It was at a board meeting in the middle of 2009 that I finally lost it as a corporate director.
It had been a sometimes exasperating three years since I joined the board of directors of a small, TSX-listed manufacturer-let's call it XYZ Corp. What made this moment stand out was the response I got when I read a passage aloud from a two-year-old report on one of the company's factories.
The report observed that the departments at the plant communicated with each other so poorly that the place tended toward "disaster management only." Engineering, maintenance, quality control and the rest each did their own thing, coming together as a team only when there was a serious problem. But then there would be no plan to get production back on track once matters were under control. This pattern, the report noted, tended to lead to new problems erupting in other areas.
I then asked the CEO-who we'll call Smith-if things had improved. Smith admitted that, now, two years later, the problems at that facility had not been fixed. Well, top marks for honesty.
It was disturbing enough to learn that this situation had been festering for two years after XYZ had been told about it. But even worse, it soon became clear that the board was simply not going to hold CEO Smith, or anyone else, accountable for this mess.
This actually didn't come as a huge surprise. Alas, XYZ was a model of the lax corporate governance that plagues too many Canadian public companies.
Between its IPO and its sale to a competitor roughly a decade later, XYZ lost money in all but one year. The sale price was less than 4% of the IPO price. Over the final three years, Smith, who had been CEO since before the IPO, had terminated seven senior executives, each of whom had been with the company for less than three years.
But the board was never able to bring itself to seriously consider replacing Smith. I was not the first board member to try to bring about change at the top. It just couldn't happen.
Why? Because of the too-close relationship between board and senior management-the most intractable problem in corporate governance. It's something often framed in moral terms: Think of the outrage in the United States over monster CEO bonuses. But the costs go far beyond any affront to our values.
Suffer the little shareholders, to begin with. Boards that will not impose accountability on a CEO are rolling out the red carpet for financial underperformance.
And when workers see that the higher-ups are not held accountable for their missteps, it engenders a cynicism that over time can permeate an entire organization. If a workplace starts to resemble the anti-office of Dilbert, make no mistake about who is responsible: the board of directors. Ordinary employees deserve better.
On a larger scale, if companies are being run more for the benefit of management than shareholders, or if they are run poorly because cozy governance keeps weak management in place, it will involve the entire economy in a misallocation of resources and thereby make all of us-well, most of us-a little poorer.
The implicit message from directors to shareholders runs something like this: "Give us your money and we will represent your interests in an organization managed by people who have an incentive to steal from you and who we've known for years and with whom we confer regularly in private meetings. You don't get to attend these meetings or even get to know what goes on in them. In the meetings with management, we will set their level of compensation and then, with their approval, we will set our own level of compensation. Don't worry, the two processes are totally unrelated. No, you don't get to vote on the level of compensation for either them or us-and, yes, you will be paying for all of it. You can trust us because we're independent of these people with whom we've been conferring privately for years." It's almost like something out of a Kafka novel, with the shareholder in the role of the confused and doomed protagonist.
You might respond that the reality at most companies is not so bad as this caricature would suggest. But the egregious cases that do come to light illustrate a basic contradiction that all public companies must contend with: Boards have to fulfill two roles that can be hard to reconcile.
On the one hand, the board is the agent of the shareholders in the oversight of the company. From this perspective, the relationship between board and shareholders is like the one between lawyer and client. The interests of shareholders and management are not entirely aligned. While both will want to see the company prosper, the CEO might also like a $10-million salary-or maybe just the glory of building an empire financed by dilutive share offerings. The board's job is to keep the costs of employing management under control and otherwise keep management from putting their personal interests ahead of those of the company.
On the other hand, the board is also the governing body of the company and so has to interact with management extensively to understand what it is governing. So the board acting as agent must view management as something akin to a legal adversary, while the board acting as governing body must work with them as colleagues or even friends.
Alas, all too often boards let their friendship with management win out. A stunning example was Enron, which collapsed in 2001. A highly regarded board showed willful blindness for years, and on several occasions even waived the company's own code of conduct in allowing CFO Andrew Fastow to set up improper partnerships. Later, even after former chairman Kenneth Lay had been convicted of fraud, one director, Charls E. Walker, told The Washington Post that he still couldn't believe that Lay had ever known about the improper accounting. Touching.
