There are four elements to our annual governance survey: independence, accountability, total shareholder return and disclosure. Most of the information used in the survey is gathered from the company's annual management proxy circular distributed to shareholders in advance of the annual general meeting. When company disclosure is wanting, however, we turn to secondary sources such as annual reports, explanations of proxy voting records published by the Ontario Teachers' Pension Plan, as well as other independent sources.
1. Independence
The highest possible score in this category is 25 points, but companies could score as low as -19 points. In this category we look at the independence of the board and its committees, and whether the company has a democratic share structure. We also attempt to measure just how independently the board acts by looking at some of its compensation practices.
Independence, as defined by Canadian Business magazine, means the director has no business, personal or family connections to either the company or its senior management. The director should hold shares in the company, but the only compensation he or she should receive is the annual retainer awarded for acting as a director. For instance, a director who works at a bank or law firm employed by the company is considered a related director. A director who was employed by the company is considered “related” for three years after leaving the company.
Board Independence
(Highest possible score: 10 points; lowest possible score: 0 points.)
Companies where at least two-thirds of the directors are considered independent are awarded the full ten points. Five points are awarded to companies where between 51% and 65% of the board are independent directors. Two points are awarded to companies where only half the board is considered independent and no points are awarded to companies whose boards have less than a majority of independent directors.
Committee Independence
(Highest possible score: 10 points; lowest possible score: 0 points.)
Companies with no related directors on the audit, compensation or nominating committees receive the full ten points. Three points are deducted for each related director on each committee. If the same related director appears on more than one committee, three points are deducted for each committee on which the director sits. Five points are deducted if company managers sit on either the audit or compensation committees.
Chairman/CEO Split
(Highest possible score: 5 points; lowest possible score: 0 points.)
Companies that have split the roles of the chairman of the board and chief executive officer receive the full five points. Companies that have split those roles but have appointed a director not considered independent are awarded two points. Boards that have not split the roles but appointed an independent “lead director” are also awarded two points. If that lead director is considered related, however, the company is awarded just one point. Boards where the roles of the chairman and CEO have not been split, and no lead director has been named, are awarded no points.
Share Structure
(Highest possible score: 0 points; lowest possible score: -10 points.)
Multiple-voting share structures give one class of shareholder more control than equity ownership would normally allow. As a result, we penalize companies that use these dual-class share structures. Points are deducted on a sliding scale. Multiple-voting shares that represent more than 50% of the votes but less than 25% of the company's total equity are penalized ten points; five points are deducted for companies where the voting shares represent more than 50% of the votes and between 25% and 49% of the company's equity. Two points are deducted for all other multiple-voting share structures.
CEO Compensation
(Highest possible score: 0 points; lowest possible score: -9 points.)
Five points are deducted from companies that increased the overall CEO compensation despite a drop in share price over the same period. Another four points are deducted from companies that awarded the CEO more than 49% of the options granted in the previous year. Two points are deducted from those that awarded between 25-49% of those options.
2. Accountability
The highest possible score for this section is 35 points, but companies could score as low as -42 points. In this category we look at how accountable directors and managers are to shareholders, as well as how well the board manages and evaluates its own performance.
Director Share Ownership
(Highest possible score: 10 points; lowest possible score: 0 points.)
Share ownership is the best way to align the interests of directors and managers with regular investors. We award the full ten points to boards where all non-management directors who have been on the board for two years or more hold at least three times the value of their annual retainer in company shares. We count actual shares as well as share equivalents such as deferred share units. We do not count stock options. If all the directors are shareholders, but some fail to meet the three-times-the-value-of-annual- retainer threshold, we award five points. No points are awarded if any director on the board for more than two years owns no shares.
Director Share Ownership Requirement
(Highest possible score: 5 points; lowest possible score: 0 points.)
Five points are awarded if directors are required to own stock.
CEO Stock Ownership
(Highest possible score: 5 points; lowest possible score: -2 points.)
Five points are awarded if the CEO holds at least three times his base salary in company shares. Two points are awarded if the CEO holds less than three times the base salary, and two points are deducted if the CEO holds no shares.
