Written By Stephen P. Sibold, Q.C.

Corporate governance remains a dynamic and evolving area of law and practice. Over the past year, a number of issues have emerged that warrant consideration by directors and management. In this second annual report, we highlight three of the more significant emerging issues in corporate governance in Canada.

Executive Compensation

Last year, we highlighted executive compensation as a leading issue and it continues to be at the forefront of every corporate governance agenda this year. Again, the debate focuses on pay-for-performance and transparency in the compensation- setting process. Both the United States Securities and Exchange Commission (SEC) and the Canadian Securities Administrators (CSA) are increasing disclosure requirements for executive compensation so that investors will better understand how pay is determined and how compensation relates to issuer performance. As a result, many issuers are grappling with both new executive compensation plans and new disclosure requirements.

CSA Disclosure Requirement Changes

In March 2007, CSA published a proposed new executive compensation form to replace the current Statement of Executive Compensation (Form 51-102F6). In late August, CSA announced that it has decided to revise the proposal and will publish an amended proposal late this year. Accordingly, CSA will not implement the new form on December 31, 2007, as originally indicated.

While adopting a number of key features of the new SEC rule, CSA's approach is less prescriptive than the approach adopted by the SEC; it also tries to recognize the differences between Canadian and U.S. capital markets. For Canadian companies, the result is a modified SEC executive compensation disclosure rule. The most significant proposed changes include:

• A new compensation and discussion analysis (CD&A) section will require issuers to explain the rationale for specific compensation programs for executives.
• In addition to the currently required performance graph (illustrating the cumulative total shareholder return over the last five fiscal years compared to the cumulative total return of at least one broad equity market index), each non-venture issuer must now explain how its performance trend compares to the trend in the issuer's compensation to executives over the same period.
• Issuers will be required to disclose target levels for specific quantitative and qualitative performance-related factors for Named Executive Officers (NEO).
• Issuers will be required to disclose practices for granting options and whether executives are involved in determining who is awarded options.
• The new summary compensation table includes a column showing the total compensation provided to each NEO.
• Three new columns will be added to the table dealing with stock awards, option awards and non-equity incentive plan compensation.
• There will be more specific disclosure of potential payments to NEOs when they leave the issuer. Also, more detail will be required concerning retirement benefits, such as the present value of the accumulated benefit of all defined benefit plans and the material terms of any defined compensation or defined contribution plan relating to each NEO.
• The proposed executive compensation form will require expanded disclosure of director compensation, including a summary table and equity disclosure similar to what is required for NEOs.

Institute of Corporate Directors Report

In June 2006, the Institute of Corporate Directors established a Blue Ribbon Commission on the Governance of Executive Compensation in Canada.

The Commission's final report, published in June 2007, advocates that pay for performance be the basis of all executive compensation packages, with a view to aligning managerial interests with those of investors. The report recommends three ways to align pay with performance:

• Establish meaningful goals for performance-based compensation, defined relative to a variety of well thought-out metrics (both qualitative and quantitative) and preset targets. Payment should be tied to achieving goals, avoiding possible windfalls due solely to general market performance.
• Incorporate a greater element of downside risk in compensation arrangements by ensuring that a meaningful portion of compensation is subject to performance-based vesting criteria.
• Require the CEO to have an ownership position in the firm, aligning CEO interests with those of shareholders.

Canadian Coalition for Good Governance

Earlier this year, the Canadian Coalition for Good Governance (CCGG) published its Best Practices in Compensation Disclosure, which makes the following recommendations:

• Build an independent compensation committee composed entirely of independent directors.
• Develop an independent point of view through the use of independent external compensation advisors.
• Test pay to performance linkages by establishing meaningful goals for performance-based compensation and tying payment to achievement of these goals.
• Establish share ownership guidelines requiring executives to build and maintain a significant equity investment in the issuer.
• Disclose all facets of the compensation regime.

Notwithstanding the difficulties in assessing whether organizational performance is truly connected with the performance of particular executives, the push to align compensation with performance is gaining momentum with large institutional investors and governance commentators.

Similarly, there is a growing push for increased disclosure concerning the design of compensation packages, as well as for increased independence of board compensation consultants.

