Proceedings of the Standing Senate Committee on
Banking, Trade and Commerce
Issue 21 - Evidence
OTTAWA, Wednesday, May 28, 2003
The Standing Senate Committee on Banking, Trade and Commerce met this day at 4:10 p.m. to examine and report upon the present state of the domestic and international financial system and the Canadian perspective to the Enron collapse.
Senator E. Leo Kolber (Chairman) in the Chair.
[English]
The Chairman: Honourable senators, we have two witnesses today. Our first witness will appear by video conference. I welcome Mr. Finlay to the committee. I know that he has an opening statement.
Mr. Finlay, if you could please proceed, we would appreciate that.
Mr. J. Richard Finlay, Chairman, Centre for Corporate and Public Governance: Honourable senators, I am delighted to respond to the committee's invitation to address a matter of vital importance to investors and to the economic well- being of Canadians.
A common refrain and one invariably heard when corporate scandals occur is that directors need to direct. The idea that boards have a critical role to play in both the performance of the organization and in the preservation of public confidence and capitalism has recurred with astonishing regularity and has returned again in the aftermath of Enron, WorldCom, Tyco and so many others.
In my view, these disasters are the predictable consequence of an all-too pervasive corporate culture characterized by excessive CEO compensation that has created a mindset of short-term thinking, complacent boards dominated by past and current CEOs, who are often more interested in not offending management than aggressively representing the interests of shareholders, and an ethos among too many gatekeepers, including auditors, investment bankers, analysts and advisers, who sought to please management as a means of advancing their own professional interests.
I make these comments as one who has spent the past 30 years in the private sector, much of that time connected to boardrooms. We need to face the fact that many are questioning the moral legitimacy, indeed even the competency of our system of corporate governance and boardroom leadership.
My belief in capitalism compels me to be candid about the changes that I think are required so that the benefits of this system will be preserved for future generations.
As I stated in my letter to the committee more than a year ago when it announced its intention to examine Canadian implications of the Enron debacle, no institution in modern business has so persistently failed to perform or has so regularly under-performed as the board of directors.
I am not suggesting there are not diligent boards with conscientious directors, but the spectacle of Enron's board appearing live on television before a committee of the United States Congress pleading ignorance to the advancing dangers that brought down the company has been a scene repeated in far too many corporate disasters of the past century. This long-running production of the disengaged director must come to an end.
Dysfunctional boards have left their fingerprints on corporate disasters in Canada as well. Like their U.S. counterparts, Canadian boards are still dominated by past and current CEOs who often share the same mind set and who have a vested interest in maintaining the same compensation system. There is very little meaningful assessment of boards or director performance. There are too few women on Canadian boards. In addition, we have one structural impediment to effective oversight and improved corporate governance that the U.S. does not have — that is, an outdated and cumbersome system of securities regulations that sees 13 provinces and jurisdictions exercising control over that field.
In 1994, I appeared before this committee and recommended the passage of a number of corporate governance reforms for federally incorporated businesses. These were a desirable objective in 1994. They are an urgent prerequisite for Canada's ability to compete and to protect investors today.
The scandals of recent months have prompted an unprecedented questioning at the highest levels of government and other institutions about the responsibilities of the board and the principles of modern corporate governance. What can we conclude from this experience?
First, in too many cases, CEOs dominate the board to an unhealthy extent. A culture of boardroom complacency has led many corporations to adopt a practice of corporate governance of, by and for the CEO. This is especially true where the CEO is at once the head of management and the leader of the board he purports to report to. When that occurs, meaningful oversight is thwarted. Corporations enjoy enormous power and trust. There must be no doubt that they are governed by a commensurate level of accountability. Occasionally, the public trust requires structural adjustments through mechanisms of public policy and legislation. This is one of those occasions.
Second, excessive CEO compensation has become a highly corrosive force in the boardroom, tempting top management to focus on what is in their own immediate interest, often to the exclusion of what is in the longer-term interest of the company.
CEO compensation has reached unprecedented levels. No other time in history has seen such a massive transfer of wealth as there has been between shareholders and CEOs during this period.
One indication of the extent to which many boards have become obsessed with the subject of CEO compensation was revealed by the Centre for Corporate and Public Governance in Business Week. In an alarming number of cases, board compensation committees met two and three times as often as their audit committees.
There is no question what CEOs got out of these deals, but there is more than a little doubt about the benefit to investors. Even during a time when trillions of dollars in share value have been wiped out of the market, the median salary for CEOs is still growing.
In my view, adding bonus upon bonus for a job that already pays incredibly well, paying CEOs a small fortune when they fail to perform or a king's ransom when they are terminated, or paying them incentives just to stay on the job, amounts to nothing less than corporate socialism. It is a betrayal of everything responsible capitalism stands for, and makes a mockery of the work ethic. It sends a very bad message to all of the other players in the marketplace, who are beginning to think of themselves as chumps for doing a good job and getting paid a basic salary to do it.
The excessive nature of these pay schemes has created something of a moral hazard in the boardroom. The vast sums that CEOs are able to command often insulate them from the consequences of their actions. When men become disconnected from the folly of their ways, they tend to exercise less care than moral prudence requires.
Honourable senators might ask what legislators should do about excessive compensation. What can you do? Abuses in CEO compensation have far-reaching implications for public faith in the economy. As legislators, you must be concerned whenever the fabric of public confidence, which is so vital to our economic well-being, is undermined. A powerful statement about these concerns by this committee would seem, at the very least, appropriate.
The third lesson from recent experience is the extent to which so many in society depend upon the success of the modern corporation and the integrity of its governance leadership. In the 1980s, I wrote a lengthy article in Business Quarterly in which I coined the term ``stakeholder capitalism.'' Nothing more poignantly illustrates the ethical, emotional and financial investment the public has in the success and integrity of its corporations than the sight of betrayed Enron employees presenting tearful testimony before Congress last year.
All Canadians have a stake in sound governance, the accuracy of financial reporting, the professional integrity of auditors and analysts, and in a boardroom culture where directors actually direct.
Lord Macaulay advised: ``Reform, that you may preserve.'' The conclusion of all this is that change is necessary. It is, I think, a change that must be framed in law.
I am no friend of unnecessary law or bloated bureaucracy. However, as James Madison observed, ``If men were angels, no government would be required.'' Alas, we are all human.
The conduct of corporations in society is too important to be left to the scruples of directors and CEOs themselves. Private principles supplement the rule of law; they are no substitute for it. This is the way it is in baseball, on our highways and in larger society, and this is the way it must now be in the boardroom.
