The road to good governance

By Carol Hansell
Illustration: Carey Sookocheff

Directors today may be facing a great challenge, but new regulations may make it easier for them to perform their duties

It is finally happening — a new phase in governance is dawning in both the United States and Canada. The Canadian "rules versus principles" debate in governance is being resolved. Canada's securities regulators (excluding BC's) are in the process of introducing rules modeled on aspects of the US Sarbanes-Oxley Act. The tension between the Ontario Securities Commission and the Toronto Stock Exchange may finally have exhausted itself, with the OSC drafting rules that would bring corporate governance disclosure under its regulation. And while there will be no regulatory action taken in connection with Bre-X Minerals Ltd., former Livent Inc. executives have been charged by the RCMP in connection with Livent's financial statements. Added to this are the court decisions in Repap Enterprises Inc. and Peoples Department Stores Inc. cases, as well as the OSC decision on YBM Magnex International.

Where does this leave boards of directors? There is no doubt that more is being demanded of boards — more time, more involvement, more accountability. While a great deal about governance developments of the past two years has made corporate directors' lives more challenging, some aspects of the new environment may actually make it easier for boards to perform their oversight function.

More rules mean more certainty
At times it can be difficult to be enthusiastic about the plethora of new rules and disclosure obligations relating to a public company's corporate governance. From a director's perspective, however, there is more certainty surrounding the decisions they are called upon to make. Here are some examples:

•  Director independence from a corporation's management is one of the most important themes in corporate governance. In most cases it is the board's responsibility to determine whether a director satisfies the independence tests. Many boards have struggled with whether the company's outside advisers or former executives can really be seen to be independent of management. When the outside adviser or former executive is a strong contributor in the boardroom and acts in an independent-minded fashion in dealing with management, the answer is not clear. Both Sarbanes-Oxley and the governance standards proposed by the TSX and the New York Stock Exchange are taking much of this discretion out of the hands of directors. "Bright line tests" have been adopted to prevent directors with certain current and past relationships from being classified as independent for regulatory purposes, no matter how independent-minded they are seen to be by their colleagues. As a result, some boards may lose experienced, thoughtful directors, but from the board's perspective the determination process is more straightforward, and from an investor's perspective it is more transparent.

Private and not-for-profit companies have more flexibility than public companies but should not ignore the question of independence. They should look at the bright line tests applicable to public company boards and determine whether they are relevant in their circumstances. They should then consider whether additional restrictions on the one hand, or exceptions on the other, may be appropriate in their circumstances in order to establish a board that will be able to serve the entity most effectively.

•  Many companies have had compensation committees in place for a number of years, largely because of securities law requirements that a report on executive compensation be included in an issuer's annual disclosure materials. However, there has been little guidance about what the committee should do. The relationship between the committee and the experts who advise it has been underdeveloped. In fact, in many cases, management retained and supervised the compensation consultants. Today, the importance of an independent compensation committee that has the authority to retain and hire its own advisers is more widely acknowledged. The NYSE is proposing rules that require listed companies to have a fully independent compensation committee with a mandate that includes reviewing and approving corporate goals and objectives relevant to CEO compensation, evaluating the CEO's performance in light of those goals and objectives and setting the CEO's compensation level based on this evaluation. This is useful guidance for boards and their compensation committee, whether or not they are listed on the NYSE.

More management accountability
Much of governance reform is about increasing management accountability. From a director's perspective, this introduces a framework for the oversight function that would have been difficult for most boards to create. For example:

•  Few if any boards would ever have asked senior executives to provide written comfort about the financial statements or about the corporation's internal or disclosure controls. CEOs and CFOs are now being required to certify financial statements and to confirm that they have designed or supervised the design of both internal and disclosure controls. This requirement already exists under Sarbanes-Oxley and is being introduced by securities regulators across Canada (with the exception of BC). It requires a reporting discipline that should support the oversight function of the audit committee and board in connection with their review of the company's financial reporting system and the statements it produces.

•  Codes of ethics and codes of business conduct are being strongly encouraged, in some cases mandated. Sarbanes-Oxley introduced a requirement for public companies to disclose whether they had a code of ethics in place for their senior financial officers. The US Securities and Exchange Commission broadened this to include CEOs. The NYSE is proposing that listed companies have a code of business conduct that covers seven important requirements. Although the TSX has been reluctant to impose much in the way of governance requirements, it is prepared to insist that listed companies adopt and disclose a code of business conduct. The process of developing and approving codes of ethics and business conduct provides the board with an opportunity to observe and influence the corporation's ethical framework. Monitoring compliance with these codes is an important aspect of the board's oversight function.