U.S. Developments

In April 2007, the U.S. House of Representatives enacted the Shareholder Vote on Executive Compensation Act. The bill gives shareholders a non-binding advisory vote on executive compensation, as well as a vote on any previously undisclosed "golden parachutes" a company gives while it is in talks to be bought or sold. The bill has not yet received Senate approval. Compensation recovery policies, often called "clawbacks," are becoming an increasingly prevalent component of corporate governance policies at a number of U.S. companies. Clawbacks give companies the ability to recoup incentive-based compensation from executives whose fraud or misconduct leads to a financial restatement of the company's performance. Essentially, "if it isn't earned, it must be returned."

The SEC requires a company to disclose its policies and decisions regarding the adjustment or recovery of awards or payments if the relevant company performance measures upon which they are based are subsequently restated or otherwise adjusted in a manner that would reduce the size of an award or payment.

In the wake of the recent compensation scandals, it is not just executives that are falling under shareholder scrutiny – compensation consultants are now being named as defendants in lawsuits targeting company executive pay practices. As a result, compensation advisors (who have until now been largely shielded from shareholder lawsuits) are increasingly asking their clients to protect them from liability.

Another SEC rule requires disclosure of information concerning the role that compensation consultants play in determining or recommending the amount or form of executive and director compensation. Paragraph 7(d) of Form 58-101F1 is the Canadian version of this provision.

Recommendations for Directors

In light of the continuing focus on executive compensation, directors should:

• Become familiar with CSA's proposed new executive compensation disclosure form;
• Focus on pay for performance and consider how to disclose the performance rationale for all executive compensation awards; and
• Promote director education respecting executive compensation.

Corporate Social Responsibility

Corporate Social Responsibility (CSR) is an emerging issue that issuers are facing more frequently in the boardroom. The underlying principle of CSR is that business organizations should shift their exclusive focus from shareholder wealth maximization to include consideration of the societal impact of their activities and the interests of other stakeholders.

What is Corporate Social Responsibility?

Issuers that embrace CSR explicitly recognize and take responsibility for the impact that they have on society, the community and the natural environment by considering these factors, as well as the interests of stakeholders (such as employees, customers, creditors and citizens) during the decision-making process.

Depending on the industry and the nature of the business, CSR hot topics include business ethics, community investment, governance, human rights, the marketplace and the workplace. Environmental sustainability continues to be a primary focus, as CSR advocates cite the need to ensure that the natural resources society depends on are not depleted, reducing the future access to those same resources.

Why Now?

There are a number of reasons why CSR has gained acceptance by various issuers:

• Stakeholder activism has grown because of recent corporate scandals. Society and stakeholders alike now hold greater expectations that business organizations be more socially responsible.
• Issuers are increasingly being held accountable by stakeholders, society and the media for the practices of their business partners, particularly in respect of environmental, labour, and human rights practises.
• Issuers are facing demands from stakeholders for greater transparency, including periodic reports concerning the societal impact of their activities that go beyond former reporting practices.
• Issuers are adopting CSR practices to avoid liability. For example, Kellogg Company was facing threats of lawsuits for its advertisements and its contribution to childhood obesity when it announced this June that it would no longer market products that are unhealthy for children. Consequently, one group is no longer pursuing its lawsuit against Kellogg.
• Activists, the public and the media can more easily track the results of CSR rankings and surveys due to developing voluntary CSR standards, codes and other measurement tools. For example, the United Nations has developed the Global Compact, which purports to outline universal values that promote a more sustainable global economy (by increasing the accountability and transparency of corporations). Each year, an issuer that signs the Compact must provide examples of progress made in following its principles, which are posted on the organization's website. In Canada, over two dozen Canadian CEOs have pledged organizational support to the voluntary initiative, including Mountain Equipment Coop, Nexen Inc., Petro-Canada and Talisman.
• Issuers are encouraged to adopt CSR initiatives aimed at reducing emissions of carbon dioxide, as global warming looms larger as a major political issue.

