Even with recent market volatility, share prices of cannabis companies are still well above where they were half a year ago. With new shareholders, increased scrutiny of investors, and a growing list of possible buyers, the decisions made by cannabis company directors in the next few months could decide their fate. Will their company go up in smoke?
With rising share prices and a rosy outlook, the temptation for directors to be complacent to outside threats — from hostile bidders or activist shareholders — is strong.
In meteoric fashion, some of the now-large cannabis companies have graduated from the TSXV to the TSX, and in some cases the S&P/TSX Composite Index. While this has created huge returns for seed investors, it has also dramatically changed shareholder bases: large cannabis companies have started to see a turnover from retail to institutional investors.
While institutional investors, and the capital they bring, has been welcomed by the sector, it’s also created a new a reality for cannabis boards. Unlike retail shareholders, institutional investors place more scrutiny on board governance. And, importantly, proxy advisory firms Institutional Shareholder Services and Glass Lewis — firms tasked with providing vote recommendations on proxy items — will now have a say in shaping their future.
This new reality can seem daunting for rapidly growing companies and the entrepreneurs who started them.
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The good news is that there are proactive steps companies can take to strengthen their governance and avoid having their hand forced by a negative shareholder vote.
Know your shareholders. Volatility and share turnover means companies will have a tough time keeping track of who their shareholders are. As we enter annual meeting season, boards have an excellent opportunity to identify and engage a new shareholder base. Not only is it important to use the solicitation process to reach out to shareholders, but also to understand the voting policies and practices of institutional investors.
Set up your defences. As consolidation activities continue, cannabis companies should be thinking about whether their defence mechanisms are up to date. Adopting a proxy-advisor-compliant advance notice by-law and a new-generation shareholder rights plan is a good start to preempt any unwarranted activist attack.
As seen in the Aurora/CanniMed takeover drama, more than one-third of CanniMed shareholders were subject to hard lockup agreements pursuant to Aurora’s hostile bid. This significantly jeopardized CanniMed’s acquisition of Newstrike Resources, as the bid was conditional upon the termination of the Newstrike acquisition by CanniMed. Had CanniMed had a shareholder rights plan in place, the hard lockup agreements would have been prevented.
Independent leadership on the board is Governance 101. The board structures of Canadian cannabis companies are lagging when it comes to independence: average board independence at the largest cannabis companies (market cap of more than $1 billion under the Canadian Marijuana Index) as of their 2017 AGM was only 66 per cent.
Improving the independence level of boards can simply be achieved by adding more independent directors. Good directors do not necessarily need to be in the sector, but should provide a diversified skill set on a range of topics such as capital markets, risk management and legal and corporate governance.
Strong link between pay for performance. Good corporate governance demands sophisticated and robust pay-for-performance compensation schemes tying senior executives to pay for performance over both the short and long terms.
Selecting a Performance Share Unit (PSU) peer group and setting up relative total-shareholder-return target thresholds are important first steps. What’s more challenging, however, is designing a systematic and objective scorecard approach for the Short-term Incentive Plan, and incorporating long-term financial or operational goals for the PSUs. Setting appropriate target criteria will require some deeper thinking due to the expected high volatility and significant exogenous factor influence in the sector.
Lack of gender diversity won’t be excused. Proxy advisors have introduced new gender diversity policies impacting TSX issuers, specifying formal written policies and female representation on the board. Cannabis companies may have a long way to go before achieving balanced boards: 40 per cent of the largest cannabis companies in Canada did not have a female director as of their 2017 AGM.
Like it or not, as Canadians acclimatize to the legalization of a previously controversial industry, those operating within the industry need to be beyond reproach. Going above and beyond in terms of corporate governance will be critical to bridge the credibility gap in a new industry and live up to what institutional investors have come to expect of high grade investments.
Victor Guo is executive vice-president, Governance Special Situations, at Kingsdale Advisors, and former vice-president of M&A and proxy contest research for the U.S. and Canada special situations research teams at Institutional Shareholder Services.