The Conference Board of Canada
Nouvelles perspectives en matière de rémunération
et de ressources humaines 2004
Le 3 novembre 2004
After Sarbanes-Oxley
Designing an Effective Governance and Executive
Compensation Strategy in the Age of Transparency
Bernard Sinclair-Desgagné, Ph.D.
International Economics and Governance Chair
HEC Montréal and CIRANO
Plan de la présentation
• The Background
• The Sarbanes-Oxley Act
• Implications of non-U.S. companies
• Beyond Sarbanes-Oxley
- The paradox of compliance
- A statement of the Canadian Council of Chief Executives
- Shareholders vs. Stakeholders
- What governance experts have to say
The background:
warnings and trigger
• Business ethics codes throughout the 1980-90s.
• Demands for governance reforms throughout the 1990s:
Cadbury Report (UK), Rapport Viénot (France), Dey
Report (Canada), Principles of Corporate Governance
(OECD), GM’s Board of Directors Guidelines, Johnson
& Johnson’s “credo” , etc.
• The Multilateral Agreement on Investment (MAI) failure
and the rise of the anti-globalization movement.
 Corporate Bankruptcies (Enron, Worldcom,
Adelphia, etc.)
The Sarbanes-Oxley Act
Enacted July 30, 2002
• Accounting Standards and Oversight
- Establishment of a new accountant oversight panel
 Board Composition/Membership
- Mandatory registration
- Auditing quality control
 Inspections
 Investigations
- Sanctions
 SEC oversight
- Accounting standards
- Board/ FASB Funding/Budget
The Sarbanes-Oxley Act
Enacted July 30, 2002
• Auditor independence
 Prohibited non-audit activities
- Pre-approved requirement
 Audit partner rotation
- Audit reports
- Audit firm conflict
 SEC authority on auditor independence
- State authority for standards
The Sarbanes-Oxley Act
Enacted July 30, 2002
• Corporate Responsibility
- Audit committee matters
- Officer certification
- Improper influence on audits
 Forfeiture of bonuses/trading profits
 Officer/Director bars and penalties
- Trading during pension blackout periods
- Professional responsibility of attorneys
- Funds for investor restitution
 Prohibition of personal loans to executives
The Sarbanes-Oxley Act
Enacted July 30, 2002
• Enhanced Financial Disclosures
- Accuracy of financial reports
- Off-balance sheet transactions
- Pro-format financial information
 Loans to executives
 Officer/Director bars and penalties
- Changes in stock ownership
- Internal controls
- Code of ethics
- Audit committee expertise
- SEC enhanced review of periodic disclosures
- Real-time disclosure
The Sarbanes-Oxley Act
Enacted July 30, 2002
• Analyst Conflict of Interest
- Analyst Protections
- Disclosure
- Appropriations
- Changes in stock ownership
- Censure authority
- Credit ratings agencies
- Investment banks
The Sarbanes-Oxley Act
Enacted July 30, 2002
• Corporate and Criminal Fraud
 Criminal penalties for altering documents
 Destruction of corporate audit records
- Debts nondischargeable
- Federal sentencing guidelines
 Protection of whistleblowers
- Criminal penalties for defrauding public shareholders
- Investment banks
• White-Collar Criminal Penalties and Enhancements
- Increase in criminal penalties
 CEO/CFO certification of financial reports
- Prohibiting persons serving as officers/directors
Non-U.S. Companies and
the Sarbanes-Oxley Act
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Officer certifications
Loans to directors and executive officers
Bonus and other forfeitures in event of restatements
“Whistleblower” protection
Reports of personal securities transactions of directors and
executive officers
Audit committee organization and responsibilities
Independence of accounting firm
Registration of U.S. and non-U.S. accounting firms with board
Disclosure of material correcting adjustments
Codes of ethics for senior financial officers
Internal control assessments
Off-balance sheet transactions
Best Practice Calendars and Agendas for U.S.
Corporate Boards and Committees
Full Board
January
February
March
April
May
June
July
August
September (retreat)
October
November
December
X
X
Audit
Committee
X
Compensation
Committee
X
Governance
Committee
X
X
X (phone)
X
X
X
X
X
X (phone)
X
X
Best Practice Calendars and Agendas for U.S.
Corporate Boards and Committees
Compensation Committee Meeting Agendas
 Approves option grants and bonus awards (based on planned designs
approved at prior meetings) and drafts financial results being presented to
Audit Committee.
 Approves compensation (including options) and bonus plans designs for
coming year, for recommendation to full Board.
 In November: annual committe self-evaluation
 Compensation of newly-hired senior executives
 Adoption of any golden parachute or other employment agreement
 Adoption of equity-compensation plans, subject to shareholder vote
Beyond Sarbanes-Oxley
• The paradox of compliance
“There is a negative correlation between the number of
complying corporations and the number of white-collar
crimes.”
Principles-based vs. Rules-based approaches
Beyond Sarbanes-Oxley
• A statement of the Canadian Council of Chief Executives
Serving as the chief executive officer is a privilege that comes with
substantial responsibilities – to our shareholders, to our employees, to our
customers and suppliers, and to the public. Our primary responsibility is
to run the company well, in a manner that builds value for the
shareholders who have entrusted us with their investments. Specific
operational responsibilities include:
- Leading the strategic planning process by developing plans, presenting
them to the board, implementing them, and suggesting changes;
- developing and implementing annual operating plans and budget;
- recruiting, developing and retaining talented and motivated employees;
- Identifying and managing the risk that the corporation takes;
- Putting in place ands supervising a reporting system.
