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March 2004 —
Back to the Basics of Corporate Democracy
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The current issue of RBC Letter is dedicated to the
memory of Robert Stewart, who was one of only two editors
of the modern letter. Mr. Stewart, who passed away on Dec.
28, 2003, began this issue of the letter and others have
supplemented his work.
One of the great historic flashes of inspiration struck in
mid-Victorian England, when Lord Bramwell, an Exchequer judge
and former banker, had an elegant solution for the issue of
limiting liability for a business corporation. By simply adding
the word "Limited" to the names of joint stock companies,
shareholders of a business corporation would be liable for
its debts only to the extent of their investment in it. It
was an idea whose time seemed to have come; and with the proviso
of making this "limited liability" clear to potential
investors, the concept became British law in 1862.
By shifting ultimate financial obligation from the individual
investor to the corporation itself, limited liability provoked
an explosion of economic energy. Vast sums of dormant capital
and credit were put to work, generating wealth and employment.
Adopted in every country that had free capital markets, limited
liability gave rise to two of the most important institutions
of modern times - the large business corporation and the public
stock market. Splitting the capital into small affordable
units spread the rewards of business investment widely by
making the market accessible to people of moderate incomes,
at the same time allowing them to diversify their risks. With
the later invention of investment trusts and stock-based mutual
and pension funds, many millions of citizens were brought
into the market indirectly. (In Canada, for example, it is
thought that as much as half the population has an equity
interest in at least one of the chartered banks.) Corporations
for their part gained access to unprecedented capital resources.
Limited liability made the Canadian Pacific Railway possible
- while building other railways from China to Peru. Bramwell
had joked that the word "limited" should be inscribed
on his tombstone: it could equally well be said that if you
wish to see his monument, look around you.
 As
always, there is another side to the story. Like all business
relationships, the limited liability corporation requires
a climate of trust to deliver its full potential. Recent events,
notably in the United States, have shown how completely that
trust can be misplaced. A series of resounding corporate scandals,
Enron foremost among them, have made stock values collapse
or disappear. Thousands of employees have lost their jobs
and often their pensions too. Revelations of fraud, deception
and outright robbery by senior management have frightened
small investors and disgusted the public, while galvanizing
governments into belated displays of severity with corporate
wrongdoing. Not least significant, demands that such scandals
be prevented in future have placed the issue of good corporate
governance high on the public policy agenda in the U.S., Canada
and Europe. In particular the role of corporate boards of
directors - too often revealed by scandal to have been inattentive
at best or complicit at worst in the misdeeds of management
- has come in for highly critical scrutiny.
The founders of the limited liability corporation were cautious
revolutionaries. In designing the new investment vehicle they
drew on two long-standing traditions. First came the business
partnership, which since the Babylonians at least had made
a partner's share of control and reward directly proportional
to his investment. One share, one vote and one dividend. Ten
shares, ten votes and ten dividends. This is an equitable
distribution of rewards, hence the word "equity"
for investment in common shares. Next, the legislators adapted
the political idea of representation, with its roots in the
European Middle Ages. Just as all the commoners of England
could not easily be assembled in one place and therefore elected
members to represent them in Parliament, so the widely scattered
shareholders of the unlimited corporations that had existed
since the early 1600s had elected boards of directors with
powers to manage the assets of the company. Limited liability
companies also had boards, but with a highly significant change.
Early boards had been expected to manage the corporation as
well as represent the shareholders. In the new "Limited"
companies, boards were expected to appoint managers but not
to do the managing themselves. Rather they supervised the
managers to ensure that the best interests of the shareholders
were safeguarded and advanced. Directors could be managers,
and managers directors, but in principle the two entities
were distinct - and the passage of time has made the distinction
of steadily greater importance.
In the words of the early 20th century jurist Edward Manson,
a board's powers were "in the nature of a trust, and
the directors must exercise them with a single eye to the
benefit of the company." Directors were bound by a set
of rules. They could not accept monetary gifts from suppliers,
favour family or friends in the allocation of shares or divert
the company's funds to any purpose not defined by its articles
of association. Above all, directors had to protect the company's
capital against dilution.
