Corporate Governance and Control in Europe Nico Dewaelheyns Faculty of Economics & Business

Why do governance and control matter? Central financial goal of companies: maximize shareholder value, while respecting the rights of other stakeholders (e.g. employees, creditors, clients, suppliers, government, etc.) In practice, managers or board members do not always make decisions which are optimal for the value of the company Extreme cases: accounting fraud, for instance: ‒ WorldCom: 3.8 billion USD of costs were not taken into account ‒ Enron: 1.7 billion USD ‘hidden’ losses → more regulation (US: Sarbanes-Oxley) ‒ Europe: Parmalat, Ahold ‒ Asia: Hyundai/Kia, Olympus Europe Inside Out Corporate Governance and Control in Europe 2

Why do governance and control matter? Europe Inside Out Corporate Governance and Control in Europe 3 Negative consequences for company value are severe: Source: euroland.com

Why do governance and control matter? Europe Inside Out Corporate Governance and Control in Europe 4 Source: euroland.com

Agency problems Potential causes of suboptimal behaviour: agency problems Day-to-day management of the company is delegated by shareholders (the principals) to managers (the agents) Delegation improves the probability of a company’s continuity – shareholders can sell their stake – managers can leave Delegation allows for a higher level of professionalism However: differences in incentives and information Europe Inside Out Corporate Governance and Control in Europe 5

Agency problems Problems caused by separation of ownership and management  managers may not always have an incentive to maximize the overall value of the company Agency costs – excessive luxury spending – obtaining personal influence and power – costs of internal and external auditing (monitoring costs) – risk avoidance in project selection (entrenchment) Europe Inside Out Corporate Governance and Control in Europe 6

Agency problems: solutions Make sure that the incentives of managers and shareholders are well aligned Incentive pay: stock option plans given on top of base pay  large bonus if stock price increases Downside: increases short termism and rewards risk seeking behaviour Europe Inside Out Corporate Governance and Control in Europe 7

Agency problems: solutions Market disciplining corporate results and behaviour are monitored by financial analists, major investors, journalists, etc. badly performing managers can be fired (golden/platinum parachutes?) badly managed companies may be acquired by outside parties (e.g. Arcelor/Mittal Steel) Europe Inside Out Corporate Governance and Control in Europe 8

Agency problems: solutions Corporate governance regulation Set of best practice rules and principles on corporate structure and organization (for instance, OECD 2004 list) Different regulations in each country, but typically imposed on publicly traded companies and advised for private companies Legal enforcement vs. auto-regulation? Europe Inside Out Corporate Governance and Control in Europe 9

Corporate Governance Principles: Examples – Board of Directors acts in the best interest of the company – Directors show integrity and dedication – Transparant procedures for appointing and evaluting directors – Committees for renumeration and nomination – Role of executive directors is clearly structured – Directors and managers receive fair compensation – The rights of all shareholders and stakeholders are respected – Full disclosure on all goverance related issues –... Europe Inside Out Corporate Governance and Control in Europe 10

Corporate Governance Regulation in the EU Attempts at harmonization across member states, for instance: Recommendation on the Role of Nonexecutive/Supervisory Directors and Supervisory Board Committees (2004) Directive on Takeover Bids (2004) Recommendation on the Remuneration of Directors (2005) Transparency Directive (2005) Directive on Company Law, Accounting and Auditing Rules (2007) Directive on the Exercise of Shareholders’ Rights (2007) Directive on Transparency Requirements for Listed Companies (2013) Europe Inside Out Corporate Governance and Control in Europe 11

Shareholder concentration & control Anglo-Saxon countries: ― stylized fact: dispersed ownership ― supervision by financial markets (e.g. institutional investors) Drawback of dispersion: free rider problems ― individual shareholders have little incentives to use voting rights ― lack of control on management if financial markets are not well organized Rest of the world: often highly concentrated ownership Asia: Japan (keiretsu), Korea (chaebol) Europe: controlling shareholders; complex mechanisms Europe Inside Out Corporate Governance and Control in Europe 12

Ownership in the US Limited direct control by founders/founding familiy Ownership transparant and straightforward Europe Inside Out Corporate Governance and Control in Europe 13

Ownership in the US Europe Inside Out Corporate Governance and Control in Europe 14 Source: finance.yahoo.com

Ownership in the US Europe Inside Out Corporate Governance and Control in Europe 15

Ownership in the US Ownership of mature companies often very dispersed Example: PepsiCo Agency problem: shareholders vs. managers Europe Inside Out Corporate Governance and Control in Europe 16 Source: moneycentral.msn.com

Ownership in Europe High levels of ownership and control by founding families/insiders Complex ownership mechanisms: pyramids, holding companies, cross holdings, dual class stock, etc. Allows for the control of companies with relatively low use of financial resources Dual class stock (↔ one share-one vote; also popular in the US): ― Class A shares: high cash flow rights; low voting rights ― Class B shares: low cash flow rights; high voting rights Europe Inside Out Corporate Governance and Control in Europe 17

Direct and indirect ownership Europe Inside Out Corporate Governance and Control in Europe 18 Direct control Indirect control with majority of cash flow rights Indirect control without majority of cash flow rights Percentage of company B’s cash flow rights held by company A: 50.01% 20% + 60% x 50.01% = 50%50% x 50% = 25%

Complex ownership: GBL Europe Inside Out Corporate Governance and Control in Europe 19

Complex ownership: GBL Europe Inside Out Corporate Governance and Control in Europe 20

