Corporate Governance
Renewal or Restraint?
Are the regulations contained in the new U.S. Sarbanes-Oxley Act a fresh start on the road to better corporate governance structures, or mere over-regulation of an already taxed industry?
FROM: MAR-APR 2003 ISSUE | BY JEFF BUCKSTEIN
The corporate scandals of 2002 have put not only corporate accounting practices under the microscope; the entire governance structure of many corporations has been called into question. This scrutiny has also thrust CGAs and other professionals into the thick of a serious debate on what changes need to take place in the Canadian corporate world.
Much of this debate centres on the U.S. Sarbanes-Oxley Act, tough new legislation passed last summer that sets fresh standards for corporate governance south of the border. Issues addressed within the legislation are audit committee composition and independence, enhanced financial disclosure and corporate fraud, to name a few. (See below, "Sarbanes-Oxley Snapshot .") The debate among business leaders in this country concerns the degree to which Canada should follow the legal and regulatory framework contained within Sarbanes-Oxley.
"I think [Sarbanes-Oxley] will be positive over the long run in that it will help weed out or limit those corporations that don't have appropriate measures in place," says Sandy Campbell, CGA, senior vice-president and chief financial officer at WestJet Airlines Ltd. in Calgary.
David Brown, principal of governance and board issues at the Conference Board of Canada in Ottawa, takes Campbell's thoughts a step further. "I believe that sooner or later corporations — and the leading ones are already recognizing this — will have to comply with the highest international standards. It's not so much a question of grudgingly complying with new mandatory standards, but voluntarily embracing a culture of leading governance practices, regardless of their country of origin," he says.
But Jack Smit, CGA, president and chief executive officer of St. Willibrord Credit Union in London, Ontario, fears the fallout from Enron, WorldCom and other recent high-profile scandals has sparked an overreaction. He cites the Sarbanes-Oxley provision requiring the chief executive officer and chief financial officer to sign off on annual and quarterly reports and material events as an example of unnecessary regulation of existing practices. "I shouldn't have to sign a disclosure form," he says. "All public companies and a lot of large private companies have for years given representation letters to auditors from management making disclosure about a number of things."
Calls for Independence
One thing many experts agree on, however, is that any discussion about corporate governance reform must centre on the composition of the board of directors and audit committee. Independence, whereby directors and committee members are not officers, senior managers or major shareholders of the company (or related to those who are), is a major theme in these arguments.
"My sense is there are very few standards that need to be mandated, but the two that probably need to involve the composition and skills of the board of directors as a whole and those of the audit committee," says Brown. "A lot of these other things — how many people should sit on boards, how often they should meet, how many committees boards should have, and whether the chair and CEO should be separated — should be voluntary," he adds.
Currently the Toronto Stock Exchange (TSX) does not require listed companies to have an independent board leader, although it does recommend that the board infrastructure consist of a director capable of running it independently of management.
A totally independent board ought to be the first priority of corporations that are intent on governance reform, says Smit, adding that this would set the tone for everything else when it comes to corporate governance. He cites as an example the fact that all of the board members at his own credit union are independent.
"The board needs to be independent and looking out for the well- being of the company and its shareholders. We've seen too many cozy relationships where management basically almost appoints the board of directors. That is not a healthy thing to do," says Smit, who is currently chair of the audit committee of the Credit Union Central of Ontario, as well as chair of the board of the Credit Union Central of Canada.
John Yuen, CGA, president, chief operating officer and a director with institutional money manager Lloyd George Management (Canada) Inc. in Toronto, also believes an independent board should serve as the foundation for an effective corporate governance model. "All the rules and regulations will be totally meaningless if we don't have the people to enforce them in the first place. You need individuals with the guts to stand up and speak and who are prepared to resign to protest against any actions by senior management. With the right people on the board of directors, I think half the [corporate governance] problem is resolved," he says.
WestJet is fortunate to have representatives from the Ontario Teachers' Pension Plan, one of the earliest, most powerful advocates of corporate governance reform, participate on its board, says Campbell, who attends all of the WestJet board meetings in his capacity as CFO. This has helped the company assemble a strong and independent audit committee even prior to the latest push for reform, he says.
The composition of the audit committee itself constitutes one of the most integral components of corporate governance. This vital committee, many experts believe, should have an independent director acting as its chair, with preferably all or most of the other members also independent.
