Search The BoardAgenda

Saturday 9 April 2011

EU lays out a way forward for boards, shareholders, compliance

The European Union appears to be on the verge of taking collective action on corporate governance. The European Commission has issued a green paper – an early stage of policy-making – examining the role of boards and shareholders in the affairs of corporations, as well as the principle known as "comply or explain", which makes existing provisions in most countries voluntary.
  • Boards: How do boards deal with the phenomenon of groupthink? What difference can policy make? The green paper's tentative answer lies in improving how boards work and ensuring they are composed of a mixed group of people. That means gender diversity, a variety of professional backgrounds and skills, and different nationalities. The inquiry will also look into guidelines about the availability and time commitment of directors, as well as risk management and director pay.
  • Shareholders: The paper identifies several underlying reasons for what the commission calls "the lack of appropriate shareholder engagement", including short-termism in financial markets, principal-agent problems between investors and their asset managers, conflicts of interests and difficulties with shareholder cooperation. The green paper seeks views on encouraging them to take an interest in sustainable returns and longer term performance. It also wants ideas about the role of proxy voting agencies, protecting rights of minority shareholders, shareholder identification, and employee share ownership.
  • Compliance and explanation: The commission seeks ways to improve monitoring and enforcement of existing national corporate governance codes, focusing in particular on quality of information provided by companies and the oversight by monitoring bodies.

In previous attempts – particularly after the lapses at Enron in the US, Parmalat in Italy and Ahold in the Netherlands – the European Commission has backed off, leaving the matter in the hand of member states, apart from a requirement for companies to make some sort of statement on their governance arrangements. But this time there seems to be a greater sense of urgency. After the financial 2007-09 financial crisis it seems less likely to yield to national sensibilities. You can tell that from the introductory paragraph:

The Commission recently reiterated its commitment to a strong and successful single market which refocuses on citizens and regains their trust. As its Communication Towards a Single Market Act stated, "It is of paramount importance that European businesses demonstrate the utmost responsibility not only towards their employees and shareholders but also towards society at large". Corporate governance and corporate social responsibility are key elements in building people's trust in the single market.

The way that the financial crisis spread across boundaries, together with a more centralising and interventionist commissioner – the former French agriculture minister Michel Barnier – now in charge of the directorate on the internal market, suggests stronger intent for collective, EU-wide action this time, not just a collection of separate national moves. But the paper notes that remedies for the financial sector might not be appropriate across all of industry.

This paper is not just an EU matter. The subtitle of the paper – "Text with EEA relevance" – suggests that any change in regulation would probably apply across the European Economic Area. This is, however, just a green paper, not a white one, which would signal legislative intent.

Source documents: The EU green paper "The EU corporate governance framework" is a 26-page pdf file. The consultation page gives links to other information, including how to reply. Comments, please, by July 22.

Comply-or-explain depends on explanations

The principle in corporate governance known as "comply or explain" makes the codes that use it voluntary. The term came into the corporate governance lexicon through the Cadbury Code in the UK. Published in 1992, it didn't actually use the term directly, though once in circulation, it stuck. The principle was an explicit acknowledgement on the part of the Cadbury committee of the difficulty of prescribing any formula for the complex set of issues and relationships on boards. Under this notion, companies need to take heed of code provisions, but they needn't follow them. They should, however, be transparent about how their practices differ from the code. The value of the exercise falls, then, on the quality of explanations of non-compliance.

Growing disquiet? There are signs, however, that while this principle still holds the attention of policy-makers in the European Union, the practice of it seems to be trying their patience. The European Commission's green paper, seeking views about possible future central legislative or regulatory action, signals an interest in making the quality of explanations rather less arbitrary. It makes reference to a study that


showed that the informative quality of explanations published by companies departing from the 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. It is therefore appropriate to consider how to improve this situation.

That study, conducted in 2009 by the proxy voting service run by RiskMetrics with help from a variety of other organisations, looked at governance reports from companies around the European Union, examining a total of 1,141 cases of explanations that companies made about how they had deviated from whichever code they used as a benchmark. Only 39 per cent of the explanations were "sufficiently 'informative'", in the eyes of the researchers. Companies in France, Sweden, the Netherlands and the UK gave the best accounts of deviations from norms. Those in Denmark, Hungary, Portugal and Spain did the worst. By category of disclosure, statements on remuneration were the least informative. Only 27 per cent of such explanation met the standard of giving "specific" information or stating that the company was in "transition" to code compliance.

Compliance or defiance? Academic studies have also found fault with the quality of disclosures in corporate governance reports. But directors often grumble about all the bureaucracy associated with complying – even with complying through explaining the reasons. Let's take a hypothetical example. A longstanding director, a sophisticated, sharp accountant, sits on the audit committee. He's been around so long that he's seen three CEOs come and go, and he's able to smell the faintest whiff of fish in the accounts. But he's been around so long that the code says he's no longer "independent" and so no longer an appropriate person for the audit committee. What can you say, in a public document, about the "specific" value that director brings? Moreover, there's a real shortage of people with these skills and experience, so finding a replacement would be difficult. It might take two or three years for a good replacement to learn enough about the management accounts to know why the financial accounts didn't stink. An explanation saying – as many such do – that "the board is confident of Mr. Smith's independence of judgement" isn't specific, but what else can you say? Non-compliance isn't always defiance.

