In late 2001, Enron Corp. filed for bankruptcy protection under Chapter 11 of the United States Bankruptcy Code. Following its application, a flood of questionable accounting practices of a company that, on the surface, had a perfect governance structure, began to come to light. This shook investor confidence in both the US and Canada, and continued with other suspected scandals such as Tyco and WorldCom. All of this caused legislators in the United States to enact the Public Company Accounting Reform and Investor Protection Act of 2002, more commonly known as the Sarbanes-Oxley Act of 2002 in June 2002.

As a result of these corporate scandals, as well as reduced confidence among Canadian investors due to declining share values of a large number of interlisted companies including Nortel, Livent, Cinar, Bre-X, and Laidlaw, among others, the Canadian Standing Senate Committee on Banking, Trade and Commerce undertook, in May 2002, to study the circum- stances resulting in these US scandals, with a particular eye to whether the same could happen in Canada. The study was very thorough, and witnesses representing large investor groups, accounting firms, interlisted Canadian companies, academics, securities commissions, and consulting firms, among others, appeared before the Senate Banking Committee in Canada.

Additionally, the Senate Banking Committee travelled to New York City and Washington, DC, in April 2003 to meet with US legislators, including Messrs. Sarbanes and Oxley, regulators, and policy groups to get their views on the effects of the Sarbanes-Oxley Act and its impact, if any, on restoring investor confidence. During this time, corporate governance and accounting standards were also at issue in Europe, and the Senate Banking Committee was able to hear evidence from Sir Robert Smith and Derek Higgs with respect to the UK’s attempts to restore investor confidence. The final results of the year-long study were contained in Navigating through ”œThe Perfect Storm”: Safeguards to Restore Investor Confidence, tabled in the Senate of Canada in June 2003.

Analysts had generally agreed that three factors played a role in the financial scandals that triggered, in Canada, the Senate Banking Committee study and, in the US, the enactment of the Sarbanes-Oxley Act. Those factors are: failed corpo- rate governance; lax accounting standards and oversight; and the incen- tives provided by executive compensa- tion systems. In our Canadian system, the obvious issues that arise when a Parliamentary committee sets out to review areas such as these are, firstly, how can these areas be legislated, and secondly, how can the federal govern- ment make changes across the country without infringing on the division of powers with the provinces. In the end, the Senate Banking Committee was only able to recommend changes to the Canada Business Corporations Act, which applies to a limited number of compa- nies across the country, and make strong recommendations that the provinces review its findings and make necessary changes provincially.

From the beginning of the study, the different starting points in Canada and the United States with respect to tackling these issues was apparent. The US system is far more rules-based, while the Canadian system has historically been principles-based. Derek Higgs clearly stated the concern with which approach is better when he testified, ”œif you set up a series of rigorous rules backed by the law the exercise becomes one of finding your way around the rules. If you set up a series of principles and this flexible framework of ”˜comply or explain’, you then encourage respon- sible behaviour and intelligent judge- ment and discussion.” However, other evidence showed that voluntary ”œcom- ply or explain” systems, such as that used by the Toronto Stock Exchange, were not yielding satisfactory compli- ance or explanation. The Senate Banking Committee considered how best to balance the two systems, and in the end, as is clear from its report, came to the conclusion that some measure of each system is necessary in order to fully restore investor confidence.

The Senate Banking Committee made various recommendations relating to governance, accounting standards, and executive compensation from this perspective of needing to find a meas- ured balance between carrots (to encour- age appropriate behaviour) and sticks (to punish when the behaviour does not meet standards). On the topic of gover- nance, the specific concerns that came from looking at such scandals in the US as Enron, WorldCom, ImClone, Tyco and Health South, among others, showed indulgence and potential con- flicts of interest on the part of the boards of directors and the audit and compen- sation committees. Additionally, there were also problems with external audi- tors, particularly their independence from management or lack thereof.

It is impossible for boards of directors to do the job that is their mandate, which is to represent the shareholders and protect their interests, if their members are spread too thin through multiple directorships. Although the Senate Banking Committee made no recommendations about number of directorships or the concept of term- limits on directorships, which is part of the new governance package in the UK, these areas were considered. A key con- cern was the lack of independence on boards of directors. Director independ- ence is a difficult principle to enhance when, as one witness put it, many directors begin their tenure feeling beholden to the CEO for the presti- gious appointment. The importance of independence is also the reason that the Senate Banking Committee felt it was imperative that the positions of CEO and chair of the board be split. As William Dimma, Chairman, Home Capital Group said, ”œyou cannot report to yourself. The [roles of Chair and CEO] are designed to be complementary through what has been called cre- ative tension and interaction. You really cannot do that effectively if one person is playing both roles.” A lead director does not address the conflict that exists where the CEO is also chair- man of the board. Therefore, the Senate Banking Committee did not accept this as an alternative, but rec- ommended a splitting of the roles, with possible exceptions for closely held companies and small- and medium- sized businesses.

