Proceedings of the Standing Senate Committee on
Banking, Trade and Commerce
Issue 43 - Evidence
OTTAWA, Wednesday, May 29, 2002
The Standing Senate Committee on Banking, Trade and Commerce met this day at 3:40 p.m. to examine and report upon the present state of the domestic and international financial system.
Senator E. Leo Kolber (Chairman) in the Chair.
[English]
The Chairman: We meet today to look into the problem that we call ``Enronitis.'' We have two witnesses today. The first is Professor Daniel Thornton from Queen's University. Welcome, Professor Thornton.
Professor Daniel Thornton, Queen's University: Honourable senators, I am delighted to have a chance to talk to you today about financial reporting quality. My presentation will summarize the ideas in the submission that I made earlier. They will also address certain issues about which your senior policy adviser suggested you might be interested in hearing.
There is a financial reporting quality chain that consists of several links forged in a competitive international market. Strong regulatory oversight — which is probably something you can do something about directly — is an important mediating factor. However, I will submit to you today that regulatory oversight can only temper a chain that is already strong. It cannot forge a new one by itself. If information is poor or if the other links are weak, the chain will still fail to produce quality financial information.
I would like to start by reviewing some of the accounting literature regarding how audits are priced in competitive markets and how accounting principles are forged in competitive markets. The theme of these remarks is that both auditing and accounting are social constructions for which there is a supply and a demand. The rules we see are basically the result of the interaction of people who voluntarily provide accounting information and people who voluntarily purchase it.
In well-functioning markets, investors price protect themselves. This is a fundamental tenet in the academic literature. By price protection, we mean that they demand higher rates of interest or return from companies whose financial reports are less credible. Companies, therefore, voluntarily incur the costs to issue audited financial statements because the benefits of doing so exceed the costs. In such a market, auditors with strong reputations command a fee premium. They know they have a lot to lose if their clients issue financial information that is misleading. They know they can be sued. They must purchase liability insurance. They have much on the line.
High fees, then, signal audit quality because they have to capture the cost of liability insurance when they provide an opinion on financial statements.
The Chairman: You say that there are high rates of return from companies whose financial reports are less credible. Would you enlighten us as to how an investor knows a report is less credible?
Mr. Thornton: In the academic literature, the primary signal of financial reporting quality is the strength of the audit signal and the audit committee. In recent years, this has been supplemented by other measures of financial reporting quality, which I intend to outline on subsequent slides.
In these well-functioning markets, companies voluntarily demand that there be a central institution that sets generally accepted accounting principles. They voluntarily apply them, and they support this institution. In such a market, nobody needs to forbid auditors to earn non-audit sources of fee revenue. If the company wants to signal to the market that the quality of their financial reporting is high, then, among other things, they will voluntarily incur the extra costs of decoupling their audits from any consulting services that appear to conflict with auditor independence. In recent weeks, we have seen this happen with two of Canada's major banks; the CIBC and the Toronto-Dominion Bank did just that.
Markets are seldom, if ever, perfect. The auditing market has its share of imperfections. Some people allege that accounting is an oligopoly, with only a handful of firms auditing most of the world's major corporations. However, the academic literature has had difficulty verifying this claim, primarily because it is difficult to measure the quantity of the service. It is also difficult to disentangle what might be viewed as oligopoly profits from a fee premium that compensates the auditors for providing global reach and higher quality services.
Some people also allege that limited liability partnerships — the sort of LLP phenomenon — have also blunted the quality of audit signals in our market. In the economics literature, limited liability is looked at as a substitute for liability insurance. However, it is an imperfect substitute because the shares of audit firms are not traded in competitive markets, the auditors may not feel the costs of liability as directly they did in the days when they had to purchase liability insurance, and they were jointly and severally liable. This allegation has also been made, and there are people who would support and refute it.
I would submit to you today, however, that the most serious market imperfection is an information problem. Most investors do not understand what auditors do, and many managers — at least up until recent weeks and months — did not see the value of a good audit. As a result, audit firms had to resort to what in the academic literature is called ``low- balling.'' They had to use their audit as a loss leader for introducing other sorts of business on which they could make more profit.
There was also pressure on the quality of new accountants entering the profession. If audit fees were not high, and if other services such as tax, management consulting and information services were the ones that commanded the greater fees, profits and respect within the firm, the highest quality students did not want to become auditors. We are seeing this already at Queen's University where during the past few years the very top students at our business school do not go into accounting.
Another problem is that the finance profession, for the last decade or so, has been one step ahead of accounting in designing exotic instruments and transactions. Accounting standards setting, as I will submit in future slides, is a rather ponderous process; it takes time to gain consensus in the business community. However, designing a new or exotic instrument takes only a few minutes and can be instituted immediately. Our mutual goal would be to strive for financial reporting quality in these imperfect markets.
What we have is a financial reporting quality chain. There are four links in the chain. The first link is management incentives and attitudes. We have seen in the Enron situation that if intelligent managers are intent on bending rules, managing earnings and getting unseemly accounts off the balance sheet into special purpose entities, then the other three links in the chain need remarkable strength to compensate for that weakness.
Audit quality is the second link in the chain. It is usually measured — at least in the accounting literature — in terms of the percentage of fees that an auditor charges a client for the audit as opposed to other services. There is evidence in the literature that auditors can stand up to management when management tries to bend the rules, but they have more difficulty doing so when the accounting standards are loosely written or when estimates are involved in the numbers that appear on financial statements.
Audit committee expertise is another link in the chain. In the submission that I sent to you will see that there has been some exciting new research looking into how audit committees interact with auditors, and what constitutes a high quality audit committee. It depends on such things as how often the audit committee meets, the expertise of the people on the board, and so on.
The fourth link in the chain is strong accounting standards. This is an area where I have direct experience. It is very difficult to set accounting standards because generally accepted accounting principles need to garner the respect of the business community. This means that we must canvass their opinions. We must make sure that the people for whom we are setting the standards are able to apply them. It is a ponderous exercise in many cases. As well, if the accounting standards are too precise, they may show management precisely how to get around a rule and portray their firm in a rosy light. Therefore, setting accounting standards is a difficult process.
It is a process that takes place in an international context. At the Accounting Standards Board, of which I am a member, we often feel that we have lost control of our agenda; that we are converging towards U.S. accounting principles in most respects. We are converging towards international accounting standards. We really do not have the ability to set our own agenda. We are part of international forces that are setting standards today that have many components, competitive markets and expertise all the way along the line.
I have look at regulatory oversight as a mediating factor. I will mention briefly some of the experiences I had last year at the Securities and Exchange Commission in Washington, D.C. I would view the SEC as the world's premier regulator, but better regulation and stronger oversight can only temper a chain that is already strong. It cannot forge a chain on its own.
I would also like to present to you some of the results that have appeared recently in the accounting literature regarding quality of financial information and earnings management. The theme here is that the accounting numbers that we actually see on companies' financial statements are the product of the strength of all four links in that chain, plus regulatory oversight. This literature, for the first time, is beginning to show us in dollars and cents how higher quality financial reporting rewards companies with a lower cost of capital and therefore rewards shareholders with higher share prices.
This research generally proceeds by looking for indicia of earnings quality by examining the numbers in various jurisdictions around the world and theorizing about the properties that these numbers would have if there is a high or low quality financial reporting process behind them. For example, we research or measure the proportion of firms that have positive earnings but negative cash flows. You may be surprised to learn that, in developing countries, this is a phenomenon that happens much more frequently than one would like and much more frequently than it does in Canada. This is one indication that perhaps the people who are producing these numbers are managing them to portray their firms in the most favourable light.
This is not the kind of thing we could measure for one company with any degree of confidence, but when we look at thousands of companies across many countries worldwide, the statistical properties of a measure like this become much more convincing.
Another indication is the ratio of accruals to book value — accruals being things that increase earnings without any cash flow behind them. Generally, this is measured on a per share basis.
Another indication is the ratio of the number of companies reporting very small positive earnings to the number of companies in a jurisdiction reporting very small negative earnings. The theory here is that small losses are very damaging to companies. Managers do not want to report them. They do everything they can to get the earnings number just into the black. This ratio, then, would reflect the degree to which this happens.
The Chairman: Can we return to your first indicator for a moment? You make it sound — perhaps you mean to — that if your positive earnings versus cash are larger, or your cash flow is larger than your positive earnings, that this is necessarily a bad thing.
Mr. Thornton: It is not necessarily a bad thing at all for an individual firm in a single year. It may be part of a long- term strategic plan. However, looked at over many hundreds of companies, if we see many of instances of this, then it suggests that maybe earnings management was the culprit. Certainly, I would agree with you that in a single year, for an individual company, this kind of measure does not necessarily signal anything. It may, or it may not.
The final indicator is exploratory measures. I have only become aware of this myself in recent months. When I visited the University of Iowa last month, one of the doctoral students there was looking at deferred tax balances as an indication of earnings management. The theory was that, all else being equal, companies want to look poor to the tax authority and rich to shareholders. Therefore, they will try to minimize their taxable income and maximize the income that they report to shareholders. Across large samples of companies, then, companies with larger deferred tax balances would, all else being equal, tend to be the ones that were managing earnings.
