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Should Proxy Advisory Firms Be Regulated? Yes.

The Ontario Securities Commission 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 creditworthiness of the company. The business model for proxy advisory firms needs to change such that there is no non-assessment services offered by them. Similar to auditors being restricted only to the audit, and compensation consultants being restricted only to compensation assurance services, any firm charged with independent assurance of governance should not have a consulting revenue stream. Having an alternative revenue stream to an assessment undermines the independence and objectivity of the assessment, and the appearance and confidence in the marketplace that the assessment is not unduly influenced by proprietary interests.

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

Second, there is limited peer-reviewed evidence that proxy advisory firms actually measure governance quality, or that what they do measure predicts shareholder value. These are commercial firms whose business model is predicated on volume-based, externally measureable metrics. What is measureable, such as structural independence governance metrics, such as separate chairs and director independence, does not necessarily impact board effectiveness or shareholder performance, the research shows. What is relevant are qualitative factors like board and director qualities, culture, judgment and circumstances. These are more difficult to measure from outside a boardroom. We see the inconsistencies in proxy advisory firms’ ratings where the same company receives divergent ratings from different proxy advisor firms, or companies that experienced governance failure formerly received high ratings. Proxy advisory firms should be required to assess and incorporate qualitative and firm-specific factors into their ratings and recommendations, with a process for independent review, audit 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 under “The Governance of Proxy Advisors.”

Lack of Transparency

Third, the transparency of proxy firms should be increased. Proxy advisory firms’ rating methodologies and weightings to various factors are divergent. If they were measuring governance quality with rigor, we would expect to see convergence. 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.” They further examine governance rating systems by academic researchers and conclude that predictive ability of a rating index on future firm performance has not been reached.

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.)

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 it from others. It seems to me that there is merit in concerns that boards have.

 


Shining a light on NHL governance and concussions

Hundreds of former players are suing the National Football League and equipment manufacturers for head injuries and other damage, saying concussion data was ignored by the league and it had a duty to protect players.

This litigation could be precedent for a similar lawsuit against the National Hockey League. Concussions and the associated neurological damage are a problem in Canada’s game – “the fastest game without an engine.” The players and equipment are bigger, faster, stronger and harder, but the rinks and rules of the game have not kept up. And we have credible medical evidence now that we didn’t have before.

For examples of concussion damage, see “Concussion numbers were staggering in NHL’s 2011 and 2012,” the YouTube video “Suffering in Silence: NHL concussion issue,” more press here and here, and USA Today’s “NHL concussion tracker” (with 100 pictures).

See just some of the medical evidence here, and Peter Mansbridge’s coverage of the “Brain Lab That Could Change Hockey.” And, as many hockey fans know, Sidney Crosby’s performance may never fully recover from hits to his head.

The question is, is the NHL’s Commissioner, Gary Bettman, listening? What about the board?

Sporting governance is shrouded in mystery. Transparency International, in “Corruption and sport: building integrity and preventing abuses,” writes,

“There is generally a low level of transparency in many sport associations when it comes to publicly sharing information and documentation. This often linked to the disclosure practices of team owners — who are often individuals or companies. This characteristic is troubling given the process for making internal decisions and conducting elections in national and international sport organisations. Board members of international federations as well as members of working committees are often expected to vote unanimously, with dissenting votes not registered in the minutes. Such practices prevent any real accountability, both for the boards and for sport in general.”

In analyzing boards, I scrutinize the governance practices of the organization, compared to best practice, and how decisions were made, or not made. Here are just some issues I see with the NHL’s governance:

  • Gary Bettman has been NHL Commissioner (which means “CEO”) since 1993. A tenure of almost 20 years for any CEO is highly anomalous. I would want to know the NHL Board’s plans for CEO succession, and whether it meets in closed session to discuss succession. I would also want to see Mr. Bettman’s position description, which is common now for CEOs.
  • Mr. Bettman’s salary was, according to the National Post, US$7.5M for the year ending June 30, 2010. It was 3.7M in the 2004-05 season. Here, I would want to know how Mr. Bettman’s salary and incentive structure is set by the Board, what the performance metrics are (e.g., expansion, relocation, revenue targets, growth rates, television and radio metrics, etc.), and whether the metrics and compensation are risk-adjusted, including health and safety. I would, in short, examine how Mr. Bettman’s compensation drives his behavior.
  • Every board has to identify and oversee risk. Here I would want to know the reporting and assurance protocols the NHL Board used and/or rejected for incorporating medical evidence for concussions in its oversight of management, rule-setting and strategy for the league.
  • Every board has to have a reporting and accountability structure independent of executive management. Here I would want to know why the Board meets only twice a year (see “NHL’s secret constitution revealed”), what independent directors sit on the board, what the reporting and decision-making structures are, how rule-setting occurs, and the independent assurance and internal controls over player safety and league reputation.
  • Lastly, I would want to know why there is minimal at best disclosure over governance on the NHL website. There are opportunities for development in this regard.

