Author: | Published: 9 Oct 2003
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Over the last few years, corporations around the world have been faced with nothing short of a corporate governance revolution. First, there was the US response to the bubble era scandals: The Sarbanes-Oxley Act (SOX) and its implementing regulation by the Securities and Exchange Commission (SEC); the tough, new (still draft) listing requirements of the New York Stock Exchange (NYSE) and the NASDAQ. These mark the onset of the new regulatory approach. But over and above the regulatory overhaul, governance has now moved to the mainstream of public concerns. Shareholders are not the only ones who care. Current and former employees, suppliers, consumers and the public at large all think of good governance as a basic characteristic of a good company.

In roughly the same period, European regulators started revamping their own framework. Marconi, France Telecom, Vivendi, ABB and Ahold were strong reminders that large corporate governance failures could also happen on the other side of the Atlantic. New laws appeared in France (in 2001 and 2003), in Greece (2002) and in Italy (2003). In May 2003, the EU Commission (the Commission) issued a comprehensive Corporate Governance Action Plan (ECAP), which enunciates a far-reaching programme for regulatory action and sets the tone of reform for the years to come (up to 2010). If one could sum up in one word the emerging European regulatory approach, that word would be choice. In contrast to a surge of prescriptive regulation in the US, Europe's policy makers are moving the other way, in an interesting departure from the typical civil law approach of detailed, ex ante legislative prescription. They are increasing possibilities for companies to chose their governance regimes and shape their own benchmarks.

The willingness of public policy to defer to best market practice, facilitate voluntary arrangements and promote market-based benchmarking is a unique opportunity for companies. They may preserve their cultural idiosyncrasies, the unique ways they control and manage resources, which often lie at the heart of their competitive advantage, but it enables them to define and benchmark these idiosyncracies in relation to global standards. This brief paper will show that if European companies are to seize the opportunity they need to develop an important new skill: the capacity to explain their governance to the markets, over and above piecemeal regulatory disclosures.


Overall, the European reaction to the governance crisis was tempered. The Commission sums the mood up well in the introduction to its May 2003 ECAP:

"The EU must define its own European corporate governance approach, tailored to its own cultural and business traditions ... In many areas, the EU shares the same broad objectives and principles of the Sarbanes-Oxley Act and in some areas robust, equivalent regulatory approaches already exist in the EU. In some other areas, new initiatives are necessary."

There are 3 elements in this statement that sketch out the European approach:

Europe has its own cultural and business tradition. This, more than anything, means that continential Europe's corporate control patterns are often very different from those prevailing in the US - but also in the UK. Continental European companies have owners large enough to be active. More often than not, they in fact are active, with the possible exception of governments, who still control a significant share of corporate assets. Hence, the classic agency problem of dominant managers versus weak owners is not necessarily the central issue, as is the case in the US and UK. The key regulatory concern in Europe is how to prevent large, core owners from expropriating minorities. For example, expropriation may occur through asymmetries between cash flow and control rights, such as the multiple voting structures permitting the Wallenberg family to control a vast percentage of the Swedish market capitalization with a relatively small risk exposure. Or from pyramid structures in listed companies that allow for the expropriation of considerable value from minority shareholders, as in Telecom Italia, which assumed the mountain of debt of Olivetti, its 51% majority owner, itself ultimately controlled by Pirelli. Business traditions and legal cultures are widely divergent within Europe itself. EU legislative efforts for a pan-European takeover regulation have come to naught after 14 years of negotiation. The issues of pyramidal ownership and one-share/one-vote are addressed in the ECAP, but only at its tail end, that is, after 2008. Because top-down harmonization through regulation seems fraught with difficulties, market practice will be the prime instigator of change.

In many areas addressed by the Sarbanes-Oxley Act, Europe and/or many of its member states have developed robust, equivalent regulatory approaches: CEO and board liability for the annual accounts, shareholder control over the appointment of auditors (and other measures to ensure auditor independence such as auditor rotation and the appointment of two external auditors), an accounting system based on principle rather than detailed rules, accounting for off-balance sheet transactions, prohibition of loans to corporate officers, independent systems of audit supervision roughly equivalent to audit committees - this is an off-the-cuff list of issues where European regulations match or even exceed SOX standards. I have extensively argued elsewhere that SOX can in fact be seen as a convergence step, bringing the US closer to the more prescriptive corporate regulation of the continent. Notwithstanding the wails of market Cassandras, the problem in Europe is not too little regulation but too little entrepreneurship, choice of financial contracting and focus on shareholder value. This is partly evidenced by the non-trivial valuation premiums that US equities command over their European counterparts, even after the devastating loss of confidence in the US.

