Corporate
Governance and Value:
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Company A - ‘Poor’ governance |
Company B - ‘Good’ governance |
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Question:
Would you be willing to pay more for company B's stock than company A's?
If yes, what percentage premium do you estimate you would be willing to pay for B's stock?
McKinsey Investor Opinion Survey - June 2000
Corporate governance structures send two important messages to the market. The first has to do with the way that corporate power is accommodated within a free society: its legitimacy. The second has to do with the ability of a corporation to be competitive and to optimise long-term value: its competitiveness.
Both relate to risk assessment. Capital will not be attracted to a venture, however promising, unless the investors can be confident that it is profitable and sustainable, which requires that it has the support of the communities in which it is domiciled and does business.
The US, the UK and Germany have been the leaders in creating the new vocabulary of corporate governance. The US is considered to be the paramount economic force in the world and its governance standards, especially regarding transparency, are widely considered to be the standard. The UK has the most clearly demarcated standards and is the centre for international scholarship on the subject. Germany has devoted some of its best minds and has taken significant steps to developing a fully competitive theory and structure.
In the US, as in many other countries with established and complex legal systems, there is a sharp disparity between law and its practice, and acknowledging the nature of that disparity helps us to understand its enduring appeal. In order for such a system to survive, even thrive, the disparity itself must serve some purpose.
A complex network of rules established by federal agencies, state law and stock exchanges determines the roles of shareholders and directors. The pervasive influence of corporate decision-makers has traditionally been justified by the accountability of agents to principals, meaning managers to owners, or directors and officers to shareholders. For example, statutory language typically states that ‘the shareholders elect the directors.’
In practice, however, the board of directors is a self-perpetuating institution: management nominates the candidates, no one runs against them, and management communicates with the shareholders and counts the votes. No one becomes a director of a company without at least the acquiescence of the chief executive officer. The involvement of shareholders in the selection of directors might most accurately be described as ‘coerced ratification.’ Only slightly less misleading is the asserted power of the board of directors over the principal officers. Notwithstanding the clear statutory mandate that the directors select and can (and, in recent times, occasionally do) remove the chief executive officer, boards have universally proved incapable of controlling executive compensation. This ultimate proof – if they can pay themselves whatever they want, don’t they really have full power to do anything – of executive autocratic power may well be the ‘smoking gun’ that offends political and social sensitivities. When business and stock prices turn down, CEO pay will be the target of public rage and the excuse for government involvement. Until that unhappy day, all parties have thought it worthwhile to leave intact the illusion of meaningful corporate accountability to anyone in the United States. The appearance of accountability is all that was required by the McKinsey survey. It is worth carrying on so long about the dichotomies of the American situation as a base against which to couch judgements about the situation in other countries.
In the United Kingdom, shareholder power is real. The statute is clarity incarnate: 10% of the members may call an extraordinary general meeting (EGM), a right virtually non-existent in the US, at which a majority of those present may fire any or all of the directors with or without cause. The homogeneity of the financial community and the concentration of institutional ownership in few hands mean that the City of London has ready control over virtually all companies chartered in the UK. It is no secret, however, that UK companies are rarely competitive and even more rarely world class. Shareholders will react in cases like Marks & Spencer and Tomkins only when failure is huge and public. The value destroying final years of Lord Weinstock at GEC passed with barely a murmur. At some important level, ‘best practice’ continues to be the imagined ‘behind the scenes’ cleaning up of messes. This presents the conundrum of owners having power that they only rarely exercise. In light of the competitiveness of the ‘money management’ business to achieve the highest ‘total returns,’ how can one explain the demurral by institutions from using their undoubted authority to improve the returns that would make them more competitive in attracting new business? There is the sense in both the US and the UK of a pervasive momentum in favour of preserving existing power arrangements.
Implicit both in the UK and the US is the conviction that the principal officers must have full authority in the direction of private enterprises. Whatever appearances are thought necessary to accommodate political and public sensitivities about power in a free society, the entrenched wisdom persuades that the ‘golden goose’ of corporate wealth generation will in fact be destroyed if outsiders insist on and are permitted to meddle. Corporate power is ‘legitimate’ in the UK as the hegemony of the elected political leadership is real and apparent. Government has, when necessary, taken over ownership of critical businesses. While there is little prospect of this reoccurring in the near future, the capacity of government to proscribe the rules under which business operates is unchallenged. A mildly disturbing trend is the extent to which the major parties depend on business contributions for the financing of election and re-election. As with executive pay, the UK has not yet caught the full ‘vice Américain’. In both countries, the almost total ‘conflict of interest’ of the investing institutions who hold controlling interests in virtually all companies is tolerated.
