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Proceedings of the Standing Senate Committee on
Banking, Trade and Commerce

Issue 15 - Evidence

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OTTAWA, Thursday, February 27, 2003

The Standing Senate Committee on Banking, Trade and Commerce met this day at 9:05 a.m. to examine and report upon the present state of the domestic and international financial system (Canadian perspective to the Enron collapse).

Senator E. Leo Kolber (Chairman) in the Chair.

[English]

The Chairman: We will continue this morning to examine and report upon the present state of the domestic and international financial system, otherwise known as the Canadian perspective to the Enron collapse.

We are pleased this morning to have Sir Robert Smith, Chairman of the Weir Group PLC, from London. Good morning, Sir Robert.

Sir Robert Smith, Chairman, Weir Group PLC: I assume that your committee has had an opportunity to read the hard copy of the report.

The Chairman: Yes, we have, thank you.

Mr. Smith: In my opening remarks, I wish to say that our report is less rule-based and prescriptive than Sarbanes- Oxley. Basically, what we tried to achieve was to give audit committees power, for example, over the appointment of auditors — the correct people — and we give recommendations on the sort of qualifications needed; a clear mandate that everyone could examine; and making them accountable so they had to report each year in the directors' report and the annual reports and accounts; and, finally, to have a policy on non-audit services and actually to work out for their particular company what non-audit services they ought to have.

At this stage, I could give you a quick summary of what the report contains, if you would like.

The Chairman: Yes, please.

Mr. Smith: As a bit of background, after Enron, there was quite widespread United Kingdom government activity. Basically, we reasoned that although we felt we were less rules-based and believed in substance over form and true and fair views rather than box ticking, no one was able to say it would not happen here. Several things were put in place: the Higgs review, which looked at the role and effectiveness of non-executive directors; something called the coordinating group on audit and accounting issues, which was part government, part the accounting profession and part regulators, and which particularly looked at a review of regulation of the accountancy profession and came out with recommendations on that; and there was a comprehensive statement by our Minister of State, Patricia Hewitt, on January 29. The audit function has been at the heart of all this.

I was asked to chair a committee in September last year that reported by Christmas. We set out in our report what audit committees are for, and the duties of the audit committees are found on page 6, section 2 of the report. I will not take you through those, but you will notice a prevalence of words like ``monitoring'' and ``reviewing.'' It is important to emphasize that audit committees should not take on the role of management or auditors. We must be careful not to undermine the function of other people.

We were keen to reinforce the independence of auditors. That meant that the audit committee from now on would have a key role in appointments; subject to shareholder approval, the remuneration; the monitoring performance; and the policy on non-audit services. On remuneration, we give some guidance about how important remuneration is to a particular firm of auditors or to a particular branch or city practice of a particular firm of auditors, and whether it would be important to the earnings of individual partners. We came out against mandatory rotation of firms of auditors. We felt that we should look at the issue of independence each year.

The most controversial element is the policy on non-audit services. We know that Sarbanes-Oxley outright banned certain types of non-audit service. We decided we would not have a prescribed list of non-audit services. Instead, we felt that blanket bans on specific services were unlikely to be the best policy and could interfere with effectiveness and efficiency through not being able to use our auditors. Even if we were to put in bans, it would not be sensible to do it through the medium of guidance to audit committees. Other routes were available, such as toughening up the ethical guidance to auditors. We did recommend the audit committee should develop and implement a policy on the protection of auditor independence. They would decide which non-audit services ought to be banned for that company, which services ought to be approved, and which services the auditor might be undertake, provided that they do not exceed a certain amount of money.

We spent time on the membership and resources and there is a section here on those. It is difficult to prescribe in detail what is needed. Again, Sarbanes-Oxley has been quite specific about the requirements. We felt that sometimes, people who are not necessarily qualified in accountancy could nevertheless have enough independence and robustness to keep asking very embarrassing questions until they had an answer. We felt that at least one of three independent directors on the audit committee — we are talking about lists of companies here — should be financially expert, that is, perhaps a former finance director or a former senior partner of an audit firm. We did not say they necessarily had to have an accounting qualification, but it would be desirable.

Much more important is whether these people are independent-minded, tough and persistent, the sort of people who continue asking questions even after experts might have stopped. They must be given the resources necessary to look for a second opinion and the company must pay for that.

We found reporting and accountability were important. It is all very well to set out a clear mandate and put the right people in place, but there must be transparency. We felt that the audit committee should report as part of a directors' report within the annual report, and that the chairman of the audit committee should be available at the annual general meeting to take questions through the group chairman. This is a crucial element of the package.

If, for example, the audit committee thought that an auditor should be replaced or they should go out to tender and the group chairman at the main board overturned that, both would have to report what happened to the annual general meeting. On the subject of the role of the audit committee within the board, we were strongly supportive of having a unitary board. We turned away from the idea that the audit committee would operate completely independently of the rest of the board and be like a supervisory board. We believe that because, unless you are fairly close to the day-to-day running of the company, as a non-executive director, it is difficult for you to sit in judgment on various actions that are taken. You can become too divorced from the action.

These proposals are now out for consultation. The consultation will be completed by April 14 and the intention is that they will be enshrined into our combined code. The combined code is a set of rules by which listed companies must live. They either comply with those rules, or they have to explain why they are not.

I am happy to take any questions.

Senator Kroft: I should like to turn, first, to the issue of resources for the audit committees, which you just mentioned. On page 8 of your report, point 314, you touch on a point that is interesting to me. You state that the board should make funds available to the audit committee to enable it to take independent legal, accounting or other advice when the committee reasonably believes it is necessary to do so.

In the course of our hearings, we have heard, on occasion, the suggestion that it would be useful for the audit committee to have available completely independent audit advice, separate from the company's auditors. It has been suggested that they employ a senior retired partner of an accounting firm or someone similar, not to rethink, redo or recheck whole audits, but to provide an extra resource to an audit committee when looking at statements. As one of these advisers, I would not go in and do another audit, but I could say it might be useful for you to pursue this or that area, or point out that there are valid questions along a given line. It would be that kind of relatively permanent resource. Certainly the accounting profession, when I have raised it, has not jumped up and down at the idea. I am quite serious. For retired accountants, particularly given the young age at which they tend to retire, there is a ``boutique'' professional opportunity here.

I have been struck by the possible advantages. Having served on a large corporate audit committee, I feel there are advantages to having that kind of resource. I do not want to read too much into your recommendation, but would that be consistent with some of your thinking?

Mr. Smith: It would not be inconsistent. What we were very much thinking about when we came to this conclusion was, imagine you are sitting on an audit committee. In comes the finance director and the main board is meeting in one or two hours' time. You have had some papers beforehand. You are not the world's leading authority on a particular tax scheme. You are told that the finest firms of auditors and lawyers in Canada, counsel's opinion, if you have such a thing in Canada, have ticked off a particular accounting treatment. That accounting treatment will massively add to the profits of the company. You are told that the chairman, the CEO, the finance director and the entire finance team have also signed off on this. You are sitting there, with perhaps less than expert knowledge, and you say, ``I do not like this.'' They also say, by the way, that you have already agreed to a couple of these things, on a smaller principle, on previous audit committees. You are in some difficulties. What would someone on the audit committee do, if ranged against them is all this technical opinion? We wanted the audit committee to be able to say, ``No, I do not buy it. I am still unhappy. I still do not understand the detail of the accounting principle. I would like another opinion,'' and they could go to another firm to get that opinion.

I do not see anything particularly wrong with having a resource handy. We did say that inside the company, perhaps the company's secretariat should be available to the committee. If that resource is around, I think the membership of the committee should come from the board of the company. I do not think they should have members of the audit committee who are not part of the unitary board. I do not see anything wrong with having someone sitting in with you purely as a resource. However, what we had particularly in mind here were investigations in extremis, where people felt uncomfortable.

If there were people on the audit committee who felt inadequate on particular subjects, I do not see anything wrong with having that facility at your right hand and being able to say, ``Look, could you summarize this for us?'' However, you want to ensure you do not have two groups of auditors. That would be wrong; you would have guardians guarding guardians. There must be a balance between entrepreneurial creation of wealth in the company and people watching out for malfeasance.

Senator Kroft: I agree with all your cautions completely. The last thing I would want to suggest is, as you say, guardians on guardians. We cannot lose sight of the fact that the responsibility for the management of the company is with management and the board. Creating an army of second-guessers would not be productive.

I should like to ask you in this context if the issuance of quarterly reports in the U.K. has become as rampant as it has in North America. In my audit committee experience, the year-end is one thing, because there is more lead-up time. There tends to be more opportunity to look at the work and to prepare for the year-end, but the audit committee faced with quarterly reports typically sits down at a meeting knowing that there is a conference call with all of the market analysts in two days. Then the timetable that you suggested occurs. The whole thing gets compressed and the opportunity to say, ``We may need to get someone to look at that,'' is diminished unless there is some preparation for it. Do you share this view?

Mr. Smith: I would respond with my personal view as chairman of a listed company in the U.K. I personally do not like quarterly reports. I feel that you are tying down a lot of company time to produce slightly more up-to-date information for people. However, I have friends in companies who actually welcome them. They are welcoming them because, if an analyst asks them in between quarterly reports for any view of the company, they can say, ``I am not telling you anything. Read the next quarterly report.''

You can look at this both ways. I do not like it. I think an interim report, halfway through the year, and the full year's results are enough. If you have to make some sort of statement during the year because trading has worsened or whatever, then you do that. However, that would only be in relatively extreme circumstances. I am against quarterly reports. I think it adds to the bureaucracy of sales companies and it does not make for better-informed markets. That is a personal view.

