Long-term stability of European companies could be achieved by a rigorous reroute from the current European Commission’s proposal for encouraging shareholder engagement.
Name: Sarah Herzet Date: July 2015
Long-term stability of European companies could be achieved by a rigorous reroute from the current European Commission’s proposal for encouraging shareholder engagement.
Name: Sarah Herzet Date: July 2015 Address:
Telephone: E-mail:
Table of Contents
1. Introduction ... 4
2. Shareholder Engagement ... 7
2.1 Proposal to amend Shareholder Rights Directive ... 8
2.2 Short-termism and excessive risk taking ... 9
2.3 Comply or Explain ... 11
3. Alternative 1: Shareholder Activism ... 12
3.1 Shareholder activism ... 14
3.2 Corporate response to shareholder activism ... 16
3.3 Social shareholder activism ... 17
4. Alternative 2: Responsibility of the board of directors ... 19
4.1 Board Structures ... 20
4.2 Remuneration ... 21
4.3 Evaluation of board performance ... 23
5. Recommendation ... 24
6. Conclusion ... 26
1. Introduction
The financial crisis has left Europe in need to review her legal and regulatory framework for dealing with market abuse and regulatory measures that were exposed as deficient by the crisis,1 which are contributing to the demise of a strong and successful single market. Corporate governance will play a key role in rebuilding people’s trust in the single market and is classified as a system by which companies are directed and controlled2 and focuses on the relationship between a company’s management, its board, its shareholders and its other stakeholders3. The European Commission deemed the crisis to be commanding a climate of uncertainty, and led to increased risk aversions, market failures, reduced investor confidence, and an inclination towards high liquidity.4
To tackle these issues the Commission released two Green Papers (“Corporate Governance in Financial Institution” 5 and “the European Corporate Governance Framework”6) where stakeholders were consulted to determine what they consider to be the most important and pressing issues to be tackled at European level.7 The Commission’s 2011 Green paper seeks to evaluate the effectiveness of the existing corporate governance framework and deems three subjects to be ‘at the heart of good corporate governance’: the board of directors, shareholder engagement, and the application of the ‘comply or explain’ approach.8
Based on these Green Papers and further analysis the Commission has set up an action plan that describes ‘effective, sustainable shareholder engagement’ as one of the cornerstones
1
Tomasic R., Folarin A., Towards a New Corporate Governance after the Global Financial Crisis (July 25, 2011). International Company and Commercial Law Revies, No. 8, p. 237-238
2
Report of the Committee on the Financial Aspects of Corporate Governance (The Cadbury Report), 1992, p. 15, accessible at http://www.ecgi.org/codes/documents/cadbury.pdf. 3
OECD Principles of Corporate Governance, 2004, p. 11, accessible at http://www.oecd.org/dataoecd/32/18/31557724.pdf.
4
Communication from the Commission to the European Parliament and the Council on Long-Term Financing of the European Economy COM(2013)0462
5
COM (2010) 284 final 6
European Commission, Green paper: The European Corporate Governance Framework COM (2011) 164 final
7
COM (2014) 213 final, p 2 8
European Commission, Green paper: The European Corporate Governance Framework COM (2011) 164 final, p 3
of corporate governance for listed companies.9 In order to achieve the best corporate governance regime the plan announces a number of initiatives, amongst others, a proposal to revise the Shareholder Rights Directive.10
The 2007 Shareholder Rights Directive11 expressly states that effective shareholder control is a prerequisite to sound corporate governance and should, therefore, be facilitated. Its declared objective is ‘to strengthen shareholders’ rights, in particular through the extension of the rules on transparency, proxy voting rights, the possibility of participating in general meetings via electronic means and ensuring that cross-border voting rights are able to be exercised’.12
The overarching objective of the current proposal to revise the Shareholder Rights Directive is to contribute to the long-term sustainability of European companies.13 The proposed directive contains a double set of requirements addressed on the one hand to the institutional investors14 and on the other to the asset managers. The Commission has put emphasis on institutional investors since they hold most of the capital of listed companies and are most meaningful when it comes to shareholder engagement.15 These investors are expected to develop an engagement policy aimed at improving the performance of their equity portfolio and to undertake specific actions listed in the proposal. Institutional investors should disclose how their investment strategy corresponds to their liabilities and contributes to the performance of their assets.16
Institutional investors rely for the largest part on portfolio diversification when it comes to investing in shares in listed companies. Better known as the Modern Portfolio Theory (MPT), which provides a mathematical forecast of expected returns, on the basis of historical trading data. The Organisation for Economic Co-operation and Development (OECD) noted, that in the countries affiliated with the OECD, pension funds, investment
9
European Commission, Action Plan: European company law and corporate governance – a
modern legal framework for more engaged shareholders and sustainable companies (2012)
section 3. 10
European Commission, Proposal for a Directive of the European Parliament and of the Council amending Directive 2007/36/EC as regards the encouragement of long-term shareholder engagement and Directive 2013/34/EU as regards certain elements of the corporate governance statement, Brussels 9.4.2014 (COM2014) 213 final.
11
Directive 2007/36/EC 12
M. Belcredi, G. Ferrarini , Board and shareholders in European listed companies. p.323 13
COM (2014) 213 final. p. 2 14
Article 1, amending the shareholder directive, article 2 (f). 15
J. Winter, Shareholder engagement and stewardship, The realities and illusions of
institutional share ownership. P. 3
16
funds and insurance companies have in the last decade more than doubled their total assets under management to USD 73.4 trillion in 2011 with public equity being the single largest asset class.17
Since the aim for the proposed directive is to facilitate a change in the current business environment a paradigm shift needs to be obtained. Still the proposal is yet another attempt from the Commission that will probably not last due to the lack in determination and vision. In order to achieve a paradigm shift the gloves need to come of.
To find a way in which long-term stability can actually be accomplished a few questions need to be answered. Starting with the research question: Long-term stability of
European companies could be achieved by a rigorous reroute from the current European Commission’s proposal for encouraging shareholder engagement. The first chapter will focus
on the level of shareholder engagement as the Commission wishes to see it and challenge this view. Furthermore we will discuss two alternatives on how to achieve long-term stability of European companies. Shareholder activism will be the first alternative to be presented. Secondly, through enhancing the responsibilities of the board of directors. In the end a recommendation will be made as to which alternative will have the best outcome to facilitate long-term stability.
