©2005 A. Paul Mahaffy. All rights reserved.

When the Sarbanes-Oxley Act of 2002, or SOX, became law in the United States, the business community wondered how much influence it might have upon the governance practices of Canadian companies that lacked a U.S. presence. Well, it didn't take long for Canadian securities regulators to suggest their own versions of SOX. But in adopting or recommending a series of national rules and polices designed to raise the governance standards for Canadian public companies, the regulators may have indirectly raised the governance standards for Canadian private companies as well.

While many private companies may be unwilling or unable to conform to these higher standards, if they are even aware such standards exist, some may be better off if they try to conform as best they can. Good governance is arguably good for business, even though a private company isn't required by law to have it. Public companies in Canada aren't required to have it either, although they are expected to voluntarily comply with the governance standards recommended and are required to publicly disclose what governance structures they do have in place.

Many private companies, especially those with just a few shareholders, lack effective governance structures. Their boards are often in place only to "rubber stamp" those decisions of management which need to have board approval to satisfy a request from a banker, supplier or other third party, or to meet a technical legislative requirement. And their boards are often comprised of only the major shareholder and his or her family members. Yet many of these private companies like it this way. After all, many feel the absence of governance is one of the benefits of being private, with little bureaucracy to slow things down.

Benefits of Good Governance

However, a board or board committee with a few members who are independent of the major shareholder and management can serve as more than just a comforting watchdog for the other shareholders, on the prowl for conflicts of interest and digging up personal expenses being disguised as business expenses. In addition to keeping management "honest" by overseeing transactions that might benefit the major shareholder but not the company, such a board or committee can also serve as a vehicle for arriving at better informed decisions. The senior executive of a private company can often benefit from the objective review and advice of others who are familiar with the company though separate from it. Setting company strategy and planning for growth, as well as realistically assessing ongoing performance, can often be done more effectively with the help of outsiders having broader perspectives.

But not just better informed decisions can be made. Tough decisions can be made as well. A board comprised of just the major shareholder and his or her family members may be less inclined to initiate changes which may threaten their own personal interests, even though such changes may be badly needed by the company in order to keep up with the competition. Removing unqualified family members from executive positions, putting in place a business succession plan, cutting long-standing ties with an underperforming supplier or loyal but non-paying customer, dropping an unprofitable product which was invented by the major shareholder, or taking away various perquisites like expensive cars and clubs, are more likely to be suggested by a board or committee consisting of a few outsiders.

In addition to enabling tough as well as better informed decisions to be made, more rigorous governance standards are supposed to provide greater transparency of the process followed in arriving at such decisions. They are also supposed to facilitate accountability of those making the decisions. It's not only the shareholders, but also the employees, creditors and other stakeholders of the company, who take some comfort in knowing who makes the decisions and how the decisions are made.

Resistance to Good Governance

Despite the benefits that may be gained through the implementation of better governance structures, some private companies take the view that such structures just aren't for them. Many feel they are just too small, lacking the breadth of resources and operations which justify the maintenance of such structures. If they have only a few shareholders, all of whom are actively involved in management, they may feel there is no need for independent watchdogs, and that their decision-making process works just fine, with no need for a fix. They may feel that they are so "closely held" that they already have as much transparency and accountability as they want or need.

If they have never appointed an outside accounting firm to perform an audit in connection with their annual financial statements, how can they be convinced of the merits of appointing outside directors to serve on board committees? Why should they adopt a shareholder communication policy and feedback structure for just a few people? Why should they incur the time and expense in setting up and maintaining audit, nominating and compensation committees which may well turn out to be too unwieldy to deal quickly with fleeting opportunities?

Some of the benefits gained from governance structures recommended for public companies can be gained in the private company context by way of contract, without putting such structures into place. Subscription agreements and shareholders agreements can provide private company shareholders with ready access to information, and with rights to review and veto proposed transactions if they so choose, whether or not they sit on the company's board or on a board committee, and whether or not the board or its committees are comprised only of insiders. The shareholders of public companies don't ordinarily enjoy such contractual rights.

Pressures to Implement Good Governance

The reluctance of a private company to implement more comprehensive governance structures may be understandable so long as it is financed by supportive family and friends. It may have to change its position, however, when it attempts to raise funds from other sources. Venture capitalists and other professional investors are starting to insist that the private companies they invest in adopt many of the governance practices now followed by public companies.

Not only do these investors want increased governance to ensure transparency, accountability and good decision making in order to protect their investment, they also want increased governance to protect their own nominees on the board who are under a director's duty to exercise care, diligence and skill. They also have to account to their own corporate and institutional shareholders, many of whom are under strict governance standards themselves. These standards often have to be observed by the professional investors and by the companies they invest in.

Since an initial public offering of the company, or a sale of the company to a third party, can provide an exit from their investment, professional investors often insist that increased governance be put into place when the company is private in order to make it easier for the company to either go public or be acquired by a public company.

Recommended Governance Structures and Practices

Recommending that one generic package of governance standards and practices be adopted by each and every private company would be misguided. There are just too many variations of private company ownership. Some private companies have just one shareholder, but that shareholder may be an individual with little business expertise, or a large public corporation with operations around the world. While other private companies have a number of shareholders, the shareholders may all be full-time officers of the company, or they may have had nothing to do with the company since they invested in it years before. Some private companies have one controlling shareholder, others don't.

When a private company is prepared to put more comprehensive governance structures into place, either at its own instigation or upon the request of a professional investor as a condition to funding, it has a number of alternatives to consider. Most of the alternatives are conveniently included in the corporate governance guidelines recommended by the Canadian securities regulators for public companies. Some of the guidelines are inappropriate for certain kinds of private companies. Actually, some are even inappropriate for certain kinds of public companies, such as those listed only on the TSX Venture Exchange, which is why they are partially relieved from providing the governance disclosure required of larger TSX listed companies.

