You Can Run, But You Cannot Hide: Transparency and Disclosure in Corporate Governance

January 30, 2003

The new expectations of corporate governance sweeping across the world are based on a simple reality — you can run, but you cannot hide. Inquisitive eyes and ears of governments and regulators, analysts and money managers, customers and NGOs, journalists and whistleblowers are everywhere. Communication is instant. Analysis follows quickly. And the market’s judgment can be swift and brutal.

In short, anything a company does anywhere in the world can affect its reputation everywhere in the world. Reputation has become the cornerstone of both investor confidence and public trust. What happens to a company’s reputation therefore has an increasingly direct impact on its relationships with everyone from governments and regulators to customers, employees and investors.

The growing demand for transparency is reinforcing the role of the market as the primary driver of good corporate governance. Failure to follow acceptable standards of governance can hurt both a company’s business and its share price. By the same token, good governance practices are seen as reducing risk and enhancing performance, and therefore constitute an increasingly important competitive advantage.

The impact of governance on competitiveness can be seen on both individual companies and entire countries. For instance, as Ron Farmer of McKinsey & Company noted yesterday, international surveys of institutional investors show clearly that money managers are willing to pay significant premiums for the shares of companies with good governance practices, especially when they operate in countries where the legal framework and norms of practice are weak.

Major investors are also passing judgment on entire markets. Last year, the California Public Employees Retirement System (CalPERS) brought in a new review process to select emerging economies for its stock market investments. Its criteria include key corporate governance measures such as stock market regulation and transparency. As a result of the new system, three markets where CalPERS had investments — Indonesia, Malaysia and Thailand — were blacklisted. The Asia Times recently estimated that the withdrawal from their markets of this one major investor took a total of U.S. $120 million out of the three countries.

This reality, the importance of good governance to companies and countries alike, is what persuaded the members of the Canadian Council of Chief Executives to launch our Corporate Governance Initiative last summer.

Not everyone saw our willingness to take a leadership role as appropriate. Shortly after we launched our initiative, for instance, we received a letter from the Ontario Teachers Pension Plan Board, one of Canada’s strongest advocates of improving governance. While welcoming our interest in governance issues, it suggested that we had misunderstood the role of chief executives. Governance, we were told, is the responsibility of shareholders, working through boards of directors and within government regulations: "It is neither the responsibility nor the prerogative of management to set the standards for corporate governance."

Certainly we agree that shareholders, and the boards of directors they elect, have the right to decide how they want their companies to be run. But I reminded our friends at Teachers that the chief executive officer plays a critical role in managing not only a company’s operations, but also its reputation. And our members, the chief executives of 150 of Canada’s leading enterprises, believe that it is vital for CEOs to play, and to be seen playing, a leading role in restoring public trust — not only in their individual companies but also in the workings of capital markets in Canada and worldwide.

Through the direct involvement of individual CEOs, the Council achieved a remarkable degree of consensus, and especially so given the diversity of our members’ ownership structures. On one subject, however, there was unambiguous unanimity — the belief that good governance matters, and that CEOs do have an important role to play in improving governance practices. Let me quickly recap our key recommendations.

Our first recommendation focused on CEO accountability. Our members have always signed off on the financial statements of the companies they lead. And they have said they also are ready and willing to put their word on the line in terms of a comprehensive personal certification comparable to that required by the Sarbanes-Oxley legislation.

In addition, we called for more vigorous enforcement and tougher penalties for breaches of the law, faster and more comprehensive disclosure of insider trading, and a critical review of CEO compensation practices, especially in terms of pay for performance.

More broadly, we affirmed our belief that the key to good governance is more a matter of values than of rules, and that a fundamental responsibility of the chief executive is to live those values. That is why our second and third recommendations dealt with the expression of a company’s values — internally through a comprehensive code of ethics and conduct, and externally through good corporate citizenship and stakeholder relationships.

We went on to recommend in considerable detail a wide range of good governance practices that should lead to stronger, more independent boards of directors, reinforce the integrity of the audit process and enhance the degree and extent of public disclosure. And while our formal recommendations were limited to actions that could be taken within the company by shareholders and boards, we also drew attention to a broader systemic challenge. We therefore went on to discuss the vital roles to be played by institutional shareholders, accountants, analysts, investment dealers, educational institutions and the media, in addition to governments and regulators.

Throughout our statement, however, we emphasized the importance of values, of the moral compass that must guide decision-makers, of the tone at the top, or as the title of this conference puts it, "intention at the top". Rules matter, but what happened at Enron was against the law well before the enactment of the Sarbanes-Oxley Act. As David Leslie said yesterday, "it is trust, transparency and integrity" that are the cornerstones of good governance. And this is why we emphasized that most of what needs to be done to restore and enhance confidence in markets must be achieved through the combined efforts of all the key private sector actors.