Beyond Sarbanes-Oxley
• A statement of the Canadian Council of Chief Executives
In addition to managing the corporation and delivering results, we must
report clearly and accurately on the results of our decisions and be
accountable for our actions.
While the level and form of compensation is a matter to be decided by the
boards of individual companies, we understand the frustration felt by
investors when senior executives are rewarded handsomely for past
performance that proves to be short-lived. We continue to believe that
executive compensation should be tied significantly to both short and
longer-term performance, but suggest that boards could consider a heavier
emphasis on compensation tied to sustained appreciation in shareholder
value.
For example, boards could consider the payment of some or all
performance-based pay in the form of stock that must be held until
retirement or departure, or a requirement that a significant portion of
after tax proceeds from the exercise of stock options remain invested in
company shares for a minimum period.
Beyond Sarbanes-Oxley
• A statement of the Canadian Council of Chief Executives
Canada’s existing rules and regulations ensure that a material misrepresention would expose chief executives to significant consequences
through the courts and regulating bodies as well as the marketplace. We
would, however, encourage governments and regulators to enforce these
rules more vigorously and ensure that penalties for violations better reflect
the gravity of the offence.
Just as boards decide how best to align the interests of chief executive
officers with those of shareholders through the provision of bonuses and
other incentives for meeting designated performance targets, compensation
agreements also could provide for sanctions that would complement and
reinforce legal and regulatory penalties.
Beyond Sarbanes-Oxley
• A statement of the Canadian Council of Chief Executives
Codes of ethics. In order to serve the interest of our shareholders, it is not
enough to make business decisions guided only by what is permitted by the
letter of law. Sustainable growth in sharehoder value requires that we set
high ethical standards for operating our businesses and champion a
corporate culture based on doing what is right. We recognize that it is the
actions rather than just the words of the chief executive that sets the
tone for the behavior of employees within our companies and that
determines the company’s reputation with customers, suppliers and other
stakeholders.
Beyond Sarbanes-Oxley
• Shareholders vs. Stakeholders – an old debate
Friedrich Hayek: “The present tendency not only to allow but
to encourage such use of corporate resources [in the service
of some “public interest”] appears to me as dangerous in its
short-run as in its long-run consequences. The immediate
effect is greatly to extend the powers of the management of
the corporations over cultural, political, and moral issues
for which proven ability to use resources efficiently in
production does not necessarily confer special competence;
and at the same time to substitute a vague and indefinable
“social responsibility” for a specific and controllable task.”
Beyond Sarbanes-Oxley
• Shareholders vs. Stakeholders – a recurrent debate
“[The] directors have fiduciary responsibilities to shareholders
which, while allowing directors to give considerations to
the interests of others, compel them to find some reasonable
relationship to the long-term interests of shareholders. [...]
A Delaware Supreme Court's decision to enable directors to
give consideration to the interests of others does not suggest
that the court intended to authorize redress of an adverse
impact on a non-shareholder constituency at the expense of
shareholders.”
- American Bar Association -
Beyond Sarbanes-Oxley
• Shareholders vs. Stakeholders – a recurrent debate
Moderate social pro-activism
Cadbury Report (UK), Rapport Viénot (France),
Dey Report (Canada)
Principles of Corporate Governance (OECD)
GM’s Board of Directors Guidelines
Johnson & Johnson’s “credo” , etc.
“The present status enjoyed by the business community also yields certain
duties towards intangible, yet fundamental, features of the social fabric
– such as trust – that legitimize their business activity.”
Beyond Sarbanes-Oxley
• What governance scholars have to say.
Management guru Peter Drucker (1993)
Step back on equity-based incentives
“One of the basic problems is that management has no way to judge by
what criteria outside shareholders value and appraise performance. The
stock market is surely the least reliable judge or, at best, only one judge
and one that is subject to so many other influences that it is practically
impossible to disentangle what, of the stock market appraisal, reflects
the company’s performance and what reflects caprice, affects the whims
of securities analysts, short-term fashions and the general level of the
economy and of the market rather than the performance of the company
itself.”
Beyond Sarbanes-Oxley
• What governance scholars have to say.
George Baker (2002):
“Problems do not arise from a lack of available performance measures,
but from a lack of undistorted performance measures. To determine
the weight to be placed on a given performance measure, what matters
is not the correlation between this measure and firm value, but whether
both would always move in the same direction and proportion as the
executive’s effort.”
Beyond Sarbanes-Oxley
• What governance scholars have to say.
Gerard Sanders and Mason Carpenter (1998):
“Results from a sample of large U.S. firms support this perspective,
suggesting that firms manage and cope with the information processing
demands and agency issues arising from internationalization through
higher, longer-term CEO pay, larger top management teams, and the
separation of chairperson and CEO positions.”
Beyond Sarbanes-Oxley
• What governance scholars have to say.
Kevin Murphy (1999):
“The paucity of relative performance evaluation in options and other
components of executive compensation remains a puzzle worth
understanding.”
Beyond Sarbanes-Oxley
• What governance scholars have to say.
Organizational behavior expert Steven Kerr (1975)
On the Folly of Rewarding A while Hoping for B…
Bengt Holmstrom and Paul Milgrom (1991)
The desirability of providing incentives for any one activity decreases
with the difficulty of measuring performance in any other activities that
make competing demands on the executive’s time and attention.
Beyond Sarbanes-Oxley
• What governance scholars have to say.
Bernard Sinclair-Desgagné (1999, 2002)
Two tasks A and B.
Task A is routinely monitored, but not task B.
The principal commits to investigating about task B when task A’s
outcome is high.
The executive is penalized after the investigation reaches a negative
conclusion.
On average, however, the executive is better off when an investigation
takes place.