The methodology used in order to answer the aforementioned research question and sub questions, is a traditional literature research. This research includes an analysis of primary sources such as legislation, official policy documents, as well as secondary sources. In the first chapter, legislation and proposals have been consulted in order to ensure an up to date discussion on shareholder engagement. In the second and third chapter, secondary sources such as books, articles and research papers are primarily used to define difficulties in the current economic situation and probable solutions as to solve the problem. The modern views on good corporate governance and the existing European framework will be used throughout this thesis. There is no need to analyse the entire corporate governance structure, only the provisions which are important in light of the discussion surrounding the research question. This analysis ends with a conclusion that puts together the entire analysis on ways to establish the long-term stability of European companies.
17
S. Çelic & M. Isaksson ‘Institutional investors as Owners: Who Are They and What do They Do?’ OECD Corporate governance working papers, No. 11 (2013), OECD Publishing, p. 9-11
2. Shareholder engagement
Following the Shareholder Rights Directive18 it has been suggested in the literature that the Commission should increase shareholder protection in order to restore trust in capital markets.19
The proposal aspires to enhance the level of communication between shareholders and the board of directors. The positive effect envisioned with this proposal will be for investors’ to provide better risk and resource allocation in the economy as a whole and a strengthening of corporate governance in particular.20 Corporate governance is taken as an implicit promise that, once the proper decision-making processes are in place, external regulation of corporate action will become increasingly superfluous, as corporations will be best positioned to govern themselves.21
In the modern economic theory on the agency conflict, the shareholders are ‘residual claimants’, given that shareholders bear the ultimate economic risk of the enterprise and only receive return after all creditors have been paid. Therefore shareholders have the best incentive to take decisions about the company’s objective and strategy.22
However, studies suggest that boards and shareholders have differing perspectives regarding what constitutes effective engagement as well as what constitutes a successful engagement. These differing perspectives create the potential that shareholder engagement could produce negative results. Ineffective engagement could increase shareholder frustration and disconnect with corporate officers and directors. This is particularly true if shareholders have no desire for true engagement, but instead want to use interacts with directors to advance their own personal agenda, or otherwise act as a corporate gadfly.23
18
Directive 2007/36/EC of the European Parliament and of the Council of 11 July 2007 on the exercise of certain rights of shareholders in listed companies.
19
ibid, p. 203 20
G. Schaeken Willemaers. The European call for more shareholders’ engagement: state of play and forward. In: revue trimestrielle de droit financier, Vol. 4, no. 4, (2011) p. 164 21
M. Pargendler, The Corporate Governance Obsession (February 4, 2015) p. 6 22
F.J. Easterbrook, D.R. Fischel, The Economic Structure of Corporate Law, Harvard University Press 1991, p. 67-70
23
Nevertheless, with the current amendment in place we will look whether these rules have really profited shareholders with a strong voice in the corporate governance of public companies.24
2.1 Proposal to amend Shareholder Rights Directive
The aim of the proposal is ‘to contribute to the long-term sustainability of European companies, to create an attractive environment for shareholders and to enhance cross-border voting by improving the efficiency of the equity investment chain in order to growth, jobs creation and EU competitiveness’.25 The lack of a ‘long-termist’ view amongst shareholders is believed to be a fundamental contributing factor to the financial crisis.26
The proposal comprises recycled ideas, especially the notion that European markets focus on short-term gains is maintained by mass media, policy makers, and the general public. Yet in research it shows that both short-termism as long-termism can cause distortion and no evidence proves one prevails over the other.27
The main principles and components of corporate governance are as follows: protection of shareholder rights: equal treatment of minority and foreign shareholders, considering their interests, disclosure of publicly required information and responsible boards. The focus is on knowledgeable and capable boards, independent directors and gradual rotation of board members. Corporate social responsibility is among the priority as well. In some jurisdictions principles are prescribed by law, in others the above principles and codes for corporate governance determine mechanics.28
The Commission proposes a requirement for institutions to develop a policy for shareholder engagement, to disclose potential or actual conflicts of interest that might interfere with this aim, and to publicly present how the policy is implemented and what the
24
P.E. Masouros, ‘Is the EU Taking Shareholder Rights Seriously?: An Essay on the
Importance of Shareholdership in Corporate Europe’ (2010) 7 European Company Law 195, p. 196
25
COM (2014) 213 final. p. 2 26
R. Ufland, M. Morrison, D. Antao, new proposals to amend shareholder rights directive p. 1 (http://lexology.com/library/detail.aspx?g=2128d4cb-e4f7d-af81-5666dc91a9173?
27
T. Strand, Re-thinking Short-termisms and the Role of Patient Capital in Europe: Perspectives on the New Shareholder Rights Directive, (March 8, 2015) p.55 (see also J. A. McCahery and E.P.M. Vermeulen, The ‘Ignored” Third Dimension of Corporate
Governance, ECGI – Law Working Paper No. 235 (2014))
28
B. Boeva, Corporate Governance and its European Dimensions: Current trends and perspectives. P. 7
results are. In addition, institutions will be required to publicly disclose how their investment strategies are aligned with the duration of their liabilities, and how this contributes to long-term performance of the corporations. If asset managers are used, they will be required to disclose to the institution how investment decisions contribute to long-term performance in line with the same requirements that apply to institutional investors.29
Furthermore, authors have investigated how willing companies are to enhance shareholder engagement. It turns out that there is little sympathy with greater shareholder empowerment as a part of regulatory response to the financial crisis.30 However, it is clear that there is need for a paradigm shift in investor cultures. These days’ institutional investors often outsource their investment decisions to external asset managers.31 These asset managers, if ‘pushed by regulation and cost that require or expect such engagement they will at best engage at what I call a compliance level: engaging because and to the extent they have to.’32
The culture remains that most institutional shareholders are interested in returns on investment, which is monitored via the market share-price index, without need of engagement in the internal governance of the company. There is need to revert to a culture that focuses on the long-term sustainability of companies rather than short-term value gains where one puts large sums into enterprises they believe in.33 Especially since share prices will drop if governance or risk management standards are low because investors will sell their shares or refrain from buying.
