Good Corporate Governance the relevance for companies and investors. Christian Strenger

Transcription

1 Campus for Finance WHU - Otto Beisheim Graduate School of Management Koblenz, January 15, 2004 Edited Lecture Notes Good Corporate Governance the relevance for companies and investors by Christian Strenger Member of the Supervisory Board, DWS Investment GmbH, Frankfurt Member of the German Government Commission on Corporate Governance I. Good governance: good ' housekeeping' Good corporate governance is often seen as the 'art of good housekeeping'. With transparency and independence as key ingredients, it provides a marketoriented framework for the running of companies. Fulfilling demanding standards, it can ensure a proper balance between management, supervisory board and shareholders, adequate levels of transparency, appropriate compensation schemes and the prevention of conflicts of interest. II. The importance of corporate governance: the value proposition Empirical research confirms that companies with above average governance standards enjoy a significantly higher market valuation: Studies by McKinsey and the World Bank show that large international institutions pay a substantial premium for companies with good corporate governance. 1 For Germany, the premium is 13 %. In countries where good governance is still young like Russia, this premium increases to 38 %. A study by authors of the 'Harvard' and 'Wharton' business schools analysed companies during a period of 10 years until Companies with excellent governance performed on average 8.5 % p.a. 1 McKinsey (2002): Global Investor Opinion Survey, undertaken in cooperation with the Global Corporate Governance Forum. Internet: / 2

2 - 2 - better than companies with poor governance. 2 For global companies, the international rating agency 'GovernanceMetrics' reported in September 2003 a total return difference of 15 % p.a. between the top 10 % and the bottom 10 % over a 10-year period. 3 For 91 companies traded on the German stock exchange, there was a difference of 12 % p.a. between the best and poorest performing companies in the period These findings confirm that the pursuit of good governance has significant value potential: Companies can reduce their cost of equity capital by a higher market valuation. Investors, particularly professional asset managers which face increased performance demands from their clients and media attention, look to realize the higher stock price potential for competitive reasons. Other stakeholders (employees, customers, suppliers, and the general public) can substantially benefit from the key improvements brought about by higher transparency, openness and adequate handling of possible conflicts. III. The drivers of and the resistance to good governance Despite the sometimes dramatic cases of fraud and mismanagement, as well as evidence of the importance of good corporate governance, many companies and even investors are still hesitant to actively pursue corporate governance issues. Driving factors that play an important role are: Severe company mistakes and failures, not only Enron and Worldcom in the U.S. but more recently Parmalat or Ahold in Europe, have created lasting irritations, followed by intensive demands for change. This forced reactions from the political and supranational arena. In the U.S., the remedial actions by the Sarbanes-Oxley Act of July 2002 have been quite intensive but not as far reaching as necessary (no change was prescribed for the customary joint Chairman / CEO-role and the possibility for overly generous option awards that were reasons for the big Gompers / Ishii / Metrick (2003): Corporate Governance and Equity Prices, in: The Quarterly Journal of Economics, Issue 118, No. 1. GovernanceMetrics International: Summary of global research performance analysis, September Internet: Drobetz / Schillhofer / Zimmermann (2003): Corporate Governance and Expected Stock Returns: Evidence from Germany. Internet: indexresearchpapers.htm/. / 3

3 - 3 - governance failures). In Germany and in the EU, governance developments were initiated more proactively in the late nineties after the publication of the global Governance Principles of the OECD in These Principles were designed as key headlines for global application; an updated version is currently in the consultation process and will be finalized during this year. 5 The Action Plan on Company Law and Corporate Governance of the EU Commission from May 2003 is a further milestone in these developments. 6 Increasing influence on governance matters is exercised by professional investors, mainly investment and pension funds. Due to their considerable voting power they are in a preferred position to get their views across to the companies. Nevertheless, there are also significant resistance factors: Companies in Germany and in Europe still show widely differing reactions. While many companies publish their commitment to good governance principles, this is often formal and masks a lack of true governance quality inside the company and vis-à-vis the shareholders. Extensive disregard of important elements can still be observed in the areas of: Board independence, control issues, disclosure and remuneration. In some EU countries retail participation in equity investments is still not significant enough to bring about political or investor-induced pressure. Finally, individual country laws and customs inhibit a faster cross-country progress. In Europe, at least 34 governance codes exist not counting additional codes from the 10 new member states joining the EU in Especially companies with major international operations are faced with the considerable challenge to comply with such diverse requirements. The EU Action Plan is therefore an important step to reduce this diversity. IV. Key governance issues the value drivers Which key governance issues are most relevant for the creation of value? Board independence and board structure A crucial element of good governance is the board's quality, i.e. the ability to effectively monitor and control the management without stifling its entrepreneurial drive. The corporate scandals of the recent past have sharply increased board accountability. Closely connected is its 5 6 OECD Principles of Corporate Governance, May 1999 and Draft Version for Update, January Internet: EU Commission: Modernising company law and enhancing corporate governance in the European Union A plan to move forward (Action Plan), Brussels, May 21, / 4

