Corporate governance remains a dynamic and evolving area of law and practice. Over the past year, a number of new issues have emerged that warrant consideration by directors and senior management. In this special edition of Securities Watch we highlight a number of the more significant emerging issues in corporate governance in Canada.
Majority voting in director elections has emerged as a leading issue in Canada and the United States. Institutional investors and shareholder advisory firms are pressing for changes in the procedures governing the election of directors of public issuers. Advocates of majority voting want issuers to abandon the current plurality-voting approach for all director elections, and move to a system under which directors must obtain a majority of the votes cast in order to be elected. Majority voting, it is argued, gives shareholders a more meaningful and direct voice in determining the composition of corporate boards.
Majority voting stands in sharp contrast with the current plurality system. Under the plurality system of voting for directors, shareholders vote either “for” a director or “withhold” their vote (i.e., they do not vote) for a director. Under the plurality system, withheld votes do not count and, technically, a director needs only one “for” vote to be elected to the board, as shareholders are not provided with an opportunity to vote “against” a nominee.
Under majority voting, all votes are taken by ballot and a separate vote is tallied for each nominee. If a nominee has more votes withheld than voted for, that nominee is considered not to have received the support of shareholders and, while technically elected under current corporate laws, would be required to tender his or her resignation immediately. The board would then have to accept the resignation, or explain publicly why it has not accepted it, within a prescribed period (typically 90 days). If the resignation is accepted, the board would exercise its discretion to fill the vacancy or leave it unfilled. Majority voting does not apply in contested elections.
Majority voting has typically been implemented through the adoption of an internal policy by the board of directors, although the process could also be implemented through bylaws or as an amendment to articles of incorporation.
Majority voting is supported by shareholder advisory firms such as Institutional Shareholder Services (ISS), corporate governance advocates such as the Canadian Coalition for Good Governance, and certain major Canadian corporations such as TSX Group Inc. (which stated earlier this year that it endorses majority voting and recommends that all TSX and TSX Venture-listed issuers consider its adoption). According to ISS, more than 30 Canadian public companies (including the six major banks) have adopted some version of a majority voting policy. In the United States, close to 200 public companies have adopted majority voting.
Interestingly, majority voting has been used by some institutional investors to express their displeasure with the executive compensation packages approved by the compensation committees of some large U.S. public companies.
A board considering the implementation of majority voting as a policy should be aware of a number of important practical issues. First, failed director elections could destabilize a board of directors and adversely affect board composition. This is of particular concern in light of securities regulatory requirements mandating independence and financial literacy for audit committee members. Failed elections resulting in the removal of incumbent directors could result in non-compliance with these requirements and could cause significant disruptions in operations in cases where a defeated director possesses unique and crucial knowledge, which make that director a valuable asset to other members of the board.
Majority voting could also deter qualified individuals from standing as director nominees and further politicize and increase the costs of director elections. Opponents of majority voting also cite the absence of consistent or predictable measures of past performance of directors nominated for reelection. As well, opponents note that uninformed or disinterested shareholders would be able to influence an election outcome by merely withholding their votes. Under majority voting, withholding approval no longer constitutes an abstention from voting.
Another weakness of majority voting is that shareholders can, in effect, “pick and choose” among individual candidates without appreciating that the effectiveness of a board as a group may be adversely affected by removing certain candidates from a slate of nominees.
A number of developments this year in the United States suggest that majority voting has become an entrenched concept in corporate governance. In June, the Delaware General Assembly adopted amendments to the Delaware General Corporate Law to better accommodate majority voting standards for directors. While retaining plurality voting as the default standard, the new legislation permits irrevocable agreements by directors that they will resign if they do not receive a specified vote for re-election, and prevents boards from changing majority vote bylaws without shareholder approval. Also in June, a committee of the American Bar Association proposed an amendment to the Model Business Corporations Act, which provides that a majority voting standard could be adopted unilaterally by either the board or the shareholders without the need to alter a company's articles of incorporation. Finally, the California State Assembly has proposed that majority voting be the default standard for companies incorporated under the laws of California, unless the bylaws or articles of incorporation specify an alternative approach.
Majority voting will continue to be a key issue in corporate governance for the 2007 proxy season and beyond. Larger Canadian public issuers can expect to receive pressure to adopt majority voting policies from both institutional investors and through shareholder proposals.
Executive compensation has emerged as another leading governance issue, particularly in light of certain recent high profile compensation packages, which entail significant compensation notwithstanding a decline in an issuer's overall performance. The debate surrounding executive compensation has focused on the level of transparency in the disclosure of executive compensation; whether pay should be connected to performance; and whether equity- based compensation is appropriate. The new Securities and Exchange Commission (SEC) disclosure rule for compensation will likely spawn renewed debate concerning executive compensation in Canada.
