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Diversifying Corporate Boards ~ How to Do It

Oct 6

Posted in Diversity | Comments Off on Diversifying Corporate Boards ~ How to Do It |

There is a movement to diversify boards of directors in almost all industrial democracies as a result of the financial crisis. It has been termed “the number one issue in corporate governance.”

Diversity extends beyond women to include ethnicity, age and other areas. Depending on the survey and country, women on corporate boards have hovered anywhere from 10-15 % for several years. The statistics for non-Caucasians are worst, at about 3%.

Boards surprisingly are a self-selected and homogenous group. There is little ability for shareholders who own companies to propose or remove directors. The qualifications to be a director are minimal. There are no requirements for ongoing education and no license to practice, unlike other professionals such as lawyers, accountants or doctors. Past CEOs are preferred on boards, but the evidence does not support CEOs making better directors. And this practice discriminates against women and perpetuates reciprocity and favoritism.

Boards are a fixed size averaging about 7-10 directors depending on the company. Directors nominate people they know and feel comfortable with. To bring someone “different” on is, well, different, and someone else would need to go off the board. The pressure for the status quo is fraught with inertia and self-interest.

Governments have stepped in. On the one hand is the US approach, which is to require companies to disclose a “diversity plan.” On the other hand are full-fledged quotas, like the one proposed in Europe to have 40% of boards composed of women. In between both approaches is to have companies define diversity and objectives for diversifying their board, and report annually on progress. This seems to be the best approach.

The argument for diversity on boards is a “business case,” although there is no clear evidence that diverse boards create greater shareholder value. There is however evidence that diverse groups make better decisions and mitigate group-think, which is the tendency for similar groups to decide on the basis of agreement and social cohesiveness rather than the best decision, which could create dissent at least initially. There is also evidence that women make better monitors of management, and that performance of men increases when women join boards.

The other business case for diversity is a simple talent issue. By restricting boards to one type or class of director, boards are not making full use of available talent to match their stakeholder base. Women in many industries make the majority of purchase decisions. North American boards sorely need international directors from China, India and other huge markets. The last argument is perhaps the strongest – morality. Discriminating on the basis of prohibited grounds such as gender, race, military status, and sexual orientation or otherwise is not only unfair but also illegal.

So how do boards diversify themselves? What are leading practices the best boards are doing? Three steps:

Step 1: Recruit directors solely on the basis of competency, not whom you know

A board is a team. Team members have different abilities. “Competency” can include experience, skills, knowledge and behaviors. A good board draws up a matrix of competencies it needs on one axis and individual directors along the other. It defines the competencies and the scale, and then individual directors assess themselves relative to each other. If done right, it is apparent which directors may not be needed, and what competencies are needed in future directors.

Step 2: Recruit directors whom you do not know personally and who are first-time directors

Once you have the desired director competencies, the next step is to recruit directors who fill this gap. Cast your net wide and go beyond personal and professional networks. Have a diligent way of short-listing resumes and ask candidates to address the specific competencies you need. Conduct background checks, reference checks and individual interviews for open spots, as you would any other management position. Don’t be afraid to short-list diverse candidates whom you likely will not know, including first-time directors who have stellar qualifications your board needs. Most directors now serve on one and at most two boards; so admitting first-time directors is very common.

Step 3: Link director time on the board to performance

Have onboarding, coaching and development for new directors. Then, assess each director on his or her contribution at regular intervals. This is difficult to do if done in a superficial way or through a self-analysis given unconscious biases. Have a rigorous director performance assessment with assistance from an expert third party, and link the results to re-nomination. Each director competes for his or her own position every year. No guaranteed tenure or indefinite service.

Then, you should disclose the basis upon which directors are recruited, developed and assessed so shareholders can vote meaningfully on each director at the time of renewal or removal. This sets the tone that the board holds itself responsible and accountable to shareholders in the same way it expects management to be accountable to itself. Your board and organization will be the better for it.

Lastly, expect that a current director who objects to any of the above best practices is doing so out of self-interest. When he objects (and it most often will be a “he”), it could include phrases such as “No one knows this person” or “This person is not qualified like we are,” which is code for entrenchment, ask this director to phrase all objections with the following language: “I believe it is in the best interests of the organization that…” This should address the objection.

E. Coli, Contaminated Beef and Shoddy Governance

Oct 3

Posted in Risk Governance and Combined Assurance | Comments Off on E. Coli, Contaminated Beef and Shoddy Governance |

I interviewed an independent director of Canadian food retailer Loblaws about risk and he told me the most important risk for Loblaws that could cause a ‘run on the bank’ (his words) was food safety. Food safety was front and center in his mind, and each of the other independent directors and management. It seems the management of XL Foods Inc., which is owned by Nilsson Brothers Inc., has not figured this out. “Governance” does not even appear on their sparse website. Safety does, in a general way, here. Neither company appears to have any independent directors.

