Corporate Governance Code and the Role of Regulators

Corporate Governance Code and the Role of Regulators Role of the Regulator Best Practices Implementation Process David A. Brown, C.M., Q.C. May 5, 2009 Bahrain

Overview • Policy makers and thought leaders are turning their attention to corporate governance issues • For three reasons • Good governance works! • Investors expect good governance • Government social agendas

Good Governance Works! • Institutional investors recognize that good governance contributes positively to corporate performance • Example – Canadian Coalition for Good Governance – 41 pension funds holding $1.4 trillion assets of Canadian public companies • “good governance practices contribute to a company’s ability to create value for its shareholders” • Corporate activist

Investors Expect Good Governance • Confidence in fairness has been shaken by recent events • Corporate failures (Enron, etc) • Global financial crisis • Perception that inadequate governance contributed to the destruction of shareholder values

Government Social Agendas • Governments seeking to foster economic development • Create jobs • Create opportunities for wealth creation for their populations • Recognize advantages of a viable capital market • Good corporate governance a cornerstone

Particularly Important for Bahrain • Relative infancy of capital markets • Historical and cultural background - survey • Companies owned by families or closely held • Boards reflect ownership structures • More representative than strategic • Boards must evolve to align more with structures in developed markets • Fulfill several functions including oversight of management, strategy setting, risk management • Assist establishment of a viable capital market

Why is a Corporate Governance Code Necessary? • To compete for issuers and investors, must have a viable capital market • Issuers and investors must have confidence in the integrity of the market • Fair and efficient access for issuers • Safe environment; level playing field for investors • Market reputation is critical • Must be seen as a fair place for investors to invest

A Viable Capital Market • Major determinant of a marketplace’s reputation for fairness will be the principles by which listed companies conduct themselves • Compliance with a robust governance code is essential

A Viable Capital Market • Draft Bahrain Code captures the best practices that have been developed since the failures of Enron, Parmalat, etc. • Adapts internationally accepted principles to the environment here in Bahrain

A Viable Capital Market • If the new Code is embraced and enforced by all of the principal players, Bahrain will be a viable competitor for investors and listings among competing marketplaces • There will be tangible improvements in the businesses that adopt them • Economic development will be enhanced

Role of Regulators • Pressure on regulators to provide marketplaces with a competitive edge • From politicians • Benefits in fostering social change • From market participants • Convenience – burden with complying with foreign regulations

Role of Regulators • Difficult role for regulators • Very least – ensure regulatory systems not a drag • Probably pressured to go further – create a favourable regulatory climate • Not an impossible job • Effective regulation and competitive markets have common roots • Both require fair treatment of investors

Role of Regulators • Must have investors who want to invest • Climate in which investors confident of protection against fraud, manipulation, unfairness • Wide choice of listed companies • Must have listed companies • Efficient and fair marketplaces • Will be attracted by presence of investors • Not if rules designed to attract investors place unreasonably high regulatory burdens • Need an environment attractive to both sides • Real challenge is to maintain a proper balance

Global Context • Useful to examine your draft Code in the context of global corporate governance developments • Explain why some principles evolved • Discuss objectives sought to be achieved • Underscore the desirability of implementing and enforcing the Code

Global Context • Global pressures for governance reform • Enron etc. collapses attributed, in part, to failures of corporate governance • Failure by boards of directors to provide independent oversight of management • Failure to ensure that external auditors provided independent, objective review of financial reports • Failure by companies to provide timely and accurate information • Rules and practices evolved to rectify these failures

Core Principles of Bahrain Code • Examine the principles of your draft Code against the background of this global evolution • Focus on four key areas • Empowering the board • Role of the audit committee • Protection of minority shareholders • Compensation and incentives

Empowering the Board • Enron and other failures exposed serious issues about board effectiveness • Boards had been comprised of competent, experienced people; some with high profiles • Yet, management wasn’t challenged • Necessary stewardship wasn’t provided • No one was protecting the best interests of the corporation and its investors

Empowering the Board • Global response to board shortcomings • Require some degree of board independence from management • Clearly articulate the board’s accountabilities, duties of loyalty • Many countries have gone further • separate the roles of the chair of the board and the CEO • Require CEO and CFO certification of financial statements

Empowering the Board • Result • Public companies are recruiting knowledgeable, independent directors • Legitimized conduct by directors • Questioning, probing management • Holding management accountable • Now widely accepted as part of board culture • Draft Bahrain Code incorporates these best practices

