We said a while back that there would be more surprises coming out of Research In Motion’s options backdating scandal. A big one came today.
Two years ago, I raised a number of concerns about Research In Motion’s corporate governance, describing it as a relic of the past. As its backdating scandal unfolded, I expressed serious reservations about RIM’s board practices, the role of its directors in the backdating review, and, ultimately, the outcome of that internal investigation. Simply put, there was something terribly fishy in the Waterloo-based boardroom, and in the flimsy excuses offered up by RIM’s founders and co-CEOs Jim Balsillie and Mike Lazaridis. As I noted in 2006:
In my view, these most recent developments at RIM are part of a larger problem involving its corporate governance practices, the structure of its board, the practice of awarding stock options to directors, the over-presence of management on a small board, the lack of an independent director as chair or even a lead director, among other concerns.
I said in an earlier posting that we have not seen the last of surprises at RIM over its stock options probe. This is one to add to the list. There will be more to follow.
A big one came today, when the company settled with the Ontario Securities Commission over allegations related to improper options backdating. A number of officers and directors will pay $77 million in fines and penalties. It is a record settlement for the OSC.
We will be taking a further look at the settlement and the failures that led to it in the days ahead. Here’s a clue as to what’s at the center of it. It comes in the words of OSC vice chair James Turner, who cited a “fundamental failure” in RIM’s corporate governance, which gave rise to the improper backdating and a host of misleading and inaccurate company disclosures. Sound corporate governance was definitely absent at RIM. But this costly outcome is also a lesson in the importance of ethics, transparency and integrity -three values that were more than occasionally missing in RIM’s boardroom.
Our previous postings on RIM are available here.
Research In Motion holds the distinction of being Canada’s top company in terms of market capitalization. Its boardroom governance practices fall considerably short of that mark. It is a seismic shift in Canada’s corporate governance landscape that appears to have passed The Globe and Mail by without causing a ripple.
The Globe and Mail’s Report on Business came out with its annual corporate governance survey on Monday. I’ve been on the front line in the battle for corporate governance reform for a few decades now, but I have never been a fan of these kinds of beauty contests. BusinessWeek began the idea some time ago but dropped it several years back because it seemed in a perverse way to give comfort to the worst offenders while discouraging those who took the subject seriously. In between, a lot of people and companies were just plain confused about the findings. BW rated Computer Associates a big improver ?that was just before its CEO, Sanjay Kumar, was indicted for accounting fraud. Tyco was also once considered a darling of the cause by some corporate governance champions, like Robert Monks. That fleeting honor will be of little consolation to its former CEO, Dennis Kozlowski, who along with Mr. Kumar and numerous other CEO colleagues, is currently a guest of the United States Federal Bureau of Prisons. They also have a space ready for Conrad Black, another convicted former CEO who seemed unable to distinguish between other people’s money and his own.
When the Globe started its annual contest in 2002, the series was published over five days. There were a number of insightful comments about the state of corporate governance in Canada and its future. It was the first and only time I participated in the survey and recall spending several hours with a couple of reporters to help them with their stories. Five years later, the Globe’s commitment to that issue has shrunk to a slim Saturday and Monday effort.
What struck me about the Globe’s survey, in addition to its rather obtuse and non-sequential rankings, was the fact that nothing qualitative was said about Research In Motion, which it rated 78 out of 190 companies. The silence was odd for a number of reasons. RIM was caught up in a high profile stock options backdating scandal earlier this year. Members of its compensation committee, who, as it turned out also received backdated options, thought they could oversee the investigation but had to be replaced. RIM gave incorrect information to investors in its proxy statements over a number of years as to how its stock options were being administered, and for several months in 2006 and 2007 it failed to file accurate financial statements. Eventually, it restated its earnings and made a number of changes to its antiquated board structure –after The Centre for Corporate & Public Governance brought the shortcomings to light. RIM is still facing investigation by the SEC and the Ontario Securities Commission.
