EU Tweaking Governance Rules

Yesterday, the European Union announced that it will consider implementation of new rules to enhance corporate governance practices in EU markets. The Green Paper addresses several areas of concern and posits that the voluntary "comply or explain" approach is not working well in every area. If you want to read more about the comply or explain approach to corporate governance, go to these older posts: the EU's Corporate Governance Forum or the UK's Financial Reporting Council. They explain the fundamental differences between a rules-based approach to accounting principles and corporate governance and a principles-based approach. Other relevant older posts are: here (accounting)and here (internal controls).

The Green Paper, written under the direction of the EU's Internal Market Commissioner Michel Barnier, identifies several key issues where the principles-based approach that gives companies the option of either complying or explaining why they don't is not working well. Through the Green Paper, the EU is soliciting feedback on a number of specific questions.

The three key areas discussed in the paper are the following:

1. Boards of Directors -- The Green Paper addresses issues of what backgrounds and skill sets make for a diverse board having "appropriate professional experience." The Green Paper reviews issues of professional diversity, international diversity and gender diversity. In addition, the Green Paper addresses the time commitment required of directors and asks for comments on whether the EU should limit the number of boards on which someone serves. Other topics addressed are regular external board evaluations, directors' pay, and risk management.

2. Shareholders -- Observing that lack of shareholder interest may have contributed the financial market issues of recent years, the Green Paper examines several shareholder questions, including:
a. Engagement by shareholders through active monitoring of the company, dialogue with management and, where needed, the exercise of shareholder rights to improve the company.
b. Short-term strategies -- High-frequency and automated trading have contributed to short-term holding periods. The EU expresses concern about the short-termism among investors and asks how the EU's rules could be changed to prevent this behavior.
c. The relationship between institutional holders and asset managers -- Current fee and commission structures can be viewed as further encouraging the short-term strategies that do not help with the creation of long-term value. Further, despite the fiduciary duty owed by asset managers to their institutional investors the level of transparency necessary for a healthy fiduciary relationship is not always present.
d. Proxy advisors -- The number of organizations giving proxy advice has proliferated in recent years. The EU observed that some have expressed concern "that proxy advisors are not sufficiently transparent about the methods applied with regard to the preparation of the advice." (For my take on a recent proxy advisor gaffe in the U.S., see this posting about Hewlett Packard).
e. Shareholder identification -- Issuers generally do not know who holds the vast majority of their shares. That's because the shares are held in street name (i.e.
through a broker rather than in one's own name). If issuers had a means of identifying shareholders, this could lead to more dialogue and greater transparency.
f. Minority holder protection -- The Green Paper expresses concern that a "comply or explain" approach can lead to potential abuse by the controlling shareholder(s).
g. ESOPs -- Employee share ownership leads to greater commitment and motivation of employees, but some employees may not diversify sufficiently (remember Enron?). The EU asks how employee share ownership can be promoted in a responsible way.

3. Comply or Explain Approach -- The EU observes that many companies fail to explain adequately deviations from policy. The EU noted, for example, that in Sweden a company need only state the reasons for not complying. There is no requirement that the company explain what approach it used instead.

The Green Paper also notes that CG policies, once adopted by companies, are often mothballed. The company publishes a good policy, but then fails to monitor compliance with the policy on a regular basis. Allowing regulators to do periodic checking on this and the disclosure issue could be helpful to shareholders.

The EU has invited comments on the Green Paper issues by July 22, 2011. Comments can be sent to: markt-complaw@ec.europa.eu