What is the actual evidence? I would like to briefly describe the results of some research that was done by my colleague at Queen's University, Professor Michael Welker. He and his colleagues in the United States looked at the first two indications and collapsed them into a composite score. They added control variables across more than 30 countries to try to soak up any other effects that earnings management was not capturing, and they asked the research question: What is the cost of earnings opacity? What is the cost of managing earnings as measured in this statistical fashion? The answer: On average, an increase in overall earnings quality from the 25th percentile to the 75th percentile rewards companies with a 3 per cent decrease in the cost of equity capital. That is 300 basis points, which is an absolutely enormous swing. They conclude, then, that financial reporting quality is a bargain. I take from their research the implication that audit quality is likely an undervalued good.
These cross-country comparisons are very interesting, but how would we go about assessing earnings quality and financial reporting quality domestically? On the basis of what I have observed over the last five years or so, and particularly through my experiences in the United States last year at the SEC, I would say that we are verging on a consensus that financial reporting quality has at least five essential qualities. Many people would say, ``I just know it when I see it,'' but recently people have tried to articulate what the qualities would look like. I would like to try to enumerate those for you.
There is also a consensus now that earnings quality is a subset of financial reporting quality and that audit committees must interpret and apply these ideas and try to institute them.
What are these five qualities is make financial reporting useful or that make earnings quality and financial reporting quality high? First, high quality financial reporting is as clear and simple as possible, because even sophisticated readers mentally check out when it is overly complex. Einstein said that science should be as simple as possible, but no simpler than that. I think this idea is sort of adapted from the physical sciences.
Second, high quality financial reporting reveals the results of business segments through the eyes of management. The MDNA, the management discussion and analysis, explains why segments did well or poorly rather than just restating the numerical results verbally.
Third, high quality financial reporting is forward looking and is timely. The MDNA forthrightly discloses any known events or uncertainties that could affect future reported results.
Fourth, high quality financial reporting segregates nonrecurring items from normal revenues and expenses, and it convincingly explains why they are nonrecurring. This is something that every analyst wants to know about: ``What kind of an earnings multiple should I slap onto this component of earnings in estimate the price or intrinsic value of a stock?''
Finally, high quality financial reporting identifies intangible assets and key performance indicators, including those that accounting does not explicitly recognize such as a high quality work force or patents that are not shown at market value.
Accounting quality or earnings quality is subset of all this. The consensus in the literature now is that it has three attributes: First, it adheres to generally accepted accounting principles but it also discloses cash flow, preferably using the direct method. Investors need to be informed about both. Second, high quality accounting is neutral. It is not aggressive in recognizing revenues and does the not rely and accounting alternatives to smooth earnings. Third, high quality accounting discloses management basis for all estimates on the financial statements.
I will now spend a few moments talking about regulatory oversight, because I know that the honourable senators are particularly interested in this issue. I will relate my experience at the SEC last year.
The SEC, as I am sure you are aware, has statutory authority to prescribe accounting principles. Most Canadians are surprised to learn that the SEC thinks that it has the authority also to set auditing standards. However, uses this authority to encourage and support the development of accounting and auditing standards by private sector bodies — principally the Financial Accounting Standards Board, which is the U.S. counterpart of the Accounting Standards Board in Canada, of which I am a member.
It is a long-standing tradition that the SEC has this authority but has voluntary stepped back and delegated this authority to the private sector. Occasionally, they have taken back that authority and established principles of their own. Generally, they let the FASB establish accounting standards. This delegation of authority does not mean that the SEC does not get involved. Far from it. First, the office of the chief accountant of the SEC oversees the FASB in a more invasive way than anyone oversees accounting standards in Canada.
The enforcement division is active. In August 2001, it was preparing to prosecute over 2,000 security market violations, many of which involved financial reporting deficiencies.
The SEC has a full disclosure program. Every day, hundreds of professional accountants and lawyers from the division of corporation finance challenge accounting and disclosure policies of registrants. I spent most of my time with the SEC in this division. It is difficult to explain, if you have not seen the SEC headquarters in Washington, what an enormous building it is. There are 2,000 people in that building. There are another 1,000 in the operations centre across town. There are hundreds more across the country. All of these people are enforcing and examining registrants' financial statements and providing real time feedback in the financial reporting system.
Their digging unearths a surprisingly large number of accounting errors, a surprisingly large number of disclosure deficiencies and many iffy interpretations of applications of the accounting literature. The purpose of this is to provide real time feedback within the U.S. standard setting process. On a daily basis, U.S. regulators are more evasive and influential than Canadian ones.
It is important to note that the sentiment in the U.S. is that going to the SEC is like going to a finishing school. Some of the country's best young lawyers and accountants see a stint in the division as a ticket to success in the private sector. As you are aware, the current chairman of the SEC, Harvey Pitt was there. He then practiced law in the private sector, and now he is back in that division. It is a common sort of phenomenon that people rotate between the private and public sectors. This continually refreshes the intellectual vigour of the organization. The SEC levers this enthusiasm by providing weekly training relating to contemporary legal and accounting issues and giving the staff access to seminars presented by some of the world's finest accounting and finance scholars. There is an office of economic analysis there that has more Ph.D. economists than most universities.
I am sure that you have heard about Chairman Levitt's earnings management initiative. He decided to chair a task force to examine the filings by registrants and look for evidence of earnings management. His task force uncovered a shocking number of irregularities — I called them ``Trojan Horses.'' They were smuggled past the eyes of unwary investors. As an upshot, accounting firms rewrote internal guidance and implemented special training for their audit teams. Implementation questions, unearthed in task force reviews, percolated onto agendas of accounting bodies such as the emerging issues task force.
The SEC published informal guidelines for registrants and auditors in staff accounting bulletins. Some of you may have heard Staff Accounting Bulletin number 101, or SAB 101, that addresses revenue recognition. This has had an enormous impact on the practice of accounting in the United States and it is beginning to have an equal impact in Canada.
Some issues stemming from task force reviews were even so fundamental as to influence FASB standard-setting projects.
One might ask if the U.S. system seems better, why do we not just adopt U.S. GAAP system in Canada? Why do we have an accounting standards board? The answer is simple: We cannot import U.S. GAAP, like U.S. beef, into Canada without the necessary regulatory infrastructure.
I have only hinted at what a huge and vital organization the SEC is. We do not have a tenth of the horsepower in Canada. When we talk about U.S. GAAP, we are talking about a huge package comprising written standards and interpretations, auditing practice and strong continuous SEC oversight and feedback. I doubt that any non-SEC registrant could seriously claim to be following U.S. GAAP because they are not part of that package. That is why we need an accounting standards board in Canada.
I will summarize and offer some concluding thoughts.
I have argued that quality financial reporting requires expertise and integrity all along a financial reporting quality chain consisting of management incentives and attitudes, audit quality, audit committee expertise, and strong accounting standards.
I have also developed a thesis that strong regulatory oversight can temper and improve a chain, but it cannot forge a chain from scratch.
Finally, I will leave you with an opinion. Unregulated market forces can eventually nudge expert resources toward their efficient uses, provided that market participants understand what they are paying for, that standard setters are adequately resourced and that there is strong regulatory oversight, preferably at a national level.
Senator Angus: I am one of the many Canadians who have, at some stage in their lives, been told that accounting is very boring and dull. I must admit that in the context in which we are living today I found your presentation and the documents you sent us to be fascinating. I could go on for a long time here but I will try to focus on the lessons to be learned from the Enron debacle.
Are you an accountant yourself, sir?
Mr. Thornton: Yes, I am.
Senator Angus: Are you a CA?
Mr. Thornton: Yes, I am.
Senator Angus: What is the difference between a CA and a CGA?
Mr. Thornton: To me, the biggest difference between a CA and a CGA is simply that CAs have specialized in financial accounting. I am a professor of financial accounting. Many competent CGAs understand financial accounting. However, most of the practice of public accounting in Canada is carried out by CAs, and most of the people who want to specialize in that particular area probably go the CA route rather than other routes.
Senator Angus: I asked that because we do have the CGA Association coming here, as well as CICA. The CGA people feel they do not have the same recognition and privileges as the others and it is all getting diffused at the moment, given our current in the environment. You will have read their professional executive director speaking out on some of the issues that are before us.
I am very pleased that you are a CA, and that you are on the standards board, because we can really get right to it. You said that regardless of whether we have the infrastructure in Canada to support a U.S.-type system, you still believe the U.S. system is better than ours. Is that correct?
Mr. Thornton: I believe the regulatory oversight is better, yes.
Senator Angus: Are the standards and this so-called package you describe U.S. generally accepted accounting standards principles?
Mr. Thornton: We need to remember it also produced Enron.
Senator Angus: That was going to be my point. It is a better system, according to you and others, and yet Enron happened in the States. Here in Canada, cross-border companies run into the problem every day. Do they report in U.S. GAAP or Canadian GAAP? What do they do when the auditors come to the audit committee? They get into a big brouhaha. It is dysfunctional, in my opinion.
If we do some reforms and beef up the Canadian rules and regulations, and standards and principles to protect investors — which I gather is the bottom line — what is the quickest way to that end? I have always understood that accounting is a self-regulating profession through its own professional body. Fellow accountants are the ones who set the exams and decide whether an individual gets to be a chartered accountant.
However, getting back to my question, I always felt, ``Oh, well, you have a chartered accountant who belongs to the CICA. The CICA is a respectable organization. As long as your company's statements are preceded by a certificate from that auditor and that auditing firm is a member of this association, everything is fine.'' Investors have operated on that basis. Now you are suggesting that is not the case.