Contrast this with the other major beef processor in Canada, Cargill Ltd., which is owned by Cargill, Inc. in the U.S. See Cargill’s commitment to food safety here; their “ethics open line” here; their core competencies that include supply chain and risk management here; and that their board has six independent directors and five managers, according to Wikipedia. (Their 2008 accountability report stated a third of the board were independent directors.) Cargill claims to be the largest private company in the U.S. in terms of revenue. Although private companies like Nilsson Brothers and Cargill are not required to have independent directors, forward-thinking ones do. See McCain Foods here. Independent directors bring objectivity and an external perspective into the boardroom. They are honest brokers to keep an eye on management. A good independent board will not prevent a disaster but almost always will lessen its likelihood.

According to the Mayo Clinic, the most common way to acquire an E. coli infection is by eating contaminated food such as ground beef: “When cattle are slaughtered and processed, E. coli bacteria in their intestines can get on the meat. Ground beef combines meat from many different animals, increasing the risk of contamination.”

The way you mitigate food safety risk is through internal controls, including segregation of duties, restricted areas, approval, records and reconciliations – and a culture of food safety and not cutting corners. Management is inherently conflicted in assuring such controls, and internal controls cost money. This is the reason for government inspectors and, most importantly, a competent and independent board of directors to approve the control regime to begin with.

I am heading to Calgary next week to give speeches to the directors of Livestock Identification Services Ltd., as well as directors of a few additional beef industry groups and one being a newly formed national beef agency called Canada Beef Inc., on internal controls and risk. I have given speeches to farmers in the U.S. and am going again to Colorado in November to talk to CEOs and director-farmers on the latest trends in corporate governance, risk management and internal controls. Good agri-businesses take governance very seriously.

Risk management and internal controls are not profit producing activities per se. No one likes to be controlled, least of which entrepreneurial employees. However, ask yourself if defective internal controls are worth the price, reputationally and financially? Do you think XL Foods has taken a financial and reputational hit because of the tainted beef? What about the farmers coping with a price decline? What about Maple Leaf Foods? Most importantly, what about the health and safety of customers? It can indeed be a run on the bank if consumers don’t have confidence, and it can get worse unless governance checks are put in place.

See the long list of beef recalled here from the Canadian Food Inspection Agency, and the update from the USDA Food Safety and Inspection Service, here. Recall that the American inspectors detected the tainted beef before Canadian inspectors did. Rather than prioritizing the federal agency to re-open XL Foods, the premier of Alberta, Alison Redford, should insist that food safety for all Canadians (and consumers in America and other countries too) is number one. Then, and only then, should XL Foods be re-opened. Tainted beef from Alberta seems to be a pattern. And the Prime Minister should reform the governance of the Canadian Food Inspection Agency to require independent directors and an independent chair (it appears not to have either on its website here and here) like many other federal or provincial agencies. Maybe it’s also time that some private companies that affect a broad swath of the population should have a requirement for independent directors too.

 

How to conduct a proper workplace investigation

Sep 28

Posted in Uncategorized | Comments Off on How to conduct a proper workplace investigation |

I am giving a speech in later today on the ethics of conducting proper workplace and board-level investigations. (See slidedeck here.) The evidence shows that many investigations conducted suffer from serious setbacks that need to be corrected to be effective. The impetus for change is the new Securities and Exchange Commission (SEC) “whistle-blowing” rule that permits employees now to go directly to the regulator with a complaint and completely bypass the company’s internal processes. I remember when Mary Schapiro, the SEC Chair, spoke to about 700 corporate directors at a conference I attended at the time the rule was being developed. Schapiro said the rule was the right thing to do to address toxic workplaces in the aftermath of the Madoff fraud – which was presented to the SEC but ignored. Directors then and now voiced stiff opposition to the rule, saying it would result in “bounties” (monetary rewards) to employees.

Not only are rewards a good thing to incent employees to come forward, but companies, I will argue in my speech today, should match these rewards for employees to come forward with concerns of fraud and ethical wrongdoing.

The practical effect of this new rule is to put the heat on many companies and corporate boards to reexamine their workplace investigations of potential wrongdoing – and that is a welcome development.

Where do investigations go wrong? Three key areas:

1.         Lack of Anonymity and A Protected Mechanism for Employees to Come Forward

Employees are rational. Why would anyone – especially executives – come forward if they know their identity will be revealed, the complaint will not be properly investigated, and they will suffer scorn and even retaliation? What happens then is the wrongdoing festers and gets worse, when it should have been addressed earlier. It becomes part of workplace culture. The identity and personality of the person are largely irrelevant. What is relevant is the nature of the complaint itself. Without a system that guarantees anonymity, an important source of intelligence is suppressed.

2.         A Weak Audit Committee and Board

Boards now need to know what best practice reporting channels are and when to get involved and even lead an investigation of conduct that involves management and can put the reputation of the organization at risk. This is changing now with contagion and social media.

Employee and culture surveys, informal walk-arounds, and a strong internal audit provide excellent intelligence. There is a natural tendency for management and company lawyers to unduly influence the investigation, which is a red flag for employees not to come forward. The audit committee should have its own independent advisors to receive the complaint directly, and then communicate with management on behalf of the audit committee. If the complaint is serious enough, independent advisors should lead the investigation, not management.

