Legislation and regulations definitely can ensure higher standards of governance, but the most effective and compelling force may be the market itself, especially in this era of newfound investor empowerment.
For some time now, we have been hearing the call for changes in the composition and responsibilities of boards of directors. More recently, charges of corporate fraud and inappropriate accounting practices have refuelled the demand for new regulations, standards and practices for both boards and management. This is an ideal time to consider the role that market forces can play in enhancing board ethics and competency. As we suggest in this article, the market may in fact become a more powerful catalyst for change than any new, mandated regulations.
Boards of directors today must act as adjudicators, standing guard between management’s day-to-day operations and the longer-term interests of shareholders. This means that board members must incorporate a new attention to ethics into their adjudication process. A particular concern: What is the appropriate timeline for the maximization of shareholder value? While management’s interests are geared to the short term, many shareholders are focused on the long term. Recent corporate disasters have emphasized the importance of this trade-off, as management in certain corporations has sacrificed the corporate entity itself in order to maintain profitability and share values. Individual shareholders and institutional investors will now be playing a far more active role in pressuring the board to consider long-term value. At the same time, the growing need to strengthen international competitiveness brings with it the requirement for enhanced credentials on the part of board members, yet again underlining the need to consider long-term value.
New shareholder action
Until recently, individual investors had little means of monitoring a company’s performance, other than the occasional story in the media or the annual and financial reports that public companies are legally bound to provide.
Today, we are witnessing the rise of investor education and investor mobilization. Through the Internet, individual investors are now able to access a wealth of information, not only on the financial results of most public companies, but also on upcoming annual meetings, on the issues being addressed and on how institutional investors are planning to vote. Investors are now voting on-line at annual meetings of companies that allow such practice. It is fair to say that most shareholders wouldn’t have bothered filling in their proxies before the advent of the Internet.
The Internet has empowered small investors, who can now make their voices heard, to communicate with other investors, present their points of view and influence decisions. While communicating with other investors was possible in the past, it was very tedious, inefficient and expensive. Nowadays, contacting other shareholders is cheap, fast and only a few clicks away. “The Internet has opened the floodgates for companies facing dissident shareholders-and the problem is only going to get worse,” says Morrow & Co. managing director Tom Berg. “The Internet is allowing threats to grow at a much smaller cost for activists, corporate raiders and individual investors. It’s more important than ever to know how your shareholders will vote. The trick is to beat proxy contestants at their own game by communicating with shareholders early and often about any issue that may prove contentious come proxy season.”
Stories abound of individual investors who join forces by using the Internet to push their agenda with companies. The determination of one single investor forced a debate at annual meetings of the Royal Bank of Canada and National Bank of Canada (he held one share in each company) about corporate governance policies, including capping the CEO’s compensation and restricting access to the board for related directors. The impressive, although insufficient, support for his proposals from other shareholders led banks to change the way they interact with investors.
Individual investors are now forcing public companies to change the way they deal with their shareholders. Companies must now consider small investors in their communication strategy as well as in their structure and governance policies. “Institutions that control large blocks of shares have long been able to prod lagging companies into action. But individuals, unable to pool their power, have rarely had an impact. ‘Corporate structure depends on shareholders not being able to find each other,’” says Nell Minow, a co-founder of money manager Lens Inc., who now runs the Corporate Library, an on-line clearinghouse for corporate governance information. It had been an insurmountable problem-until the Internet.” (Feldman, A., “Shareholders of the world unite!” Money Magazine, May 2000).
The rise of this new, better-informed class of investors is forcing companies to comply, increasingly, with what is publicly perceived as ethical governance behaviour: “Not surprisingly, the Internet has spurred a movement to make corporations more transparent. And increased access to corporate knowledge has created increased expectations for corporate accountability. It also has enabled watchdog groups to monitor a corporation’s practices more closely. (“Activists Seize Control of Corporate Purse Strings Over the Internet,” PR News, June 26, 2000).
The power of this new brand of activism, labelled “organized cyber-campaigning” by one commentator, is potentially immense. Whatever investors are concerned with, be it value creation, social or environmental issues, they will now have the means to exercise power consistent with their status, and to influence the company’s corporate governance.
The increase in Securities Class Actions (SCAs) initiated by dissatisfied shareholders is another way to make management and boards more accountable. These legal proceedings are typically taken after unsatisfactory quarterly results by shareholders who allege that management failed to release negative information during a period of time called the “class period.” This alleged faulty inaction by management harms shareholders who purchase shares during the class period and hold them until the negative information is released. Examples of this are the legal proceedings launched by Nortel shareholders against the company after it announced its below-expectation results in 2000 and 2001. In other cases, companies have been sued for releasing financial statements that were false or misleading, or even for questionable management decisions that affect share prices, such as M&As and takeovers.
The rising voice of institutional investors
In Canada, about 40 percent of the value of all publicly traded stock is held by mutual funds and other institutional investors. These investors include OMERS (the Ontario Municipal Employees Retirement System), the Ontario Teachers’ Pension Plan Board and the Caisse de Dépot et Placement du Québec. U.S. institutional investors that have become increasingly vocal include the previously mentioned CalPERS, the state pension systems in Florida and Wisconsin, and New York City.
Today’s institutional investors are behemoths. In the past 25 years, U.S. pension- fund assets have grown almost tenfold, from $400 billion to $4 trillion (U.S.). In Canada, pension and mutual funds now hold about $800 billion in assets, over 35 times their value in the mid-1970s-and almost the value of Canada’s annual GDP. These huge institutional investors have the incentive and the means to monitor management’s performance, unlike small individual investors who, until the advent of the Internet, relied mainly on the information provided by public companies in accordance with the relevant securities laws and regulations.