The guidelines recommended for public companies generally address the process a company should follow in selecting, orienting, compensating and assessing directors, and in promoting ethical business conduct, but don't address the specific tasks which should be assigned to the board or the decisions which require the board's prior approval. Although they recommend that the board assume responsibility for strategic planning, risk management, management succession planning, and corporate governance, the guidelines don't prescribe what goes on a board's agenda. They do, however, recommend the establishment of nominating and compensation committees of the board, in addition to the audit committee which is required for public companies by law.

Although "best" governance structures and practices will continue to evolve for all companies, both public and private, private companies evaluating their current governance structures have to start somewhere. Perhaps they should start by addressing what are often regarded as the fundamentals of corporate governance. These fundamentals include independent directors, nominating and compensation committees as well as an audit committee (assuming outside auditors are already engaged), a code of business conduct, director orientation and continuing education programs, and the regular assessment of director performance. These recommended structures and practices are described in more detail below.

The Board and Independent Directors

The board should have a majority of independent directors, and the chair of the board should be an independent director. If it's not appropriate for the chair to be independent, an independent director should be appointed to act as "lead director" to ensure that essential tasks make it onto the board's agenda. The independent directors should hold regularly scheduled meetings which members of management do not attend. In order to be independent, a director must not have a relationship with the company, or with a subsidiary or parent of the company, which would be expected to interfere with the director's independent judgment. For example, employees, or individuals receiving more than $75,000 a year in compensation for other than director's fees, are deemed not to be independent.

Audit Committee

The board should establish an audit committee, preferably with only independent directors who have a good grasp of financial statements. The audit committee should recommend to the board the external auditors to be nominated for appointment by the shareholders, and the compensation to be paid to the auditors. It should oversee the work of the external auditors and attempt to resolve any disagreements between the auditors and management over financial reporting. It should also pre-approve all non-audit services to be provided to the company by the external auditors, and review the company's financial statements before being released generally to the shareholders or other stakeholders. The audit committee should have authority to communicate directly with both the company's internal and external auditors.

Nominating Committee

The board should establish a nominating committee, preferably with only independent directors, to assist the board in nominating or appointing individuals to serve as board members or committee members. The nominating committee should help the board identify what competencies and skills the board, as a whole, should possess, and assess what competencies and skills each existing director possesses. The nominating committee should determine what competencies and skills each new nominee should bring to the board, and should recommend individuals with such competencies and skills to be nominated as new directors at the next annual meeting of shareholders.

Compensation Committee

The board should establish a compensation committee, preferably with only independent directors, to review and approve the company's objectives which are relevant to the CEO's compensation, to evaluate the CEO's performance in light of the objectives, and to determine the CEO's compensation level based on the evaluation. The compensation committee should also make recommendations to the board regarding non-CEO officer and director compensation, incentive-compensation plans and equity-based plans.

Code of Business Conduct and Ethics

The board should adopt a written code of business conduct and ethics which applies to all of the company's directors, officers and employees. Designed to promote integrity and deter wrongdoing, it should address conflicts of interest, including transactions and agreements in which a director or executive officer has a material interest. It should prescribe the proper use and protection of corporate assets and opportunities, confidentiality of company information, compliance with laws and regulations, and reporting of any illegal or unethical behavior. It should require that all of the company's security holders, customers, suppliers, competitors and employees are dealt with fairly. The board should be responsible for monitoring compliance with the code, and only the board or a board committee should be able to permit non-compliance by an individual in particular circumstances.

Director Orientation and Continuing Education

All new directors should receive a comprehensive orientation so that they fully understand the role of the board and its committees, the contribution they are individually expected to make, and the nature and operation of the company's business. All directors should be provided with continuing education opportunities, not only to maintain or enhance their skills and abilities as directors, but also to ensure they remain current in their knowledge and understanding of the company's business.

Regular Board Assessments

The board, its committees and each individual director should be regularly assessed regarding their respective effectiveness and contribution to the company. The assessment of each individual director should be based upon the role that the director was expected to play on the board as well as upon the competencies and skills the director was expected to bring.

Next Steps for Private Companies

Once a private company has compared its current governance structures and practices with the above fundamentals and concludes a few things are missing, it then faces the decision of what to change and what to leave as is. For the private company with professional investors as shareholders, it probably won't have much choice unless it is a start-up or early stage company. It is likely to be asked to put the fundamentals into place if it hasn't already done so, although there may be considerable overlap in the membership of its committees and the members themselves may not be fully independent.

For those private companies that have a choice, the decision of what's in and what's out is not easily made. Being convinced of the benefits of good governance is one thing, but having the time and resources to implement and maintain it is another. Perhaps all that can be easily decided is that the fundamentals will not be put into place all at once. They are more likely to be phased in over time. While recruiting individuals who are truly independent to serve as directors is not an easy task, having at least one independent director is a good step to take. Having a code of business conduct is another. Nominating and compensation committees with only independent directors, or director performance reviews and continuing education, may follow later.

Whatever governance structures and practices the private company decides to implement, it will nonetheless be influenced by what other private companies it envies are doing at the time. Despite the cynical view which some private company owner-managers may have that the recommended structures and practices are mere window-dressing, good governance may become commonplace. It may become an indicator of the well-managed company. It won't be looked at as a quick-fix management technique that falls in and out of fashion. It will instead be looked at as having enduring value, respected for no better reason than it's just the way things are done.

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