At a minimum, I would urge the passage of federal legislation that requires the following of all federally incorporated corporations whose shares are publicly traded. First, the board should be composed of a substantial majority of outside, independent directors. The definition of ``independent'' should be stringent. Recently adopted New York Stock Exchange rules provide a good beginning for that definition.
Second, the board should be chaired by an independent director and the positions of CEO and board chair should, by law, be separated. I believe CEO accountability and a healthy sense of perspective is assisted when the CEO sees at the other end of the table a strong and respected figure in the form of an independent board chair, and not just a mirror reflection of his own image.
Third, with respect to financial oversight that governs corporations, I have not seen anything that improves upon or is more comprehensive than the Sarbanes-Oxley Act of 2002. I think nothing short of it is required for Canada when it comes to the function of audit committees, the oversight of auditors, CEO certification of financial results, and the very heavy penalties that are now associated with violations of the law.
Fourth, consistent with the recommendations of the Royal Commission on Corporate Concentration called in the 1970s, there should be a limit on the number of board memberships that any one director can simultaneously hold. I would set that number at three.
Fifth, it is time to finally close the doors on the cosy boardroom club. Unlike the fields of law, accounting and stockbrokerage, there is no professional organization that oversees directors. Legislation should create a self- regulatory organization for directors of publicly held corporations. The purpose of the SRO would be to establish and enforce a code of professional conduct for directors. All directors of publicly held corporations would be required to comply with the code and there would be stiff sanctions, including disbarment from holding the position of director, in the event of violations of the code.
Sixth, it has been made abundantly clear over the last several years that wrongdoing can be prevented or at least minimized through the efforts of principled and vigilant employees. However, these employees need to be protected in their efforts to expose corporate impropriety. In that respect, I urge the committee to draft whistle-blower legislation designed to protect employees from reprisals.
Seventh, Canada needs a national securities regulator. We stand alone among the G8 countries in not having a federally chartered body such as the Securities and Exchange Commission in the United States. Some have suggested that we devise a hybrid whereby the provinces will form one giant commission, still leaving the federal government out of the equation. That is like a committee trying to create a racehorse out of a mule. A made-in-Canada solution will not work. We already have one. It is not working. It takes too long to pass common rules. There are too many conflicting visions as to what the future of Canada's capital markets should look like among regulators themselves. Nothing less than a national body with full accountability for its operations will do.
Allow me, if you will, to conclude with this thought: If Canada is to compete in a world that has rightly become suspicious of those who lead and govern corporations, it should commit itself to the task of becoming the most investor-friendly jurisdiction among the industrialized nations. This means adopting corporate governance standards and enforcement measures that are second to none and that lead all others. In doing so, we would send a signal of a return to a basic concept that is the defining hallmark of corporate governance.
The late United States Supreme Court Justice William O. Douglas summed it up this way: ``We begin and end with the assumption that directors are trustees by virtue of business ethics as well as the law; and that the powers which they exercise are powers in trust.''
Honourable senators, if we are to be true to the principles of responsible capitalism on which all of us depend, our private conscience as well as our public duty must call upon us to make the changes necessary to preserve this important trust.
I appreciate the opportunity to make my modest contribution to that end and I would be happy to take your questions.
Senator Kroft: We are near the end of our hearings on this subject. I should like to get your reaction to several of the things that we have been hearing.
Quite often, we hear a litany of excesses on the compensation side or malfeasance on the directors' side. Most of the examples are U.S. examples. As a matter of fact, although there are some Canadian examples in your paper, naturally there are mostly U.S. examples. Do you think the nature of our problem in Canada is substantially the same as it is in the U.S.? Should there be differences of seriousness or other differences that we should be aware of as we come to our conclusions? We do not want to impose solutions on a situation that does not exist or does not exist so seriously.
Mr. Finlay: Senator, I can tell you that I spent a lot of time dealing with companies and institutions on both sides of the border. I see no indication of any higher level of corporate governance or diligence among Canadian boards than those in the United States. In both cases, you will find good and bad, diligent and passive. We probably want to avoid a situation whereby we do not take the lessons of the United States seriously and shore up those areas that should be dealt with in order to prevent the kind of abuses that occurred in the United States from occurring here, particularly in light of the fact that we do have some experience with serious shortcomings in corporate governance in Canada. That was one of the reasons this committee held hearings in 1994 and again in 1996 and why we have had several studies by the Toronto Stock Exchange, looking at the future of corporate governance. There is a problem, but it is really time to fix it.
Senator Kroft: Moving on to the issue of compensation, which has been a focus of this committee and of people appearing before us. There seems to be a broad acknowledgement that at least in too many cases senior management compensation is far too high.
Would you have any guidelines to suggest or any way of approaching the idea conceptually or otherwise as to what is appropriate? We have heard some talk about the CEO as a multiple of an average work employee in the company. Others talk about trying to relate it in some way to company performance in terms of dollars. Have you found any way in which you might suggest to us is a way, a guidance, as to what is appropriate in compensation or how you might approach that problem?
Mr. Finlay: I believe if you had independent boards chaired by independent directors who really took their job seriously, if you had limits on the number of directorships an individual could hold, if you have fewer past and current CEOs on boards of companies, you would have a different mindset.
We must break this current cultural mindset that exists whereby it is in the interests of directors to support a compensation system that, as a CEO, they will benefit from.
When you see the statistics of so many companies, their compensation committees meeting two, three, four times as often as their audit committees meet, you know that there is an obsession here, and that is not a healthy obsession, I would submit.
Senator Kroft: It is not just that they are taking their jobs seriously?
Mr. Finlay: They are taking their jobs very seriously. That is a dominant concern and an obsession in too many boardrooms. We must get some sanity and reality back into the boardroom about the subject of compensation.
I would not propose a figure, but I would certainly say that the multiples have been going through the roof over the last 10 years. If you extrapolate that into the future, it will create an absolutely untenable situation, where you will find, if not among investors, then certainly among employees in the ranks, an incredible backlash, a strong feeling of resentment that has certainly been evident among employees of Enron and these other companies that failed. It was evident among the employees of Nortel.
I would put the onus back on the board in making structural changes around the board to ensure that it does its job, that it is empowered to do it, that it is accountable for what it does and, frankly, to encourage different people to get into the boardroom to become directors.
Senator Kroft: On the issue of directors, you have referred to the Bryce Commission in the 1970s on corporate concentration in regard to the number of directorships and you referred with approval to the number of three. You suggested that three directorships might be an appropriate limit. A culture or a given has developed on major corporate boards in this country that, to be impressive as a corporation, its board has to have several CEOs of other big corporations as members. Corporations are in a race, so to speak, to have this gallery of glittering corporate names on their boards. We see all of them come together with common cause talking about many things in corporate governance, but with very little preoccupation with issues of compensation when they act together.
