Is Corporate Governance Better Across The Atlantic?

THE EUROPEAN MODEL

In Part I, we discussed differences between corporate governance in the US and Europe, we focused mostly on the US. In this article we focus on the European model.

The European model gives importance to all stakeholders including the shareholders. The separation between ownership and management is not that clear with boards comprising of representatives of various stakeholders like majority shareholders, lenders (banks), employees, suppliers etc. The board is a two tier structure with a supervisory board comprising of Non-Executive Directors which controls decision making by the Executive Directors.

The presence of these stakeholders, who are also shareholders (owners), on the board further increases their influence in strategic management decisions. The ownership patterns are more concentrated & complex with cross-holdings being common. The relevant financial markets are less liquid and there is higher dependence on debt to fund growth and operations of the companies. The concept of audit committee is existent in the European model also, but the composition of the committee is not that stringently laid down. The Chairman & Chief Executive Officer positions may or may not be held by the same person.

For instance, Bayerische Motoren Werke AG (ETR:BMW) (ETR:BMW3) (FRA:BMW) has a Supervisory Board (SB) & a Board of Management (BOM). The BOM regularly provides information to the SB (regarding strategy, sales volume, growth prospects, production planning etc.) which has a monitoring and advisory role. The SB also reviews the compensation of the BOM members and examines if there are any instances of a conflict of interest. Of course, the SB monitors its own efficiency and performance from time to time. In addition, there are several other Committees in the BMW board including an Audit Committee. The two boards have different Chairpersons.

As per the BMW  Annual Report 2011, “Corporate culture within the BMW Group is founded on transparent reporting and internal communication, a policy of corporate governance aimed at the interests of stakeholders, fair and open dealings between the Board of Management, the Supervisory Board and employees and compliance with the law”. Here, the importance of stakeholders (as opposed to shareholders alone) is clearly reflected. Similar board structures and roles can be seen in other European organizations like Renault SA (EPA:RNO) though the nomenclature of the Supervisory & Management bodies may be different.

The rules and regulations in the European countries are not that strictly enforced as there is a philosophy of “comply or explain”. This approach gives room for deviations, provided a proper justification is furnished for non-compliance. This flexibility is perhaps necessary because the influencing stakeholders are more diverse and they monitor the performance of the company more closely. The diversity mandates an incorporation of the principles of accommodation in enforcement to achieve collaborative decision making. There is longer term orientation in the with the stakeholders, as the stakes are deeper than simple stock holdings. These pulls and pressures by the large stakeholders obviously rein innovation and risk taking ability of the management. This may be good in certain situations but mostly, the lack of ‘out of the box’ thinking may be detrimental to the competitive advantage of the firm. These effects increase the response time of the organizations making it less lean and mean.

MMINENT COMPARISON AND CONCLUSION

In the US system it is presumed that the highly liquid financial markets continuously make efforts for efficient price discovery of the enterprise at all times. For this, free flow of information is required which is ensured by regulatory disclosure norms and oversight mechanisms like board audit committee or separation of ownership & management. Further, the American philosophy of survival of the fittest makes it mandatory for organizations to get rid of chinks in the armour of its board by removing under-performing Directors  Managers. Implementation of internal controls is ensured by Rules and through forced internal control. Genuine financial disclosure is given utmost importance. The fact that CEO is mostly the Chairman also works towards strengthening the hands of this most important functionary of the board. This supremacy makes the executive more powerful than the non-executive Directors thereby improving operational efficiency and supporting innovation / differentiation to a great extent. Of course, this absolute power has a tendency to corrupt or become arrogant. This sometimes makes executives work towards personal gains rather than shareholder interests. The fact on the ground is that the shares are widely held and most of the shareholders, whether institutional or retail, are not concerned enough to interfere in day to day management of the company. Reasons for past frauds in the corporate world have been traced to disinterest and short-term outlook of the dispersed shareholders. This lack of interest has, on occasions, resulted in excessive autonomy being exercised by the Board or individual managers for their personal benefit.

In the European model, the effort of governing & managing an organization is more collaborative and the majority shareholders / stakeholders are directly concerned with the performance of the organization. For example, the banks are definitely affected by the cash flow position of the company because repayment of their loans is supported by it. Thus, each stakeholder on the board has his own (albeit relatively narrow) outlook towards the governance of the company.

The varied perspectives may, in effect, moderate the enthusiasm & efforts of the professional managers who work towards improving the competitive advantage & pricing power of the firm. In Europe, the emphasis is on voluntary internal controls rather than enforcement of controls by statutes. The Government does not have a didactic approach because the board structure appears to have inherent checks and balances which prevent the Directors from taking decisions which may be to their own advantage.

Obviously, both these systems are relevant in their own contexts and are perhaps nearly optimal in their respective political, regulatory, economic and cultural environments. In this context, the US system appears to be more apt, provided the shareholders stop being oblivious spectators to the performance of the board. This is because the US system gives free hand to professionals and has sufficiently strict statutory framework to ensure proper disclosures and reporting.

Globalization has made it extremely important for organizations to maintain and enhance competitive advantage. This cannot be achieved if novices or vested interests interfere in strategic decision making. Shareholders should be involved in selection of Directors, should keep a tab on the performance of the organization and become active only when mandated or allowed by the laws or in exceptional circumstances. With stakeholders investing trillions of dollars in future of thousands of companies, it is natural that there is an endeavor to continuously develop better corporate governance models which increase value of companies in the long term.

To summarize, the fundamental basis of any good corporate governance system lies in positive & professional intent and capability of the Directors and the board / management. If any of these elements are absent or faulty, the performance of the company will be adversely affected. The key to shareholder wealth maximization is long term performance which can be achieved only if the Directors are efficient and capable, the board is reasonably diverse (in respect of culture, expertise, gender etc.), is substantially committed (i.e gives adequate quality time) and does not have any material conflict of interest. Thus the selection of professional Directors is of utmost importance.

Passive approach of the retail and institutional investors blunts the efficacy of democratic principles of the board. The shareholders, especially the large ones need to be coaxed into becoming more proactive in the selection of the Directors of the organization. Activist investors & proxy voting organizations also play an important role in keeping the management on its toes. Thus, unless the shareholders are more active in overseeing the performance of “their” companies, all corporate governance mechanisms may not achieve best results. Of course, regulations are continuously developing to guide and coerce compliance, but real democracy will come only when shareholders take real time interest and develop a long term outlook.