Canada's largest companies have made major improvements to their corporate governance practices in the past year, driven by new U.S. regulations and growing pressure from shareholders for greater accountability. A comprehensive Report on Business study of Canada's most prominent boards has found improvements across a range of issues, including more independence of directors and more thorough disclosure of board practices.
The study looked at 207 companies in the benchmark S&P/TSX index Canada's largest public companies and examined a wide range of key governance factors, including board independence from management, share ownership by directors, stock option programs and the quality of board practices such as director assessments.
The study also included new categories that were not assessed in the ground-breaking 2002 review, including the quality of executive compensation disclosure and the presence of women on boards.
Scores improved for more than two-thirds of companies in the study, with the average mark climbing to 66.5 out of 100 from 61.7 for the same group of companies last year. And scores would have risen even more significantly, and for more companies, if ROB had not introduced tougher new marking standards in its 2003 review.
Indeed, the demanding new marking standards caused some companies' scores to drop in 2003 from 2002, even when there was no weakening of the company's governance practices.
Although there have been widespread improvements, major institutional shareholders say governance work is far from complete, and too many companies still demonstrate weak practices. For example, the study found that 58 per cent of Canada's largest companies that make up the S&P/TSX index do not have both independent compensation and nominating committees the key committees that set executive pay and recruit new directors. As well, 58 per cent of companies do not require their directors to own shares in the company, and 25 per cent of companies have excessive potential stock option dilution, more than 10 per cent of outstanding shares.
"I don't think we're there yet," said Claude Lamoureux, chief executive officer of the giant Ontario Teachers Pension Plan Board, one of Canada's largest institutional shareholders. "You still have these abuses. I don't think that it's over."
Responding to continuing pressure for reform, regulators in Ontario have said they will introduce a set of new governance guidelines for major companies, including a new definition of director independence. Ontario Securities Commission chairman David Brown said the new guidelines will supplement mandatory audit committee standards unveiled in June.!
Royal Bank and TransAlta tops
Similar to last year, two companies tied for first place in ROB's 2003 study, with Royal Bank of Canada and TransAlta Corp. both earning a score of 94. TransAlta, a Calgary-based electricity utility, also tied for first place last year, while RBC moved up the rankings because of significant changes to its practices. Among its improvements in 2002, the bank introduced high ownership requirements for directors and executives, and improved its stock option program. RBC is also considering further changes this year, said chairman Guy Saint-Pierre.
"Even though other people over the years have said that we've done well, we've never been satisfied to say what we do is perfect," Mr. Saint-Pierre said.
At the other end of the spectrum is Markham, Ont.-based CoolBrands International Inc., which ranked the lowest in the study with a mark of 30. According to the company's most recent shareholder proxy circular, CoolBrands has just one independent director on its board, while all other directors are members of management. As well, executives of the ice cream treats maker also sit on all the board's committees, including its audit and compensation committees. The company also has unequal voting rights with its dual-class shares and high stock option use, and it offers scant disclosure of key information such as director attendance and payments to its outside auditor.
"We are clearly a company where management is heavily involved in the corporate governance of the company," said David Stein, president and co-chief executive officer.
"The world of corporate governance is a rapidly evolving one and as we grow ... we will be reviewing our corporate governance practices and making sure that they are adequate to the state and size of our business."
CoolBrands was not assessed in 2002 because the company was not part of the S&P/TSX index at that time.
Perhaps most striking in 2003 are the companies that have made dramatic improvements in their practices in the past year, driven by the U.S. regulations and shareholder pressure for stronger practices and increased scrutiny from other parties such as rating agencies.
Toronto-based FirstService Corp., for example, saw its mark climb 29 points this year to a total of 69 after the company undertook a broad study of all its governance practices and implemented a slew of reforms. FirstService chairman and CEO Jay Hennick said the company's reforms were partly in response to Sarbanes-Oxley, but in the end went beyond what was required.
"We've always believed we're a strong corporate governance organization. If somebody says, 'Is there anything you can't do,' I say, 'No, we'll do it all.' With the exception of two or three things, we've done everything," Mr. Hennick said.
