How effective is corporate governance in the EU? What are the lessons for the global community?

The European Commission has published a ‘Green Paper’ that assesses the effectiveness of European corporate governance frameworks and includes a number of suggestions for improvement.

The observations are interesting and have relevance beyond the EU. The paper is relatively short and includes an invitation for comment. Before reviewing the sections I found of particular interest, we should examine their definition:

Corporate governance is traditionally defined as the system by which companies are directed and controlled and as a set of relationships between a company’s management, its board, its shareholders and its other stakeholders. The corporate governance framework for listed companies in the European Union is a combination of legislation and ‘soft law’, including recommendations and corporate governance codes.

The source for this definition is the UK’s Report of the Committee on the Financial Aspects of Corporate Governance (The Cadbury Report). Note that rather than confine corporate governance to board activities, and like the South Africa King Code, it extends to both directing and controlling the company.

As the report comments at length, the ‘comply or explain’ approach underpins the EU corporate governance framework. The report discusses whether the approach is effective:

Surveys among companies and investors show that most of them consider ‘comply or explain’ approach as an appropriate tool in corporate governance. Under the ‘comply or explain’ approach, a company which chooses to depart from a corporate governance code recommendation must give detailed, specific and concrete reasons for the departure.

However, the general introduction of the ‘comply or explain’ approach in the EU has had its difficulties.

According to the study cited above, the overall quality of companies’ corporate governance statements when departing from a corporate governance code recommendation is unsatisfactory. Its explanations are used by investors to make their choices and assess the value of the company. The study showed, however, that in over 60% of cases where companies chose not to apply recommendations, they did not provide sufficient explanation. They either simply stated that they had departed from a recommendation without any further explanation, or provided only a general or limited explanation. In many Member States a slow but gradual improvement in this field can already be observed. Companies are learning, and better explanations are being provided thanks to the educational activities of public or private bodies (financial market authorities, stock exchanges, chambers of commerce, etc). However, further improvement could be achieved by introducing more detailed requirements for the information to be published by companies departing from the recommendations. The requirements should be clear and precise – many of the present difficulties are due to misunderstanding of the nature of the explanations required.

‘Comply or explain’ could work much better if monitoring bodies such as securities regulators, stock exchanges or other authorities were authorised to check whether the available information (in particular, the explanations) is sufficiently informative and comprehensive. The authorities should not, however, interfere with the content of the information disclosed or make business judgements on the solution chosen by the company. The authorities could make the monitoring results publicly available in order to highlight best practice and to push companies towards more complete transparency. Use of formal sanctions in the most serious cases of non-compliance could also be envisaged.

A recent study showed that the informative quality of explanations published by companies departing from the corporate governance code’s recommendation is – in the majority of the cases – not satisfactory and that in many Member States there is insufficient monitoring of the application of the codes.

Do boards have the skills and experience to perform?

Diversified expertise is considered the key to efficient board work. A variety of professional backgrounds is needed to ensure that the board as a whole understands, for example, the complexities of global markets, the company’s financial objectives and the impact of the business on different stakeholders including employees. Companies interviewed by the Commission acknowledged the importance of identifying complementary profiles in selecting board members. However, this is not yet general practice. For example, 48% of European boards have no director with a sales or marketing profile and 37% of audit committees do not include a chief financial officer (CFO) or former CFO.” [Note: while there are alternative sources for financial risk expertise – such as former chief internal auditors – it is understandable that preference be to those with CFO experience).

The report tackled the issue of gender diversity and whether it is desirable.

Gender diversity can contribute to tackling group-think. There is also evidence that women have different leadership styles, attend more board meetings and have a positive impact on the collective intelligence of a group. Studies suggest there is a positive correlation between the percentage of women in boards and corporate performance31, though for certain the overall impact of women on firm performance is more nuanced.

Another topic was whether non-executive directors have sufficient time to discharge their responsibilities. This is certainly an issue for members of the audit committee, especially where that committee – or the members of a risk committee – find themselves spending more time on risk management oversight.

Member States have sought to establish the principle that non-executive directors should dedicate sufficient time to their duties. Some Member States have gone further and recommend or limit the number of board mandates a director may hold. Limiting the number of mandates could be a simple solution to help ensure non-executive directors devote sufficient time to monitoring and supervising their particular companies. The limits would have to cater for the individual situation of non-executive directors and of the company in question. They should take into account whether the mandates are held in non-group or non-controlled undertakings, whether the person in question also holds executive positions, whether it is an ordinary non-executive mandate or a chairmanship, and whether additional positions are held in supervisory bodies of companies with requirements similar to those of listed companies.

The report also commented that the board’s self-assessment should include the “quality and timeliness of information received by the board. (I have added emphasis to the key sections).

…a mismatch between performance and executive directors’ remuneration has also come to light. Poor remuneration policies and/or incentive structures may lead to unjustified transfers of value from companies and their shareholders and other stakeholders to executives. Moreover, a focus on short-term performance criteria may have a negative influence on long-term sustainability of the company. The Commission has addressed problems related to directors’ remuneration in three Recommendations. The main recommendations are disclosure of remuneration policy and the individual remuneration of executive and non-executive directors, the shareholders´ vote on the remuneration statement, an independent functioning remuneration committee and appropriate incentives which foster performance and long-term value creation by listed companies. Commission reports show that a number of Member States have not adequately addressed these issues. On the other hand, there appears to be a growing tendency among Member States to legislate on disclosure and the shareholders´ vote. In 2009, the European Corporate Governance Forum recommended that disclosure of remuneration policy and individual remuneration be made mandatory for all listed companies. It also recommended a binding or advisory shareholder vote on remuneration policy and greater independence for non-executive directors involved in determining remuneration policy.

Discussion of risk management oversight is limited to comments on board approval of risk appetite and the following statement: “It is.. crucial that the board ensures a proper oversight of the risk management processes.”

On the other hand, there was concern about a lack of shareholder activitism.

The June 2010 Green Paper found that a lack of appropriate shareholder interest in holding financial institutions’ management accountable contributed to poor management accountability and may have facilitated excessive risk taking in financial institutions. It found that, in many cases, shareholders deemed the expected profits from taking these risks worthwhile and so implicitly supported excessive risk taking, especially though high leverage. The reason is that shareholders would fully benefit from the upside of such a strategy, while they participate in losses only until the value of shareholder equity reaches zero, after which further losses would be borne by the creditors (known as the “limited liability” of shareholders).

As I said, I found these comments interesting. Do you? What are the implications outside Europe?