You listed the links, and you talked about it being only as strong as each link. However, I think what you really would have said if pushed, and maybe we will ask, is that ``it is only as weak as.'' Would that be an equally appropriate word in your sentence?
Mr. Thornton: I suppose so.
Senator Angus: As our chairman said before we started this study, there are laws, standards, and regulations out there, but things like Enron happen when people ignore those standards. When people go and rob banks, we have police. We have the usual laws. We have always heard you cannot legislate morality and so forth.
Can we no longer have faith in those letters ``CA''? Is it not good enough? Are you saying that, unlike the banks where there can be security plans and criminal laws, in this sort of amorphous area, where so much judgment and standard setting is required, we just have to trust the integrity of the policing body — which is the accountants themselves?
Mr. Thornton: I have three points that I should like to make in response.
First, the research that I have alluded to in my submission would suggest that if there is one weak link, it is indeed possible for the other three to compensate for it. There is interaction. Each link is not independent of the other. However, when one link is very weak, then the other three need to be much stronger than they would have to be if all four links were strong.
In the Enron case, I would submit that all four links were weak. It was like ``The Perfect Storm — if you saw the movie — everything conspired together. The management attitudes and values were not strong. The audit was obviously not strong. The audit committee did not do much. There are standards that, frankly, we need to fix, and guarantees and special purpose entities and so on. All four links were weak, and when that happens, it is difficult for an overseer like the SEC to pick up on what is going on because they are not getting high quality information.
As far as the standards are concerned, I being a member of the Accounting Standards Board do not consider myself to be setting standards for the CICA. In fact, the handbook is not set by the CICA; it is set by the Accounting Standards Board. I feel that we are completely independent of the CICA. If they are influencing me in any way in how I vote or how I think about accounting, it must be subliminal, because I certainly have not noticed it.
We have had CGAs on the accounting standards board. At the moment, I do not think we do, but as recently as just a year ago, we had one who is the Deputy Auditor General of Quebec. It is not a monopoly of CAs or an ``old boy network.'' The Accounting Standards Oversight Committee is simply trying to find individuals with both some technical expertise and some breadth of knowledge to set the standards. It would not matter what kind of professional designation a person had if we thought he or she would a useful addition to the board.
You will be hearing from Tom Allen, and he will be able to testify to this. The Accounting Standards Oversight Council, AcSOC, of which he is the chair, appoints people like myself. In fact, one of the members of the board is Senator Kirby, one of your colleagues. I would not say that there is a problem there at all in terms of a monopoly for chartered accountants.
Senator Angus: Certainly I was not suggesting that, on the contrary. I happen to be a member of the legal profession, and it is also self-policing. This has fascinated me.
Some of the members of this committee went to the U.K. a couple of years ago to do a comparative study of the oversight in the context of banks. They had just established the Financial Services Authority, FSA in the U.K. They were regulating in terms of financial statements, prospectuses and other financing reporting data purporting to regulate accountants and lawyers. We found this quite unusual.
I like to think that the legal profession has its standards. The ethics are continually under review. We do get the bad apples in the barrel.
On an audit committee, the information you have has come from management. If it is a big public company, no matter how expert the members of the audit committee members are, they will not really know. The auditors are constantly saying that there are levels of materiality and they rely on the statements, undertakings and the certificates of management for the voracity of that. Your first point of integrity of management is that they are either going to be honest or not.
The tricky point for me is the independence of the auditors and if these folks really have professional integrity, regardless of whether they are doing consulting work. What you described earlier is simple conflict of interest. If they are not independent because they are going to be relaxed with management on a couple of tricky goodwill issues and because they want to get the fees on setting up a new computer system, they have a conflict of interest. I do not think people will disagree with that.
What about maintaining independence? I agree with you that auditing is a valuable commodity. Can we rely on their integrity to maintain their independence and stand up to management? Should not the audit committees be constantly on the lookout for any breach of that?
Mr. Thornton: We can certainly rely on them to be on the lookout for these things and try to stand up to the management.
Recently, following the Blue Ribbon Committee report in the United States, a rule was instituted that requires the auditor to meet with the audit committee and must give his or her opinion on the quality of financial reporting — not just the acceptability of accounting but the aggressiveness or conservativeness of the accounting. This would go a long way toward a alleviating some of the inability of the audit committee to relate to some of the numbers.
We see violations every day on the highway. I mentioned this in my submission. We see people speeding. I am sure if you set up a radar gun on Highway 401 and left it there for a year, you would find someone driving 120 miles an hour. There will always be someone exhibiting extreme behaviour. What percentage of offences can we tolerate? You will never stop speeding. People will always speed. There will always be an Enron cooking some place. How many would be acceptable? Zero is what we would all like; that is for certain.
Business is evolving every week. Financial economists are coming up with new financial instruments that accountants have not yet to learn. Things are changing all the time. We cannot expect to fix something today once and for all because things change.
There will always be an Enron in the making. It is a question of whether the links in the chain are strong enough to stop it before it boils to the surface.
The Chairman: In testimony before Congress a couple of months ago, Alan Greenspan said that when he was in private practice, he had been on a number of audit committees and did not know what questions to ask. That gives us pause for thought, I would think.
Senator Furey: In your closing remarks, you indicated a need for a national standards board. How do you see that differing from the standards board on which you presently sit?
Mr. Thornton: I alluded to the need for a national securities regulator. We already have a national standards setter. We consider ourselves national anyway. We may not have representation from every province and territory on the board every year because there are not 13 of us on the board. We consider ourselves setting standards for Canada, not for any regional interest.
Senator Furey: I will push a bit on the independence you referred to with respect to the ASB. Is the ASB a creature of the CICA? If so, how is its membership composed? Is it elected or appointed, and by whom?
Mr. Thornton: How are accounting standards boards members appointed? We are appointed by the Accounting Standard Oversight Committee, which is composed of mostly non-accountants. I have a list of the members that I could read to you. I think that there are 18 members, including: Senator Kirby, the president of the Toronto stock exchange, various lawyers, business people and clergy. It is an eclectic board.
Senator Furey: This relates to the question that Senator Angus just asked as well. The oversight committee is set up by the CICA.
Mr. Thornton: The CICA kicks the ball off, as I understand it. They appoint the people, but once appointed, they are completely independent of the CICA. They make up their own mind about who should be on the accounting standards board.
Senator Furey: If your board were to decide that a certain practice should be implemented, how long would it take to actually put that in place?
Mr. Thornton: To put a new standard into play? Paul Cherry, the chair of the standards board, will be here shortly. He would be able to give you an exact number and distribution on that. I am speaking from memory. On the average, I would say that it takes about a year and a half.
We cannot just set standards that would not garner the support of the business community. We need to expose proposals for comment, and sometimes this takes several versions.
The chief accountant of the SEC remarked before the U.S. Senate that accounting for business combinations has been on the Financial Accounting Standards Board, FASB, agenda ever since his son was born and now his son has graduated from university. They have not got that standard nailed down. Standard setting can take a long time because of the complexity of the standard and testing whether the proposed solutions are actually feasible and acceptable to the business community.
Senator Furey: I want to explore one other area relating to the audit committee that Senator Angus was briefly discussing. My understanding is that most corporations have an audit committee made up of directors and senior management. Generally, when they are looking for information, they turn to the corporation's accountants. You are suggesting, of course, that the audit committee be independent. I take it that you would see an outside auditor independent of the accounting firm that represents the corporation as the one that oversees this committee.
It has been suggested to us that such a practice would be somewhat repetitive and cost-prohibitive. How would you comment on that?
Mr. Thornton: I would not see it as repetitive because I think it is a fresh set of eyes looking at things. It is another aspect of independence. I would not see it as repetitive so much as complementary.
It is costly. I believe, personally, that Canadian companies will have to get used to paying a lot more to signal that their financial reporting is of high quality. Part of that will be higher auditing fees, because if auditors are just not able to recover some of their costs doing the audit from lucrative consulting, they will have to charge higher fees, and part will be a result of paying higher directors' fees to people who serve on the audit committee. We will have to get used to it.
I am not sure where the market will settle down, but I feel certain that we will end up with companies spending more money on signalling to the market that their financial reporting is of high quality and they have had independent audits and independent audit committees.
Senator Hervieux-Payette: I have the impression that 15 years ago, companies were not negotiating and bargaining on their auditing fee. Was there a trend that companies held a competition and the lowest bidder was getting it? You say it will cost more. I agree. Is this a phenomenon that took place in cost cutting, and auditing fees became one part of the cost cutting exercise?
Mr. Thornton: In the last decade or so, there has been intense price competition on the part of auditors. If anything, management, in some instances, has tried to minimize the audit fee because they have not really appreciated the value of a good audit. We have seen instances of audit firms bidding for jobs. There is evidence in the academic literature that in the early years they do not even recover their costs. They are hoping to gradually recover the costs of the initial engagement during a long tenure with the client.
I believe that, post-Enron, companies will want to ensure they have a good audit and will go to great lengths to ensure the audit is independent. They will not mind paying higher fees because they will be more than compensated by lower costs of capital and higher shareholder wealth.
Senator Kelleher: Senator Angus raised a point I wanted to explore a bit. We went to England a year or so ago, and we were there at the time they were setting up their new regulatory body.