Senator Kroft: Finally, and related to this, because it deals with the available talent for audit committees and also with the board, with the increased sensitivity on these issues leading to more regulation and more guidelines, what comment would you have on the size and quality of the potential director pool in the U.K.? Has this become a problem for you?

Mr. Smith: It has. Incidentally, if you have not looked at it, there is a report out by someone called Derek Higgs. Are you aware of that?

Senator Kroft: Yes, we have that.

Mr. Smith: This addresses the gene pool of non-executive directors. My personal view is that it can be widened. I think there is a lot of talent out there — and I am not talking about diversity or anything. I am talking about quality people out there who have not been in the circuit where one generally finds the non-executive directors. I think headhunters need to try harder; they need to think out of the box a bit more.

For audit committees, which we particularity dread, you mentioned audit partners retiring early. In some companies, it tends to be in the 50s. These people would be ideal for service on audit committees. If they actually had been involved in a wider role in the professional firm, they would have something else to bring to the table. I think we have not looked widely enough. The talent is out there; it just needs to be found.

Senator Kroft: There is a concept of term limits in the Higgs report. It states that, beyond 10 years, they are no longer qualified as outside directors. Then there is the 10-year commitment; the report suggested that non-executive directors should normally be expected to serve two three-year terms, although a longer term could be appropriate in exceptional circumstances.

Again, it is relevant to our subject. In my observation, in any experience like this, there is a time period when you build up the knowledge and then gain the expertise. However, there is always the risk that, after a time — and this is true for directors of non-profits, for-profits or anything else — the eagerness for new learning experiences is somewhat diminished.

Mr. Smith: I think Higgs was saying that two three-year terms would be normal, but it would be possible to take three three-year terms. I think he felt that after you have been on an audit committee for nine years — and I take a similar view — it is very difficult to claim that you are independent. However, there are complex groups where it might take several years for a non-executive director to understand how that company operates. As you have quite rightly suggested, then you become very useful for a period of years. You have seen chairmen come and go; you have seen chief executives come and go, and perhaps life gets a wee bit too comfortable. Having said that, although you can no longer claim after nine years to be independent, I can still see a role for old-timers, as you guys would describe it, on boards. These are people who have long corporate memories, who have been through recessions before and so on. Do not pretend they are independent, but perhaps they are handy people to have around to explain to youngsters how life used to be 15 years ago.

However, I have to say that once you have been on a board for 10 or 12 years, perhaps you should try something else for your own spiritual development.

The Chairman: Sir Robert, about eight or nine months ago, I was watching Alan Greenspan on television testifying before some Congressional committee. He said he had been on a number of audit committees of large companies, and he did not know what to ask. This is not a naive guy. This appears to be a brilliant man; yet he stated categorically that he did not know what to ask.

I myself served for a number of years on the audit committee of DuPont, which is a huge company. Frankly, I did not know much of what to ask either. Has there been any empirical evidence or study to show that audit committees historically have been an efficacious way of dealing with the problem of overseeing a company's books? Also, have you done any, as you say, thinking outside the box in trying to come up with a solution that, at first, might sound outrageous? Perhaps we should be thinking in the long run of substituting something else for an audit committee, maybe a professional group that would critique what the auditors have done. They could bring a great deal of professional experience to the table; whereas people like myself may have a lot of experience in business, but may not be totally conversant with the ins and outs of tax planning and other esoteric matters.

Mr. Smith: First, I know of no empirical evidence. I am old enough to have served on boards when there was no such thing as an audit committee. The board generally looked at the accounts, spoke to the auditor and so on. I have seen a lot of that develop.

Personally, I do not think it is right to have another group of professionals giving a second view. The secret in this thing is to ensure that your auditors are independent and that they carry out an efficient audit. I know of no better way to do that than to take some members of the board who are better qualified than others — perhaps through bringing marketing or other commercial knowledge to the table — and hold their feet to the fire, hold them accountable. The people who have the time to spend weeks and months inside the company examining how the internal audit system is working in real detail are the external auditors. They should be external to the company; they should be quite independent; and they should be examined for independence and efficiency each year. I think it is the members of the board who should be doing that. After all, the board is responsible to the shareholders and stakeholders in the company for its performance and for anything that is going wrong.

I think these independent directors on the board should hold the auditors to account. If you introduce yet another set of auditors, who will decide on their independence? Who will instruct them? Who will ensure that they are doing their job properly?

Provided that the existing external auditors are independent, properly remunerated, properly instructed and held accountable at the end of year — and members of the board are holding them to account — I honestly think that is a sufficient safeguard.

I have some experience working in companies with supervisory boards. The danger is that the people on the supervisory board get too far removed from the day-to-day business of the company. You need to know what is going on.

You are quite right; we have all been in a position where we were not quite sure how to deal with something that came before a board or an audit committee. None of us should feel ashamed of that. There are some people who run entire countries and who claim that they know everything that is happening.

If you sit on an audit committee, you are entitled to ask for explanations. You are not the finance director. You are not the external auditor. You are not the internal auditor. You are just there to ensure that some of these systems are in place.

If you ask, ``Have you applied any financial judgments this year that are different from previous years or are material to the accounts?'' and people lie to you or do not tell you, you have to draw your conclusion nonetheless. You have done your duty.

Knowing about chemicals in DuPont is not the issue. You are there to question the people whom you are paying to look into the proper running of the company and to ensure that there is no malfeasance. The internal audit department ensures that controls are in place and that the counter at the top of the company is not corrupt. We all have a feeling for what is corrupt at the top of a company.

The Chairman: That certainly is a good answer. If you are diagnosed with some kind of an illness, it is wise to get a second opinion. I was going down that path. We all accept the fact that the large majority of companies are honestly run. At least, I hope they are.

Mr. Smith: You could be uncomfortable even without understanding some complicated tax scheme or whatever. You just keep saying to yourself, ``This is materially changing the profit this year, materially changing the assets, or materially changing the tax charges.'' You are just uncomfortable. No matter what the experts are telling you, you have the right to call for a second opinion. However, I would not have a standing army of an audit group that comes in each year. You will overcomplicate the situation. However, you absolutely have the right and the duty, if at the end of the day you are uncomfortable, to say to the company that you have heard everything they had to say. ``I know that the quarterly accounts will be sent out next week, I know when the annual meeting is being held, but I am unhappy. I want a second opinion in this before we go any further. You are paying for it.''

The Chairman: I am sure you are right. You are an expert on this subject. However, look at the Enron debacle. From what I read, they had hundreds of offshore companies all over the place. You would have to guess that their audit committee did not have a clue as to what was happening.

On the other hand, we had witnesses here some months ago from the Ontario Teachers' Pension Plan, which is one of the largest funds in Canada, who sold Enron at the top simply because they sat down and read the financial statements and all the footnotes and decided something was wrong. It makes you wonder why the audit committee did not do that at Enron.

Mr. Smith: It would be perhaps dangerous for me to comment too much on the Enron story. However, I have to believe that if some of the best accountants, the best lawyers, and all these other people said something was technically correct, maybe it was indeed technically correct.

I understand that there used to be an ethics committee that was disbanded at Enron at the time these decisions were being made. I understand that the decisions made were material to the profit of the company. It may be that people should have asked questions. This is very dangerous territory, because I do not know enough about what actually happened.

I am not an expert in derivatives, although I have dealt with them. I am not an expert in all tax matters, but I would like to think that as a non-executive member of an audit committee, I might ask questions until I was satisfied.

The Chairman: I am sure you are right. We are just having a wide-ranging discussion here. Our committee's challenge is to come out with a report and recommend moves to our government that could prevent these kinds of things. You seem to be on the side of principles-based rather than rules-based action. You could be right.

Mr. Smith: Let me tell you why. There is a great danger in rules-based anything because people tick boxes. Where you do not have to tick boxes, presumably everything is okay. The accounting principles system in the U.K. is such that at the end of the day you say it is all perfectly legal and technically correct, but what is the substance? Is this a case of form over substance? Is this a true and fair view? It is not only that it is legally correct and technically okay, but does it also tell a fair story about the trading for this year?

Those are the sorts of questions I would be putting to auditors, and to others. If you get too prescriptive if any area of life, the danger is that people say A, B, C and D, is good. There is no E and F. Everything else must be okay.

My second concern about a rules-based approach to catching problems is that something that could be allowed for one particular type of company might not be allowed for another. You should keep the heat on the audit committee. The independence of auditors should be reported each year.

For example, when it comes to non-audit services, they will decide what the policy is for that company and have to report on it at the end of the year. If you list things, saying the following are forbidden but the rest are allowed, then you could be heading for problems.

I know that Americans, and other people, like absolute certainty. This is allowed; this is not allowed. My concern is that you tend to tick boxes. Once you get outside that, it is relatively free and easy. There should be the overriding test of is it true, is it fair, and is it substance over form.

The Chairman: You are probably quite right. Our problem, and yours, is to restore investor confidence that seems to have waned. I just do not know if the average person can accept what you are saying. I can.

Mr. Smith: Huge damage has been done to capital markets over this exercise, because people do not know whether they can rely on sets of accounts. I thought that we were making great progress. A number of international accounting standards boards and the Accounting Standards Board in the U.K. were making pretty clear how you had to treat various assets and various types of expense and income. Then Enron came along, and we all had to reconsider this thing.

We have generally accepted accounting principles in each country. They tend to be coming together under the international rules. Presumably, Enron and others were complying with those. An auditor was signing off on them. A board was signing off on them. Presumably, many professional people were saying they were okay.

Therefore, I would throw the question back to you. The rules are clear. You must treat various assets in various ways. It is prescribed.

