Corp Gov Europe Paper

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European Corporate Governance:

A Changing Landscape?

MIT Sloan School of Management 50th Anniversary Research ProjectOctober 2002 Celebrations

Authors:Giovanni Carriere, Andrew Cowen, Jose Antonio Marco, Donald Monson,

Federica Pievani, Tienko Rasker

We would like to thank Professor Stewart C. Myers for his support to our

research and for his coordination work. Special thanks also go to his assistant.

Gretchen Slemmons, a behind the scenes leader.

This work would not be the same without the opinions and suggestions of all

the inspiring people whom we have interviewed over the past year. Our sincere

acknowledgements go to:

Karl-Hermann Baumann, Siemens; Lori Belcastro, The Carlyle Group; Ilja Bobbert, PrimeTechnology Ventures; Prof. Richard Brealey, London Business School; Albrecht Crux, Roland Berger;Rolf Dienst, Wellington Partners; Peter Englander, APAX Partners; Massimo Ferrari, Romagest(BancaRoma Group); Prof. Julian Franks, London Business School; Arno Fuchs, Viscardi; Fabio Galli,Assogestioni; Anne Glover, Amadeus Capital; Prof. Dietmar Harhoff, Odeon; Damien Horth, ABN Amro;Prof. Simon Johnson, MIT Sloan School of Management; Prof. Peter Joos, MIT Sloan School ofManagement; Dave Lemus, Morphosys; Prof. Donald Lessard, MIT Sloan School of Management; Prof.Richard Locke, MIT Sloan School of Management; Dirk Lupberger, Polytechnos Venture Partners; MarcMalan, Zouk Ventures; Prof. Gordon Murray, London Business School; Sven-Christer Nilsson, StartupFactory; Julia Otto, Cinven Ltd.; Andrew Phillips, Intermediate Capital Managers; Maria Pierdicchi & herteam, Borsa Italiana Spa; Prof. Malcolm Salter, Harvard Business School; Rene Savelsberg, PhilipsInternational; Raffaele Savi, Romagest (BancaRoma Group); Dario Scannapieco, Italian Treasury Ministry;Prof. David Scharfstein, MIT Sloan School of Management; Prof. Antoinette Schoar, MIT Sloan School of

Management; Prof. Lester Thurow, MIT Sloan School of Management; Roberto Ulissi, Italian TreasuryMinistry; Prof. Jiang Wang, MIT Sloan School of Management


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TABLE OF CONTENTS

1. INTRODUCTION

2. CAPITAL MARKETS- 2.1 INSTITUTIONAL INVESTORS- 2.2 RISK MANAGEMENT IN EUROPE

3. THE CHANGING NATURE OF EUROPEAN BOARDS4. THE MARKET FOR CORPORATE CONTROL5. THE NEUER MARKT6. ENTREPRENEURSHIP: A BOTTLE-NECK IN EUROPEAN

VENTURE FUNDING?


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1. CAPITAL MARKETS

The London Stock Exchange

The European corporate and investment community considers the UK -- not theUS -- as their model for capital markets.1 The US and the UK markets are similar inmany respects, including accounting, exchange reporting requirements, corporatestructure and laws surrounding events such as takeovers. The UKs membership in theEU, however, and its proximity to the rest of Europe, gives the UK similarities to thecontinent and differences with the US: namely, laws, taxation, the recent move toderegulated/privatized national industries and dual stock listings.

The London and Continent Connection

Although the UK is under Common Law and the continent is based on Code, the

regulations affecting securities create a similar environment. For example, violations ofinsider trading are subject to criminal -- not civil -- standards in the UK and in continentalEurope. Therefore, prosecuting violators of insider trading laws is just as difficult in theUK as it is in Continental Europe. Unlike the US, corporate officers in the UK andEurope face little or no risk of monetary loss for breach of fiduciary duty.

Tax laws in the UK and in continental Europe are also similar, particularlyregarding corporate compensation and capital gains. For example, in the UK, taxes equalto 17% of the value of a stock option have to be paid upon issuance. While optionshavent caught on as much on the continent, similar tax policies exist surrounding them.

Enforcement of governance laws is another shared trait between the UK and thecontinent. In the US, although exchanges enforce certain requirements with their traded

entities, the Securities and Exchange Commission (SEC) is the main watchdog ofcompanies and their officers. In the UK and the continent, the exchanges themselves arethe main watchdogs. This situation might change in the UK, however, with theestablishment of the Financial Services Agency (FSA) in September of 2001. The FSA isthe result of the combination of all of the governmental agencies with securities industryoversight. It is still too early to gauge the FSA's effectiveness, but one might guess thatincreased governmental vigilance in enforcing securities laws will result.

The deregulation/privatization push further links the UK with the continent. Veryfew American industries have ever had European-style government influence. Althoughthe American private sector has had some assistance from the government in terms of taxsubsidies and tariffs to develop some capital-intensive industries, the American

government has never had the role of economic engine that European governments haveplayed. The role of the English government changed in the 1980s when the Thatchergovernment ushered in privatization of most big industries, such as airlines, auto,telephone systems, and utilities.

1 Dick Brealey, London Business SchoolJulian Franks, London Business SchoolDamien Horth, Airline Analyst, ABN-Amro


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The continent started to follow this UK model in the early 1990s. Europeangovernments sold over $200 billion worth of assets between 1992 and 1998. 2 Althoughvestiges of government ownership still exist, a mandate of the EU is to continue thisliberalization of industry. This mandate has enormous implications for capital markets.Shares of nationalized companies are not traded on stock exchanges. When the largest

companies in a country or region are not publicly traded, the affected capital markets lackliquidity. With reduced liquidity comes less investment and fewer investors, making itmore difficult for other companies to access the capital markets. In contrast, access tocapital markets is a hallmark of the Anglo-Saxon (i.e., UK and US) business model.

The Big Bang

This traditional lack of liquidity and access to capital is what historically attractedEuropean companies to dually list their shares domestically and in London. Thisattraction became realized for many firms as result of a 1986 law called the Big Bang,which opened up the London Exchanges.

The Bang had a massive effect. First, ownership of member firms by foreigncompanies became permissible. American and continental European investment banksestablished a beachhead. This development, along with more liberal commissionschedules, increased the competition for brokerage business and caused a surge in tradingvolume.

The increased volume, along with the establishment of the Stock ExchangeAutomated Quotations (SEAQ) system, enhanced Londons capital drawing powersbeyond what anyone anticipated. For example, over 60% of all Swedish stocks weretraded in London at one point. Trading volume in some foreign stocks became so heavythat home countries had to use tax policy and liberalizing exchanges to repatriate marketcapitalization

Despite this interference, London has continued to draw trading volume. In 1987,the first full year of trading after the Bang, an average of $600 million pounds worth ofinternational shares traded in London. This number has grown spasmodically with themarket gyrations to $24 billion that were traded daily in 2001.3 Just over $3.3 billionwere traded daily at the Deutsche Borse, the next largest continental exchange.

London is also the worlds largest center of equity assets under management. Asof 2000, almost $2.5 trillion was managed from London. New York was second with justunder $2.4 trillion. Paris ranked as the largest European center with less than $500billion.4

In addition to a boost in volume, these developments were catalysts for change ofEuropean corporate governance. First, companies who list their shares in London mustcomply with the UK reporting and accounting standards, regardless of the requirementsin their home countries. This means quarterly reporting of operating income as well asbalance sheets and statements of cash flow. Second, dual-listed companies can expect tobe plied for data and pushed in new ways by the English and American investment

2 OECD3 London Stock Exchange Historical Statistics4 Thomson Financial, International Target Cities, Report 2000


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community. Many management teams got their first taste of Anglo-Saxon investmentcommunity requirements when they listed in London.

Addressing these requirements was the price of admission for access to the USand UK capital pools, access which European companies looking to grow quicklywanted. Continental Europe was almost devoid of large equity pools until very recently.

Governments on the Continent controlled most of the largest companies and thus thelargest pension funds. These pension funds usually invested a minority of their assets inequities. In Italy, for example, the pension laws almost entirely precluded pensioninvestment in equities.

This void encouraged companies like Mannesmann to attract foreign -- mainlyAmerican and UK -- investors in order to obtain the funds to make large acquisitions.Mannesmann, of course, had to comply with Anglo-Saxon disclosure standards andreporting frequency. Ironically, this exposure to foreign investors led to the largesthostile takeover in European history. Over 60% of Mannesmanns shares were held byforeign investors when Vodafone made a tender offer. With no blocking minority, andforeign investors eager for a good return on their investment, Mannesmann fell into

Vodafones hands.