Mr. Thornton: Is this the International Accounting Standards Board?
Senator Kelleher: No, this is the body that oversees the lawyers, the accountants and the stock exchange.
I think it is natural that we would look to the States to see what they are doing because of the situation between our two countries. However, is there anything in that British structure that would be useful or helpful to what we are trying to do to correct the situation? Would what they are doing have helped?
Mr. Thornton: I cannot think of anything specific on that dimension. We monitor what goes on in the international accounting standards committee very closely. That is centred in England. With respect to regulatory structures in the U.K., I am frankly not familiar enough with how they go about it. I do not have any first-hand experience with it. I am afraid I cannot help you there.
Senator Kelleher: Many people have been saying, ``Let us not get rash here. Let us not ooh and aah and bring in so many regulations and so much legislation that we stifle the operation of business.'' How real a concern or threat is this to what we are going through at this particular time?
Mr. Thornton: I do not have any hard data to give you.
Senator Kelleher: I do not expect it. I would like your opinion. Is this something that we should be concerned about?
Mr. Thornton: I would offer the thought that you ought to be concerned with trying to fix this problem with nothing but new regulation and instituting a lot of costly hoops for companies to jump through, because they will not work unless the other links in the chain that we have been talking about are strong. The things that determine strength in those links are primarily market forces. I think disciplinary oversight from one's profession certainly matters a lot, but getting the best people and the brightest minds into a profession is the result of supply and demand in a vigorous market; it has little to do with regulatory oversight.
I am all in favour of minimizing transaction costs. I have been trained in economics. I think many economists would say that minimizing transaction costs is a good thing to do. However, some sort of oversight is obviously required, and there will be unavoidable transaction costs. If you asked an average company whether it is easier to deal with the SEC or with a whole bunch of Canadian securities commissions, they would be kind of ambivalent. They would say that the SEC is far tougher to deal with; they must jump through a lot more hoops, but at least there is only one of them, whereas, in Canada, while there are not so many hoops, if you want to raise capital, you might have to contend with many different securities commissions, each with a different agenda.
Senator Fitzpatrick: This is obviously a very complex issue and takes some time to digest. I want to cover a number of areas, and perhaps I can list them and you can answer them.
The first is the turnover of auditors for corporations, particularly the major corporations. My experience is that there is a tendency for auditors to be selected and reappointed year after year, and there is a tendency to negotiate the fees. I think that works both ways. I am wondering if there is a required turnover after a certain period of time and if that would keep the process more focused.
My second area is a matrix of measures and ratios and indicators that should be included in the MDNA statement. I think the MDNA statement has been a major improvement in the reporting process, but I am wondering if there is something that auditors should do in that regard. We often rely upon the same ratios and the indicators that the analysts do. I would much rather look at those ratios and indicators from an auditor's rather than an analyst's perspective.
Then there is the question of professionalism within the committees. I think audit committees now, if not required, are mostly made up of non-executive members of the board of directors, and I think they should be. However, should there be a professional content in audit committees? Again, this may be hard for some of the smaller companies to meet. It is hard to suggest that you have to test your audit committee members, but they should know something about accounting in order that they would know the right questions to ask. I have served on audit committees. The chairman has indicated that he has, too. You do not always know what questions to ask. Both of us have had some experience in business.
The other question may somewhat controversial. Compensation packages are tied to share value and profit measures. Frankly, I think some of our compensation packages become outrageous. I am just wondering if that is another element at which we should be looking. I realize that is not necessarily an accounting issue but I would like to have your comment on it.
If I could ask you to answer those questions, please.
Mr. Thornton: In respect of the question whether a required turnover in auditors would enhance the quality of financial reporting. It is very difficult to answer that question because nobody has any data on it. It has never been the case. No one has ever been able to run an experiment to see whether that would work. I am just shooting from the hip here.
In a sense, when you have a turnover of auditors, you sacrifice a bit of depth because the old auditor has a lot of experience with the company that may be valuable. On the other hand, you may gain a fresh pair of eyes, which would perhaps notice some things that the old auditor would not. That might enhance the independence and the quality of financial reporting in a different way.
I think that there would be a difference, but whether it would be better, I could not say for sure.
Senator Fitzpatrick: There is also within an audit firm a turnover of personnel, which may somewhat mitigate the depth value to which you are referring. Please continue.
Mr. Thornton: The MDNA is an area in which I am interested and in which I was actively involved during my time at the SEC. The SEC for some time has required managers to report in the MDNA, through their eyes, how they manage the company. Basically, if there is something that they are worried about, they must discuss it. They also have to interpret the numbers and explain why things turned out the way they did. They also must report on liquidity.
There have been a number of high profile cases in the U.S. where companies have not provided a good MDNA. Sony hit the headlines prominently because they did not separately report that one of their important segments was doing badly. They mixed it in with the results of the other segments. When the SEC pushed them, they found that at directors' meetings they talked about this segment that they did not bother segregating strategically — they did manage it. Therefore, they did not report through the eyes of management in the MDNA. We need to try to encourage companies to report their management issues because that really is the only way that some of these deeper issues will come to the surface.
I will say that, almost as we speak, the CICA is publishing a research study on MDNA, written by Julie Desjardins and Allen Willis. The study is based partly on a visit they made to the SEC while I was there last year. They will be recommending that we move closer to the U.S. system where management really must tell shareholders how they see the business and what they think the opportunities and risks are.
As for professionalism on the audit committee, I think that I mentioned in my submission that following the Blue Ribbon Committee report in the U.S., audit committees now have to be composed of people who are either financially literate or financial experts. Financial experts are people who have had very senior involvement in the financial reporting process, for example, chief financial officers or senior officers of audit firms who are perhaps retired. These are people who would be able to probe the details and understand the intricacies of the accounting. Financial literates are people who know enough about accounting to ask intelligent questions.
Some of the very interesting results coming out of contemporary research are that these two breeds of audit committee members actually complement each another. The financial literates tend to ask high-level questions that are very important to outside investors, such as: Does this company have any SPEs? If so, why are they not consolidated? What is an SPE, anyway? Why did the company do that? Why did they try to get rid of these assets and hive them off into an SPE? What does this goodwill represent? Did they test it for impairment? These would be sort of naive questions in the vocabulary of an expert but in the vocabulary of a financial literate, they would be just curious questions that might deserve answers and shareholders would be eager to know those answers.
The financial experts tend to get right down into the accounts and ask questions such as: Why was depreciation calculated differently this year from last year? How did this consolidation work? They ask detailed, nitty-gritty questions. The research evidence that we see coming out in the accounting literature is that these two breeds of watchdog are mutually reinforcing. You need both on an audit committee to get the best outcome.
Finally, with respect to compensation and the fact it is tied to share value is a topic in which I have taken a tremendous personal interest over the years. In the mid-1970s, I learned how to value options. I have always been very puzzled as to why regulators have not insisted that the true cost of stock options is not reflected in financial statements. We have the apparatus for it. Undergraduate students at Queen's University can calculate the value of these options when management gets them, yet virtually no companies in Canada, until recently, have voluntarily put these numbers on their financial statements. Things are changing, however. As you may have noticed in the recent press, several banks will now start recording the actual stock option expense at the time that they are granted to management.
In the United States, there are 16,000 companies registered with the SEC, and only two of them have voluntarily recorded the cost of stock options on their financial statements. The FASB, our counterpart, tried to make companies do this, but companies lobbied Congress and basically forced the FASB to retreat from that position.
The FASB, and now we in Canada, are insisting that companies report the expense in footnotes, but still companies do not have to put these numbers on the financial statements themselves. Post-Enron, we will see more and more companies doing this, because it is another way that a company can signal to the market that it is reporting high quality numbers in its financial statements.
Sooner or later, these expenses will go through the income statement. It is just a question of when — the sooner the better, as far as the stock options are concerned. When I say go through the income statement, they will go through sometimes in an indirect way as an opportunity cost to the shareholders, but eventually those stock options will show up in the results of the companies.
Senator Fitzpatrick: I do not know if it is required, but I know that the companies with which I am associated have the audit committee review quarterly statements as well as annual statements.
I would be interested in your estimate of that time that it takes to properly have an audit committee review a set of statements, let us say for a medium-sized company.
Mr. Thornton: I would be amazed if someone could do it in less than a week, each quarter.
The Chairman: A whole week?
Mr. Thornton: If you want to understand what is going on, counting meeting time and so on, it would take a long time, yes.
The Chairman: I was on the audit committee at Dupont, and it took three hours.
Senator Angus: Did you read the material before the meeting?
The Chairman: Yes.
Senator Angus: How many hours was that?
The Chairman: Not many.
Senator Kroft: I must say I am increasingly depressed. This is the second witness to say that our system is significantly deficient or weaker than the American system. The American system had Enron, so I do not know where that puts us in the chain of success, or likely success.
There are rules, and there are the mindsets and the attitudes, relationships and presumptions — the framework of human inter-relationships — on which these rules are applied. It probably is not at all fair, but it sure is easy to come to the conclusion that the relationship between auditors and management has changed in a way that is not particularly flattering to management.
If you were to take a private company that had no obligation to weekly reports or first calls and so forth and was just concerned with building the strength of a balance sheet and keeping its banking relationships satisfactory, you would tend to have a conservative point of view where. I would suggest, that maybe the auditors and the bankers are more on the same side.