What do you do if they have not done that? I imagine that is what happened in Enron, or did they comply with the rules?

The Chairman: Apparently they did not comply with the rules because they were turning all kinds of debts into assets.

I agree with what you are saying. The bottom line is that there are a bunch of crooks involved, and crooks have to go to jail.

Mr. Smith: Allegedly. I am never sure about the legal position in these matters, but let us say they were.

Will the people on the street be more reassured if they are told that there is a set of rules drawn up by the SEC, the Bank of England or the financial services authority, or can they have confidence in the board of the company, who have clearly set out what their mandate is and have to report each year and to take questions? The chairman of the audit committee will be standing in open session at the annual general meeting and the shareholders can say, ``We notice there is 10 times the amount of non-audit fee to audit fee going to this particular firm. How can they still be independent? Why did you allow this? We notice that you commented on various expenses. Tell us exactly how you arrived at that,'' and they have to answer those questions.

The Chairman: There has to be someone there who is sufficiently informed to ask the questions. I wish I could give you an intelligent answer. I do not know the answer. That is why we are having these hearings.

Mr. Smith: I wish I could give you an answer, because it is about confidence and about what restores that confidence. If international accounting standards boards draw up rules to say this is the way you treat particular assets and particular liabilities, and if your board is enjoined to ensure that the external auditors are checking to see that things are done, I do not know what else you can do.

The Chairman: Do you see any way of changing what has evolved into a short-term culture? I do not know if that is your field. You talked about quarterly statements. Forty years ago, when I was in business, I really did not give that much attention to quarterly statements. I ensured that they were proper and issued, but we did not have a first call, a second call, and guidance of this and that. That drives managers nuts and puts them on the wrong track. Can you see any way of changing that?

Mr. Smith: You are asking about changing the attitude to capital markets. It is not just short-termism today, it is whether the government is making people more prosperous or whether kids are doing better at school. There is so much pressure on people to perform faster, earlier and so on.

It may be that some of the things that are going on in world economies right now are taking some of the heat out of the situation, but if you report to shareholders that you are going to grow at 15 per cent compounded over the next five years, they tend to look at you and say, ``That is inadequate. When are you going to buy something?''

The Chairman: Perhaps what is needed in this discussion is a philosopher rather than an economist.

Mr. Smith: I do not know how you take greed and short-termism out of human nature, but I think it is beyond the scope of the audit committee in the U.K.

Senator Moore: Good morning, Sir Robert, and thank you for being here. I want to ask you about the membership of the audit committees. On page 6 of your report, you say that audit committees should include at least three members who should be independent, non-executive directors. Are we to presume that some of the other members can be executive directors?

Mr. Smith: No. All members of the audit committee must be non-executive. I think that later in the brief I make that a little clearer. Audit committees must be composed of non-executive directors. There should be no executive directors on the audit committee, and the extra test is that they should all be independent.

Senator Moore: Yes.

Mr. Smith: On page 37, I lay out what independence is. The chairman of the company cannot, by definition, be independent. He is concerned about deadlines and all sorts of other things. He should not be a member of the audit committee. If that is unclear, let me make it absolutely clear now. All members of the audit committee have to be non- executive, all members of the audit committee have to be independent, and we hope there will be at least three members, but this combined code covers all sizes of listed companies and it may be that a small listed company does not even have three non-executive directors, let alone three independent ones. They would then either comply or explain in their report that they are a small company with only one executive director — the chief executive — and two non-executive directors and that the two non-executives make up the audit committee.

Senator Moore: Normally the directors are elected by the shareholders. Are non-executive directors elected by the shareholders as well?

Mr. Smith: Yes, they are. They usually come up for reappointment on rotation every three years, but it can be less than that. If a non-executive director is appointed during the year, he has to be reaffirmed by shareholders at the end of that year, and thereafter every third year.

Senator Moore: At the bottom of page 6, you refer to the Higgs report. On page 27 on the Higgs report we see that non-executive directors should scrutinize the performance of management in meeting agreed goals and objectives and monitor the reporting of performance.

I thought that the directors were there to look after the interests of the shareholders and to ensure that management was performing properly and in pursuit of agreed goals. Are we having guardians of guardians? Who has the dominant role here, the directors or the non-executive directors?

Mr. Smith: All directors on the board, executive and non-executive, are responsible to the shareholders for the performance of the company, but the executive directors have particular roles to do with the overall day-to-day running of the company. The non-executive directors are working with them and monitor them, but they are all equally responsible.

Senator Moore: Is the role of the non-executive director more important that that of the executive director in scrutiny of management?

Mr. Smith: Yes. You would not typify an executive director as being one of these guardians, if you like. They are there to run the company. Of course they have responsibilities to ensure there are internal audits in place and that they tell the truth when they report on the accounts. The non-executives are there in a dual role. One is to help promote the company, perhaps by introductions, perhaps by contributing to strategy, but the other is to ensure that there is proper corporate governance of the company.

Senator Kroft: My confusion perhaps arises more out of the Higgs report than yours, but I understand that you are familiar with both.

It is not clear to me from reading the collective material we have whether there is a strong view on whether the chairman should be non-executive.

I think the Higgs report talks about the position needing to be independent at the time of appointment. Could you clarify the expectation for the chairman, both as to independence and being non-executive?

Mr. Smith: Higgs refers to being independent at the time of appointment. Higgs states, and he is quite right, that there is no such thing as a non-executive chairman. He may be part time, but at the end of the day, the chairman has a role in ensuring that the board functions. At the end of the day, he is the person who will arrange for the chief executive to be hired or fired.

The chairman has a pivotal role in a company. He is more than someone who just comes along to monthly board meetings and takes part in one or two committees of the board. He has a major responsibility for making sure the board functions and that the chief executive is doing his job. It is a much bigger role than a non-executive director and should be remunerated accordingly.

Senator Kroft: I am glad I raised this because it is an extremely important issue. I do not disagree with you at all that the role of the chair of the board is significant and carries significant responsibilities, first and foremost in seeing that the board operates properly and in leading the board in the succession planning for senior roles, that of the CEO particularly.

There may be a cultural or linguistic difference between us here. In my experience and in the view that is developing rapidly in this country and in the United States — perhaps not as rapidly as some of us would like — the word ``executive'' attached to ``chairman'' does not relate to the fact that there is more work for the chairman to do. Rather, it makes very clear that the chairman has absolutely no operational responsibility in the company.

When we talk about a non-executive chairman, it does not necessarily mean one who does not have a large role for which he may be substantially compensated. The role is fundamentally defined in terms of maintaining the independence of the board from management. When you start talking about chairs having so much to do that they sort of fall into the position of ``executive,'' I get lost.

Mr. Smith: I was careful not to say they were executive. I said they might be paid a lot more and had a big job to do. I certainly did not say they were executive. I completely agree with you that the chairman should not be an executive chairman, or he is effectively the chief executive of the company.

You are absolutely right. If the non-executive definition helps in that, then I will use the non-executive definition. The chief executive and the other executives of the board are the executive directors. They are concerned with the day- to-day running of the company. The non-executive or part-time chairman is not an executive director of the company. It may be that we not only have a difference with language, but that I speak with a strong Scottish accent. I do not think I speak English too well either.

Senator Kroft: Very specifically on the issue of audit committees, what are your ideas — and I know this will vary with the size of the company — about time commitment, compensation and training? This is a perplexing subject and your comments will be welcome.

Mr. Smith: Higgs tried to attack the subject of payment. Just for reference, most directors of listed companies in the U.K. would be thinking of the basic non-executive payment of something like 26,000 or 27,000 pounds sterling per year for a relatively small company, through to 35,000, perhaps even 40,000 pounds, for a multinational-based non- executive director's payment.

On top of that, if you were a member of a committee, you would be collecting more money. Perhaps you would get another 5,000 pounds as the non-executive director of a small company. Perhaps there would be another 10,000 or 20,000 pounds if you were in a very large multinational. If you chair a committee, there might be money on top of that again. I am talking about very large companies.

We said there should be at least three meetings of the audit committee each year. They would tend to coincide with the run-up to half-yearly or full-year results and then a meeting to plan the audit for the year ahead. You might need more frequent meetings. The meetings should not be just one-hour meetings before the board meets.

I have served on many audit committees and boards. Often, meeting the day before or for one evening together, before the full board meets, allows you time to run on if there are some complex subjects to be discussed.

The role requires more than just attending three or four meetings per annum. You will need to do a bit of reading. You may need to meet to discuss specific subjects. On an audit committee you are perhaps putting in four or five full days per year. You may put in a similar amount of time on a remuneration committee or a health-and-safety or risk committee. Large, complex companies may need quite a number of non-executive directors.

You mentioned training. Your Chair was saying earlier, in a very candid way, that he did not know which questions to ask sometimes. We have all been in that position. We have recommended here an induction program, not just for all directors, but also especially for audit or subcommittee members of the board. There they can be told exactly what their duties are as members of an audit committee. They can even be steered toward the questions they may think about asking as members of the audit committee. From time to time, you would perhaps have teaching sessions about particular financial reporting standards coming out.

For example, we got very exercised in the U.K. recently about the treatment of pension funds in companies. It was quite complex, involving the effect of the profit-loss account and the balance sheet, actuarial calculations and so on. It took some understanding. That is the sort of issue where you could not properly function as a member of an audit committee, or even of the main board, unless someone had talked to you about how the standard was worked out, what effect it had on the accounts and when and how it should be applied.

There should be some technical training and some initial training when one joins the board. I have covered time commitments from your earlier question. I do not know if I covered all the points you raised.

The Chairman: Thank for your generosity of time and your articulation of the problems. I hope, when you read our report, it reflects some of what you said.