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Londons status as the center of European finance has not diminished withthe introduction of the Euro. Many people expected that Frankfurt or Berlin wouldbecome the financial center of Europe after the introduction of the Euro, but Londonretains its status atop European capital markets.

The London Stock Exchange leads in terms of daily share volume, with over $4.5trillion of annual volume compared to the Deutsche Borses $2.1 trillion.6 In order toretain volume and compete against larger exchanges, the smaller and regional exchangeshave either consolidated or gone public to raise their profile. For example, Paris, Belgiumand Amsterdam merged to form Euronext in the spring of 2000. Euronext had $1 trillionof annual volume in 2001.7

Although the migration of shareholding to London led to modifications inreporting and capital markets, four other causes underlie the changes: pensionadjustments to address population aging, tax law changes, the Euros introduction, andseveral mandates of the European Union.

Introduction of the Euro brings Convergence

The Euros introduction has had major implications for reporting and capitalmarkets as well. Total European Securitization has surged from just under 40 billionEuros in 1996 to almost 154 billion Euros in 2001. Although the UK has historicallyaccounted for the bulk of these issuances, the market for new asset-backed and mortgage-backed issues is growing robustly in several countries on the continent.8 Naturally, alarger marketplace around a unified currency attracts capital. Companies have found itmuch more efficient to issue debt via these larger capital markets than from banks.

5 The Economist, Lean, Mean, European Apr. 27 20006 The Economist, The Battle of the Bourses May 3, 20017 The Economist, The Battle of the Bourses May 3, 20018 ESF Securitisation Report Spring 2002 pgs. 1-3.


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Companies using the capital markets need to have better public disclosure of operatingresults and capitalization than companies using bank debt.

Moreover, although the over-the-counter nature of the bond market makesmeasuring capital employed in these alternative securities difficult, the growth of theEuropean high-yield market signals an overall increase in capital focused on Europe.

Investors wanting one currency and one set of fiscal and monetary fundamentals findinvesting in Europe much easier now after the introduction of the Euro than under the oldmulti-currency model.

Accounting Standards

The rules of the European Union form another stimulus for change. Governmentsare not allowed to own dominant stakes in companies, thus making management muchmore susceptible to the demands of a non-paternal investor base. The EU has also issueda directive for the implementation of IAS by 2005 by companies in all member countries.

One important footnote to the introduction of IAS instead of something closer to

the UK GAAP is the lack of prescriptive requirements. Both UK and US GAAP call forspecific treatment of issues, allowing for little leeway if an auditing firm is honest.Conversely, IAS has certain parameters that can allow for reporting methods that are notthe most beneficial to shareholders. Therefore, investors need to guard against beingforced into a false sense of security by companies that claim strict adherence to IAS.

One aspect of corporate governance that could be exacerbated in a non-shareholder-friendly version of IAS emerges from tax policy. Most continental Europeancountries do not allow companies to keep two sets of accounting booksone for thegovernment tax authorities and one for the markets. Therefore, shareholders could loseout in situations where CEOs feel more pressure to pay the least in taxes rather than bookthe most earnings.9

Patterns of Change

While there are EU directives for restructuring, a pattern of adoption has emergedover the years. Changes typically begin in London and spread eastward across thenorthern half of Europe to Germany. The changes then make their way south to theMediterranean countries.10 This pattern is apparent in accounting and reportingfrequency and in pension reform.

Although a lot of policy comes from the EU, member countries have notcompletely relinquished their autonomy. Consequently, there are exceptions to this west-to-east and then north-to-south migration. The Assogestioni, a trade group for the Italianasset management industry, is working with Italian Borsa management to push throughlaws that make hostile takeovers easier to accomplish in Italy. The two entities are alsosuccessfully lobbying for laws that will require disclosure of insider selling of blocks ofstock greater than a certain percentage of the company. Contrast these moves withGermany, where hostile takeover laws are still restrictive and insider trading disclosure ispractically non-existent. Another exception to the north-to-south migration pattern is the

9 Peter Joos, Professor of Finance and Accounting, Sloan School of Management at MIT10 Dick Brealey, Julian Franks, Damien Horth


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securitization market. In 2001, Italys asset-backed and mortgage-backed issuanceincreased three-fold over 2000. By contrast, Germany actually decreased its issuance.11

Summary

Recent developments on the continent and the trends going forward suggest to anapparent embracing of the Anglo-Saxon model of corporate disclosure and structure ofcapital markets. However, although there have been many changes -- specifically interms of reporting standards, capital mobility and the role of outside shareholders -- thereare still many differences.

Many differences between the continent and the UK and US will remain, giventhe historical context of the countries. For example, the majority of continental countrieshave a history of universal banks, acting as holders of equity and providers of debt.Many of the largest banks -- including Deutschebank, Societ General, BNP Paribas --have purchased US and UK investment banks, and they appear to be evolving into more

pure investment banks. But, considerable equity ownership of borrowers by continentallenders continues. Given the structure of boards, the state of capital markets, thestructure of tax laws and the training of management, the continental country systemsmay be the most effective for those countries.

Each country also retains its own standards in almost every facet of capitalmarkets, accounting and disclosure. Differences can exist even within the newly-consolidated exchanges. Euronext came out of a merger between the Paris, Brussels andAmsterdam stock exchanges. However, French companies listed on Euronext have farweaker reporting standards than their Dutch counterparts. French companies do not haveto report quarterly or even semi-annually. In another example, retroactive adjustments toearnings announcements are forbidden in London and Holland, but they are permissible

in Germany (even though Germany is leading the move to IAS on the continent).

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As one can clearly see, the relationship between London and the continent has along and complicated history. All indications are that this relationship will continue toevolve with the nature of financial and operational disclosure and the structure of capitalmarkets in both places. While it is impossible to predict exactly what will happen, allsigns point to an increased alignment of systems both within continental Europe andbetween the US, the UK and the continent.

2.1 INSTITUTIONAL EQUITY INVESTORS

Institutional investors (in particular life insurance companies, mutual funds andpension funds) own an increasing amount of equity. More and more firms are enteringcapital markets. As a result, a greater fraction of the economic base of a company iscoming under the purview of institutional investors.

11 ESF Securitisation Report Spring 2002 pgs. 1-3.12 Damien Horth, European Airline Analyst, ABN-Amro, London


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As E. Philip Davis statistical analysis13 shows, the volume of total financial assetsrelative to GDP (an indicator of the financial market dimension) has grown over the lasttwenty years, with a parallel increase in the proportion of assets held by institutionalinvestors. The high level of institutional assets as a proportion of the total financialassets has accompanied a decline in deposits held in household portfolios, a lower level

of corporate loans, and a higher level of corporate equity. These tendencies are trueacross all G-7 countries, with institutional investors growing in importance relative to thecontinental banking system.

The emergence of large shareholders able to channel the investments of a largenumber of individual investors could offer a possible solution to the principal-agentproblem in equity finance. Through the strategy of diversification, institutional investorswould seek an optimal size of shareholding that justifies the costs of exerting their rightsand of monitoring managers, without overriding the interest of minority shareholders.14The growing dominance of equity holdings by institutional investors, both in the AngloSaxon countries and in Continental Europe, would lead to a new corporate governance

model (direct control via equity or shareholder value model). This new model wouldmake the traditional separation of the Anglo Saxon paradigma (the market control viaequity or predatormodel, in which the threat of hostile takeovers acts as a marketdisciplinary device against incompetent or fraudulent managers), and the Continentalparadigma (the direct control via debt or corporative model, in which credit institutionsare both the more important shareholders and the main providers of debt thus raisingserious risks of discriminating against minority shareholders.) less rigid and morecomplex.

The Rise of Institutional Investors in Europe: the Role of the Pension Reform

The trend in which institutional investors have increased their share of listedcompanies over time in continental Europe is likely to continue due to the developmentsin retirement financing.

