Over the weekend of 5 - 7 September we met, at the invitation of the Canadian Ditchley Foundation, at the beautiful rural resort of the La Sapiniere in Val David outside Montreal. Our objective was to look in the round at Corporate Governance against the background of some very public corporate scandals at a time of exceptional loss of shareholder value. This had led to considerable activity by Governments and legislators in an attempt to restore confidence. We were fortunate to have around the table participants with wide experience of finance, corporate management, regulation and audit, and especially fortunate in having two co-chairmen of such eminence to guide our discussions.
We looked at the present situation from the points of view of corporate governance generally, compensation and audit. Before doing so, however, we had an exchange of views to try to establish if there really was a crisis, and, if so, how widespread it might be. It appeared from public opinion polls that large multinationals were not trusted and that businessmen were close to the bottom of the league table. Those who were inclined to think that we were in a crisis pointed out that politicians were as unpopular as businessmen. If neither economic nor political leaders could command the trust and respect of the public, then something fairly fundamental was wrong. A recurring theme was the level of executive remuneration. It had risen from 44 to 1 as a ratio of executive to worker pay a few years ago to 300 to 1 in 2002. This was the issue to which the public most frequently referred when asked for their views.
Others urged a more cautious judgement. Care needed to be taken to distinguish between acts which were clearly illegal and acts of excessive self interest which were nevertheless legal or which “pushed the envelope” at the margin of legality. It was the nature of bubbles to see both rule bending in their build-up and recrimination after they burst. Market cycles were often followed by regulatory cycles. As far as institutions were concerned, we were living through a period when public trust in all institutions had fallen sharply. A comment was made that the problem was less acute in Continental Europe where a lower proportion of wealth was held in the stockmarkets. Some of us pointed to a link between the corporate sector and political interests – although it was noted that, in perhaps the most notorious of the corporate scandals, Enron, the Chief Executive had not been helped by his political contacts. Nevertheless, in an area where public perceptions were as important as the reality, we thought that Governments wished to be seen to be responding to public disquiet by being active, hence the stream of regulation and guidance in most industrialised countries. Political concern extended to the top. At the bidding of the G7 the OECD was engaged in revising its 1999 principles of corporate governance. This had thrown up the perennial problem of principles versus rules. Across such a wide spectrum of cultures and countries, including both Developed and Developing, it was virtually impossible to find specific rules which fitted them all. Principles allowed local interpretation and implementation while maintaining common objectives. The comment was made that it was better to satisfy your conscience than your lawyer. At the end of this exchange, although there was not unanimity on the description of “crisis”, there seemed to be wide agreement that there were serious problems which needed to be tackled. A balance had to be found which restored trust but which did not drive out entrepreneurial initiative. The cure should not be worse than the ailment. One participant concluded that, if what were clearly illegal acts went unpunished, it was hard to see public trust returning. The sound of a prison door closing needed to be heard.
In addressing corporate governance, we spent some time trying to ascertain whether there was a direct link between good corporate governance practice and shareholder value. No firm evidence was produced for this thesis, although there was some evidence which showed that good corporate governance could help to moderate some downsides. For example, studies showed that companies with well run audit committees had to restate their accounts much less frequently than those without them. A doubter voiced the view that where the CEO and directors’ interests were aligned with those of the shareholders, corporate governance would occur naturally and where those interests were unaligned, a strong and determined CEO would probably prevail. Enron was cited as an example of a company with excellent corporate governance principles and an impressive list of non-executive directors.
Nonetheless a number of us held the view that over the long term those who invested in companies with good governance would receive better returns on their investment. This raised the issue of long-term versus short-termism and the nature of the investor. Some of us had had experience of major institutional investors whose interest in governance was minimal and whose overriding concern was with the numbers in the quarterly returns (which were themselves criticised as abetting the short-term culture). The view was expressed that institutional investors, who were more share-owners than holders, should also have governance practices on issues such as voting on corporate questions and that these practices should be made public.
Whatever the view from within the corporate and institutional worlds, there was a general recognition that from a political and public policy point of view, both corporate and government leadership needed to be seen to be tackling the problem. Corporate leaders would also do well to acknowledge the need for some corrective action in order to contain any tendencies to hysteria and over-reaction which could lead to damaging over-regulation.