These events are hardly so common as to rate being ignored in any self-respecting survey of corporate governance practices. Even more peculiar is this: Research In Motion stands today as Canada’s most valued company in terms of market capitalization. It dislodged the Royal Bank of Canada from that position early in November. What do you suppose is the significance of such a highly prized company coming in so far down in corporate governance rankings? We don’t know what The Globe and Mail thinks because it never address this watershed development. Here’s another one: there has never been a time when Canada’s most valued company has placed anywhere but in the top ten in terms of corporate governance. Now, the winner of that prize ranks below such companies as Biovail (which faced its own regulatory investigation this year) and Nortel, the serial re-stater of corporate earnings that had to pay a $35 million penalty to settle accounting irregularities with the SEC. Nor has there ever been a case where Canada’s top shareholder valued company has been ensnared in an accounting scandal and has had to restate its earnings because of it.
Until RIM, the most coveted spot in market capitalization always went to a well-established company with a long institutional history and a vast treasury of assets. The company that led Canada’s capital market generally also led in corporate governance. RIM, on the other hand, is headed by some bright and youthful fellows who have earned a reputation for marketing and technological innovation. They have done exceedingly well for themselves and their shareholders, but they are also inexperienced in many ways, including apparently not knowing that backdating stock options was wrong and was not consistent with what investors were being told. And the company’s corporate governance credentials have been less than impressive for most of its life in the capital markets.
Still, RIM’s newly won distinction among investors suggests that the landscape of Canada’s corporate leadership is shifting in far-reaching ways. It is an event that appears to have passed The Globe and Mail by without causing a ripple.
When a board gets to the point where it feels it needs to have a widespread automatic stock sales program, maybe it’s a sign that it’s giving out way too many stock options to insiders
I’ve been receiving a number of calls from the press regarding Research In Motion’s new automatic stock selling plan for insiders. RIM has a problem, it seems, in managing its abundance of insider wealth. With so many directors and officers having so much stock –much of it gained by an extraordinarily generous stock option plan that saw millions of shares awarded through option grants– it has had to set up a program to sell insiders’ shares in a way that avoids any hint of impropriety. RIM is still recovering from the backdating scandal that involved the company’s co-CEOs, the CFO and a number of directors. For several months in late in 2006 and into 2007, insider stock trades were frozen because the company could not produce accurate financial statements due to option-related accounting problems. During that period, co-CEOs Jim Balsillie and Michael Lazaridis exercised more than 750,000 options between them alone. And that was just a fraction of their total awards. We’ve had some thoughts on RIM’s accounting/backdating fiasco on a number of occasions. This latest move, which will see nearly $400 million worth of stock sold over the next 12 to 18 months, is no doubt also intended to help shore up RIM’s image with the SEC, which apparently is still investigating the backdating episodes. Finlay ON Governance was the first to raise the issue of RIM’s noticeably deficient corporate governance practices that were also implicated in the backdating scandal. The company has since scrambled to repair some of its board practices, as well.
You may recall at the time the company produced the report on its internal investigation (which we thought might as well have been written on Swiss cheese because of all the holes it contained in the form of unanswered questions), Mr. Balsillie, RIM’s co-founder, who, as his company’s bio boasts, holds the Canadian chartered accounting profession’s highest certification, and Dennis Kavelman, RIM’s former CFO, who is also a professional accountant by training, both claimed not to know that undisclosed backdating was a no-no under accounting rules. RIM’s board, some of whose members also received backdated options, did not keep complete records of stock option decisions and transactions, according to the internal report. They never explained who approved the backdating for directors.
As a rule, investors like to see management and directors buying stock, not selling it. This is especially the case in a company where most of the top people are still under 50 and aren’t planning to leave anytime soon. Insiders selling significant blocks of their company’s stock en masse is not something the market sees very often and is seldom prepared to overlook.
Here is an excerpt from what I told today’s Financial Post:
I am never a fan of companies where there is a lot of insider stock selling. They are the leaders. Would they like other stockholders to sell too? The market is entitled to view mass selling by insiders as an indication of a lack of confidence in the future, since, if the price of the stock is expected to rise, a rational investor –even an insider– would not want to sell.
