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Saturday 27 November 2010

EU wants views on scope, quality of narrative reports

EU regulationThe European Commission is looking, again, at whether to require companies to adopt a higher standard of reporting about environmental, social and other non-financial aspects of corporate affair. "The disclosure of non-financial information is important in the context of the current crisis and the challenge of sustainable development," it says in a consultation document. "Better disclosure of non-financial information may be a tool to further increase the number of European enterprises fully integrating sustainability and responsibility into their core strategies and operations in a more transparent way." So far for ordinary.

Benefits: The difficulties involve the lack of any consistent and broadly accepted standards, owing in part to the lack of a clear understanding of the interaction of these elements with corporate performance or social well-being. Proponents of enhanced reporting believe – as the European Union's document suggests – that the mere fact of having to report focuses the minds of managers on issues of the sustainability of the business. Seeking to measure performance on these matters gives managers a lever for changing policy and direction. Such information could also give investors insights into how well management is looking after the longer term issues of the business.

Drawbacks: Reporting is a burden, and disproportionately so for smaller companies. Adding detail will also serve to lengthen corporate annual report, making them harder to digest and understand. Ensuring the accuracy of their assertions – through external assurance statements or audits – isn't straightforward, raising questions about how managers might manipulate the reports.

So what to do? "The current EU programme is in favour of better regulation that aims at cutting red tape rather than adding to administrative burdens," the commission writes. But a variety of international activities are pointing increasingly towards common standards. The Global Reporting Initiative, the United Nations Global Compact and the Organisation for Economic Co-operation and Development's guidelines for multinational enterprises all get specific mention. So, the EU wants to know:

  • How good is your country's current regime?
  • What could be done to improve it?
  • What items should such reports include: policy statements, risks, details of engagement and activities?
  • To achieve "materiality and comparability" should any EU rules focus on principles, performance indicators, or something else?

And more. There is no formal consultation paper this time, just an online questionnaire, with boxes to be ticked and fields for free text entry. There's not even a discussion paper to explore the issues. Perhaps the issues are well enough understood not to need elaboration. Perhaps elaborating would tend to skew responses. Perhaps it's just an economy drive, or a way of forcing responses into standardised format that makes them easier to collate and less easy to challenge. Response, nonetheless, by January 14, please.

Source document: The consultation response form must be completed online in one go.

Italy seeks stronger minority protection in takeover rules

Italy's securities regulator thinks it's time to review takeover regulation to give greater protection to minority shareholders. Consob ran a consultation during October and November to collect views on what the new rules should look like, though its thinking was already well advanced before the process started. The most significant changes in envisages are:
  • Reopening completed bids: The possibility, in case of success of the takeover bid, to reopen the offering period in order to allow shareholders who initially chose not to sell their securities to accept the offer. This would allow bidders to tidy up the shareholding by sweeping up the rest of the shares which would anyway be subject to disadvantage in future policy changes at the company.
  • Best price: Extending the best price rule to the six months following the closure of the offer. Bidders would have to pay the best price paid during the offer to latecomers to the offer.
  • Including derivatives: Counting indirect holdings – through equity swaps or the like, towards the pricing in offers and towards the 30 per cent threshold that triggers a full bid.
  • Concert: More precise definition of what actions would be considered "acting in concert" between shareholders, and therefore trigger full bids.

"The proposed amendments align the national regulation with the best practices at international level," Consob said. "For example, the application of the rules regulating public offers for sale or subscription has been allowed for public exchange offers of debt securities, overcoming the existing obstacles to an effective equal treatment of Italian and foreign investors."

Source document: The English-language version of the news release wasn't ready before the consultation closed for responses, but it summarises the issues at stake.

Backdating is back – in an SEC settlement

The news came with a faint smell of a history lesson, though not an altogether obvious one. Jacob "Kobi" Alexander, a co-founder of Comverse Technology, has agreed to pay $53.6 million to settle a complaint by the US Securities and Exchange Commission about a scam that awarded him stock options backdated to make them a better value for him, and a worse one for shareholders. Alexander will be barred for life from serving as an officer or director of a public company. This case has been kicking around for a while, since the days of the backdating scandal in 2005 and 2006, when many cases came to light of boards awarding executives options that were already in the money, in violation of securities law. This, however, is a case with a twist. The SEC originally charged Alexander and two other former employees of Comverse with running a slush fund of options that they awarded themselves, which had originally been awarded to fictitious employees. "The SEC’s complaint alleged that Alexander made material misrepresentations to Comverse investors regarding Comverse's stock option grants and concealed from investors that Comverse had not recorded compensation expenses for the grants."

