Reforming Corporate Governance
Anförande vid Kreabs tioårsfirande i Bryssel, Belgien
The subject of today’s Kreab anniversary seminar is certainly topical. On the other side of the Atlantic, corporations are struggling with the regulatory fall-out from the reaction to the series of corporate scandals that shook the confidence in corporate America earlier this year. The leaders of Iraq might have replaced the leaders of Enron as the chief villains of the world, but all the issues brought to the surface by the series of corporate scandals are certainly not gone. And on this side of the Atlantic, we saw the publication only yesterday of the report by the High Level Group of Company Law – the so-called Winter Group – with its recommendation for European action in a number of areas. The subject is now truly on the European agenda. No one that cares about the future of the European economy can ignore it. Corporate governance is certainly not a new issue. All countries have their own legislation. All stock exchanges have their set of demands on companies they are prepared to trade the shares of. And we should not forget that the debate on corporate governance often also has focused on other stakeholders in a company than the shareholders that are in the focus of the debate today. It was not long ago that much of the debate focused on participation by the employees in the structures of governance of a company. And often there are demands by different public interests to have consideration of their interests or points of view taking into consideration when the structures of governance of companies are discussed. These are legitimate concerns. There are many stakeholders in a company. The customers – key to the future of any commercial endeavour – should certainly not be forgotten. But today the debate really centres on the shareholders, thus on the capital markets and thus on the core of the economic system sometimes referred to as the capitalist system. Any market economy is based on rules. These might be implicit or explicit. It is by accepting or made to adhere to a common set of rules and values that a market is established. Without such common rules and values, a functioning market is hardly feasible. The most important of the rules establishing a market are those establishing the rights of property. The more studies that are done, the more clearly we see the link between firm property rights and economic development, and between firm property rights and a law-based society and democracy. This is a central fact we must not lose sight of. The share-holding company was a major innovation, and a critical part in the evolution of our modern economic system. It can be argued, that it was the inability of Karl Marx to see this development, and the significance of it, that rendered his studies and theories concerning the evolving new economic system basically irrelevant. Capitalism was doomed not to dramatic destruction - but to phenomenal success. Thus, we can safely say that the share-holding companies are at the hearth of our economic system. Their governance structures are not a matter of peripheral concern. Many of the laws that are regulating corporate governance in our different countries today have their background in those periods when there has been a major crisis in the system, and a public perception that some sort of legislation is needed in order to restore the legitimacy of the economic system. In the United States, to take the most obvious case, almost all the rules - up until the most recent decisions - had their background in the experience of the 1929 stock market crash and the subsequent great depression. And this is of course the reason why we are having the debate today. In the United States, were major decisions have been made and new ones are pending, it is all driven by the accounting scandals and outright financial fraud that we have seen primarily in the case of Enron. The fact that share ownership is far more widespread now than in the past, that pensions are more important as the average life span increases, and that a substantial part of the savings for pensions is in shares, gives these issues a political weight, and even a social significance, which they certainly did not have some decades ago. Popular capitalism in the form of a widespread direct or indirect ownership of shares creates a public concern with also the governance issues of the corporations that are at the hearth of the capitalist system. This is essentially a good development. My background is certainly not in the field of corporate law, but I am a non-executive director of publicly listed companies on both sides of the Atlantic, thus with at the least some understanding of some of the issues involved. The key issues to focus on are obviously the issues of transparency and accountability. Transparency applies primarily to financial information. To invest in shares is to invest in risk, but in order to be able to assess the risk, it is imperative that there is access to relevant financial information on the performance of the company in question. Transparency is obviously in the interest of the shareholders. This is one of the reasons there is a legitimate interest in different rules that establishes standards for financial transparency. But it should not be forgotten that it is also, at the end of the day, in the interests of the companies themselves. If they are interested in attracting the capital of the financial market, and encourage investors to take the risk in investing in their shares, they have an interest in the transparency that builds thrust. There could be a short-term temptation to withhold information of the one sort of the other, but there is always a severe long-term penalty for doing so – or even be suspected of doing so. Contrary to some of the popular myths, the market is a mechanism that over time rewards honest and decent behaviour. People – and it’s people with their money that makes up the markets – do not like to be cheated. It’s a testimony to the mechanism of the markets in these respects that the Enron’s of the world end up in disgrace, bankruptcy and even prison. It is equally a testimony to the mechanism of the market in this respect that every corporation in the United States is now involved in a competition of decency and transparency in order to fulfil these very central demands of the marketplace. To understand this is central to the debate. If one is guided by the basic belief that markets rewards crooks rather than honesty, then there is obviously a very strong case for very intrusive regulation and legislation in order to safeguard the economic system as such. The market must then be saved from itself. But if one is guided by the assumption that the markets rewards honesty and punishes dishonesty, the conclusion is a very different one. There is still the necessity of basic legislation establishing the basic standards and rules necessary in any market environment. But there is a much larger scope for different types of self-regulation, as well as for relying on the mechanisms of the market itself. It is necessary to take a long view when considering issues of regulation as basic as these. When there is a rush to legislation