Governnance ... Who Needs It?
	Delivery copy. An Address by Claude Lamoureux President & Chief Executive Officer Ontario Teachers’ Pension Plan Board February 27, 2002 Thank Daniel LeClair … Pleasure to be in MTR to …and to talk with a Sophisticated Group like the Financial Executive International Headlines from recent events: 02/05/02 Following an article raising questions about it’s accounting, drug maker Elan’s stock dropped 50%. This related to accounting practice regarding it’s research J.V. In 2001, profits as reported were 97¢ / share based on broad interpretation of accounting rules…but under a narrower interpretation these should have been 59¢ / share. 02/12/02 Nortel Executive resigns, because of insider trading. He sold before the release of worse-than-expected losses in 2001 and bought before better-than-expected results. Par hazard, the stock sank 18% after the first transaction on 03/27/01 and jumped 12% after the second on 12/18/01. You could excuse him if he had been the VP of Marketing…but the CFO? 02/15/02 Steve Mi/Lu/, Merrill Lynch’s Top Technology strategist (where is Henry Blodget…or Mary Meeker (Morgan S.)) told clients that if the Levin/McCain bill that would stop corporations from getting deductions in their tax return for options that do not decrease earnings in their GAAP P/L – the following would happen in the Technology sector -- If this had been in place in 2000 pro-forma profits would have been 60% lower and cash flow would have been cut in half – and he concludes “this could make earnings look bad” – Understatement It’s easy to answer the question is there to help his client? AIMR survey – 1900 worldwide analysts 83% wished that options be expensed on income statement 2/3 looked for option info in footnotes IASB chairman got a critical note from Trade Association of V.C. Biotech Ind. Assoc. U.S. Chamber of Commerce stating expensing options would hurt: High-technology firms World economy In addition, “the debate on this issue could endanger the current consensus supporting the IASB” 2/11/02 SEC to review annual reports more closely -- What does all of this add up to? A Martian looking from a distance would flash back to an article that appeared in Fortune one year after the Emerging Market bubble burst – The headline was: You cannot trust the accounting You cannot trust the analysts You cannot trust the regulators – Do you have the impression that this applies to Canada and the U.S. today? Today I would like to talk about the following topics – 1. Proxy Voting 2. Options 3. The importance of good governance and why our corporations and institutions need it more than ever … and I will conclude with some modest proposals Over the last year, you may have seen our name in the papers in relation to the voting of proxies The reason for this is that since December 2000, we post on our Web site how we vote on each proxy. Why do we do that? We try to be transparent in everything that we do and want to inform the 230,000 members of the Teachers’ Plan how we vote. On average they have over $300,000 at stake. We, in management are ultimately accountable to the members of the Plan and we invest and vote our proxies in their sole interest. Journalists are also very interested in what we do … especially if the company is a large one. We also hope that individual shareholders and even Institutional Investors who do not have the resources to research each issue will at least consider how we vote before doing so themselves. I might add I want to encourage every one in this room to vote for their proxies – In Canada, only 6% of proxies are voted for – Every year we give our board a summary of how we vote our proxies. In the last few years we have voted against one particular proposal … and lost over 70% of the time. This proposal has to do with options. Given our success rate … we sometimes wonder if our standards are unrealistic. What are our standards? We do not want dilution to exceed 5 to 10% and we do not like options that are distributed at a rate of more than 1 to 2% per year. We also prefer options that vest based on performance targets. Are these standards the one a rational investor would use? Are we unfair to the Compensation Committees who approve these matters and to the directors who represent us the shareholders? … or is there something else at work? Let’s look at the real world … In 1990, the typical large cap U.S. company annually granted 1.2% of its outstanding shares in options according to Pearl Meyer and Partners. By 2000 this had increased to 2.3% and today the average accumulated overhang for S&P 500 is nearly 13% … doubled the percentage of 1990. Another way to look at this is that today the Black Scholes cost is roughly 6% of the market value of the S&P. The question that boards face is how much is enough to motivate employees. Note that I did not say align the interest of management and shareholders… by now everyone knows that most option plans do not really do this. Our preference for senior managers are options that vest based on performance criteria or even indexed options … but this is even a poor second choice in terms of aligning our interest as shareholders, because a much better choice is to pay