1. Definition

Broadly speaking, corporate governance is the organisation of the control over, and management of, a firm. It covers:

• the definition of the legal framework of the firm: specifically, the organisation, the functioning, the rights and responsibilities of shareholders attending meetings and the corporate bodies responsible for oversight (board of directors or executive board and supervisory board);
• the rules for appointing managers and directors;
• management rules and any conflicts of interest;
• the organisation of control over the management and the running of the company: internal controls, regulatory controls, auditing;
• the rights and responsibilities of other stakeholders (lenders, customers, suppliers, employees);
• the disclosure of financial information on the firm and the role and responsibility of external analysts: financial analysts, rating agencies and legal and financial advisors.

In a more narrow definition, the term “corporate governance” is used to describe the link that exists between shareholders and management. From this point of view, developments in corporate governance mainly involve the role and functioning of boards of directors or supervisory boards.

We would suggest¹ that corporate governance covers all of the mechanisms and procedures surrounding decisions relating to the creation and sharing of value. They concern four main areas: shareholders’ rights, transparency of information, organs of management and control and the alignment of compensation.

2. Recommendations and guidelines

It should always be remembered that the organisation of corporate governance is determined, first and foremost, by company law, which defines the field of possibilities:

• prerogatives of the market regulator;
• listed companies’ information obligations (shareholders’ agreements, etc.);
• vote by shareholders on managers’ compensation;
• composition of the board of directors (maximum number of directorships);
• possibility of separating the function of chairman of the board of directors from that of CEO;
• transparency with regard to conditions for preparing and organising the work of the board of directors and internal control procedures.

Over the years, a number of recommendations and guidelines have been added to the purely regulatory and legislative framework, in the form of reports and best practice codes (commissioned and/or drafted by employer bodies, investor associations, governments and government agencies, stock exchanges, etc. in various countries). It is important to note that these codes remain recommendations and guidelines only,² and are not legally binding laws or regulations.

The main recommendations and guidelines in terms of corporate governance all focus on key issues: transparency in the way that the board and management operate, the role, composition and functioning of the board and the exercise of shareholder power at general meetings.

However, each country has its own category when it comes to companies and their shareholders:

• employee rights in Germany (and also in Denmark, Austria and Sweden);
• the role of banks in Japan;
• very widely held shareholdings in the UK or USA;
• etc.

(a) Transparency

The first recommendation is for transparency in the way the company’s management and supervisory bodies operate.

For example, this is the way transparency evolved in France:

TRANSPARENCY FOR THE TOP 40 LISTED GROUPS IN FRANCE

	1995	2004	2010	2015
Firms disclosing the number of board meetings per year	0	40	40	40
Average number of board meetings	3	7	8.8	8.3
Number of boards with internal regulations	0	40	40	40
Number of boards with a board of directors’ charter	n/a	10	37	40
Number of boards that carry out assessments of their performance	0	21	40	40

Source: Korn/Ferry International and AMF

Transparency surrounding the compensation of managers and directors is also recommended. For a long time, this was a taboo subject, and most listed companies have only recently started disclosing clear figures on the compensation paid to their managers and directors. As we saw in Chapter 26, the way in which firms compensate management plays a key role in reducing conflict between shareholders and managers.

In some countries, shareholders vote on management compensation (say on pay). It is either a consultative vote (USA, Spain) or a binding one (France, Germany, Sweden, Netherlands, Switzerland, UK).

With the granting of variable compensation or stock options, managers have a financial interest that coincides with that of shareholders, to whom they are accountable. Since stock options are options to buy or subscribe to shares at a fixed price, managers have a direct financial stake in the financial performance of the company, i.e. the higher the share price, the larger their capital gains will be. Accordingly, there is a major incentive to make decisions that will create value.³

Stock options are not, however, a cure-all, as the short-term vision they encourage may sometimes tempt management to conceal certain facts when disclosing financial information and, in extreme cases, they may even consider committing fraud. This has resulted in the development of alternative products, such as the granting of free shares, the payment of part of their compensation in shares, etc.

The principle of transparency also applies to transactions carried out by management in the shares of the company. These have to be made public due to the signals that they may give out.

Finally, in reaction to the payments made to managers who had failed (Thomson, UBS, etc.), which were, and rightly so, shocking in terms of both the amount and the principle, it is often recommended that these “golden parachutes” only be paid in the event of forced departure and linked to a change in control or strategy and for an amount that does not, in general, exceed one or two years’ salary. Sometimes this compensation is subordinate to performance conditions.