What you have pointed out has been pointed out by others. A CEO on one board tends perhaps to point out some of the frailties rather than some of the good things that happen on the board.
Talking generally, how do you break that cycle? How do you deal with the fact that there may be people out there with equal or greater wisdom than other corporate CEOs?
Mr. Finlay: I do think it would be helpful in two ways.
First, there should be a limit. In respect of larger companies, there should be a limit on the number of directorships any one individual can hold. By the way, the Bryce Commission, as you rightfully conclude, did not set a limit. They recommended that a small number be held. They did not set a limit. The limit I am proposing is three. It is time to advance this idea, because it has been almost 30 years. It is time to have some specifics around it so it can be debated. To do that, to impose that requirement, is important.
Second, there needs to be a statement from a committee such as this that the pool of directors needs to be enlarged. One way to enlarge the pool is to encourage the appointment of more qualified women to the boardroom. In many cases, less than 10 per cent of a board's membership is women.
The Toronto Stock Exchange, which you would think would be a leader in some of these matters, has only one woman, and that is the CEO, out of a board of 14. That sends the wrong signal.
For a number of years, it has been evident that we need to increase the number of women, but that will not be done, and I am not suggesting it be done, by either regulation or law, but perhaps by moral suasion. A statement from this committee to that effect could be helpful in at least reminding the nomination committees of boards that they need to look elsewhere. As well, perhaps shareholders will become more vigilant about this subject when it comes time for the annual meeting and make their voice known on the subject as well.
The Chairman: At this moment, we are in the process of trying to put together a report; we are in the final hours.
How do you interpret the vast difference of opinion that we seem to have amongst decision makers in our country? For example, Mr. Brown at the OSC has told us that we should absolutely emulate Sarbanes-Oxley. Ms. Stymiest of the TSX says, ``Do not go near any legislation.'' Mr. D'Aquino, who took his group down to Washington, appeared before us and said, ``Leave it to us; we will look after ourselves,'' despite the fact that they have failed horribly. That was his impression. Mr. Stephen Jarislowsky of the institutional investor group says that they can handle it.
We are going to do what they think is right, but how do you interpret all these mixed signals?
Mr. Finlay: There is probably room for all of them. That does not help you, but there is certainly room for principles. There is room for more vigilant institutional investors, absolutely.
I do think the lesson is clear in the United States, honourable senators. Sarbanes-Oxley was a very important piece of legislation to shore up some significant gaps in the law and in the penalties that could be imposed. It has certainly concentrated the attention of the boardroom there, unlike anything else that is current in the United States since the original passage of the legislation.
It has had this additional effect, and this may be of interest to you: There is a recent case of fraud arising from a company in the United States called HealthSouth that was disposed of fairly quickly through admissions of guilt. Sarbanes-Oxley is one of the reasons it was so quickly dealt with — its provisions and the penalties that would be imposed. It encouraged people to come forward and admit their wrongdoing. That would not have been possible with just a principles-based approach. It required the legislation to move it forward.
Because there have been so many examples over the years of dysfunctional boards, it is time for the law to come forward and say, ``This is the minimum standard we think should apply with respect to certain key items on the agenda of board accountability.''
That is not in any way to suggest that there is not room for people to come forward with principles to improve. Currently, there are a number of boards in the United States that are working to go beyond Sarbanes-Oxley. If that floor had not been raised there, they would not be trying to raise the ceiling. That is the effect that it has and it will be an important part of the evolutionary progress of corporate governance and capitalism if the law now comes forward to state what it feels is important for society's protection.
The Chairman: When this group was in New, York we met with the COO of the New York Stock Exchange, who told us that had Sarbanes-Oxley been in effect prior to Enron, Enron would still have happened. That kind of gives me the jitters. What does it do to you?
Mr. Finlay: There are a number of people who say that the greatest scandal is still that there were not any laws on the books to prevent that from happening. The book is not yet closed on Enron with respect to the criminal indictments that are currently before the court. It may well be found that there was law breaking there. Certainly on the ethical side, a company's reputation is important. The omissions of that board will forever be a classic in terms of a failure of a board to stand up and do its job. That will have quite an impact. I do not think anyone will long forget that either.
Senator Moore: Mr. Finlay, with respect to your article dated February 26, 2003, which was published in The Globe and Mail and which you distributed to the committee, I would ask for your comments and for you to expand upon it. That article states, in part:
The fact that this rule maker —
And here you are referring to the Toronto Stock Exchange.
— for others hardly seems the model of corporate governance itself perhaps helps to explain why the TSX opposes reforms with teeth.
I suppose that alludes to the chairman's comment about them not wanting any legislation.
The TSX has failed to enforce the modest boardroom guidelines that have been in place since 1995, even though surveys confirm that dozens of top TSX listed companies don't comply with the minimum requirement to disclose annually whether they follow the guidelines.
Could you tell us something about that? What guidelines are not being enforced? What types of reporting are not being followed? How is the TSX not enforcing those reporting guidelines?
Mr. Finlay: That is a good question, senator. I appreciate you raising it. It does go to this issue that we need more than voluntary practices. In 1995, the TSX adopted a code of improved corporate governance standards; through the Centre for Corporate and Public Governance, I made a number of recommendations, which they accepted. It was a good code. However, a company was only required to disclose whether it had abided by the code and, if not, to disclose where it did not abide. A company did not have to actually follow any of the points for the corporate governance guidelines.
Although there seems to be some flexibility there, the problem is that many companies do not even bother to follow the disclosure requirements vis-à-vis where they did not abide by the code. They are either silent on it or, through many proxy statements that I have read over the years, rather misleading in what they have to say about what they are doing.
As far as I know, and I have made this statement on a number of occasions, there has not been a single occasion where the TSX has levelled a penalty against any of the hundreds of companies that do not follow the bylaw that they must disclose whether or not they are following these guidelines. That apparently has not been taken seriously, which in turn sends a disturbing signal to corporate Canada and to the investment community that the regulator, in effect, does not care enough about the guidelines to enforce them. Even the modest requirement of disclosure is not being enforced.
Senator Moore: Does that not give credence to the suggestion that legislation is the recommendation for our committee to make?
Mr. Finlay: I believe it does.
Senator Moore: At the beginning, you said it is a little bit of everything. I do not think that is much of an answer. I believe the chair was looking for a little more direction other than ``Oh, we can have a bit of that, a bit of that, a bit of that.''
Mr. Finlay: I am saying that the floor must be legislation.
Senator Moore: Are you?