Although some Canadian companies trading in the United States are exempt from some of the new regulations, experts say many of them are nonetheless adopting the higher standards. Governance consultant Beverly Behan of Mercer Delta Consulting said many Canadian companies that do not even trade in the United States are also aligning themselves with the U.S. benchmarks.
"If you are listed on an American exchange, or even if you are competing in a North American capital market, you're going to be judged on similar standards," Ms. Behan said. "It is not a particularly good idea to just say 'Hey, I'm different,' because you're going to be held up to the same standards."
U.S. reforms drive improvements
The ROB study shows that some of the areas of greatest change in Canadian practices mirror the reforms in the Sarbanes-Oxley Act, the new U.S. legislation. For example, many companies have stopped providing loans to their executives, which is now banned under the act, and many have made changes to their audit committees to make them fully independent of management.
Also this year, companies are providing more information about the relationship their directors have with the company, often referring to the tougher New York Stock Exchange definition of independence in their disclosure.
ROB's survey also shows improvement in other areas. For example, in the category of board composition which assesses factors such as board independence from management, independence of key committees, the quality of director performance reviews and the frequency of board meetings held without management present companies posted an average score of 26.5 marks out of 40, compared with an average of 25.2 marks out of 40 in 2002.
ROB applied its own strict standard of independence in its assessment, and did not rely only on companies' own definitions. Report on Business called directors "related" to the company if they are management, former members of management, relatives of senior managers, or parent company representatives on a subsidiary board. ROB also called directors related if they or their firms provide professional services to the company, such as lawyers, bankers and consultants.
The largest gains were made in the area of disclosure, with the average rising to 9.9 out of a maximum of 15 points, compared with an average of 6.4 points in 2002. In the disclosure category, the study looked for full statements of corporate governance practices, as well as details about director independence, auditor pay levels, director attendance and the frequency of board meetings.
Over all, 18 per cent of companies scored more than 80 marks in the 2003 study, while just 9 per cent scored more than 80 marks in 2002. Even more important, just 13.5 per cent scored below 50 points in 2003, compared with 24 per cent of companies falling below 50 marks last year.
"The feeling of our members is that we've made a start on this, and we're encouraged by the progress," said David Beatty, managing director of the Canadian Coalition for Good Governance, which represents 23 of Canada's largest institutional shareholders. "But there's still a long way to go. There are companies that still haven't caught up with the fact that governance is an important component now of investor decision making."
ROB developed its marking system to reflect industry "best practices," hoping to create a gold standard of corporate governance criteria. The marking system goes far beyond regulatory requirements, reflecting the highest standards set by various institutional investors and other governance experts.
That said, many companies argue that there is no simple formula to good governance, and say they reject some of the practices that are becoming increasingly common in the corporate world. For example, some but not all majority-owned companies say they should not have to meet the same independence standards for their boards.
For example, Edward Johnson, vice-president and general counsel of Power Corp. of Canada, said the company's governance practices have evolved over the past 30 years and reflect the importance of the company's majority shareholders, the Desmarais family of Montreal. Instead of changing the composition of its board, he said Power Corp. has changed the way it reports and comments on its governance.
"We object strenuously to a governance rating system which penalizes a company because a majority of its directors are not independent from its majority shareholder," Mr. Johnson said. "This confuses independence from management, which is vital, with independence from a controlling shareholder."
He said such a standard would damage the capital markets.
"Why would any entrepreneur go public? Why would any parent company take a subsidiary public?"
Nonetheless, the ROB study found many other closely held companies that have appointed boards with a majority of independent directors, such as George Weston Ltd., Brascan Corp., Thomson Corp., Jean Coutu (PJC) Inc. and FirstService Corp.
As well, a number of Canada's majority controlled companies also voluntarily identify directors who have a relationship with their major shareholder as "related" directors. For example, companies such as Quebecor World Inc., Brookfield Properties Corp., Falconbridge Ltd., Loblaw Cos. Ltd., WestJet Airlines Ltd. and Barrick Gold Corp. all identify directors with links to their major shareholder as "related" directors.