in restricted shares or deferred share units. Another preferred way to align our interests with those of management’s, is to pay a portion of the free cash flow after taking into account the cost of capital. But the more we look at this issue of options, the more we think we are barking up the wrong tree – this is not an issue of options but of proper accounting – On January 24th there was an interesting article in the WSJ – Senator Lieberman of Connecticut was wondering when FASB was going to clean up the bad accounting we see in corporations – It is the same senator Lieberman who objected when in 1994 FASB wanted to have proper accounting for options – As a result of his pressures and of other people in Congress, FASB has given us an unrealistic accounting for options To refresh your memory, the U.S. accounting standard for option states that to charge “the cost of employee options to the P+L is the preferred method, but footnote-only disclosure is permitted” FASB reached that conclusion “not because it believes this solution is the best way to improve financial accounting and reporting…but to bring closure to the divisive debate on this issue”. FASB’s decision was a political one influenced by Congress where many members got millions from management of corporations. And Canada in 2002 will follow this example. Therefore, the issue is not whether options are good or bad but that the cost of all transactions done by a corporation regardless of how it is paid i.e. in cash, in stock, in options, or in services should be reflected in the financial statements. What is also interesting with current accounting rules, because they do not require an expense charge result, is an overemphasis on fixed stock options as opposed to our preferred option performance stock options – or restricted stock options that would require such a charge – Now here is a question – How many companies in the S+P 500 change their options to the P+L? The answer is 2--- 498 misrepresent their earnings – Therefore the accounting system we have in North America is not the best we can have – It is influenced too much by Corporate Officers, government people…and not enough by investors If you want to know why investors are not involved enough, read the splendid report written by Myners for the U.K. – Have the compensation consultants look at these plans through the eyes of the shareholders of Jet Form, Imax, Tundra Semi Conductor, MDSI Mobile Data, Aimglobal, Centrinity Creo Products, who faced a dilution of over 25% … or through the wallets of the shareholders of 30 other Canadian Corporations that faced dilution of 15 to 25%? If you want to read the work of a reformed consultant … If you want to know about abuses, read the columns of Graef Crystal on Bloomberg news. When he retired from his post as the Managing Partner of Towers Perrin, he first wrote for Fortune … then for Financial World … then he had his own newsletter and now he is at Bloomberg.com. I understand the first 2 job changes were not because he lacked readership. There were pressures … pressures similar to the ones that were placed on the FASB when it was looking at the accounting for options in the U.S. … and wanted to charge those to earnings. The management of large corporations put pressure on the FASB while the board members who represent us did nothing. If options are the best motivators that a consultant can come up with, maybe the board who represent the shareholders should at least consult other experts to find alternatives. In addition, boards should start a campaign for better accounting for options and should lobby the department of Finance for tax neutrality on different kinds of incentives. Canada could take the lead on this but it maybe asking too much or is it? A recent report of the OECD states that in order to attract capital a country needs good governance. How do you do this … it is by having laws, regulations and practices that promote 4 ideas: fairness, transparency, accountability and responsibility. Everyone benefits when we adopt these concepts. But I digress … let me come back to options… As Warren Buffet said “ Arrangements that pay in capricious ways, unrelated to a manager’s personal accomplishments … are wasteful to the company and may cause the manager to lose focus on what should be his/her real areas of concern” and he adds “who, after all, refuses a free lottery ticket”. There are trends that we applaud like the one that requires directors to own a multiple of their retainer in shares. In 1999 in the U.S., 18% of the corporations required this… up from 3.4% in 1994. In Canada the percentage is around 10%. In the face of such many practices that depress shareholder value, we are often asked if good governance matters. Can it really make a difference? Ira Millstein and Paul MacAvoy demonstrated through a study of 154 large publicly traded corporations (published in the June 1998 issue of the Columbia Law Review) that the presence of an active and independent board leads to significant increases in economic profit. Economic profit is defined as operating earnings in excess of the costs of capital. These results from 1991 to 1995 do not prove causations but the study does demonstrate that these types of boards would have performed much better than those of passive, non-independent boards. In their views, independent boards have the following characteristics: 1. A non-executive chair or a lead director. 