I am hypothesizing here that in fact we have moved to a situation where the relationship between the auditor and the manager is very often more adversarial. Leaving aside whether or not there are inappropriate arrangements between audit firms and management — such as may have been in Enron — but in a fair and honest relationship, there is, it appears obvious to me, so easy an invitation to management, with profit-driven, stock performance-related compensation schemes, that they have really come into an adversarial position with the auditors.
There is a lot of supposition, — and this is perhaps loose language for the purpose of provoking some thought — but that relationship has become more adversarial, or has the potential of it because the hypothetical management are trying to inflate profits, which in turn will inflate their stock prices, which in turn will enhance these highly leveraged compensation schemes.
That is a lot of generalization, and that condemns many people unfairly. However, as the public looks at this and reads in the daily papers about highly leveraged, basically non-accounted type of compensation schemes where management is encouraged to see what they can get by in the way of inflating the profits, what does that do to the whole professional relationship where one could be driven to almost the assumption of wrongdoing? I am taking great liberal exaggerations but reflecting what is not hard to get from reading the press.
You move from there to the role of the audit committee, which has a dramatically inflated role and responsibility. I did not read earlier witnesses the same way Senator Furey did on the subject of independent advice to audit committees, but I am getting to the view that audit committees need absolutely independent advice if they will do this. Dr. Rosen suggested this could be done at not too high a cost.
What would be your comment on the changed nature of the relationship between management and the profession as stimulated by the kind of compensation situations we see in large companies?
Mr. Thornton: I would like to try to answer that from an academic point of view first. In the submission that I made, I cite an article by Eugene Fama, a distinguished finance professor at the University of Chicago, in which he stated that managers have an incentive to try to cooperate with auditors and people like that, because it enhances the value of their human capital. In other words, if management sort of pulls a fast one and runs the stock price up briefly and benefits, they can do that once, but the value of their human capital and their future employment will be lowered. In the long run, perhaps they do not have as strong incentive to do that as you have suggested. That is the academic explanation.
The practical explanation would be that in the dot com era, back in the 1990s when stocks were so volatile, when stock prices often ran up so quickly and back down again, this adversarial relationship that you mention became a problem. I would hope that now it will not be as big a problem as it was back then. However, whether I am right about that or not, no one knows.
I do think that reporting the value of stock options on the financial statements would help immensely in mediating that conflict. If managers knew they had to report the fair value of the options they got when they got them, I think that would help to mediate the conflict.
The Chairman: It is not up to accounting firms to decide who gets what options? It is up to them to report it properly.
Senator Angus: It is accounting for the options.
The Chairman: I understand that perfectly, but we cannot hold the accountants responsible for everything. There is corporate governance involved here.
Senator Angus: I am not suggesting that, Mr. Chairman.
The Chairman: I know you are not suggesting that. We are rambling a lot. There seems to be a melange here.
Senator Kroft: I am trying to get us focused on the relationship between quantum and methodology of compensation as a prime contributor to the Enron problem. That is one of my principle focuses because I think that is one of the principal causes.
You have talked about the strength and mass of the regulatory body in the United States. We have 200 years of accounting tradition and still these things going on. I am tempted to ask, ``What is new and different?'' One of the things that is new and different — not brand new but accelerated — is the quantum and method of compensation, which has sort of gone off the charts. That instantly makes me suspicious, by deduction, that that is a central part of this emerging problem.
Mr. Thornton: It becomes a central part of the problem to the extent that managers could run the stock up by manipulating the accounting. Part of the problem to which you allude is the act of granting such compensation in the first place. Perhaps that is something that boards of directors would be interested in examining now. It is not just an accounting problem.
Senator Kroft: I am talking about a governance issue more than accounting.
Senator Angus: On the point of what is new and different, the witness told us what might be new and different. This is where I find the accountants wanting. You admitted that these accountants do not understand these new and sophisticated products — the derivative-type financial products could be put together in a matter of minutes. Quite properly, they are so complicated. Yet, at Enron the accountants did not say that they could not understand something and would not sign the statements. That does not happen in any other large company either.
It is not just Enron who had the perfect storm. There are 50 big public companies, according to the Wall Street Journal, that are like Enron, but not to the same degree.
The accountants had the temerity to pretend that they understood the products and sign-off on the statements. I am just a dumb lawyer, but this is where the problem really gets sticky. Look at the banks. They are writing-off hundreds of millions of dollars because they got sucked in on global crossing.
You put your finger on it. You should have put the breaks on it. Due diligence was not done by the lenders.
The Chairman: We met with a lender, and he said that they took the statements at face value, or no value.
Senator Setlakwe: You might wonder after all the questions that have been put to you if there are any left. I have two small questions. You may have spoken briefly about both of them, but I would like you to expand on them further.
To what extent, given the globalization that we have witnessed, are international accounting standards converging?
My second question has to do with your mentioning the regulatory oversight that was needed and the problems with the options and the new financial instruments. I was wondering to what extent the CICA, in your view, would become a regulatory body that could be compared with the Canadian Bar Association?
Mr. Thornton: In regard to the emerging of the international accounting standards, our stated strategy is to try to converge Canadian accounting standards with U.S. GAAP. That would be our first priority. However, if the international standards being promulgated by the body in London are better than U.S. GAAP, then we would adopt those.
Furthermore, our accounting standards board tends to write rules more in the format of the international rules and less like the American rules. The American accounting rules would fill a bookshelf along this whole back wall, whereas the international and Canadian standards can be relegated to several binders. They are much less verbose. They are more judgment driven, less precise and more principle-based than U.S. standards.
Still, our objective is to harmonize in spirit, at least, and usually even in terms of the details, with U.S. standards. We have our eye on both balls. We realize we are a small player on the international scene but our primary obligation is to Canadians. We are trying to extract the best of both worlds.
As to whether the CICA is evolving toward being an organization like the Canadian Bar Association, or the Law Society, the disciplinary authority in the chartered accounting profession does not reside at the national level in the Canadian institute. It resides at the provincial level. If I were to commit some sort of heinous accounting act, I would be disciplined by both Alberta and Ontario, but not by the CICA. As far as the accounting standards board is concerned, that activity is completely independent of the sort of disciplinary authority of the provincial accounting bodies. We see ourselves as simply setting accounting standards. We do not see ourselves as acting as CAs or anything like that.
Senator Setlakwe: The law societies have disciplinary measures. Do you?
Mr. Thornton: Yes, the Provincial Institutes of Chartered Accountants have vigorous disciplinary bodies. I get a regular newsletter from the organization that lists disciplinary actions that have been taken against chartered accountants for not applying generally accepted accounting principles properly or not carrying out audits in accordance with accepted auditing standards. There is an analogous set of disciplinary mechanisms.
Senator Hervieux-Payette: I have a brief question regarding the mechanism to adopt these accounting standards and how they implement and police them. I was wondering why there were not accounting standards applied to stock options. How much is the U.S. way of doing things influencing the establishment of standards? On one hand, we hear that they have better standards or better practices, and on the other hand, we seem to have adopted not such good standards and are not doing something that we should do.
Where do we stand on this because the Europeans seem to be in a different world? How do you complete the evolution in the establishment of accounting standards?
Mr. Thornton: It is a very difficult process. One of your subsequent witnesses, Paul Cherry, would be the best person in the country to discuss that with you. He is the man that has to keep his eye on all of these balls and juggle them to come up with the best solution for Canada.
When it comes to the stock option problem, the fact that up until recently companies were not expensing these stock options, in my view, was a direct result of the fact that U.S. companies lobbied Congress and refused to do it. Then, in Canada our business community said that if we make them do it, they would be at a disadvantage to the U.S. companies in raising capital and their earnings will be lower. No one would want to set up shop in Canada; every one will move out. They did not want to do it either. We were reluctant to impose a standard on Canadian companies that would be more stringent than the ones that they deal with every day in the U.S.
There is always this tension. You want to do the right thing but not something that is completely unacceptable to the business community. We must be relevant to the business community as well as faithful to our profession.
Senator Hervieux-Payette: You should be relevant to the shareholders by giving them the proper information. It is pension funds. Everyone's future is at stake. My concern with companies such as Enron and others in Canada who have lost pension funds, have lost those funds forever. Why do we have the worst of both worlds? We do not adopt their good things. We are not doing the proper things.
I understand the rationale. You gave me the answer. However, I have the feeling from your statement that when you have good accounting practices the value of your company is well recognized. Mr. Rosen said to us that bad reporting is also a detriment for the investors because they do not trust the figures that they are seeing. The more you can trust, the more the analysts would buy the stocks because they are the buying the stocks through the big pension funds.
Mr. Thornton: The stock option situation is sort of an outlier. Ninety-nine per cent of the time we do insist on doing the right thing. Now, for example, we are trying to tighten up the rules on special purpose entities and guarantees and trying to do it quickly because we realize that these issues are extremely important to investors and we need to protect them from faulty information. The stock option issue has been one that has been unusually intractable because of the strong opposition to it from the business community.
The Chairman: Thank you, Professor Thornton for being with us. Our next witness is from the Ontario Teachers' Pension Plan Board.