We attempted a definition of corporate governance and some of us thought it referred to how a company could operate effectively and appropriately under the existing laws, regulations and guidance to the longer-term benefit of shareholders and stakeholders. We thought that it needed to take account of the unique cultures of both companies and countries and therefore a single set of rules could not apply - one size could not and would not fit all. The objective of governance was to protect shareholders from the opportunity costs associated with management ineffectiveness and ineptitude and the “agency costs” associated with illegality or other issues such as control of information not available to the full board, shareholders or the public, and as a means of mediating the problems of conflict of interest. One participant expressed the view that the cornerstone of good governance was the independent directors fulfilling their fiduciary duty. While this was not contested, several voices expressed caution that not too much should be expected from the non-executive directors. Marconi was an example of failure by non-executives to control a powerful chairman/CEO. Their role was obviously important and they should be called on to exercise both their judgement and, where necessary, resolve in facing management but they could not, on their own, deliver governance.
A number of recommendations were made, with the caveat that they were just that and should not become regulations given the diversity of the market place to which they might apply. Many of us thought that the roles of Chairman and Chief Executive Officer should be separated. This would provide a mechanism which would allow the board to operate independently of management. The Chairman should be able to set the agenda of board meetings and ensure that the board received all the necessary information it needed. This would help to prevent a CEO avoiding difficult issues and controlling the flow of information to the board. The Chairman should run the board and the CEO, the business. Some argued against such a separation, citing experience of a single strong CEO leading a corporation to success. Others thought that the tide was running in favour of separation, even in the USA where a generational change in corporate leadership was under way. Reference was made to practice in Germany where the division between supervision and management was at its clearest. The point of view was expressed strongly that, where a Board decided not to split the functions, then a public explanation should be given: comply or explain. And where there was no separation then there should be a strong representative or presiding independent director. In addition, it was suggested that non-executive directors should meet separately from executive members on at least two occasions annually. Great emphasis was also laid on disclosure and transparency. One of the best ways to ensure that governance was taken seriously would be for corporations to develop, from the existing body of principles and rules their own code of corporate governance and publish it as part of the regular process of proxy reporting to investors and regulators.
In terms of the structure of boards, a preference was expressed that at least 50% of directors should be independent of management. Once appointed, however, Directors should be properly inducted into their roles and continuing education should be required as part of the regular schedule of the board. We discussed what qualifications directors should possess but thought it unwise to be specific. This could best be judged by shareholders and stock-exchanges during the appointment process. We were not in favour of setting fixed terms for directors, which was more properly, we thought, a matter for shareholders. A good director could remain independent and valuable for more than 10 years contributing to organisational memory and continuity. On the other hand, mechanisms needed to be put in place for retiring ineffective directors without delay. Boards, however, needed to be refreshed on a regular basis and this, it was suggested, applied in particular to the Chairman of the Board and the Chairmen of the various committees of the Board. Retirement by 70 in Britain and Ireland was noted. Most of us were, however, opposed to age restrictions for directors as long as the appointment process was robust. Finally, in addition to the normal practice of the CEO being nominated by the full board, there was support for the view that new executive directors to the board should be nominated only by the independent directors.
We spent some time considering the vexed question of remuneration against the background of press and public criticism of “fat cat” pay and “rewards for failure”. There were those who thought this was an issue which should be regulated with care, predominantly by Boards with the market as a final arbiter. Regulation could, as it appeared to have done in the USA, lead to unintended consequences. The question was, however, asked as to why executive pay had risen so dramatically. One senior participant maintained that he was unconvinced that CEOs were now ten times more effective than their predecessors. Transparency was seen as essential. Investors should be kept fully informed. But a corollary could be that once salaries were firmly in the public domain there might be a “race to the top” by other CEOs which would need to be controlled. Some of us recommended that any further regulation should be dependant on an evidence-based assessment of the need for it and an examination of the effects of current regulation to determine its success or failure. In an explanation of “reward for failure” it was claimed that many such cases arose where a CEO had been recruited to try to turn round a failing firm. Without some assurance about their own financial future such people would not take on these high-risk operations. These exceptions apart, the problem was acknowledged. Transparency about salaries and approval by shareholders seemed the best response.