Source document: The SEC news release gives further details.
http://www.sec.gov/news/press/2010/2010-232.htm

Between enterprise and ethics

One of our occasional looks at old-ish books
There are times when you find something that just makes sense, irrespective of the data and independent of the criteria we might apply to prove a point through logic. Reading John Hendry's book is one of those. Published in 2004 in the aftermath of Enron and the rest, this isn't just a book about corporate governance. It's bigger, deeper and richer than that. It doesn't recite the platitudes of conventional ethics-in-action texts, with their "how-to-avoid" approaches to the practical but intractable problems that confront business people every day. Indeed, it's about that intractability, but somehow it also avoid the impenetrable language of the ethics-in-theory texts, with their "how-not-to-understand" approaches to the problems left over from the Greeks, the Reformation and the Enlightenment. And yet …

Buy the bookHendry's book asserts in its subtitle that we live in a bimoral world. This uncomfortable phrase is key to understanding the book. On the one hand, we have – we all seem to have – some inherent understanding of morality that's linked, without the ponderous prose, to Kant's notion of an imperative, things that are simply the right thing to do. Hendry calls this "traditional morality", which many of us got from our parents and the church. But the family and the church are in decline around the Western world, at least, and the power of their voices have diminished. On the other hand, we have – almost all of us, at least – some recognition of good as arising from the benefits to well-being that derive from freedom. These values describe the utility functions of economists and the beneficial force of the invisible hand of markets that Adam Smith described way back in 1776. They have been in the ascendency as the sources of traditional morality have declined. They are both good, but they are not the same. Living in a bimoral world involves recognising the tensions between them, the fact that both are real and signify something of value.

In Hendry's view, both corporate governance and management are fields in which the tensions are laid bare, where we make decisions to side with one view and then the other, reconciling the irreconcilable, because somebody has to. The flexible organisations we need to respond to constant change and market-based competition undermines the traditional morality of hierarchical organisations in evidence in corporate cultures or codes of conduct. Yet our response to crisis – like Enron, then, or Lehman, now – is to grab for hierarchical solutions in law, regulation and codes of conduct, even though their traditional morality is on the wane. "Rules are still used for many of the unimportant things," he writes. "But for the more important things, such as development of markets and products, of the development of people, rules have become a hindrance. The consequence is that management must now learn to manage without rules."

But this isn't just about corporate governance or management. Society as a whole faces challenges in a bimoral world, as we wrestle with the value of saving for the future, helping those in need, or observing some notion of human rights.

This is a good, rich, thoughtful book, but not a dense one. It is a book full of answers that raise questions of a higher order. Don't read this, though, if you're looking for the answer that will settle the debate and tell you what to do. This book will tell you why it's so difficult to decide.

Source document: You can buy the book Between Enterprise and Ethics: Business and Management in a Bimoral Society, by John Hendry, at Amazon.

Saturday 20 November 2010

Breaking the deadlock on climate policy – a path forward?

Everybody knows that the Copenhagen summit in December 2009 was a disaster. Everybody knows that Cancun's follow-up, due shortly, will be, too. Global governance doesn't work. Even the Group of 20 is finding it hard to agree on urgent matters, like how to regulate the banking sector. How could we expect 190-odd countries to agree on sharing the burden of carbon reduction when there's nothing much to gain before the next election? We can't.