2.2 Short-termism and excessive risk taking
Before the 2008 financial crisis, investor culture had shifted from long-term to a short-term orientation. High returns are at the core of investing, institutional investors base their decisions on risk assessment. Diversified portfolios provide higher returns than less well-diversified portfolios. Risk distribution results in risk reduction without sacrificing expected
29
T. Strand, Re-thinking Short-termisms and the Role of Patient Capital in Europe: Perspectives on the New Shareholder Rights Directive, (March 8, 2015) p.26 30
F. William W. Bratton and Michael L. Wachter The Case Against Shareholder Empowerment,, University of Pennsylvania Law Review Vol), pp. 653-728 31
J. Winter, ‘Shareholder Engagement and Stewardship: The Realities and Illusions of Institutional Share Ownership’ (2011) 5, at <http://ssrn.com/abstract=1867564> 32
Winter, op. cit., n. 61, p. 8 33
J. Mukwiri and M. Siems, The Financial Crisis: A Reason to Improve Shareholder Protection in the EU? Journal of law and society, Volume 41, N. 1, 2014, p. 64
returns.34 Nevertheless it has been shown by the crisis that the mathematical forecast that is brought with the MPT for example, could differ from reality. All other circumstances such as strategic moves, social or other factors are left out of the equation. Without these circumstances in the equation one can never manage their risks effectively. Still the MPT is at the core of investing, it is embedded into every aspect of investment. There are however rules set into place to maintain certain standards when it comes to investing. For example, the ‘prudent-person’ rule as described in the European Pension Directive.35
This Directive requires pension funds to pursue an investment policy that is in line with the prudent person rule, which entails that the security quality, liquidity, and profitability of the portfolio as a whole is to be safeguarded and the assets should be properly diversified so that an excessive reliance on certain assets or a particular issuer or group of undertakings and risk accumulation in the portfolio are avoided.36
Asset managers often focus on share-price movements and the structure of capital market indexes. This strategy has led to sup-optimal returns for the end beneficiaries of institutional investors and puts short-term pressure on companies.37 Shareholders who give asset managers a free pass to do as they please, within the borders of their assignment, do not consider investing in ‘shareholder engagement’ as beneficial and will not actively monitor individual companies, entering into dialogues with the relevant company boards and exercising their own voting rights. This in turn will lessen the results of effective shareholder engagement.
The UK Financial Reporting Council (FRC) has recently identified the following barriers to shareholder engagement: lack of resources, limited influence as a result of the size of a holding, concerns over acting in concert and being made insiders, differing opinions among portfolio managers and shareholders, and lack of client demand.38
In the Green Paper on Corporate Governance, the European Commission found ‘evidence that the majority of shareholders are passive and are often only focused on short-term profits’.39 Short-term investors hardly engage with corporate governance for greater
34
David. F. Swensen, Pioneering Portfolio Mangement, an Unconvential Approach to Institutional Investment, The Free Press, 2000, p. 62
35
Directive 2003/41/EC 36
Article 18 of the European Pension Directive 2003/41/EC 37
T. Strand, Re-thinking Short-termisms and the Role of Patient Capital in Europe: Perspectives on the New Shareholder Rights Directive, (March 8, 2015) p. 4. 38
FRC Corporate Governance and Stewardship Report 2011, supra n. 12, p. 26 39
European Commission, ‘Green paper: The EU corporate governance framework’ (COM (2011) 164 final). P. 3
sustainability. We can assume that since the financial crisis this short-term investor culture has not changed. Most shareholders of large public companies hold their shares to maximize their financial return.40
2.3 Comply or explain
The ‘comply-or-explain’ method entails that a company is to comply with a code’s provision; but if the company does not do so, then it is to state that it does not comply-and-explain why it does or will not comply with the aforementioned provision. The aim of comply-or-explain is to empower shareholders to make an informed evaluation as to whether non-compliance is justified, given the company’s circumstances. In addition, the comply-or-explain mechanism relies on the market expressing itself through price. The idea is that companies with inadequate governance or which publish low-quality explanations of deviations from certain corporate governance standards will be sanctioned by a lower share price.41
Companies could, through a governance report, ensure compliance with current regulation and evaluate whether all the standards are maintained. However, since there is only a need to explain that non-compliance is justified without demanding further explanations, these reports are therefore often of low-quality. Conducive to the formulation of a new regime the Commission has conducted a study on the effectiveness of the comply-or-explain mechanism, which they concluded does not appear to have worked effectively. The empirical finding is that less than half of explanations can be qualified as sufficiently informative.42 Low-quality governance reports enhance the idea that there is a standard of low-level shareholder engagement. It seems that companies would pay more attention to their governance regimes, and the reports explaining these regimes, if shareholders were more engaged as regards governance and risk management.43 At the moment it seems that the Commission has wilfully left the option for comply-or-explain open as a way out for shareholders.