Mr. Smith: Thank you very much. I look forward to hearing how you are going to improve capital markets. We are all on the same journey, but we do not have all the answers.

The Chairman: How about if we just do not harm them any further?

Mr. Smith: Yes, that would be good. I was president of the Scottish chartered accountants in 1987. In my closing speech when I left I said: ``We have compliance committees, audit committees, regulators. Basically we all know what is right and what is wrong.''

I do not know where things started to go wrong.

The Chairman: God bless you, sir. I wish you luck in all your endeavours.

Our second witness this morning is Mr. Ken Hugessen from Mercer Human Resource Consulting.

Welcome, Mr. Hugessen. We are extremely interested in what you will have to say. We hope to have the report on corporate governance ready by the end of June or, perhaps, sooner. We have the challenge of making some recommendations and we would appreciate an overview of compensation practices. We also hope that you will include in your articulation some suggestions that could lead to proposed legislation. Perhaps you could point us in a direction that we could contemplate accepting.

Mr. Ken Hugessen, Canadian Compensation Practice Head, Managing Director, Mercer Human Resource Consulting: Thank you for asking me to appear before the committee today. I will offer a couple of fairly specific suggestions for the committee to consider.

I will take about 10 minutes for my presentation. Given that I am a consultant, I am wedded to slides, of which I believe you all have copies.

The first point I would make is on page 3. I will give you the context of our work and our perspective, which have shifted dramatically over the last 10 years — a process that has been even further accelerated post-Enron. That is to say that our client for executive compensation advice has moved from being predominantly management 10 or 15 years ago to, in my own case and that of a few others, exclusively the human resources committee of the board of directors or the compensation committee. That is over governance concerns about who should be deciding how the CEO and other top officers are paid. In fact, our firm has adopted a set of guidelines that requires us to have a written mandate from the compensation committee prior to offering an opinion or advice on the compensation of top officers.

Some companies have led the way on this. I have to mention that five years ago, the Bank of Montreal encouraged the then chair of the compensation committee to retain us independently of the management relationship. Many others have followed. It is my belief that about half of the TSE 60 right now have consultants working directly for their compensation committees.

I leave this page by saying that it is probably obvious that our work in the marketplace is with the largest companies in Canada. My own space is working exclusively with the committees of the boards of those companies.

Pages 4 and 5 show what the hot items are on those clients' agenda these days. In the post-Enron environment, I would have to say that the first one is clarity of mandate and the independence of the committee, including how it acts, how it is seen to act, how it gets its information and how it makes its decisions. The most volatile issue they have to deal with is pay for performance. We have all read the papers recently. There were some glaring examples in the public perception of where pay has been wildly out of context of the business performance. The committees are finding that they have to get into the performance assessment business, which they did not do originally.

Undoubtedly, the hottest topic of all is stock options, their effect on behaviour and whether or not they are a good thing. You have no doubt seen that the Canada Pension Plan has come out in opposition to them, while Teachers has said that they can live with them, as can OMERS. Our view is that they are a useful tool, although they have been overused. There are things legislators and regulators can do to help with that.

The attitude to the overall level of executive compensation is a very Canadian thing. They do not like people who make a lot of money. Concerning directors' compensation, including stock options, there are two clear issues. We need more work, time and attention out of our directors. They need to be paid much better than they have been. Most of the pay levels now are reminiscent of the country club legacy of board membership. That changed 5 to 10 years ago. There is a visceral reaction to stock options and the perception that directors are, as I said in a recent article, drinking from the same poisoned cup as management. At least for the foreseeable future, we would not recommend the use of options, but rather, that share grants and phantom share grants, which are whole shares, be used in their stead.

There is a whole raft of compliance issues. With regard to Sarbanes-Oxley, I hope you do not do that to us here in Canada. I was saying earlier that this was an appropriate response to a frighteningly bad situation in terms of the perception of business and corporate governance in the U.S. However, it has left a legacy of extraordinary compliance work and of doubtful gain in the long run. I suggest that what we really want here is to change the behaviour of directors, rather than tie them up with rules that, as your previous witness suggested, end up being something they can hide behind. Enron is famous not for the illegal acts, but for the legal acts that resulted in the collapse.

With regard to disclosure practices, there is a real mood out there. There is hot competition among the biggest to be the best at disclosure and disclose everything. There is actually very little to hide here. However, there has been a legacy of legal compliance, that is, the less we say and the more obscure it is, the better. That has pretty much gone away.

Finally, we are grilled about the independence and accountability of executive compensation consultants. In a nutshell, our world is becoming a microcosm of what you know the auditors and the audit committees are going through. It is not quite as high a profile, but it is much the same thing.

Concerning page 6, I will not bore you with all the details. You asked us for our view on the effects of various forms of compensation. Large option grants without some sort of hold period foster the potential for pump-and-dump. We have had some great examples of that here in Canada without having to look at the worst cases in the U.S.

There are some other things out there that are not so much on the radar screen, and that includes SERPs. A number of these programs represent a massive transfer of wealth from shareholders to executives. That is fine, provided that the committee understands what they are agreeing to when they agree to it. However, in my view, it is the last of the stealth bombers of compensation.

Most of the other things are fairly predictable. The hot topic is options. There is a school of thought that options foster wildly bad behaviour, which is not our view. The excessive use of options in the absence of any constraints does foster such behaviour. However, the proper use of them, properly monitored, can be helpful. I was glad to see the OSC has said that they want disclosure on hedging. We strongly support that. Giving options and then hedging them is hardly consistent with the original reason they were given.

Page 7 gives some of the history. We actually spoke out on a number of these topics before Guylaine Saucier`s committee. We believe the shareholder community in Canada needs to become a lot more active. Knowing that your previous witness was from the U.K., I should say there are some good ideas over there. There are more coalitions and coalescing of shareholders together to act.

The biggest challenge we see coming up is the pool of competent independent directors. The job is being made so miserable and the pay is so rotten, why would anyone choose to do this? That will become a major issue when the current generation of directors departs. It already is. I will return later to the business of empowering directors.

Perhaps some things can be done in legislation, but what I am about to address is really more behavioural. Currently, many directors feel that they are beholden to the CEO for the prestigious position of being on a board. That is a bad place to start if your job is to oversee the CEO. The fostering of a more independent culture among Canadian directors would be a positive move, in our view.

The creation of the Canadian Coalition for Good Governance is a good step. It was led by Claude Lamoureux, Stephen Jarislowsky and several others. We think it is a good first step. Historically, their pattern has been to throw grenades into annual general meetings, which in many cases was called for. They are evolving into a more constructive mode.

It is my view that there are accounting and governance concerns over their behaviour. They are quite expert on the governance failures in corporations, but very fuzzy as to their own governance and how they will act and be accountable individually.

People often speak, as they should, as shareholders. Many are in fact paid employees and not shareholders in the sense that people think they are. In my experience, there is a big difference between employees of institutional shareholding groups and shareholders like Ted Rogers or Galen Weston. They act quite differently.

Page 8 is our contribution. It is on the Web link and I would be happy to supply it. It would be our road plan for the compensation committee. If we pick a single thing, it is the independence of the chair and of the members of that committee. They must be accountable for performance. We would encourage regular in camera discussions so that the whole agenda and flavour of the meetings is not totally dominated by management making incomprehensible presentations. That has been a real impediment.

Finally, there is public accountability. We have seen a couple of resolutions at the banks calling on the chair of the compensation committee to get up and present a report. That would have a salutary effect on the thinking behind these things, although it would be a big step.

I spoke about enhanced disclosure. This is fixing itself. It has become a bit of a race to be the best discloser and have the clearest proxy.

Dispensing of stock options is a real problem because no one knows how to do it in a way that makes a lot of sense. The absence of that expensing has encouraged overuse and the taxation of stock options, particularly here in Canada, makes them much preferable to any other form of compensation.

Stock grants and retention, the things that everyone wants to see, are penalized under our tax act. We have a tax system that currently is encouraging the behaviour we now realize we no longer want.

I will give you some final thoughts and then I will turn it over to you for whatever questions I can answer.

My caution on legislation is that we are looking at a situation with a few bad apples. When people say that we need massive change, I love to say, ``Give me the list after you go through Enron and maybe another five.'' It peters out quickly. Even Ken Lay`s reputation is being resuscitated. He did not know what he was doing. That is not reassuring, but that seems to be the flavour.

The effect of options is my next area of concern. There is no question in my mind that they have been overused and that this has been encouraged by their free-ride nature. People cannot see that expense, there has not been enough clarity about the cost to the shareholder and the tax incentives are wrong.

If we could change one thing, it would be to stress not only the independence, but also the compensation committee. There is a philosophy here. In my view, you can either tell people what to do and create a situation where they are highly motivated to do end runs around it — and that, in some way, is the Enron story — or you can empower them and require them to account to their constituency, in this case, the shareholders. We think that would be more positive.

In closing, I give you my two directions. I do not want to be on record as having proscribed legislation. That is your task. First, it is important to have equalization of the tax advantages among the various forms of stock incentives and retaining the preference for stock ownership over straight cash. If the solution here is simply to abandon the tax preference for stock options, you will end up with a lot of cash programs and frustrating what all the shareholder groups are saying, namely, they want to see more real ownership. Options and ownership are useful. These things should be incentives, because they will improve the performance of corporations.

Second, I should like you to consider not so much what Sarbanes-Oxley did as what the New York Stock Exchange did. Therein was a message as well — perhaps for the private sector to deal with — namely, to look at the private members of the compensation committee, most or all of them being independent; a process in terms of the requirements for in camera; and the ability to act freely of management to form their own view on things.