I would like to welcome Brian J. Gibson. There was a story on Mr. Gibson in the National Post a couple of days ago. It said that he is in charge of $13 billion in equities for the Ontario Teachers Plan. He faced the same choices as every other money manager when Enron was highly toted for growth. What did he do? He sold it. Why did he sell and make much money while no one else could understand to do that.
Welcome, sir. Please proceed with your presentation.
Mr. Brian J. Gibson, Senior Vice-President, Active Equities, Ontario Teachers' Pension Plan Board: Honourable senators, it is an honour for our organization to come and address you today. I hope our presentation is of use. I will be brief because we did send in a written presentation. I will give some highlights. I want to leave all the time to answer your questions. I will probably have to start by answering Senator Kolber's question on Enron.
With all the recent corporate failures and stock price declines, there has been a renewed focus on corporate governance, accounting standards and management compensation — all the issues of concern today. For the past 10 years, these issues have been concerns for our plan. Our experience is that better governance equals better returns. If any one thinks that may not be case, I would recommend they look at the record of investment returns in countries such as Russia and Indonesia, where governance standards are lower. They make a difference.
That is why governance is important to us as investors. Why do we think it is important to the country and to the committee? Canada has an open and fairly small economy and we depend on the world to provide us with capital. We need to attract capital with global financial markets. We must be competitive in a number of ways, including transparency and good governance.
There is another aspect of capital attraction that we do not think about and it is one of the worst parts of my job. I often have to sell good quality Canadian companies to foreign buyers. That happens when our companies are valued for less than companies elsewhere in the world, especially in the U.S. To the extent that governance raises the cost of capital and depresses valuations, it causes us to run the risk as a country of not being able to attract capital and also losing many of the good companies that we already have.
We have been dealing with these issues for quite some time. We know that making major regulatory changes and reforms are both difficult and time consuming. I am not here today to suggest major reforms. We believe that with a few amendments to some existing statutes we could have an immediate and improving effect on corporate governance and accounting standards.
We believe that the role of the government is to provide a framework so that the capital market investors can all work to achieve in the detailed decisions of day-to-day life the kind of results for which we are all looking. We are asking for the government to give responsible investors a few more tools to help us do the job to press for improved governance and transparency.
We do not think that we should be shy or timid in demanding high standards. We have seen a presentation earlier today that pointed out that high standards gives you a lower cost of capital. From our experience in investing in dozens of countries around the world that low standards gives you higher cost of capital. That is not in Canada's best interest.
Some might think that we would then have a competitive disadvantage as a country by having higher standards than the rest of world. I give you the example of London. It has the largest financial capital market outside of North America. It is a broad deep market. British companies have low cost of capital on a world scale. London and the U.K. have the highest standard of corporate governance in the world. I cannot see from the example of London why any of us should be afraid to demand and insist on high standards. As well as trying to lead the world in other ways, our country can certainly lead in terms of governance and transparency. The benefit would be a lower cost of capital and better ability to attract capital to support our companies and our country.
We covered many topics in our presentation and made a number of recommendations, but there are six key recommendations I want to highlight for honourable senators and then turn to your questions. These are the six things that will help give basic tools to do our job better.
The first recommendation is to amend the Canada Business Corporations Act, CBCA, to require all publicly traded companies to publicly disclose the results of all votes at shareholders and special meetings. Currently, there is no requirement to do so, and it makes it very difficult for interested shareholders to press for change and to know how much support there is for change.
The Chairman: Are all publicly traded companies federally incorporated?
Mr. Gibson: Not all of them. The vast majority of TSE-type companies over the last 10 years have re-incorporated as CBCA companies. Not all, but a great number are.
The second recommendation we are making is to amend the Pension Benefit Standards Act to require all managers of pension funds governed by that act to have proxy voting guidelines and to publicly disclose every year the results and details of their voting. One of the big issues faced in the area of governance and improving transparency is many proxy votes are not used.
A third recommendation is a CBCA amendment to remove the limit on the ability of shareholders to talk to other shareholders discussing company issues and pressing for change. The current limit is 15 other shareholders and that makes it difficult for concerned shareholders to compare thoughts and ideas in order to seek change.
Our fourth key recommendation is to amend the CBCA to require that all audit committees adopt the Blue Ribbon Committee's recommendations for audit committee duty and performance. That is voluntary in Canada. They are very good standards. If every company had to adopt them, we would be further ahead.
Our fifth recommendation is to amend the CBCA to require that all publicly traded companies include the cost of stock option plans in their income statement.
Finally, our sixth point would be to recommend that the Income Tax Act be amended to remove the distortion and treatment of different kinds of stock-based compensation plans. The present act favours the granting of options over other types of equity such as share grants and restricted share units that are actually better compensation tools. There is a distortion in the tax system that encourages the use of options at the expense of other things that could be more effective.
That is a quick overview of our submission. I will take your questions and do my best to respond.
Senator Angus: Were you here during the previous witness's submission?
Mr. Gibson: Yes, I was.
Senator Angus: You mentioned that the U.K. has the highest standards of corporate governance in the world. I was amazed to hear that. Are these U.K. standards of corporate governance set down somewhere? All we have are the TSE guidelines from the Dey report, but are these actually in a code somewhere?
Mr. Gibson: They are in a written code and they are quite well spelled out. There is a central regulatory body in London responsible for regulating these matters. It is kind of an omnibus entity that covers insurance companies, stock markets, banks and so on. They have specific and clear reporting standards, standards of conduct for companies, and processes for investors to be able to take action if they think the boards or the management are not doing the proper thing. They also have rigorous standards for what they accept in accounting.
Senator Angus: You are referring to the Financial Services Authority, FSA, the body that Howard Davies chairs. It is a regulatory body for the financial services sector.
In terms of strict corporate governance, should there be a split between the chairman and the CEO? I was not aware they had a list of things like we have here in Canada. In fact, since the Dey report, I would have thought our standards ranked with the corporate governance standards of any country in the world.
Mr. Gibson: Some of those issues involving the CEO and chairman are not part of their main standards. Their main standards have to do with fair dealing in markets, disclosure, rights of investors and the ability of investors to take action. The Dey report, which was adopted by the TSE, has a number of good guidelines that we wholeheartedly accept. The limitation in Canada is they are purely voluntary. The result has been that the well-managed, well- governed companies have adopted the standards and they provide disclosure.
However, those are not the companies that are at issue. The companies that are at issue are the companies that are not well governed. Those companies are not compelled to adhere to the standards or even make a filing. It is purely voluntary. One of our other recommendations in our submission was to make those standards mandatory so that all companies had to adhere to them, and we suggested using the CBCA as a lever to make that begin to happen.
Senator Angus: I have no argument with that. I was getting at the U.K. situation. I believe it is a question of nomenclature. You are referring to corporate governance and the other types of things that are corporate law and disclosure issues that do not fit my definition of corporate governance.
There has been much talk today about stock options and accounting for them in an income statement. It is a non- cash item. How would you account for the stock options? Today, the companies are required to refer all kinds of senior executive compensation in their statements to CBCA requirements. The requirements state that the CEO and the CFO have so many options, at such-and-such a price. I agree with you, it is not in the income statement and I agree that it is a big issue, but I do not know how to do it.
Mr. Gibson: The accounting bodies, both in the U.S. and Canada, have given detailed instructions on how to do that. The problem to which the last witness alluded is that under the rules, the main rule states that you have to expense stock options and they give detailed instructions for how to do that. However, the rule in the U.S. and our new Canadian rule have an exemption in them, however. The exemption says that if you are an insider or an employee, then the company does not have to record the cost of the stock options. It is a choice that any company can make.
If a company wants to expense stock options, it is free to do so tomorrow. The standard is already there. They just have to choose not to use the exemption, and the standard then would explain the proper way to do the accounting.
Senator Angus: It seems that the exemption is the rule. How many non-insiders and people that are covered by the exemption get stock options? That is pretty rare.
As an investor, you want the stocks in your pension fund to go up and you hope that they do well. We have heard of ``black shoals,'' and we can point out as many flaws in the black shoals formula as there are virtues; in fact, I would suggest that there are many more flaws than virtues. How would you as the investor, as the teachers, like to see the CEO's stock options accounted for at, for example, Bombardier?
Mr. Gibson: I can tell you how we do it in reality, because for every company we invest in we do adjust for stock options. That is one of the adjustments we make in every case. We are interested in the future earnings of the company when we make our decision. Therefore, we get all the information on the stock option plan from the proxy material and from the annual report. Then we project out the likely exercise of options over the future. If we have an earnings forecast for the next five years, before we turn that into an earnings per share, or cash flow per share type number, we adjust the number of shares to reflect the exercise of the stock options. We then make some small changes to the income statement to show the company has received the money for the exercise.
Senator Angus: You are looking at fully diluted earnings per share as opposed to the other measure, are you not?
Mr. Gibson: Exactly. If you want to just look at this year's EPS, for example, the simple way to do it is to think about a company coming down to the net income line: It is not going to change no matter how many options you give out. If the company earned $10 million, it earned $10 million. The trick is when you do it on the per-share basis. When those per-share calculations get done, they ignore these effects, which is what we try to pick up in our forecast.
When you are buying a share of the TD Bank, you are not interested in the bank's total earnings. You want to know how much the share will earn and, if you are paying $50 a share, is it a good price for these earnings? The problem has been that depending on what survey you look at, in some cases 20 per cent to 30 per cent of the earnings per share are not there because of the dilution of the stock options. If you knew that as an individual investor, you probably would pay 20 per cent to 30 per cent less for those same shares.