40
J. Payne, ‘Minority shareholder protection in takeovers: A UK perspective (2011)
European Company and Financial Law Review 145, p 163
41
E. Mecheler – Facilitating Investor Engagement and Stewardship p. 33 42
RiskMetrics Group, Study on Monitoring and Enforcement Practices in Corporate
Governance in the Member States, contract no. ETD/2008/IM/F2/126, 23 September 2009, at
p.173 available at <http://ec.europa.eu/internal_market/company/ecgforum/studies_en.htm> (accessed 12 December 2012)
43
We have also seen a predecessor of the proposed amendment in the UK, in the form of the UK Stewardship Code (the Code). The Code aims to ‘enhance the quality of engagement between institutional investors and companies to help improve long-term returns to shareholders and the efficient exercise of governance responsibilities. The Code set out good practice on engagement with investee companies to which the FRC believes institutional investors should aspire…’.44 The Code operates on a voluntary basis were institutional investors are free to apply it. The Code would work better if it were supported by a mechanism that enabled and encouraged institutional investors to show their commitment to responsible engagement. The Code is currently supported by a comply-or-explain mechanism, which, by its very nature, as previously stated, is limited in effect.45
As far as the effectiveness of comply or explain goes, there are two main problems that are standing in the way of its true value. First, there is a lack of shareholder engagement with the principle of comply or explain. As this principle is based on the notion that shareholders will be the ones who monitor board compliance with code provisions and, if they do not comply, shareholders are to ensure that the board provides adequate explanations for deviating. Secondly, statements by companies that are designed to explain why the company has not complied are often very brief and uninformative.46
3. Alternative 1: Shareholder activism
This chapter examines the possibility of shareholder activism as a tool to support a stable market. The Commission has touched this subject in their proposal but neglected to define the term ‘active ownership’, it could mean a weak form of shareholder activism or it could refer to strong engagement. However, by not defining the way forward, the Commission has once again left too much for the imagination.47
Shareholder activism is known in two different forms. First, there is the corporate governance related activism that centres on issues such as board structure, takeover defences, compensation, and political, social and environmental concerns. The second is
44
UK Stewardship Code 45
E. Micheler, facilitating investor engagement and stewardship EBOR 14, 2013, p. 33 46
A. Keay., Comply or explain in corporate governance codes: in need of greater regulatory oversight? Legal studies, p. 303
47
T. Strand, Re-thinking Short-termisms and the Role of Patient Capital in Europe: Perspectives on the New Shareholder Rights Directive, (March 8, 2015) p. 26
related or economically motivated activism and aims to fundamentally alter the destiny of a corporation.48
Shareholder activism has a specifically negative connotation. Nonetheless, shareholder activism gained popularity around the world during the past several years. In fact it could help to improve corporate performance by stirring up much-needed debate about strategy and leadership, just as in democracies the government of a country is improved by the existence of an effective opposition.
At one extreme, shareholders can simply vote with their feet by selling their shares. At the other extreme is the market for corporate control, where investors initiate takeovers and buyouts to bring about fundamental corporate changes.49
Shareholder activism can be defined to include any action(s) of any shareholder group with the purpose of bringing about change within a public company without trying to gain control.50 Even though shareholder activism has been a feature of corporate governance for over one hundred years, only recently have all the pieces come together for shareholder activism to become a powerful force in corporate governance. These pieces include the growing dominance of institutional investors in the investment of publicly held stock, helping to reduce investors collective action costs; the shift from managerial capitalism to shareholder-centric capitalism, such that the board of a public company now feels an increased need to respond to shareholder demands.
The types of activism engaged in by institutional investors differ from hedge funds for instance. Where hedge funds tend to engage in what they term “offensive shareholder activism, which is typically event-driven: the offensive activist agitates for change at the company, seeking to squeeze out value that, in the view of the activist may be locked up in a subsidiary. In contrast, some large institutional investors engage in “defensive” activism. The defensive activist monitors the firm not to seek ways to force value-creating changes, but to prevent losses from mismanagement. A short conclusion to be that offensive activism is designed to produce wealth in the short to medium term. Defensive activism is designed to
48
D.A. Katz and L.A. McIntosh, “the mainstreaming of shareholder activism in 2013”, New
York Law Journal, September 26, 2013. P, 2
49
Gillan, S. and L. Starks 2007. ‘The evolution of shareholder activism in the United States’,
Journal of applied corporate Finance 19; 55-73.
50
Rose, Paul and Sharfman, Bernard S., Shareholder Activism as a Corrective Mechanism in Corporate Governance (November 9, 2014). Brigham Young University Law Review, Vol. 2014, No. 5, 2014; Ohio State Public Law Working Paper No. 225. p. 103
protect wealth in the long term. 51 Shareholder activism can be accompanied by certain aggressive actions that lead companies in a defensive mode. Offensive shareholder activists are proactive while defensive shareholder activists are reactive. Moreover, offensive shareholder activists provide additional information to the corporation and the marketplace in the form of recommended changes to corporate strategy.52
Offensive shareholder activism often serves as a corrective mechanism and thus results in a legitimate sharing of authority on a discrete basis. The traditional understanding of shareholder activism is that it is a tool of accountability used to minimize agency costs. Alternatively, the cause for activism could be a lack of good decision-making ability on the part of the board and executive management as a group or in their respective capacities. The real thrust of offensive shareholder activism is to challenge board decision-making when it is not maximizing shareholder wealth.53
Offensive shareholders focus on the short-term, while defensive shareholders put their orientation on the long-term. The law should however facilitate both forms of activism, since the combination of the two forms will aid a strong and agile market.
The Commission’s proposal, to some extent, alters the setup by imposing requirements on certain investor categories that in practice removes their option to abstain from active engagement, even in the case that the investor considers abstention to be most efficient.
3.1 Shareholder activism
Not only can we differentiate between the types of activism engaged by institutional investors we can also separate between private actions and public moves. Private activism is obviously unobservable and can take many forms like private negotiations with management and the board of directors. It is also called “quiet diplomacy”. Public activism includes, openly talking to other shareholders, calling meetings and – ultimately – seeking to replace individual directors of the entire board.54
51
Rose P., Sovereign Shareholder Activism: How SWFs Can Engage In Corporate
Governance. P.3
52
Rose, Paul and Sharfman, Bernard S., Shareholder Activism as a Corrective Mechanism in Corporate Governance (November 9, 2014). Brigham Young University Law Review, Vol. 2014, No. 5, 2014; Ohio State Public Law Working Paper No. 225. P.120
53
Ibid, p. 122 54
C. Van der Elst, The corporate response to shareholder activism, ERA Forum, July 2014, Volume 15, Issue 2, P. 233
Shareholder activists use their right to introduce and vote on resolutions at companies’ annual general meetings to try to make them change their policies on certain social or environmental issues or engaging in dialogue with corporate managers, sending out press releases.55 Writing letters to them directly, to set up meetings with them or to simply go to their corporate headquarters and try to talk to them, could start the direct dialogue with corporate managers or directors. Since activist shareholders have certain powers because of their equity stake in the company they can take corporations to court. Corporate law allows the stockholder legal recourse if he believes that management’s practices is ultra vires, negligent, illegal, fraudulent or involve a clear abuse of discretion.56 Managers would not listen if their threats are not backed up by some kind of real power, shareholder activists’ campaigns are much more likely to achieve their goals if forces outside corporations are used to put pressure on these companies.57 We should probably concede that any successful activist campaign on the part of an investor is likely to both extremely time-consuming and quite costly. This in turn could spark the long-term investment we so long for, or even stop it from happening.