Finally, a sensitive issue concerns reporting to the AGM. Requiring someone to stand up and account for why they did what they did is salutary and will make people think carefully.

Senator Kroft: I will start with your last point, namely, the salutary effect of having people stand up and account for what they are doing. I have sat in on a lot of annual meetings, as have you. How do you get around the mechanics of allowing enough time in an annual meeting for this to happen? You look at the program and, between the slide slow, the introductory remarks, the election of directors and the lunch, you end up with four and one-half minutes for all this to happen.

That is a simple question, but it is a real issue. Even with all the good ideas in the world, somehow it often does not happen. I should not forget the programmed employees who stand up and ask pre-prepared questions.

Mr. Hugessen: First, let me be honest. That is much too practical a question to get an intelligent response from a consultant. More realistically, much of it would be done on a consent-agenda basis. The issue is that the individual who is accountable is identified, perhaps gives a summary report and is available for questions. The real problem that you are alluding to is if Mr. Verdun shows up at your AGM, it can be a long meeting. The fact is that such people grab the agendas anyway and probably are doing it at CIBC as we speak.

The Chairman: Senator Kroft, it has been my experience, and yours, perhaps, that the shorter annual meeting is a Canadian phenomenon. The DuPont annual meeting went on for several hours. Even the primed Jesse Jackson would show up for some reason or other. When the DuPont guys came to the Seagram annual meeting, they would ask, ``How do you get away with it?'' Our meetings would take maybe an hour or an hour and a half.

Senator Kroft: Let me go on to more specific things. On page 8 of your brief, you deal with this issue of in camera meetings.

I am of the view that the route to effective governance is through an independent, non-executive chair separate from the CEO. That is to say, you would have to pick one fundamental principle from which almost everything else would flow, and if you did not have that principle in place, it would be extremely hard to do the other things.

Given that you have that, you are talking about in camera meetings here of the compensation committee?

Mr. Hugessen: It is where we have included it, but we would also suggest, as all do, that the compensation committee should be able to report to the full board in camera.

Senator Kroft: In camera, by definition, means what?

Mr. Hugessen: Ex-management. I do not want to ignore your first point because I certainly agree with the statement about the existence of an individual other than the CEO who has the powers required to achieve those same events. I have worked with several companies with part-time leads that have, in my view, achieved it. Certainly, there is a lot of independent work being done. I would not get caught up in the names. I do think the content is what matters.

Senator Kroft: I would not dispute the content if it were what matters. I am sure it does. However, the odds of that happening are better when there is an independent chair rather than a lead director. I have been through this argument with enough lead directors who are adamant that they can accomplish everything that a non-executive chair can. My answer is always, ``Why not make us both happy and you be the non-executive chair?'' It always seems to end up being an ego thing with CEOs, because there is someone else called the ``chair'' and they do not like that. My sense is that, finally, that is breaking down.

I do not want to take you beyond your specific area of expertise, but on the governance issue and in camera meetings, meaning outside non-executive directors meeting for broader purposes than just compensation, there cannot be many broader issues than compensation. Again, we all speak from our own experience. If you are talking about compensation, you cannot help but talk about succession, about performance and how you measure that, about what the strategic plan is, whether or not the person is producing, and so on.

It is a wide-ranging subject. It is not just how much this person gets paid.

Is it your experience that, through all this, CEOs and senior management are getting more comfortable with the idea of non-executive boards meeting for a retreat or a half-day or a dinner meeting, whatever works for any individual company, to work on compensation, HR subjects and otherwise, or is there a retrenchment and a sort of circling of the wagons in response to what is going on?

Mr. Hugessen: I can certainly answer the last part of the question. That is not the flavour. The overall answer to the first part is yes, there is a much higher level of comfort.

I think how it is done matters. It is important, in my view, that you institutionalize the process rather than put someone in the difficult position of saying, ``Do we need to go in camera?'' That is tough when essentially you are asking other directors if they want to say something about management that would require that management leave. It should be a regular part of the meetings, in our view. The chair of that meeting, who is independent of management, should be sensitive.

The timeline should be reasonable. If someone is reviewing my compensation and performance and we have had a big discussion of it and we presumably have a direction, unless there is a problem, it is respectful to try to keep that meeting to a reasonable length. On the other hand, if there is a problem, take all the time you want.

I caution, when you mention a retreat without the CEO —

Senator Kroft: That may be going a little far.

Mr. Hugessen: The sensitivity, if there is any, is over directors who really want the CEO's job, and that is where you get some pushing back. On the other hand, they have come around on issues of audit and compensation.

Senator Kroft: We heard a witness yesterday dealing with the same area. I would like to consider your comments in light of some of his. I was interested in what is now, I believe you said, an internal requirement for a written mandate from an HR or compensation committee to set out the appointment and its terms of reference, in whatever form that might take.

Mr. Hugessen: Correct.

Senator Kroft: Can I go back to where that process actually begins? Again, drawing on experience and observation, and also on evidence before this committee, it seems that very often, if not most often, even though that may happen at the next stage, it is management that identifies, recommends and maybe even in some tentative way retains the services of an HR compensation consultant, and it is then picked up by the committee. Who really hires you?

Mr. Hugessen: I understand the question perfectly. You are on to a very good point, one that is going into history. If I had answered that question five years ago, I would have had to tell that you that any appointment I had came because Matt Barrett decided to introduce me to the chair of the compensation committee. Today, a network of directors is independently choosing to work with a consultant, and that model has changed dramatically.

The other thing is, 10 years ago most of my fee income came from management. They made the approvals. To some extent, it always will be that way because the corporation is making the payment. However, as time evolves, the proportion of your business that has been obtained independently grows. We deal with large businesses where we have received a request from the chair of the board and chair of the compensation committee saying, ``We want you to show up at this company to make a presentation, we will have the CEO in for part of it, and we will decide.'' That is an increasingly common practice, but historically, what you have described is true.

We did not get to where we are today in one big step. I would have said that process, at least in our firm, was more true five years ago or three years ago. One of the things we felt we had to fix was what I think you are alluding to, which is, management says, ``We will hire the consultant, check him out and make sure he is a good consultant for you, and we will take two months to make sure he does not show you anything stupid.'' By the time you get to the committee, this thing is completely baked, and you are there with a thick report and all kinds of rationale for doing what management wants to do. The committee is dead in the water. You can pretend they are your clients, but they are not.

Our process is very clear. We require a written mandate from the committee. The chair of the compensation committee signs it. Also, we need in camera access, at our call, not management's, because it is so easy to control process. In particular, we are not hiding the fact we are a large firm. We have many interests out there. Another feature of our guidelines is to disclose all other relationships with management.

Senator Kroft: Taking it to the next line now, because these things are all linked in my mind, how often have you, in different assignments in different companies, seen the same people turning up, because they are CEOs on each other's boards, or different people on the same boards, so that you are interacting with the same people in different corporate contexts?

I will go ahead and ask the last part of my question and let you deal with it altogether, because I was pursuing this with yesterday's witness: Typically, when you do your matrix and you are positioned as to where your salaries are, what quartile or where on the median line, above or below, would, most typically, a company want to be? Would they say as a matter of policy they would like to have their executives — and I am talking about executives — in the third quartile, or median? My concern is if it is the median, how does the arithmetic work, and who is below and who is above in order to make it a median. If it is a quartile above the median how do you stop it from just leapfrogging?

Mr. Hugessen: I know that disclosure of pay has its detractors, but one of the clearly good things about it is that the consultant does not have to make that decision for a board. What a consultant needs to do is display the alternatives to the executive who is running the place in a clear hierarchy, and they can decide for themselves.

How would they make that decision? I suggest scope and scale, which is the traditional scale — revenues, market capitalization — but increasingly it is performance. Is this company a higher performer, and if it is, we will award more incentives and more stock, and if it is not, we will not.

We have done a fairly detailed analysis and we will update it this year. There is some pretty good evidence in the banking sector in Canada that there is significant differential now.

Senator Kroft: Performance tends to mean operating line performance, balance sheet performance or stock performance?

Mr. Hugessen: Many short-term incentive programs are well-known to be driven by simply looking at operating results, EPS, EPS growth, those sorts of things. In our view, a committee should be sensitive to the shareholder experience. Going to a group of shareholders and saying, ``We made our EPS goal and therefore are paying bonuses,'' in a year where your stock relative to your comparables has not done very well is something that we believe needs a rethink.

The overall package would certainly include absolute share price return, but just as importantly, relative share price return. What were my shareholders' alternatives to investing in this company? Those are things we believe should be looked at very carefully every year by the compensation committee, and throughout the year. We think they will spend more time in the future, on our advice, monitoring four or five measures of performance, most of which you can get out of an analyst's report, and then at the end of the year, making a decision about pay that reflects that cumulative experience of how the company was run during the year.

Senator Moore: Mr. Hugessen, I should like to ask you about the executive compensation on page 9, the taxation of stock options. You said in your opening comments that the tax system encourages the behaviour that we now know we do not want. For my own information, as well as to get it on the record, what is the tax regime now with respect to stock options?

Mr. Hugessen: Stock options have three very significant benefits. I think everyone recognizes an option has a value. If you know anyone who thinks otherwise, I will give them $10 for all their options and we will both be very happy. They clearly have a value.

First, at the time they are given by a corporation to an individual, there is no tax payable. I will be taxed on anything else I get, but there is no tax at the time the option is granted.