Mr. Finlay: Yes, definitely. I am saying that that is no substitute for individuals seeking to do better, or the principles that they bring to the table. We always need to encourage that. In the boardrooms that I have been in, there are always a number of men and women of great principle there. However, we need to establish a new floor. I have looked at this over many years, and I think the only way to do that now is through legislation.
Senator Kelleher: I should like to ask a question of you, Mr. Finlay, dealing with the Accounting Standards Board. I get the impression or feeling, and I am not sure of my grounds here, that they will not be as independent as the American counterpart will be; is that correct?
Mr. Finlay: To the extent that the American version is a creature of legislation, with oversight by the Securities and Exchange Commission, which I understand is pretty vigorous right now in the way it is overseeing it, I would agree with you, sir.
Senator Kelleher: If that is the case, at the back of my fertile little mind it seems that what we have opted for in Canada is self-governance by the organization itself. In this day and age, and given what the Americans have done, will this be sufficient?
Mr. Finlay: I do not think it is any longer sufficient given the magnitude of the crisis that we have had to face, the greatest crisis since the Great Depression, in terms of the public's confidence in the markets, capitalism and in the leadership of business.
Senator, it is hard for me, as someone who has been observing this and studying it and who has been associated with business for 30 years, to overstate the impact that this has had. This has been a watershed moment. It has been a serious wake-up call. The fact that so many committees of the United States Senate and Congress are holding hearings on this, along with the fact that the President, who is a pretty strong free market advocate, signed Sarbanes-Oxley, is evidence that something has changed. Believe me — and I think you know this — they would not have done this in the United States through two parties agreeing on something like Sarbanes-Oxley if it were not very important, if they did not feel that it was essential to the preservation of confidence in the market, which is, at the end of the day, all that we have. Once that becomes eroded, it is very hard to get it back.
The many people who looked at that were shocked, and wanted to avoid anything like that in the future. We have in Canada an opportunity to learn from that and to take some steps. I am not saying we should copy Sarbanes-Oxley exactly; I think we can build on it, to come up with improved legislation. However, the framework is there, along with the lesson that we need to set some new standards and we need legislation to deal with tough enforcement mechanisms. Certainly, we will not succeed in this task if we do not have a national securities commission in Canada that is capable of protecting investors the way the SEC does in the United States.
Senator Kelleher: I have no axe to grind with the chartered accountants association, but it seems to me that we should look seriously at some form of legislation similar to that of the Americans. Do you agree with that?
Mr. Finlay: I certainly second that, honourable senators. I would support that. That is very important. The role of the gatekeeper is in all of this. The auditors and the experience with analysts, as well, constituted a massive betrayal of trust in the opinion of many. We have to, again, take steps to ensure that that trust is never violated in Canada to that extent. Legislation is the way to accomplish that.
Senator Baker: I just have one question. If I understand what you are saying, you are recommending more regulation and more control. You are suggesting some outside, independent control over boards. You refer, to use your words, to ``the incompetence of securities commissions.'' You recommend a national security regulator or regulation.
You think we could improve things in Canada if we had an outside, independent look at what is going on. While you were talking, I was thinking about the ordinary company in Canada, an insurance company or a trust and loan company, that has its own auditor and then has to have, by regulation, an independent auditor every six months or every year put forward a report to the regulator, the superintendent of insurance or the securities commission. You have an independent, unqualified auditor's report that goes in and that auditor has audited the auditor of the company. Then you have the regulator's auditor, another independent look at that auditor who audits the independent auditor who audited the auditor.
You are now recommending independent, further oversight. How do you feel about that? Some people would put forward just the opposite argument that you put forward here today as it relates to regulation and perhaps over- regulation in the marketplace.
Mr. Finlay: Senator, I am certainly no fan of over-regulation. If there were a way to avoid it, I would be the first to say, ``Let us do that.'' What I am interested in doing and I think needs to be done is that the work that goes on in the boardroom has to be taken from a different, longer-term perspective. There should be less on the CEO, more on the shareholder; less on short-term results, more on the long-term bests interests of the company. If you separate the positions of CEO and board chair, for example, you would go a long way toward doing that. If you had a substantial — and I underline ``substantial'' — majority of independent directors and tightened the definition of independent directors that would go a long way to advancing that as well.
What you describe, the process of the auditors auditing the auditors, happened in the United States. That happened with Enron, Tyco, WorldCom and all of these others. You can see the problems they got into. That happened. That process was going on at Livent, Bre-X, Confederation Life and National Bank, and so many other companies that have failed or run into serious problems.
We have gone through that process. It is still a very important part of the checks and balances, but it is no substitute, I submit, for the kind of reforms that have been passed in the United States and I think we need to be passed here in Canada.
Senator Baker: If you could prioritize, is having a national securities regulator the most important thing, and then you go down the line. Is that your opinion? You did not say that was the first one. You started out with independent outside directors and independent directors.
Are you telling us that you would, first of all, recommend the national regulation?
Mr. Finlay: Yes, senator. Certainly, my number one priority, if it were possible to do so, would be a national security regulator in Canada. We are alone, as everyone knows, with this model that we have. It is not working. It is time-consuming and expensive.
Let me give you an example. The Ontario Securities Commission recently announced that it will, in June, propose for public comment some changes in audit committees. These are good proposals. They mirror, to a certainly extent, Sarbanes-Oxley. There will then be months of public discussion. If it goes the way of a national rule, across all the provincial and territorial jurisdictions, it could take a year or year and a half to come back as a final rule. It is a very long process in Canada.
Capital moves at the speed of light. We are at a horse-and-buggy type situation with our system of securities regulation. We do need to change it.
What I was suggesting, however, about the changes in the governance of corporations could probably be done through federal legislation as it stands now. With your jurisdiction over federally incorporated corporations, the Canada Business Corporations Act, the chartering of telecommunications and banks, for example, you could probably impose those kinds of changes, aside from whatever it would take for the national securities commission. You could probably do those things now.
Senator Baker: An independent, outside look in your first mandatory requirement of regulation provincially, of course, the securities commission, is that there is a code of conduct. If there is no going concern noted at the first point, then one would think there would be a going concern noted at the second audit or certainly a going concern noted at the third audit. How would that solve the basic problem that you are trying to solve directly or indirectly?
Mr. Finlay: In the audit process, we have had a situation for a very long time where de facto audit firms and accounting firms, outside auditors, were hired by management and reported to management. The message of Sarbanes- Oxley is that the audit committees of boards take responsibility for that in a big way, which they have begun to do there.