Unlike individual investors, institutional investors often take positions in companies that are so large they can’t sell the stock when they are not pleased with the way management operates, since this could drive the stock price down considerably. Consequently, the most effective way they can affect their investment is to influence the management of the company. A key mechanism for such influence consists of better governance structures and policies. “Governance practices are continuing to evolve in Canada and around the world, and not just for public companies. Recognizing the value of good governance practices in enhancing long-term value, the Ontario Teachers’ Pension Plan Board chose, beginning in their 1998 annual report, to comply with the TSE’s corporate governance disclosure guidelines, stating ‘we believe we should measure our own behaviour by the standards we expect of others, and we provide pension services to 312,000 individual customers who have the right to know how their pension plan is governed and managed.” (McConomy, Bruce, “Corporate Governance: Enhancing shareholder value,” CMA Management, October 2000, 10-13).
The managers of institutional investors’ assets are themselves evaluated and compensated on their performance. It is therefore no wonder that we are now witnessing increased institutional activism. This new attitude is seen in CalPERS’ regular review and ranking of the 1,000 or so companies in its portfolio, and in its insistence that under-performing companies undergo specific changes in their governance, strategy or operations.
Today, American, Canadian and European institutional investors are pressuring large domestic and foreign companies (and, increasingly, mid-size and small companies) into electing directors who are independent of management and who have a diverse portfolio of experiences and competencies to fulfill the board’s new responsibilities. Among other things, their actions have played a role in the gradual disappearance of the old boys’ network approach of selecting directors, and helped to replace them with independent, value-adding, competent members that constitute a stronger and broader portfolio of skills.
Globalization and international competitiveness Increasingly, if companies want to survive, let alone do very well, they must operate as efficiently as any of their competitors. Best practices from around the world are being analyzed and imported by multinational and local players alike. About the role of corporate governance in this global marketplace, former SEC chairman Arthur Levitt has said that, “Strong corporate governance is more than just sensible business practice. It’s an indispensable by-product of market discipline.” One commentator has stated that the recent flurry of M&A activity has turned many U.S. corporations into global entities. By 2001, only 29 percent of the Fortune Global 500 were U.S.-based companies, down from 34 percent in 1998.
While Canadian inward Foreign Direct Investment (FDI) has increased in recent years, so has our outward FDI: Canadian investors are taking advantage of investment (and control) opportunities abroad almost as much as foreign investors in Canada, and the gap is still narrowing.
Many high-profile Canadian organizations have been acquired by foreign players, including the acquisitions of Seagram by Vivendi (France), MacMillan Bloedel by Weyerhaeuser (U.S.), BioChem Pharma by Shire Pharmaceuticals (U.K.).
As enterprises become more international and increase in size due to M&A activity, boards of directors will also be modified to include qualified individuals who represent both the new, large shareholder blocks and all parts of the multinational’s operations. This process will weed out the “related” and lower-value-adding directors and, through the cross-fertilization of culturally different types of management, help implement best corporate governance practices in these organizations.
In the face of increasing international competition, Canadian companies are recruiting talented directors wherever they can be found, and the selection is no longer limited by the Canadian border.
In selecting board members, Canadian-based corporations are being pressured to include:
- More women
- Members of cultural communities
- Professionals and people with diverse backgrounds
- Political leaders and academics
- Community leaders
- Institutional investors’ representatives, and
- Recruits from outside the industry’s inner circles
More diverse representation will bring more objectivity to the board table, as well as international experience and a network of contacts that enrich the board’s contribution to company decisions:
A board that seeks to operate internationally when it is composed entirely of U.S. citizens who have had only minor opportunities to master foreign cultures and markets-a fair characterization of a large number of contemporary U.S. boards-governs with one eye shut. The easiest way to gain the necessary international vision is to open the boardroom to talented foreign executives who will be able to add an accented voice where one is desperately needed. (Grundfest, Joseph A., “The board as a portfolio,” Directors and Boards, 1997, 28)
The same holds true for Canadian boards. The result? Boards are more sensitive to regional, ethnic and gender viewpoints; they know how to operate in multiple cultures, and think and act globally; and they provide new perspectives on management issues.
The flip side of globalization is that borders are no longer constraining talented Canadians, who are increasingly being solicited to serve on boards of foreign or multinational corporations. Companies have to present interesting perspectives and efficient structures and policies to attract the top talent to their boards, which adds to the other globalization-induced pressures on corporate governance. This is all good news for Canadian directors, whose waning influence at home may be compensated by increased opportunities abroad. Canadian business people, with their wealth of knowledge and experience in cutting-edge management practices, and with their sensitivity to multicultural and social issues, are well positioned to take advantage of the new opportunities triggered by this opening of borders and boards to foreign directorships. For Canadian companies, however, this means added challenges to keep the best domestic talent on their boards, as well as attract the best foreign representation.
The rise of the Internet, the growth of institutional investors and the intensified pressures of international competitiveness may do more to change the form and function of Canadian boards than any report. The impacts of these three influences are far-reaching, affecting the composition of boards, their responsibilities, the way they function, and the compensation and time commitment of directors.
While governments and agencies will create new rules, enforcement will depend upon periodic inspection and prosecution. As a result of new market forces, however, boards will be looked to for ongoing assurance that their corporation is acting on the basis of ethical considerations and competitive competence.
In this new corporate governance paradigm, questions remain about how to ensure the right “balancing of power” between mammoth institutional investors, Internet-enabled individual investors, company management, the public, and each stakeholder’s agenda, be it the maximization of shareholder value or responses to social or environmental concerns. It is in this “balancing of power”-particularly in the context of an ethical analysis of short-term versus long-term shareholder- value maximization-that boards will be playing a new, powerful role in corporate governance.