Demographic trends and public pension spendingDemographics will impact Europes pension system in a monumental way and

might cause corresponding changes in capital markets and corporate governance.Continental Europe, in particular France, Germany and Italy, has the largest pure pay-as-you-go pension system in the industrialized world. Under these systems, payments topensioners are funded by taxes on the working populations. These systems work at high,but sustainable, tax rates when the Old-Age Dependency (OAD) ratio (the ratio of people65 and older versus those aged 20-64) is low enough to ensure a fully funded program.According to the ECOFIN Group, however, the German OAD ratio will increase from26% in 2000 to 54.7% in 2040. The Italian OAD ratio will similarly increase from

13 Davis, E. Philip. Institutional Investors and Corporate Governance. West London: BrunelUniversity, 1995

14 Davis, E. Philip. Institutional Investors and Corporate Governance. West London: BrunelUniversity, 1995


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28.8% to 63.9%.15 As the population ages, the pay-as-you-go system (under whichpayments to pensioners are funded by taxes on the working populations incomes)automatically creates imbalance. The International Monetary Fund estimates that publicpension spending in the countries listed above will increase from the low teens to over20% of GDP between 1995 and 2030. If this estimate is true, French, German and Italian

workers will pay, respectively, 38%, 41% and 62% of their wages to the pensionsystems.16Although the pay-as-you system also depends on the development in labor

productivity, the high proportion of government spending on pensions in relation to GDPsuggests that the state pay-as-you-go models are already overstrained and that they havebecome a drag on economic growth. Indeed, in all the countries mentioned above, therehave been pension reform proposals and reforms in recent years. These changes have notslowed system membership, however, nor have they stabilized contribution requirements.Academic research, particularly Boersch-Supan and Winters advancement of Gruber,Wise, and Schnabels studies on the negative incentive effects of public pension systemson labor supply,17 suggests that workers who have grown up in a generous pay-as-you-go

system tend to prefer early retirement or to take jobs that avoid social security taxation.Structural reforms of the public pension system

Many studies have been conducted on the structural remedies to the instability of thepay-as-you-go system. A common thread is the necessity of a funded component toaugment the existing public system, in particular by encouraging occupational pensionschemes that have the advantages to achieve a well-balanced risk mix, cost efficiency,and wide reach. Currently, the occupational pension component is underdeveloped inmany European countries. In Germany, 82% of retirement income is paid from stateresources, while occupational schemes account for 5% and personal provision 15%.Within Europe, only the Netherlands and Switzerlandhave a more balanced three-pillarpension system. Switzerland has 42%, 32%, and 26% of retirement income generated,respectively, by state contributions, occupational schemes, and personal savings. TheEuropean market per pension funds (meaning all pension products excluding lifeinsurance, financed outside the sponsoring firm) was worth about US$2,750 billion in1999, with the UKalone accounting for 50%. In contrast, Germany, the most powerfuland most populous economy in Europe, accounts for just 5% of the European market.18

Germanyhas recently taken action to stabilize its pension system. According to anew law, theAltersvermgensgesetz(AvmG), all employees now have a legal right to askfor employee-financed occupational pension plans. Moreover, the new law introduces anew German-style pension fund (Pensionsfonds) as a new occupational scheme. Thesepension funds invest the assets outside the sponsoring firm, are financed by bothemployer and employees, and can offer either defined-benefits schemes or defined-contribution schemes with guaranteed minimum benefits. Italy now allows new pension

15 Population Aging, Savings Behavior and Capital Markets, Working Paper 8561 AxelBoersch-Supan and Joachim Winter. October 2001

16 IMF Occasional Papers 147 Aging Populations and Public Pension Schemes, Chand andJaeger

17 Population Aging, Savings Behavior and Capital Markets, Working Paper 8561 AxelBoersch-Supan and Joachim Winter. October 2001

18 Deutsche Bank Research, Special Study: Europe on the road to pension funds? -June 15 2001


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plans only as externally-funded, defined-contribution schemes. The contributions madeby employers -- and, in some cases, by the employees -- are channeled into a legally-independent pension fund organization, which calls on an investment fund to manage orinvest them. Spain has taken a similar step. Since 1995, only external funding has beenpermitted as an occupational scheme. Companies must decide by mid-October 2002

whether to write back their book reserves and pay them out in cash or convert them intocertified pension funds.Essentially, we are witnessing the development of the private pension system in

Europe. According to Deloitte Research and Goldman Sachs19, the impeding shift frompublic to private retirement provision will create a private retirement market worth EUR4 trillion ($3.6 trillion) by 2010, rising to EUR 11 trillion by 2030. Overall, the studyestimates the market for long-term savings in Europe to be worth around EUR 26 trillionby the end of 2010, up significantly from around EUR 12 trillion in 1999.

The forms and effectiveness of institutional activism in Anglo-Saxon

countries

The empirical evidence from the Anglo-Saxon countries that institutionalinvestors can improve the performance of the targeted firms can be useful tounderstanding the economic effects of an increase of the European private pensionmarket.

Evidence from USIn the US, institutional investors own 50% of the top fifty companies, and the

top twenty pension funds own 8% of the stocks of the ten largest companies.When US institutional investors are dissatisfied with firm performance, they can

choose to:1. Follow the Wall Street Rule (vote with their feet) by selling shares2. Take an active role in the corporate decision-making process through shareholder

proposals and proxy fights3. Negotiate directly with management and, when a compromise cant be reached,

sell shares with a public explanation of the reasons underlying the sellingdecision.

According to recent work by Parrino, Sias, and Starks,20 voting with their feetby US institutional investors significantly affects board decisions, forcing CEO turnoversand often replacing the CEO with an outsider.

The second alternative is often mentioned in the academic research as the onlyform of institutional activism. The definition is too narrow because it applies to just asmall set of US public pension funds, in primis CalPERS. The US Department of Labors1989 Proxy Project Report requires pension fund managers (but not mutual fundmanagers) to regard proxy voting as part of their fiduciary responsibility.

Moreover, how effective this form of activism is in improving the financialperformance of the portfolio companies is ambiguous. Wahal21 analyzes activism by nine

19 Retail Banker International, page 12, January 15, 200220 Parrino, R., Sias, R., and L. Starks. Voting with their Feet: Institutional Investors and CEO

turnover, mimeo. 2000


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public pension funds over the period 1987-1993 and concludes that there is no significantevidence of increase in the long-term stock performance of targeted firms. On the otherhand, Smith22 analyzes activism (proxy fights) sponsored by CalPERS from 1987 to 1993and comes up with empirical evidence that there is a significant positive stock pricereaction for successful targeting events and a significant negative reaction for

unsuccessful events. Overall, the evidence indicates that shareholder activism is largelysuccessful in changing governance structure and, when successful, results in astatistically significant increase in the shareholder wealth (251).

The third way of activism is more vocal than the mere sell-off of shareholdings,and it is precisely what has been observed in the recent years within the wide communityof private funds. For example, the stock price of General Electric Co., dropped almost byhalf between October 2000 and May 2002 because of the strong sell-off by institutionalinvestors like Pacific Investment Management Co. This sell-off raised valid concernsover disclosure and over GEs ability to pump out future profits.23 GEs CEO, Mr.Immelt, was forced to take visible initiatives to regain investors trust. The work ofWahal24 confirms that efforts by institutions to promote organizational change via

negotiation with management are associated with abnormally high stock returns.Evidence from UKThe case of the UK pension funds shows that a well-developed pension system is

not sufficient to ensure change in corporate governance practices. In fact, although UKpension funds have a percentage of share ownership of about 20% of the total in 1999,there is no evidence25 that UK pension funds tend to reduce the size of the board or topush firms to adopt the Code of Best Practice, (which provides for a separation betweenthe role of the chairman and the CEO), or to increase the value of the targeted firms withrespect to the others. Moreover, pension funds do not even vote with their feet, becausethey do not reduce their holdings when performance is poor.

The Myners Report,26 a Treasury-commissioned review of institutional investorsin the UK, underlines the lack of investment expertise among the UK pension funds. Thislack of expertise is, in part, attributable to the requirement introduced by the Pension Actof 1995, which provides that one-third of the trustees should be member-nominated. Inresponse to the Myners recommendations, the UK government established a set ofprinciples resembling those reported in the USProxy Project Report. UK trustees will beexpected to disclose any non-compliance to these principles to members on an annualbasis. In particular, the UK government says that a requirement to intervene in companiesin certain circumstances should be incorporated into the investment mandate.

21

Wahal, S. Pension Fund Activism and Firm Performance. Journal of Financial and QuantitativeAnalysis. Vol. 31, issue 1. 1996

22 Smith, M. Shareholder Activism by Institutional Investors: Evidence from CalPERS. TheJournal of Finance. VOL. LI, NO.1, 1996

23 Businessweek, The Education of Jeff Immelt, by Diane Brady, April 29, 200224 Wahal, S. Pension Fund Activism and Firm Performance. Journal of Financial and Quantitative

Analysis. Vol. 31, issue 1. 199625 Faccio, M. and Ameziane M., Lasfer (2000), Institutional Shareholders and Corporate

Governance: The case of UK pension funds, CeRP working paper No. 11/0126 The report was published on 6 March 2001


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Other reasons for the passive attitude of UK pension funds are:1. The lack of competition. Unlike the US pension fund industry, the UK pension

fund industry is also highly concentrated. The largest 68 schemes, whose assetsvalue exceeded 1 billion in 1995, accounted for 57.3% of all occupational

pension funds assets.