The push for ever-greater board independence has long been at the centre of regulatory efforts to make boards work on behalf of shareholders. However, the project has produced mixed results, as experience at XYZ demonstrated.
At XYZ, there was a director-called Jones, for our purposes-who used the position's influence to get a job at XYZ for a significant other. Soon after, a meeting of XYZ senior executives heard from CEO Smith that this new hire "is coming on board and there'll be no questions asked." Some time later, Jones approached the head of human resources and attempted to have the significant other's salary increased.
Jones sat on XYZ's compensation committee and its audit committee. XYZ's public disclosures included a declaration that Jones, among others, was independent of management.
Obviously that declaration would require investigation. But even if regulators had found out about Jones's conflict, even if the entire matter had been made public, neither Jones nor CEO Smith would have been in any particular legal or regulatory trouble. At most, Jones might have been embarrassed to the point of resigning.
But the damage caused to the company by this conflict of interest may have been substantial. One of many issues was this: Jones played a role in the board's annual confidential interviews of senior staff. To whatever degree the story of the significant other was known among those staff members, the entire process would have been compromised.
This deed was easy to conceal, the consequences would have been mild if it had been discovered, and it was hardly a criminal act. Many things that happen in Canadian corporate high places are much, much worse. Yet this episode left Jones's "independence" in tatters.
When the subject of the annual option grant for executives came up at an XYZ board meeting in 2007, CEO Smith honourably volunteered to take a pass, as a way of taking responsibility for poor results. But a member of the compensation committee-who we'll call Brown-started arguing with Smith, insisting that it was "not right" that Smith take no options. XYZ's market capitalization was then under $20 million and the share price was down more than 90% from the IPO price, while Smith's base salary was approaching $400,000, up more than 60% from where it had been five years earlier.
I remember wondering what shareholders would think if they knew Brown was pushing the CEO to take more compensation than he was asking for. Recalling the board-as-agent role, this episode is like a lawyer sitting down with his client's legal opponent and telling her that she should ask for an even larger settlement than the one she's already accepted. Yet Brown met the TSX definition of independence.
Management and directors are in a position to help each other. Each controls, or strongly influences, the job security and compensation of the other. Even if directors are independent by any rule-based measure, the two sides can still drift into a kind of symbiosis. In nature, symbiosis just happens. The clown fish and the anemone serve the interests of each other very well, but it's not as if the two plan it out or are even aware that they have a mutually beneficial arrangement.
So, too, with many board-management relationships. We humans may have greater self-awareness than sea creatures, but we have also never been lacking in the ability to lose sight of our original purpose, especially when dealing with people we've known for years, all within a more or less closed community. It is a small step from symbiosis (the comingling of the interests of different parties) to groupthink (the comingling of the thinking of different parties). Unfortunately, both are all too consistent with a social environment that favours civility and consensus-building.
If nothing else, this reality should cast doubt on a box-ticking approach to independence. A common view is that if a company moves from having 60% of its directors independent to having 90%, then its governance has, by definition, improved. This attitude has done real damage. In the case of two boards I've been on, there were executives who would have made outstanding board members. But the rage for independence meant this could not happen. Both companies ended up with independent directors who had at best a vague idea of what was going on inside the company but had nevertheless convinced themselves that they knew what was best, and both companies suffered for it.
What annual general meeting would be complete without the slightly obtuse shareholder who drones on and on with his pointless question while the directors politely wait for it to be over? This, sadly, is what often passes for engagement between shareholders and the company they own.
Many companies are actually happy to talk about governance issues with shareholders but find them not to be interested. Scholars speak of shareholders as "rationally apathetic" regarding governance. Will small shareholders read the proxy circular? Will they understand it? Institutional shareholders may understand, but if you're a fund manager with 200 stocks in your portfolio, are you going to read each holding's circular so you can fuss about CEO pay being $800,000 instead of $770,000? Only in the most extreme cases is it going to be seen as worth the trouble.