The need to rotate auditors, for example, is very important, and the need to limit what other work the firm of auditors and their accounting partners can do is very important. We need to take a serious look at those provisions, as they have in the U.S. It is clear that there are many steps in the auditing process — and I am certainly by no means an expert in it. However, notwithstanding those steps, there were serious shortcomings and disasters as a result of even those steps in the United States. We have had some problems in Canada as well with restatements having to occur where auditors were misled by management.
You must impose a situation where the audit committees take full control and there must be independent directors who do that. They must, in my position, have a mandate and a checklist of what they need to go through. At the end of the day — and I would add this to Sarbanes-Oxley, they have not included it in their certification — I would require the directors of the audit committee themselves to sign off on the certification of results and not just the CEO and CFO. At the end of the day, the board must take responsibility. The CEO works for the board, but the board should be the final word in these kinds of certifications. I would add that as something where we could improve on Sarbanes- Oxley.
Senator Meighen: Building on what Senator Baker was saying, we are all ultimately concerned that we may over- regulate. If you look at the Enron debacle, when you strip away the verbiage, it comes down to base venal, criminal activity. They were crooks, many of them.
You mentioned how important it is to have more independent directors and auditors. I agree with that. You also said management misled the board.
Whether it is a related bunch of people or an unrelated bunch of people, assuming they have the same degree of integrity, if management misleads them, there you have a criminal act for which management should be put in jail.
Could you give me some comment on what I perceive to be a public perception, that is, that many white-collar criminals get off far too easily? If we crack down a little now, we might go some way toward preventing wilful misleading of independent, related, unrelated or whatever directors and auditors.
Mr. Finlay: Let us pursue the Enron example. The board created an internal committee to investigate what happened there, known as the Powers Committee. The Powers Committee determined, under Dean Powers, who became a member of the board at that time, that the board itself did not do its job. It did not ask the right questions. When undertakings were made to it, it did not follow up. It did have a code of ethics, and it waived the code on at least two occasions and maybe more.
When you look at the minutes of the meetings, at the time it took to do that and at the questions that were raised, you get the impression that this was not a board that was up to the task. The chairman of the audit committee of that board had been in that position for 15 years, which is a very long time. Boards need to look at rotating chairs and committee members, as you well know.
There are many things that board could have done. It could have asked discerning questions, followed up on undertakings and spent more time on key issues and less time on the compensation. Enron's board was meeting far more often as a compensation committee than as an audit committee.
These are failures of that board. The board itself and directors bear full responsibility for that. They may well claim that management misled them, and perhaps they did and at the end of the day there may well be criminal convictions, but I maintain that that was not the model board. They could have done more but they chose not to. They must bear some responsibility for the fate of that company.
Senator Meighen: I agree. I am not sure you gave us an assessment of the importance of enforcing greater penalties against those who are guilty of corporate fraud. It may make no difference, I do not know, but I am interested in your view.
Mr. Finlay: They have done that in a serious way in the United States. As I mentioned, the impact of that created a situation where they settled that case. People came forward to admit their wrongdoing because of the legislation of Sarbanes-Oxley and the penalties there.
In our system in Canada in provincial administration of securities, we have some limitations, as I understand it, on the penalties and jail time that can be imposed upon wrongdoing. That is one of the reasons I think we have to make securities issues a federal jurisdiction in Canada.
At the end of the day, there is a recurring pattern of directors who, during times of crisis, come forward and say, ``We did not know. No one told us.'' You must look beyond those questions. For example, one of the directors of Atlantic Acceptance in the 1960s when that company failed, rather than trying to avoid responsibility as so many directors do and blame others, came forward to the Canadian Club and gave a very important speech, which I have recommended that all directors look at, wherein he admitted that the board should have asked more questions than it did, and it did not do that. He said: ``In the future, learn from our example. Make yourself a nuisance to management if you have to. Pry at what they are saying. Get into the details because that is your job as a director and, if you do not, you may well have a disaster on your hands the way I had one on mine.''
I admire what he did. In fact, I raised that in 1994 in my testimony before your committee. I think more directors should look at that and take that as a model.
We have to finally come to grips with the fact that the way to concentrate attention on the road and elsewhere is sometimes through laws. If we had a highway where only principles governed and it was left to the individual conscience as to how you could drive, would you want to drive there with your wife, children, family and all your belongings, or would you prefer to drive on a road where there are speed limits and you see the occasional police officer who you know is prepared to enforce the law? That is the point shareholders have arrived at with respect to corporate governance and the need for laws to ensure greater order and greater integrity in the market.
Senator Kroft: You have talked a great deal about the need to change committees and rotate directors on different committees to bring freshness of view, and you are always weighing freshness of view against experience on the assignment.
Have you given any consideration to taking the same principle to board membership, which would lead you to the issue of term limit on board membership on the principle that the longer one is there, the longer and more familiar one is, whatever the arm's length nature of the legal relationship, it tends to compromise independence? Have you a view on that?
Mr. Finlay: This might surprise you, senator, but I am a great believer in institutional memory. I believe that if you have a process where directors are assessed as to their performance in a meaningful way, not through the high school exam that exists today, and where performance assessment is part of that, the directors who are not up to it will take an early retirement. Frankly, the best directors I know are well into their 70s and take their jobs very seriously. They are men — and I wish there were more women in boardrooms of whom I could say this — of very high principle who want to do a good job for the shareholders. They are not there for the money and they take the job very seriously. I would not want to do anything to disturb the ability of boards to have the benefit of that kind of thinking.
If you have safeguards of turnover of committees and board chairs, and if you have a meaningful system of assessing and reviewing board performance, you will still be able to have the benefit of the long-serving directors who are there to do a good job.
The Chairman: The committee had before it Mr. Gibson from the Ontario Teachers' Pension Plan. He is a vice- president in charge of $13-billion worth of equities. He was known for having sold Enron near the top, and we asked him why he had. He told us that one afternoon three of them decided to read all the footnotes in the Enron statement and that it became clear to them that there was something wrong. They did not know what was wrong, but they knew something was wrong.
It was the auditors who wrote those footnotes. They surely must have known something was wrong. I agree with Senator Meighen 100 per cent, and with Senator Kelleher, whose prime objective is to see more orange suits. I think we ought to pursue that. The fact is that Canada has the philosophy of almost never putting people in jail for tax evasion or anything else, and I think that is a big mistake.
Thank you for being with us, sir. It has been most illuminating.
Mr. Finlay: Thank you very much.
The Chairman: Our second and last witness is from the Accounting Standards Board of the Canadian Institute of Chartered Accountants in the person of Mr. Paul G. Cherry.
Welcome, sir. Proceed with your opening statement.