CSR

Reports and Committees

A developing trend is the increase in different types of CSR reports, such as sustainability reports, which identify practises that incorporate environmental and social aspects of sustainability into corporate operations. Some issuers have established ethics or social responsibility committees of their boards to review strategic plans, assess programs and monitor CSR issues.

Strategic Partnerships

Strategic partnerships are another growth area in CSR. Businesses are forming partnerships to facilitate their understanding of CSR issues, to create business opportunities and to avoid negative publicity. In particular, some issuers are collaborating worldwide, developing intra-industry partnerships to find solutions to supply-chain sustainability conditions and reduce the perceived environmental effects of international trade. Further, government agencies have launched government-industry partnerships across several industries.

Socially Responsible Investors

The increase in the number of socially responsible investors is focusing greater scrutiny on business practices. Investors are finding that they are able to invest in issuers exhibiting socially and environmentally responsible practises without compromising returns on their investments. One example is the growth of "ethical funds" – mutual funds that only invest in companies that satisfy certain social, moral and environmental ethical standards.

Trading Programs

At the international level, emissions trading programs have increased. Achieved through voluntary initiatives (such as the Chicago Climate Exchange) or national regulatory systems (such as those in the UK or Denmark), these programs allow various organizations to sell or loan reduction credits to other firms for cash, allowing the latter to purchase credits for less than the cost of reducing their emissions.

Recognition

Five Canadian companies made Corporate Knight's 100 Most Sustainable International Companies in 2007: Royal Bank of Canada, Enbridge Inc., TransCanada Corp., Sun Life Financial Inc. and Alcan Inc. Corporate Knight's ranking rates 1,800 public companies around the world on their environmental records, corporate governance practices, how they manage human resources and how they relate to communities. 

CSR Benefits

Adoption of CSR policies has reportedly resulted in reduced operating costs in certain cases. Advocates maintain that sustainability practices can save organizations money by using low- or no-cost practises that increase resource efficiency in the workplace. Recycling is a simple example. In addition, flexible scheduling and a focus on work-life balance has been reported to reduce absenteeism, increase employee retention and save money by increasing productivity and reducing hiring and training costs.

Another benefit identified by CSR advocates is enhanced corporate reputation and brand image. Customers may be attracted to brands and companies with good CSR reputations.

There are also opportunities for businesses to develop new products and services that cater to socially responsible consumers, providing organizations with a competitive advantage in existing and new markets. For example, General Electric Co. has predicted that revenues from its ecoproducts and services will yield $20 billion by 2010.

CSR Strategies

Once a decision is made to adopt CSR, it is important to set priorities by focusing on those issues of most concern to the public and which will have the greatest effect on the business. The secret to success for CSR and organizations is to understand the interdependent relationship they have with each other and to identify overlapping interests.

To improve the organization's reputation, it is essential to effectively communicate CSR practices to the public. In making changes to address social issues, businesses should demonstrate a unified front on the social issue, with the lead taken by the CEO. CSR also needs to be addressed by legal counsel, to review issuer and supplier codes of conduct, for example.

Issues and Critiques of CSR

Because CSR is such an abstract concept with varying definitions, it is sometimes unclear what CSR encompasses and where the corporate responsibilities of business organizations end.

Although some criticize CSR as too broad and expansive, others maintain that CSR does not do enough to solve social issues. Critics have noted that CSR practises only allow organizations to understand and address the social issues that could affect their particular businesses rather than the economy or society as a whole.

Another emerging issue concerns the prospect of issuer liability in cases where their CSR statements are inaccurate.

There are also issues surrounding CSR in the United States where some states have enacted "constituency statutes" that either permit or mandate boards to consider certain interests before making a decision. These provisions have been criticized because they do not sufficiently protect stakeholder interests, provide guidelines for director discretion, or allow for a remedy to enforce the provisions.

Conclusion

CSR is gaining priority on the agenda of boards worldwide and will continue to do so next proxy season. Issuers incorporating CSR practices into their operations have found that socially responsible initiatives do not necessarily equate to abandoning the goal of making a profit and may give rise to competitive advantage in certain circumstances.