Second, you have extraordinary flexibility, if the stock does reasonably well, as to when do you finally realize the tax. Most options are for a 10-year term, and they will typically vest over 3 or 4 years. You therefore have this window of opportunity, from a tax perspective, in which you can decide when you want to realize income, assuming of course that the stock has gone up. When you do finally, the taxation is similar to that on capital gains. When you put that up against a dollar of pay or against granting someone some shares, which many shareholders think would be a better thing to do, those are non-starters. The grant of the shares is taxable immediately. The best we can do are some fairly complicated things called restricted stock units and deferred stock units. However, the restricted stock units only give you a three-year deferral, which is not as good as anywhere from three to ten. They also do not produce the capital gains at the end.

Observers will tell you there is a trade-off here. Options do not create a deduction for the corporation, whereas the ultimate payment under these other programs does. The combination of those three benefits is very difficult to equal. What we would suggest is that you preserve the beneficial taxation of options relative to cash and enhance the opportunities on these other, restricted shares, subject to the individual holding those shares for a meaningful period of time.

I have not thought this through, so I do not have a specific proposal for you.

Senator Moore: With respect to the third feature, upon disposition of those shares that an executive received by way of an option, is the taxation level not the same as it would be if I sold shares that I bought in the marketplace? Is this treated differently from the capital gains regime to which I would be subject?

Mr. Hugessen: It is not actually the disposition of the shares. The first event is receiving the option; the second event is you have all this flexibility; the third event is you acquire the shares. You have an exercise price of $10 and the stock is now $25, so it is a good day. You have to deal with that $15, which is treated as if it were capital gains.

The fourth event, for many people, is to immediately sell the stock. Their cost base on the stock is the $25, and if they sell it coincident with the acquisition, there will be no capital gain one way or the other. Therein lies the real problem of why people do not hold stock. As a CEO, if you get an option on $1 million worth of stock and it goes up to $2.5 million, you then exercise the option. First, you need the million bucks; it is not for free. Second, you have the tax, which is admittedly a lesser tax. However, you still have to come up with $300,000 or $400,000, plus the million, and there are brokers and dealers around who say, ``We will push a button and give you the net on the spot.''

[Translation]

Senator Biron: The Investment Bureau of the Canada Pension Plan has just announced that they would vote against share options plans and that, at future AGMs, any resolution relating to any form of compensation with share options would have to be voted on by the shareholders who are not interested in those plans.

[English]

Mr. Hugessen: I am sorry. I am not getting the translation.

Senator Biron: I will say it in English. At the annual meeting, the stock option should be accepted by the shareholders who do not have an interest. That is to say, the insiders who could gain advantage from that decision would not be allowed to vote on that. Would that not help to avoid the problem, as you said on page 4, if only the shareholders who are not insiders could vote?

Mr. Hugessen: Yes. I cannot see into the future, but it is my understanding that the TSX will change the rules for approval of stock options. The closely related issue, in my view, is that of multiple voting shares. The worst abuses I have seen in the compensation area are where that has occurred and where, effectively, there is complete control, and obviously they are not disinterested. I am not sure I know how to fix it, but it is a very real problem.

It would certainly help to require on stock options that the disinterested, or a ``majority of the minority,'' which I think is the wording they use, approve it. I understand the TSX is considering this as we speak.

The Chairman: I do not think there is anything can you do about multiple voting shares, except maybe stop it in future, but I am not sure about that either.

Could I ask several questions here? I would like you to clarify something for me. For three years, I was head of the HR committee at the TD Bank. When I became chair, I decided to hire our own consultant from New York, Fred Cook, a good guy whom I had known in my DuPont days.

Having said that, we hired him, not management; however, I still had to confer with the executive VP, and he was reporting to the CEO. I was not really sure how much independence I had. Does that happen to you?

Mr. Hugessen: It does, and it is one of the reasons why we have put these guidelines in place. There can be a very fine line where you are just going through an exercise. We are comfortable that, in the vast majority of situations, we are able to do enough work that we can independently advise the committee. Of course, Fred is a busy guy, he has all of North America, but you need enough time to know what you are advising your client on and not become overly reliant on what is being provided by management.

Having said that, we are strong advocates of a collaborative environment. Adversarial environments are a huge waste of time and a director will sit there trying to figure out which of the duelling consultants is smarter.

The Chairman: Have you advocated anywhere that we legislate against repricing an option?

Mr. Hugessen: No, and I would not.

I have been the victim, effectively, of their being disallowed. That is a good example of trying to second-guess the good judgment of your directors. The company I am thinking of was hurt very badly by a regulatory move, if I can put it that way. The net effect on us was — and I am speaking as a shareholder — we either had to re-price or reissue. The tax and accounting consequences of re-pricing were so onerous that we reissued. The net effect of that is we have double the dilution that we would like.

The Chairman: Could you have cancelled the first option?

Mr. Hugessen: If you do, it is a re-pricing. That is the definition.

The Chairman: I understand that, but the shareholder who has been hurt cannot re-price. How does management rationalize giving the executives who caused the downturn an option at a lower price when the shareholder is still stuck with the higher price?

Mr. Hugessen: Management does not. This was the shareholders. They are looking at this saying, ``We have a handful of people we need to keep in this company, which is basically valueless because of a regulatory change. What do we need to do?'' They did what they needed to. They issued the additional options, but left the old ones out there.

That happens all the time. Ultimately, the effective prohibition of re-pricing makes the working assumption that any event where it might occur is somehow attributable to the management; or management should suffer the same consequences as the shareholder. It is a great concept and a good one 90 per cent of the time. The difficulty I see every now and then is the other 10 per cent. I see it not just as an adviser, but also as an investor. I do not see why I should have to tolerate that extra tranche of options. That was the directors' call, not management's, to issue those new options.

The Chairman: I hear what you say, but I find it hard to agree. On the question of the various differences in taxation for different forms of options, grants, et cetera, have you ever made a submission to the Department of Finance?

Mr. Hugessen: We have not made one directly. We have had some institutional shareholders ask us for our views and thoughts. I understand they may have done so, but we have not.

Senator Kroft: I have one question. I thought I was fairly familiar with most of this field, but SERPs have escaped me.

Mr. Hugessen: SERPs are Supplemental Executive Retirement Programs.

Senator Kroft: I had not seen the acronym before.

Mr. Hugessen: They are something to watch for.

The Chairman: Is it a relatively new concept?

Mr. Hugessen: It is not that new, but as compensation levels have moved up, so have SERPs. They are connected to your cash compensation. Everyone may see their bonus doubled from $1 million to $2 million. They may not understand that because that happened to a long-serving executive in his late 50s, the pension liability probably went up $10 million.

Senator Kroft: Maybe I do need a little more explanation. Is the pension liability based on the combined income of base salary and bonus?

Mr. Hugessen: Often.

Senator Kroft: Is that a decision of the company?

Mr. Hugessen: Yes.

Senator Kroft: Unless it is actually written into the provisions of the pension plan one way or the other, which, presumably, it can be.

Mr. Hugessen: Or they could take it out.

Senator Kroft: Does that mean that the injection of that large bonus — the greater impact of it — is to revise the pension retirement benefit as opposed to the current income benefit?

Mr. Hugessen: That is correct.

Senator Kroft: It is much more direct and explosive than trying to do it through a base salary increase.

Mr. Hugessen: Precisely, and it is invisible, hence calling it a ``stealth bomber.''

Senator Kroft: So that is the link. Your best five years are $100,000 a year, you throw in a $1-million bonus, and suddenly the numbers change and the pension dramatically increases in one jump.

Mr. Hugessen: Yes. It is normally not quite as insidious as you suggested, but bonus levels have moved up smartly until recently. They moved up smartly in the late 1990s.

One of the things we were a little worried about was the fact that you do not actually see the change in liability in the pension program. If it is a long-serving executive who is in a plan that includes bonuses, it is simple math. If the cash compensation doubles, the pension doubles. It works like that.

Senator Kroft: We will not even get into the issue of the status of defined pension plans.

Mr. Hugessen: Not with me. You would be badly misled.

Senator Fitzpatrick: I am sorry I was not here for your testimony. I have enjoyed your answers to the few questions I have heard.

I want to go back to the issue of options. I am trying to find out what you would recommend. My understanding is that you are not opposed to cancelling options and reissuing new ones at a lower price.

The problem, and correct me if I am wrong, is that the Toronto Stock Exchange changed their rules a few years ago, so that you now have to have an option plan. You used to be able to do what you are talking about; and they used to have a level of 10 per cent, I think it was, as to how many options could be outstanding.

Frankly, I thought it was a better system than the one they have now, perhaps with one change. It did not have to be submitted to shareholders for approval. You were just up against that 10 per cent maximum.

I am wondering out loud if it should revert to the old system, in which you can cancel options. You can issue new options at a lower price if circumstances seem to merit that, provided that the shareholders give approval.

Can you comment on whether or not you think that would be a useful approach?

Mr. Hugessen: It would. Our whole theme would be that you either regulate the activity of the directors or you hold them to a higher personal accountability for the actions they take. You cannot do both. If you try, you end up with people who will run around the regulations, and that is the Enron story. Very little of what was done there was illegal.

We are suggesting that those directors should explain to the AGM why there is a resolution suggesting any of these things. That would have a much stronger effect than trying to say, ``We know better than you what you might choose to do under what could be a very extraordinary set of circumstances. We will stick to that.''

Trying to second-guess what should be done in a particular situation and overriding the thinking of a group of directors — provided they are independent and demonstrably acting that way — strikes me as very high risk. Why would we want to do that?

Senator Fitzpatrick: If the directors made a recommendation to cancel options and issue new options at a lower price, would the shareholders have to vote on that, just as they vote on the directors who are nominated or the audited financial statements?

I am not sure if I understand what you are saying.

Mr. Hugessen: I thought we were talking about the possibility of legislating a prohibition on re-pricing.

