Or on being politically correct
You may be surprised to find a chapter on corporate governance in a corporate finance textbook. Corporate governance is not, strictly speaking, a financial issue and is based on the legal considerations underlying the framework within which a company is run. However, as you may by now have come to expect, we approach the subject mainly from the angle of value. In other words, we attempt to find answers to the question “Will good corporate governance foster the creation of value and will poor corporate governance necessarily destroy value?”
Problems with corporate governance arise as a result of changes in the capital structure and organisation of companies. Corporate governance is not an issue for companies where the manager is the sole shareholder. But gradually the founding shareholder’s stake will be diluted and corporate governance issues will arise between the majority shareholder, who is also usually the manager, and minority shareholders. When a company starts out as family owned and evolves into a company with a fragmented shareholding of institutional and retail investors, new problems of corporate governance will arise. These will relate to control that the shareholders have over the managers, who will have less freedom as a result of the fragmented shareholding structure.
Broadly speaking, corporate governance is the organisation of the control over, and management of, a firm. It covers:
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.
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:
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:
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.
Corporate governance codes all recommend that a firm’s corporate strategy be defined by a body (board of directors or supervisory board) which enjoys a certain degree of independence from management.
Independence is achieved by limiting the number of managers who sit on the board, and by setting a minimum number of independent directors.
For example, in the UK the latest recommendation is that at least half of the directors of listed companies should be independent. There are very few companies with no or hardly any independent directors on the board.
The definition of the term “independent director” is the subject of much controversy. As an example, the Bouton report defines an independent director as follows: “Directors are independent when they have no link of any nature whatsoever with the company, the group or management, which could compromise them in the exercise of their free will.” Even though this definition makes it clear that a member of management or a majority shareholder representative would not be considered independent, it allows for a great deal of leeway, which means that deciding whether or not a director is indeed independent is not as easy as it might appear.
The importance given to the need for independent directors on the board tends to overshadow the importance of other more vital matters, such as their competence, their availability and their courage when it comes to standing up to management. These qualities are indispensable throughout the financial year, whereas their independence only becomes an issue in situations of conflict of interest, which fortunately are the exception rather than the rule.
The importance of independent directors is highlighted by the appointment of an independent director to the position of vice chairman of the board or lead independent director (Nike, GSK, Danone, etc.), which is now common practice at most listed large European and American groups.
Lawyers will surely forgive us for pointing out that the development of corporate governance has brought an end to the idea of the board of directors as an entity invested with the widest of powers, authorised to act in all circumstances in the name of the company. This gives the impression that the board was responsible for running the company, which was quite simply never the case. This erroneous idea put management in a position where it was able to call all of the shots. These days, boards are designed to determine the direction the company will take and to oversee the implementation of corporate strategy. This is a much more modest mandate, but also a lot more realistic. The board is asked to come up with fewer but better goods.
Corporate governance codes insist on the creation of special committees which are instructed by the board to draw up reports. These committees generally include:
It is clear that anything that stands in the way of the exercise of shareholder power will be an obstacle to good corporate governance. Such obstacles can come in various forms:
On the other side, making it compulsory for institutional shareholders to vote in general meetings of shareholders, or allowing shareholders to vote without having to freeze their shares a few weeks before the meeting, can clearly improve voting habits and enhance shareholder democracy.
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:
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:
It’s now up to researchers to determine whether this simplification was the cause or the consequence of the spread of corporate governance.
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.
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:
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.
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.
An initial response to the question “Does good corporate governance lead to value creation?” is provided by a survey of institutional investors carried out by McKinsey.14 The investors surveyed stated that they would be prepared to pay more for shares in a company with a good system of corporate governance in place. The premium investors are prepared to pay in countries where the legal environment already provides substantial investor protection is modest (12%–14% in Europe and North America), but very high in emerging countries (30% in Eastern Europe and Africa).
The very large number of studies on the subject focus on the problem of coming up with a definition of good corporate governance. Existing studies merely rely on ratings provided by specialised agencies to back up their conclusions, which in our view provides no new insight into the subject.
Their results15 show that good corporate governance does lead to the creation of shareholder value. Bauer, Guenster and Otten have shown that the shares of groups listed on the FTSE 300 that were given a good rating for their corporate governance (by the agency Deminor) performed significantly better than groups with “weak” corporate governance. These results tie in with results for US companies put forward by Gompers.
The results are all the more revealing when one considers that local law does not guarantee satisfactory corporate governance. For example, it would appear that a Russian group that adopts (and communicates) an efficient system of corporate governance will create value (Black).
More generally, Anderson and Reeb in the USA and Harbula in France have shown that the financial performance of companies with one main shareholder (for example, a family) is better than average. But the best-performing companies are those with one major shareholder and also a fairly large free float. Ideally, the main shareholder should hold a stake of between 30% and 50% in the company’s share capital. This may seem counterintuitive, in as far as family-owned companies are generally less transparent and comply less willingly with the rules of corporate governance.
On the other hand, majority or dominant shareholders are very motivated to ensure that their firms are successful, given that such firms often represent both the tools of their trade and their entire fortune! This is the reason why the only French company that declined to bid in the auction for UMTS licences at the height of the Internet boom was a family-owned company (Bouygues), reticence that clearly paid off as far as its minority shareholders were concerned. The minority shareholders of Orange (a state-controlled company at that time) and Vivendi (a widely held company) probably wish that their managers had been a little less gung-ho!
We can thus see that there are limits to the systemisation of corporate governance, even though compliance with a certain number of basically simple, common-sense rules16 will help prevent disreputable behaviour on the part of managers and the inequitable treatment of minority shareholders.
To conclude, we shouldn’t lose sight of the fact that it is too soon to say whether the introduction of recent innovations in terms of corporate governance have really made a difference. Research focuses mostly on the correlation between good corporate governance and high valuations. Very few studies have been able to demonstrate any real correlation between corporate governance and the long-term financial performance of the company. But then nobody has shown that corporate governance has a negative impact on financial performance either!
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