In our discussion of compensation we came to the thorny problem of stock-based incentives, in particular stock-options. The latter were described as the root of all evil by one participant and by another as a perverse incentive that had done much to drive a wedge between the interests of CEOs and directors and their shareholders. Others argued, from the point of view of start-up firms or those operating in certain high-tech or communications sectors, that stock-options were a reasonable way of incentivising senior management. If they were expensed, they could make a serious impact on the bottom line. And commented another, if they were expensed when issued and then never taken up, the accountants had no clear answer as to how to remove them from the accounts. Notwithstanding this, there was support for the view, that while share-options might have a role to play in certain specific situations, in general they could lead to distorted behaviour. Some thought that mega-options were the most objectionable and that all share-options should indeed be expensed at the time they were granted. It was suggested that if the interests of the directors and other employees needed to be aligned with the shareholders then a straight grant of stock might raise fewer problems. This led to a discussion about investors and speculators. Investors were there for the long term and speculators strictly for the short. A former Chairman commented that in his view, the directors’ responsibilities were to the company and its long-term future and not necessarily, in the first instance, to the shareholders. We were told of companies where stock had been allocated right down the line to all employees in proportion to their salaries. Some of us thought that an important test of alignment would be investment by executives in the company’s stock. Nominating committees might, we thought, encourage new directors and senior executives to invest their own money - and to consider the implications of a refusal to do so. A word of warning was, however, expressed about heavy pension plan investments in the shares of the parent company. Greater diversity was desirable for such critical long-term instruments.
In our look at audit we considered its three fundamental dimensions - governance functions, in particular, the audit committee; accounting and auditing rules and practices; and the independence, role and culture of the auditing firm. Together with law firms, auditors were among the most important of the gatekeepers in the market. It was essential that investors should be able to rely on their judgement and integrity. Great importance was attached to the role of the audit committee which should be independent and staffed by the independent directors, led, we hoped by an independent Chairman of the Board who could strengthen the committee functions by ensuring that the Committee and the Board received the information they needed. Another important function of the committee was to create a direct channel of communications between the external auditors and the Board. The hope was strongly expressed that there would be convergence of accounting standards around the world to reflect the requirements of the globalisation of business and capital markets. Such convergence should, we thought, ideally take place on the basis of the profession’s own efforts. We noted the role of the International Accounting Standards Board as the standard setter. Some expressed real concern that, under prompting by France, the EU might seek to exercise political pressure on the outcome. If this proved to be the case, warned a US participant, the SEC would be bound to weigh in on the other side. In achieving effective disclosure, the role of financial analysts was raised. They, unlike auditors, were not subject to regulation or professional discipline. If rules and generally accepted standards were important, so also, we thought, was enforcement. Reference was made to the lack of resources at the SEC to ensure compliance. We were advised that consistent accounting standards, implemented and enforced uniformly were the best means of protection.
We also looked at the role and responsibilities of the individual audit partner. Possibly the single biggest influence on the audit process was the quality and character of the person conducting the audit. Willingness to stand up to powerful management and say “no” was essential but difficult given that audit partners’ jobs were sometimes thought to depend on their audit clients not moving their accounts. This independence should, we suggested, be fully supported by the audit committee and be recognised in the remuneration of the audit partners concerned.
Concern was expressed over the reduction of large auditing firms from 5 to 4, with the demise of Arthur Anderson which had high-lighted the problems caused by the drive to provide non-audit services. Although the big 4 had now divested themselves of their consultancy businesses, it still seemed to some of us to be reasonable and cost-effective for them to provide some non-audit services, like taxation advice. But if the 4 were to be further reduced to 3, and some thought the risk was real, choice and competition would effectively be ruled out, prompting government intervention. Even in present circumstances, according to one participant, there was effectively little or no choice, given the differing expertise of the big 4 and their relationships with possible competitors. We noted the practice in France where all corporate accounts were audited by two firms, usually one large and one small. This had helped to maintain diversity and choice.
The question of auditor’s liability came up. Engagement letters which sought to limit this were regretted but thought essential given the otherwise open-ended nature of the liability. If, however, auditors wanted a cap on their liability then it was argued they should do a more thorough job. They had, after all, failed to identify discrepancies of billions of dollars in some of the highest profile cases. This led us to the practice of some companies trying to reduce their costs by doing an audit “on the cheap”. If auditors were to be asked to do more, they should receive realistic fees for the work done. Audit committees should assure themselves that fees were set at proper levels.
In a look back at the ground we had covered we asked ourselves if the policy response to recent events had been adequate and likely to restore the legitimacy of the markets with the public. Unlike previous “crises”, this one had not been precipitated by a failure of the Banks or other financial institutions. It had been triggered in the board-rooms which had, it was suggested, been exposed to problems caused by share-options. Incentive schemes needed to be established which had legitimacy with the public. The comment was made that markets and those who worked with them were motivated by carrots and sticks. At the moment the stick seemed to be the preferred instrument of influence. Capitalism was a messy business. It was not possible to take the risk out of it. Quotations from Lord Keynes and Edmund Burke were adduced in favour of constructive imprecision to allow for this “messyness”. The major audit firms had, it was claimed, caused some of the problems by franchising their names around the world without ensuring uniformity of quality in their service. With the accent on the split roles of Chairman and CEO, the independence of the audit committees etc, concern was expressed, by one participant, that boards were becoming less unitary with a corresponding diminution in their effectiveness. Nonetheless, in a final round on two of the key issues - Independent Chairmen and CEOs and stock-options, a majority seemed to rally to the desirability of the former with the onus on those not so doing to explain why they were not splitting the roles. On the latter a view was strongly expressed by a number of us that it would be preferable not to use them, but if exceptionally they were, they should be carefully circumscribed and subject to a public explanation of why they were being issued. Overall, we were again cautioned against encouraging the impression that legislation had taken the risk out of markets. Investors needed to be reminded of their own responsibilities for assessing risk.