Mr. Paul G. Cherry, FCA, Chair, Accounting Standards Board of the Canadian Institute of Chartered Accountants: Mr. Chairman, honourable senators, it is a pleasure to be before you again. Few topics have generated as much controversy as the accounting for employees stock options. I was led to believe that this is a topic of some interest to you.
I should like to cover briefly three aspects. First, I will report to you what the Canadian Accounting Standards Board, the United States Financial Accounting Standards Board and the International Accounting Standards Board have been doing. Second, I will comment on why we believe investors in the capital markets will be better served. Third, I will speak about where we are headed.
I also brought a handout of which I believe you may have copies. I apologize that it came out at the last moment. We were trying to pull some data together. In addition, there is a colour version of Appendix F. My tired eyes find it easier to grasp the main message from the colour version.
The Canadian Accounting Standards Board issued an accounting standard in 2001. That standard sets out the current financial reporting requirements for Canadian enterprises. It permits enterprises to disclose the effect of employee stock options in a footnote, instead of recording them in the income statement.
The most commonly used accounting method for employee stock options today is the intrinsic value method. No compensation expense is generally reported under the intrinsic value method, provided the exercise price is at least equal to the market price when the option is granted, which is almost always the case. The result is that companies rarely report any expense for their employee stock options in the income statement.
Accounting standards seek to produce information that is neutral, unbiased and faithfully reflects economic reality. The intrinsic value method fails these tests. It produces a result that is absolutely wrong. Investors are not well served by a method that systematically overstates earnings, which is precisely what the intrinsic value method does.
Accordingly, in 2002, the Canadian Accounting Standards Board issued proposals that would revise the accounting standard so that all stock-based compensation would be measured at fair value and recorded as an expense. This is already a requirement for all but ``plain vanilla'' employee stock options.
The Canadian Accounting Standards Board is in the process of evaluating the 27 comment letters we received to proposals. The board has confirmed its intention to, first, require that the cost of all employee stock options be recorded as an expense in the income statement; and second, to require the measurement to be at fair value.
The International Accounting Standards Board and the U.S. Financial Accounting Standards Board are adopting the same two fundamental principles.
There is general agreement that employee stock options have value and that the value can be substantial. The comment letters have not identified any significant new arguments or insights that would cause the boards to retreat from their conclusion that the fair value of employee stock options should be recorded as an expense in the income statement.
There is significant and growing support, some might say a groundswell, for our position. It is particularly gratifying to note the strong support from regulators, corporate governance advocates, financial analysts and institutional investors.
Many public companies in the U.S. and in Canada, including major financial institutions and other prominent enterprises, are beginning to record the fair value of employee stock options as an expense or have declared their intention to do so.
The issue that has attracted the most comment and concern is the reliability of option pricing models. The Accounting Standards Boards has consulted various experts with substantial experience in option pricing. The experts have advised us that the technology exists today to price employee stock options reliably and without undue cost or effort. Option pricing is already a crucial part of our capital markets. The handout material includes some interesting comparisons of the results using enhanced option pricing models that were specifically designed to accommodate the special features of employee stock options.
The Accounting Standards Board intends to convene a meeting of interested parties to discuss issues and concerns and appropriate solutions for pricing employee stock options, particularly of small-cap companies, thinly traded companies and private companies.
The Canadian, the U.S. and the international boards are at different stages in our respective due processes, but we have all confirmed our intention to hold fast to the two fundamental principles I mentioned earlier. All three boards are working towards a single, global standard.
A key milestone was reached last week when the international board voted to eliminate the major differences between their proposals and the methodology already used in Canada and the U.S. to measure the fair value of employee stock options and record it as an expense.
The Canadian Accounting Standards Board believes it will be possible to have the new standard in place for 2004.
I would be pleased to take questions and any observations you may have on the handout material.
The Chairman: Several words of explanation before we start the questions: As I understand it, to evaluate an option, you use either the Black-Scholes or something else that is predicated on the belief that the stock will go up. Otherwise, is there an expense if the stock goes down?
Mr. Cherry: It is predicated that the possibility of the stock going up has a value. It is not predicated on second- guessing what the value of the stock will rise to. It is rather an exercise of evaluating the possibility of price fluctuations, and that is what the value of the option is derived from.
The Chairman: Is Black-Scholes not very often dead wrong?
Mr. Cherry: I do not think anything can be more dead wrong than zero, which is the current system. In fact, the Black-Scholes method has been widely used now for well over 25 years. It is true it estimates a fair value, and, like any other estimate, there is always the chance that the actual number will be different.
The Chairman: They also got the Nobel Prize for that, I think.
Mr. Cherry: At the time, they did. One of the two, and I cannot remember whether it is Black or Scholes, participated in our most recent round of discussions.
I should like to clarify that none of the three boards is stipulating which model or modelling technique has to be used. In fact, we are urging people to put their creative energies to getting the best modelling procedures possible.
Based on many years of experience, at least six parameters are known to potentially influence the value of an option. The requirement is that you cannot ignore those six. There is only one exception to that, and that is for a private company. At the moment, we allow them to ignore volatility, which understates the value of the option, because the single biggest contributor to value is volatility. It is true that if something is volatile it can go down as well as up, but the market puts a significant value to the possibility of it going up, even though you also have the risk of it dropping.
The Chairman: Could you take the committee through one example? Let us say the Paul Cherry Company is selling at $5 a share and you grant a million options to you, the CEO. How do you handle that, and why is it an expense?
Mr. Cherry: There are two questions. As to how you would handle it, in order to arrive at the value of the option, you need to know several things. You have given me one, which is the exercise price of $5.
The Chairman: That is what the stock is selling at today.
Mr. Cherry: That is very common. Under the intrinsic method, that would say there is no value to be recorded, because if the exercise price is the same as the current trading price the intrinsic method says there is zero value.
Economists and financial intermediators would not stop there. They would say you need to know several other pieces of information. You need to know how long the option runs. An option for a three-year period usually does not have the same value as an option that runs five years. It is not a lineal relationship. Therefore, you have the term.
You have to also allow for the time value of money, so you need the risk free interest rate, which is relatively straightforward.
If that stock would pay dividends in the interval, you factor that in. Again, that is easy to do. Many stocks just do not pay dividends. That is relatively uncontentious.
The final piece is the volatility. That relates to the fluctuations in market price. You can get that in a number of ways. It is an estimate. You do not have to drive it solely by past history.
Those are the factors that we say have to be considered in arriving at what the market would likely price that option at if it were given to anyone, whether it is an employee or not.
The Chairman: In other words, if you bought the option.
Mr. Cherry: Yes, and on some of these there are options that trade in the market. Volatility is the most difficult to estimate, certainly.