As regards European public policy, the Commission believes that:

"... a common approach should be adopted at EU level with respect to a few essential rules and adequate coordination of corporate governance codes should be ensured".

The thrust, then, of ECAP is the development and co-ordination of national voluntary codes, implemented on a comply-or-explain basis.

The Commission took the advice of its high-level group of experts, which produced the Winter Group Report in November 2003 and has, by and large, steered away from regulatory heavy-handedness. It seems that the comply-or-explain approach is also gaining favour with many national regulators in the continent, in spite of their instincts for mandatory rules.


Voluntary comply-or-explain codes

ECAP places national voluntary codes at the heart of European corporate governance. The obligation of listed companies to comply with certain codified standards that represent best practice or explain why they do not comply was pioneered in London in the early and mid-1990s. It was consolidated with the adoption of the Combined Code on Corporate Governance (the Combined Code) in 1998 that has since been appended to the listing requirements of the London Stock Exchange.

By putting the accent on country codes, the Commission is simply reflecting the ongoing spread of voluntary corporate governance codes among member countries. There are more than 40 codes in the EU, with only one member not having at least one code. But having a code is not enough. ECAP effectively mandates the adoption of a comply-or-explain framework. This is an intermediate normative category that postulates a benchmarking process of individual governance arrangements against a clearly codified body of principles and best practice. One might call it soft law: soft in the sense that you are allowed to deviate from the substantive norm; but law as it requires implementing action in relation to a norm (comply-or-explain), in the absence of which certain sanctions of a regulatory nature might apply. However, notwithstanding its legal consequences, the main objective of comply-or-explain codes remains the empowering of the market to impose its own reputational sanctions on corporate issuers that fail to comply with best practice or to adequately explain their governance.

According to its action plan, the Commission will create a European Corporate Governance Forum, a peer review mechanism among member countries to boost the effectiveness of national voluntary arrangements - a quite novel institutional set-up in the already very complicated institutional landscape for European capital markets. This peer review process is expected to boost convergence between substantive norms (principles and best practice) across Europe.

The Commission is also planning to issue recommendations suggesting minimum common content of national codes, such as board committees (audit, nomination and remuneration), some remuneration policy standards and independence standards for the board - including an ill-advised recommendation that executive directors should be nominating the non-executives members of the board. There will also be some mandatory requirements for European companies, in the form of directives, including the obligation to report extensively on their corporate governance on an annual basis.

At present, the large majority of the national codes are just best practice guidelines. They do not meet the clarity and conciseness requirements for comply-or-explain implementation, neither are they backed by credible sanctions. But all this is changing. In Germany, the Cromme Code, drafted by a group including issuers and the buy-side, is being implemented through the adoption of a special 2003 Transparency and Disclosure law that requires listed companies to comply-or-explain against the code in an annual corporate governance statement. A similar process has been adopted in Italy, following the adoption of the Preda II Code for listed companies. Stock exchange authorities oversee the process. Acknowledging that the 1998 Peters Code (which only recommended a comply or explain regime) was implemented by less than half of Dutch listed companies, the drafters of the new (draft) Dutch Corporate Governance Code of July 2003 are proposing an amendment to the Civil Code that would provide the comply-or-explain principle with a statutory basis, similar to the one adopted in Germany. The UK itself is seeing some major changes in the way the comply-or-explain principle will be implemented in the future, as the much-discussed 2003 Higgs Report is being woven into the Combined Code. Until now, the comply-or-explain process has been a fairly loose and vague affair. There was no real supervision of proper implementation by listed companies and no particular challenge as to the claims of compliance or the weakness of the explanations by issuers. The proposed new Combined Code aims to make implementation more forceful and transparent, by distinguishing between principles and core Code provisions and setting different disclosure standards for each category.

Last but not least, more than 400 large European private issuers which have issued American Depositary Receipts (ADRs), will also have to report on a comply-or-explain basis against considerably enhanced NYSE and NASDAQ listing rules (additional to Sarbanes-Oxley requirements) which are mandatory for US issuers. While the comply-or-explain obligation might be interpreted fairly broadly by foreign private issuers, the provisions of the US listing requirements are set to become another pole of best practice around the world, Europe included.

