Boardroom evaluation

By Josef Fridman

What do the big hitters of business and accounting think of corporate governance today? some answers may surprise readers

It is easy to forget that business schools, even those that base their curriculum on the market-based, case-study method of teaching, really are institutions of higher learning. In the end, it really is all academic. Proof of this can be found daily when the whims and vagaries of the marketplace force CEOs and managers to throw away the book and to disregard previously accepted theory. For example, consider corporate governance, now widely regarded as the root of the corporate scandals of recent years. These failures revealed that many directors were asleep at the board table. They have also confirmed for all of us — insiders and individual investors alike — that a significant gap was created between the theory and practice of corporate governance.

In personal interviews with more than three dozen individual directors, chairmen and CEOs of some of the country's most widely held corporations, as well as members of the legal and accounting communities, I found a significant difference exists between the legal requirements of governance and the way it is actually practised. However, a common theme raised by the participants interviewed in my study was that corporate governance is in the process of reinventing itself and responding positively to many of the challenges raised. Examples of positive responses, it was suggested, can be found in the joint Ontario Securities Commission and Canadian Securities Administrators' Investors Confidence Initiative, as well as in the accounting profession's new independence standard.

Two of the identified challenges facing more effective corporate governance are what I refer to in the study as self-interest and funneling. Self-interest appears to have too often devolved into greed, or the greed factor, which could be described as certain parties serving themselves at the expense and in disregard of their obligations to others. The funneling syndrome is a concept that suggests material information, including independent advice from third parties, is controlled by management (that is, the CEO) ostensibly to ensure quality control, but that it may in fact be used to capture and to help predetermine, if not control, the outcome of decisions, including those made by a board of directors. In other words, greed and funneling are two elements that lead to breakdowns in corporate governance and unscrupulous behaviour by executives, directors and managers.

The interviews probed a number of roles, functions and issues at play in a traditional corporate governance structure, including those of chairman, CEO, directors, controlling shareholders and ordinary shareholders.

The chairman
There have been considerable calls for separating the position of chairman from CEO. Appointing a lead director would appear to be a less satisfactory attempt to respond to this recognized need. Therefore, it was not surprising to find that a strong majority of interviewees supported the introduction of a non-executive chair, a measure that would lead to more independent decision-making. While just less than half the interviewees thought appropriate mechanisms are generally not in place to deal with conflicts between the chairman and the CEO where these two functions are separated, a strong majority believed changes were required to make the position of non-executive chairman more effective. They also responded that effective checks and balances between these two vital functions — as well as between the board and management — did not exist. However, they thought these checks and balances could be effective only if the board is prepared to be constructively critical, something some participants suggested that new directors not entrenched by their own decisions could bring to the table. A majority of participants also thought the former CEO of a company should not be allowed to become its chairman. They said ineffective chairmen are often tolerated and almost never replaced.

The interviewees' characterization of the CEO as someone with an inordinate amount of power is consistent with the calls for the separation of the chairman and CEO's roles. For example, they recognized that the CEO plays an important role in the appointment and removal of directors and external auditors, as well as in deciding compensation.

The directors
In theory, directors are supposed to ask the tough questions and make the tough decisions. However, about half the people interviewed believed this does not always occur, mainly because of the directors' loyalty and close association with the CEO. As well, half of those interviewed believed directors do not take the time required to really understand the issues and to make a meaningful contribution. A strong majority favoured limiting the number of directors, having a minimum and maximum term, limiting the number of boards a director can sit on, and disallowing a retiring CEO from sitting on the board of the corporation from which he or she had retired. To enhance the boards' independence, respondents indicated that employees (other than the CEO) should be prohibited from sitting on boards of companies from which they retired, that professional advisers should not be allowed to sit on boards of their clients, and that directors should not be allowed to engage in consulting or other activities with the corporations on whose boards they sit.