Shareholder Activism

Shareholder activism continues to gain momentum as activist investors attempt to influence fundamental facets of corporate governance. The growing participation of large institutional investors, which focus significant attention on changes to corporate governance policies, has led to an upswing in support for activist proposals. Likewise, the emergence of hedge funds as activist investors, motivated primarily by financial concerns, has stimulated strategic change within a number of corporations. In addition, social and environmental issues – once the exclusive domain of special interest groups – are now seen to be relevant to an organization's financial performance and investor returns.

Governance Issues

Corporate scandals and oversight failures have resulted in reduced deference paid by shareholders to management and boards and increased shareholder activism with respect to governance matters in particular. In the current environment, the three biggest governance issues for shareholder activists are executive compensation, elimination of takeover defenses and majority voting for directors.

Executive Compensation

• In the United States, some activist proposals aim to tie compensation to the issuer's share performance and to measures of the issuer's performance in improving its environmental footprint.
• In light of the options backdating scandal, activists have submitted proposals asking issuers to reform their options policies to fix grant dates before the fiscal year begins and to price options at an average of the stock's opening and closing price on the grant date.
• Other executive compensation issues include compensation recovery – "clawback" – provisions and shareholder advisory votes on compensation plans.

Eliminating Takeover Defenses

• Shareholders are targeting takeover defenses, such as "poison pills" and supermajority voting requirements, which may entrench existing management groups.
• Shareholders in the United States have expressed strong support for holding annual elections for all directors, eliminating staggered board structures.

Majority Voting for Directors

• The support for majority voting has increased tremendously since its introduction three years ago, making it the most widely adopted reform in U.S. corporations this past proxy season.
• 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 (CCGG), and certain major Canadian corporations such as TSX Group Inc.

U.S. Legislative Developments

Amendment to NYSE Rule 452

The New York Stock Exchange (NYSE) is proposing to restrict voting by brokers in director elections beginning in 2008. Currently, brokers are able to vote on certain "routine" proposals, including director elections, if the beneficial owner of the stock has not provided voting instructions to the broker at least 10 days prior to a scheduled meeting. The NYSE estimates that 80 percent of all public company shares are held by brokers and that broker votes account for roughly 19 percent of votes cast at U.S. corporate meetings. As brokers usually vote in favour of management's recommendations, the absence of this promanagement voting bloc could have a significant influence on the outcome of some director elections.

SEC Proposed Proxy Access Rule

The U.S. Securities and Exchange Commission is proposing rules to give shareholders the right to nominate directors to the boards of public companies through a relatively inexpensive "direct access" security holder proposal procedure. Only applying to shareholders who have owned more than five percent of a company's voting securities for at least two years, the proposed rules are intended to promote an effective proxy process by providing a mechanism for nominees of long-term security holders (with significant holdings) to be included in company proxy materials.

"Say on Pay"

In April 2007, the U.S. House of Representatives passed the Shareholder Vote on Executive Compensation Act. If enacted, this legislation would give shareholders a nonbinding advisory vote on executive compensation, as well as a vote on any previously undisclosed "golden parachutes" an issuer provides while it is in talks to be bought or sold. The bill has not yet received Senate approval. 

Hedge Fund Activism

Increasingly, hedge funds are taking an activist approach to investing by inciting change in the business strategy and management of target corporations. Activism ranges from publicly pressuring a portfolio company to change its business model to threatening or commencing proxy contests to gain seats on the board of directors. Hedge funds are also active in transactions involving potential changes in corporate control, preventing deals from occurring, blocking deals in order to improve terms for the target, or acquiring a company and urging governance or structural change.

In general, activist hedge funds are more strategic in nature and more directed to significant changes in individual companies than other institutional investors. Hedge funds pursue investments specifically to become activist and implement the changes they seek in an effort to maximize short-term financial return. In fact, studies of the performance of activist hedge funds suggest that the companies they target outperform the broader market. In the wake of hedge fund activism, institutional investors are becoming more activist themselves in matters of corporate control by joining with hedge funds in pushing for strategic change.

Although only a minority of hedge funds has adopted an activist stance to this point, that number is increasing and will likely continue to do so – especially if activism proves to be more profitable than passive investment strategies.