Nevertheless, there are risks involved when activists pressure. It can cause the companies to focus on short-term results, which is exactly what we want to prevent. However, all shareholders, whether they have a short- or long-term investment horizon, value shares that have significant liquidity. That is, all shareholders want to have the ability to sell their shares at a moment’s notice at the maximum price possible.58
The Commission’s proposal risks undermining the only institutional activism found to be somewhat successful – private negotiations. Requirements to make information on monitoring activities publicly available could have a negative effect on institutional as well as corporate willingness to engage in this type of activism.59 The commissions aim is to increase dialogue, the effects of the proposal risk doing the opposite. Moreover, the transparency
55
Sandberg J., Changing the world through shareholder activism?. Etikk I praksis – Nordic Journal of Applied Ethics, North America, 5, may 2011, p 52
56
C. W. Powers, Social Responsibility & Investments. Nashville: Abingdon Press. 1971, p 107
57
Sandberg J., Changing the world through shareholder activism?. Etikk I praksis – Nordic Journal of Applied Ethics, North America, 5, may 2011., p 71
58
Rose, Paul and Sharfman, Bernard S., Shareholder Activism as a Corrective Mechanism in Corporate Governance (November 9, 2014). Brigham Young University Law Review, Vol. 2014, No. 5, 2014; Ohio State Public Law Working Paper No. 225. P.128
59
T. Strand, Re-thinking Short-termisms and the Role of Patient Capital in Europe: Perspectives on the New Shareholder Rights Directive, (March 8, 2015) p.29
requirements can create perverse incentives for activists to politicize voting to extract private benefits in the competition for new customers.
Research on liquidity shows that better liquidity improves firm value, provides stability, lowers the price impact of block holders’ trading, increases market efficiency in incorporating information about long-term projects, allows activist investors to purchase more shares, increases the quality of governance, and implicitly also makes the CEO’s incentives more oriented toward the long term.60
There are two major barriers to institutional investors’ activism, free-riding, conflicts of interest giving rise to an agency cost. As the literature has identified, there are many sources of such conflict that could interfere with the ability of institutional investors to function as effective monitors of public corporations. This does not offer much of an incentive for active monitoring since the institutional investor itself, unlike its member-beneficiaries, would reap a very small proportion of the monitoring gains.61
There are considerable obstacles, but institutional investors have proven they can be active (albeit not proactive) some with the assistance of a third-party proxy. Some activism on behalf of institutional investors can be expected, but there are certain limitations. If they were to act in concert with other institutional investors, while guided by some third party they could be quite potent and aggressive.62
3.2 Corporate response to shareholder activism
Companies are guarding themselves against shareholder actions; those protective shields are already in place. One of the shields is the Enterprise Risk Management Integrated Framework63, which is often used to fill the need for the corporate response to shareholder activism. In order for directors to manage shareholder activism in an effective way, in the company’s best interest, they will have to ensure ‘internal control’.64
COSO defines internal control as “a process, effected by the entity’s board of directors, management and other
60
Ibid, p. 31 61
Hannes, S., Brave New World: A Proposal for Institutional investors. Theoretical Inquiries
in Law p. 250-251
62
Hannes, S., Brave New World: A Proposal for Institutional investors. Theoretical Inquiries
in Law p. 253
63
Collectively referred to as “COSO” framework. 64
C. Van der Elst, The corporate response to shareholder activism, ERA Forum, July 2014, Volume 15, Issue 2, pp 229-242 P. 240
personnel, designed to provide reasonable assurance regarding the achievement of objectives relating to operations, reporting, and compliance”.65
This risk management and internal control system to incorporate the risk of shareholder activism can be used to the advantage of the internal market. The system can ensure that the response to the actions of the activist will be in line with the disclosure rules. Shareholder activism addresses “managerial deficiencies”. Both shareholder activists as well as corporate executives identify financial underperformance as the main driver for shareholder action.66 Financial firms are so interconnected with the major players in every financial market around the world that problems with a single name could create dramatic spill over effects transforming almost immediately what would seem a specific risk in a very systematic turmoil.67
The Commission’s proposal risks to undermine institutional activism as private negotiations need to be made public. This forces companies to respond to shareholder activism since the requirements to make information on monitoring activities public will deter corporate willingness to engage out of fear of the possible consequence. Publicly visible activism should be the last attempt, when all other options have failed. With the aim to increase dialogue, and yet still expect full transparency, it could create incentives for activists to use this provision for an entirely different purpose; extracting private benefits in the competition for new customers. 68
3.3 Social shareholder activism
Social shareholder activism may be successful in enhancing the corporation’s sensitivity to stakeholder issues through improvements in the stakeholder governance mechanisms within the corporation. Societal pressures exerted by social shareholder activists are expected to induce changes, such as creating new boundary spanning roles to sense the social environment and to implement changes in order to conform to the societal expectations and norms. To preserve organizational legitimacy, companies create mechanisms to
65
Committee of Sponsoring Organizations of the Treadway Commission (COSO): internal control integrated framework, New York (May 2013)
66
C. van der Elst, “the corporate response to shareholder activism”, ERA 2014, p 237 67
P. Gottardo, A.M. Moisello, The Fragmentation of Entrepreneurial Function and the Role of External Control on Management Behaviour. P. 341
68
T. Strand, Re-thinking Short-termisms and the Role of Patient Capital in Europe: Perspectives on the New Shareholder Rights Directive, (March 8, 2015) p.28
demonstrate their commitment to a cause. The process of social shareholder activism through filing social resolutions is closely related to organizational legitimacy, and the process of social shareholder activism aids corporations to engage in socially responsible practices.69
The focus of shareholder activism lies on the direct impact of proposing and voting on resolutions. According to some writers, filing and voting on resolutions can have considerable indirect, or social effects.70 Even though there is no real chance of the resolutions’ passing there is still the possibility of managers and directors to be hypersensitive to the threats of exposure which such acts are thought to consist of.71
In theory considerations suggest that it would be unimaginable that companies would hire managers who are highly susceptible to the whims of the smallest group of people. The central aim of managers has not changed, maximizing the share prize and maximize shareholder wealth will continue to be at the core of the economic theory. Even though managers are people, and as such, prone to outside influence and in no way economically rational, it is still their job to stay rational. So although it is irrational for them to pay attention to possible threats of exposure from social investors, it is still possible to rattle them if the threats in fact are backed up with some kind of real power.72