I am grateful to Canadian Ditchley for the admirable arrangements they made for our conference and for financing it so generously. My thanks go also to Pierre Lortie and Paul Volcker for chairing our discussions and contributing their own wide experience to them. I am grateful to the participants for sparing the time from their busy schedules to be with us, some from a considerable distance and to Francis Finlay for his contribution which assisted the travel of the group from Heathrow. The comment was made at the conference that in four or so years’ time we might know better if the recent measures taken had proved effective or whether memories had, once again, proved short and the same problems were on their way back. It is a subject to which Ditchley will need to return.
This Note reflects the Director’s personal impressions of the conference. No participant is in any way committed to its content or expression.
Mr Pierre Lortie
President and Chief Operating Officer, Bombardier Transportation (2000-); President and Chief Operating Officer, Bombardier Capital (2000-); President, Bombardier Regional Aircraft Division (1993-00)
The Hon Paul A Volcker
Chairman, Board of Governors, Federal Reserve System (1979-1987); Chairman, James D Wolfensohn Inc (1987-1996); chair, International Accounting Standards Committee; Emeritus Professor, International Economic Policy, Princeton University
Mr Jim Baillie
Counsel, Torys LLP; non-executive Chair, Independent Electricity Market Operator (Ontario) and Corel Corporation; Director, Sun Life Financial Corporation; a Director the Canadian Ditchley Foundation
Mr David Brown
Chair of the Ontario Securities Commission (1998-)
Mr Derek Burney
President & CEO, Member of the Board of Directors Corel Corporation
Mr Terance Corcoran
Financial Editor, National Post (1998-); Formerly MD, Executive Editor and Editor the Financial Times Canada
Mr Raymond Garneau
Chairman, Industrial Alliance Insurance & Financial Services (2000-); President & CEO Industrial Alliance Life Insurance Co. (1988-2000); Member of Parliament Laval-des-Rapides (1984-88); National Assembly, Minister of Finance, President Treasury Board (1970)
Mr Jan Grude
Advisor to boards on corporate governance
Mr Bob Hamilton
Assistant Deputy Minister, Financial Sector Policy Branch (1996-); General Director, Financial Sector Policy Branch (1995)
Mr Claude Lamoureaux
President and CEO Ontario Teachers Pension Plan. Formerly: President & CEO Metropolitan Life Holdings, Vice President of group insurance and Vice President of pension and financial services Met Life, USA
Mr David Longworth
Deputy Governor, Bank of Canada (2003-); Adviser to Governor Bank of Canada; Chief of Research, Chief of Monetary and Financial Analysis, Bank of Canada; Deputy Chief, International Department, Bank of Canada
Dr Mike Maila
Bank of Montreal (1983-): Executive Vice-President and Head of Risk Management Group (2001-); a Director and Treasurer, Canadian Ditchley Foundation
Mr Roger Martin
Dean of Joseph Rotman School of Management, University of Toronto (1998). Chair, Ontario Task Force on Competitiveness, Productivity and Economic Press
Mr John McNeil
Director and Chairman of Executive Committee, Sun Life Assurance Company of Canada, Chairman and Chief Executive Officer, (1988-99); a Director, Canadian Ditchley Foundation
Mr Grant Reuber OC FRSC
President, Canadian Ditchley Foundation (1989-); Senior Adviser and Director, Sussex Circle (1999-); Economic Adviser to Prime Minister of Lithuania (1991-92); Bank of Montreal: President (1983-87), a Governor, The Ditchley Foundation; President, The Canadian Ditchley Foundation
Mr Willliam Robson
Director of Research, C D Howe Institute; Canadian Liaison Officer, British-North American Committee; author
Mr David Smith
President and CEO of the Canadian Institute of Chartered Accountants (2001-); Chair and Senior Partner of Pricewaterhouse Coopers Global Board Member
Ms Barbara Stymiest
CEO, Toronto Stock Exchange Group; Board Member, TSX Group, World Federation of Exchanges,Business Development Bank of Canada, Public Policy Forum