It is also good practice to have the company's CFO report directly to the audit committee and not senior management to provide assurance they have the independence to take a tough stand against management accounting practices if necessary. In addition, it should be the committee — not management — that has the sole authority to hire and fire auditors. After Enron, the notion that audit committee directors should be understanding of and experienced in financial matters has also gained wide-ranging credence.
The TSX, for instance, issued revised guidelines last April recommending that all audit committee members be financially literate, that is, they should be able to read and understand a balance sheet, income statement and cash flow statement. It also recommended that at least one member of the committee have accounting or related financial expertise, with the ability to analyze and interpret a full set of financial statements, including the accompanying notes, in accordance with Canadian Generally Accepted Accounting Principles (GAAP).
Other important factors in a model of good governance that have received prominence of late include ensuring that members of the compensation or nominating committees are independent, and splitting the role of the board chair and chief executive officer.
"Many people do a fine job with the combined function because of the type of people they are. [But] I think it provides a healthier environment to separate the chair and the CEO role because they keep each other in balance, and that's better for the entity," says Wynne Powell, FCGA, president and chief operating officer of London Drugs Limited and other private, family-owned businesses in Vancouver.
However, Campbell points out that some of the potential negative effects associated with having a strong chair who also happens to be the president and chief executive officer, could be mitigated by having a strong and independent board that isn't afraid to challenge that leader.
Having a formal system in place to evaluate the performance of the overall board as well as individual directors may be key to ensuring a strong board and leader. On a couple of the boards Powell serves on, for instance, the chair along with other individual directors have all come under greater scrutiny. Not only is the propriety and technical accuracy of their actions closely examined, so too is the perception of how they will appear to the public shareholders and constituents the company represents, he says.
Powell also finds that board and key committee meetings are taking place more often and are considering a greater range of issues than in the past. In particular, the audit and finance committees have definitely stepped up in intensity now, he says.
Options to Disclose
Efforts to improve the disclosure of financial information, material non-financial events and governance practices, as well as provide greater transparency in general also rate highly among corporate governance experts.
Disclosure is a powerful tool for improving governance and enhancing public trust, says David Stewart-Patterson, senior vice-president of policy at the Canadian Council of Chief Executives (CCCE). He emphasized this position at a recent CGA-Canada Economic News Luncheon in Ottawa. "In the corporate sector, anything a company does anywhere in the world can have an immediate and real impact on its reputation everywhere. And greater transparency is critical to more effective accountability," he said.
Tied to this need for transparency is the issue of whether or not to expense stock options as part of executive compensation. In retrospect, one of the major corporate governance failures of the late 1990s stock market boom was that some executives were too focused on the short-term rise in value of the company's stocks for personal reasons — their own personal gains on their stock options.
The problem at companies like Enron and WorldCom, Yuen says, was that they did everything they could to make the next quarter's financial statement look good. "The very senior executives thought only in terms of their immediate needs. They wanted to make the financial statements shine and got a huge salary increase, large bonus and great executive stock options when the stock prices shot up," he says. "And for a very short period of time, everybody was happy — even the shareholders."
To prevent such abuses from recurring and, worse, being hidden from shareholders since stock options currently need only be disclosed as off balance-sheet items, Yuen sees a lot of merit in expensing stock options and including them on the financial statement. This is also advantageous from an accounting principle standpoint, he says, because it is a form of compensation analogous to a large salary increase, which would be immediately expensed to match corresponding revenue.
Smit agrees with expensing, but would prefer to see stock options done away with altogether in favour of management compensation that involves a direct stock investment up front and/or built up over time. "Management should accept the same risks as the company's ordinary shareholders and not enjoy the special privileges that options entail," he says.
Stewart-Patterson indicated that CCCE members agree there should be a strong link between executive pay and long-term performance. The organization has a number of suggestions, including requiring executives to repay all or part of their bonus if the company ultimately has to lower its original reported earnings, withhold a significant portion of stock bonuses until their departure or retirement, and keep a major portion of their after-tax stock option proceeds tied up in company stock for a minimum period.
CGA-Canada stated its position in support of expensing stock options in its submission to the Accounting Standards Oversight Council last September. The Accounting Standards Board is now considering amendments to CICA Handbooksection 3870, its rule on stock-based compensation and other stock-based payments. For its part, the Financial Accounting Standards Board (FASB) has recommended that companies in the United States start expensing stock options by early 2003. And a number of prominent corporations on both sides of the border have already announced their intention to do so voluntarily.