It also recommended that legisla- tion require a majority of independent directors on the board, leaving the leg- islators to consider special circum- stances that may appear in closely held corporations or small- and medium- sized enterprises. While the Senate Banking Committee was travelling to New York and Washington, one indi- vidual suggested that the acid test of independence is an affirmative answer to the question, ”œCould you fire the CEO or deny the CEO a bonus?” It seems that a director with that mind- set would be truly independent.

The same independence that is key in the board of directors is of utmost importance with respect to the appointment of auditors. Although in Canada, under the Canada Business Corporations Act and some provincial statutes, the shareholders appoint the auditors, the practice has become that the shareholders appoint the auditors that are recommended by manage- ment. The Sarbanes-Oxley Act sets a requirement that the audit committee, which must consist of independent directors who have financial expertise, appoint the auditors. The Canadian system of requiring the auditor to be appointed by the shareholders seem- ingly removes any potential for con- flicts, but to ensure that the auditors selected by management and appoint- ed by the shareholders do not feel beholden to management, the Senate Banking Committee recommended that legislation be introduced requir- ing the auditor selected by the share- holders to be overseen by the company’s audit committee.

The Senate Banking Committee also recommended that legislation be introduced requiring all audit commit- tee members to be independent and financially literate, with one member being classified as a financial expert. In order to ensure the independence of both the auditor and the audit com- mittee, the audit committee must have in camera meetings with the auditor. Additionally, the audit committee, in order to effectively perform its func- tion, must have the ability to hire its own independent expert advisor if necessary. The role of this advisor would not be to duplicate the func- tions of the auditor, but merely to assist the audit committee in its over- sight of the audit and the auditor.

Auditors play a central role in any financial system. As a result, any review of investor confidence in capital mar- kets must look to the role of auditors. The Senate Banking Committee heard much evidence and made recommen- dations for changes to the role of audi- tors as well as financial analysts in seeking to restore confidence in com- panies’ financial statements. The Sarbanes-Oxley Act sets out strict limita- tions on the nonaudit services that can be performed by auditors and requires permission of the US Public CompanyAccounting Oversight Board (PCAOB) with respect to any nonaudit services that are not specifically provided for in the act. Following the introduction of the Sarbanes-Oxley Act, some Canadian companies voluntarily limited the nonaudit functions their auditors could perform.

For example, CIBC led the pack in announcing that its two audit firms would no longer be eligible for non- audit contracts. The concern that aris- es over auditors performing nonaudit work is a potential for real or per- ceived conflict of interest. Where an accounting firm receives sub- stantial nonaudit work from a client, there may be a percep- tion that the firm would ensure a favourable audit to continue to receive the non- audit contracts. Therefore, the Senate Banking Committee recommended that restrictions based on those developed by the Canadian Public Account- ability Board, the Canadian equivalent of the PCAOB, be legislated with respect to large companies, and that some con- sideration be given to the spe- cial needs and circumstances of small- and medium-sized enterprises. These real or perceived conflicts can be exacerbated where one firm performs audits over many years. There is clearly a benefit to the gained insight and company-specific experience a firm may acquire over many years as auditor of a company; therefore, firm rotation was not rec- ommended but rather that lead audit partner rotation every seven years be legislated to reduce any potential for conflicts.

A balancing needs to occur to ensure that the potential liability of accounting firms is not increased to the extent that the risks to them in per- forming an audit far exceed any possible gains. As a result of the new standards that the Senate Banking Committee rec- ommended be legislated, it also returned to a subject that has been con- sidered in some previous Senate Banking Committee studies: propor- tionate liability. Accounting firms must be able to shield themselves either through broadened limited liability partnership legislation or some form of proportionate liability ”” in the words of Bill MacKinnon, CEO of KPMG LLP Canada, ”œlimited to the auditor’s share of responsibility for a plaintiff’s loss.” The current scheme in Canada is not consistent across the country, and as Christine Sinclair of Ernst & Young LLP said, it leaves auditors ”œin an unfair posi- tion where they can be forced to pay for the mistakes of others.” In recognizing the important role auditors play in restoring investor confidence, care must be taken not to unduly burden them without some capacity to protect them- selves from increased liability.