In the absence of profits, capital could not be used to
buy the company's own shares or to pay dividends. In practical
terms this meant that the directors had to take due care that
the company's financial statements gave a true picture of
its condition and to retain independent auditors to certify
the accuracy of the company's books.
The courts could enforce these rules, but courts have been
reluctant to second-guess directors because they felt that
directors were in the best position to act in the best interests
of the company and shareholders. However, human ingenuity,
human greed and human laziness make a formidable team and
all of them soon targeted the immense new wealth created by
limited liability companies. As the decades passed, it became
increasingly clear in virtually every jurisdiction that the
annual meeting was a woefully inadequate safeguard against
wrongdoing by managers, directors and auditors, especially
if any of them were in collusion with the others. Public demand
for closer government regulation of corporations to defend
the interests of shareholders grew, and became loudest in
times of economic hardship or, as today, after resounding
corporate scandals. Governments listened to these demands.
A massive body of statutes, regulations and precedents governs
corporations today in every jurisdiction. Complying with this
body of law has become a major corporate activity in itself,
and interpreting it the province of professionals.
Yet the view that no amount of regulation can ever replace
trust as the foundation of corporate life has not gone away.
In a recent speech calling for better corporate governance
in Canada the president of the Canadian Council of Chief Executives,
Thomas d'Aquino, said: "We called for more vigorous enforcement
and tougher penalties of breaches of the law, more comprehensive
disclosure of insider trading, and a critical review of CEO
compensation practices, especially in terms of pay for performance."
So far his listeners might have thought that the speaker favoured
more corporate regulation, but d'Aquino went on to say: "More
broadly, we affirmed our belief that the key to good governance
is more a matter of values than of law, and that a fundamental
responsibility of the chief executive is to live by those
values." This is a fairly explicit appeal to Canadian
investors to trust our corporate leadership to put things
right, along with a stricter application by regulators of
the existing rules.
Unfortunately the recent scandals have left many, if not
most, investors in Canada and elsewhere with grave doubts
about the values of the country's chief executives. Simply
saying "trust us" is unlikely to change their minds.
It is a matter of common observation, after all, that people
who deserve trust do not usually have to ask for it.
All the same, the advocates of a trust-based system have
powerful arguments on their side. Regulation is a blunt instrument.
It is much more effective in punishing breaches of the law
than in preventing their happening in the first place. It
is almost always costly to administer; and while the costs
are certain, it would be difficult to place a firm estimate
on the benefits. The law of unintended consequences seems
to operate with particular force in a highly regulated environment;
each regulatory solution is all too often a new problem. And
it is undeniable that regulation, intended to stamp out wrongdoing,
has itself often generated highly sophisticated wrongdoing,
on occasion by the regulators themselves.
 Perhaps
the crux of the issue is that the "trust vs. regulation"
debate has been framed in the wrong terms. Trust and regulation
are not polar opposites but both essential and complementary
components of a healthy investment climate. The goal of regulation
is not to replace trust but to strengthen it. Regulation should
give directors and their assistants, the auditors, the powers,
the information, the confidence, and perhaps most important,
the climate of opinion in the business world they need to
do the job they received in 1862. It should assure investors
that malfeasance will be detected early in the game and when
detected, punished appropriately and without interminable
delay. Finally, the best regulations are always those which
mathematicians would call the most elegant - those that are
a rapier rather than a sledgehammer, achieving the most with
a minimum of words and a minimum of bureaucracy.
The debate on the role of regulation
mirrors another important issue: the perception of regulators'
effectiveness.
The 17th century French writer, La Rochefoucauld, once observed:
"In the misfortunes of our best friends there is always
something that does not displease us." This was certainly
the unwarranted reaction to the recent corporate scandals
in the U.S. in some quarters outside that country, including
Canada. To be sure, Canada has had its fair share of high
profile scandal, though perhaps not on the scale or scope
of those in the U.S. With this in mind, Canadians cannot afford
the luxury of thinking their standards are adequate. Indeed,
Canadians must continuously find ways to ensure their standards
are beyond reproach: The important point is not whether Canadians
believe their standards are high, but whether the international
capital markets think so too.