This emphasis on compliance with the spirit rather than simply the letter of the law puts us at odds with the predominant approach in the United States. I would add here that many of our members are directly affected by the American legislation, and for them, the debate over its merits and deficiencies is moot. But this still leaves the question of whether, or to what extent, it would be beneficial to other Canadian companies and to Canadian capital markets to harmonize with the new American rules.

In launching its comprehensive review of Canadian rules last September, the Ontario Securities Commission suggested that harmonization was the most logical route forward. It argued that allowing a significant gap to open up between Canadian and American practices would undermine confidence in Canadian markets and could send capital fleeing. Hence it adopted an initial assumption that Canada should harmonize unless compelling reasons were advanced for not doing so in particular cases. The Ontario government has since introduced legislation to give the OSC the necessary power to proceed along this route.

Before deciding on the specifics of regulatory and legislative changes in Ontario and elsewhere in Canada, I think it is important to remember that investor confidence flows not from governance practices in and of themselves, but rather from the superior and sustainable growth in profitability that should flow from good governance. In other words, if new rules on governance are so complex that they force directors and executives to spend more time looking over their shoulders at regulators and consulting lawyers than they do growing their businesses, the new rules would be defeating their own purpose. This concern is widely shared by CEOs on both sides of the Atlantic. Three days ago, at the World Economic Forum in Davos, Nestlé CEO, Peter Brabeck-Lemathe, said "If I have to handle three thousand pages of SEC regulations, I am in big, big danger of forgetting to handle the affairs of the company…Regulations will never be a substitute for good personal integrity." A similar point was made this morning by Henri-Paul Rousseau when he warned that too much regulation may in fact reduce the supply of good governance.

There is no question that the Sarbanes-Oxley Act has become the standard against which the efforts of other countries are being measured. But I would argue that in the spirit of enhancing Canadian competitiveness, our goal should be to do better than Sarbanes-Oxley — and that does not mean simply trying to go further down the same road.

By better, I definitely do not mean looser or laxer. I do mean that Canada’s approach should aim to achieve equal or superior outcomes in terms of good governance and sustainable growth in shareholder value, and do a better job of preventing rather than just punishing both ethical lapses and legal wrongdoing. In other words, we have to make sure that our approach to strengthening governance in fact leads to better corporate performance.

In this sense, it is already becoming clear that the Sarbanes-Oxley approach is full of problems. The very complexity of this piece of American legislation, rushed into law in a matter of weeks, is causing immense turmoil and confusion. Last autumn, for instance, Stephen Sibold, Chair of the Alberta Securities Commission, noted that it took a joint effort by 25 of the top law firms in the United States to come up with a 14-page memorandum that tried to provide some guidance on how to interpret just one provision of the bill, the prohibition on loans.

Let me offer another example, the Sarbanes-Oxley requirement that audit committees include at least one "financial expert". After a long and contentious discussion, the Securities and Exchange Commission finally did come up with a set of attributes to define such a person. But in publishing its definition earlier this month, the SEC then substituted a new term, "audit committee financial expert", and included a so-called safe harbor provision to ensure that this person would not be considered an "expert" under the law for any purpose, even within the Securities Act, and would face no additional duties or liabilities.

Finally, the SEC decided not to make the appointment of such a person mandatory. Instead, a company must simply disclose either that its audit committee includes such an expert, the person’s name and whether he or she is independent of management or that it has not appointed an expert and its reasons for doing so. In short, at the end of the day, even the SEC decided that the best way to implement this provision of Sarbanes-Oxley was to rely on voluntary action backed up by mandatory disclosure.

All the fuss over Sarbanes-Oxley is also having an impact on American markets. Media reports have suggested that dozens of publicly traded American companies are now looking for ways to delist their stocks and go private because of the burden being imposed by all the new regulations.

Lawyers in the United States have pointed out that the new rules could hurt smaller companies in particular by making it even more difficult to get analyst coverage and therefore by decreasing the liquidity of their shares. This observation is of special concern to Canada, because the vast majority of our publicly traded companies are decidedly small-cap by American standards.

Yet another problem created by the Sarbanes-Oxley Act is that some of its rules conflict with existing law in other countries. The European Union, for instance, has complained that the Sarbanes-Oxley requirement for personal certification by CEOs and CFOs conflicts with the fact that in some European countries, management boards have collective responsibility by law. Similarly, the American requirement for totally independent audit committees is incompatible with laws in Germany, the Netherlands and elsewhere that mandate employee representation on boards. Here too, though, there have been signs that the SEC, overwhelmed as it is by the complexity of crafting regulations just for domestic issuers, is looking for ways to work with securities regulators in other countries to come up with acceptable forms of mutual recognition.

In Canada, the Council’s emphasis on voluntary action and mandatory disclosure — rather than a host of new regulations — has been portrayed by some people as a "laissez-faire" attitude, a go-slow approach that is out of touch with today’s market realities.

