Corporate governance has been described as the “architecture of accountability”. This is a useful metaphor.
Bad corporate governance brings down companies, as the collapse of Enron in the US and Parmalat in Europe demonstrates. Good corporate governance, on the other hand, builds shareholder value. A survey by US consultants McKinsey & Co, for example, found that most investors would pay more for companies with high corporate governance standards.
The same is true for companies in Europe. Frits Bolkestein, the former EC internal markets commissioner, told a European Corporate Governance Conference in The Hague last October that corporate governance was important not merely because of the wave of scandals in the US and Europe but because businesses that have sound corporate governance practices perform better and are valued more highly.
He said: “Corporate governance has both a positive and negative charge. The negative charge is no more Enrons and WorldComs. The positive charge is that the companies that are well run in a corporate governance sense are good investments.”
Corporate governance is the framework within which companies are run. Stephanie Maier, senior research analyst at UK consultancy Ethical Investment Research Services (EIRIS), points out in an EIRIS research paper that this framework has two basic components – structural and behavioural: “Structural components include whether the roles of chairman and chief executive officer (CEO) are separated and how many independent directors are on the board.
“Behavioural components include the level of the directors’ attendance at board meetings, disclosure of directors’ remuneration and remuneration policy.”
Over the past 10 years, there has been a number of corporate governance initiatives aimed at improving the integrity of this framework.
At an international level, the 29 governments of the Organisation for Economic Co-operation and Development (OECD) endorsed the OECD Principles of Corporate Governance in 1999. These principles, revised in 2004, are a declaration of the minimum acceptable governance standards for companies and investors around the world and are regarded as the international benchmark of corporate governance.
They form the basis, for example, for the corporate governance guidelines of the investor-led International Corporate Governance Network (ICGN).
At a national level, most developed countries have now introduced corporate governance codes. Within Europe, the UK has set the pace.
The collapse of Polly peck International in 1990 led to the setting up of the Cadbury Committee, which issued the first set of corporate governance recommendations in the UK in 1992.
These recommendations together with those of the Greenbury Report in 1995 and the Hampel Report in 1997 have been incorporated in a Combined Code, which became part of the London Stock Exchange’s listing requirements in 1998.
The Combined Code was revised in 2003 to incorporate recommendations from other reports, notably the Higgs Report which considered the role of non-executive directors.
Between 1995 and 1998, most other European countries also issued their own corporate governance recommendations, based on industry-commissioned reports such as the Viénot Report in France, the Peters Report in the Netherlands and the Olivencia Report in Spain. These recommendations have now been incorporated in a wide range of national governance codes.
Outside Europe, the US introduced the Sarbanes-Oxley Act in 2002 perhaps the most sweeping reform to US corporate governance law since the adoption of the initial federal securities laws of the New Deal in 1933/34.
Although increasing globalisation will ensure that corporate governance codes to some extent converge, currently they vary widely from country to country. Eddy Wymeersch, a fellow of the European Corporate Governance Institute (ECGI) and chairman of Belgium’s Banking Finance and Insurance Commission, distinguishes three basic approaches to corporate governance codification.
The first is entirely voluntary, a form of self-regulation. This applies to most European jurisdictions. The second approach is also a voluntary approach but with legal backing. This describes the corporate governance codes in operation in Germany and the Netherlands, for example. Finally there are mandatory rules. The provisions of the Sarbanes-Oxley act clearly fall into this category.
These different approaches have caused problems, says Marco Becht, professor of finance and economics at the Université Libre de Bruxelles. In a background note on corporate governance for a Euro 50 Group meeting on corporate governance in Luxembourg in 2003, he predicted a clash of cultures between the US and Europe in the corporate governance area.
“The European approach to transatlantic corporate governance has been based on single market idea of mutual recognition. So far the US authorities have not recognised the relevant European standards as ‘equivalent’ and have started to impose their own new rules, in particular those enshrined in the Sarbanes-Oxley Act.”
This has now happened. Hundreds of non US companies whose shares or American Depository Receipts (ADRs) trade on the New York other US stock exchanges have been told they must comply with section 404 – the controversial section that compels public companies and their accountants to provide an annual, thorough evaluation that their controls over financial reporting are effective.
Earlier this year, successful lobbying by European companies persuaded the SEC to grant non-US businesses listed on US markets a year’s reprieve for compliance. However, a number of European companies have said they will withdraw their New York listings rather than comply.
The basis of most European corporate governance codes is the principle of ‘comply or explain’ the essence of the principle is that compliance with the codes is not mandatory but that disclosure relating to compliance is.
The attraction of the comply or explain approach is its flexibility. A ‘one size fits all’ approach to corporate governance codes does not work, its proponents say, chiefly because companies that are subject to the codes differ considerably in terms of size, structure and organisation.
The other attraction is that it allows the market, rather than regulators, to assess the adequacy of a company’s corporate governance practices.
The ‘comply or explain’ principle is based on the assumption that the market will monitor compliance with a code and will either punish non-compliance with lower share prices or accept that non-compliance is justified in the circumstances.
It is a principle that has won acceptance in most of the developed world. EIRIS estimates that 19 of the 24 developed economies it covers incorporate this principle in their codes.
This is the approach the European Commission has taken with its Action Plan ‘Modernising Company Law and Enhancing Corporate Governance in the EU’. The Action Plan is the EC’s response to the final report of presented in November 2002 of the high Level Group of Company Law Experts chaired by Jaap Winter.