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2. The small size of shareholdings. Even if UK pension funds, like US funds, are notsubject to explicit quantitative constraints, they tend to have holdings thatrepresent a small fraction of their assets value (less than 1%).28 The smaller thesize of the holdings, the more costly it is for the fund to monitor the firms in theirportfolio.

Institutional Activism in Europe

The leading role of domestic institutional investors

The developments in the European pension market will gradually lead to anincrease in the demand for equity by domestic (European) institutional investors, whowill be acting as the depositors of occupational pension schemes. In this changingenvironment, domestic institutional investors could play a leading role for pushingcompanies toward better corporate governance standards. In turn, a greater transparencyin providing information and the direct threat to poorly-performing management wouldattract new foreign capital in the domestic firms.

Together with the crisis of the public model of social security, and the reform ofstock market exchanges and the advent of a single currency has led domestic institutionalinvestors to change how they approach corporate governance issues. European investorsare increasingly looking outside their national borders for higher returns, makingcomparisons on a pan-European basis. Until now, their performance was largelymeasured against that of other managers in the same country. Now that institutionalinvestors have to compete internationally for investment capital, they are far more eagerto make the most out of their assets. They put pressure on the managements of their theportfolio companies to increase the shareholder value orientation.

Forms of institutional activism

1. Collaborative investigations and public focus lists. To publicly voice doubts abouta bad corporate practice marks a dramatic shift for European fund managers. Aboveall, they have started joining forces to push change. For example, in March 1998, 15Dutch pension funds with $42 billion worth of holdings in Dutch companies teamedup to investigate the corporate-governance practices of all the companies on theAmsterdam market index. At the top of their hit list was Royal Philips Electronics.Fund managers at the companys annual meeting openly protested the juicy options

27 Pension Funds and their Advisers (1996), as quoted by Faccio and Lasfer.28 Faccio, M. and Ameziane M., Lasfer (2000), Institutional Shareholders and Corporate

Governance: The case of UK pension funds, CeRP working paper No. 11/01


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scheme, (then worth $175 million), that Philips had put in place without fullydisclosing its details to investors.

2. Exerting voting rights. Sometimes the decisions made by institutional investors atshareholders meetings has led to formal investigations. For example, the OsloStock Exchange and the Norwegian securities started investigating insider trading

in the stock of Kvaerner, an Anglo-Norwegian engineering and shipbuildingcompany, after the Norwegian investment company Odin Forvaltning asked for andgot the resignation of Kvaerners CEO, who had been responsible for the highly-leveraged acquisition of Trafalgar House, a British conglomerate several times thesize of the company.29

3. New investment styles. Besides public criticism and active participation inshareholders meetings, European fund managers have started to approachcorporate governance issues under a different perspective as well. For example,Frances ABF Euro VA invests in European stocks and benchmarks itself againstthe FT Europe Index, but it favors holdings in companies that it expects will takeactions to enhance shareholder value through good corporate governance practices.

The strategy has turned out to win. The fund out-performed the market by 7.4%against a tracking error of 1.7% since its inception (in Jan. 1998). This form ofinstitutional activism disciplines management through markets, by timed buyingand selling of target firms and by exerting voting rights when there are under-valued assets.

The Italian case: strengths and weaknesses of the investment management

industry

The Italian system of institutional investing provides a representative example of therole of institutional investors in a continental corporate governance system. Analyzing theItalian case reveals positive signals as well as some limits of the current role ofinstitutional investors. The case can be easily extended to other continental cases.

In the Italian financial system, the most common type of institutional investor is theinvestment fund (fondo comune di investimento), where the funds are invested indifferent financial activities and managed by a company (societa di gestione delrisparmio). In Italy, about 90% of money managers are affiliated with banking orinsurance groups. Different oversight authorities regulate money managers according tothe specific kind of client whose assets are under management (individuals, high-net-worth individuals, pension funds or insurance companies).

With shareholdings amounting to about 35% of the Italian stock market capitalization,the Italian money managers system is ranked third after the US and France. At thebeginning of 1990 it ranked 12th. The percentage of assets invested in corporate equitieshas moved from 12% in 1990 to 38% in 2001.30

29 Businessweek, 11/30/1998, Bosses under fire30 Mr. Fabio Galli, Secretary-General of Assogestioni


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According to some financial authorities,31 Italian money managers have started toshow a more active form of shareholding than foreign investors, who are more inclinedto vote by feet in the Italian companies where they invest. The increasing awareness ofcorporate governance by Italian money managers is confirmed by the important role thatthey played in issuing the Draghi law (Testo Unico della Finanza, 1998). In particular,

they directly proposed the rule under which the Board of Directors cannot do anything toprevent takeovers unless two-thirds of the General Assembly approves the defense action.Assogestioni, the trade group for the Italian asset management industry, has recentlystarted to take public actions against badly-managed firms, thereby making it increasinglyexpensive (in terms of reputation costs) for firms to resist market forces. For example, inJuly 2001, through a formal communication to CONSOB, Assogestioni opposed SAI'sacquisition of the insurance company Fondiaria because of the lack of information aboutthe action and the inconsistency of the acquisition with respect to the expecteddevelopment strategy of SAI.32

Despite these favorable signals, the evidence about the activism of Italian institutional

investors is still sporadic. A study of Italian mutual funds by Bianchi and Enriques

33

isuseful for understanding the problems that might prevent the expected pension reformsystem from being an effective driver for corporate governance. Bianchi and Enriques'empirical analysis shows that Italian money managers could potentially play a moresignificant role in the corporate governance of Italian listed companies, (in terms ofshareholding size), but other factors gain ground, de facto limiting the activism of theItalian institutional investors. Examining the number of shareholdings larger than 1%,among 221 holdings, about 60% is concentrated in the hands of five Italian fundmanagers. Each fund manager has an average of 25 relevant holdings. However,ownership concentration in the targeted firms, dependence on banking groups, andcompetitive disadvantage with respect to occupational schemes are the main factors thattend to reduce the incentives for activism.

1. Ownership concentration. The ownership structure of Italian firms is still highlyconcentrated: at the end of 1988, only 35 out of 218 listed companies could bedefined public companies. The threat of submitting a shareholder proposal willbe more effective when controlling shareholders are a stable group.

2. Dependence on banking groups. Of the 221 relevant shareholding groupsanalyzed by Bianchi and Enriques, only 4% belonged to independent mutualfunds managers, while the rest belonged to bank or insurance groups. Thisaggravates the problem of the influence of banks, because banks might increasetheir control through the institutional investors shareholdings. It is important tomention, however, that almost all the Italian asset management firms haveadopted the Independence Protocol, a self-regulation that aims to protect the

31 Ms. Maria Pierdicchi, Head of Nuovo Mercato and Mr. Fabio Galli, Secretary-General ofAssogestioni

32 Assogestioni, Corporate Governance Committee Acquisition of Fondiaria by SAI-Reportpublished on the website http://www.assogestioni.it/novita/novita.asp

33 Bianchi, M. and L., Enriques (2001), Corporate Governance in Italy after the 1998 Reform:What role for institutional investors. Quaderni di Finanza CONSOB, No. 43


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provision of management services from banking group influence. The firstItalian money manager to adopt the Independence Protocol was Romagest(BancaRoma group) at the end of 1999.

3. Lack of competition. The less competitive the asset management industry, thefewer incentives investment funds have to enforce their rights as shareholders.

Despite the recent steps toward pension system reform under current regulations,the fiscal benefits for employees are only associated with investment in thetraditional system of occupational schemes (trattamento di fine rapporto)

Conclusions and open issues

In Europe, the importance and number of institutional investors is expected to risein the near future due to ongoing pension system reform. The development of the fundedcomponent of the pension system will lead to an increase in the demand for equity by

domestic institutional investors, acting as professional money managers of the pensionplans. However, as the empirical evidence about the institutional activism of UK pensionfunds shows, a well-developed pension system is not, by itself, enough to ensure changesin the corporate governance practices of companies in which fund managers invest.

The discussion of the role of institutional investors as effective agents for changein Europe should address two issues: 1) pension funds as a particular case of institutionalinvestors, and 2) the relationship between fiduciary responsibility and investmentresponsibility.

1. What is the optimal internal structure that new European pension funds should

adopt?