Try a different tack: When the winds are against you, you change direction. That's what a Stockholm-based think-tank is proposing that the world – no, some of the world – should do to address the issues of climate change. The Global Utmaning report, "An International Climate Investment Community – breaking the deadlock," suggests that the top-down approach we been trying, under guidance of the United Nations, cannot work, but a different, bottom-up one can. To be fair, it's not entirely bottom-up. The report, co-authored by Allan Larsson, a former Swedish finance minister who instigated that country's carbon tax system, suggests that governments and not the people they govern are the place to start. Given that European countries have something of an advantage in green technology development, there's even an economic incentive to start there. Not all European countries will go along with it, and under European Union rules that might be enough to damn his initiative as a non-starter. But Larsson thinks he has a way around it. Develop a "coalition of the willing" – not quite the phrase he uses, but close – and plough ahead. The much-disputed Lisbon Treaty, which now provides the EU's operating framework, contains a little-discussed provision to allow any nine member states to take action together towards common goals without having to bring everyone else on board, too. So Larsson and his co-authors reckon there's critical mass in a group that might include the Nordic EU members, Germany, France, the Benelux states and the UK. These governments all profess an interest in taking the lead on mitigating climate change. Their innovative capacities might benefit from measures that shared the climate opportunities and not just the climate burdens. They could club together to form an international investment community that would stimulate private-sector demand in investing in climate-friendly technologies. These states would need to do something to kick start the process, like enacting carbon taxes. These are likely to be unpopular measures, but so too are a lot of the other taxes that governments are raising now to fund their budget deficits. And carbon taxes, the authors argue, can be justified in that they counteract the "subsidy" in place in carbon-intensive industries, given that their damage isn't included in their cost.

Will it work? There are issues. When Larsson presented the report in London, among the objections was that the UK would never go along with ceding power to the European Union, or even to a subset of it, without a fight within the Conservative Party, which leads the coalition government. Perhaps. Importantly, Germany would resist any carbon tax, given that all parties, including the Greens now serving in coalition in the state of North Rhine-Westphalia, seem to be trying to squirm out of an agreement to end subsidies for the coal industry. Without Germany, the plan won't work.

What about a different coalition? Why not get a European grouping but add India, South Africa and Brazil? That notion comes from Michael Grubb, a Cambridge economist, who argued that the politics of climate change is more important now than the economics. Anthony Giddens, former director of the London School of Economics, worried about the Jevons Paradox: Any gains made in efficiency in one place will just lead for more consumption in another. Look at Spain: The wealth benefits of its strides in solar power were spent on increased use of cars and long-distance travel. The Jevons Paradox suggests that successful efforts on resource savings perversely increase the rate of resource depletion.

Climate change is a complex problem. And as Mike Hulme has written, complex problems often require messy solutions. The starting point of this report – that the simple answer is a global regime is wrong – seems right. What's less than clear is whether a portfolio of initiatives – like this and the others that will compete with it, should it show signs of being a success – will add up to the savings that climate science suggests we need.

Source document: The manifesto from Global Utmaning – or Global Challenge in English – is a 22-page pdf file.

Women do better, CIMA says

Amid all the talk of boardroom and senior management diversity, there's a nagging worry: does it matter to the economic health of the business? Would women do any better than men in leading economic enterprises? The Chartered Institute of Management Accountants has produced a report with the conclusion that it does matter, at least for the accountants. Female members of CIMA are six times more likely than men to reach the post of CEO, CFO or similar senior titles. This might, of course, be a circular argument. The pressure to have more women creates more jobs for senior women, and in a profession that is wildly disproportionately male, scarcity of female candidates drives up profession success. But CIMA found other link to support its case:
  • Results: Having more women in senior roles is linked to stronger financial performance.
  • Advantage: Women leaders work in different ways from men and can bring real competitive advantage to business.

Women still lag behind men in terms of seniority and salary, and the salary gap widens significantly after 10 years' work experience. "Employers can help by encouraging mentoring, offering flexible working practices, and actively developing female staff," it concludes.

Source document: The CIMA report "Breaking glass: Strategies for tomorrow’s leaders" is a 28-page pdf file.

In this climate, audit committees should be more watchful – FRC

The financial crisis may have receded to somewhat deeper parts of our consciousness, but audit committees shouldn't be fooled into complacency. The UK Financial Reporting Council, which oversees the accounting and audit professions and corporate reporting, has issued a note calling on audit committee to stay vigilant. Some wholesale financial markets remain illiquid and some banks are still dependent of government finance. "Audit committees are likely to want to be convinced that key judgments are supported by a more rigorous and robust analysis than in more benign circumstances and to consider how such matters have been explained in the annual report," it advised. "As part of this process they should set the appropriate expectations of the audit team and management." The document includes a list of key questions that audit committees should be asking, to keep management and internal audit on their toes. First on the list:
Has the Board set out in the annual report a fair review of the company's business including its principal risks and uncertainties? Are the risks clearly and simply stated? Are there many of them and if so, are they really principal risks? Is it clear how the risks might affect the company?

Source document: The FRC update is a seven-page pdf file.