•  Much of the bite in Sarbanes-Oxley has come through the accountability and restrictions that it has placed on management. Prohibitions on loans, forfeiture by the CEO and CFO of certain bonuses and profits where the financial statements have been restated, sanctions for improper influence on the conduct of audits and prohibitions on insider trades during pension fund blackout periods address some of the types of conduct that many found so objectionable at Enron, WorldCom and others. They also support an overall culture of transparency and accountability.

Advice on the business judgment rule
The Repap decision (UPM-Kymmene Corp. v. UPM-Kymmene Miramichi Inc. 2002) provides helpful guidance for directors in the application of the business judgment rule. This decision dealt with an unusually generous employment contract awarded to the recently appointed board chairman. The arrangements included a five-year employment term with renewals; a signing bonus of 25 million shares; a stock option grant of 75 million shares; a market capitalization bonus; immediate pension credit of eight years; executive employee benefits; and generous change of control and termination provisions. When the compensation committee approved the arrangement, only two of the three members were present and the discussion lasted less than 10 minutes. The board devoted only 30 minutes to the matter before it too approved the arrangements.

While the nature of the action didn't lend itself to sanctions brought against the directors, the directors did receive a stinging rebuke from the court. The court found they didn't understand how the compensation arrangements worked, relied inappropriately on a highly qualified opinion from a compensation expert and generally had not discharged their duty of care in approving the employment arrangements. The court found the directors would not be entitled to rely on the business judgment rule because they had not exercised any business judgment.

Regulatory guidance on the duty of care The much-anticipated OSC decision in YBM was released in June. It dealt in part with whether YBM directors had met their due diligence defence with respect to a prospectus the OSC found not to include full true and plain disclosure. The OSC considered the actions of YBM's eight directors and sanctioned five of them.

In this environment, many expected a harsher decision from the regulator of Canada's largest capital market and consequently the YBM decision has been something of a relief for Canadian directors. Beyond that, however, some aspects of the decision will be instructive for both directors and their advisers. The detailed discussion of the directors' duty of care breathes fresh life into some long-standing principles governing directors' duties. For example, the decision acknowledges that directors are not obliged to give continuous attention to the affairs of the company they serve. However, the decision states, their duties are "awakened" when information and events that require further investigation become known to them. The decision also notes that more may be expected of inside directors than outside directors. A CFO who sits on the board may be held to a higher standard than one who does not, particularly in the context of a public offering. Sometimes more may be expected of certain outside directors, depending on the function they perform. For example, the decision states an outside director who serves on a committee may be treated like an insider director with respect to matters that are covered by the committee's work.

Like the analysis in Repap, the comments made by the OSC about the appropriate standard of conduct for a director in order to discharge his or her duty of care should be noted by directors in all sectors.

Directors' duties to creditors
Whether directors owe a duty to the corporation's creditors is an issue of continued uncertainty in Canada. Courts in other jurisdictions, including the US, have found there are circumstances in which such a duty does exist. However, there is no basis for this in Canadian law. Until recently, two difficult lower court decisions created the impression that the law here might be moving in that direction. However, this year the Quebec Court of Appeal reversed a lower court decision, the Peoples Department Stores case (see "Directors make mistakes," November Law), ruling the court had erred in finding the directors owed any duty to the corporation's creditors. Still, the issue hasn't yet been laid to rest. A recent ruling in the action against the former directors of Dylex Corp. has allowed the action to proceed to trial on the basis that it is open to the court to decide such a duty may in fact exist. Although, the Ontario court acknowledged the Quebec Court of Appeal decision, it went on to say: "It remains to be seen whether it will be followed in other jurisdictions or whether other Canadian courts will follow the lead of the British, Australia and New Zealand courts. Until this issue is finally resolved by the courts, directors can anticipate actions by unpaid creditors."

A similar sentiment was expressed a few months ago by an Ontario court. The Supreme Court of Canada will settle this issue, likely some time next year, when it considers the appeal in the Peoples case.

Where does that leave us?
The situation for boards of directors is different today than it was two years ago. However, thoughtful, diligent directors can discharge their responsibilities effectively without running the risk of legal liability. In fact, it may now be easier. Parliamentary and congressional hearings, legislative changes and new regulatory requirements have charted a clearer road map for directors. Those who discharge their responsibilities without self-interest and who follow the now well-defined course of diligence will be able to make effective contributions in the boardroom without fear of reprisal in the courtroom.

Carol Hansell is a senior partner with Davies Ward Phillips & Vineberg LLP in Toronto.