Role of the Audit Committee • External auditors had become too aligned with management • Audit not a reliable independent, professional review of management’s financial statements • Auditors looked to management as their client • Required a knowledgeable body, independent of management, to direct external auditors

Role of the Audit Committee • Global response was to mandate and empower an audit committee of the board • Independent of management • Members financially literate • Audit committee rather than management would become the external auditor’s “client”

Role of the Audit Committee • Result • Audit committees are part of virtually every public company • External and internal auditors report to the audit committee • Boards are now allocating additional responsibilities to the audit committee • Danger that they will become over burdened • Draft Companies Law and Code mandate and empower an audit committee

Protection of Minority Shareholders • Regulators recognize the importance to markets and economies of the entrepreneurial drive of family groups and other controlling shareholders • For the most part, interests of controlling shareholders are aligned with the minority • Corporate scandals exposed areas where controlling shareholders can use their position to advantage • Need to find a proper balance

Protection of Minority Shareholders • Responses to these issues vary depending on local environment • Universal requirement – all directors owe their duties to the corporation and all of its shareholders • All shareholders are equal • In many countries there are further protections • Nominees of controlling shareholders are not classified as independent directors • Dealings with controlling shareholders must be approved by independent directors • Draft Companies Law and Code adopt these provisions

Compensation and Incentives • Following Enron and other failures – recognized that form of management compensation could create perverse incentives • Stock options seen as fostering short term outlooks • Interests not aligned with shareholders • Particularly when awarded to directors • Share ownership better aligns interests with shareholders • Many companies require directors to own shares

Compensation and Incentives • Still, properly designed compensation plans can be an effective tool for motivating management • Some forms of incentive plans are here to stay

Compensation and Incentives • Global response in the post-Enron period • Governments generally reluctant to legislate the form or amount of compensation • Instead required compensation committees of the boards • All or a majority independent of management • Required extensive public disclosure of management compensation • Amounts and components • Factors considered in designing compensation • Draft Bahrain Code adopts these approaches

Compensation and Incentives • Recent economic crisis has exposed instances of compensation excesses • Particularly in some financial institutions • Incentivizing excessive risk-taking

Compensation and Incentives • Responses are still being formulated • In the U.S., caps are put on executive pay in corporations receiving government monetary support • “Say on pay” votes by shareholders • Bahrain draft Company Law and Code require shareholder approval of executive compensation

Comply or Explain Approach • Rationale • Alternative to US-based “rules” approach • Principles based, flexible • Allows companies to phase in, adapt to specific circumstances • Canada adopted a code and a comply or explain approach in response to Sarbanes Oxley

Comply or Explain Approach • Properly administered, comply or explain can be very effective • Theory is that market forces will determine whether a company is following appropriate governance practices • In Canada – market and peer pressure have prompted uniformity of adoption of all aspects of the code

Comply or Explain Approach • Success depends on effective, constant oversight by regulators • Failure to address disclosure items • “Boilerplate” disclosure • Guidance; assistance to help issuers make appropriate disclosure • available precedent • After initial start up phase • Regulators can issue public report highlighting deficient areas of disclosure

Comply or Explain Approach • Targeted reviews of problem areas of disclosure • Enforcement • Require delinquent companies to republish correct disclosure • Fines, sanctions of directors and/or officers • Delisting last resort • punishes shareholders, not those responsible for the failure

Comply or Explain Approach • Challenges • Be wary of relying on the stock exchange to police disclosure • Possible confusion of responsibilities under the Code • Ministry of Industry and Commerce (MOIC) • Central Bank of Bahrain (CBB) • Bahrain Stock Exchange (BSE) • Should be a single authoritative voice

Summary • Compliance with a robust governance code is essential to a financial market’s reputation for fairness • Draft Bahrain Code captures best practices that have been accepted by investors, listed companies and regulators around the world

Summary • As regulators you play an important part in ensuring that the Code is complied with • If listed companies embrace the Code and you enforce it • Bahrain will be a viable competitor for investors and listings among competing financial markets • There will be tangible improvements in the businesses that adopt them • Economic development will be enhanced • Thank you

Dialogue, Questions • Dialogue • Discussion • Questions?

Implementation Process • Discussion of some of the provisions of the Code • Some issues to watch for • Review and discussion of precedent materials • Dialogue and discussion

Corporate Governance Code and the Role of Regulators