Previously published in Lexpert Magazine in June 2011.
While regulators in the US attempt to carve a definition of director independence into stone, authorities in Canada seem to be taking a more considered approach — one that will ultimately lead to better governance.
The movement to regulate corporate governance continues to pick up pace. After an initial focus on audit committees, the more recent target has been compensation committees, responsible for managing the executive compensation process.
In the United States, the Securities and Exchange Commission (SEC) has proposed new rules, pursuant to Dodds-Frank. These rules require US stock exchanges to introduce new requirements for US-listed companies (except foreign issuers, including most US-listed Canadian companies). While US exchanges already require independence in compensation committees, the new rules would focus on the specificity of the definition, and require that exchanges define independence for this purpose. They would require compensation committees to have authority to retain and pay advisors, to consider the independence of the advisors, and to make disclosure about issues identified.
In Canada, compensationcommittee independence (in the sense of absence of material interests, as determined by the board) is already recommended by the Canadian Securities Administrators (CSA), and disclosure of independence determinations is required. Advisor conflicts must also be addressed, and related disclosure is required.
It is stunning, but not surprising, that the SEC proposals proceed as they do. Once again, independence is perceived as the single assuring quality, and there is a focus on objectifying the basis on which independence is to be measured. The simplistic sense here is that a suitably independent director will be a good director.
While independence may represent an apparently objective criterion, even early advocates have recognized its limitations and have recommended greater sophistication. In the current context, compensation-committee proposals made by the CSA represent a considerable advance over what the SEC has recommended.
Under the CSA's proposal, companies would have to describe: (a) whether committee members have direct experience relevant to their responsibilities in executive compensation; (b) the skills and experience that enable the committee to make decisions on the suitability of the company's compensation policies and practices consistent with a reasonable assessment of the company's risk profile; and (c) the responsibilities, powers and operation of the committee.
Moreover, the Canadian regimen would have independence determined by the board (on the basis that the director has no conflicting material relationship with the company). In short, the CSA's proposed policy would promote independence, but also the appointment of qualified committee members.
Institutional investor advisory groups have rarely suggested criteria of this sort, because they are not "objective." However, a check-thebox mentality is not at all suited to the subtlety of corporate governance. After all, "compensation literacy" is hardly less concrete a concept than "financial literacy," which applies to audit-committee members.
It's unfortunate that so many glaring examples of inadequate corporate governance have forced legislators and regulators to step in to tell directors how to do their jobs. This, coupled with a so-called shareholder democracy movement, has led not only to a variety of specific requirements, but also to current or proposed reforms in areas of say on pay, golden parachutes in connection with changes of control, slate versus individual director majority voting and the proxy voting system.
By contrast, the European Commission recently issued a consultation paper on corporate governance. Eschewing intense specificity, the discussion focused on suitability of the board to the company's business, accurate assessment of a directors skills and experience, gender diversity, the willingness and ability of directors to devote sufficient time to their duties, and annual board evaluation.
Unintended consequences of the SEC's more specific approach include a form-over-substance mentality and the ceding of power to sometimes tyrannical shareholder groups. New governance rules give activists more tools with which to pressure companies to business strategies advocated by the activists.
While governance reform and regulation may be necessary, it's important to ensure that the result will be what's intended. The CSA has the better approach here.
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