Policy direction? What happens next in the European consultation is far from clear. There's a centralising strain in EU policy-making, more pronounced in the past year or so, since Michel Barnier, the former French agriculture minister, took over the European Commission's directorate for the internal market. The UK authorities will no doubt resist any attempt to pull control to Brussels or to impose mandatory measures to replace "comply-or-explain". The green paper's questions on this issues point towards a possible direction of travel:

  • Detailed explanations: Do you agree that companies departing from the recommendations of corporate governance codes should be required to provide detailed explanations for such departures and describe the alternative solutions adopted?
  • Enhance powers of enforcement: Do you agree that monitoring bodies should be authorised to check the informative quality of the explanations in the corporate governance statements and require companies to complete the explanations where necessary? If yes, what exactly should be their role?

Neither points towards a less voluntary regime, though both suggest a more interventionist approach.

Source document: The 2009 study "Monitoring and Enforcement Practices in Corporate Governance in the Member States" is a 199-page pdf file.

Governing universities – a role for alumni?

As a field of academic study and public policy, corporate governance has focused its attention largely on the affairs of larger companies, those listed on stock exchange, and their relationships with investors. The world of organisations is larger than that, and yet corporate governance has set the language of the debate about how other organisations are governed. Whether the lessons from the corporate arena extend to charities, public sector bodies or private companies is a matter of considerable debate, not least because the purposes of such organisations diverge from the norm of profit-maximisation, if not perhaps from the goal of value creation. So how might the governance of different entities – say, universities – differ from what happens in corporations?

Role of boards: In the corporate setting, boards hold legal, fiduciary responsibility for the corporation, and so for the twin goals of controlling the activities of managers and striving to ensure that the company creates value. The first of these – reflected against a history of dramatic corporate failures – has brought about codes and rules to bolster the ability of boards to challenge management. The standard recipes involve greater independence in structure and composition, involving strong committees, and greater accountability to shareholders. This approach hasn't necessarily solved the problems, as what in 2003 Paul MacAvoy and Ira Millstein called the "recurrent crisis" of corporate governance just had another recurrence – concentrated in the financial sector. Nor it is clear that mechanisms to focus attention to shareholder interests have parallels in other parts of the economy.

The case of universities: Places of higher education mainly take the public form of charities, with internal governance more akin to partnerships. Notions of academic freedom – and in some countries, academic tenure – are designed to protect the independence of the scholar. Students are really customers. The beneficiary of whatever "charitable work" they do is, vaguely, knowledge. Often heavily dependent on government funding, universities increasingly face demands for accountability to a public that gets little direct benefit from the expenditure. Indirect benefits accrue to society at large, though we're rarely sure where or how. In a time of economic strain, the strain on university governance increases. How might universities organise their boards, committees and controls to monitor the quality and performance of academics and to help them create value? In short, how should we govern the university?

Malcolm Gilles is vice-chancellor – CEO, in effect – of London Metropolitan University, an institution that has seen more than its fair share of fiscal stress and governance strain over the past half-dozen years. He joined it a little over a year ago, a year or so after having left neighbouring City University after what was said to be differences with the board over governance issues. Now, with all universities in England facing radical cutbacks in government funding, he has collected his reflections in a report for the Higher Education Policy Institute, and issued a call for a radical rethinking of university governance.

The governance issues: By 2015, he writes, the sector will be in a state of state denial: Students will be the undisputed majority funders of most English universities. Government will take on the (considerable) risk on student loans. But the risk to universities themselves will rise, and that comes after poor financial control at several universities, where their boards of governors seem to have failed. Meanwhile, universities are "increasingly mixed businesses", working in a variety of educational and research fields, and needing entrepreneurial activity to capture market niches, to respond rapidly to changing international trends, and even to close down selective operations. This is not the right place for what he calls the "slower forms of civic-minded external and collegial internal governance".

Governance through alumni: His remedy isn't a simple one – complex problems rarely have simple solutions – but it involves a crucial shift in thinking. Instead of assembling group of civic-minded individuals, universities need to find entrepreneurial sorts of people to keep the academic leadership on its toes. In current arrangements, governors can be too disengaged, and then, in times of stress, too concerned about their own reputations to solve the problems of the universities. Universities need risk-takers with a serious stake in maintaining the reputation of the institution. The former provides a focus on strategy and direction, the latter a readiness to challenge, monitor and control. Who better than the alumni?

Source document: The HEPI report "University Governance: Questions for a New Era," by Malcolm Gillies, is a 16-page pdf file.