The Hon Michael Wilson PC
President and CEO, Brinson Canada Co; Chairman, Michael Wilson International Inc (1994-); Member of Parliament (1978-93); former Minister of Industry Science and Technology, Minister of Finance and Minister of International Trade
M Philippe Lagayette OLH
Chairman, J P Morgan et Cie SA, Paris (1998-); Head of Staff, Economic and Finance Ministry (1981-84); Deputy Governor, Banque de France (1984-92); Chairman, Caisse des Depots et Consignations (1992-97)
FEDERAL REPUBLIC OF GERMANY
Herr Wilhelm Bonse-Geuking
CEO, Deutsche BP AG, Group Vice President Europe
The Rt Hon Donald Johnston PC QC
Secretary General, Organisation for Economic Cooperation and Development (1996-); MP for St. Henri-Westmount (1978-1988); Minister of Justice and Attorney General of Canada (1984); Minister of State for Economic Development and Technology (1983)
Mr Tullio Cedraschi
President and CEO, CN Investment Division (1977-); Director, Toronto Stock Exchange, Helix Investments (Canada); Chairman McGill Investment Committee
Mr Ashish Bhatt
Deputy Director, The Ditchley Foundation (2001-); formerly: Special Assistant to The Rt Hon Paul Boateng MP (1996-2001)
Sir Nigel Broomfield KCMG
Director, The Ditchley Foundation (1999-); Non-executive Director, Smiths Group plc (1998-); formerly: HM Diplomatic Service (1969-97)
Mr Jeffrey Coorsh
Chairman and Executive Officer, PCG (Pragmatic Corporate Governance) (2001-); Board Member, Centurion Press Publishing; co- founder, Prospect Magazines; Independent Director and Chairman, Steering Committee of European Business Forum; formerly: Chemical Bank (now Chase) New York, London
Mr Roger Davis
Global Regulatory Leader, UK Head of Professional Affairs, PricewaterhouseCoopers (2000-); Deputy Chairman UK Turnbull Corporate Governance Committee (1999); UK Government Company Law Consultative Committee (1999-2001)
Mr Anthony Gilbert
Group Management Development Director, Vodafone Group Services
Mr Ian Hay Davison
Chairman, Regulatory Council, Dubai International Financial Centre
Mr David Lillycrop
Director and General Counsel, Smiths Group plc
Mr John Plender
Leader Writer, Financial Times
Mr Ken Rushton
Director Listing, Financial Services Authority
Mrs Barbara S Thomas
Executive Chairman, Private Equity Investor Plc; Deputy Chairman , Friend's Provident Plc; Director CapitalRadio Plc, UKAEA and The Energy Group of The Department of Trade and Industry; formerly, Commissioner US Securities and Exchange Commission; Executive Director, News International Plc and Samuel Montague Plc. A Governor the Ditchley Foundation
Ms Anne Willcocks
Director, Corporate Law and Governance, Department of Trade and Industry; Director Higgs Rview of Non-Executive Directors (2002-3)
UNITED STATES OF AMERICA
Mr Thomas Donlan
Editor, Editorial Page, Barron's National Business and Financial Weekly (1992-); Washington Editor (1981-91); author
Mr Francis Finlay
Chairman and Chief Executive Officer, Clay Finlay Inc. (1982-); formerly: Head of International Investment Department, Morgan Guaranty, New York; Member, International Advisory Board of EURONEXT and Dubai International Financial Centre; a Director, American Ditchley Foundation
Mr Hoffer Kaback
President, Gloucester Capital Corporation; former Director, Sunshine Mining and Refining Corporation, Lewis Galoob Toys, Biotechnology General Corp
Mr Bevis Longstreth
Retired partner, Debevoise & Plimpton, New York; Commissioner, Securities and Exchange Commission (1981-1984); member, Panel on Audit Effectiveness, Public Oversight Board (1999-2001)
Professor Jeswald W Salacuse
Henry J Braker Professor of Commercial Law, The Fletcher School of Law and Diplomacy, Tufts University (1986-); Dean, The Fletcher School (1986-94)
Dr Richard F Syron
Executive Chairman, Thermo Electron Corporation (2002-); Chairman and CEO, Thermo Electron Corporation (1999-2002); Chairman and CEO, American Stock Exchange (1994-99); President and CEO, Federal Reserve Bank of Boston (1989-94)
Professor Mr Lynn E. Turner
Professor and Director, The Centre for Quality Financial Reporting, College of Business