2. Periodic meeting of independent directors to provide the opportunity to evaluate management against the strategic plan. 3. Formal rules for the relationship between the board and management. The authors admit that these are surrogates that indicate that a board is independent and has a well-governing culture. The board of these companies had answered a letter from CALPERS asking them how well they were following the 28 specific governing guidelines published by General Motors. The answers were graded from A to F. A+ meant that the board of that company submitted a comprehensive list of guidelines … whereas F indicated a failure to respond. The group rated A+ clearly demonstrated value-added performance for each of the 5 years, whereas for the other one it was not as clear. But the authors concluded that “our test of active governance indicates that such behaviour generates improved corporate performance” and the methods used to measure an activist board demonstrate statistically significant relationship…in superior corporate performance. So it is clear that good governance does matter, and that is why we, at Teachers, take the issue seriously. We also applaud the work done by the Saucier committee … and like its members we are disappointed by the progress made since the Dey committee because the culture of governance and performance has not been adopted by all TSE listed corporations. To conclude, I would like to offer some modest proposals … to improve the performance of corporations. 1. Options: If a corporation uses options, a change should be made to net earnings and the dilution should be clearly divulged. 2. Spread the grant of options over 12 months of the year instead of doing it at one time. This would remove some of the lottery aspect that we observe. 3. Every compensation committee should describe what is a sustainable level of dilution. 4. Transparency: When buy back of shares occurs, the Board should demonstrate how the buy back is accretive to the shareholders. In the U.S., a recent Federal Reserve study warns that many companies will have to devote virtually all of their future profits to buy back programs just to keep pace with their option grant rates. 5. Legislation should be changed so that corporations are required to divulge the vote on each of the issues presented within one day of the annual meeting. Currently, few companies divulge this because it is not required. 6. Charles Elson who was instrumental in removing Al Dunlap from his position as CEO of Sunbeam suggest to pay directors largely in company shares which cannot be sold during their term in office because there is a positive correlation between high levels of director share ownership and high levels of performance. Corporate governance experts do not agree on everything … but one thing they agree on is that the interest of shareholders and directors should be aligned. A US study by Harvard demonstrated positive correlation between good corporate performance and directors owning ½ Million or more in shares. This is an area where we have seen progress but more corporations can adopt such plans. 7. Pension Plans/Mutual Funds: Any organizations that invest money for the general public should publish its proxy voting guidelines and should publish at least once a year how it has voted. This would ensure that the vote is in the interest of the investors and not in the commercial interest of the Investment Management firm as is too often the case. 8. Openness: Board Members should find out who the largest shareholders are and not be afraid to meet with them. To open parentheses, a few years ago, things were not going well at Moore Corporation. I had arranged with 2 directors to meet with our people to discuss the situation … They both accepted but within days they both bowed out gracefully … probably after having talked to their boss, the CEO. 9. Our security regulators in Canada need much better tools and the ability to impose fines – how many of you know that the OSC cannot impose fines? They need better tools to penalize people who get involved with insider trading. Investors should applaud the decision of the OSC panel to reject the fine of $1 million who Mike Copeland, the ex CEO of Corel was asked to pay for the $5 million he allegedly made on insider trading. Why was he not asked to repay the $5 million and a fine of 50% on top? 10. Before each board meeting, there should be a pledge of allegiance to remind board members why they are there and who they represent. I will end here for my suggestions … and I am sure you can come up with even better ones. Private enterprise must find a solution to these problems – they must act in concert with governments in the interest of shareholders and the population – Even modest improvement in current compensation practices … or in the governance of a corporation can have an enormous impact on your wealth and even more importantly on the wealth of all Canadians…. You deserve no less. Thank you.

		TOP