Senator Angus: In any event, it is an excellent answer because you have brought the how into focus, because $10 million earned is $10 million earned on a cash basis. The stock price might be affected more by that $10 million than that very last line on the financial statement, on the earnings per share on a fully diluted basis. However, that is an argument for another day, and I think it is currently being debated and my jury is still out on how it needs to be dealt with.
Today a report came out from the five-year review committee, the so-called Purdy Crawford Committee, and they have made some significant recommendations. Have you had a chance to take cognizance of those?
Mr. Gibson: I read the summary in the newspaper this morning. I was travelling here all day, so I have not talked to Mr. Crawford in detail.
Senator Angus: In a general way, do you feel they are on the right track? They are recommending huge fines for insider training and related offences. They are recommending many things along that line.
Mr. Gibson: We think the recommendations that were reported in The Globe and Mail are really sensible, particularly increasing the fines and the penalties for abuse. Manitoba is trying to amend their securities act to expand the maximum penalty from $1 million to $10 million. When you think about cases of securities fraud or financial fraud, when people do those things they are usually trying to get tens of millions of dollars. If you are one of those people and, should you be caught and censured, the worst that will happen is a million-dollar fine. That seems to me a pretty cheap price to pay. That is not a deterrent.
The whole energy that gets spent by regulatory bodies such as the OSC in enforcement and compliance really does not have the effect it should have because at the end of the day, if people do not have significant and serious penalties, they will not worry about it too much. That is one area where I think the U.S. model is better. Everyone in the U.S. knows that if the SEC proves that you have done something fraudulent, they have the power to throw the book at you or put you in jail. They can fine you and make you disgorge all of your profits. People still try to do things down there but they must think twice.
Those penalties have greatly multiplied the deterrent effect that the commission has. In Canada, if you told me I could not write a submission and asked if there is one thing in this country that would help these issues, I would answer that the one thing we should do is more rigorously enforce our existing laws and make the penalties a lot stiffer.
Senator Angus: Thank you for that answer.
Senator Kroft: I have three short questions.
First, further to your reference to the U.K., various people involved in the investment regulation, monitoring and governance of the investment industry in Canada have cautioned us not to go too quick or too tough and get ahead of the U.S. because we will create an unfriendly environment that may discourage American investigators. At the same time, we are hearing that the U.S. is tougher. Now we hear a clear statement that the U.K. is the toughest of all. Have we got any fear of being reasonable but tougher in the sense of scaring away investment?
Second, what are your thoughts on requiring independent accounting advice to audit committees? You may set a minimum size threshold for the company.
Third, I read an article in the National Post, March 26, quoting comments as to why you got out of Enron as an investor. I will take two or three of the things that you gathered from 10-Ks or from shareholder memoranda. For example: Ken Lay's sister owned 50 per cent of a travel agency that did business with the company; the executive committee that was given all this power was substantially not an arm's-length committee at all; and the leverage on some of these undisclosed investments was outrageous and they were reported as minority when in fact they were majority. These are all clear wrongdoings. Not to put too fine a point on it, we can write rules all we want. If someone wants to be dishonest, they will be dishonest. I do not know how that shapes its way into a question. I guess it plays into your last answer — namely, to hit hard with the penalties.
Mr. Gibson: You remind me that I owe Senator Kolber an answer to that same question. I will start with Enron and come back to your other two questions later, if I may.
I wrote that article because, as an investment professional, I found it extremely embarrassing to have peers in my profession go to Washington and say they had no idea anything was wrong at Enron. These are investment professionals who worked in big New York firms and who are also financial analysts. That bothered me because we are all trained and paid to manage people's money. It is not our money; it is other people's money. That requires a duty of care. We charge for that service.
I was bothered that sophisticated analysts went to Washington and said that they had no idea what was going on because that, in my opinion, was untrue. That is what led to that article. We got involved with Enron through a private investment we made through our merchant bank in a company called MetroNet. We subsequently sold this company to Enron for a fairly high price. In exchange for that, we got Enron shares. That has been disclosed in the press release we put out last fall. Those shares were worth about $450 million at the time. We did not really want shares but that was what the transaction was. We had to make an important decision: Now that we are shareholders of Enron, a company that we were not shareholders of up until that time, what should we do? The stock was around U.S. $50 at the time.
We did something that might surprise some people here. We did not turn on the computer. We did not even get a calculator. We did two things that took about an hour. We read the footnotes to the annual report. The footnotes did not have one or two red flags; there was a whole armload of regular flags. There was the lack of independence and skill of the audit committee. There was the abdication of all board responsibility to this small committee. There were the SPEs. This is the annual report they published a year ago, for the year 2001. We got these shares just around last year- end, December 2000. This was in the first quarter last year when we sold the shares. The true extent of the SPEs was not disclosed. We since found out, in recent months, that there was a lot more there than met the eye.
However, a lot was disclosed. We could see several billion dollars invested in these SPEs that were not on the balance sheet but the footnotes disclosed they were highly levered and losing money. The footnotes showed a particularly interesting SPE whereby they contributed their own shares to the SPE as assets of the SPE. They had a call option on those same shares. If their share price went up, they would call them back and they would book the gain on their own share price as normal income. You can imagine the circle: Their share price goes up, they book a gain of, let us say, $1 million, on their income statement. Their earnings are now up $1 million. Their multiple was 30 or 35 times. The company's value now goes up by $35 million, the shares go up more so the SPE sells some more under these call arrangements.
This was all disclosed. Nothing we have read in the press since October surprised us at all, except that some of these things were more extensive than we thought. The corporate governance violated almost every single provision we had. We have governance guidelines on our Web site that we urge companies to follow. They were in violation of almost every one of those. If it was a company where one or two of these things happened, you would say, ``Well, it is not great but it is not the end of the world.'' However, Enron had such a long list of these things, we did not even see the point of turning on our computers and running spreadsheets. Those were not the kind of companies we want to own, so we sold the stock.
With regard to your question about standards in the U.K., they did not get ahead on regulation. We hear that refrain often — especially from some of the provincial regulators. We do not think it holds water because in our experience, — at least in the long term — investors are fairly astute. When they see good quality earnings and good quality governance, they are prepared to pay more and the multiples will be higher. When they think the governance standards are not there, the multiples will be lower. If you say it is a competitive disadvantage to have high standards in Canada, then you are saying that you want to have a higher cost of capital for Canadian companies. That is a trade-off that can be made. However, our argument is, the lower the cost of capital, the better off we are.
If you think about regulatory competition, if you go to lower standards, then you get markets like you have had in Russia or Indonesia in recent years. If lower standards were really so great, everyone today would have a high opinion of Arthur Andersen.
In the long run, lowering standards does not work. Canada is a relatively small country. Our stock market accounts for about 2 per cent of the world capital markets. People outside of Canada do not have any reason to invest here in particular as it is a small market. If they have any question at all about the integrity of our markets, then it is easy for them to say, ``Do not worry about Canada. It is too small anyway.'' We are not large like the U.S. We cannot afford to gamble with our reputation and expect we will still get the capital. We are too small for that. We must not give people a reason not to invest in our country.
At the same time, you can also discourage Canadians. These days, with a click of a computer mouse you can invest in companies all over the world. As a Canadian, I do not have to invest in Canadian companies nor does our pension fund. The only reason we will invest in Canadian companies is if they will offer us a competitive return and have fair and transparent disclosure. We might invest, but we would pay a lot less than we would somewhere else at the margin. I just cannot understand how having high standards — even if they are higher than our neighbour — creates a problem. We are too small to gamble with our reputation.
Your other question had to do with independent advice to audit committees. That is something that audit committees can now do if they choose. They can say, ``We do not understand this issue. We want advice from the outside, from an independent expert.'' They can pay for that. Many of them just do not think about doing it, partly because it is a lot more work. We are involved with many companies. We have made many presentations at no charge to audit committees and to other board committees to help them understand some of these complex issues — particularly where we are a large shareholder. We think all interested shareholders should offer to do that.
We do not think can you expect that every audit committee will be filled with brilliant people who know everything about accounting and finance. It is just not reasonable. You want people who have high integrity of character and who know when to ask questions when they do not understand something. One of the best questions they could be asking is, ``Yes, we understand these are the minimum requirements for this issue, but what are the best requirements, or what are we really trying to show our shareholders?'' Simple questions like that can really open up a lot of discussion on things that might just slide through.
Audit committees can now get advice. Unfortunately, they just do not think of doing it, and they rely too much on internal information.
Senator Kelleher: I felt our last witness — rightly or wrongly — was steering us towards the American standards. He had the feeling that they were the best. I can understand why, given the trade between our two countries.
I was a little disappointed, frankly, when I asked him about the British system. He was very forthright about it. He said, ``I am sorry, but I really do not know anything about it.'' When our committee was in the U.K. two years ago, we were impressed with their approach, which was different from ours.
I would like to think that, before we settle on a course of action, we can hear from someone, Mr. Chairman, who knows something about the other system, to ensure we are getting the best of both systems.
Can I have some comments from you on that subject?
Mr. Gibson: First, if you would like to hear a witness who is expert in the U.K. system, we can help find a number for you. We can work with your adviser to do that, because we have extensive business dealings with investment managers in the U.K. We can certainly be a resource to help you find those people.