But the Council favours a principles-based rather than rules-based approach to improving governance practices precisely because we believe that the former sets the higher standard. As respected shareholder activist Stephen Jarislowsky put it, an excessive reliance on rules can lull the ordinary investor into a false sense of complacency. Nor do rules necessarily lead to what the Joint Committee on Corporate Governance referred to as moving beyond compliance in order to build a culture of good governance. Even in the absence of specific rules, on the other hand, strong investor expectations coupled with peer pressure can have a powerful impact.

As Janet McFarland said in her column in The Globe and Mail yesterday, the recommendations of the latest study in the United Kingdom by Derek Higgs call for standards that in some respects exceeds both Sarbanes Oxley and current Canadian practice. But the Higgs Report, like our Council’s statement, in fact embraces the "comply or explain" approach.

As an illustration of that power, just look at how Canada’s performance stacks up against that of the United States on some key issues. For instance, as Spencer Stuart noted in its most recent survey of board practices, the boards of large, widely-held Canadian companies are far more likely than their American counterparts to evaluate their own performance and that of individual directors and to give directors access to outside experts.

Perhaps most striking, however, is the growing trend in Canada toward the separation of the positions of chair and chief executive. In the United States, this issue was highlighted in early January by the Conference Board’s blue-ribbon Commission on Public Trust and Private Enterprise, which in its final report recommended that American companies break with their tradition of joining the two positions. Yet even as this issue of corporate leadership is ignored by the Sarbanes-Oxley Act, the boards of most major Canadian companies have concluded that the separation of the two positions leads to both better governance and better corporate performance. Investors have been expressing a preference, and boards have been listening.

The bottom line is that all the rules in the world will not restore public confidence. And while regulators can make new rules and shareholders can vote for new governance practices, it is CEOs who must set the tone at the top for their enterprises. And in any recipe for rebuilding public trust, there is simply no possible substitute for honesty and for personal integrity. Yes, we need to do a better job of catching and punishing those who break the rules and abuse that trust. But in an age of information overload, character matters more than ever.

This, in the end, is why the Council’s recommendations on improving governance have emphasized that so much of what needs to be done to restore and enhance investor confidence can and should be achieved within the private sector. As Frank McKenna observed yesterday, rule changes alone cannot create world class boards or world class companies. Individually and collectively, it is business leaders who must earn the public trust that they need to build their enterprises and strengthen the economy. No government can legislate that trust. No regulator can restore it. Businesses, and business leaders, must earn it.

And to earn trust, companies and their leaders must both set high standards and then live up to and be seen living up to these standards. In other words, strong values and thorough disclosure are no longer mere virtues; they are becoming necessities. A commitment to transparency is both necessary to avoid perceptions of increased risk, and desirable as a means of creating competitive advantage. Yes, transparency also can create risks, but none so great as the risk of trying to hide.

More to the point, everything that is disclosed is receiving much greater scrutiny. Here, I am referring not to the legal review of the kind of detailed certifications required by the Sarbanes-Oxley Act. Rather, I am talking about exercises like The Globe and Mail’s league-table ranking of corporate governance practices. Whether or not you agree with every element of the newspaper’s methodology, the fact is that the data that went into its rankings has been available publicly for years. Only now, however, is it being collated and compared. And I would suggest to you that such public comparisons are generating tough questions and prompting action to improve governance far faster and more effectively than the tortuous process of drafting regulations that has engulfed the SEC since the passage of Sarbanes-Oxley. I was therefore delighted to hear that Ed Greenspon last night committed The Globe and Mail to continuing its ranking exercise in future years.

There is still plenty of room for improvement in Canadian governance practices — and indeed always will be as public and investor expectations rise over time. But I am seeing in Canada an emerging consensus that the right course for our country will continue to involve a sensible balance between rules and guidelines, one that acknowledges the importance of a sound legal base, but that also understands and takes advantage of the power of transparency and disclosure.

As Bank of Canada Governor David Dodge noted in a recent speech, the market has become very effective at rewarding companies that successfully maintain investor confidence and punishing those that have abused investor trust or are not sufficiently transparent.

While the Governor said he has been impressed by how seriously the private sector has responded to the challenges raised by the events of the past year, he too agreed that it is important both to continue working on these issues and to be seen working on them: "We live in a world where impressions matter and where capital markets are increasingly global. Canadian issuers will be judged not only against our own standards, but also against the worldwide standards for accounting, disclosure and governance."

I have heard similar sentiments expressed over the past week at the World Economic Forum in Davos where the overarching theme was building trust in private and public institutions and their leaders. One speaker summed up the new level of expectations among citizens world-wide on this issue. "Simply saying trust me no longer is acceptable", he said. "Now", he added, "you must show me." All of us who carry fiduciary responsibilities must continue to respond to this challenge, and I believe that we in Canada have a special role to play. If we are prepared to build on a strong record and aspire to ever higher standards in the practice of transparent and accountable governance, we can be the example to the world which in many of its parts is still struggling with concepts of governance in their most rudimentary form. This we must do. Based on what I have heard at this conference, I believe we are well on our way.