One of the other factors that seem- ingly was the cause of the corporate scandals in the US was auditing and accounting standards and oversight. Even after potential auditor conflicts are addressed, there remain simple questions such as: what auditing stan- dards are being used and who is setting them? In the US, the Financial Accounting Standards Board (FASB) oversees standards, and internationally, the standard setter is the International Accounting Standards Board (ISAB). In a global economy, it seems that inter- national standards are appropriate, par- ticularly in light of the onus on interlisted companies to comply with different standards in each jurisdiction. Therefore, the Senate Banking Commit- tee recommended that Canada work with the FASB and the IASB toward the development of global accounting stan- dards. Additionally, with a goal to improving investor confidence, the Senate Banking Committee determined that legislated certification, by the CEO and CFO, of a company’s annual finan- cial statements would be an improve- ment in this area.

While both governance and accounting standards are important to improving overall investor confidence, it appears that there is a disconnect between company performance and executive compensation. Additionally, executive compen- sation schemes have become somewhat outrageous. While it once was accepted that the CEO would make a million dollar annual salary, those amounts are now tens of millions and some- times more, once base salary, bonuses and stock options are taken into consideration. The question that arises is: do these individuals really have the best interests of the company in mind, or are they looking simply to the bottom line for themselves personally?

One of the main elements that seems to be present in every one of the corporate scandals in the past few years is greed. As William Dimma told the Senate Banking Committee, ”œgreed is a natural and normal part of the human condi- tion…an essential motivator. It is part of the engine of economic growth in a free enterprise system…Of course it must be checked and kept under control. It is somewhat like a muscle car with a 350 horsepower engine and faulty brakes, or maybe no brakes. Corporate greed with- out the appropriate checks and balances leads too often to corporate disaster.”

In an effort to ensure the appro- priate checks and balances are in place, the particular focus of a com- pensation package should be to act as an incentive for the executive to focus on long-term corporate goals and increases in share value and mak- ing decisions that focus on shareholder rather than personal interest. The pos- sible increase in personal gain to executives must not be permitted to result in less ethical corporate behaviour. How good behaviour in this respect can be legislated is impossible to sur- mise. This is one reason that the Senate Banking Committee did not make any specific recommendations in this regard other than to impress upon CEOs their fundamental responsibility to consider shareholder and public interest in their actions and decisions.

There are some areas where legis- lation can be introduced to attempt to stem this overwhelming greed. Firstly, it is imperative that a company’s com- pensation committee be entirely inde- pendent of management and that it operate with the compensation expert in much the same way as the audit committee does with the auditor. Therefore, the Senate Banking Committee recommended legislation to require independence, as well as expertise in the areas of compensation and human resources management among the compensation committee. Also, the Senate Banking Committee recommended that the compensation committee have the ability to retain a compensation expert and that legisla- tion require in camera meetings between the compensation committee and its expert. Another issue in this area is the conflict that may result from cross-directorships. Particularly, it is clear that a perceived conflict, if not a real one, exists where the CEO of Company A is on the compensation committee of Company B, the CEO of which is on the compensation com- mittee for Company A. Although the Senate Banking Committee did not make specific recommendations in this regard, it is clear that legislators and regulators should be aware of the concerns that arise in such a situation.

With respect to legislating safe- guards in the area of compensa- tion, the second step is to look both at the types of executive compensation and the alignment of executives’ inter- ests with those of the company. While stock options are a valid form of remu- neration and may, in fact, lead to a bet- ter alignment of the interests of executives with those of shareholders, there are adverse effects of granting stock options, including dilution of ownership for shareholders. As an ele- ment of compensation, stock options must be expensed. Additionally, all pos- sible steps should be taken by the com- pensation committee to ensure that compensation reflects corporate per- formance. From a shareholder’s perspec- tive there is an obvious loss of investor confidence when share performance falls dramatically but the CEO is granted a huge bonus in the same year. This type of disconnect must be remedied.

Following a year of study in this area, one thing that was certain from the beginning remains clear: action must be taken to restore investor confidence. It is needed to enhance and sustain econom- ic growth. On the Senate Banking Committee’s fact-finding mission to New York City, in answer to a question whether the Enron debacle would have happened had the Sarbanes-Oxley Act been enacted five years ago, the New York Stock Exchange representatives responded ”œmaybe.” Additionally, the chairman of the Federal Reserve Board, Alan Greenspan, elaborated that, in his experience, corporate corruption runs in 10- to 15-year cycles. While the Sarbanes-Oxley Act may not be necessary today to stop corporate corrup- tion in the US, the benefit of it is that it will be available when the next cycle of corruption occurs. Keeping these two discussions firmly in mind, it appears that while legislation and increased regulation may not stop all instances of corporate corrup- tion, the existence of the legislation may make the after-effects less debilitating to equity markets.

 

The committee’s report on corporate gover- nance, Navigating through ”œThe Perfect Storm”: Safeguards to Restore Investor Confidence, can be viewed and downloaded at www.parl.gc.ca/37/2/parlbus/commbus/senate/com-e/bank-e/rep-e/rep12jun03-e.htm  

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