On the issue of further aligning the interests of directors and shareholders, a majority of respondents said directors should own a meaningful number of shares (though meaningful was not defined), that granting of stock options to compensate directors is not appropriate, that crossboard relationships should not be permitted, and that directors should have access to outside, independent advice. 

The external auditors
The role of external auditors played a major role in the debate on corporate governance reform. A majority of interviewees thought the role of external auditors should be revised. For example, many felt external auditors should not be allowed to engage in consulting while serving as a client's auditor.

However, respondents believed external auditors are in the best position to provide tax planning and tax compliance advice and that a firm should be permitted to deliver both services to an audit client. A few respondents even volunteered that the limited number of major auditing firms made the rotation of external auditors quite impractical, favouring the rotation of the audit partner instead. Since the interviews were conducted, it has been suggested to me that these issues have been addressed by the OSC/CSA proposed rules and the CA profession's independence standard.

A majority also felt that external auditors are aligned with management and for that reason, about half the interviewees said auditors did not appear to make the tough calls other than in clear cut cases. While there are differing views on how to make external auditors more accountable to shareholders, a strong majority supported the idea of giving the audit committee authority to hire and fire external auditors.

The role of shareholders
Some successes of shareholder activists and the ability of shareholders to dominate or even disrupt annual meetings has created the belief that shareholders are winning back some control of a company from management. However, other than the expanding role of the institutional investor, with both the benefits and the challenges it brings, the notion that shareholder capitalism is gaining ground is mostly an illusion. Real power, for the most part, still rests in the hands of executives, a view a majority of those interviewed held and wished to perpetuate. In fact, for what they see as very practical reasons, most would not like to see shareholders given greater control as they believed it could lead to mismanagement.

The investment community
Nowhere is the lack of confidence in the workings of the capital markets — and corporate governance — expressed so clearly and strongly as it is on the role of the investment community and analysts. interview subjects painted all the players in the investment community with one broad negative stroke. Among the widely held views: the investment community does not act in a fair and responsible manner or in the public's best interests; analysts are not independent of the investment banking and underwriting groups; bankers do not avoid conflicts of interest; the investment community and analysts should be liable for their actions and should not be indemnified by the firms for which they act; investment analysts should be liable to the public for misleading information. Such negative perceptions strongly suggest that firm steps need to be taken to restore confidence in the players who are integral to the efficient operation of the financial markets.

Compensation
Executive compensation is arguably the most conspicuous component of corporate governance, and has been one of the main examples of abusive practices cited by critics. Respondents agreed with the widely held view that compensation is out of control. A recurring criticism revolves around the issue of how compensation is determined. For example, in addition to being determined by management, compensation is determined by reports delivered by independent compensation consultants who provide the board with independent and credible information as to what management should be paid. But, as most of those interviewed noted, it is management that selects the independent consultants, who in turn work with management to prepare guidelines to determine compensation. Yet despite their widespread concern that compensation is out of control, only a minority of the interviewees believed compensation should be subject to shareholder approval if above a predetermined limit. As one naysayer said, this would entail micro-managing and could lead to the wrong results for the wrong reasons.

Stock options
Options too have become a flash point for the discussion on corporate governance, and while a majority of those interviewed supported granting stock options to members of management, they also strongly opposed granting them to members of the board. Interviewees were unanimous that options should not vest immediately, and they expressed strong agreement that the total annual granting of stock options should be subject to shareholder approval and that stock options be long-term in nature and related to the performance of the corporation (adjusted to take out normal growth) so that payment is only made for above normalized growth. A strong majority believed that the current system of granting options encourages management to take short-term risks to maximize potential upside at the expense of longer-term value creation.

Disclosure
Earnings, especially the way they are disclosed, have long been one of the most controversial aspects of corporate governance. On this particular issue, there was almost unanimous agreement that earnings are indeed managed to meet street expectations, but most interviewees believed the methods used are legal and acceptable under GAAP.