3.         Flawed Investigation and “Lawyering Up”

There is a tendency to become defensive and even passive-aggressive with very serious allegations. Who is on the investigation team, how documents and other evidence are preserved and collected, how interviews are conducted, and how upward reporting occurs are very important and will determine how conclusions are viewed by regulators and other stakeholders. Self-reporting and ready co-operation to cure the complaint can be viewed favorably by regulators and the public. The best example of proper crisis management is Maple Leaf Foods when its CEO Michael McCain publicly apologized and promised to make it right. See the video here. Lawyers have a tendency to hone in on process and not see the bigger public relations picture and opportunity.

Conclusion:

In the age of social media, simply an employee with a cell phone may publicly trigger an investigation. The consequences of not being ready, conducing a flawed process, or being defensive, can be more damaging to the company’s reputation than the original allegation. (Just ask Mitt Romney, who may have lost the election as a result of ill-advised off-the-cuff recorded remarks.) A company’s actions are now one step away from going viral. The scrutiny and risks have never been greater.

Employees, the media, customers and others need to have confidence that an issue when it surfaces is being investigated independently and appropriately. Good boards are insisting on advance planning and investigation protocols, and warning employees that all actions are public. Maybe Mitt Romney’s team should have done the same.

Are Law Firms Conflicted in this New Governance Normal?

Sep 21

Posted in Shareholder Accountability | Comments Off on Are Law Firms Conflicted in this New Governance Normal? |

Should a board use the same law firm that management uses? I don’t think so. They teach you in law school that you cannot act for two clients whose interests are, or could be, adverse, e.g., a husband and wife in a divorce, a purchaser and vendor of a home, and so on. You can only act for one client at a time. Governance is really no different. The job of the board is to control management in the interests of shareholders. So how can a board use the same law firm that management uses? The interests of the board are inherently adverse to management.

When a board negotiates compensation for the CEO, it should have independent compensation consultants and lawyers. I sat beside a CEO at a conference once and he remarked to me “I will outgun any compensation committee.” When I asked why, he replied that they do not have the expertise or resources. Well, maybe they should.

Another real example: If a lawyer has drafted anti-takeover devices to entrench management, such as poison pill, should that same lawyer act on behalf of a special committee of the board? This is an inherent pro-management bias, is it not? What about an investment bank that has also done work for management? This is a conflict too.

The issue is that it is far more lucrative for professionals to do work for management, rather than the board. In Sarbanes-Oxley, we now have auditors who cannot do non-audit related services for management, absent explicit approval. The Securities and Exchange Commission, in implementing Dodd-Frank, announced a few months ago that compensation consultants working for the board must now be independent from management. Proxy advisors may be regulated prohibiting their offering consulting services to management. The same rule should apply to lawyers.

The board must be free to retain its own advisors so they are not “out-gunned.” Shareholders will lose when this happens.

Aligning Pay to Value Creation and Performance

Sep 18

Posted in CEO, Organizational Performance and Compensation | Comments Off on Aligning Pay to Value Creation and Performance |

Compensation is a very emotional subject for executives. And it is personal, sometimes inspiring competition, greed, wrongdoing, or even feelings of self worth. The legacy of the financial crisis will not be as much the quantum of compensation, but rather ensuring that boards and shareholders are more involved, and that pay is more tied to performance and risk-taking. Regulators have stepped in to ensure that shareholders have a vote; compensation committees and consultants are independent; and that, in expected regulations to come, pay is more linked to performance and compared to the compensation of the average worker.  The intent of compensation reform should not be a compliance exercise dominated by consultants and lawyers, but rather a re-thinking by the compensation committee of linking compensation to value creation for shareholders, and listening to their concerns. This is the heart of the issue.

In my review of the evidence and work with investors, boards and compensation committees, here is a list of opportunities for linking pay to performance and shareholder value:

  1. According to a study by an advisory firm, 95% of equity vesting in the US top 250 firms are time-based rather than performance-based. If this is the case, this is a serious lapse in oversight and alignment with shareholder value by boards. Non-executive directors should receive performance-based restricted stock also.
  2.  University of Delaware researchers claim there is a 17% structural annual increase in CEO compensation simply by virtue of peer groups being used that are based on size rather than value creation, coupled with CEO compensation being awarded at the 50th, 75th or 90th percentile. This structural increase occurs irrespective of performance. As long as the current system of awarding pay continues, this ratcheting will continue.
  3. Increased disclosure of compensation has resulted in compensation consultants devising multiple vehicles, methodologies and time periods that are complex for investors to understand. There is a case to be made for the simplification of key value drivers associated with shareholder value, coupled with high wealth maximization for executives. Private equity firms do this very well.
  4. An independent advisor to a compensation committee should be one who has not done, nor is doing, nor seeks to do in the future, any non-committee related work for management. This restriction should apply to the firm as well as the person. If an advisor’s colleague has a relationship with management, then he or she does as well.
  5. There are examples of equity vesting when ethical transgressions have occurred. This should not be the case. Malus clauses should be used rather than clawbacks. The compensation committee or an independent advisor who has no relationship to management should draft the clause and the conditions. A clause properly drafted will be adverse to the interests of management.
  6. The periods covering pay and performance should be aligned and simplified. Right now there is overlap among intended, earned and realized compensation. This causes confusion in assessing compensation. Companies should do this on their own, and if they are incapable or refuse, regulators should clarify.
  7. Research studies suggest bonuses are not based on stretch goals in many companies, but are forms of disguised salaries. Bonuses should be discretionary and awarded by the committee over time as performance effects are realized and risk tails assessed.
  8. Despite the high say-on-pay approval rate, the controversy over executive compensation is not a blanket “CEOs are overpaid,” but is based primarily on two factors: examples of pay for non-performance, and the internal pay inequity (both officers and the average worker). Boards should take a look at these two issues specifically.
  9. Researchers have found no causal relationship between stock ownership by executives and firm performance. This should be kept in mind for target ownership plans. Large equity positions could promote entrenchment, asset misuse, and accounting and grant manipulation.
  10. Compensation committees need to make greater progress on adjusting compensation for risk, including incorporating risk into performance metrics and allowing equity to vest after risk has been assessed. There is much progress to be made here and regulations are emphasizing this.
  11. Greater progress needs to be made by boards on CEO succession planning, which affects compensation and firm performance. Survey data according to Stanford researchers have found that the board spends only two hours a year discussing CEO succession, and that 39% of boards do not have an internal successor. Outside successors cost more and there is considerable evidence they perform worse than internal successors.
  12. Proxy advisory firms should not be overly influential as they are now. Weak governance systems are associated with excessive compensation, research suggests. However, in considering recommendations of proxy advisory firms, they neither assess governance quality nor predict shareholder performance, the research also suggests. Compensation committees and boards should not necessarily amend practices to suit proxy advisory firms if their reliability cannot be established.

Conclusion: The compensation landscape for 2012 and 2013 will include all of the above touchpoints. They will require most importantly compensation committees with courage and expertise, particularly if there are systemic problems or questionable linkages to performance and value creation for shareholders.

The Board’s Right to Know and Red Flags To Avoid When You Don’t

Sep 14

Posted in Information, Resources and Reporting, Meetings and Decision-Making, Relationships and Communication | Comments Off on The Board’s Right to Know and Red Flags To Avoid When You Don’t |

I was called into the Chairman’s office. I received a message on my voicemail from his assistant saying the meeting was urgent. The company was splashed all over the newspapers because of misstep after misstep. People were saying the board was asleep at the switch.

The Chairman shrugged when I met him and simply said, “We missed it.” (Again.) Part of my job was to interview each director and find out why, and produce a report to the full board and regulator. I had a month to do it. The Chair’s office would book any plane flights I needed.

This scenario – my assessing a board – has repeated itself in situations ranging from fraud, stock option backdating, bribery, property destruction and death. When a board “misses it,” it’s rarely because they were not complying with rules or laws. They were. The reason is what goes wrong inside the boardroom – with relationships and people.

Here are some questions that go beyond the rules and more often than not in problematic boards the answers I receive (and see) is “No,” “I think so,” or “I don’t know.” Ask yourself as you read these questions if you can answer, “Yes” to all of them for the board or boards you are on.

Does bad news rise in your organization?

This is a favorite question to ask a director. It’s simple but powerful. If you are not getting the real goods, sooner rather than later, consider this a red flag, as you may be the last to know.

Do your CEO and CFO have integrity?

Another favorite. If the CEO or CFO holds back, funnels information, manages agendas, is defensive, or plays his or her cards too close to the vest, this is a warning sign.

Do you understand the business and add value?

If you asked the management team whether you as a director understood their business and added value strategically, what would their response be? What if you asked shareholders? You would be surprised at the answers I get. Frequently there is a disconnect.

Do you know how fraud occurs in your company and industry?

Depending on your local markets and the business you are in, there are tried and true ways to commit fraud that work and are being practiced by your employees and key suppliers. Do you know what they are?

Do you compensate the right behaviors?

You are at the helm as directors. Whatever you compensate, management will do. Ask yourself whether you are rewarding what you intend to reward.

Do you get disconfirming information?

If you get your information only from management, this is a red flag. Use social media, go on unscripted tours, listen in on analyst calls, move a board meeting to a jurisdiction you need to know, and get industry presentations on your competition.

Do you get exposure to key business lines and assurance functions?

Bring these people into the boardroom, with no PowerPoint slides. See how they think on their feet. It is good for succession planning, and is an excellent source of information.

Do you get good advice and stay current?

Don’t let management pre-select advisors. Bring tailored education into the boardroom and stay on top of emerging developments. Get the information you need to do your job.

Do you meet with shareholders – apart from management?

Ten years ago I had to ask CEOs to leave the room when independent directors met separately. Now I am doing so when directors meet with shareholders. Meet with key shareholders regularly. Listen to them. Don’t let lawyers interfere.

I brought the Chairman of the Hershey Company, James Nevels, into my corporate governance class that I taught at Harvard this past summer. We talked about people and relationships, but what Jim also said was how important the Board chair position is to create the climate and environment for the above questions and practices to occur. Jim has a saying he uses to focus his fellow directors – “We need all hands on deck for this one” – for a key decision, and makes sure each director brings their “A” game all the time. He goes around the table and he speaks last.

You need to bring your skills forward as a director. Every director slot matters now more than ever.