As the lawyers allege in their statement of claim suing the NFL:

“The NFL, like the sport of boxing, was aware of the health risks associated with repetitive blows producing sub-concussive and concussive results and the fact that some members of the NFL player population were at significant risk of developing long-term brain damage and cognitive decline as a result,” the complaint charges.

“Despite its knowledge and controlling role in governing player conduct on and off the field, the NFL turned a blind eye to the risk and failed to warn and/or impose safety regulations governing this well-recognized health and safety problem.”

We will see how this lawsuit plays out. In the interim, perhaps we might consider that the game might be better served by those who lead it coming to grips with advancements in medical research and what it is telling the sport about how the game is being played. Perhaps there are better governance practices in particular that could be put in place in order to help the game thrive in the future.

Labatt has a right to protect its brand and image

Let me defend Labatt for a moment. A media outlet – or anyone else – cannot as a matter of law publish a photograph containing a Labatt product or logo without permission of the trademark owner, and certainly not a photo with a Labatt product being held up by an accused killer whose picture is now recognizable all over the world.

The association and brand impairment is unambiguous when you see the picture. The accused is holding up the beer bottle tilted towards to the camera, where the Labatt label is front and center and unmistakeable. Labatt would be fully within its rights to seek an immediate injunction enjoining further publication of the photo and suing for monetary damages to its brand. I am surprised it has not done so already.

Labatt – and any other company – has the absolute right to protect the unauthorized publication of its trademark brand and image. For beer companies in particular, they spend millions of dollars in advertising and marketing. In the age of social media, where hashtags are a click away, satire and humor does not excuse the original impairment. The original publication could have been cropped or blurred out without the Labatt product appearing, or another photo could have been used. The fact is the beer, with the bright blue color and label, made the photo immediately more recognizable and viewed. It was included for this reason, with the media outlet with broad circulation trading on reputation and brand it does not own.

The Dodd-Frank Wall Street Reform and Consumer Protection Act ~ Significant Corporate Governance and Financial Services Changes Forthcoming

On July 15th, after passing the US House of Representatives, the US Senate passed, by a vote of 60 to 39, the Dodd-Frank Wall Street Reform and Consumer Protection Act.  The Act was signed into law by President Obama on July 21st.  This legislation (over 2,300 pages) is the most significant omnibus financial services and corporate governance legislation since the Great Depression.  Mary Schapiro, the Chairwoman of the Securities and Exchange Commission (SEC), called it a “giant step.”  Paul Volcker, former Chairman of the US Federal Reserve, said the bill “must be supported by more effective and disciplined regulation and supervision.”  The President remarked, “For years, our financial sector was governed by antiquated and poorly enforced rules that allowed some to game the system and take risks that endangered the entire economy.”

Here are some of the most significant highlights of the Act:[1]

  • “Say-on-pay” – Shareholders will have a right to a non-binding vote on executive pay and “golden parachutes” arising from mergers and acquisitions.
  • Proxy access – The Act affirms the authority of the SEC to create rules over proxy access (these are forthcoming).
  • Board leadership – Companies must disclose and explain whether the board chair is independent and separate from the CEO, as well as the structure of their board leadership.

  • Women and minorities – The Act creates an Office of Minority and Women Inclusion at each of the federal banking and securities regulatory agencies, to coordinate assistance, address diversity matters and seek diversity in the workforce of regulators.

  • Clawbacks – Companies must recover executive incentive pay derived from incorrect financial statements.
  • Compensation committees and compensation disclosure – Compensation committees must have fully independent members and advisors.  Committees must disclose the relationship between past compensation and company performance, and the ratio between the median annual compensation of all employees of a company, excluding the CEO, and the annual compensation of the CEO.
  • Oversight of compensation in the financial services industry – The Act requires full disclosure of incentive compensation.  Regulators can prohibit any incentives deemed excessive or that could lead to significant financial losses.