Institutional investors need to put their big panties on and become shareholder activists. Even though institutional investors are very much like large companies where they have managers who are hired on the basis of their leadership skills and their understanding of economics and finances. These managers are expected to live up to certain economic goals; they have beneficiaries who expect a certain return on their assets and so forth. In fact, institutional investors may even be more bound to the goal of maximizing profits than commercial companies. According to the so-called prudent man rule to explain why they refrain from engaging in shareholder activism on social and environmental issues.73
In order not to tarnish the reputation of the companies they invest in, institutional investors are more likely to approach members of the board directly in order to raise
69
Uysal, N., and Tsetsura, K. (2015), Corporate governance on stakeholder issues: shareholder activism as a guiding force. J. Public Affairs, 15, p 213
70
Sandberg J., Changing the world through shareholder activism?. Etikk I praksis – Nordic Journal of Applied Ethics, North America, 5, may 2011. P. 62
71
Sandberg J., Changing the world through shareholder activism?. Etikk I praksis – Nordic Journal of Applied Ethics, North America, 5, may 2011. p. 63
72
Sandberg J., Changing the world through shareholder activism?. Etikk I praksis – Nordic Journal of Applied Ethics, North America, 5, may 2011. P. 64
73
Sandberg J., Changing the world through shareholder activism?. Etikk I praksis – Nordic Journal of Applied Ethics, North America, 5, may 2011. P. 65-66
grievances than to resort to shareholder proposals or to vote against recommendations of the board.74
4. Alternative 2: Responsibility of the board of directors
Knowing that the financial crisis did not happen just because of corporate governance failure, causes additionally seem to lie in risk management, which is a question of judgment for directors, and not as such a question of shareholders’ role in corporate governance.75
Boards of directors lacked effective oversight of risk management. Corporate governance reports pointed out that failing financial institutions fell short of corporate governance best practices, such as the split in the positions of board chair and CEO.76 Other accounts called into question the role of institutional investors in monitoring firm risk and performance.77
The economic theory regarding the agency cost paradigm78 considers the shareholders as “residual claimants”, those who will bear the ultimate economic risk of the enterprise and only receive a return after all creditors have been paid. As residual claimants, shareholders have the best incentive to take decisions about the company’s objective and strategy.79 This leading theory can be the key issue that holds companies back from long-term stability. It might be time to change the balance and take away some of the shareholders influence and shifting the decision rights to the board of directors.
Decision rights, thus sent inside the organization, are split between two groups. The powers of initiation and implementation go to management. For this reason management is separated from residual risk bearing, with a main focus on agency-cost reduction. Given a complex business organization with knowledge diffusion, business decision-making should go to agents with relevant knowledge. At the same time, controls need to be imposed to protect residual claimants from expropriation by the managers. This second aspect of
74
Strätling, R. (2003. General Meetings: A dispensable tool for corporate governance of listed companies? Corporate Governance: An International revies, 11 (1), pp 74-82
75
J. Mukwiri and M. Siems, The Financial Crisis: A Reason to Improve Shareholder Protection in the EU? Journal of law and society, Volume 41, N. 1, 2014, p. 59 76
Millstein Ctr. for Corp. Governance & Performance, supra note 67, at 18 77
M. Pargendler, The Corporate Governance Obsession, October 2014, P. 25 78
Claire A. Hill and Brett H. McDonnell, The Agency Cost Paradigm: The Good, the Bad,
and the Ugly, 38 SEATTLE U. L. REV. 561 (2015). P.561
79
J. Winter, Shareholder engagement and stewardship, The realities and illusions of institutional share ownership. P. 2
cost reduction calls for having a separate decision controller to monitor and ratify management decisions. As a result, a board of directors that includes outsiders performs the monitoring function.80
4.1 Board Structures
Institutional investors have put pressure on incompetent directors and have been demanding enhanced disclosure of board practices. An indicator of the increased interest of other market parties in corporate boards is the rise of board rating tools and the scoring of boards as part of the broader corporate governance rating systems.81 In this respect there are three main characteristics frequently used in academic research, board size, board composition and board leadership structure.
The agency theory holds that managers will not act to maximise the returns to shareholders unless appropriate governance structures are implemented in the large corporation to safeguard the interests of shareholders.82 The board of directors has an important function in regards to agency theory and in particular the relationship between the chairperson and the chief executive officer is key. Shareholder interests will be safeguarded only where the CEO does not hold the chair of the board or where the CEO has the same interests as the shareholders through an appropriately designed incentive compensation plan.83 This dilutes the power of the CEO and reduces the potential for management to dominate the board.84 The owners are principals and the managers are agents and there is an agency loss which is the extent to which returns to the residual claimants, the owners, fall below what they would be if the principals, the owners, exercised direct control of the corporation.85
80
F. William W. Bratton and Michael L. Wachter , The Case Against Shareholder
Empowerment, University of Pennsylvania Law Review Vol. 158, No. 3 (February 2010), pp. 664
81
L.A.A. Van den Berghe and A. Levrau, Evaluating board of directors: what constitutes a
good corporate board?, vol 12 no 4 2004, p 461
82
M.C. Jensen & W.H. Meckling, Theory of the firm: managerial behavior, agency costs and ownership structure, Journal of Financial Economics, (1976) 3, p 305-360
83
L. Donaldson, J.H. Davis: Stewardship theory or agency theory: CEO governance and shareholder returns p. 50
84
L.A.A. Van den Berghe and A. Levrau, Evaluating board of directors: what constitutes a
good corporate board?, vol 12 no 4 2004, p 463
85
M.C. Jensen & W.H. Meckling, Theory of the firm: managerial behavior, agency costs and ownership structure, Journal of Financial Economics, (1976) 3, p 305-360
In order to have an effective working of the board, a company needs the right board structure, which needs s to be adapted to the stage of the company’s development and its strategy, that passes the test of the international and national corporate governance recommendations. Moreover there is a need for a high level of transparency of board issues and an appropriate structure of the board. Structures are no guarantee for an effective board working: they are only a facilitator.86
The current shift is taking place in board structure is that public companies have opted for boards that consist entirely of independent directors, with the CEO the only exception. The CEO typically serves as the chair of the board. Although appearing to benefit shareholders, the structure actually promotes the interests of the CEO by enhancing control over the information flow to independent directors and reducing the risk of board intervention.87 A board that consists of directors primarily selected for their willingness to reliably support management will consecutively let the benefits to shareholders fade away. The decision to exceed a percentage of two-third of the board consisting of independent directors is a choice made by management.88
More than once directors themselves have offered their views on what is considered to be a functional board. Where information, the quality of the discussion or debates, role of the chairman, the way the decisions are taken by the board of directors and engagement or involvement of the directors are viewed to be the most important factors in making the decision on what constitutes a good board.