In August 2006, the SEC adopted a new set of rules governing the disclosure of executive compensation. Highlights of the new rules are:
We understand that a Canadian Securities Administrators (CSA) staff committee is currently studying the new SEC compensation rule and that CSA expects to publish revised compensation disclosure rules for comment in early 2007.
Effective March 31, 2006, Revised Financial Accounting Standards Board Rule SFAS 123(R) requires companies to expense the value of stock options provided to employees. This revision has spurred a move towards granting equity in the form of restricted stock, as opposed to stock options, as a form of compensation.
The backdating of options has also emerged as an important issue in the United States. More than 50 U.S. companies are being investigated by the SEC, which has resulted in the forced resignation or termination of several executives, as well as the laying of criminal securities fraud charges in a few cases. In essence, the challenged practices involve the fixing of exercise prices for options as of dates before a stock price run-up, rather than the actual date of grant.
In June, the Institute of Corporate Directors established a Blue Ribbon Commission on the Governance of Executive Compensation in Canada. A draft report is expected in November 2006, with a final report in early 2007. The report will rely on empirical data on executive compensation in Canada over the past five years, as well as interviews with over 50 informed experts from across the country.
Also in June, the Canadian Coalition for Good Governance (CCGG) released a working paper entitled “Good Governance Guidelines for Principled Executive Compensation”. The paper indicates that the compensation committee of a public issuer:
One of the most significant recommendations of the CCGG relates to the nexus between executive compensation and the achievement of meaningful goals. In particular, the guidelines call for a “pay for performance” table that relates total consideration paid to the CEO to absolute and relative performance measures.
While tying executive compensation to the performance of the issuer may have intuitive appeal to certain advocacy groups, its application may give rise to difficulties. For one, it is difficult to ensure that the performance of a business is truly connected with the performance of one particular executive, or whether it is the result of a combination of external factors over which an executive has no control, such as commodity prices or foreign exchange fluctuations. Notwithstanding the difficulties of empirically linking executive compensation to performance, this issue has grabbed the interest of institutional investors and governance commentators.
This month, the CCGG released its study of the executive compensation disclosure of the companies included in the S&P/TSX Index. Based on the results of its study, the CCGG suggested four areas where companies can improve upon their compensation practices and disclosure:
Later this year, the CCGG is expected to publish its “best practices” for compensation practices and disclosure.
In CSA Staff Notice 51-320 Options Backdating, released on September 8, 2006, CSA staff commented on the recent options backdating scandals in the United States and offered the following guidance to directors:
In light of the increasing focus on executive compensation, directors should consider the following governance practices:
In two notices released this past summer, staff of the CSA sought to clarify their expectations concerning the presentation of “distributable cash” and other non-GAAP financial measures by income trusts. CSA staff stated that distributable cash is, in all circumstances, a cash flow measure, and that distributable cash is fairly presented only when reconciled to cash flows from operating activities as presented in the issuer's financial statements.
In CSA Staff Notice 52-306 Non-GAAP Financial Measures, first released on November 14, 2003, CSA staff outlined concerns respecting the use of non-GAAP financial measures by issuers, including “distributable cash” and “cash earnings”. CSA staff noted that these terms lacked standard, agreed upon meanings and that each may be used differently by different issuers and even by the same issuer from period to period. CSA staff stated that in order to minimize the potential for confusion, such non-GAAP financial measures must be accompanied by a clear statement that the measures do not have a standardized meaning, an explanation of their composition and a reconciliation to the most directly comparable measure in the issuer's GAAP financial statements.
The Staff Notice confirms that CSA staff expect issuers to define clearly any non-GAAP financial measure and to explain its relevance, to ensure it does not mislead investors. Specifically, issuers should:
CSA Staff Notice 52-306 was revised on August 4, 2006. In this revised notice, CSA staff repeated its expectation that distributable cash disclosure include a reconciliation to the most directly comparable measure calculated in accordance with GAAP. Importantly, in the staff 's expressed view, the most directly comparable measure calculated in accordance with GAAP is cash flow from operating activities as presented in the issuer's financial statements.
CSA staff reiterated its views on distributable cash in CSA Staff Notice 51-319 Report on Staff 's Second Continuous Disclosure Review of Income Trust Issuers, released on August 4, 2006. Noting that income trust issuers need to improve the distributable cash disclosure in their Management Discussion and Analysis (MD&A), the notice states that income trusts should supplement the distributable cash presentation in the MD&A with comprehensive disclosure of the assumptions, risks and uncertainties, working capital requirements and financing decisions related to the trust. In staff 's view, this information helps investors determine whether the amount of estimated distributable cash is reasonable and sustainable.
We understand that CSA staff are working on a further notice or policy in which they will seek to develop more consistency among income trusts in the treatment of distributable cash.