Societas Europaea – good but not great

EU policyIt seemed a good idea, back in the days when European integration was proceeding apace and the euro was becoming the currency of so many countries. With implementation of the single market in many aspects of life in the European Union, one barrier in this increasingly borderless market was that of incorporation. To do business in what soon thereafter became 27 member states required an awful lot of paperwork. The solution was "The European Company," also known by its neutral, Latin name: Societas Europaea, legal form created in 2001 and available since 2004 – well, in eight member states; the others were slow in letting it happen. Among major listed companies, there's been a serious lack of interest, at least outside Germany. For small companies it allowed a single corporate entity to employ and conduct business. Now the European Commission has published a commentary on an "external study" – that is, conducted externally but perhaps not entirely independently – into how it works. The conclusion could be summed up as good but not great. Most worrisome is this: The statute created 27 different types of SE, not one. The commission's summary notes – sadly without the statistics and detail – that "more SEs have been set up in countries that allow only the two-tier corporate governance system, rather than in countries that allow only the one-tier system, and very few SEs are set up in countries that already allow both systems". Nonetheless, here are some "pluses" the report found:
  • Transfer of seat: The European Company has made it possible for companies with a European dimension to transfer the registered seat across borders, facilitating movement and competition. It also makes tax and regulatory arbitrage easier, an aspect not particularly highlighted in this report.
  • Organisation design: The device makes it easier to "reorganise and restructure and to choose between different board structures, while maintaining the rights of employees to involvement and protecting the interests of minority shareholders and third parties". Note the language: "while maintaining the rights of employees". The reference here is to German and Austrian co-determination rules, while can't be breached by changing legal form, though they can change the character of the board, as Puma recently did. Some see this preservation of worker rights as a drawback of the compromises that allowed the legislation to pass and contributed to its differentiated adoption in different member states.
  • Image: The report suggests that the SE form gives companies access to a "European image and supra-national character". Perhaps it just makes small companies look bigger than they are.

Six years of experience with the SE Regulation show that "application of the Statute poses a number of problems in practice", the report suggests. "The SE Statute does not provide for a uniform SE form across the European Union, but 27 different types of SEs. The Statute contains many references to national law and there is uncertainty about the legal effect of directly applicable law and its interface with national law. Furthermore, the uneven distribution of SEs across the European Union shows that the Statute is not adapted to the situation of companies in all Member States."

Source document: The SE report is an 11-page pdf file.

Saturday 13 November 2010

Asking 'fundamental' questions about the basis of corporate governance

Here's a thought experiment, courtesy of the IRRC Institute and Stanford University: Imagine an investor holds a million shares of a company's equity. How might it mess around with the company and make money? "It is today quite easy for investors to construct portfolios that increase in value as a corporation's stock price declines while retaining the right to cast large blocks of votes in shareholder elections," according to the report, sent to the US Securities and Exchange Commission as a guide to its rule-making under the Dodd-Frank Act. It works this way: The shareholder – remember, this could be a "long-only" investor, not a short-seller – enters into what the wizards of Wall Street call a "total return equity swap". The swap contract, a rather simple derivative strategy, creates, in effect, and insurance policy against losses. The swap protects against losses but requires the investor to forgo gains. So the investor is neutral on the company's fortunes but still gets to vote the shares, and under Dodd-Frank maybe even nominate directors. That's called empty voting and it's a puzzling notion of rights. Now imagine that instead of writing a swap for a million shares, the investor writes one for two million. It now has an incentive – quite a powerful one – to see the share price decline, and it retains its right vote and perhaps to nominate directors. That's called negative voting and it's not just puzzling – it's perverse.

The report, commissioned by the Investor Responsibility Research Center Institute and conducted by the Rock Center at Stanford, raises concerns that the financial markets now have the ability to divorce economic interests from ownership rights in ways that have outpaced both corporate governance approaches and bankruptcy law. "Ironically, we just enacted a massive reform of the financial system. The underlying presumption, however, was that economic and ownership interests are inseparable. We know this is not true," said Jon Lukomnik, IRRC Institute program director. "[I]f those who control ownership rights can be incentivized towards value destruction rather than value creation, it is only a matter of time until the real economy is affected due to a large-scale impact on corporations." So, what should directors and policy-makers do?