Canada has been a massive importer of capital throughout
its history as an industrialized country. While Canada now
generates large amounts of capital internally - and invests
significant amounts of it abroad - Canadians are still heavily
dependent on capital imports to maintain their standard of
living and an adequate rate of economic growth. In today's
world this means that Canadian companies are competing for
a limited amount of capital with scores of other capital markets
around the world. That in turn means that Canadian companies
have to convince investors abroad that the quality of the
country's corporate governance matches or exceeds that of
other nations. The Canadian regulatory system must be state
of the art, and the quality of companies' boards of directors
second to none.
The U.S. authorities have responded to the wave of scandals
with the Sarbanes-Oxley Act of 2002 (known as SOX or Sarbox)
and new listing rules on the New York Stock Exchange (NYSE).
CEOs and chief financial officers must personally vouch for
the accuracy of financial statements, ruling out the defense
of ignorance that has been used in past investigations of
fraudulent disclosure. The responsibility of audit committees
of boards for managing the relationship with auditors and
the whole financial governance of a company has been tightened.
And the NYSE now requires more board independence and more
independent directors, reducing real, perceived and potential
conflicts of interest.
The SOX reforms have now become the widely watched standard
for corporate governance regulation around the world. The
Ontario Securities Commission (OSC), by default Canada's most
important market regulator, has sought to adopt many features
of SOX to the Canadian markets in a way that is effective
without being overly constraining. The OSC has made it mandatory
for boards of corporations listed on the Toronto Stock Exchange
to have audit committees comprised only of independent directors.
As in the U.S., CEOs and CFOs are required to certify that
financial statements filed with the OSC fairly represent their
company's financial condition. These measures are the minimum
needed to let investors around the world know that Canada
is keeping pace with the changes in the U.S.
Improving the quality of boards is a more complex and subtle
business. A recent study at the Clarkson Centre for Corporate
Effectiveness in the University of Toronto's Rotman School
of Management suggests that the 214 leading publicly traded
Canadian firms have made impressive improvements but that
several governance risks remain which will harm Canada's ability
to attract capital. The study found that Canadian companies
today have many more independent directors and many more directors
who do not sit on multiple boards than they did even two or
three years ago. Many more companies have split the roles
of CEO and chairman of the board, resolving what is a key
concern for investors. Boards and board committees are becoming
more active, more informed, and more independent of management
- and more of them are evaluating their own performance as
boards and as individuals.
This is an encouraging story, but a significant number of
companies - including some of the largest - have yet to take
these steps. Overall, the most effective change for reassuring
investors is significant stock ownership by directors, but
almost half the companies studied did not meet investors'
expectations in this area. Nonetheless there is reason to
be optimistic on this front. A recent study by McKinsey &
Company of more than 200 institutional investors - managing
an awe-inspiring US$3.25 trillion in assets - found that three
quarters of them said that board practices were as important
as financial performance in evaluating companies for investment.
In other words, good board quality is worth money. Other studies
have shown that companies with good board practices and good
response to shareholders tend to be more profitable than "corporate
dictatorships" where only one opinion counts. Virtue
does not have to be its own reward in corporate governance,
and this fact will sooner or later move corporate mountains.
Canadians, by investing in companies known for excellence
in governance, can help move those mountains sooner and thereby
benefit both themselves and their country.
It has been memorably and truly said that the price of liberty
is eternal vigilance. The same seems likely to be true of
effective corporate governance. Neither Canada nor any other
jurisdiction will ever attain a fortunate state in which they
can sit back and enjoy the benefits of a perfectly regulated
market. Unscrupulous people can always take advantage of a
situation and give reason to be watchful: Human ingenuity,
human greed and human laziness are as active as ever, and
the restless, ever-changing dynamism of the capitalist system
will continue to give them many opportunities for separating
the unwary from their lawful property. Vigilance is the price
to be paid for the prosperity unleashed by those Victorian
legislators more than 140 years ago. If Canadians can keep
the quality of their capital markets as good, or better, than
any others on earth-- if men and women are able and willing
to give full value on boards of directors - the rewards will
be great. "Limited" by name, the modern corporation
is anything but limited in its potential for shaping the twenty-first
century.
Published by RBC Financial Group. All editions from the
RBC Letter collection are available on our web site at www.rbc.com/community/letter.
Our e-mail address is: rbcletter@rbc.com.
Publié aussi en francais.
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