The main objectives of the plan are to strengthen shareholders’ rights and launch a series of corporate governance initiatives aimed at boosting confidence on capital markets.
Yet a key feature of the Action Plan is not what the EC proposes, but what it does not propose. Crucially it does not propose to create another international corporate governance code.
The Commission rejected the idea of a European Corporate Governance Code, saying that it would not add value to existing codes and would merely place an additional layer between international principles and national codes.
In the place of a corporate governance code it has set up a European Corporate Governance Forum. Its purpose is to encourage convergence between national codes and to advise the Commission.
The forum, which meets two or three times a year, comprises 15 experts, including Alastair Ross Goobey, former chairman of ICGN, and Gerhard Cromme, president of the German Corporate Code Commission.
The Commission has also taken a ‘softly softly’ approach to legislation. Some legislation is necessary. The Commission proposes that all listed companies should be required to include in their annual documents a coherent and descriptive statement covering the key elements of their corporate governance structures and practices. This will require a directive.
Yet the two main planks of the first phase of the Action Plan – the role of non-executive directors and directors’ remuneration – will be introduced as recommendations rather than directives. This was at the instigation of the High Level group, who argued that it was necessary to act quickly to bolster investor confidence and that recommendations would take effect more quickly than directives or regulations.
The Commission says that non-executive and supervisory directors “have a duty to fill the gap between uninformed shareholders and fully informed executive managers, by making executives more accountable”. It recommends that member states pay special attention to the role, quality and integrity of non-executive directors.
The Commission also recommends that member states should ensure a high level of transparency for directors’ remuneration and encourage shareholders to make their voice heard on the remuneration policy of the company. Both recommendations were adopted in October last year
One area where the EC does intend to introduce a directive is shareholders’ right. The Commission want to help EU shareholders exercise their voting rights and to resolve problems of cross border voting.
Cross border voting is now a key issue. The proportion of non-resident shareholders in EU countries is significant. In large markets such as the UK, Spain, Italy France and Germany, non-resident shareholders hold more than 30% of the share capital of listed companies. In other countries such as Luxembourg, Latvia, Hungary, Belgium and the Netherlands, the percentage can be as high as 80%
The Commission says non-resident investors find it difficult to vote on shares held in other member states. This is partly because national laws governing shareholders meeting were drafted at a time when most shareholders were resident.
This is an area where the Commission says legislation is necessary. Charlie McCreevy, the European Commission for Internal Market and Services, speaking at the second European corporate governance conference in Luxembourg in June, said: “Shareholders must be given the means to hold management to account and to ensure that this principle is effectively enforced. They must be able to express their views at general meeting which, essentially means they must be able to vote.
“Shareholders must be able to exercise their rights easily and receive appropriate information no matter where in the EU they are based, if there are undue obstacle preventing this in the Single Market then we need to remove them.”
One way of achieving this is by setting minimum standards. The Commission intends to introduce a directive on cross-border voting by the end of next year. The proposal, unusually, has strong support from a broad cross section of industry representatives, institutional investors and financial services providers.
The danger of legislation, however, is that it attempts to impose a ‘one size fits all’ solution to corporate governance issues. And just as national corporate governance codes vary from country to country so corporate governance practice varies.
Economists distinguish two basic models of corporate governance – the blockholder and the widely held corporation. In the block holder model an individual, or a group of individuals, controls most of the votes at the corporation’s shareholder meetings.
In the widely held corporation model there are a large number of small shareholders holding, individually, a small number of votes. Most corporations in continental Europe are controlled by a block holder while widely held corporations predominate in the US and the UK.
Becht says there are drawbacks to both models. In the widely held model, shareholders do not have enough say in important decisions. One solution is to improve the effectiveness of shareholder voting mechanisms, for example by allowing corporate voting by mail or electronic voting. In the blockholder model, too much voting power is concentrated in too few hands. The solution here is to reduce the power that the blockholder has over the board. The OECD principles of corporate governance, for example, recommend the appointment of directors who are independent of block holders.
But how important are codes of corporate governance in shaping the behaviour of companies? Is it possible to have companies with good levels of corporate governance operating in countries with poor or non-existent principles of corporate governance?
Peter Cornelius, group chief economist at Shell International, compared the quality of governance at the company level with the quality of the of the legal and institutional frame work in which companies operate.
The aim was to identify over-achievers, companies whose corporate governance transcends local practice, and under-achievers, companies whose corporate governance was below the national par.
Generally, he found there was a relatively close correlation between the quality of corporate governance at the country level and the company level.
However, there were important exceptions. They identified several countries whose companies on average appear to follow better practices than the quality of their legal and regulatory environments would suggest.
In EU accession countries, in particular, corporate governance performance at the company level is lower than the legal framework would suggest. Erik Berglöf and Anete Pajuste of the Stockholm Institute of Transition Economics have looked at disclosure in a sample of 370 companies listed on stock exchanges in Central and Eastern Europe.
They found widespread non-disclosure of even the most basic elements of corporate governance arrangements, in spite of existing governance regulation.
This suggests that national and international corporate governance codes are useful only up to a point. Thereafter it is up to the company how well or badly they run themselves. This suggests that institutional shareholders rather than legislators must be the ultimate judges of whether companies’ ‘architecture of accountability’ is sound.