The Focus on Shareholder Activism, Value and Engagement: A Counterpoint

Sep 9

Posted in Shareholder Accountability | Comments Off on The Focus on Shareholder Activism, Value and Engagement: A Counterpoint |

There has been a critique lately by retained advisors to management and academics about activist investors and the focus on shareholder value. See for example, here, here and here. This is a counterpoint on why shareholder activism occurs, what “shareholder value” is and is not, and what “shareholder engagement” really means.

Why do activists emerge?

There have been several recent examples of shareholder activism, at Yahoo, J.C. Penney, P&G, Chesapeake Energy, and in Canada, Research in Motion and CP Rail. As experienced non-executive chairman and activist investor Henry D. Wolfe has written, “the best activist investors play a vital role in shaking up complacent boards/managements and positioning companies to for maximum performance and value creation.”

Wolfe goes on to write, “the recent Canadian Pacific Railway situation is a classic case in point. Both the incumbent board and management had presided over multiple years of the “plan of the moment” all of which resulted in a dismal operating ratio for the railroad. Bill Ackman and his team at Pershing Square were made aware of the CP situation, took a deep dive into the industry and the company resulting in a detailed analysis of the company’s underperformance and a high level plan to maximize its performance and value which included a new CEO and a partial board slate with director candidates that all had a greater awareness of the need for the board to have performance and shareholder value maximization as the top priority.” (See also the culture shift brought to Canada because of CP, here and here.)

Wolfe concludes by saying, “What does not seem to dawn, at least not completely, on people such as the authors of this article (see “What Good Are Shareholders, Harvard Business Review”), is that if public company boards really understood and did their jobs, there would be no need for raiders, activists or “shareholder empowerment.”

 

What is the board’s responsibility when an activist emerges?

The board’s primary responsibility is to ensure that the company’s performance and value is maximized. Directors have a legal obligation to act in the company’s best interest, not management’s, and not their own. The question – the only question – in responding to a “concerned” shareholder (otherwise known as an activist) is what is in the best interests of the company and its shareholders? In many cases, doing so is not further entrenchment such as shareholder rights plans, staggered boards, dual class shares, restrictions on calling meetings or voting, or other restrictions on corporate control. Directors are there to control management in the interests of shareholders, not be beholden to management or hostile to shareholders.

Self interest by boards when an activist emerges?

And – this is very important – directors cannot act out of self-interest. An activist has emerged because the board was not doing its job. If the company assets and performance were being managed efficiently and effectively, there would be no need for shareholder activism. Activism occurs when voices are not heard. When the board responds, it must take a look in the mirror. Activists may have ideas that are in the best interests of the company that include addressing poor management and board performance. The board needs to address this independently and dispassionately.

This is tough to do because the right thing to do may be to step down and let other directors take over, who can do a better job. Surprisingly, sophisticated investors often know more about the business than existing directors. This is further evidence of complacent directors and the current corporate governance model being broken.

Even more surprising, apart from self interest, are views of shareholders: “Other academics, such as Roger Martin, the highly regarded dean of the Rotman School of Management at the University of Toronto, are critical of the emphasis on shareholder value.” As Henry Wolfe comments, “And if one does not believe that Roger Martin supports this, just look at the material decline in performance and total destruction of shareholder value at RIM during Martin’s tenure as an RIM board member and his non-sensical comments regarding criticism by investors of RIM’s board.” John C. Caravella added, “Jay Lorsch, also quoted in Joe Nocera’s New York Times column [see here], served on the board of Computer Associates in 2004, when CA paid $200-plus million to the U.S. Department of Justice in restitution to shareholders to settle charges of accounting fraud and obstruction of justice. Caveat emptor.”

Does a board have a “duty” to stakeholders other than shareholders?

Accountability to everyone is accountability to no one. It is simply folly to suggest – as some have – that shareholders should be treated the same as other stakeholders or even subservient to them (see my blog here as an example). Or by extension of the directors’ duty to the company that this duty extends to all stakeholders. Directors, legally, do not have duties to multiple stakeholders, any more than an agent or fiduciary can act for multiple principals. Shareholders are not the same as non-shareholders, such as customers, employees, suppliers, creditors, etc., who contract with the company for their protection. Shareholders do not have contracts with the company, contrary to what Professor Stout stated. They are residual claimants and boards must consider their interests in light of this. Shareholders are principals and they elect directors to preserve and enhance their investment. Public companies are not social institutions and investors do not risk their capital for this purpose, but by the same token, boards cannot unfairly treat its stakeholders and has to be a good corporate citizen.

Shareholder value defined

Next, the obsession with quarterly earnings has been used to mis-characterize shareholder value. This is not what shareholder value is all about. When companies do not maximize their assets or performance, from unsound diversification, complacency regarding costs, or cash in excess of capital needs, these inefficiencies – which should be addressed by boards – are addressed by activists irrespective of quarterly earnings. More often than not, activist investor activity has nothing to do with quarterly earnings.