In a notice issued this September, CSA staff expressed their view that certifying officers of a reporting issuer can certify the design of the issuer's internal control over financial reporting (ICFR), as required by MI 52-109, even if the certifying officers are aware of a weakness in the design of the issuer's ICFR. In such a situation, it would be necessary for the issuer's disclosure about the identified weakness to present an accurate and complete picture of the condition of the design of the issuer's ICFR. In a second notice, CSA staff noted the failure of a number of reviewed issuers to include in their annual MD&A the required disclosure regarding disclosure controls and procedures.
In March of this year, CSA announced that they would not proceed with an internal control rule that had been modeled on Section 404 of the Sarbanes-Oxley Act of 2002. However, CSA proposes to expand the existing requirements contained in MI 52-109 Certification of Disclosure in Issuer's Annual and Interim Filings to include ICFR provisions requiring the CEO and CFO to certify in their annual certificates that they have evaluated the effectiveness of the issuer's ICFR as of the end of the financial year and that they have caused the issuer to disclose in its annual MD&A their conclusions respecting the effectiveness of ICFR as of the end of the financial year. These provisions will be outlined in proposed amendments to MI 52-109 to be published later this year and will not apply before financial years ending on or after December 31, 2007. In the meantime, MI 52-109 provides that, beginning with financial years ending on or after June 30, 2006, CEOs and CFOs (or persons performing similar functions) are required to certify that they have designed ICFR and caused certain changes in ICFR to be disclosed in the issuer's MD&A. Implementation of these requirements is not deferred, even though the CSA proposes to implement the requirement to certify the evaluation of the effectiveness of ICFR at a later date.
On a related note, certain issuers have apparently asked CSA staff whether certifying officers can certify the design of ICFR if the certifying officers are aware of a weakness in the design of ICFR that has not been remediated.
CSA staff feel that the certifying officers can certify the design of the issuer's ICFR in the face of an identified weakness if the issuer's MD&A disclosure about the identified weakness presents an accurate and complete picture of the condition of the design of the issuer's ICFR. In CSA Staff Notice 52- 316 Certification of Design of Internal Control Over Financial Reporting, released on September 22, 2006, staff note that MI 52-109 requires the certifying officers to cause the issuer to disclose, in the annual MD&A, the certifying officers' conclusions about the effectiveness of the disclosure controls and procedures (DC&P), which conclusions should, in their view, include disclosure of identified weaknesses in the DC&P. Analogizing to ICFR, staff feel that the certifying officers should cause the issuer to disclose in the annual MD&A the nature of any weakness in the design of the issuer's ICFR, the risks associated with the weakness and the issuer's plan, if any, to remediate the weakness.
In CSA Staff Notice 52-315 Certification Compliance Review, released on September 22, 2006, staff note the results of their review of compliance with MI 52-109. The primary concern identified is the failure of a number of issuers to include disclosure in their annual MD&A regarding the certifying officers' conclusions about the effectiveness of DC&P. As well, in a limited number of cases, the form of CEO/CFO certificate fi led with securities regulatory authorities was incorrect.
These two CSA staff notices underline the increasing links between the CEO/CFO certifications and the required disclosure in MD&A. Currently, the annual MD&A must disclose the conclusions of the CEO and CFO respecting the effectiveness of DC&P, including disclosure of identified weaknesses in DC&P. Beginning with financial years ending after June 29, 2006, the annual MD&A must also disclose the nature of any weakness, risk and remediation plan to deal with identified weaknesses in the design of ICFR. In addition, the annual and interim MD&A must disclose any change in ICFR that occurred during the most recent interim period that has, or is expected to, materially affect ICFR.
Under applicable securities rules, audit committees are required to review MD&A and directors are required to approve annual MD&A and either approve interim MD&A or delegate this responsibility to the audit committee. Under the new secondary market civil liability regime introduced in Ontario at the end of 2005 (and coming soon to Alberta), officers and directors can be personally liable for damages in respect of a misrepresentation contained in MD&A. In order to rely upon the statutory due diligence defence, a director or officer must prove that, before release of the MD&A, the director or officer conducted or caused to be conducted a reasonable investigation and that, at the time of release of the MD&A, the director or officer had no reasonable grounds to believe that MD&A contained the misrepresentation. In determining whether or not such an investigation was reasonable, the courts are directed to consider the existence and nature of any system designed to ensure that the issuer meets its continuous disclosure obligations. The court will also consider the role and responsibility of the person in the preparation and release of MD&A or the ascertaining of the facts contained in the MD&A.
Directors – particularly audit committee members – are cautioned to exercise sufficient care and involvement in their review of MD&A to enable them to successfully rely on the due diligence defence in the face of an action commenced under the secondary market civil liability regime.