Sky-high CEO compensation for unexceptional performance is the Scarlet Letter of lax board oversight. The practice of boards relying on compensation consultants has freed much CEO pay from market realities. Arcane methodologies built on self-serving definitions of CEO "peer groups" has led to CEO pay being ratcheted ever skyward.
This system is too entrenched for radical change to be likely. But governance organizations are trying to at least mitigate the damage by promoting greater shareholder influence on executive compensation.
The centrepiece of the effort to increase shareholder input is "Say on Pay," which allows a non-binding vote at the AGM on executive compensation. It has now been adopted by some Canadian companies, and it will help boards remember who they represent. But investors should understand that this weapon could backfire. Some executives are worth every penny of their bonus, and if shareholders reflexively vote thumbs-down on Say on Pay, they could end up initiating a poisonous standoff or even see executives hired away. Executive search firms will likely watch Say on Pay votes with the mindset of a hungry cat looking for an easy meal.
The beauty of Say on Pay is that its power is far more in the threat than in the execution. Boards may already be behaving better not because they are required to hold a Say-on-Pay vote but simply because they know it might be in their future.
The United Kingdom has been a leader in encouraging large shareholders to meet with independent directors and provide input on compensation issues. In Canada, the Canadian Coalition for Good Governance has proposed something similar, and has also floated the idea of electronic town hall meetings where independent directors could communicate with many shareholders. In either case, management would not be present. But these worthy ideas have not generated much activity.
The place to start this dialogue may be in the annual general meeting itself. Board meetings usually include a so-called executive session in which independent directors meet without management present and discuss CEO performance, compensation and possibly succession. There is nothing outrageous in the idea of an executive session within an AGM. After management's presentation and the Q&A, management would leave the room. What might then be discussed? If nothing else, the independent directors could report to shareholders on executive and director compensation-not in the form of tedious text buried on page 23 of the proxy circular, but face-to-face, in plain language.
If the CEO is worth $5 million per year, then let the independent directors explain why and answer related questions. Are executives truly paid for performance or simply according to some consultant's formula? Is there reason to think the CEO would leave if paid only $4.5 million? Many questions would be off-limits, but it's hardly as if independent directors would have nothing to discuss with their clients.
Next time you go to an AGM, if you think there is cause for concern, ask the CEO during the Q&A if management could leave the room for 15 minutes because you have a few questions to ask the independent directors concerning executive compensation, and point out that it would not be appropriate for management to be present for such a discussion. Don't be afraid. The meeting is for you, the shareholder. If the CEO gets defensive, that might be taken as a bad sign. If the independent directors get defensive, that could be taken as a really bad sign, because it would suggest that, in their hearts, they don't represent shareholders at all.
Shareholders have the potential to give to corporate governance the same gift that voters give to politics-the imposition of the test of common sense. As one corporate scandal after another has shown, you can put all the highest-paid experts together and end up with nothing more than a Humpty Dumpty that has no hope of being reassembled.
Of course, shareholders don't have any sort of sacred knowledge simply because they're the owners. They can be just as foolish as anyone else. But no one has their incentives better aligned with those of shareholders than shareholders themselves. And sometimes the clearest perspective on things comes from not being in the conflicted milieu of the boardroom.
Caveat Investor: When Governance Goes Bad
- Beware of any company where the CEO stays in place with high compensation for year after year of mediocre performance.
- Watch for the departure of any board member. If a company doesn't thank the member for past service, it probably means the parting was sour.
- Pay careful attention to acquisitions a company has made. This was another area in which XYZ's record was inglorious: Of four acquisitions made early in this decade, one was aborted, one was completed only to be shut down three years later at a cost of more than $4 million, and the other two took years to produce positive returns.
- Being able to acquire and successfully integrate a sizable target company is one of the toughest tests of management, and it's a good indicator of the board-management relationship. Toromont Industries is an example of a company worthy of praise on this score. Conversely, companies that acquire too much, too fast may blow up. Remember Dome Petroleum?
- Never underestimate the capacity for bad governance to destroy wealth. If the board stumbles repeatedly, yet insists on staying and cannot be removed, then it may be best to avoid the shares, no matter how cheap they look.