Principals, agents, and the system that keeps them honest

Lakehead Marine’s annual meeting

Lakehead Marine Corp. builds aluminum work-boats in Thunder Bay and has been listed on the TSX for six years. On the second Tuesday of May its shareholders meet. Most of the 4,000 shareholders are not there; they have voted by proxy from wherever they live, one vote per share. In forty minutes they elect the seven directors by ordinary resolution, appoint the external auditor, and receive the audited statements. Then they go home, and for the next twelve months they own a company they will not see.

That gap — owners who are not managers, managers who are not owners — is the agency problem. The shareholders are the principals: they put up the money and bear the risk. The managers are their agents: they run the business day to day and know far more about it than the owners do. An agent’s interests are not automatically the principal’s. A CEO paid a bonus on this year’s profit has a reason to cut research that pays off in five years; a CFO with an aggressive target has a reason to choose the friendliest estimate. Module 1 called this moral hazard — hidden action — and it is the problem governance exists to solve.

What corporate governance is

Corporate governance is the system of structures, controls and accountability by which a company is directed and its managers are held answerable to its owners. It is not the audit, although the audit is one of its tools; it is not the board alone, although the board is its centre. It is the whole arrangement: who elects whom, who approves what, who reports to whom, and who can remove whom.

The structure: elect, appoint, report

Under the Canada Business Corporations Act the arrangement has three tiers:

1. Shareholders elect the directors by ordinary resolution at each annual meeting (s. 106(3)). For a distributing corporation — one whose shares are held by the public — each director’s term ends at the next annual meeting (s. 106(3.1)), so public-company directors face the shareholders every year. Shareholders also appoint the auditor (s. 162).
2. Directors manage, or supervise the management of, the business (s. 102(1)). In a public company they do the second: they appoint the officers — the CEO, and through the CEO the rest of senior management — set their pay, evaluate them and, when necessary, replace them. A distributing corporation must have at least three directors, at least two of whom are not officers or employees of it (s. 102(2)).
3. Management runs the company and reports back up the chain: to the board through management reports and, at year-end, to the shareholders through audited financial statements the board has approved.

Directors are not employees. They are elected representatives of the owners, paid a fee for their oversight; an executive who also sits on the board wears two hats and is called an inside director (lesson 5.3). The CEO reports to the board, and the board reports to the shareholders — never the other way around.

Five events, sorted

At Lakehead this year: shareholders elected a new director (tier 1); the board appointed a new CFO (tier 2); the CEO signed a supply contract with an aluminum mill (tier 3, management); the board approved the audited statements (tier 2); the CEO presented the quarterly results to the board (tier 3 reporting to tier 2). Being able to place any event on this triangle is the skill the rest of the module builds on.