The second parameter that has a big effect on value is the life of the option. A number of people have pointed out that if you went to the market, it is very tough to buy long-term options. Some people have questioned why, from a corporate governance point of view, you would give long-term options to employees that you would not sell into the market.
The Chairman: Could you take us through the mechanics? You give an option for a million shares. The employee has a price of $5. The stock goes to $8. He decides to sell. What then happens?
Mr. Cherry: The calculation is done at the time the option is granted. It does not matter.
The Chairman: I hear you, but just I want to know the end result first.
Mr. Cherry: In your example, let us assume for purposes of argument that an option pricing model would suggest a value on the option of about $3 a share. The accounting would say that $3 should be recognized as an expense over the period in which the employee earns the option.
The Chairman: Are you saying you are betting the stock will go to $8?
Mr. Cherry: Not necessarily, because there is also the risk it could go to way more. It could also fall less. It is a statistical calculation.
The Chairman: At what point do you settle the books?
Mr. Cherry: At the outset.
The Chairman: Then it is never changed?
Mr. Cherry: It is not changed.
The Chairman: Even if the stock goes up quintuple?
Mr. Cherry: No, there is no subsequent adjustment. The only adjustment that would be made would be if the option were forfeited. Then would you get zero.
Senator Moore: What if the value goes down?
Mr. Cherry: There would be no adjustment for that. The logic, and I believe that it is sound, is that the option had value at the time it was issued, just like if you bought an option or a warrant or a put or a call in the marketplace. Some of them end up being very lucrative, and others not. The possibility of substantial gain has value, as evidenced, because there is such a keen interest in preserving these arrangements. Another approach that some would favour would be to wait until it is actually exercised and see what happened.
If you took the Nortel approach of a number of years ago and waited until it was exercised when the stock was trading at $110 or $120, that might reflect what the holder of the option actually realized in cash. Just about every financial analyst I know would say that is a gross overstatement of what someone would have paid for that option. If it were trading at $3 a share, you would never have gotten a premium of over $100 for the option.
The dilemma is: Do you wait until you know, with certainty, the outcome, but then you misstate the true value of the option? Alternatively, is the better approach, and we think it is, to proceed as you do with other estimates where you give it your best shot? What we want to know is: Is there sufficient methodology and experience here that people put a reasonable effort into it, or is the number almost certain to be wrong? That is not the issue. If we took that approach, we would not put a set of financial statements together because we would not know the figures for pensions, income taxes or depreciation. Estimation underlines most of what financial reporting is about today.
Senator Kroft: I am a little nervous, because I am beginning to understand a little and I do not want to be lonely.
As I have been trying to work my way through this and in listening to what I feel have been very helpful comments from you, if you juxtapose the granting of an option to the actual purchase of an option, if one were purchasing an option, as you suggested, that would have all of the factors that make up a marketplace, all the economic, emotional and predictive factors that would lead someone to say, ``I think that stock is worth something,'' or ``I think that option is worth something.''
Many of these models are ways of creating an imaginary marketplace. There is no marketplace. As you say, it is a concept of value. The fact that it turns out to be right or wrong, is no more relevant than if I am right or wrong if I go to the stock market and buy a share today thinking it will go up. When we come up with a depreciation estimate, from the point of view of making that valuation, we do the best with what we have got as opposed to doing nothing. For example, if it turns out that Black-Scholes model produces an average value of 33.4 per cent over a block of shares in a block of time but, in fact, it turns out to be 22 or 42, it does not really matter. You have done your best to estimate the effects of the marketplace and established value.
The search for a perfect model is not really a preoccupation of yours; is that correct?
The Chairman: That is the part that I do not understand. If I start to build a building and my construction contractor tells me it will cost $8 million and I enter that into my books and I have a huge cost overrun, do I ignore it?
Senator Meighen: The next building will have a huge cost under-run.
Senator Kroft: Mr. Chairman, to take your example, instead of a building, if you bought a wheat option or indeed the stock itself, and your analyst and adviser told you that the stock would produce a certain amount for you in two years, it may or may not do that. The market is quite different from constructing a building; it is a different animal.
The Chairman: I understand. However, your company either has an expense or it does not have an expense, and the expense has to be accurate.
Senator Kroft: No, it does not. How accurate is your depreciation effect? You may say that a certain piece of equipment will last for 20 years. That is the notion that underlies the whole notion of depreciation.
The Chairman: You have a tax act that tells you how much you can depreciate.
Senator Kroft: You could use that machine for 60 years.
The Chairman: That may be.
Senator Kroft: You are introducing the tax element. Tax has nothing to do with it. I am talking about the amount at which you expense it. The theory of depreciation is that, at the end of the depreciation term, the item is worth zero. That is the theory of depreciation. The tax people complicated it because they included a tax aspect. The original idea of depreciation was that you could put away enough money so that, when the item was no longer worth anything, you could buy another one.
Mr. Cherry: Mr. Chairman, I would like to follow up on your example to see if, in my mind, it would come closer to what I see as being the analogy.
If you were to embark on a major construction project and know from experience that there is a significant risk of cost overruns and occasionally you come in under, rather than a fixed price contract, you could, perhaps negotiate with your builder a risk sharing arrangement, pick the ratio, 70:30, 60:40 or whatever, but agree on the value of that shared risk today.
The Chairman: At the end, it is a precise number.
Mr. Cherry: Maybe I am not expressing myself clearly.
The Chairman: In your example it is not a precise number.
Mr. Cherry: Perhaps I could just clarify. If your budget for your project was $100 million and you wanted a fixed arrangement — someone else would share that risk of variation — what would you negotiate today to share that risk? You would say, ``Let's come up with a premium.'' The cost of getting someone to bear the risk of an overrun and also the benefit if it comes in under would be priced in the market. You would have no difficulty coming up with a price. It sounds like insurance.
The Chairman: When the deal is done, it is a precise number.
Mr. Cherry: At the end of the day, from your perspective, once you have bought the risk-sharing arrangement, you have paid a risk premium. That is the more appropriate analogy to a stock option, there is variability to gain or to suffer a loss. The market can price that. It is true, these particular stock options usually do not trade in the market, but many of these companies do also issue stock options.
Compensation experts have advised me that companies often consider various combinations of cash options and other forms of their benefits package, and people ask them to value out different combinations. People tell me that is done, and it is not considered unreasonable. That suggests to me that these things do have a value that can be determined, but one of the important decision points in this is: Do you price it at the time the arrangement is entered into, or do you pick some other date? That issue has been hotly contested over the years and consensus now, certainly in the three boards that have looked at it most recently, is that the appropriate time frame is to price it up front.