  • Hedging – There is to be full disclosure of directors’ or employees’ use of instruments to hedge against decreases in the value of the company’s shares.
  • Broker voting – Beneficial owners must consent for a broker to vote shares on their behalf.

  • Consumer protection – The Act provides for the creation of an independent Consumer Protection Financial Bureau with clearly defined oversight powers to develop rules and enforce them, to educate the public and, more generally, act in the interests of consumers.
  • Investor protection – The Act also provides for the creation of the Office of Investor Advocate and an Investment Advisory Committee for investor protection.  There is to be increased funding and resources provided to, and management reform of, the SEC, the creation of a SEC program whereby whistleblowers are incented financially to come forward (with the promise of 30 percent of funds recovered), and SEC authority to impose a fiduciary duty on brokers who give investment advice.
  • Derivatives trading – There is to be central clearance and exchange trading for derivatives that can be cleared, a code of conduct applied to swap dealers and participants, and enhanced market transparency and regulatory oversight for over-the-counter derivatives.
  • Systemic risks – The Act provides for the creation of the Financial Stability Oversight Council with expert membership and technical expertise.  There are strict rules for leverage, capital standards, liquidity and risk management.  Non-bank financial companies will come under regulation.  Finally, there will be the power to require large, complex companies to divest some of their holdings, subject to risk assessment.
  • Too big to fail – “Funeral plans” are to be submitted by large, complex financial companies to the Orderly Liquidation Authority and other regulators, and to the Treasury Secretary, who ultimately will determine whether the “failure of the financial company would threaten US financial stability.”  Orderly liquidation mechanisms (with judicial review) will provide for shareholders and creditors to bear losses and management and culpable directors to be removed.
  • Reform of the Federal Reserve – The Act provides for enhanced audit, transparency, governance and supervisory accountability of the Federal Reserve, the election of Federal Reserve Bank Presidents by elected and appointed directors who represent the public (not by members elected to represent member banks), and limits on emergency lending and debt guarantees to an individual entity.
  • Mortgage reform – Lenders are to ensure the ability of borrowers to repay.  Penalties are to be imposed for irresponsible lending.  Consumer disclosure is to be strengthened and consumers are to be protected from high cost mortgages.
  • Hedge funds – There is to be registration with, and trading portfolio disclosure to, the SEC and greater state supervision of hedge funds.
  • Credit rating agencies – The Act creates an Office of Credit Ratings at the SEC and requires the examination of “Nationally Recognized Statistical Ratings Organizations.”  These organizations are to have independent boards, disclose methodologies and track records, consider independent credible information, pass qualifying exams for personnel, institute continuing education, and address and disclose conflicts of interest.  The SEC is to create a new mechanism to prevent issuers of asset backed-securities from picking the agency that provides the highest rating.  Regulatory requirements for externally-sourced ratings are to be reduced and investors are to be encouraged to conduct their own analyses.  Investors are to have private rights of action against rating agencies.
  • Volcker rule – Proprietary trading by banks and investment in and sponsorship of hedge funds and private equity funds are to be prohibited, with small exceptions.
  • Credit card fees and scores – The Federal Reserve is to issue rules to ensure fees are reasonable and proportional.  Consumers are to have free access to their credit score as part of an adverse decision or action taken that is detrimental to the consumer.
  • Securitization – Companies selling mortgage-backed securities are to retain at least five percent of the credit risk and disclosure of the underlying asset quality is to occur.
  • Extraction Industry – The Act requires public disclosure of payments made to US and foreign governments relating to commercial development of oil, natural gas and minerals.

The above legislative changes are significant and far-reaching, affecting investors, consumers, credit rating agencies and financial services companies.  Several new and powerful regulatory offices are created, with recommendation and rule-making abilities yet to come.  The Act marks an end to regulatory deference to the financial services sector and signals a firm regulatory hand in this vital sector in the US.  There is no doubt that corporate governance practices in US financial services firms will need to adapt quickly to the new landscape.  Boards of non-financial firms should take note too as changes in this sector could signal further legislative and regulatory changes more broadly.


[1] Majority voting, interestingly, was not included in the legislation. Anne Simpson, head of corporate governance at Calpers, calls the lack of majority voting, coupled with proxy rules applied only to uncontested elections, a “big hole” in the Act. The Financial Times reports, “without majority voting [in the Act] to allow shareholders to remove incumbent directors, proxy access is next to worthless.”  See “Investing: Rules of Engagement” The Financial Times (July 11, 2010).

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