4.2 Remuneration
For the first time a mandatory and binding ‘say on pay’ provision will be introduced in all member states.89 Say on pay mandate the requirement that companies periodically give shareholders the opportunity to cast a nonbinding, advisory vote on executive compensation. Justifying this rule based on the revelations following the financial crisis of exorbitant pay packages in the face of poor company performance. Listed corporations will be required to
86
L.A.A. Van den Berghe and A. Levrau, Evaluating board of directors: what constitutes a
good corporate board?, vol 12 no 4 2004, p 467
87
J. R. Brown, The Demythification of the Board of Directors, American Business Law Journal, volume 52, Issue I, spring 2015, p. 135
88
ibid p. 173 89
Described in detail through the newly inserted articles 9a and 9b of the Shareholder Rights Directive, supra note 1
publicly disclose their remuneration policies and to facilitate shareholder votes on remuneration proposals. Furthermore, the corporation should explain how the policy and remuneration levers serve the long-term interests of the shareholder collective and the sustainability prospects of the corporation.90
In the United States there has already been a movement following the crisis where non-binding provisions were introduced through the Dodd-Frank Wall Street Reform and Consumer Protection Act. The aim of the Act has not been achieved, after the act the say on pay provisions have increased. When shareholder approve, executives are exempted from legitimizing their compensation levels, this could be one of the reasons why it has not led to the initial goal. It has left the effectiveness of say on pay provisions to halt in growing inequity in uncertainty.91
The Commission has formulated the proposal and the objectives after consultations with market participants, in particular investors, and further analysis. Therefore the proposal probably will be welcomed. Member states however already see say-on-pay as an instrument to increase the level of shareholder engagement, but will this be enough?92
There are principles that describe the responsibilities of the board, foremost, that the executive and board remuneration with the long-term interests of the company and its shareholders should be aligned.93 In general there are performance-based remuneration policies designed to relate some portion of the salary to individual performance. However, these schemes are reactive since they do not provide a mechanism for preventing mistakes or opportunistic behaviour, and can elicit myopic behaviour. Research on the relationship between firm performance and executive compensation does not identify consistent and significant relationships between executives’ remuneration and firm performance. Not all firms experience the same levels of agency conflict, and external and internal monitoring devices may be more effective for some than others.94
90
T. Strand: Re-thinking Short-termisms and the Role of Patient Capital in Europe:
Perspectives on the new Shareholder Rights Directive, (March 8, 2015) p.31
91
T. Strand: Re-thinking Short-termisms and the Role of Patient Capital in Europe:
Perspectives on the new Shareholder Rights Directive, (March 8, 2015) p.35
92
T. Dijkhuizen. ‘On the Remuneration Of Directors of Listed Companies (Again)’,
European Company Law 11, n.4 (2014): 199-200
93
OECD Principles of Corporate Governance (2004) 94
Steven N. Kaplan, Executive Compensation and Corporate Governance in the U.S.: Perceptions, Facts and Challenges, Chicago Booth Paper No. 12-42, Fama-Miller Center for Research in Finance, Chicago, July 2012
Listed corporations will be required to publicly disclose their remuneration policies and to facilitate shareholder votes on remuneration proposals. The corporation should explain how the policy and remuneration levels serve the long-term interests of the shareholder collective and the sustainability prospects of the corporation.95 Executive compensation packages aim to curb agency problems. Still, remuneration has come to be perceived as an agency problem in itself.
Shareholders are also affected by competition in the executive work market. The shareholders’ perspective on this matter can be viewed as a prisoner’s dilemma where a silent agreement to keep endorsing excessive pay functions as the dominant strategy for the players. Attempts by any individual firm to lower CEO pay will make the shareholders of that firm vulnerable to shareholders from other firms that can approve higher executive pay to win the CEO over. Compensation levels therefore need to be kept at a certain level to prevent the corporation from losing the battle for competent management. Nevertheless shareholders lack the incentives and ability to make the critical business decisions that advocate a ‘say on pay’ provisions hope for. Consequently institutions prefer to delegate monitoring to the board and instead be protected by its fiduciary duties.96
4.3 Evaluation of board performance
One of the main principles and components of corporate governance are responsible boards. The focus is on knowledgeable and capable boards, independent directors and gradual rotation of board members. Ethical behaviour and integrity of board members is a must. Corporate social responsibility is among the priorities as well. In some jurisdictions principles are prescribed by law, in other the above principles and mechanism are determined by the laws and codes standards for corporate governance.97
Social connections between directors and management can support a functional and working board where the risk of needed intervention is reduced. Data show, that the existence of social connections can “undermine active monitoring of the firm” and is associated with negative performance, reduced reliability of reported earnings, greater risks of fraud, and higher levels of CEO compensation. Such boards are not likely to dismiss the CEO.
95
T. Strand: Re-thinking Short-termisms and the Role of Patient Capital in Europe:
Perspectives on the new Shareholder Rights Directive, (March 8, 2015) p. 31
96
Ibid, p. 35 97
B. Boeva, corporate governance and its European Dimensions: current trends and perspectives.
Management, therefore, has an incentive to, and regularly does, place directors from reliable categories on to the boards of public companies. Executive officers of other firms are among the most “sought after” category of independent directors.98
In the annual report of the company there needs to be a disclosure about a company’s board of directors. In theory the board is responsible regarding the shareholders and is supposed to govern a company’s management. To evaluate a board performance many use a checklist, which includes: the size of the board, the degree of independence, committees, and related transactions. If we change some of these standardized rules and regulations we might be able to augment our disclosure reports and simultaneously the effectiveness of the board in general. Where one would hope that the notion of a puppet master, the CEO of the company, influencing the board as he pleases will disappear. The disclosure reports need to be more flexible, if we let go of standardized rules and instead, make a guideline of what will contribute to a well rounded report we might be able to eliminate checklists and make room for more detailed and useful reports.