By way of summary, the US and UK both recite a legal and publicly understood mantra of shareholder suzerainty. Such is plainly untrue in the US and largely untested in the UK. Directors are more or less a myth, although less so in the UK. The result is that absolute authority – in the absence of some unignorable outrage (and even then sometimes) – resides with the principal officers who are largely self selected and self perpetuating. It is felt that this reality is not politically or psychologically acceptable, so laws and codes continue blithely to recite what is untrue.
Before thinking about specific proposals for a Corporate Governance Code for continental Europe, one needs to consider carefully local sensitivities. Simply, is it believed in each country that absolute authority should rest in the corporate officers and that this reality is best obscured in the words of the laws and codes? Is the structured arrangement between shareowners, employees, supervisory and management boards more myth than reality? These are not questions on which an outsider can have much relevant insight, but they are important questions that European experts should ask themselves.
It seems to me that the present provision in German law for labour representation on the Supervisory Board of the largest public companies equal to that of shareholders is at odds with the situation on the ground. Certainly if the draftsmen of the statute intended to confer real power on labour through this sort of representation they have not succeeded. The reality is that labour tends to lose confrontations with management and this has tended to neuter its representatives’ participation on the board. Is this a metaphor for the balance of the proposed Codes? Is the reality of politics that meaningless rituals are necessary?
We can generalise about the utility of ‘codes’ in the Anglophone world. Their greatest utility has been in sensitising the various corporate constituencies to a range of concerns. Codes have been trivialised to the extent they are perceived as requiring ‘box checking’ or as explicit management wiring diagrams. That the codes on important occasions are myth has not destroyed their value in the US and the UK. McKinsey, in the study described earlier in this letter, courageously quantify ‘good governance’ in explicit and easy to verify terms. As we have earlier suggested, the provisions in that survey with respect to the ‘independence’ of boards of directors simply does not fit with the reality. Maybe the Anglophone experience demonstrates one simple conclusion: recite whatever is necessary about governance so long as the autocracy of executive management is undisturbed. Is this pattern applicable to continental Europe?
Germany has given evidence over the last year of a determination to develop high standards of governance. The societal willingness to acquiesce in Vodafone’s acquisition of Mannesmann, tax amendments enabling the end of cross shareholding and the new law permitting proxy voting by fax, email or telephone are substantive steps towards making Germany a world leader in this field. Avoiding SEC requirements to disclose executive compensation in the Daimler case is a step in the other direction. Perhaps the final word is The New York Times’s comment on the precarious position of Daimler Benz CEO Jurgen Schrempp: ‘Even facing problems like these, Mr. Schrempp once could have counted on Germany’s clubby system of cross shareholdings to protect him from being ousted. That may not be true much longer.’ (My italics. Andrews, Edmund L. and Bradsher, Keith, ‘This 1998 Model is Looking More Like a Lemon’, New York Times, Section 3, pp. 1-11, November 26, 2000). It is clearly perceived that German companies these days are being managed more to accord to the discipline of the market place.
The problem of the independence (or lack thereof) of ‘outside’ auditors is world-wide. It may be that the only simple interim answer will be to have the shareholders actually engage and manage the relationship with the auditors.
Institutional investors will pay a ‘good governance premium’ if certain conditions exist:
Transparency. Information must be publicly available permitting fairness in the market place and informed reaction by government;
Accountability. Executive management must be effectively accountable to some informed, motivated, independent and empowered body. In some cultures, this may be the government (Japan); in some it may be the residue of bank control (Germany); in others an independent chairman (UK) or institutional investors in the United States. Whether the body is in fact independent or effective or both will be determined by the facts and circumstances of each case.
Legitimacy. There must be social, business and governmental commitment to the transcending obligation of management to optimise the value of the enterprise. (‘Optimise’ is the correct word rather than ‘maximise’ so as to make clear that the determination of value must be long term and holistic). If and when these conditions are found not to exist in practice, the market will rapidly lower values and punish investors.