under the immediate impact of an immediate crisis, every experience ever gained tells us that the result is often less than ideal. This has been demonstrated once again by the so-called Sarbanes-Oxley Act that President Bush signed July 30, and which one is now struggling to start to implement in the United States. The basic issues that the Act wants to address are important ones. It aims at strengthening the independence of auditors and audit committees, improve quality and transparency of corporate financial reporting and improve timelineness of insider’s reports of changes of beneficial ownership. It also seeks to address possible conflict of interest of directors and executive officers as well as securities analysts. All of this is highly relevant in the post-Enron world. The question is whether the measures proposes overshoots the target by introducing rules and regulations that will be more of a burden than a help, and which might even introduce strong disincentives to behaviour that is central to the entire economic system, primarily the willingness to take risks. The willingness to take risks is the lifeblood of a dynamic economic system. This applies in particular to periods like the one we are living in now. We are in the midst of the most dramatic scientific and technological revolution mankind has ever experienced, and we are in the midst of the second great wave of globalisation of our economies. The combination of these two makes for an environment where there are no such things as stability and certainty, and where the winners will be those willing and able to take risks. If the outcome of every decision is known in every detail it is very easy to say that we should have rules that put heavy penalties on those taking decisions that evidently and obviously have consequences that are wrong or not acceptable in some other way. But that is not the way the world works – or should work. Inherent in the concept of risk is the concept of failure. If we want to encourage risk taking, we must accept failure, and if we increase the penalties for failure in different ways, we are bound to discourage risk-taking, thus slowing down the very dynamics of the economic system that we need. It is a difficult balancing act. We should be aware of it, and we should follow closely the debate in the United States on the issue whether Sarbanes-Oxley has gone too far in one direction, possible to the detriment of the dynamism of the economy as a whole. The Winter report issued yesterday seeks to address some of the same issues from a European perspective, but then adds the issue of the remuneration of directors. It calls for European law on some issues, and calls for the setting up of a structure to co-ordinate the corporate governance efforts of the Member States. It must be studied in more detail than it has been possible at the least for me to do in the hours since its publication. But what I have seen and heard does not fully convince me that we have managed to avoid the pitfalls demonstrated by the US in the Sarbanes-Oxley Act. I do believe, however, that there could be merit in the proposal to set up some structure to discuss and coordinate the different corporate governance efforts in place or underway throughout the Member States. And such an effort might have particular value seen in the perspective of the coming enlargement with first ten and then an additional two states during the coming years. There might – just to take an example – be issues of the rules of financial transparency in Cyprus that would merit discussion in a wider European context. And many of these countries will want to learn from our different experiences when it comes to fine-tuning the different systems that they have put in place during recent years. There are at present no less than 94 different codes for corporate governance listed on the web page of the European Corporate Governance Institute. Although the overlap is bound to be significant, it points at the diversity of the different efforts in the area. Clearly, it would be unrealistic to try to mould them all into one uniform structure but, equally clearly, a strong case can be made for a process of convergence between them in the years ahead. And let’s hope that this will be the conclusion of the debate now underway. We have no reason whatsoever to assume that our countries are free of the risks of corporate scandals, but neither should be ignore the fact that the scandals that triggered the debate of today occurred not in Europe but in the United States. And when moving forward here with the steps that can be called for, we should avoid the mistakes of undue haste, over regulation and possible disincentives to risk taking that were made on the other side of the Atlantic. The issues of corporate governance is only part of the agenda we are facing. The invitation of today mentions also the need of maintaining competitiveness. And I would argue that while restoring market confidence through sensible steps of reforming corporate governance is important, highlighting the urgency of taking steps not to maintain, but improve, the competitiveness of Europe is truly imperative. We are not there just yet, but we are clearly close to the point when it will be said that the Lisbon agenda of economic reform, aiming at creating the most dynamic knowledge-based economy in the world by the end of this decade has been abandoned. This would have severe repercussions not only for the economic performance of European societies in the next few years, but for their social stability and cohesion in the somewhat longer perspective. The facts are there: while productivity continues to improve in the US economy at rates that are historically impressive, rates of productivity increase in the European economy are not only substantially lower but also declining. And while the working age population of the United States continues to increase, not the least due to the ability of a dynamic economy to integrate new flows of immigrants, the working age population of our countries will decline substantially in the years ahead, with difficulties to integrate immigrants only adding to the pressures that are building up. These trends will have consequences. Today, the European Union and the United States are each app 30 % of the global economy. On present productivity trends, the US will be closer to 40 % of the global economy within two decades, and the EU will, also taking enlargement into account, be well below these 30 %. While Western Europe today has more than 100 million more inhabitants than the United States, present trends point at a situation in which in half a century the US will have close to 50 million more inhabitants than Western Europe. These are issues that must be addressed. Structures of corporate governance that encourages risk-taking, creates incentives to capital creation, further spreads share ownership, supports a much better environment for entrepreneurship and truly increases the flexibility of our economic system are very clearly part of what we need. But priorities are important. It is not absolute financial fraud – but rather relative economic decline - that is the key economic governance issue threatening the future of Europe.