The Chairman: When John Roth sold $100 million-plus of Nortel stock or exercised options, what mechanism was put into play that day?
Mr. Cherry: I am speculating here. I assume he exercised options and sold them in the marketplace.
The Chairman: Did he have ownership of the stock?
Mr. Cherry: I am sorry, I do not know.
Senator Kroft: The broker took over the whole deal; took the options and handed him his cash, exercised the options, sold the shares and completed the transaction.
The Chairman: Why did that cost the company money?
Mr. Cherry: The exercise of an option does not cost the company. The transfer of wealth from the financial statements he was trying to capture is the value of giving Mr. Roth or anyone else the possibility of gain without the corresponding exposure to loss.
The major difference between owning the stock outright and having the option is that, in the option, you just do not have the exposure to loss. You have an opportunity cost, but that is it. You do not get the negative.
The Chairman: It sounds fictitious to me.
Senator Kroft: You are missing the piece, with respect, that those shares that he sold that day are now part of the outstanding shares. The capitalized value of all of the other shareholders has been diluted. That is where the cost was to the other shareholders.
Mr. Cherry: I might point out that this discussion is very much in the context of employee stock options. Stock options are widely used in many other situations, such as buying a business. It is not uncommon to give the vendor some combination of cash, shares, warrants and whatever.
We have been valuing those and accounting for them. There is no controversy. The controversy seems to arise because it is connected with an employee rather than anyone else. The failure to account for employee stock options is the anomaly. All of the other instances are captured in the accounting model.
Our board sees it as getting neutrality of accounting, getting all of these transactions in front of shareholders in a consistent manner.
The Chairman: Is it true that in many corporations both in Canada and the United States, large amounts of corporate profit will disappear if companies start doing this?
Mr. Cherry: It will vary by sector. In some cases, no. I did include some information in the handout material. Appendix E shows some data that comes from the U.S. done by Solomon Smith Barney. They looked at the period of 1998 to 2000. For example, in the energy sector, it would be 3.1 per cent of net income. The two high ones are information technology and utilities. The information technology is at a little more than 12 per cent. That does not surprise me because it has been in the press. The utilities one surprised me. It is at 21.8 per cent. That reflects some circumstances in the U.S. of deregulation in some areas.
Senator Kroft: If brokers counted as utilities —
Mr. Cherry: That would have been a good question. They would have been in that category once upon a time. I have not delved into that to see if there is some other explanation.
There is some Canadian data on page 20 and some more on the technology sector. It gives you a sense of magnitude. In some individual companies, it can be fairly dramatic.
Senator Biron: Let's say that an option had a time frame of three years. On a million shares you could provide for a $3 expense on each of the million shares. That would make it $3 million. In the specified time, you would know that the value of the shares could be reduced by $3 million. However, they found that three years after that their shares had been reduced by $3 million.
Mr. Cherry: There is an effect on the existing shareholders. I am glad you raised that point.
There are two important effects of stock options. The one I have been discussing most is the purchase of employee services. In my example, the $3 million is what we are proposing as a reasonable measure of the employee services purchased. That would be expensed over the vesting period. Plans typically vest over three to four years, four to five years, something in that range. You would get an expense of around $1 million a year.
The other effect is that the existing shareholders suffer a dilution in the event that the option is exercised. We capture that information in diluted earnings per share. That still is a very important dimension. It will still have to be measured and reported.
In fact, that is reported right from the day the options are issued. A shareholder really wants to be warned in advance. If shareholders wait until the option is exercised, it is too late from their perspective.
Senator Biron: Which is the case now.
Mr. Cherry: The diluted earnings per share is being disclosed now. However, at the moment, we are not getting the purchase of the employee services being recognized as a cost of doing business.
The Chairman: You are saying that the dilution is reported.
Mr. Cherry: Dilution is reported at the moment.
The Chairman: That is what I thought. Years ago, I had some options at Cadillac Fairview. Every year or so I had to buy or sell a third of them.
Senator Kroft: You vested it.
The Chairman: I had the right to buy it. I guess that is what happens now.
Mr. Cherry: There are any number of variations in these arrangements. Almost all involve some element of vesting before you can exercise.
That is a difference from an option that is traded in the marketplace. Option pricing models have been developed to take that into account. An option you cannot exercise for three years is not as valuable as the identical option that you could exercise at any point in time.
Some plans require that, once it has vested, you have a limited period of time in which to exercise. Others are more or less open-ended until you retire or terminate employment.
The Chairman: When Roth sold his shares, the company issued treasury shares that day or the day before, equal to what he was selling. As Senator Kroft said, the broker did the transaction and he paid back the strike price.
Mr. Cherry: In all likelihood, yes.
The Chairman: I am totally confused.
I assume some student somewhere has done a Ph.D. on this.
Mr. Cherry: I did include in my handout a very short list of some recent academic literature. There is an enormous amount of it. We tried to select items that were in a North American context. I would be happy to provide further references if that would be useful.
The Chairman: I was in business for about 45 years. I am so skittish about some of the methodologies, such as IRRs, that people accept. Obviously, I am learning much from what you said. I must rethink it.
Senator Meighen: Succinctly, if you were writing our report, what would be the nub of the recommendation?
The Chairman: That is the best question.
Mr. Cherry: On this topic?
Senator Meighen: Yes.
Mr. Cherry: Stock options to employees should be handled just like any other kind of transaction, and some estimate of fair value must be better than effectively treating them as having no value. If we accept that general proposition, because there is such tremendous talent out there, we would be close to the point. People have been fighting about whether anything should be measured and recognized, but we have now overcome that resistance. Many people are stepping forward to say that they want to help us get the number right.
I believe that, if the requirement is there, we will quickly come up with enhanced guidance. That is why we are holding this round table. The mission in my mind now is to give people the best guidance. We have some excellent advice on how employee stock options differ. There are two or three characteristics that are important, and they do affect how these options are valued. We could explore those kinds of things.
The Chairman: When does the round table take place?
Mr. Cherry: It will be this summer. We are trying to confirm a date.
The Chairman: How long will it be — one day?
Mr. Cherry: I suspect we will have a series of these sessions. We will certainly want to have a range of perspectives and not just those of the technical gurus. We want to hear from the financial intermediaries. Company representatives will have an opportunity to attend, but we want to keep it small enough so that we can have a meaningful exchange of views.
The Chairman: It would be helpful, although our report will have been written, if we could send someone to attend as an observer.
Mr. Cherry: We would be delighted to arrange that.
The Chairman: This subject will be raised again.
Mr. Cherry: We could inform you of the dates as soon as we confirm them.
The Chairman: Thank you Mr. Cherry, you have been more than helpful.
The committee adjourned.