transparent director nomination and selection practices: inadequate regulatory guidance;
  25. Undue influence of Management on the competency matrix (design and administration), whereas Nomination Committee must be independent (including its work);
  26. 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;
  27. 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);
  28. Pre-ranking and not interviewing prospective Directors; Not disclosing origination of a Director (how he or she came to be known to the Board);
  29. 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;
  30. 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
  31. Matrix analysis by corporate secretary or general counsel who do not possess independence or expertise to do so.

Richard W. Leblanc, PhD

 

The new US CEO to worker pay ratio and vested interests

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.

When does it become unethical for a director to continue to serve?

I spoke to corporate and not-for-profit directors in Dallas, Texas, today, about board dynamics and board renewal. The subject of the length of board service and director retirement arose. I said there was a recent study that the optimal service for a director was nine years, beyond which firm value was adversely affected. Many directors serve beyond nine years. The most excessive example of long service occurred once when a director of a community bank board said, “Richard we have four directors who have been on our board for over 50 years.” I mistakenly thought that this was 50 years in total, among the four directors. But I was wrong. There were four directors who had been on the board for over 50 years, each.

Many directors hang on to directorships for far too long. I counted several directors who have been on corporate boards for 10, 15, 20 and 25 years. This blocks board renewal, up-skilling, and diversification. Incumbent directors offer reasons for staying: how they know the company, enjoy serving, etc., and are skillful at wiggling, raising the retirement age to 71, 72 and now 75 (from 69 and 70).

The academic evidence however does not support excessively long-serving directors, or directors who are serving on multiple boards (known as “over-tenured” and “over-boarded” directors, respectively). Firm value is adversely affected for over tenured directors (inverted U shape in relation to firm value); and oversight and long term performance are compromised by “consistent and convincing results” (according to Stanford researchers) for busy boards composed of over-boarded directors.

Often the most vocal directors are those who are the least relevant or most affected by renewal. When you do a proper board review, it is apparent who is performing and who is not. There is resistance to an expert third party board evaluation by underperforming directors for fear of being found out. Directors know who the non-performers are. I said to the audience this morning that every board has one (or more) underperforming or dysfunctional directors, and if you don’t know who it is on your board, then it is you.

If boards do not solve their lack of renewal, regulators will do it for them. It is already starting. Regulators in the UK, Australia, India, Hong Kong, Singapore and other countries are imposing term limits on directors of between 9 and 10 years, beyond which independence is questioned. Regulators are imposing diversity requirements on boards. In the UK, even auditors are subject to tendering every five years. Regulators read the press reports of directors serving 40 years, auditors even serving up to 100, and communicate with academics on what the empirical research findings are.

The fact of the matter is that boards, as self-policing bodies, may be incapable of solving the renewal issue on their own because of entrenchment and self-interest. And herein lies the ethical question, posed to me by a director today: “When does hanging on or digging in breach a fiduciary duty by the director to act in the company’s best interest, rather than the director’s?” When should doing what is right; putting oneself at risk; having proper succession planning; mentoring, coaching and developing the next generation of directors; and letting go gracefully and honorably, matter?

This is an integrity issue. If – or perhaps when – a director becomes irrelevant, or is destroying value, is it ethical for that director to continue? Is it ethical for the board to allow that director to continue? The problem is doing what is ethical vs. acting out of self-interest can get commingled in an under performing director’s mind, or even a founder’s mind, or even other directors’ minds (who have been captured by the entrenched director colleague), without an objective measurement. This is neither person-proofing governance, nor in the interests of the company and its shareholders.

Aggrandizing long service, referring to “god fathers,” compounds this renewal problem and wearing as a badge of honor how many boards one has served on, or does serve on. As one “godfather” recently remarked in open session at a corporate governance conference, “We did virtually no research.” Well, maybe research should be looked to more when policy is developed. Firm value and the oversight of shareholder investment are at stake.

Eventually, a director fights redundancy and relevance. A tipping point is reached if there is indefinite service. It is inevitable. No one wants to be irrelevant. If there is no policy or, better yet, no measurement of actual performance and follow up accordingly, self-interest is perpetuated and complacency is allowed to continue, by the very people who should be leading by example. Directors need to know when it is time to go. And if they do not, regulators will.

 


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