The fact that the plan is being unveiled at a time when RIM’s shares stand at record levels might prompt some prudent investors to wonder if the company’s insiders have a less than bullish vision of the future. Maybe RIM’s shareholders should begin to contemplate their own systematic sale of shares.
One final thought for investors to ponder: When a board gets to the point where it feels it needs to have a widespread automatic stock sales program, maybe it’s a sign that it’s giving out way too many stock options to insiders.
From the stock market watchdogs who permitted the premature listing of the company to the cops and regulators who were unsuccessful in bringing even a single fraudster to justice, Bre-X was a colossal failure at every level.
It’s not surprising that the Ontario Securities Commission has decided not to appeal the acquittal of John Felderhof, the only person ever to be charged in the infamous Bre-X fraud. Frankly, there have been so many strange twists and remarkable disappointments with this case that there is really little left to be astonished about. As we noted here with chagrin even before this recent setback, the OSC is clearly losing its appetite for criminal prosecution, partly because it has been doing so badly in that regard and partly because it has a leadership culture that prefers to retreat to its less aggressive era. This was pretty much reflected in a statement by OSC chair David Wilson, who told Macleans recently that the agency’s priority was “not to beat the drumbeat of more criminal cases.” As we observed previously, there were many problems with the case, and where it was heard at Canada’s lowest court level, that were beyond the OSC’s control. But if you look at the length of time it took to have the case tried (seven years), the three- year-long motion and appeal interval where it was trying to have the judge removed, and the full year it took for the judge to write his decision (there was no jury in this case) the outcome was probably as predictable as the bewildering process that gave birth to it.
So it is that the largest mining fraud ever has now become the biggest bungled case of its kind in history. From the stock market watchdogs who permitted the premature listing of the company on the prestigious TSE 100 without due diligence to the shut-eyed independent directors, credit rating agencies and analysts who saw only the glitter of fools gold and eventually to the cops and regulators who were unsuccessful in bringing even a single fraudster to justice —and now have given up entirely— Bre-X was a colossal failure at every level. It might also serve as a cautionary lesson to today’s old line boardroom stalwarts who argue that too much emphasis has been placed in recent years on structure and that there is no connection between the architecture of corporate governance and corporate performance. I will have more to say about the confused logic and selective memory of those who would move the boardroom back to the future in another posting. But it would be hard to find a worse example of corporate governance than Bre-X — unless of course you were looking at Hollinger Inc. during Conrad Black’s era or Research In Motion more recently or the nearly 25 percent of companies listed on the TSX Venture Exchange that do not comply with even the minimum disclosure regarding their own boardroom practices which is required as a condition of listing by that exchange.
In the entire decade since the scandal unfolded, not a single agency, regulator or individual has admitted even the slightest responsibility, however indirect, for this calamity. No apology has ever been made to the investors who lost billions or to the larger investing public which has an irrefutable stake in the integrity of the capital markets and the institutions that guard them. No criminal has ever been convicted. You would almost think Bre-X were an inexplicable act of nature for which no mortal can be held accountable. At least not in Canada.
If the Bre-X fiasco occurred elsewhere, and certainly if it happened in the United States, outraged legislators and congressional committees would be in full flight holding hearings to find out why the company went so far beyond the arm of justice. They’d call aggrieved shareholders as witnesses and demand that stock market officials, regulators and justice department chiefs appear before them. They’d want to know if this case was symptomatic of any larger problem and whether such a travesty could happen again in the form of another memorable name. But in Canada, where it is hard to imagine a more dysfunctional system of securities regulation and boardroom crime policing, the biggest disaster in mining history ends with barely a whimper. And the politicians go back to sleep.
Exactly ten years ago, in an Op-Ed column in the Financial Post, I first brought to public light a number of the corporate governance failures that allowed Bre-X to happen. As we close the book on this sad saga, I thought it would be interesting to reprise the article that in many ways foreshadowed all the other failures that came to be associated with that scandal.