In addition, shareholder value also does not come at the expense of stakeholder management, but rather results from it and ensures a highly disciplined approach to stakeholders. Stakeholder metrics such as customer service, employee engagement and culture are leading metrics that drive financial performance. These non-financial metrics are underutilized by boards and in executive compensation. This fault squarely rests with boards. Witness GE and Four Seasons when stakeholder management is done right. Witness BP when it is not. Accountability to shareholders cannot be fulfilled without proper stakeholder management and taking into account all the vital components of the business, including reputation and ethical conduct. The anti-shareholder rhetoric suggests that performance and value can be maximized without stakeholder management and ethical conduct. It cannot.

Shareholder engagement and shareholder democracy defined

Next we come to what it means to communicate with shareholders. Shareholder “engagement” as a concept has been co-opted by technocrats to mean voting or procedural rights (when these folk’s business model is predicated on these services). Shareholder engagement is not, in and of itself, say on pay, majority voting, broker non-votes, or technical process that lawyers and compensation consultants advise on. Shareholder engagement is about meeting, face-to-face, between directors and key shareholders, without management present. Shareholder engagement is, most importantly, listening. Board chairs should not be dissuaded by legal concerns over “Reg FD.” Regulation fair disclosure does not in any prohibit directors from meeting directly with shareholders. The SEC Chair has confirmed this. Boards should not allow management and retained advisors to dominate this process. And shareholders need to commit the time and resources to meet directly with boards of the companies they have significant ownership positions in.

Next, shareholder democracy means exactly what you think it means: the ability of shareholders to elect directors. Corporate management has fought vigorously to control the proxy statement and prevent shareholder from suggesting directors, but shareholders should have the right to compel management to put onto the proxy statement directors of their choosing. I have not seen any evidence that experienced investors will not put on top-flight directors. Indeed there has been evidence to the contrary – shareholder-nominated directors are better than many current directors.

What about advisors to boards?

Lastly, something needs to be said about professional advisors to boards and board committees, and specifically in the context of a change in control, a conflict of interest, or responding to an activist. Professionals who advise management should be prohibited from advising the board on responding to an activist, or any other matter involving independent review or oversight. (Independence of auditors and compensation consultants – serving just the board and not management, happened under S-Ox and Dodd Frank, but this needs to be extended to all advisors, including financial and legal advisors.) You cannot serve two masters, especially when their interests are adverse.

An independent advisor needs to be free to recommend to a board action adverse to management and supportive of shareholders and the company. Existing service providers have a commercial interest in supporting management. They are also assessing their own work when they advise a special committee or the board. This is evidenced by lawyers drafting entrenchment devices that protect management. We even see a negative regard to shareholders in their commentary. Observe words such as “attack,” “secretly,” “dissident,” and “activist” – even the title itself is pejorative: “Dealing with activist hedge funds” – and see here, the “risks of direct engagement.” As activist investor Henry Wolfe has said, “When lawyers provide defensive strategies and tactics to clients there is rarely a shareholder focused context; the context is largely to build a moat around the directors.”

Conclusion

The overall commentary of shareholder value has as an undercurrent that shareholders have too much influence and power. In my view, the opposite is true. Shareholders do not have enough impact and influence and directors are not accountable to them. The deck is far more tilted towards incumbent management, directors beholden to them, retained advisors to management, and an overall lack of accountability to shareholders. The existing model of corporate governance should address this.

 

Thirty-Five Canadian Boards with No Female Directors

Aug 31

Posted in Diversity | Comments Off on Thirty-Five Canadian Boards with No Female Directors |

In the remaining days of summer before the Labour Day weekend, given that July and August are somewhat slow months, I had an idea – a fun idea.

I thought about how many Canadian boards still have zero women on them. I did a search, assisted by some publicly available Catalyst data. As it turns out, there are many. I did not do an exhaustive search but here is what I came up with (there are more). I tried to cover industry and geographical spread, as well as high-lighting some recognizable Canadian companies such as Air Canada and others. Here is a list of 35 of the top 500 Canadian companies that are, shall we say, lacking given the movement to diversifications of corporate boards in several countries.

Look at all the men, and in most cases white men! Where are the women and minority directors? Do we not have qualified diverse directors to sit on corporate boards in Canada? (And note a number of the boards below contain men who are governance experts and who promote boardroom diversity!)

407 International Board

Air Canada

Algoma Central Corporation

Baytex Energy Corp.

Bruce Power

Canaccord Financial Inc.

Canfor Corporation

Catalyst Paper

CCL Industries Inc.

Central Fund of Canada Ltd.

Dollarama

Fairfax Financial Holdings Limited

FirstService Corp.

Genworth MI Canada

GMP Capital Inc.

Great Canadian Gaming Corporation

Hatch Ltd.

IAMGOLD Corp.

Inmet Mining Corporation

McCain Foods

Mitel Networks Corporation

North American Construction Group

Pacific Rubiales Energy Corp.

Patheon Inc.

Petrobank

Precision Drilling Corporation

Reitmans (Canada) Limited

Rocky Mountain Dealerships Inc.

Savanna Energy Services Corp.

SEMAFO

Tembec Inc.

The Jim Pattison Group

Toromont Industries Ltd.

Woodbine Entertainment Group

Yamana Gold Inc.

Yellow Media Inc.

Caveat: The above search was internet-based and may not be current. I also attempted to glean male-vs-female through first names and Google image searches when necessary. If I have made a mistake, I am happy to correct it and apologize!