I would like to go back. You have some idea of the working of the U.K. system. It is different from ours and certainly different from the American system.
Senator Kelleher: Mine is not an extensive knowledge.
Mr. Gibson: Having those standards — which in some ways are more advanced than in North America, and in some ways at a par — has not hurt their capital markets and has not caused their companies to be unable to raise money at good prices.
The argument that if we get too far ahead in Canada, we will have a competitive disadvantage does not hold water. The U.K. has done what they are doing for some time now. The equity risk premium in that market is as low as you will get anywhere. It is not costing them extra in terms of return to attract capital.
Senator Kelleher: Will it load us up with all kinds of new and costly regulations?
Mr. Gibson: You can come up with the most perfect regulations. You can go around the world, take the best of everywhere, and say, ``This is what Canada should have.'' The problem with that is, if you do not have strong enforcement and sanctions, it will not achieve the desired result. If you want to get the most leverage for the effort the government can make, our suggestion is to focus on enforcement and penalties.
Our rules in Canada are not that bad. We are doing a lot of soul-searching here because of these issues. The rules and corporate governance standards that are voluntary to TSE, our accounting standards, do need work in some areas. Yet, generally speaking, they are not that bad. The problem in this country is we do not expect high standards of conduct of the people, and when they do not perform properly, we do not prosecute them. We do not sanction them.
We have asked for six more tools. However, if we do not get those six tools, I would say that the easiest, cheapest way to improve the integrity of our markets and to improve Canada's reputation is to enforce what is on the books now. That will make a huge difference, and that will probably solve 80 per cent of the problem you are trying to solve.
Senator Kelleher: In your opinion, would it be beneficial to this committee and its hearings to have someone speak to us vis-à-vis the British system and how it is working?
Mr. Gibson: I think you would find it very useful. In light of some of the recommendations we have made, the British legal system makes it much easier for shareholders to take action when companies are not performing well. That is one of the areas where their governance is better than ours and than that in the U.S. Governance has several elements, one of which is a company being governed properly in terms of the way it is structured and organized. Another element of governance is whether shareholders can actually do something if they feel things are not being managed properly.
It is very difficult to do that in Canada, even though our laws are fairly advanced compared to most of the world. It is very difficult for interested shareholders to press for positive change in companies. I can say this because we have spent 10 years doing it in Canada, and you have all read reports of some of the actions we have taken. That is an important aspect of governance because there is a check and a balance. If the management and the board are not conducting themselves properly, first, do we have penalties and sanctions from a regulatory point of view, and second, can the shareholders actually do something about it? I will tell you that in every case where we have dealt with problem companies, when we have had enough shares and enough ability to have influence, things change fast.
Senator Furey: I am wondering if you would give us your views on the relative merits or accuracy of Canadian GAAP versus U.S. GAAP. Second, when you go about doing your due diligence for investment purposes, because of your economic influence and power, do you not have access to far more corporate information than the average investor?
Mr. Gibson: I will talk about GAAP first and then deal with your second question.
I think we must be careful to think that accounting is an accurate science. Canada has principles that we use to come up with our financial statements. The U.S. has their rules-based system. Both systems are subject to a lot of estimation; there are things such as depreciation, amortization and future exercise of stock options. There are all kinds of things that are estimates that go into earnings. If you are Bombardier and are manufacturing airplanes, when you sell the first one, you are making a big estimate about the cost of that one plane because you are trying to guess how many planes you will produce to amortize the start-up costs. There are many estimates in accounting figures in any case.
We do not really, from our point of view as investors, have a preference for U.S. or Canadian GAAP, as long as we are fairly sure that the companies are following the standards properly. We can and do adjust the numbers. In some ways, U.S. GAAP does not give a better result. For example, in the insurance industry, the way in which Canadian companies account for their income and sales costs is a more useful measure than the more liberal U.S. system. It is not always a case for the U.S. will give you less earnings or a better picture. As long as we know the standards and rules, we can interpret them accordingly.
When we look to invest in other countries around the world — Japan, or Germany or Brazil, for example — we find that their standards are completely different from those to which we have become accustomed. We use a rather short- term solution to deal with that: We tend to focus on companies that are SCC registrants that may have a bond issue or ADRs. Therefore, we will get U.S. GAAP statements, which as Canadians we can understand.
The second way we deal with accounting in these countries is that we have been active in dealing with the International Accounting Standards Board to help them come up with rules for international accounting. We prefer global standards to different national standards. The U.S., which represents half the market, may have its own reasons for not participating in that. From the Canadian perspective, we look at the entire world as potential investment. International standards are the way to go, not trying to pick between Canada and the U.S.
Your other question had to do with information. What is not generally known that we meet with companies because the last thing we want is non-public material information because as soon as we hear something like that, we have to restrict trading in the stock. We have a strict compliance system in our organization. If you doubt that, try to remember how many times in the last 10 years one of our employees has been accused of unfair trading. It is a strict system. The last thing we want is material non-public information. That means we cannot do any transactions on the stock.
We do not meet with the companies to talk to them about quarterly or annual earnings. When we sit down with the CEO, we are trying to assess whether he or she is a good allocator of capital. Does he or she know where the business must go? Does he or she know what the competitive environment is? Is there a team to lead the company?
The answers to those questions will tell us whether this will be a successful company. We make up our own forecasts and evaluations. Just as we have no idea what the companies' earnings estimates are internally, they have no idea what our estimates are. It does not matter. We are quite capable of doing evaluation work and forecasts. We want to be convinced that the management team is right team to look after shareholders capital and get a good return on the capital.
Senator Furey: I did not want to imply that you are looking for insider information, but it is the corporate culture that seems important to you when you look at where you will put your money. Is that correct?
Mr. Gibson: It is very important. Most companies are in business for 20 or 30 years or longer. If their earnings are five cents higher or lower next quarter, it will not make much difference to the value of the business. However, if the management does not allocate capital property properly in terms of investing their company's resources, and if they do not know how to deal with the competitive landscape, that makes much more difference to the value of the business than the next quarter's earnings.
Senator Hervieux-Payette: I want to apologize in advance for my nasty question. I am wondering if you applied the same technique for analysis when you were owned shares of Nortel or the Telecom Company, because it seems that this sector has collapsed. The analysts did not seem to see that there was an overvaluation. It is related to some of the figures that were shown and stocks were moving. How did you deal with this sector?
Mr. Gibson: We did not own those kinds of stocks in our active portfolios where we were picking stocks, which is what my group does. We had no exposure to that sector. Even in 1999, we still beat the market in terms of our return without owning those companies. It was not easy, but we did it.
We did own shares like that in our index funds. You probably read that we have substantial index funds. Our largest is our TSE index fund, which had about $12 billion in it at the peak in 1999. If you remember, Nortel became a third of that index. We would have had about $4 billion of exposure to Nortel for the index fund.
However, that is not what we had. We decided that it was ridiculous to have 30 per cent of our index in one stock. It did not matter if it were index fund. We questioned why we had $4 billion in a company that was trading for 80 or 90 times earnings, and we did not believe the earnings. We sold a substantial portion of the Nortel shares from our index fund, which gave our index managers grey hair for a while, but we thought that it was the right thing to do.
We still own some because we did not go to zero. To sell $4 billion worth of Nortel from an index fund would be an extreme position to take. Had we done that in 1998, it would have cost our pension fund a lot of money. In 1999, that is exactly what we did.
We also sold a number of other technology stocks from our index fund and used that money to purchase cheaper, ``value stocks'' — the ones that were reasonably valued. We also had an extremely large short position on NASDAQ, where you had the greatest overvaluation. That allowed us to generate reasonable results when all the stocks collapsed, although we still did own a portion of Nortel and the others.
Senator Fitzpatrick: I am sorry I was not here for your full presentation, Mr. Gibson. I have listened to the answers that you have been giving, and I am sure your presentation was very good.
There has been some discussion lately about making the analyst's process independent from brokerage firms with respect to making recommendations to clients. Do you think that would be a positive step?
Mr. Gibson: That is a good question. In fact, we had addressed that issue in our original submission. I took it out because I did not want to overburden you with a lengthy submission. I can tell you what our recommendation was.
If brokerage firms feel that it is important to offer research, our recommendation is that the research department should be separate. It should have a fixed budget for the year that is not tied to revenue from other revenue sources in the firm. The research department should be overseen by an advisory board of independent external directors. That would allow for the separation of duties and deal with conflicts of interest. It would then be clear to the brokerage firms how much their research is costing. They must decide then as a business if it is worth that price or not.
Having independent research would also allow them to sell it to third parties. For example, if we thought that the research arm of a brokerage firm was offering high quality research, we would be happy to buy it from them, as other people would.
If the brokerage firms cannot offer that kind of independent research, people will set up independent research firms because investors will always have a need for proper analysis and proper valuation and due diligence. We cannot all spend 10 hours a day managing our personal portfolios. We must rely on others for help. There will always be people prepared to pay; it just might be that the research is not done in brokerage firms. It might be done separately. Merrill Lynch has agreed to remedies that go part way there, but it does not fully separate research and the rest of the firm. As well, there is no provision for oversight of research by independent, outside directors.
The Chairman: You have been a terrific witness. Thank you for your time and effort. We may call you back to our committee.
The committee adjourned.