Institutional investors

Last year, I argued in these pages that "institutional investors are ... putting governance at the top of their agenda". Institutional commitment to governance has proved to be more than a fad or a short-term, knee-jerk reaction to the crisis. To begin with, institutions have to become diligent about ownership. Since the end of 2002, the US SEC is requiring fund managers to disclose whether and how they vote in the shareholder meetings of their investee companies. One of the ECAP's action points is the adoption of an EU directive to establish a similar requirement of active ownership for European asset managers before 2006.

But not all investors need browbeating to focus on governance. Many large institutions in the US, UK, Canada, the Netherlands and Germany that own considerable portfolios of European equity have explicit guidelines on what they expect from their investee companies in the area of governance. Hermes Asset Management, the UK's larger pension fund manager, has over 40 people in its governance department. In 2003, Deutche Asset Management developed a screening process for governance and management quality that is being incorporated in its investment process, following a similar step by Goldman Sachs Asset Management. Both the UK Association of Pension Funds and the Association of British Insurers are running corporate governance services and alert their members when shareholder action is required. Over the last 18 months, there has hardly been a day without the financial press reporting one or more shareholder rebellions against management in the UK or continental Europe.

The emerging buy-side governance infrastructure

The pressure to improve ownership vigilance is also bearing upon mainstream asset managers. In their case, developing corporate governance tools and capacity internally is an expensive proposition in an environment of intense competition for client fees. To meet increasing regulatory pressure, they turn to an expanding universe of buy-side ratings and voting service providers such as ISS, Governance Metrics, Deminor and other smaller players. They are now all present in the European market, rating European issuers on the basis of publicly available information. The relative complexity of governance arrangements makes outside ratings inherently unreliable and poor public disclosure of these arrangements compounds unreliability. Recently, an executive of a large European corporation privately admitted that one of their board committees existed only on paper but its mention on the website gave the company a 4/4 rating with a leading European ratings outfit.

The prevalence of a box-ticking culture will be harmful to both corporations and investors. It will make it more problematic for a company to explain its non-compliance with a voluntary norm, even when it has perfectly good - indeed, compelling - reasons to differ. There is a real danger that corporate governance will become a formulaic requirement that will add cost, destroy competitive advantage and firm-specific incentives without an appreciable lowering of risk for investors. To address this concern, the new UK Combined Code (still in draft form) has a special chapter on institutional investors, requiring them to dialogue with issuers and give due weight to all relevant factors when evaluating corporate governance. When the Commission decides to legislate in the area of investor responsibility - after 2006 - it should focus on facilitating effective and flexible ownership policies that do not encourage institutions to box-tick. EU member states should do the same as they tackle corporate governance.


Large international companies are facing an increasingly complicated universe of governance compliance. For example, picture a German company that is also listed in New York and counts among its shareholders large UK and US pension funds, with their own governance specification as well as institutions that are using some of the proxy firms and rating agencies mentioned above to fulfill their ownership functions. This firm may be facing compliance with to up to 10 different governance templates. It obviously needs to develop its capacity to explain governance in a comprehensive manner.

But corporate governance is not only about compliance, it is also about value. Here, we should ask another fundamental question: What does good governance bring to a company? Notwithstanding long-winded and very interesting debates on the issue, the practical answer is that it enhances trust. The value of governance is directly related to the level of trust it generates among the main constituents of the company. There's value in a relatively lower cost of capital when investors trust that the board has the capacity to limit insider expropriation. There is value in proper management of overall corporate risk by the board, which is in turn based on the management trusting the board with sufficient information. There is value in employee motivation, as workers (especially knowledge workers) place greater trust in an employer who has a clear sense of mission and a robust set of values that apply throughout the organization. There is value in enhanced brand recognition among increasingly sophisticated consumers for a company that not only delivers good products but also cares about its relationship with its investors, employees, and stakeholders.

To comply while adding value, companies need to fully integrate governance into corporate strategy by taking certain steps:

Design an individual corporate governance dashboard

The dashboard would track corporate governance issues in the company in a holistic way and drive compliance, disclosure and consistent explanation to the market. The dashboard should be designed along four key parameters that would normally address most of the existing regulatory or buy-side templates:

Quality of boards: independent, effective and engaged directors.

Quality of reporting systems: from management to board and from the corporation to its investors.