Bre-X Was A Failure of governance
J. Richard Finlay
Originally published in the Financial Post, August 1997
Continuing denials of culpability by former directors of Bre-X Minerals Inc. and securities regulators show once again that there is a predictable rhythm to corporate governance issues in the wake of disaster. In what has become the corporate version of line-dancing, academics and the media stamp their feet in demands for reform, regulators scurry for cover from the descending wrath of shareholders, and directors pirouette in elegant assertions that things will change. But when the revivalistic music stops, exhausted directors too often slump back into their boardroom seats, returning to their customary somnolent ways. The ritual is recurring in the Bre-X debacle.
Bre-X was a massive fraud to be sure. But it was also a massive failure of corporate governance. And the failure occurred on a number of fronts. With its insider board, dubious disclosure record, curious insider trading patterns, ever-expanding boasts about ore deposits and confusion about who owns them, Bre-X was a time bomb waiting to go off. But those who could have defused it heard only the siren song of fast money and not the tick, tick, tick, of impending ruin.
Of Bre-X’s board of six, only two members qualified as independent directors. The TSE’s guidelines for publicly traded companies call for a majority of outside, independent directors. This did not appear to bother many institutions or funds. When directors began to engage in heavy insider trading, regulators and advisors should have seen the signs and looked deeper into the details of the operation. Previous problems about licensing and ownership should have provided clues. Few followed that trail. When directors made ever-exaggerated claims about the size of the Busang find, regulators and investment advisors could have demanded more details. None did.
At its height, Bre-X had a market capitalization greater than Imperial Oil, Bombardier, Inco and Molson combined. And that was without any sales or profits. That alone should have prompted major financial institutions and pension funds, to say nothing of regulators, to take a closer look at the company. It never happened.
Another board that should also be doing some soul-searching is the TSE’s. The TSE’s guidelines on corporate governance raise an interesting question: Why does the TSE itself not comply with them?
Of the TSE’s board of 14, only four directors qualify as being independent. That’s far from a majority and far short of its own guidelines on corporate governance. Would a board composed of a majority of independent directors who are unaffiliated from member institutions have been more cautious about Bre-X? Would it have been more wary about putting Bre-X on the blue chip composite index when the company had no track record and when there were so many unanswered questions? Like many things about this scandal, we may never know. But we do know from the past, and from the TSE’s own study, that independent directors make for better boards. And better boards are motivated by the longer view, not necessarily the fastest buck.
Modern corporate governance practices, as every regulator and investment advisor has been taught, have grown out of disasters like Bre-X. The collapse of Great Britain’s Royal Mail Steam Packer Company in the 1930s (which, like Bre-X, also had a board of six directors) and Robert Maxwell’s empire, the S & L scandal in the United States and the demise of Confederation Life and dozens of other financial concerns in Canada all have involved failures of corporate governance. Had those lessons been applied in the Bre-X case, the fraud likely never would have achieved the level it did because institutional investors and regulators simply would not have endorsed a company that failed to practice even the most elementary standards of good corporate governance.
Directors, regulators and investment advisors are paid to read the signs of disaster as well as the portents of profit. The investing public is still waiting for an explanation as to why they failed in their duty over Bre-X.
Once again, the SEC has done the heavy lifting for Canadian investors by imposing, according to reports, a $100 million penalty on Nortel. Indeed, nothing could more graphically illustrate the contrast in approach toward the protection of the capital markets between the SEC and the OSC than this decision. For exactly the same kind of improprieties, the OSC thought just $1 million toward the costs of its investigation would be sufficient. Like us, the SEC was clearly not impressed with the OSC’s thinking and wanted to levy a penalty commensurate with the offense. We said at the time that the OSC hit Nortel with a wet noodle. The SEC’s action looks more like it threw the whole pot of pasta at them.
Nortel should move more aggressively to recoup these costs from the officers and directors on whose watch the wrongdoing occurred. But as long as the concept of limited liability exits, and companies have the right to sue and be sued as though they were legal persons, they will have to deal with fines and penalties. That’s why who is chosen to sit around the directors’ table and in the executive suite is important and needs to command more attention from shareholders than it often does —even when times seem so good, as they once did at Nortel.