Senator Fitzpatrick: No. I am suggesting that they change the system, so that if you do not have an approved plan, the directors can make recommendations to management and to shareholders at an annual general meeting that the options be cancelled and new options issued at a lower price.

If you are talking about legislation concerning what percentage of options you can have outstanding at any one time, I do not see a problem with that.

Otherwise, I do not see the need to consider any legislation.

Mr. Hugessen: We are on the same page.

The Chairman: I will wind up with an irrelevant question so that you can demystify something for me. I have been involved in companies that took on a new fellow. You pay him X and guarantee a bonus of 50 per cent. If you guarantee it, why is it not part of the salary?

Mr. Hugessen: You do not want to keep paying it. Suppose it is $1-million salary with a $500,000 bonus. You give it to him the first year. The second year, he is on his own.

The Chairman: It is only for the first year?

Mr. Hugessen: It could be for the first two or three years. Those are the bad old days. In investment banking, it became absurd, particularly in New York, where there were 3-year guarantees of $3 million a year. Then, you were on your own.

The Chairman: Why did I never get offers like that?

Senator Kroft: As an investment banker in New York, I can tell you those days are over.

Mr. Hugessen: We do a fair amount of work on that, and it is brutal.

The Chairman: Thank you. I hope you read our report with interest, and that you can put your name to certain things.

Mr. Hugessen: Absolutely. I hope so, too. Thank you for having me, and I hope that I was helpful.

The Chairman: Our next witness this morning is Professor Richard Long from the University of Saskatchewan. I am sorry Senator Tkachuk is not here. He takes great pride in everything that comes from Saskatchewan, as do we. We like to believe that Saskatchewan runs the country.

Professor Richard Long, College of Commerce, University of Saskatchewan: I have not noticed that. Perhaps Senator Tkachuk has information that I do not have.

The Chairman: We will ask him.

You sent some information. Would you like to make opening remarks for 10 minutes or so? I read it. It is very interesting.

Mr. Long: Thank you. I did not have much time to prepare that brief, or I would have done it differently. I was contacted Friday afternoon and asked to fax my paper by Monday morning.

I am pleased to have this opportunity to appear before your committee to discuss executive compensation, because it is an issue that has key implications for all of us. I have been asked to speak for 10 minutes, so I will try to keep my introductory remarks brief.

You need to come up with recommendations. However, it is important to understand the problem and its causes before moving to recommendations.

I will start with my bottom line. I believe that rather than rewarding good management and improving company performance, many executive compensation systems today actually create incentives for mismanagement and are harmful to company performance, shareholder interest and the Canadian business sector as a whole.

Earlier, Sir Robert Smith indicated that he did not know where things went wrong with capital markets when he was discussing Enron. There was much discussion about audit issues and problems. I would contend that in the Enron case, it was not an audit problem. It was a management problem.

That management problem was partly, or largely, caused by an executive compensation problem. For example, the year before Enron went down for the count, the top 200 executives received $1.4 billion in executive compensation. That was the same year that employees' pension plans were wiped out and ordinary shareholders lost pretty well everything.

I do not want to argue that Ken Lay was an evil person. Indeed, there are a lot of questions about the extent of actual illegality. However, the problem was that the executive compensation structure provided extremely strong incentives for doing what they did, namely, making corporate performance look better than it was. It is difficult for anyone to resist the kinds of incentives and money that were involved.

The Chairman: Are you suggesting that was peculiar to Enron, or that it exists everywhere?

Mr. Long: Not at all. This is a problem with executive compensations systems in general. They are not all as dramatic as the Enron case, but the mismanagement can occur in many subtle ways that are damaging. It may not necessarily be illegal.

There are three main things wrong with executive compensation today, and they are all interrelated. The first is the amount of compensation many executives receive. The second is the structure, the way in which executive compensation is paid; and the third is the process by which executive compensation is determined. I will address each of them briefly.

As you probably know, the compensation of top executives in North America has exploded in recent years. I will quickly give you a couple of statistic. In the 1960s, the compensation of top executives in publicly traded companies in the United States averaged 43 times the pay of an average worker. By 1990, this had jumped to 100 times the pay of an average worker; by the year 2000, it reached 475 times; by 2001, it reached 531 times.

It did not seem to matter whether a firm was well managed; executive compensation kept on rising. We see headlines in The Globe and Mail such as ``CEO pay fails to mimic profits; total compensation climbs 54 per cent in 2001 despite an average earnings fall of 13 per cent among firms surveyed.''

Executive pay has increased dramatically in Canada as well, although the payouts are not as lavish as in the United States, which leads the world in executive pay.

The question is: What are the consequences of such large amounts? Aside from the direct cost to shareholders, there is the much more subtle but much more damaging consequence of demotivation and cynicism among employees. Their salaries and benefits are constrained, even cut. Certainly, average salary and benefits for typical workers stagnated in the 1990s, while executive compensation was skyrocketing.

What will those employees who see executive pay skyrocketing and their own stagnating do when the executive announces problems? He might say that we need to pull together because we are all in the same boat. The employee says, ``Yes, except my boat is a leaky rowboat and yours is a leaky yacht. We are not the same.''

We can also look at public concern. These kinds of things bring disrepute to the entire corporate business sector in the minds of ordinary citizens and stockholders. This is an issue.

Why has executive pay exploded? Why do executives now receive so much? Part of the answer lies in the structure of compensation and part lies with the procedures for determining executive compensation.

Let me look at structure, which is my second compensation problem. These problems get more important as we move along. To me, the actual amount is the least important problem in executive compensation.

More important than the amount of compensation received by executives is the structure of the system that provides that compensation and whether it is sound. A sound executive compensation system, as for any employee compensation system, is one that maximizes behaviour in support of company objectives while minimizing the costs of doing so.

Every unsound employee compensation package is damaging to the organization. There are many unsound employee compensation systems; we do not focus only on executive compensation systems. An unsound executive compensation package can be more damaging than any of these other systems. Au unsound executive compensation system affects not only the behaviour of the top executive, but also other managers in the organization and other employees. That is known as the cascading effect.

Senior executives know what it will take to get their bonuses and to receive good payouts on their stock options, so their objectives become those of other people in the organization, particularly if other senior managers have those same objectives in terms of stock options and so on.

This cascading effect is good if the executive compensation system is sound. However, it is bad if the executive compensation system is unsound because it multiplies the dysfunctions as it goes down through the organization. To use a dramatic case, I would argue that this is one of the things that happened at Enron. The problems multiplied as they went down through the organization. I agree that Ken Lay may not have understood everything that was going on, but I think everyone understood the kind of things that would cause executives to receive their payouts. I think all the senior executives understood those things.

The biggest single problem with executive compensation structure in recent years has been the excessive use of executive stock options. They have been popular because they were seen as without cost to the corporation; although in reality they were not without cost to the shareholders. They might have been without cost to the corporation, but it certainly resulted in significant dilution for ordinary shareholders and that is beginning to be recognized.

As in the United States, attempts are now being made to expense share options. That is difficult to do because when you issue share options you do not know whether the executives will receive any benefit. You do not know whether they will cost anyone anything at the time of issue, so it is a difficult question to get into.

Another study done in the United States has found that share options are the most expensive way of compensating executives. You can achieve the same value to executives by using other types of compensation plans at less cost to shareholders. For example, regular stock plans are much less costly to other shareholders than stock options because of the way the stock options are structured in most instances.

As I mentioned, in my view, they serve as a major incentive for mismanagement as well as resulting in unfair rewards to executives across different companies.

On the face of it, executive stock options sound like an excellent idea, since they will focus executive attention on raising share prices and thus increasing shareholder wealth. That sounds good. The theory goes that executive stock options will link executive compensation to executive performance as measured by share price. The problem is that share price is not a good measure of executive performance; it is not even a good measure of corporate performance. Studies show that about two-thirds of the variation in share price has nothing to do with the performance of the firm. It has to do with industry conditions, economic conditions and market conditions. A firm can easily have very good corporate performance and its stock price can be going down through no fault of management. The converse could also be true. A company's stock price could be going up dramatically due to no particular competence or performance of its executive management. Stock price is a very uncertain indicator of company performance.

Furthermore, for a CEO to improve corporate performance through good management is a slow and gradual process. You do research and development, you put new projects in place, you look at new capital expenditures, you put new plant and equipment in place, and you hire and train better quality managers and employees. These are fundamentals of good management and they take time to work. They take time to show up in corporate performance. Thus, raising share price through good management is a very slow and uncertain process. You can end up raising the performance of the corporation and it still may not be reflected in share price for reasons that have nothing to do with you.

Ironically, it is much easier for a CEO to influence share prices in the short run through mismanagement than through good management. This is where the perverse nature of the incentive comes in. There are a wide variety of ways to manipulate information so as to manipulate stock prices — some of them legal, some of them not, and many debatable. All it takes is for an executive, when his or her options are about to come due, to muse about a new innovation that is about to come out. ``We have a new product in the offing that will revolutionize the industry.'' In a case in the U.S., that is precisely what some executives did. They claimed they had a miracle drug, stock prices went up, they sold out, and there was no drug. Those people are probably going to jail. They have been convicted, although their cases are under appeal.

However, there are many ways you can influence stock prices that are not actually illegal. For example, you can do fundamentally bad things for management like cutting research and development. That makes the bottom line look better. In two or three years, the company will be dead because it does not have new products coming down the line, but the executives will have realized their stock options by that time. You can cut training. That is not very noticeable in a two-year plan, but it is over the longer term. You can cut employee compensation. That generates immediate savings, but as your best employees start to slip away over the years, there will certainly be a reduction in performance. Deferring maintenance and capital investment saves money now, but is deadly in the longer run for the company.