Social and Environmental Activism

Social and environmental proposals are also gaining ground, to some degree because they are viewed as financial concerns in their own right by mainstream investors. Examples of recent "corporate" social issues include proposals requiring disclosure of political donations, restricting or banning the use of potentially hazardous chemicals (such as polyvinyl chloride) in products, and restricting Internet censorship, particularly in non-democratic countries. Of the social and environmental proposals that gained significant votes in the United States in 2007, many received totals comparable to or better than traditional governance proposals. As of June 2007, there were over 359 social and environmental resolutions proposed in the United States, although a large number of those were withdrawn before the applicable shareholder meetings. Activist resolutions are rarely carried by a majority of votes cast, but the willingness of corporations to negotiate with activists suggests that such resolutions remain a successful tactic to incite corporate change.

Representing over one-third of filed social proposals in the United States, environmental activism has encouraged corporations to file climate risk reports and adopt other environmental policies. As a result, activist efforts currently focus, to a large degree, on how to standardize corporate reporting.

Socially responsible investors (SRIs) are asset management groups that choose to invest, via socially-screened mutual funds and stocks, in organizations that have made commitments to improve environmental and social conditions. SRIs are estimated to hold assets valued at US$2.3 trillion – over nine percent of the total investment assets in the United States today.

Recommendations for Directors

It is critical for directors to understand the significant growth in shareholder activism in general and the rising influence of hedge funds in particular. Directors should be well informed of social issues affecting their organizations and proactively assess the risks and opportunities presented by such issues.

Bennett Jones Lawyer Appointed Fulbright Scholar

Bennett Jones lawyer Stephen Sibold, Q.C., has been named a 2007-2008 Canada-U.S. Fulbright Scholar, a prestigious title reserved for a select few in Canada and the United States.

As a Fulbright Scholar, Mr. Sibold is pursuing graduate studies in corporate governance and securities regulation at the Boalt Hall School of Law at the University of California, Berkeley, where he will be assessing Canada's regulatory response to the Sarbanes-Oxley Act (SOX) of 2002.

"The firm proudly supports Steve in pursuit of this opportunity," says Hugh MacKinnon, Chairman and Chief Executive Officer, Bennett Jones LLP. "He has made a tremendous contribution to our clients and to the community over the years, and will undoubtedly contribute greatly to the legal and regulatory understanding of corporate governance in Canada through his research."

A member of the firm's corporate group in the Calgary office, Mr. Sibold has a corporate governance and securities law advisory practice. In 2006, he returned to Bennett Jones after 10 years of working in the public and private sectors. From 1996 to 2000, Mr. Sibold served as senior vice-president and general counsel of Canadian Airlines Corporation, and from 2000 to 2005; he was Chair and CEO of the Alberta Securities Commission (ASC). From 2003 to 2005, Mr. Sibold also served as chair of the Canadian Securities Administrators (CSA), the council of the provincial and territorial securities regulators in Canada.

"We at the Foundation are especially pleased to welcome Steve to the Fulbright family. I am sure that his research will contribute greatly to his field and that he will make an important contribution to mutual understanding," says Dr. Michael Hawes, executive director of the Foundation for Educational Exchange between Canada and the United States of America.

Mr. Sibold will be on a scholastic leave of absence from the firm effective August 1, 2007, returning in May 2008. Upon his return, he will resume his corporate governance and securities law advisory practice.

About The Fulbright Scholarship

Recognized as one of the world's foremost educational exchange programs, the Fulbright program is active in more than 150 countries worldwide. The Canada-U.S. Fulbright program builds mutual understanding and promotes a deeper knowledge of Canada-U.S. relations by supporting research on contemporary public policy issues relevant to Canada, the United States and the relationship between the two countries. The Canada-U.S. Fulbright program was founded in 1991.

About Bennett Jones

As an internationally recognized Canadian law firm, Bennett Jones' unique leadership is reflected in the way we work with clients and the lasting relationships we build with them, the groundbreaking legal work we do on their behalf and the quality of all of our people. We take great pride that clients and other professionals alike recognize that our excellence, independent thought, reliability, candour and respect bring an added dimension to their business or organization.