Complex ownership: GBL Europe Inside Out Corporate Governance and Control in Europe 21

Complex ownership: GBL Europe Inside Out Corporate Governance and Control in Europe 22

Implications for board composition Europe Inside Out Corporate Governance and Control in Europe 23

Main agency problems US/UK: shareholders managers Continental Europe: majority shareholders minority shareholders managers Europe Inside Out Corporate Governance and Control in Europe 24

EU Takeover Bids Directive (2004/25/EG) General principles: improve transition of ownership; protect minority shareholders; improve transparancy; reduce takeover defense mechanisms Europe Inside Out Corporate Governance and Control in Europe 25 Source: Baker & McKenzie

EU Takeover Bids Directive (2004/25/EG) Opt-out principle has lead to low implementation of key parts of the directive Board neutrality rule (Article 9): during the bid period the board of the target company must obtain prior authorization from the general assembly of shareholders before taking any action which might result in the frustration of the bid implemented by 19 member states (with exceptions in 13) Breakthrough rule (Article 11): neutralizes pre-bid defenses during a takeover by making certain restrictions (e.g. share transfer or voting restrictions) inoperable during the takeover period and allows a successful bidder to remove the incumbent board of the target company and modify its articles of association implemented by 3 member states Europe Inside Out Corporate Governance and Control in Europe 26

EC Proposal on Shareholder Rights Wants to fix shortcomings of existing (2007) Shareholder Rights Directive Binding rules for transparancy of institutional investors on their voting behavior Shareholder vote on director remuneration Transparancy and shareholder vote on related parties’ transactions Transparancy for proxy advisors Shareholder identification by financial intermediaries … → increase influence of minority shareholders; reduce agency conflicts Europe Inside Out Corporate Governance and Control in Europe 27

Ownership: empirical studies La Porta et al. (1999): "Corporate Ownership around the World" Analysis of the ownership structure of the largest quoted companies in 27 industrialized countries (market value >$500m) Split-up into countries with strong shareholder protection/strong anti-director regulation (mostly common law countries) and countries with weak protection/regulation (mostly civil law countries) Europe Inside Out Corporate Governance and Control in Europe 28

Ownership: empirical studies Europe Inside Out Corporate Governance and Control in Europe 29 Source: La Porta et al. (1999)

Ownership: empirical studies Europe Inside Out Corporate Governance and Control in Europe 30

Ownership: empirical studies Europe Inside Out Corporate Governance and Control in Europe 31 More recent research (e.g. Holderness, 2009) questions some of La Porta et al.’s conclusions: Stylized fact that US companies have more dispersed ownership is partly due to a disproportiate focus on very large companies Ownership concentration around the world is linked to company size, age, industry, etc.

Ownership: empirical studies Europe Inside Out Corporate Governance and Control in Europe 32 Source: Holderness (2009) blockholder: >5%

Ownership across time Europe Inside Out Corporate Governance and Control in Europe 33 Life cycle theory: most companies start off small with fully concentrated ownership (founders and their family) as companies grow, the need for professional managerial skills and the need for financial resources lowers concentration most succesfull companies end up quoted with dispersed ownership

Ownership across time Europe Inside Out Corporate Governance and Control in Europe 34 Franks et al. (2012): study the ownership of the top 1,000 companies in the UK, France, Germany & Italy ( )

Ownership across time Europe Inside Out Corporate Governance and Control in Europe 35 Ownership is persistent, but more so in Continental Europe than in the UK Extrapolation: a family firm in the UK has more than a 75% chance of remaining a family firm 40 years later, and a 30% chance 150 years later; on the continent chances of forever remaining a family firm are very high

Ownership across time Europe Inside Out Corporate Governance and Control in Europe 36 Even the case for listed family firms:

The impact of concentrated ownership Europe Inside Out Corporate Governance and Control in Europe 37 Bennedsen & Nielsen (2010): >4000 quoted Western European companies from 14 countries

The impact of concentrated ownership Europe Inside Out Corporate Governance and Control in Europe 38 Value discount for concentrated ownership: worse for family controlled, disproportional cash flow/control rights, private benefit industries, low regulation countries

The impact of concentrated ownership Europe Inside Out Corporate Governance and Control in Europe 39 No consistently significant links between ownership concentration and profitability, growth, dividend policy or likelihood of bankruptcy

The future of concentrated ownership? Europe Inside Out Corporate Governance and Control in Europe 40 Ownership is ‘sticky’ Blockholders have very little incentives to reduce their stakes Minority shareholders get what they pay for Regulatory intervention is not straightforward and can have adverse effects: e.g. the Takeover Directive increased the average blockholder percentage in several EU member states

Europe Inside Out Corporate Governance and Control in Europe 41 Bennedsen, M. & K.M. Nielsen (2010), Incentive and Entrenchment Effects in European Ownership, Journal of Banking and Finance, Vol. 34, No. 9, pp European Commission - Corporate Governance initiatives: Franks, J. C. Mayer, P. Volpin & H.F. Wagner (2012), The Life Cycle of Familiy Ownership: International Evidence, Review of Financial Studies, Vol. 25, No. 6, pp Holderness, C.G. (2009), The Myth of Diffuse Ownership in the United States, Review of Financial Studies, Vol. 22, No. 4, pp La Porta, R., F. Lopez-De-Silanes & A. Shleifer (1999), Corporate Ownership around the World, Journal of Finance, Vol. 54, No. 2, pp OECD Corporate Governance Principles: References