The extent to which a plan is of defined-benefit or defined-contribution may affectthe pension funds investment horizon, thereby affecting the fund managers interestin active corporate governance. Most of the UK pension funds are run according todefined-benefit plans, where individuals dont bear the investment risk. In Germany,even under the new law, full defined-contribution schemes are not permitted, andpension funds are obligated to be members of the insolvency insurance association.Quantitative investment restrictions could have a direct impact on the extent to which

pension funds can play a role in corporate governance. In Italy, the holding of sharesof closed-end funds is limited to 25% of the closed-end funds assets. In Germany,pension funds cannot invest more than 35% of their assets in equities. Even under thenew law, the government is authorized to issue detailed quantitative investment ruleson pension funds. The European Commission has calculated that funds placingemphasis on quality management generated higher returns from the mid-1908s to themid-1990s than those operating under quantitative rules.34

34 Communication by the Commission, Towards a single market for supplementary pensions,1999, Annex, as quotes by Deutsche Bank Research, Pension Funds for Europe


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2. What is the relationship between fiduciary responsibility and institutionalresponsibility? Should European institutional investors have a duty to exercise theirvoting rights diligently as part of their fiduciary responsibility? Or should institutionalshareholders exert greatest influence through the market? In each of the two cases,what should the government's role be in promoting institutional activism? After

starting to exert their voting rights at shareholders meetings and making some publicactions, will European institutional investors start to gain a powerful bargainingpower in negotiating directly with a company's management?

The UK government has decided to adopt the first alternative to increase theactivism of occupational pension schemes, despite of the ambiguous empirical evidencefrom US, where public pension funds have the statutory duty to use shareholder powersto intervene in investee companies.

Even without imposing the exercise of shareholder rights, European governmentswould have much room to maneuver:

by introducing adequate regulations of conflict of interests or several restrictivemeasures (e.g., limits to participation in managing companies) to reduce theinfluence of banking groups on money managers

by equalizing the treatment of all different occupational schemes (Italy) by simplifying the way of voting at annual meetings (Italy, Spain) by reforming the system of cumulative vote in order to ensure that the director

designated with the vote of the institutional shareholders cannot be removed bythe decision of the majority (Spain).

Although institutional activism has made significant progress in Europe, it seemsthat domestic investment funds still lack the power exercised by US money managers,

who vote noisily with their feet by directing harsh comments to managers, eitherprivately or via the press.


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2.2 RISK MANAGEMENT IN EUROPE

In Europe, where professional investors have long tended to avoid equity as anasset class, debt plays a crucial role in the capital allocation system. Bank managersoffering credit to their customers channel scarce capital toward the best investment

opportunities. Managers of bond portfolios make decisions guiding Europes capital towhere it can work the hardest. A number of recent incidents have raised serious doubts asto whether European financial institutions have the capabilities, and the desire, to performthese functions effectively. Europe has too many banks, and banks issue debt on the basisof standing relationships and under government influence -- often at the wrong interestrates to the wrong companies. A spectacular recent example of poor judgement was thefailure of the Kirch Gruppe in Bavaria. German banks lent the company billions of Eurosto make dubious investments in a variety of media ventures, including Formula 1 motorracing. When this paper went to print, the company had declared bankruptcy. Financialexperts publicly doubted Kirchs credit-worthiness, and there were serious accusations ofmeddling in some of the banks decisions by the prime minister of Bavaria, Edmund

Stoiber. German banking regulators have subjected the transactions to review. Acomparable lack of judgement can be perceived among investors in the fledgling high-yield bond markets in Europe, which are showing very negative returns. Expertscomment that too many European debt investors lack due diligence skills.

The Reform of Banking Regulations: Basel 2

Traumatic events, such as the near-collapse of Long-Term Capital Management inSeptember 1998, highlighted the need for re-examination of current frameworks for riskmanagement within the financial system. The international Basel Committee on BankingSupervision launched a review of banks risk management and capital reserve

requirements. It has published a detailed proposal for setting banking capitalrequirements, known as Basel 2. Basel 2 will revolutionize the way capital requirementsare set, adjusting them to the banks own measures of the risks they run. The new ruleswere intended to come into effect everywhere in the EU in 2004, replacing the crudeworkings of Basel 1, which has been in place since 1988. Progress on finalizing theproposals has been slow. At the moment, commentators predict that the proposals willnot come into effect before 2006.

The intention of Basel 2 has been to stimulate banks to put in place moresophisticated schemes for risk assessment by offering a reward in the form of reducedcapital requirements. However, the rules must not give advanced banks too great a

competitive advantage over less sophisticated, perhaps smaller, competitors, or else theywill be perceived as unfair. Getting the balance right has been a serious challenge and hasdelayed the finalization of proposals.

Apart from the emphasis on improved internal risk management by banks, anothernovel aspect of the Basel 2 proposal is the intended use of market discipline -- rather thanregulatory supervision -- as a means of enforcing good practice. As the Basel committeewrites, The new framework aims to bolster market discipline through enhanced


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disclosure by banks. Effective disclosure is essential to ensure that market participantscan better understand banks risk profiles and the adequacy of their capital positions.35

Basel 2s focus on promoting good risk management through lower capitalrequirements and enhanced disclosure is designed to improve the economic rationality of

banks. So far, it seems to have been reasonably successful. The Economistcomments,There is no doubt that the Basel 2 exercise has heightened awareness of risk amongbanks. It has prompted them to overhaul their credit-scoring methods and to tighten uptheir operations.36

The Banks

Current lending practices in Europe have raised eyebrows. Risk is underpriced,comments a London fund manager. In a smaller German bank, a manager could get firedif he loses business from a company like DaimlerChrysler, even if the rate he has to offeris unattractive." In some countries, relationships between the banks and their clients have

become so close that, rather than providing critical supervision, the financial institutionstarts to go native. In Germany, long-term bank lending to large corporations is acrucial part of the funding system. Banks gradually grow together with their corporateclients. The proposed Basel 2 arrangements give incentives to promote short-term ratherthan long-term lending. It is not surprising that Germany has lobbied for the removal ofthese incentives.

Political pressure to help certain companies, such as when job losses are likely, isanother major source of bad credit decisions. This behavior is not financially irrational: abank with strong backing from its government need not worry as much about possiblelosses because the government can bail them out. A common example of banks enjoyinggovernment backing, and acting accordingly, are the publicly-owned GermanLandesbanken, which are backed by explicit state guarantees. Several of these bankswere involved in the Kirch debacle. The Bayerische Landesbank -- 50% owned by theBavarian state government and subject to political influence -- injected more than 1billion Euros into Kirch only last year. This funding decision was probably made by thebank, even if it was good politics for the Bavarian prime minister. The general perceptionis that the bank was routinely used to provide capital to companies favored by thegovernment as part of Bavarian economic policy.

In 1999, competing European banks launched a formal complaint about the unfairadvantage the German regional banks have in raising cheap funds. A deal has now beenstruck between the European Commission and the German government. The deal willlead to a dismantling of the guarantee system starting in 2005. Of course, the dismantlingof state-backed banks also has disadvantages. A very large share of small-companylending in Germany comes from public-sector savings banks. It is feared that tightercredit controls will inevitably lead to decreased access to credit and higher interest rates

35 Secretariat of the Basel Committee on Banking Supervision, The New Basel Capital Accord:an Explanatory Note, Bank for International Settlements, 2001

36 The Economist, 21/02/2002


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for some. There may well be a significant number of bankruptcies and a wave ofrestructuring. This is the pain caused by the financial discipline being forced through thesystem. Regarding Basel 2, German chancellor Gerhard Schroeder said that only anaccord that is friendly to small companies (the "Mittelstand") will win Germanysapproval. Very tight Basel 2 rules on lending to small and medium-sized companies have

already been relaxed through a variety of adjustments.

The Markets

The attempt to introduce greater market discipline on banks through better riskdisclosure may lead to a more efficient economy in the long run. Whether the Europeanmarkets are currently sophisticated enough to impose that discipline, however, is notknown. For instance, in recent years the junk bond market in Europe has seen significantincreases in liquidity. But early experiences suggest that investors have not done a verygood job of valuing these securities. Average investor returns in some classes of high-yield debt have been negative in the double digits. A trader comments: Of course

everyone was suffering from irrational exuberance the last few years, but it is certainlyfair to say that some European investors in high-yield securities have lacked thenecessary due diligence skills. Another trader mentioned: Within half an hour ofputting an issue, we get calls from buyers, without even looking at the prospectus. Theyjust go by the credit rating and are not able to do any due diligence themselves.

It is ironic that European investors are ill-equipped to handle high-yield debt.Some believe that here lies the solution for some of the German Mittelstand. As onetrader put it, Corporate Europe is not yet issuing junk, even though this is the source ofcapital for middle America. Family businesses can use junk to raise capital withoutloosing control. The negative returns on high-yield debt have scared many of theinvestors who were pioneering this market, and it will take time before they return.