CEO Stock Ownership Requirement
(Highest possible score: 5 points; lowest possible score: 0 points.)
Five points are awarded for companies that require the CEO to hold shares. Companies where the CEO is the founder or is already a significant shareholder are also awarded the five points.
Stock Options
(Highest possible score: 0 points; lowest possible score: -8 points.)
Granting stock options to directors can result in a conflict of interest for the board, which is also supposed to ensure that option dilution is kept to a minimum. Companies that continue to pay directors with options are penalized. Three points are deducted if directors are granted options that come from a director's option plan that restricts the number of options directors can grant themselves. Companies are penalized eight points if directors draw their options from the general management option plan with no limits.
Option Dilution
(Highest possible score: 0 points; lowest possible score: -10 points.)
One way to judge how well a board protects the interests of its shareholders is to look at how well it has managed its stock option plan. The higher the dilution, the less value shareholders are getting from their investment. Ten points are deducted from companies with option dilution rates of 10% or more.
Option Re-Pricing
(Highest possible score: 0 points; lowest possible score: -15 points.)
Stock options are meant to reward executives for their efforts to increase the value of the company's shares. When stocks go up, executives are rewarded with a potential stock option bonanza. Conversely, managers are penalized for a falling share price by holding options that become less valuable. Lowering the price of options is the equivalent of changing the rules halfway through the game. It shouldn't happen, and fifteen points are deducted from boards that engage in the practice.
Director Election
(Highest possible score: 0 points; lowest possible score: -2 points.)
Boards that stagger the election terms of their directors (i.e., only put a portion of the directors up for election every year) are penalized two points.
Director Evaluation
(Highest possible score: 10 points; lowest possible score: -5 points.)
How can a board expect to effectively evaluate the performance of company managers if it cannot evaluate itself? Boards that have implemented an annual, formal evaluation of both the performance of the board as a whole and its individual directors are awarded ten points. Boards that do not look at the contributions of individual directors, but instead merely focus on the board as a whole, are awarded eight points. Five points are awarded if disclosure of the type of evaluation is unclear, but some evaluation takes place. Boards with no evaluation and no corporate governance committee to oversee the effective management of the board, are penalized five points.
3. Share Performance
The highest possible score for this section is 25 points, but companies could score as low as 0 points. This is a controversial element in the Canadian Business governance methodology. Some complain that its inclusion helps companies with unusually good stock performance to hide their governance faults. Others complain that poor financial results are not necessarily the result of weak and ineffective boards. In fact, some of the best work by boards is done while a company is struggling to revive its financial fortunes.
We think the inclusion of share performance is essential. Companies that score near the top of our list have both strong governance structures as well as a proven track record of financial performance. Most of the companies that score poorly have not only weak governance structures, but also lackluster stock performance. An often-troublesome combination.
We award full marks to companies whose total shareholder returns (from March 2002 to March 2005) have outperformed their peers on the S&P/TSX Composite Index over the past three years. During that period, the index increased by 29%. Companies whose own three-year total shareholder return was between 1% and 10% higher are awarded five points; 11% to 30% higher are awarded ten points; 31% to 60% higher are awarded fifteen points; 61% to 90% higher are awarded twenty points. Companies with a total shareholder return that is 91% or higher than the index are awarded the full twenty-five points.
4. Disclosure
The highest possible score for this section is 15 points, but companies could score as low as 0 points. This is the only category where some element of judgment comes into play. We rate the overall disclosure of the company. Companies that fully disclose fees paid to auditors, and include attendance and full director biographies, are awarded points. Companies cannot receive full marks unless they have adopted new benchmark disclosure for executive compensation that outlines the total cash value of all compensation to top managers. This includes the cash value of not only the executive??s salary and bonus but also the value of any options, shares, restricted shares as well as any pension benefits. Not all disclosure will result in points being awarded. Companies will lose points for granting interest-free loans to executives or directors, related-party transactions, the existence of excessive golden parachutes, or other negative governance issues.
Total
The highest score a company can achieve is 100 points. The lowest possible score is – 61 points.