4 - 4 - responsibility to ensure that efficient and sophisticated internal controls and risk management systems are pursued by the management. Central for the effectiveness and the quality of the board is obviously the standing and independence of the non-executive (supervisory) directors. It is paramount that independence is not only confirmed by the formal absence of material company relationships. What matters more is that nonexecutive directors openly discuss and stand firm to well reasoned positions. Germany, for example, is still characterized by a high number of cross directorships that can lead to inefficient 'silence' in board rooms. In the debate whether a monistic or a dualistic board structure is better, the old idea of the one-tiered structure as the role model for boards has suffered of late. The recent corporate failures occurred mainly in one-tiered companies. The clear division between management and supervision of the two-tier structure if properly lived (and not hindered by codetermination) seems the better solution today. Given the increasing complexity of most business models and the often too high number of board members (e.g. Germany), board committees (particularly an audit committee with at least a majority of independent directors) are a governance necessity. This also underlines the increasing demands on the directors' professional qualification. Conflicts of interest All employees but especially the members of the management and supervisory board often face conflict of interest-situations. Companies should define the non-competition obligations, prohibit the pursuit of personal interests in company decisions, define an authorization framework for outside activities, and require immediate disclosure of potential conflicts of interest. In the specific case of financial institutions with broadly structured activities the professional handling of governance issues is crucial especially in the securities and asset management business. For an asset manager, a proper division within the own group organisation must be ensured to prevent conflicts of interest. Transparency / Disclosure Conflicts of interest are also lessened by increases in transparency. Any temptation might not arise if the matter has to be put in the open beforehand. / 5

5 - 5 - An important step toward higher transparency standards is the move to IAS / IFRS reporting. Companies only complying with national reporting standards will gain substantially from this effort. Taking the disclosure regarding stock options as an example, transparency through comprehensive presentation as a single item in the annual report could considerably enhance the information value in this important governance issue. Recent company complaints about mandatory quarterly financial reporting as also proposed in the EU Transparency Directive 7 are opposed to the interests of all stakeholders: Only such regular financial information presents a true picture of the company's affairs. The suggested problem of higher trading volatility has little foundation if quarterly reports confirm existing trends; unwelcome surprises, however, will cause price reactions, irrespective of quarterly or semi-annual reporting. A good way to improve transparency is the publication of company specific corporate governance guidelines coupled with a meaningful annual governance reporting. All stakeholders thus gain the opportunity to selfassess the governance quality. This can help to promote improvements of critical governance elements. Sensible and long term-oriented remuneration structures Many of the recent corporate scandals resulted from the short-term orientation of top managers caused by compensation packages that were not aligned with longer-term shareholder interests. Total compensation packages of US$ 100 million and more in one year alone have not been an exception in the US. However, in Germany and most parts of Europe the same scale of excessive payments was not observed. For share-based compensation elements (options etc.), only longer-term outperformance of relevant benchmarks should be rewarded instead of benefits arising from general market increases. Sensible share option plans require detailed ex ante analysis by the full board to prevent unwarranted and short-term gains. Full disclosure of the compensation structure should be mandatory and particularly the details of share option plans should require shareholder approval. To justify the reward of outperformance, appropriate benchmarks must be found that reflect best practice in the company's industry. Windfall profits caused by general stock 7 Proposal for a Directive on transparency requirements for listed companies, Brussels, March Internet: / 6