Experience in the U.S.

It is not surprising that the first wave of European investors in high-yieldsecurities faced a learning curve. In the late eighties, investors in the U.S. showed similarpoor judgement. Junk bond markets famously overheated, resulting in unprecedentednumbers of defaults in 1989 and 1990 and the bankruptcy of Drexel Burnham, the firmthat had promoted the junk bond markets. The boom in high-yield debt in the U.S.,however, was partly caused by the development of advanced financial insights allowingthe valuation these instruments, and the subsequent discovery that many bonds weretrading cheaply. In Europe, it appears that not insight but ignorance caused theenthusiasm. Furthermore, in the U.S., the market meltdown occurred after high-yield debthad been had been a widely-used instrument for almost a decade. The market recoveredin a few years. In Europe, trouble occurred just as the market started to grow, and it maytake longer to recover.

The U.S. has also experienced substantial trouble in the banking sector: theSavings & Loan Crisis. Between 1980 and 1994, 1,617 banks insured by the Federal


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Deposit Insurance Corporation (FDIC) were closed or received financial assistance farmore than in any other period in the history of U.S. federal deposit insurance.37 In theearly eighties, U.S. legislators sought to deregulate savings and loans institutions -- and,to a lesser extent, banks -- to give them the opportunity to adjust to changing marketconditions and stimulate modernization of the financial system. These regulatory changes

substantially relaxed limits on the amounts of risk which institutions could take.Furthermore, regulatory enforcement was weak. The resulting recklessness, and evenfraud, among banks and thrifts led to a large number of failures. The problems wereespecially severe in regions that underwent local recession, such as Texas when oil pricesdropped. An astounding 599 institutions collapsed in Texas. However, in many regions,recession resulted from banking deregulation as excessive lending fuelled a boom-and-bust economic cycle. Toward the end of the eighties, regulation was again tightened. Bythe early nineties, the situation had stabilized.

The Savings & Loan Crisis doesnt appear similar to the current trouble inEurope. In the U.S., the problems were caused primarily by shifts in regulatory practice

toward a more liberal stance, and back again, in an attempt to find the right balance. Theproblems came and went in a relatively short time. In Europe, however, the currentproblems derive from business culture. Regulators wishing to reform the financial systemare fighting a tradition of government interventionism and relationship-based banking. Itis perhaps reasonable to expect reform in Europe to take substantially more time than itdid in the U.S.

Risk Transfer between Parties

Recently, commentators have brought up additional issues with risk management.Concern has risen about the practice of transferring risks, such as credit risk, from onefinancial institution to the next, through a variety of modern financial instruments. Thiskind of transfer can be very attractive if it allows risk to be moved into a more lenient,and less costly, regulatory regime. In a recent article, Andrew Crockett, general managerof the Bank for International Settlements, commented: The pace of developments infinancial markets during the past five years means that many new financial structureshave yet to be tested in a downturn. For example, a whole new range of financial riskinsurance and transfer products has developed to spread risk more widely. How robustwill these prove if default rates rise?38 There are several possible dangers with thesekinds of transfers. The parties may have different levels of skill in assessing a particularkind of risk, and different levels of information. An example of such a transfer is wheninsurance companies and other investors insure bank loans, bonds and other corporatedebt. Some insurers may be assessing credit risk accurately. Others may find the riskattractive only because it is treated lightly by their regulators and will not voluntarilyappropriate capital to support the risk.39 Often, risk is transferred from a better-informedparty to a less-informed party. The danger is clear. Although the financial system is not in

37 History of the Eighties Lessons for the Future, FDIC, Dec 199738 The World in 2002, the Economist, 01/02/0239 The Joint Forum, Risk Management Practices and Regulatory Capital, Bank for International

Settlements, 2001


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immediate danger, the matter certainly requires attention, and it has become the subjectof public debate.

Final Comment

On the whole, the story of risk management within the European financialsystems is not a happy one. Debt investors have limited competence. Banks are oftenover-exposed. Measures to remedy the problem are only now being negotiated, and theywill likely be subject to political compromise. But at least the issues have been raised,and there is general agreement on the way forward. Things should be getting better. Theprocess of change will affect many European companies directly, and the pain ofimposing financial discipline -- in the form of bankruptcies and corporate restructuring --may be substantial. The barriers to change are cultural, thus progress may be slow.


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3. THE CHANGING NATURE OF EUROPEAN

BOARDS

Within the different countries of Europe, companies boards have special rulesand structures which are hard for foreign investors to understand. A common perceptionis that directors are not always selected on the basis of how much value they can add tothe company. Often, directors of listed European companies are not independent.Individuals sitting on the board of large corporations routinely find themselves at thecenter of complicated webs of personal relationships and pressure groups that end upconditioning their behavior. Shareholder interests, especially minority shareholderinterests, are not necessarily the first priority when making decisions.

Companies should have knowledgeable, well-informed, powerful boards for tworeasons. First, it has been proven that good boards create value for the company, theshareholders, the workers and, ultimately, for countries. Second, our interviews andresearch show that the market has recognized some problems, and trends have emerged to

correct them.

As is the case in all areas of the world, Europe does not lack examples of badcorporate governance. For example, a recentEconomistarticle on French business40reported: French bosses are particularly cozy with each other... There is the tendency fortop managers to sit on each other's boards. Mr. Messier [CEO Vivendi] sits on Mr.Arnault's [Chairman LVMH], and Mr. Arnault sits on Mr. Messier's. The Vivendi bosssits on Alcatel's board, while Mr. Tchuruk [CEO Alcatel] is a director of Vivendi andthree other big firms. Given these cross-relationships, there are strong possibilities thatpersonal relationships could win out over the best interests of shareholders.

Germany provides another example of bad corporate governance. In Germany,each company has two boards: supervisory and management. An important quota of theseats (between 33 and 50%) on the supervisory board is reserved to workers.41 Thesupervisory board can appoint and fire the members of the management board. There isno formal need to have a CEO: the Chairman of the Management board can be a strongleader. Often, however, the chairman is a mere spokesman. Value creation is, in thewords of the chairman of a German company we interviewed in January 2002, anacademic goal in such a complex environment. Shareholders who want to protect theirinterests cannot rely on independent board members to focus on value creation. Instead,they have to hold significant stakes. The phenomenon of block shareholding is muchmore common in Germany than in the Anglo-American economies.42 Edward and Fisher,

two Cambridge University researchers, report that the vast majority of Germancompanies have a single shareholder who owns 25 percent or more of the voting capital.The small shareholder has no voice.

40 The Economist, March 21, 200241 In companies with more than 500 employees. This practice is called codetermination42 Gorton, Gary and Frank Schmid; Universal Banking and the Performance of German Firms,

Journal of Financial Economics, 2000


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More cases can be found in Italy and Spain. In Spain, recent research revealed

that 50% of all listed banks of Ibex-30 do not comply with some or all of the provisionaof the code of Good Corporate Governance (Codigo Olivencia) relating to boardscompensation. Banks do not frequently disclose the compensation of their directors, and

they often fail to highlight the link between pay and performance. In the first months of2002, a group of directors of BBVA (Spains second largest bank) were found guilty ofholding secret personal accounts in tax havens. The accounts were used to embezzlecompany funds. In Italy, it can be hard to find board directors with businessbackgrounds. In the country where Roman law was invented more than 2,000 years ago,it has also become hardest to use. Typically, a board member is first and foremost well-versed in the art of reading and writing the fine print.

3.1 Why are Boards Relevant to Corporate Governance?

Boards are critical when a company seeks access to capital markets. Boardsguarantee the protection of minority shareholders by supervising management and

ensuring they do not fall into the temptations generated by the principal-agent problem.There are many studies that prove that boards matter to public shareholders.43 Atan academic level, it has been proven that investors are willing to pay a premium to ownshares of companies run according to sound corporate governance principles. Having agood board is one of these sound governance principles. Furthermore, common sensetells us that the small investor giving his money to the managers of a corporation willsleep better at night if the managers have supervisors who make sure the money is put togood use. For this reason, it is worthwhile to worry about the effectiveness of the boardsin Europe and their potential for improvement.

In our research, we performed a review of the economic literature44 to identifyprinciples of practical relevance to identify what constitutes a good board. Boards havebeen the object of extensive analysis in both the economic literature and the managerialliterature. Although many questions remain unresolved, the studies point to somegenerally-accepted principles with which boards should comply:

1. A small number of board members will be more effective and create more

value.