Here is my offer to the chair of the board or chair of the nominating committee of any company below. If you are serious about addressing boardroom diversity, I will put you in contact – either myself or via another expert third party – with women who have business and C-suite experience in your industry. I may revisit this list in the future and hopefully you will not be on it!

 

Richard Leblanc

 

 

 

Quebec Premiere Charest’s Proposed Anti-Takeover Law is Misguided

Aug 26

Posted in Global Corporate Governance | Comments Off on Quebec Premiere Charest’s Proposed Anti-Takeover Law is Misguided |

Premiere Jean Charest, who is in the midst of an election campaign that he is losing, is promising a law that would give stakeholders at Quebec companies – such as employees, management, suppliers and local communities – superiority over the interests of shareholders. This potential law is misguided and would entrench ineffective boards, management teams and firms, to the detriment of shareholders, investment and the Quebec economy overall. See here also.

When a similar law PA-SB 1310 was enacted in Pennsylvania – to preserve local employment, disgorge profits and ward off unsolicited take-overs – stock prices declined by $4B in the six-month period between the announcement and enactment of the law, according to a study by researchers Szewczyk and Tsetsekos. Pennsylvanian companies that chose to opt out of some or all of the law experienced “significant positive stock price returns,” while Pennsylvania companies that adopted the law performed “significantly worse” than firms outside Pennsylvania, according to Stanford researchers Larcker and Tayan.

While many US states have enacted so-called “stakeholder statutes,” these laws enable – although do not require – boards to consider the interests of stakeholders other than shareholders in their deliberations. These laws are largely permissive in nature in other words, and good boards always consider stakeholder interests in any event. The Canadian Supreme Court has spoken on how to do this. Pennsylvania’s law is not only mandatory – obligating certain stakeholders to be considered – but also places the interests of non-shareholders above those of shareholders, as Quebec’s proposed law intends to do. Indeed, under Charest’s proposal, shareholders, remarkably, may not even have a vote on a proposed takeover. Our high court has stated, in BCE Inc. v. 1976 Debentureholders, that a board has a duty to treat stakeholders affected by corporate actions equitably and fairly, and that there is “no principle that one set of interests should prevail over another” (page 9). Charest’s proposal, if it unfairly treats shareholders (and prima facie this is almost certainly the case if it denies them a vote), may be challenged on the basis of its constitutionality.

In the market for corporate control, accountability to everyone is accountability to no one. From an investor’s perspective, shareholder rights plans, staggered boards, dual class shares and restrictions on shareholders to call meetings and vote on corporate changes by written consent are all efforts to entrench ineffective management and firms, and enable the extraction of private wealth by insiders, to the detriment of other shareholders.

Politicians should not be in the business of picking winners and losers as they do not have the competence to do this. Government is not governance. Nor do judges have this ability to second-guess managers and boards. There is a well enshrined “business judgment rule” holding that a judge may not second-guess corporate judgment providing proper process occurred. A law like what is being proposed by Charest, which is essentially a bias against shareholders, immunizes a firm from competition, in essence saying a board can “just say no” to a takeover, full stop. Takeovers – even Rona by US’s Lowe’s Cos. Inc. – occur because of weaknesses and inefficiencies in the marketplace. (I was in a Rona store the other day and walked out when I could not find someone to help me.) If a firm cannot compete on the basis of price, quality or service, it should be taken over or replaced by a firm and a management team who can.

The Supreme Court was clear in the BCE case that the duty is owed from the board to the corporation, but that a stakeholder cannot be unfairly treated. Stakeholders include shareholders, who cannot contract with the company like other stakeholders can. While the high court did not endorse shareholder wealth maximization, it certainly did not invalidate it either. Once shareholder wealth maximization is vitiated, as this Quebec law would do, shareholders will simply invest their money elsewhere, where their rights and vote are respected, as they did in Pennsylvania. Quebec will lose.

Politicians should be more concerned with creating the fiscal and economic climate to attract jobs and investment, not enacting protective barriers that will have the opposite effect in a global world.

 

Potential Regulation of Proxy Advisory Firms: CSA Consultation Paper 25-401

Aug 25

Posted in Board and Committee Leadership, Shareholder Accountability | Comments Off on Potential Regulation of Proxy Advisory Firms: CSA Consultation Paper 25-401 |

Here is my letter to the Canadian Securities Administrators on the potential regulation of Proxy Advisors:

Should Proxy Advisory Firms Be Regulated? Yes.

I am drawing on my own research as well as materials I consulted recently in designing and delivering a new course at Harvard University, including teaching materials provided to me by Stanford University researchers (Larcker and Tayan).

The Canadian Securities Administrators has asked whether proxy advisory firms should be regulated. (Proxy advisory firms, such as Institutional Shareholder Services and Glass Lewis, which is owned by Ontario Teachers Pension Plan, provide governance assessment and recommendations to institutional shareholders on their voting at annual meetings of companies.)

In my view, proxy advisory firms should be regulated for three important reasons.