Quality of incentives: alignment of incentives of insiders with outside investors.

Quality of shareholder rights: assurance against insider abuse.

Because every company has different shareholders, operates in different markets and has different traditions and goals, dashboards can only be tailor-made. A well-designed dashboard will not only focus on compliance drivers, it will also add value by linking governance to competitive advantage. One way of doing this is to consistently benchmark against governance practice by peers. For example, a telecoms company will need to include in its dashboard the practice of its peers, the way they internalize best practice and the way they communicate with markets.

Get rid of unexplainable legacy

If a specific provision in the articles cannot be explained it might be good time to thoroughly review its utility. For example, there are companies with forgotten poison pills or other control devices with subsidiaries that are a legacy of a long-gone ownership and control context. Their timely review and restructuring might considerably enhance their stature with investors, with little impact on the company's strategic positioning.

Improve the board's competence

The board is an asset of the company. But it is often underused. Boards in otherwise good companies include people that either do not deserve to be there, or whose presence might actually harm board dynamics. To continue with the example of our German company above, there may be pressure to retire the spokesman of the management board by nominating him to head the supervisory board. Such a move is not against the Cromme Code and might be entirely justified. But it is a no-no in most institutional investor guidelines, experience suggesting that it breeds weak leadership and resistance to change. Thus, there has to be a robust justification test that will help the company anticipate the cost of such a move from the perspective of the markets.

There are interesting positive dynamics in the relationship between the competence of the board and the dashboard approach. A company needs a competent board in order to integrate governance into its strategy. Once adopted, a dashboard will make it much more difficult for management - in our example, the outgoing CEO - to impose solutions that are not adequately justified on a well-meaning board. In other words, the objective, ex ante nature of the dashboard will help overcome the constraints of boardroom atmosphere, ie, the social difficulty of going against one's peers. This is what Warren Buffet identifies as the main cause for the failure of intelligent and decent directors.

Rationalize and integrate governance with disclosure, investor relations, management and board information functions

The development of a comprehensive governance strategy and the capacity to explain it require the creation of a single focal point, at senior management level, for the collection of corporate governance information and the coordination of management support services among the senior management of an enterprise. In order to discharge her task, the senior corporate governance officer will need to be closely integrated with investor relations (the usual contact of investors), the CFO-led risk management and management information systems function and the disclosure functions that are often under the purview of the legal officer/general counsel. If structured properly, the confluence of the several platforms for information flow within the company might prove to be a source of economies and of vastly superior risk management. This will produce long-term value for the company irrespective of compliance while facilitating the active supervisory task of the board's audit committee as demanded by most governance templates. Importantly, it will also protect senior management and board members from liability, under section 404 of SOX (if the company is listed in the US) or, in the case of board members, the collective liability for the accuracy of financial accounts and disclosures facing them already in several European jurisdictions and also a feature of an upcoming EU directive, as announced in the ECAP.


Since our discussion of governance in these pages last year, there has been more empirical evidence to lend credibility to the widely shared perception that governance adds value. As regards Europe, a recent paper suggests that a broadly constructed portfolio of well-governed European listed companies would have outperformed an equivalent portfolio of badly governed companies by almost 3% over the five-year period between 1997 and 2002. Because share out-performance is, to an important extent, a function of investor perceptions and understanding of corporate governance issues, it is likely that the valuation gap between well- and badly-governed companies will become wider as investors get wiser about governance. This has been the case in the US, where research points to a performance premium for well- governed companies over badly governed peers that has widened over time: from less than 3% in 1990 to more than 8% in 2000.

Investor perceptions, increasingly diverse compliance demands and important value added: these are all good reasons for companies to start looking at their governance and explaining it to the markets; not as an incidental, crisis-driven disclosure following a severe confidence shock but as a key, forward looking component of their long-term corporate strategy. However, the importance of governance has become even broader: two years ago, when I told people what I was doing for a living I got blank stares in return. Today, governance is a household word, if not yet a household concept. A consistent explanation of governance practices to the outside world is surely about to become a factor of a company's brand value, visibly contributing to the attraction and retention of clients and employees.

The author would like to thank T Boussios, O Fremond, L Goldshmidt, J Gunderson, J Maratos and E Quinones for their comments and thoughtful suggestions. They bear no responsibility for any faults or omissions that the reader might find in this article.

Nestor Advisors Ltd
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