2. Effective boards are independent and of a reasonable size. A passive board,which makes few decisions, is either too large and suffers from afreeriderproblem, or has little independence and is too management friendly.

3. Effective boards are not packed only with big-name people. Sometimes peoplemore committed to the companys mission (such as the founders of a company)can be more valuable.

43 Edward E. Lawler III, David Finegold, George Benson, Jay Conger, Adding Value in theBoardroom, MIT Sloan Management Review Winter 2001

44 A very good summary of the economic literature on boards is contained in: Benjamin E.Hermalin, Michael S. Weisbach NBER Working Paper No.w8161 Issued in March 2001


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4. Boards must be independent and members should be adequately

compensated to create value. When a director is also a shareholder, that personis more willing to make tougher decisions, like replacing the CEO when theperformance is unsatisfactory.

5. Boards have to include younger, active people, with time to spend inunderstanding the companies and their industries. On average, boards withfewer outsiders appear to give higher salaries to CEOs. Also, CEO pay rises withthe number of outsiders appointed by the CEO, the number of directors over age69, and the number of busy directors (sitting on many other boards).

6. Practices of electing directors from lists prepared by the management haveto be restrained.

7. Effective boards must be truly independent. Not only should directors nothave financial relationships with the company or its members, but directors

should not owe favors to CEOs. CEOs with interlocking boards get paid, onaverage, more than otherwise similar CEOs.

The results of our research show, therefore, that true independence goes beyondwhat is usually required in most European governance codes. At this point, though, itbecomes interesting to understand if there are major trends in the evolution of Europeanboards, and if these changes will move boards in the right direction.

3.2 Are European Boards Changing?

Despite some problems with continental European boards, one cannot say that theGerman two-tier system has proven ineffective or that the United Kingdom model hasprevailed. Neither one is immune to critiques. No research has given obvious results onthe greater effectiveness of either system. What it is obvious, however, is that investorshave started to put a great deal of emphasis on scrutinizing the corporate governancepractices of companies and on the composition of the groups of people that representtheir interests.

As a result, in the last two years, every European country seems to have issuedsome sort of Corporate Governance Code. In addition, in the last few months, the pace ofchange has accelerated. A major stream of news has exploded after the Enron collapse.Deutsche Bank is undergoing one of the most important transformations of its history,shrinking the management board and creating an executive group. BBVA hasreduced the size of its board from 32 to 21 members, eliminating people with littleexperience in banking. A number of academic research institutions with a focus oncorporate governance have been founded or revived in the last year. Others even hope tobuild a business out of the moment: Deminor Rating, a Belgian consultancy, has recentlystarted to promote class actions on its website. Investors can go to the website and join adrive against the management and boards of European companies supposedly violatingthe principles according to which all shareholders are made equal.

Emerging Trends


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Stepping back from the daily flurry of news and opinions, we can see the bigpicture: the nature of boards in Europe is changing. In our research, we have found thatchanges across different countries and industries exhibit at least four45 different patterns:

- European CEOs are acquiring more power in their boards. There seems to be ashift to a more American style and status. Individuals are making an

international name for themselves by rejecting the stuffiness of old-style business,prioritizing value creation, and speaking openly about it in and outside boardmeetings. CEOs like Jean Marie Messier, Francois Pinault [CEO PinaultPrintemps-Redoute], Josef Ackerman [CEO Deutsche bank] and many more arereshaping the landscape of European boards and European capitalism in general.

- Boards are becoming more independent. Among the most notable examples:inGermany, the private sector adopted two codes on Corporate Governance in 2001.One of the codes, adopted by a panel led by a former influential ManagingDirector of DSW, (the asset management unit of Deutsche Bank), recommendsthat each board have asufficient numberof independent directors on thesupervisory boards46 and that boards have at least six board committees. In

France, the National Assembly and the Senate are rumored to close to approving abill that would separate the solitary post of Prsident Directeur Gnral(equivalent to the Chairman and CEO position) into two posts, unlessshareholders explicitly vote for a different solution. In UK in March 2000, theDepartment of Trade and Industry issued aReport on Company Law Reform withmany recommendations aimed at strengthening the independence of the board andthe chairman. In Italy, a new segment of the stock market, called Star, wascreated. Companies that want to be listed in Star must comply with a set ofguidelines, most of which relate to matters of board independence.

- Boards are becoming more accountable: The rise of an equity cultureacross continental Europe has led to an increase in shareholder activism.Shareholders, both individuals and institutions, are becoming able to bypassboards and voice their own interest. Boards members are being called on moreoften to give reasons why they approved transactions that negatively affectminority shareholders. In 2001, minority shareholders:

- blocked the takeover of Legrand by Schneider Electric because itdid not respect some preference rights attached to their shares

- sued Deutsche Telekom because it wrote off some assets,implying that some of its acquisitions had been grossly overpaid

- blocked the board and management of Telecom Italia fromconverting all saving shares into ordinary shares at an unfair price.

- Institutional owners cannot sell their shares without depressing market prices, andthey prefer to increase their returns by fighting with management and replacingboard members with their representatives. Financiers like the Swiss Martin Ebner

45 Some of the facts reported in this section appear in Corporate Governance in OECD MemberCountries: Recent Developments and Trends, OECD Steering Group on Corporate Governance, April2001

46 In Germany it usually happen that retired members of the management boards move up to theSupervisory board, a practice clearly against the principle of independence of the board from themanagement


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and the American Wyser-Pratte spend their time looking for under-pricedcompanies, buying minority stakes, vying for board seats, and fighting currentboard members and management. Board members can no longer sleep throughpresentations and cash their attendance check at the end. They are being called onfor involvement.

- There is a higher awareness that boards should be able to add value:Although we are not yet at the point where European board members have startedto undergo performance evaluation reviews, it has become clear that diversity,talent and experience are fundamental requisites of a board member and cannot besubstituted for by independence alone. In the UK, Patricia Hewitt, the trade andindustry secretary, recently declared: "Non-executive directors play a key role inBritish companies by helping to drive up performance. It is in all our interests thatthey do their job as effectively as possible. We need stronger, more independentand more active non-executives drawn from a wider pool of talent to play theirpart in raising productivity."47 Governance experts and institutional investors inmany OECD counties have made important strides. In Canada in 2000, for

instance, the government amended a bill aimed at, among other things, reducingresidency requirements for the board of directors and its committees. The purposeof the change was to improve recruitment of foreign board members. In Australia,regulators favored a huge increase in the degree of independence of boards overthe 1990s. In 2001, breakthrough research by the consultancy company CorporateGovernance International and the University of Melbourne found that companieswith a majority of independent directors have under-performed the stock marketin the last few years. A closer analysis showed the reason: independence has gonetoo far in Australia, and independent directors should not be selected purely onthe basis of their independence, but also with a close view to their backgroundand the fact that they can contribute to the business.

3.3 Are European Boards becoming more valuable?

The fact that change in Europe is happening, and at a remarkable speed, is nolonger a question. Perhaps more interesting is to wonder whether changes are going in theright direction. It is true that the structure and practices of boards reflect the differencesin diverse countries. On the other hand, it seems non-controversial to talk of goodboards and bad boards, regardless of where they operate. An international standard ofcorporate governance was produced in May 1999 when OECD ministers adopted fivefundamental principles. The responsibilities of the board were among these principles.These principles have become one of the 12 international financial stability standardsalong with the Basel accords and IAS. Everybody now recognizes the importance ofbenchmarking their efforts to a global benchmark, says Stilpon Nestor, the OECDshead of corporate affairs. People argued that corporate governance was local andcultural, now nobody puts these arguments forward any more. Everybody now recognizesthe cost of bad corporate governance."48

47 PRN Newswire, April 200248 New Rules of Good Behavior, Euromoney, September 2001


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Most of the current changes seem positive if evaluated in light of the principleswe elaborated:

The increase in independence of European boards is, from most points of view,positive. More independence is associated with more value to shareholders,insofar as the outsiders are truly external to the management and bring in the

adequate level of commitment and knowledge of the company and the industry. Higher accountability is providing board members with incentives to focus more

on value creation. This change, in terms of incentives, is equivalent to a moreefficient form of compensation.

Stronger awareness that diversity, talent and experience are key elements invaluable boards acts as a trigger to further changes which will improve the qualityand effectiveness of boards in Europe.

The increased strength of European CEOs is a phenomenon hard to interpret. Onthe one hand, it might be the result of an inevitable, productive specialization ofsupervisory and managerial tasks. On the other hand, it might foster the creationof docile, accommodating boards -- the last thing that static European

corporations need.