A majority felt material information is not disclosed to all at the same time, and that meetings with analysts are a way of selling the corporation's vision of the future and gaining stock support. This majority felt executive officers should be held personally responsible for failing to release material information in a timely manner or for selectively disclosing material information.

Accounting
Based on the opinions expressed, it would appear that the accounting profession does not face an expectation gap, as has been suggested in Building Public Trust, by Samuel A. DiPiazza and Robert G. Eccles. Rather, the basis for the lost or diminished credibility of both accountants and auditors is the failure to respond to the information needs of shareholders in a clear, concise manner. In fact the majority believed the annual report does not add value for shareholders. With respect to reported income there was a strongly held view that recurring income should be clearly distinguished from one-time items and that related-party transactions should be expressly reported on by the external auditors to shareholders as a specific item of disclosure and not buried in the notes to the financial statements.

Liability
While a majority of those interviewed believed directors and officers should be held personally liable for the things they do wrong, the majority said director and officer liability should be capped. Even though the findings suggest whistle-blowing should be encouraged, the majority believed class-action lawsuits should be constrained, as the only real winners appear to be the lawyers.

Proxy solicitation
More than 70 years ago, in their seminal work, The Modern Corporation and Private Property, Adolph Berle and Gardiner Means noted that ownership attributes had migrated to the chairman and CEO from the shareholders. In the book, they noted that proxy solicitation was a tool of management. This apparently is still true today, as it is a view held by the vast majority of those interviewed. And though a majority narrowly agreed management solicits proxies in a fair and transparent manner, a clear majority supported the idea that shareholders be given more leeway in proxy solicitation.

The regulators and the governments
While the majority of those interviewed perceived a need for regulatory intervention to deal with the challenges facing the financial markets, some interviewees suggested governments and regulators should establish principles, rather than detailed rules, to govern the operation of the financial markets. Corporations would then have to manage under these general principles rather than seek to comply with or to circumvent specific rules.

Sarbanes-Oxley
A majority of those interviewed believed the Sarbanes-Oxley Act will improve corporate governance by holding corporate executives and accountants responsible to shareholders. This same majority, whose corporations are generally subject to both Canadian and US regulations, also supported introduction of similar legislation in Canada.

Based on the interviews and the answers to the questionnaire, it would seem that controlling shareholders, chairmen, CEOs and non-executive chairmen are viewed as the most powerful and influential individuals within the governance structure of a corporation. Shareholders, however, are not perceived as significant players and the interviewees see them, relatively speaking, as the equivalent of bureaucrats and low-level employees.

While many corporate governance experts and shareholder activists might consider this as unacceptable, the real issue is to determine if recently introduced changes, such as the Canadian Investors Confidence Initiative and Sarbanes-Oxley, will alter directors' and executives' views and behaviours and convince investors that the responses adequately protect them. The role of sound and effective corporate governance practices is primarily to ensure that the interests of shareholders — indeed the owners — of a corporation and its managers are aligned and that the interests of the first will not be sacrificed for the benefit of the second. However, effective corporate governance does not replace the need for sound management: the most efficient and effective corporate governance rules and practices will never, on their own, guarantee the success of a corporation.

The media
When Steven Brill, lawyer and founder of Court TV, started Brill's Content, a magazine about the media (now defunct), he said that when it came to having a regard for the truth, the media ranked right up there with lawyers: They had little regard for it. That belief, or perception, certainly has resonance among the group of people interviewed. Do the media accurately reflect the state of corporate governance? The answer: "No." Is the media an ally of the shareholder in dealing with problems in corporate governance? The answer: "More so than for the other potential interest groups." Is the press responsible in dealing with issues of corporate wrongdoing? The answer: "No." Even though a number of those interviewed remained neutral on the above questions, the overwhelming opinion of the media is negative.

Josef J. Fridman is a lawyer, chartered accountant, retired business executive and a corporate director. The questionnaire and interviews were conducted as research for his law doctorate thesis.