The Future of Corporate Governance in Europe Post-Enron
The panel discussion was chaired by Brian Groom, the Editor of the Continental European edition of the Financial Times, who opened the proceedings by introducing the four speakers.
Professor Bengt Holmström, Paul A Samuelson Professor of Economics, Department of Economics and Sloan School of Management MIT, pointed out that the US corporate sector has undergone a considerable amount of restructuring during the 1980s and 1990s, in the majority of cases quite successfully. This restructuring, however, took place largely on terms determined by the market, with shareholder value being the dominant driver first through takeovers and later through stock option plans.
“Historically, attention to shareholder value has been highly exceptional even in the US,” he said. “A logical explanation for this is that during this period, the market had a comparative advantage in restructuring corporations. Then, as now, markets were good at undertaking fundamental change, such as moving capital long distances.”
Professor Holmström opined that the current crisis came about as a result of a limited number of excesses or failures in corporate governance. These should not be taken as a sign of system meltdown. He felt that the public and political uproar was very much part of the overall corporate governance system; the system reacted swiftly and it would seem, effectively. Furthermore, it is worth pointing out that since the crisis started, both the US stock market and US economy have outperformed Europe and the Asia/Pacific region, hardly a sign of total collapse.
“Europe” he said “cannot directly emulate the US model, but is has every reason to try to understand what has been happening in the US and why.” Markets will have to play a larger role in Europe too. Given the ownership structure in Europe, promoting friendly deals may be more expedient than promoting hostile takeovers, though ownership should be made more contestable.
It is not clear how this can be achieved. It depends to a large extent on country-specific features.
This suggests that regulation at the EU level should focus on transparency rather than a forceful leveling of the playing field. Self-regulation at the national and institutional (exchange) levels would appear to be a more natural route.
In the 90’s, stock-related executive compensation, including stock options, was an important lubricant for corporate restructuring in the US. Arguably, in order to expedite restructuring, Europe now needs more, not less, stock options and contingent compensation. “After all,” he said “we now know how to design them better.”
Professor Holmström concluded that biggest challenge for Europe was not the break up of old structures but rather the build up of new ones. It will take a lot more than corporate governance reforms to complete this second phase of the restructuring process.
The next speaker, Professor Julian Franks, Corporation of London Professor of Finance, London Business School, began by examining the motives behind the European Commission’s proposals for a Takeover Directive. Starting from a viewpoint that European industry needs restructuring, he felt that the Commission believed takeovers could play an important part in that restructuring. With the existing European shareholder structures, takeover markets are restricted – thus the challenge became how to make it easier for takeovers, be they friendly or hostile. (see a copy of his slide presentation, based on his presentation on a paper by Berglof and Burkhart at a Panel Meeting of Economic Policy at Copenhagen)
He made the distinction between an investor protection regime designed to prevent theft and one that disrupts private contract. Citing the example of UK regulations, he felt for instance that the mandatory bid rule and the breakthrough rule disrupt private contracts. The approach to takeover regulation has been very different in the US and the UK. The former has relied more on freedom of contracting subject to fair price rules. The latter has been predicated on detailed prescriptions, restricting particular takeovers and limiting size of share stakes through Company Law, The Takeover Panel and Stock Exchange Listing Rules. The EU could have chosen a US form of regulation but instead took the UK route.
Professor Franks said that although the rate of hostile takeovers had declined, they were still significant especially when the threat of takeover is taken into account. However, even in countries with stronger institutions, dispersed ownership and hostile takeovers are still relatively rare. In the US, in the 1980s, between 20-40% of tender offers were contested. In the 1990s, this figure had fallen to 15% or fewer. These figures, however, exclude hostility in block sales. However takeovers have an important part to play since the very threat of takeover can be a potent force for management efficiency and change.
“Do we need to dismantle ownership structures to reduce private benefits?” he questioned. The evidence seems to suggest that private benefits are large in countries with concentrated ownership and less developed capital markets.
With the premium for block transactions in Germany being 10%, Italy 37%, Canada 1.3% and the UK 1.6%, what explains this large variability and which is the odd one out since three countries have concentration of share ownership and mechanisms for separating cash flow from control rights? The odd one out is Canada because it has high levels of concentrated ownership and pyramids and yet low private benefits. Why? Because it has investor protection. Thus, dismantling concentrated ownership structures is not necessarily essential to investor protection. According to Dyck and Zingales, ‘a crude attempt to disentangle them points to diffusion of the press and a high rate of tax compliance as being the important factors.’
Professor Guido Ferrarini, Professor of Law at the University of Genova, suggested that many in the audience and elsewhere in Europe might find his views on the Sarbanes-Oxley Act (SOA) somewhat surprising and not a little controversial. He suggested three reasons why the SOA could become a benchmark in corporate governance: it 'federalizes' US (and international) corporate governance standards; it is likely to influence the reshaping of European and national corporate laws and practices, and it is applicable to many European companies having their shares listed in the US. To expand on this thesis, he went on to compare some provisions of the SOA with the conclusions of the Winter Group of High-Level Company Law Experts. (see a copy of his presentation).
Under the SOA, all audit committee members must be independent whereas the Winter Report says that a majority of audit committee members should independent. Because independence from both the controlling shareholders and the managers is important, and since the controlling shareholders do not lose out in terms of monitoring, he felt the SOA’s provision was preferable in concentrated ownership systems.
In terms of the expertise of audit committee members, the SOA says that at least one member must be a financial expert which is defined as someone ‘having experience as a public accountant or auditor or a principal financial officer, comptroller, or principal accounting officer of an issuer.’ The Winter Report’s recommendation, which says all board members should possess basic financial understanding, would implicitly reject the American requirement. He felt that the SOA’s requirement was acceptable and justified by the audit committee’s responsibilities as to financial reporting but that there was a possible mitigation of this requirement’s rigidity.