Campbell worries, however, that companies won't develop a uniform way of measuring such options. Already they're something of an art to calculate, and that's not about to change, regardless of whether they show up in a prospectus, as a note to the financial statements, or on the income statement, he muses, adding that despite suggestions about the merits of expensing options from a wide variety of experts, no standard method of measurement has yet been proposed.
Another related issue that has come to the fore involves making it mandatory for executives to own stock. After all, as Smit points out, since management is responsible for controlling the company's direction, why wouldn't they be willing to invest their own money and put it at risk in the pursuit of that vision?
But Powell disagrees. "I'd rather have an excellent director who cares about the outcome of the company, irrespective of his or her share ownership," he says, adding that the ploy could backfire if companies begin to hire on the basis of who has the best means to invest in shares.
Powell also opposes granting loans to executives, indicating that it isn't practiced within his own businesses. "In my view, when boards issue loans to staff persons, the employee becomes a debtor. And if they loan significant sums of money, boards may get themselves into the position of not being able to deal with a subject in a forthright manner because they've also become a creditor of that employee," he says.
Lessons in Accountability
Experts agree that there are no guarantees good corporate governance will remain a priority during the next bull market run. But they also suggest the implementation of greater board independence, compensation reforms and protection of shareholders' rights, particularly those of minority shareholders, will enhance the odds of the stock's long-term staying power, its sustainable value reflecting the company's true financial worth.
One of the tenets backing up corporate governance reform has been the push for more vigorous prosecution of and penalties for corporate crime, including insider trading.
"I think one of the challenges in Canada is that white collar crime is rarely accompanied by the sorts of punishments that any other form of crime would be [subject to]," says David Brown of the Conference Board. "I'm not a big fan of sending a lot of corporate executives to jail, but if we are to provide a disincentive against the wrong kind of behaviour, then we need to have some teeth in enforcement and securities regulations."
But Yuen, who until recently sat on the boards of a number of not-for-profit organizations in addition to participating on that of his own company, says, "We are taking a very narrow legalistic approach [by saying] 'If they do something wrong, put them in jail or raise the fines.' I think we're just treating the symptoms of the problem," he says.
WestJet's Campbell makes a similar point. "The liars and fraudsters will sign off on a stack of bibles that their financials are right and no amount of bureaucracy, sign offs or checklists is going to change that. At the end of the day, we're going to have to make sure officers, directors and auditors not only talk about, but also display, unquestioned levels of integrity," he says.
The root of many recent corporate maladies, Yuen believes, can be found in a lack of personal ethics — something that needs to be addressed by educators. "When everybody is enjoying good market returns, people don't care about corporate governance. They just want to make a killing. Consequently, education is the only long-term, viable solution to the issue," he says.
"If we do things right now, then in 10 or 20 years, we'll have a new crop of executive leadership [candidates] coming to the scene, [trained] in the good tradition of corporate governance and transparency, and educated in the core values of honesty and integrity. And then I think we will have a much better future," Yuen predicts.
Perhaps the legislation being put in place today may result in the better future Yuen speaks of. Currently, however, the debate over its need continues.
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Sarbanes-Oxley Snapshot
The Sarbanes-Oxley Act of 2002, passed by the U.S. Congress in July 2002, introduces legislation to enhance corporate governance for American public companies and Canadian companies listed on U.S. stock exchanges. For a complete copy of the Act, go to http://news.findlaw.com/hdocs/ docs/gwbush/sarbanesoxley072302. pdf . Following are some of the key stipulations contained in the new legislation.
Enhanced conflict of interest provisions: The Act prevents publicly listed companies from entering into new credit arrangements in the form of personal loans to their directors or executive officers. It also prevents them from extending existing arrangements or loans beyond the original terms.
Signed financial certification by both the CEO and CFO: It is now mandatory for the chief executive officer and chief financial officer of publicly listed companies to officially certify they have reviewed their financial statements, including annual and quarterly reports, and that these are materially accurate. The penalties for a false certification are harsh — up to 20 years in prison and/or a $5 million U.S. fine.
Reimbursement of bonuses under certain circumstances: If a corporation has to materially restate its profit downward due to misconduct, any bonuses received or equity profits realized by the CEO and/or CFO in the year preceding that restatement will have to be reimbursed.
Composition and role of audit committees: Corporate audit committees must be composed of independent directors exclusively. The committee will have exclusive jurisdiction for selecting, compensating and supervising corporate auditors. |
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Jeff Buckstein, CGA, is a freelance business writer living in Ottawa.