3. A one-tier or a two-tier board: an unresolved issue

The way in which power within the board is organised is, in itself, a much debated topic. The need for a body that is independent of the management of the company remains an open question. We can observe three main types of organisation:

• board of directors with a chief executive officer acting also as chairman of the board. This means that a great deal of power is concentrated in the hands of one person, who is head of the board and who also manages the company. This is known as a one-tier structure and is in place at groups such as ExxonMobil, Roche and Telefónica;
• board of directors with an executive or a non-executive chairman and a separate chief executive officer. This sort of dual structure has been adopted by Infosys, Sony and Vodafone;
• supervisory board and executive board: this two-tier structure is in place at Peugeot and Philips.

A board on which the control and management roles are exercised by two different people should, in theory, be more effective in controlling management on behalf of the shareholders. Is this always the case in practice? The answer is no, because it all depends on the quality and the probity of the men and women involved. Enron had a chairman and chief executive officer, and L’Oréal has a chief executive officer also acting as chairman of the board. The former went bankrupt in a very spectacular way as a result of fraud and the latter is seen as a model for creating value for its shareholders.

So it’s much better to have an outstanding manager, and possibly even compromise a bit when it comes to corporate governance, by giving the manager the job of both running the company and chairing the board, rather than to have a poor manager. Even if extremely well controlled by the chairman of the board, a poor manager will remain a poor manager!

An additional question arises when it comes to the choice of the chairman of the board: can he be the former CEO? Certainly not in the UK. If this were the case, the margin for manoeuvre of the new CEO would be restricted, as the chairman will be tempted to keep some kind of management role. The chairman is usually recruited from outside the company, and is often a former general manager of a company in another sector who will spend one or two days a week performing the job of chairman.

In France or Germany, for ⁷example, this is often the case, on the basis of the fact that the new chairman’s experience and knowledge of the company will be highly valuable. The split between the two functions often comes at the time of succession, so that the new CEO can prove his skills. Most of the time, the two functions are generally brought back together (Total), but there are exceptions (Sanofi).

It cannot be denied that great strides forward have been taken in the area of corporate governance, even if there is still progress to be made in some emerging countries with less experience in dealing with listed companies and minority shareholders. Associations of minority shareholders, or minority shareholder defence firms, which also provide shareholders with advice on how to vote in general meetings, have often acted as a major stimulus in this regard.

The fact that, in developed countries, many groups have simplified their structures has made this a lot easier:

• these days, it is usually only the parent company that is listed, which eliminates the possibility of conflicts of interest between the parent company and minority shareholders of its subsidiaries;⁸
• cross-holdings between groups which used to swap directors have been unwound;⁹
• assets used by the group but which belong to the founders have been apportioned to the group.

It’s now up to researchers to determine whether this simplification was the cause or the consequence of the spread of corporate governance.

1. Theory of markets in equilibrium

The classic theory is of little or no help in understanding corporate governance. What it does is reduce the company to a black box, and draws no distinction between the interests of the different parties involved in the company.

2. Agency theory

Agency theory is the main intellectual foundation of corporate governance. The need to set up a system of corporate governance arises from the relationship of agency that binds shareholders and managers. Corporate governance is the main means of controlling management available to shareholders. What corporate governance aims to do is to structure the decision-making powers of management so that individual managers are not able to allocate revenues to themselves at the expense of the company’s shareholders, its creditors and employees and, more generally, society as a whole.

Given the information asymmetry that exists between management and shareholders, corporate governance also covers financial communication in the very broadest sense of the term, including information provided to shareholders, work done by auditors, etc.

A good system of corporate governance, i.e. a good set of rules, should make it possible to:

• limit existing or potential conflicts of interest between shareholders and management;
• limit information asymmetry by ensuring transparency of management with regard to shareholders.

Unsurprisingly, agency theory shows that in firms where there are few potential conflicts of interest between shareholders and management and where information asymmetry is low, i.e. in small and medium-sized companies where, more often than not, the manager and shareholder is one and the same person, corporate governance is not an issue.

3. Entrenchment theory

Agency theory suggests mechanisms for controlling and increasing the efficiency of management. Entrenchment theory¹² is based on the premise, somewhat fallacious but sometimes very real, that mechanisms are not always enough to force management to run the company in line with the interests of shareholders. Some managers’ decisions are influenced by their desire to hold onto their jobs and to eliminate any competition.¹³ Their (main) aim is to make it very expensive for the company to replace them, which enables them to increase their powers and their discretionary authority. This is where the word “entrenchment” comes from. Managerial entrenchment and corporate governance do not make good bedfellows. But we live in a world that is less than perfect, and perhaps entrenchment is just a natural reaction on the part of management when corporate governance starts to play a major role in the firm.

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