Vivendi Universal provides an example of how a board of directors that adhere toprinciples of good governance take action on shareholder behalf. Vivendi Universalsinvestor relations website describes the company's board of directors:

The Board of Directors met ten times in 2000. It currently comprises 19 members, including 14 independent directors. Seven members are not French. All directors must own at least 750 shares throughout the period they serve on the

Board. The Board is advised by two Directors' Committees, which meet at least two or

three times per year:

The Remuneration Committee has three members, including two independentdirectors. The committee examines the remuneration of directors and of VivendiUniversal's senior executives. In addition, it is consulted with regard to stock optionsand share subscription schemes, as well as on the selection of Vivendi UniversalBoard members.

The Audit Committee has four members, including three independent directors.The committee examines the financial statements, accounting methods and internalcontrol procedures before the statements are presented to the Board. It recommends

the nomination or re-appointment of the statutory auditors.

The Financial Times (April 18, 2002) reported on Mr. Messier's firing of the CEOof Canal Plus, Vivendi's pay TV business:


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The saga at Vivendi Universal may be focused on the hubris of one

man. But it also threatens to challenge the club-like atmosphere in corporateboardrooms across France. Why did it take an outsider, Axa's Claude Bbar,to stoke things up by urging Vivendi's board to control Jean-Marie Messier?

Possibly because Mr. Messier has packed the board with friends who may bejust as loyal to him, on personal grounds, as some of his bankers are provingto be. Mr. Messier sits on the boards of four companies - Alcatel, BNPParibas, Saint-Gobain and LVMH - that provide five non-executive directorsto Vivendi's board. Even if his directors are becoming agitated by the mess atCanal Plus and the so-called "Messier discount", Mr. Messier can probablycall in some favors where it countsIt is clear Canal Plus is in need of ashake-up Separating the role of chairman and chief executive officer mighthelp.

Vivendis problems exemplify of some of the fundamental issues of boards of

directors that have yet to be addressed in Europe.

3.4 Summary: Issues Remaining to be Addressed

First, in our research and interviews, we found that CEOs in Europe are still theones who choose the candidates to directorships that are presented to shareholders.

Second, CEOs and Chairmen are the same person in most European corporationsin many countries. If we add this feature and the fact that star European CEOs havebecome more vocal, we get situations close to one-man corporations, which are oftendetrimental to shareholders.

Third, the main problem seems to be that European boards belong to quite arestricted elite, defined by personal relationships and a web of cross-shareholdingsamong the major companies. Most students of European corporations would find it easyto identify who the most influential people are. The cadre of names from which tochoose is small. While there are many sources of directors biographies in the US,European corporate information sources should display directors genealogical trees.Also, changes in legislation can help eliminate the most obvious conflicts of interest, butno royal decree will force companies like Vivendi to oppose the views of the CEO andask for his replacement. As long as public European corporations are run by a luckyminority, the debate on independence will be largely moot. Instead, the debate should beabout how new firms in Europe are created and how true meritocracy can be introducedacross the business world.


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4. THE MARKET FOR CORPORATE CONTROL

Changes, such as privatizations and encroaching capital market influence, areincreasing the pressure on managers to maximize shareholder value. Many academics 49and practitioners of management and corporate finance in America and in Europe

highlight three major sources of pressure on public firms.

First, intense pressure from international capital markets to generate sustainablereturns above industry average. The growth and the globalization of the economy hasincreased the demand and supply of equity worldwide. The shift to a savings culturebased on equity, the change in demographics, and the increase in the volume managed byinstitutional investors (especially pension funds) have significantly increased thepotential supply of funds to capital markets. On the demand side, an increase in thenumber of public companies (around 30% during the last decade) means moreopportunities for investment. Furthermore, the intense pressure for high returns hasincreased trading volume (a 130% increase during the last decade). This higher trading

volume, whether caused by an increase in the number of public stocks or by a decrease inthe length of time of stock holding, shows that companies are more exposed to investorscrutiny. Private companies that went public are now compared against the performanceof their relevant index. Investors looking for returns can get in and out of stocks easily.

Second, activism and professionalism of shareholders: institutional investorownership. During the last decade, institutional investor ownership has increasedsignificantly in Europe, becoming the most important class of investor. Institutionalinvestors focus on maximizing value because they do not have conflicting incentives suchas banks might have. While pension funds focus on generating future cash flows to paypensions, banks also consider the credit business they maintain with companies. CEOs

consider institutional investors to be the most important investor class becauseinstitutional investors can significantly influence the market value of the firm.

Last, thewinner-takes-all economy: hyper-mobile pools of capital in search offirms with best practice in governance rules and super-normal returns.Today's winner-takes-all capital market signals a new era. Across sectors, a few players are creating mostof the new shareholder value. A McKinsey study50 highlights that 5 to 10 per cent ofcompanies in a given industry create all of the shareholder value in that industry. Giventhese facts, investors are trading in and out of firms in continuous search of super-normalreturns. In fact, McKinsey and Institutional Investor research51 shows that institutionalinvestors would be willing to pay an 18% premium for the shares of a well-governed

company52

in the US or the UK and a 20% and 22% premium for the shares of well-governed companies in Germany and Italy, respectively.

49 Salter, M. (2001).50 Campbell, D. and Hulme, R. (2001).51 Combes, P. and Watson, M. (2000).52 A well-governed company was defined as one that has a majority of outside directors with no

management ties on its board, undertakes formal evaluation of directors and is responsive to requests frominvestors for information on governance issues.


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These three sources of pressure on corporate executives suggest that CEOs should

give top priority to the design and monitoring of corporate governance systems,especially those related to defensive measures, because they have a direct and visibleimpact on shareholder value.

A change in the European way of business: Telecom Italias takeover

One of the takeovers that greatly influenced the market for corporate control inEurope is the Telecom Italia (TI) takeover. Olivetti, with revenues one-seventh of TIs$30 billion and a market capitalization one-quarter of its target, created a turning point inthe European way of business.

A change in the rules of the game: the Draghi lawLegal reform in Italy made this takeover possible. The Draghi law, first

proposed by and named after the former general director of the Italian treasury,introduced two major changes that facilitated an active market for corporate control.

First, it suppressed the rights of the Italian government to veto any acquisition of morethan 3% of ordinary, voting shares if a formal offer was made for 100% of those shares.Second, once the formal offer was submitted to the Italian market regulator (Consob), nochange in the capital structure of the target and no issue of new debt could be madewithout the approval of 30% of the capital. These two actions significantly limited thenumber of defensive actions that the target could take. Managers of undervalued orpoorly-performing companies were no longer secure in their jobs. Their companies couldbe bought from under their control.

Complexities of the takeover: the alliance and TIs defensesThe fight was very intense. Many international investment banks and the powerful

Italian investment bank, Mediobanca, backed Olivetti. The takeover took the shape of anLBO in which Olivetti planned to use the cash flow of the target to pay the debt. Asyndicated loan of 22.5 billion Euros was arranged from 20 banks in three weeks,showing the corporate finance capabilities that had been developed in Europe. Thenumber of banks, speed and amount of the loan showed that European financial marketsand bankers were prepared to facilitate an active European market for changes incorporate control.

Telecom Italia hired many investment banks as defense advisors who presentedmany strategic, financial and legal defenses. Among them were: another takeover from afriend firm of Telecom Italia, a pacman defense, and a dry-up of the loan market.However, Franco Bernabe, CEO of Telecom Italia at the time, fought without consideringthe influence and power of capital markets:

I am not going to do anything I would not have considered in the normalcourse of business. I want to make a distinction between this highly leveraged,

speculative bid, and a solid commercial strategy. Our defense will be our

industrial plan.


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The CEO of Olivetti at the time, Roberto Colaninno, presented the acquisition asan opportunity to cut costs, create cell-phone alliances, invest in new services, andimprove the domestic network.

The takeover resulted in a new paradigm for the European market of corporate

control. Governance provisions protecting interests other than those of shareholders werefewer; now, the focus of the law was on preserving shareholder interests.

The Telecom Italia deal spurred similar transactions on the continent. In 1999,Vodafone completed the largest hostile takeover ever when it bought Mannesmann. OneUK analyst qualified the logic of the deal as impeccable, andthe value to be gained byboth sets of shareholders of bringing these assets together is enormous."

For all of the progress from an investor perspective, there are still some barriers tomergers and to enhancing the majority of shareholders interests. One high-profile casewas the failed merger between the Spanish telecom operator, Telefonica, and the Dutch

telecom operator, KPN. The discussions were not strictly focused on the shareholdervalue creation but on the degree of liberalization of the economy of both countries. Onthe one hand, Telefonica had already been privatized and the only right that thegovernment had on it was a golden-share option. On

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