6 - 6 - market rises that do not reflect individual achievement should simply no longer be part of a fair compensation concept. Auditing matters To rebuild the trust in the audit of financial statements, true independence of the auditor and a regular auditor change combined with the prohibition of most non-auditing services are important. In the Enron case, 25 % of the particular Arthur Andersen office's income was generated by Enron-related business (not only from audit but also from tax advice and financial engineering), thus significantly questioning the independence requirement. In the recent Parmalat case, the role of Deloitte Touche as Parmalat's auditor highlights a new problem: relying to a serious extent on the audit work of other firms. In Parmalat, the previous chief auditor Grant Thornton kept as much as 49 % of the whole group audit, particularly the crucial audits of the Cayman Islands and other offshore subsidiaries. To inhibit such malpractice in future, a new rule limiting sub-auditing work to 20 % regarding all group entities (with a maximum of 5 % to 10 % for individual group subsidiaries) should be considered. This would keep the real group audit responsibility on the lead auditor. Shareholder rights Many companies still do not give their shareholders the possibility to exercise their shareholder rights in the Annual Meeting. It is remarkable that no satisfactory solution has yet been found to implement full crossborder voting powers for many companies that have ADR's outstanding. V. Particular German governance issues The German governance framework: The Corporate Governance Code and its self-regulated application (Comply or Explain-Principle) Particularly after the Holzmann corporate crisis in late 1999, the German government realized the practical importance of better governance for German companies. After extensive work of two Government Commissions the official German Corporate Governance Code 8 was published in February Available in German and English in the Internet: / 7

7 - 7 - What is the basic concept of the German Code? The code comprises two main elements apart from a description of the legal governance provisions: - Firstly, German companies today have to comply with the important stipulations of the code: the 'Shall Recommendations'. They are the compulsory governance issues. Any deviations have to be published according to the Company Law ( 161 AktG). - Secondly, the so called Should Suggestions represent additional elements of good governance. These Suggestions do not require obligatory publication in case of non-compliance. They are, however, a big determinant of true governance quality. The Government Commission is a standing commission and meets at least annually to revise the Code as appropriate. The last update has been made in May 2003 and included the hotly debated requirement to publish the individual compensation of all management board members. Critical success factors for improved governance in Germany The major shortcomings in German governance are: - Size and independence of the Supervisory Board While the two-tiered system offers German companies good potential for satisfactory governance, this is negatively impacted by the effects of co-determination mainly with respect to the efficiency of the supervisory board. Political issues were responsible that the Government Commission so far could not deal with the German system of co-determination. The inefficiency caused by this structure remains problematical, particularly for internationally operating companies. The overdue corrections will mainly come through the EU process. This already allows holding constructions that effectively do away with co-determination. So far the unions have defended their status that is also important to them in a monetary way. The reality is: with 20 members, large German supervisory boards can simply not function efficiently. A reduction to a maximum of twelve members is needed to improve the quality and depth of the discussions. / 8

8 Modernisation of the Annual General Meeting In Germany, AGM's of large DAX companies often last a full day and are overloaded with unfounded 'shareholder' proposals and statements that have no relevance to the company's business. Shareholder questions exceeding a given number (say five) should therefore be put to the company at least ten working days prior to the AGM. The company should be required to answer by no later than five working days before the AGM and publish its answers also on the website for the benefit of all shareholders. Voting procedures should allow electronic proxy voting. The introduction of a 'record date'-system instead of the present 'blocking period'-approach should facilitate cross-border voting for international investors that today rarely vote their shares. - Protection of shareholder interests in case of a takeover bid The recent outcome of a 15-year debate on the EU Takeover Directive does not represent any material advance for shareholders of German companies as all EU member states (including Germany) can still decide unilaterally whether or not to abolish existing takeover defences. The necessity for change can be exemplarily explained by the present German takeover law: Anti-takeover measures proposed by the management and agreed by the supervisory board do not require shareholder consent, a clear violation of the investor's basic ownership rights. There is one hope, however, arising from the EU Directive: Shareholders will have the right to vote at the Annual General Meeting for an implementation of the 'breakthrough rule', which would de facto eliminate national defence mechanisms. - Better enforcement rights Although German criminal law is fairly efficient for the punishment of corporate wrongdoers, shareholders have presently no compelling process for private legal actions against boards. The German Government is therefore considering the introduction of new laws that enable shareholders to achieve compensation for wrongdoing by board members. / 9

9 - 9 - VI. A good governance framework is essential but governance quality is what matters With the publication of the official 'German Corporate Governance Code' and the many other international guidelines and regulations, a basis for better governance world wide has been laid. It is also vital to use practical tools (rating and scoring systems) to promote the implementation of good governance with investors, analysts and companies and to facilitate the understanding of its complex nature. Despite such efforts, better governance quality cannot be achieved by prescription only. Company executives and supervisors must accept that an active pursuit of good governance is paramount for longer-term success. Investors must equally play their part by precise monitoring of the companies they invest in to generate value for their clients.