I want to be clear that I do not believe that most executives are inherently dishonest or corrupt. In fact, I believe that most executives are trying to do a good job for their shareholders, employees and customers. However, if they do and there are massive stock options received, that will be in spite of the reward system and not because of it. Why have an incentive for mismanagement?

How do dysfunctional executive compensation systems get created and what can be done about it? Incidentally, there are many ways that you can have dysfunctional executive compensation systems other than through stock options. In fact, there are many things, phantom stock plans, for example, that are technically not stock options but do precisely the same thing. That is one issue to keep in mind.

The report of the Canadian Pension Plan Investment Board that came out on Monday is recommending the banning of stock options, and I will talk about that in a minute. There are other things that management or a compensation committee can do to put in those same incentives without calling them stock options. We must be careful about looking for a golden bullet.

The third main problem is the process for determining executive compensation. I will quickly go through it. How is it determined? The board of directors strikes a compensation committee consisting of several outside or non- management directors. The committee then hires a compensation consulting firm to provide data on how other corporate executives are compensated in comparable companies. The compensation consultants have to select comparable companies. Of course, the ones they select make a huge difference on the data they provide. This sounds like a rational and reasonable process. However, in a potential conflict of interest, many compensation consultants would like to get other business from firms. Many of them are recommended by chief executive officers. From their point of view, it is very dangerous to go low when providing comparisons on executive compensation. What would they get out of that? They probably would not be hired the next time. Therefore, in collecting data, if anything, they tend to err on the high side.

Senator Kroft raised the issue of what executives are typically paid when the data is received. The research shows that most boards consider their executives to be above average. They would not want to think that they are only average because the board appointed those people.

If all the firms are doing that and are awarding above-average increases to their executives, you can see what will happen — and it has.

Finally, many outside directors are themselves chief executive officers and can be sympathetic about executive compensation.

Where do we go from here? There are number of solutions. The first has to do with board governance and the compensation committee. The most encouraging development is funds like the Ontario Teachers' Pension Fund, which is attempting to improve corporate governance. This recent report by the Canadian Pension Plan Investment Board on proxy voting principles and guidelines has many principles that I agree with, including, on balance, banning stock options.

In my view, there is nothing that stock options can do that cannot be done more cheaply with other mechanisms. The potential for abuse is too high.

There are all kinds of other recommendations with regard to corporate governance. I would make a lot of those, too.

Senator Moore: In your remarks, you mentioned a phantom stock plan, which you say is the same thing as a stock option plan. I think the word ``phantom'' or ``ghost'' stock plan was mentioned by the earlier witness as well. What is that?

Mr. Long: A phantom stock plan ties an executive's cash compensation to a stock price at a particular point in time. You know how a share option plan works. An executive is given an opportunity to purchase shares at some time in the future, sometimes as long as 10 years, which is the maximum allowed, at a fixed price. If, during that period of time, the price of the shares goes above the exercise price, the executive can then exercise the share option and either receive or sell the shares.

A phantom stock plan does precisely the same thing, only there are no shares or stock options involved. Essentially, a certain number of phantom options are provided to the individual. There is an exercise price. At any point in the next 10 years, the executive can ``exercise'' — I am putting that in quotation marks because he is not really exercising anything — and the company will give him or her the cash that he would have received had he owned those stocks.

Senator Moore: Would pay him what, the gain?

Mr. Long: Yes, the company will pay the difference between the exercise price and the price at the time that the exercise takes place. I am surprised more companies do not do this. The advantage to the company is that it can expense this entire cash payment against corporate taxes. Under the rules for stock options in Canada, that cost could not be expensed.

Senator Moore: You would not have the dilution aspect that exists under the conventional stock options.

Mr. Long: No. The dispensing would be there on the balance sheet for people to see.

Senator Moore: That is interesting.

Senator Kroft: Let us just take the flip side of that. The fact that there is no expense attached to a stock option is an advantage. You said they would not be able to expense it, but the absence of an expense, with or without income, has been one of the attractive things about stock options. The request now is to have these things expensed so that the company properly bears the cost of the options.

I tend to be a hardliner on these issues. I am not necessarily an abolitionist, but I am looking for the properly disciplined use of options. There is the other side of the page, too. I understand phantom options are useful to privately held companies that do not want to disperse shares, or to closely held companies that do not want to dilute shares. That gives incentive to executives for growth and performance without having to actually disperse the shares. That is an advantage.

We can argue the case for the dot-com world, and every business cycle will have an equivalent of ``what is new.'' It may be the world arising out of the human genome project. It may be the broad bio-tech industry or new forms of energy. Whatever the case, in this technological age, companies often have enormous lead-in costs of technological development that can far exceed capacity to generate anything in the way of value as recorded on the balance sheet.

The market may get excited about the concept. You may get ``value'' — and I put that in quotation marks — as reflected in shares. Some of those may not even have been issued yet. Speaking for the companies in that position, as they try to attract relatively talented people in a competitive marketplace, options are almost unique in what they can do. Phantom shares do not have quite the same impact as options in a company that shows no profit for five years because they are investing in their technology. Would you agree?

I worry about going too far and taking away a tool that, in a proper circumstance, may have a real value.

Mr. Long: I agree with you that in the past, dot-coms have used stock options as part of their compensation strategy. That system is not really in the best interest of the broader shareholders and I do not think it is even in the best interests of the company when you look at the actual effects of using stock options versus, say, actual shares. Anything you can achieve with stock options you can achieve with shares. In fact actual shares are superior to stock options. Why? It is because shares have a value and a long-term perspective. Stock options, because of the way they are set up, are sold by most people right away. Instead of keeping the shares, research will show, I think, the majority of people sell them for cash when they get the opportunity to do so. Essentially, a stock option plan is a non-ownership plan. A share plan is an ownership plan.

American results indicate that companies with broad-based ownership plans outperform their competitors to a substantial degree, especially when combined with employee participation and decision-making in an organization that allows for and values employee input. I am strongly in favour of broad-based share systems.

Roger Martin, Dean of the Rotman School of Management at the University of Toronto, was quoted in a recent article as being against stock options, against shares, against everything related to that area. He thinks they should not be used at all. I disagree. I think shares have an important role to play because they create an ownership culture and an ownership context. I do not think there is anything you can do with options that you cannot do better with shares.

Senator Kroft: We have learned from earlier witnesses that the impact and effectiveness of such options, for both the company and the individual, depend on the tax treatment of these different methods. The company or the individual may get an advantage, one over the other, in tax terms.

Mr. Long: Yes. Right now the stock options are preferable for the individual from an income tax perspective. You used to have to pay the tax at the time of exercise, which required you to then sell a large portion of the shares to come up with the money. The tax law was changed in 1991, such that you do not have to pay the tax until you sell the shares. You are able to take the shares and sell them when you want. That is the advantage of stock options.

At the moment in Canada, if a company gives $100,000 worth of shares to an employee — a stock grant — the company cannot expense that. That is not the case in the United States, where they are able to expense that stock grant for corporate tax purposes. That is a significant savings to them as well.

In Canada, you cannot do that. In the United States, a company is also able to expense stock options. By the same token, you have to then add them to your financial statements, so there is a trade-off for companies in doing that. In Canada, you cannot expense stock options or shares for corporate tax purposes. I would suggest that you could examine changing the tax rules in respect of share plans.

In the United States, since 1973, they have had a tax plan to support the broad-based use of employee share- ownership within organizations under the Employee Retirement Income Security Act. We have nothing like that in Canada, but such a system could be beneficial from a performance point of view, from an executive compensation point of view and from an employee compensation point of view.

Senator Kroft: We obviously have to do something if we have sets of rules that state you must expense options. There will have to be a change in the rules to say that you cannot.

Mr. Long: The difficulty in expensing them properly is one of the reasons that the Canada Pension Plan Investment Board has come out against options.

Senator Kroft: In using Black-Scholes as the valuation method, there is an inherent belief that it is more about what the appropriate number is rather than what the concept is. This is a matter of enormous debate and it is a challenging concept. There appears to be an acceptance in the corporate world and in the compensation world that the option, on the day that it is issued at that day's stock price, has an inherent value under Black-Scholes that is roughly 35 per cent of the stock value. I will not begin to get into that discussion, but there has never been any attempt to recognize that value from a taxation point of view.

Mr. Long: In the United States, yes, if you are talking about corporate taxation, companies can expense that value.

Senator Kroft: However, in the hands of the recipient, there is no tax, even though conventional valuation would put a value on the receipt of that stock grant. There is no tax.

Mr. Long: That is right. There is a disjuncture because corporations are being asked to imagine what the potential cost or benefit may be when the shares are actually exercised, and there is no way of really knowing. Black-Scholes makes some estimates and assumptions based on market variability in that particular industry. There are a number of complex calculations involved. It is probable that you could have a situation where a company has expensed the options at a particular price and five years later the stock has only gone down and it ended up costing the company nothing. It did not cost shareholders anything and the employees did not receive any kind of gain.

I do think that stock options have so many problems and there is so much potential for abuse that we should look carefully at whether they add value. Some studies show that they are an expensive way to add value from a corporate point of view.

Senator Kroft: Are you an abolitionist on the issue of stock options?

Mr. Long: I have evolved toward that. I used to think that they could be used — that there was a place for them. In the United States, there are broad-based plans whereby stock options are provided to all employees throughout the organization. There is evidence that it improves company performance and improves it enough to avoid that dilution effect. Broad-based stock option plans in the United States are shareholder neutral, according to the research that I have seen.

There is a study showing that executive stock option plans in the United States are in fact shareholder negative.

The Chairman: Thank you.

The committee adjourned.

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