Conflicts of Interest

Proxy advisory firms also provide consulting services to companies to improve their governance score. This would be analogous to me as a teacher providing tutorial services for money for students to improve their grade. Or credit rating agencies receiving fees for other services other than an independent rating of the creditworthiness of the company. The business model for proxy advisory firms needs to change such that there is no non-rating services offered by them. Similar to auditors being restricted only to the audit (S-Ox), and compensation consultants now being restricted only to compensation assurance services to the board (Dodd-Frank), this practice needs to broaden such that any firm or individual providing independent assurance of governance (including governance advisory and search firms) should not have a consulting revenue stream, and should not provide any services to management or the company other than the assurance service provided to – or in respect of – the board or committee.

Having an alternate revenue stream to the provision of governance assurance services undermines the independence and objectivity of the assessment as the assurance provider is assessing his or her own work, or that of his or her colleagues within a firm. Moreover, a commercial conflict of this nature undermines the appearance and confidence in the marketplace that the assurance provider is not unduly influenced by proprietary or commercial interests. Having firewalls or separate business units within a firm does not address the reasonable perception of conflict, nor provide adequate safeguards given non-financial and personal/career influence.

Lack of Qualitative Assessment of Governance Quality and Predictive Validity on Shareholder Value

Second, based on my review, there is limited peer-reviewed evidence at best that proxy advisory firms measure governance quality in the main, or that which they do measure predicts shareholder value. These commercial firms possess a business model predicated on volume-based, externally measureable metrics. What is measureable, such as structural independence governance variables, such as independent chairs and directors, independent committees, share ownership, etc., do not necessarily impact board effectiveness or shareholder performance.

The above quantitative Stanford researchers actually go so far as to suggest “no evidence” (at page 161 of their book) for certain of these variables. Other variables offer “mixed” or “modest” evidence, while others (such as busy or interlocked boards) offer more persuasive evidence. Indeed the academic research also has not found a systemic relationship between governance rating systems (including G and I Indexes) and the predicting of long-term shareholder performance. Indexes based on entrenchment and anti-takeover provisions arguably do not measure board effectiveness.

Unfortunately, given the above lack of predictive validity, companies change certain governance practices to improve their scores when there may be limited empirical evidence that the purported practice will have impact on board effectiveness or firm performance. This pressure to change should not be the case.

What are relevant – so far as board effectiveness is concerned – are qualitative factors such as director qualifications (competencies and skills), engagement, leadership and board dynamics. These factors are more difficult, and in some cases not possible, to measure from outside a boardroom. I note the inconsistencies in proxy advisory firms’ ratings where the same company received divergent ratings from different proxy advisor firms, or companies that experienced governance failure formerly received high ratings (and in a few cases, awards from shareholder or other groups) from proxy advisory firms.

Proxy advisory firms, if they are purporting to measure governance quality, (i) should be required to assess and incorporate qualitative and firm-specific factors into their ratings and recommendations, (ii) should have the expertise and resources to do so, and (iii) should have a process for independent review, audit, contestation and arbitration if necessary. The personnel and sources consulted to produce a proxy advisory report should also be disclosed. See the paper by Leblanc et al., here and search “The Governance of Proxy Advisors.”[1]

Lack of Transparency

Third, the transparency of proxy firms should be increased. Proxy advisory firms’ rating methodologies and weightings accorded to various factors are divergent. If they were measuring governance quality with rigor, we would expect to see convergence, such is the case with credit rating agencies. Not surprisingly, individual companies may receive different ratings depending on the proxy advisory firm. This inconsistency needs to be addressed.

Governance ratings according to Stanford researchers who study them were found to have little predictive validity among the ratings of any of the three proxy advisory firms examined. The authors go on to write (Larcker and Tayan, 2011, p. 446-447), “the study found low correlation among the ratings of the three firms, low correlation between the ratings of each firm and future performance, and low correlation between the ratings of Risk Metrics/ISS and the proxy recommendations of Risk Metrics/ISS. The authors concluded that “these governance ratings have either limited or no success in predicting firm performance or other outcomes of interest to shareholders. … Our view is that  … the commercial ratings contain a large amount of measurement error. … These results suggest that boards of directors should not implement governance changes solely for the purpose of increasing their rankings.” [footnote omitted].

The use of and reliance upon ratings and proxy advisory services by institutional shareholders should also be transparent and accessible on the institutional shareholder website. (See the above paper by Leblanc et al..)

Conclusion

Boards of directors criticize proxy advisory firms for their ‘check the box’ and ‘one sized fits all’ approach to corporate governance; the enormous influence that they have; and their lack of transparency and accountability – in the governance field – when these firms and shareholders they serve insist on transparency and accountability from others. It seems to me that there is merit in concerns that boards have. More importantly however, the empirical evidence does not support many of the metrics being used by these firms, and ignores or diminishes others.

I hope this commentary is useful to your review.

Sincerely,

 

Richard W. Leblanc, PhD

[1] Leblanc, Richard, et al., “General Commentary on European Union Corporate Governance Proposals,’” International Journal of Disclosure and Governance (2012) 9:1, 1-35, where transparency, influence, inaccuracy, consulting services, institutional investor regulation and increased competition are discussed in greater depth. See online version here: http://www.palgrave-journals.com/jdg/journal/v9/n1/full/jdg201124a.html

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