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Tuesday, February 13, 2007

Cash Distributions Force a High Level of Corporate Governance

Today the Parliamentary hearings resume on the taxation of Canadian Income Trusts and other flow through entities. One area where we believe that trusts probably have excelled (and nobody seems to talk about), relative to most of their corporate cousins, is in the area of “governing” over cash distributions and the impact this has on the behaviour of management.

Governing over cash distributions is far more difficult than just approving a cash distribution. It requires the Board and Management to consider the financial impact to the organization, both short term and long term, of making that cash distribution. Cash distributions require Board approval, which means, for most trusts; they must meet at least monthly.

We believe that by paying distributions on such a frequent (monthly) basis, Managers and Directors must maintain a very good understanding of the underlying business and its current and potential future financial condition.

We believe that when both management and the directors focus their attention on the cash flow being generated by the business, and then consider on a regular basis the financial impact of making a cash distribution to its equity investors, a high level of financial corporate governance is forced on the organization. Imagine you are sitting on a board of trustees being asked to approve a monthly cash distribution to unitholders. What steps would you take in order to gain sufficient comfort that indeed the trust could afford to make the distribution this month? Now think ahead to next month, and the following months? And what about an increase to the current level of cash distributions? Do not forget the potential personal liability attached to the role of a Director. One thing is likely for sure; you would soon be very focused on many of the aspects of the business. It is a big responsibility.

Now imagine that the trust of whose board you are a member, is considering an acquisition. And to complete this acquisition, the trust will require debt and equity funding. And, after the acquisition and financing is completed, cash distributions are expected, on schedule, from an even larger constituent of investors. Trusts leave little room for error or omissions, because the expectation of cash distributions to equity investors is constant. And you can be sure the lenders have done their homework.

When it comes to monitoring the lifeblood of a business, its cash flows, and everything that can impact that cash flow, trustees are forced to have their fingers on the pulse of that business, each and every month. And that, we believe, is a high standard on the corporate governance scale.

In conclusion, we feel that the cash distributions impose better corporate goverenance on companies. Most earnings that are retained on the balance sheet seem to disappear in transactions that are not accretive to the shareholder. In the the long run the capital efficiency of our companies would improve under a regime of "forced" distributions to shareholders.

There is no better example than BCE (Bell Canada) who have a track record of squandering shareholders capital.

It is my belief that todays crisis over Corporate governance has its root cause with taxation. Our tax systems encourage company's to retain earnings rather then distribute them to shareholders. This is why today's corporations have such low yields.

Furthermore, retained earnings bloat the balance sheets and theoretically drive share prices higher which in turn make corporate stock options more valuable. This is better for option holders than for shareholders.

I wonder if this is why BCE phoned the finance minister back in 2006 begging to "level the playing field".

I hope somebody addresses this issue at the parliamentary hearing today.

P.S. Excerpts of this BLOG were derived from an RBC Capital Markets report published April 19, 2005.

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