Maybe Canadian investors should think about the added value they are getting with the SEC, which once again has acted true to its motto, “the investors’ advocate.” I’m open to suggestions as to what the OSC’s motto should be. They pay the OSC’s top level officials hundreds of thousands more than their SEC counterparts make. There are approximately 90 employees at the OSC who make as much or more than the head of the SEC. Yet time and again, it is the SEC who fills the void and makes the tough call when Canadian regulators fall short. Sort of makes you wonder what they have in mind for RIM next.
By the way, with this posting we have inaugurated a new category at Finlay ON Governance. Our Outrage of the Week has been published with regularity for a number of months each Friday and has become a popular feature. We think, however, that in the interests of encouraging a positive and balanced perspective, in those weeks where there has been a major breakthrough or step which we feel enhances the interests of transparency, accountability and sound governance, we will run that story. Outrage or Kudos? We don’t know which you will see more of on Fridays as time goes by, but it should be interesting.
We predicted last year there would be more surprises in connection with RIM’s backdating scandal. We have been following those developments regularly at Finlay ON Governance, with an admitted degree of skepticism. Most of the time it seemed we were the only ones to be doing so, as so many reporters, analysts and investors appeared to have fallen under the RIM spell that deprives certain people of the ability to think clearly.
Now, apparently some investors and analysts, like the legendary Captain Renault, are “shocked, shocked” to find that backdating has been going on here and that the U.S. attorney for the Southern District of New York and the SEC are taking it seriously. Both have opened formal investigations.
The history of this thing is tailor-made to raise the suspicions of investigators. We identified a number of them, starting with the feeble way the so-called internal probe began, RIM’s appalling state of corporate governance and antiquated board structure, the sudden bailing by some RIM directors after the investigation commenced —directors, as it turns out, who also received backdated stock options— and the flimsy, self-serving report that the company eventually produced which raised more questions than it answered. Remember how RIM’s estimated accounting restatement of between $25 million and $45 million suddenly shot up to more than $250 million? That’s some accounting.
Journalists and analysts in Canada, where RIM is headquartered, are sometimes surprised to find that the U.S. system of securities law enforcement and regulation doesn’t operate like the Ontario Securities Commission. In the U.S., they actually believe in enforcement. We have noted here before that the OSC is little more than a delayed echo of what the SEC does —and sometimes not even that— despite its top officials and staff being paid hundreds of thousands more than their counterparts at the SEC. The OSC has been meeting with, and regularly receiving updates from, RIM for nearly eight months. There is still no indication that they see anything amiss at the high tech icon. They have scheduled their next get together for June.
Here’s just one of the big problems facing RIM: The SEC gave Apple’s Steve Jobs a pass on his role in options backdating because he claimed he had no knowledge of the accounting implications of what he had done. Jim Balsillie, RIM’s co-CEO, has tried that line too. And the board committee investigating his actions —which, by the way, was also investigating its own members’ receipt of stock options and had nothing to say about how they were backdated— agreed with Balsillie. Except, as we have noted before —and Mr. Balsillie boasts about this on his company’s website— he is a chartered accountant holding the highest designation in that profession. RIM’s then CFO, Dennis Kavelman, also involved in backdating options, is an accounting professional, too. So it’s hard to see how the Jobs defense will work at RIM. They also tried the “we’re still young” defense, the “we grew too fast” defense and the “we only had metal desks when we started” defense, which we discussed here. Maybe the SEC and the U.S. attorney will be more impressed with those lines. Maybe Donald Trump will suddenly follow the teachings of Mother Teresa.
Shaken over the sudden loss of BlackBerry service last week, and now hit with formal investigations by tough regulators and prosecutors, RIM’s shareholders, customers and cheerleading chorus of journalists and stock analysts may now be poised to take a second look at what they seemed to think was a perfect company. We said there would be more surprises. Stay tuned.