According to the SOA, the audit committee is directly responsible for the appointment, compensation, and oversight of the outside auditors. Under the Winter Report proposals, the audit committee selects the external auditor for appointment at the shareholders meeting or by the full board. Professor Ferrarini contended that the SOA’s approach had substantial value, particularly with respect to companies with concentrated ownership (as is the case of many European companies).
Looking at financial reporting requirements, the SOA states that CEOs and CFOs must certify in each annual or quarterly report that the report does not contain any untrue statement of a material fact or omit to state a material fact. The Winter Report recommends that EU law confirms the collective responsibility of the board. He felt that contrasting collective responsibility to individual responsibility may be misleading for two reasons. First, collective responsibility for the accounts does not mean that all directors are equally liable. Second, the SOA makes the executives and officers well aware of their individual responsibilities for financial reporting, without excluding collective responsibility of the board.
The Sarbanes-Oxley Act requires CEOs and CFOs to certify internal controls. The Winter Report on the other hand merely lays down that the audit committee’s competencies should include monitoring the company’s internal controls. Professor Ferrarini quoted the Turnbull Report (1999) which said that the primary responsibility of the internal control system is of the board, while the executive managers should implement the board’s policy as to internal controls
“There was,” said Professor Ferrarini “substantial convergence in the area of internal controls, even though the SOA emphasizes the responsibility of managers whilst European best practices emphasize the board’s responsibility in this area.”
On auditor independence, the SOA stipulates approval by the audit committee of all audit and non-audit services as well as prohibiting a variety of non-audit services. The European Commission Recommendation of 16 May 2002 takes a principles-based approach with 'safeguards' to mitigate or eliminate threats to statutory auditors’ independence. Non-audit services are allowed if general and specific safeguards are complied with. Professor Ferrarini felt that the prohibition foreseen by the SOA is, to a large extent, justified by the conflicts of interest inherent to the provision of non-audit services to an issuer. This is confirmed by the Commission analysis of non-audit services. Furthermore, a prohibition of non-audit services is foreseen by national best practices, for example in the Bouton Report from France.
In conclusion, Professor Ferrarini said that the SOA might become a benchmark for corporate governance also in Europe, particularly in the areas of independence of audit committee members, the financial expert in the audit committee, the appointment, compensation, and oversight of the outside auditors by the audit committee, the emphasis on executives and officers’ responsibilities for financial reporting, the emphasis on executives and officers’ responsibilities for internal controls and the prohibition of a variety of non-audit services.
The final speaker, Count Maurice Lippens, Chairman of the Board of Directors of Fortis, spoke very much from the point of view of a practitioner. “Corporate Governance is an ongoing process within Fortis,” he said, illustrating this point by describing the recent history of the Group.
Fortis was founded and created in 1990 by two insurance companies, Amev in the Netherlands and AG in Belgium. The combined balance sheet was in the region of €28 billion. From the start, the Group adopted an innovative approach to corporate structure, adhering to and leveraging both the Dutch and the Belgian corporate governance models.
During the decade of the 1990’s, Fortis changed through acquisitions, merger and integration from an insurance group into a more broadly based financial services group with a balance sheet of around €500 billion. This significant development was characterised by an ability to anticipate, innovate and change. Every two or three years, the Group made structural adjustments to Fortis Corporate Governance model and business organisation. “This may surprise some people considering that some of companies constituting Fortis today were founded 100 or 200 years ago.” Count Lippens said. “It meant that within Fortis, the values, codes of conduct, policies, processes and behaviours are the outcome of a culture of personal and social responsibility and accountability, a culture deeply embedded at all levels.”
Drawing some conclusions from Fortis’ experience, Count Lippens concurred with Derek Higgs, non-executive director of Allied Irish Banks when he said that in corporate governance, “there are no absolutes, there are no black and whites”. The key lessons from Enron and other similar examples is that governance structures count for little if the culture within an organisation is not right. It is culture that determines behaviours and the ability to design and manage business direction and control.
Looking ahead, he said that Fortis would continue to make adjustments in its governance structures especially as the financial services sector within which it operated was becoming more complex and more demanding. Taking up this theme of complexity and the challenges it posed, Count Lippens opined that whilst governance continued to be a challenging issue for any business and organisation to address, governance in financial services was far more complex since it possessed additional implications for the whole economy at the macro and micro level.
Modern financial services processes are complex and often difficult to understand, to assess and to control. They are governed by extensive and diverse laws and regulations combined with high supervision. Thus in the financial services sector, governance issues go far deeper than board level and involve management of the exposure to all types of risk. Financial services sector organisations play a central role in the economy and they are probably in the most high risk sector for damage to corporate reputation and its feedback into all stakeholder disapproval.
“The high complexity and huge implications of financial services governance lead to profound changes in the way the sector will have to be organised, managed, controlled and supervised” he said. “This means a fundamental shift from 'Corporate Governance' to 'Risk Management Governance' in terms of, for instance, structure, organisation, role of Board and Management, interactions between them, skills and competence required, processes and risk modeling.”
Concluding his remarks, Count Lippens said that the main lesson from the Enron type of debacle is that corporate governance should no longer be either a concern or an issue in terms of what to do. Risks associated with the conduct and control of any organisation is today by far more complex than in the past. However, and this is probably the fundamental challenge, another lesson is that there is a huge gap between this new complexity and the ability of human beings and organisation to manage it.
In this context, he added “organisations such as the ECGI can play an important role in Europe.”