To address concerns of some closely held companies, ROB also added to its rating chart information about each company's five-year total returns as of Aug. 30, 2003. This includes share price increases and the value of any dividends granted in the previous five years.
This disclosure was enhanced after some companies complained last year that despite receiving low marks in the study, they have had a long track record of strong performance.
Similar to many academic studies in the area, the Report on Business review shows that better governance marks do not closely correlate with better five-year returns. But contrary to some arguments raised last year, there was also no evidence that companies that perform poorly in this ranking have the best financial track records.
For example, among the top 50 companies in the ROB governance ranking, only three had negative five-year returns, and the highest was 19th place Stelco. On the other hand, only six companies in the bottom 50 of the ranking had negative five-year returns.
But experts say good governance systems not only encourage better financial performance, they also provide necessary safeguards for investors by discouraging wrongdoing.
"What is important is that people have confidence in the capital markets, and they will only have confidence if our corporate governance structures and processes and laws are as good as anybody else's in the world," says Vancouver consultant Patrick O'Callaghan, who conducts an annual study of board trends.
Some companies suggested last year that ROB should go further and include financial performance as a marking criteria, but this change was not adopted. Investors have long been accustomed to studying financial performance and share price returns, and ROB chose to keep the criteria fixed directly on corporate governance measures to isolate these elements in our unique study. Moreover, by excluding financial measures the marks will not shift year by year because of stock market movements when there have been no changes to governance policies.
New criteria were added
The ROB study relies on information disclosed by companies in their most recent annual shareholder proxy circulars. That means some companies may have strong practices in some areas, but received lower marks because the details were not disclosed in their circulars.
After the ROB review appeared in 2002, many investors and companies offered feedback on ways to improve the marking scheme, and ROB made a number of amendments, adding new criteria and using tougher marking standards in some areas. Among its changes, ROB added three new marking categories.
The study looked at whether Canada's corporate boards have any female directors, and discovered that 45 per cent of S&P/TSX index companies have no women on their boards.
Indeed, a study released in January by Mr. O'Callaghan and executive search firm Korn Ferry found that the number of major companies with at least one female director has actually gone down in Canada since 1998. The study said 88 per cent of major U.S. companies have at least one woman on their boards.
Also in 2003, Report on Business added an assessment of the quality of companies' disclosure statements for CEO compensation, an area that has attracted criticism from regulators and investors who complain that too many companies provide only sketchy details about how bonuses are calculated.
Ray Murrill, compensation consultant at Watson Wyatt Worldwide, said there is a huge diversity in the quality of companies' compensation statements, with some firms offering investors "no clue" as to how they determine CEO bonuses.
"It's all over the map," Mr. Murrill said. "Some firms want to say more; they don't want to be seen to be hiding something. Others don't care."
The third addition was in the assessment of stock option plans. As well as looking at potential dilution from outstanding stock options, the study also examined whether companies had given large grants in the past year (known as the grant rate), whether there is a vesting period before options become exercisable, and whether companies have added any popular new features such as holding periods or performance requirements to their option programs.
In the end, ROB's 2003 data are not directly comparable with 2002 because of the changes in methodology, although the 2002 figures are provided because there is a rough correlation.
As well, the data were somewhat biased toward improvement in 2003 because there were changes to the list of companies included in the study.
In 2002, the S&P/TSX index contained more than 270 companies, but the index was amended significantly over the year to drop more than 40 companies that did not meet new index criteria. Many of them were the smallest companies in the index with the lowest governance marks in 2002.
Richard Leblanc, a consultant on corporate governance and a business professor at York University's Schulich School of Business, said he believes good board processes are critically important, and companies must move beyond adherence to formulaic standards.
Mr. Leblanc said he has become optimistic that many companies are keen to go beyond meeting a check-list of governance reforms, and are trying to find ways to ensure their boards operate better and make better decisions.
"I think the tide has turned and a lot of companies want to make substantive change and they want to make changes to board culture," Mr. Leblanc says.
"The better companies and the better boards go beyond compliance. They see that board structure is a minimal level of compliance."