Board evaluation is therefore of the upmost importance. Managers who gain control over the company may have the potential to pursue actions that maximise their self-interest at the expense of the shareholders. The board of directors is one of the mechanisms designed to monitor these conflicts of interest.99 Boards need to act independently of management and should include outside directors, and furthermore need to implement a system where they evaluate themselves. In order for directors to become more driven for the company instead of being driven for the shareholders, they might be able to muster the intelligence and edge that will lead a company to its full potential.
5. Recommendation
The proposal has undermined its own intention. Even if institutional investors are interested in engagement, as it is proposed, as its suits their investment policy, the legal restrictions of public monitoring. There are two reroutes that will facilitate an actual change instead of adding to the already existing legal framework without changing it.
98
J. R. Brown., The Demythification of the Board of Directors, American Business Law
Journal, p.147-148
99
L.A.A. Van den Berghe and A. Levrau, Evaluating Boards of Directors: what constitutes a good corporate board? P. 463
First, facilitating shareholder activism. Despite the Commission’s well-intended efforts, the proposed revision falls far short of addressing the underlying causes of short-termism so as to prevent future crises. The current proposal relies exclusively on shareholders to drive the shift to a longer-term perspective. Especially after the financial crisis, there is no clear reason for this exclusive reliance on shareholders. Although shareholders have and should have specific rights in corporate governance, shareholders do not own companies. Some shareholders are committed to holding for the long-term, whilst others only hold for the short-term. It is important that the former group become more engaged; however, there is a danger that the proposed revision will further empower shareholders with a short-term orientation. For this reason, there is a need for further measures to complement the proposed revision and achieve the goal of a longer-term approach to corporate governance.100
Furthermore we have to keep in mind that dialogues are the least invasive form of activism, the current proposal eliminates the possibility of using this option. The transparency rules that are set into place will force shareholders to publicly state their actions; as such this undermines the intention of the provision. Legislation that forces public statements, even in the event where shareholders can achieve their goals through a lesser form of activism, should be avoided. Private negotiations have to be kept in tact.
In addition emphasis will have to be put on social shareholder activism. This form of activism may be successful in enhancing the corporation’s sensitive to issues at hand. Societal pressures can induce change. The economic climate has changed, where we now see the importance of good functional companies. Mass media announced that companies are looking forward to engagement and see the benefits, however, with the current proposed rules the standards are never to be accomplished. We should have confidence in shareholders and managers that they will contribute to sustainability with rules that guide them and give them room to let external elements be part of their business. The aforementioned proposal gives no room for interpretation of the economic climate. The rules are set into place and will have to stand the test of time, however, the economy is not comparable to a rigid rule, it needs to be agile. Shareholders will not want to tarnish the reputation of the companies they invest in, so they are more likely to approach members of the board directly rather than to resort to proposals and invest more time and money in educating themselves.
100
Johnston, Andrew and Morrow, Paige, Commentary on the Shareholder Rights Directive (December 8, 2014). University of Oslo Faculty of Law Research Paper No. 2014-41. Available at SSRN:http://ssrn.com/abstract=2535274
Second route will be to augment the responsibility of the board of directors. Directors need to be held accountable for the way their company is run. No longer should the emphasis be put on working for maximising value for shareholders, but with a mechanism that helps directors to see the importance of their actions. The United States started a movement with the Dodd-Frank Act concerning say on pay provisions might turn out has become rather bleak. The remuneration structures should be designed to reward long-term performance, say, by way of distributing shares to directors that they have to hold until they retire from their post.
Another indicator of the increased interest in corporate boards is the rise of board rating tools and the scoring of boards as part of the broader corporate governance ratings. If such a system is set into place we can actually capitalize on the boards instead of being dependent on somewhat uninterested shareholders.
A returning component is the social factor, here it might be the social connection between directors and management where they can support a functional board where the risk of needed intervention is reduced. Even though this system might undermine active monitoring of the firm, we can also say that there could be a positive result. If directors are held accountable by social connections and the need not to loose face, combined with a mechanism as board rating tools and the scoring of boards, we will be able to enforce responsibility from directors and force them to keep a sustainable company without stating every detail being stated by law. In this time and age it is important to remain agile and allow companies to do so too. If not, we might have another crisis on our hands.
6. Conclusion
The recent financial crisis has left an impact on the entire global economy. The main objective, in the investing world, is and will always be maximizing market value especially when they are concerned about the long-term survival. In Europe we have seen a tendency of improving the corporate governance framework in order to facilitate a more stable environment. However, the measures taken by the European Commission can be considered to be non-existing and will not adequately attend to sustainable European companies. The Commission is trying to implement measures that will result to no significant change. Each green paper, proposal, regulation or directive has the same ending so far: compliance. In order to restore clarity for companies amongst the regulations and create a sustainable market we need to change the approach. The Commission is bend on attacking the problem gently, with
care. However, the approach they should take is not gentle but firm and with an iron fist.
We cannot blame the financial crisis on corporate governance in itself, the causes seem to lie in risk management, which is a question of judgment for directors, and not as such a question of shareholders’ role in corporate governance. It is difficult to see how far simply giving more powers to shareholders could have averted the financial crisis. This thesis supports the objective of the proposed revision of the Shareholder Rights Directive in pursuance of long term sustainability of European Companies. Nevertheless, in order to achieve this goal we will have to focus on one of the other routes.
Furthermore even though the Commission has conducted a study on the effectiveness of the comply-or-explain mechanism, in which they already concluded it did not appear to have worked effectively. They still have left the option for comply-explain wilfully open. This takes the incentive away from the shareholder to actually put in the effort it takes to publish well-informed reports.
As it stands now, the measures proposed could impose burdensome obligations on companies and shareholders that will result in compliance at best. The much anticipated paradigm shift is yet to be achieved.
In sum, the gloves need to come off.
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