  • Accept there's a problem: The report says the potential – as well as the reality – for of decoupling transactions that generate empty or negative voting can present challenges to shareowner and creditor governance practices.
  • Recognise its impact: Because rights and interests may be easily decoupled, regulators, directors, other shareowners and creditors run the risk of making decision on a less-than-informed basis.
  • More than disclosure: "Policy makers may therefore wish to consider substantive measures that might address the rights of shareowners or creditors to cast votes without regard to their participation in decoupling transactions that can give rise to empty or negative voting," the report concludes.

The report summarises 19 research studies and several key judicial opinions indicating in growing concerns in litigated transactions in a bid to inform the detailed rules that the SEC will produce to put Dodd-Frank into action. What the study make clear, if it weren't clear already, is that the concept of "shareholder value" needs to be rewritten or abandoned as a guide to what directors should do.

Source document: The IRRC-Stanford research report "Identifying the Legal Contours of the Separation of Economic Rights and Voting Rights in Publicly Held Corporations" is a 52-page pdf file.

Board diversity: not enough or too much?

The problem is working out what the question should be. Are we looking for boards that reflect the constituencies we serve? Are we looking for boards that monitor the performance of management? Are we looking for boards that produce a higher return on investment? Are we looking for boards that would produce a higher return on investment under different criteria for what constitutes return? Are we looking for boards that project a better image? Are we looking for boards that produce a better next generation of managers and directors?

All of the above. And that's the problem with boards. These largely part-time helpers have the world resting on their shoulders. These questions leap out from the pages of a literature review on board diversity undertaken by two scholars at the Rock Center at Stanford University. They've done an admirable job of reading both theoretical and empirical studies of the value and drawbacks of having greater numbers of women and racial, ethnic and religious groups on boards, in America, yes, but around the world as well. The picture is mixed. The relationship between diversity and financial performance has not been convincingly established, they note, though there's some basis for believing that when diversity is well managed, it can improve decision making and can enhance a corporation's public image. "To achieve such benefits, however, diversity must extend beyond tokenism and corporations must be held more accountable for their progress," they conclude. That's a pretty small outcome, given the political heat and public policy pressure for more diverse boards. Perhaps we have yet asked the right questions. What is it we really want the board to do?

Source document: The working paper "Diversity on Corporate Boards: How Much Difference Does Difference Make?" by Deborah Rhode and Amanda Packel of Stanford Law School, is a 26-page pdf file.

IFAC reforms – good, but could be better

Audit and accountingThe International Federation of Accounts issues reforms for the professions of accountancy and audit back in 2003, when the wounds from the Enron and WorldCom collapses were still hurting. After another governance crisis, the its Monitoring Group, made up of the International Organization of Securities Commissions, the Basel Committee on Banking Supervision, the European Union and three other public interest bodies, examined how well the IFAC reforms were working. The report suggests that most of its proposals have been enacted, but there's room for improvement and two issues to consider for the longer term.
  • International competence: "Whether standard-setting Boards that operate within an accountant's professional membership organization can carry out the responsibilities that ultimately come with international standard-setting in the public interest."
  • Monitoring synergies: "Whether there could be potential synergies associated with the two accountability functions now present for international standards; namely, the Monitoring Group for international audit-related standards and the Monitoring Board for international financial reporting standards."

Among the Monitoring Group's recommendations are that IFAC should stop having 15 of the 18 seats on its Audit and Ethics Boards reserved for people nominated by the professions themselves. The Ethics Board should have an independent chairman "in view of the inherent conflicts of interest that particularly relate to the work of this Board", it said.

Source document: The IOSCO report is a 22-page pdf file.

Sunday 7 November 2010

Bank governance heading for change – sometimes in wrong direction

Whatever are we going to do about the boards of banking corporations? Since the onset of the crisis in 2007, it's been apparent that directors of banks didn't have a clear view of where the risks and issues lay. Since then, regulatory moves have been set in train to alter remuneration practices and to give shareholders a greater influence over boards. Much of that work has yet to be made final, but according to a study of 25 European banks, Nestor Advisors reckons that much of the industry has already anticipated the changes in the pipeline by altering their own governance arrangements. They problem, however, is that not all of these moves seem likely to be helpful. Take one example: "The trend to promote shareholder alignment is also reflected in increasing participation of shareholders to have a say‐on‐pay," it writes. Only nine of the 25 top banks were required to involve shareholders in decisions on executive pay, by 2009 twelve of the banks did so. "Say‐on‐pay may actually be doing more harm than good," it continued. This type of shareholder engagement "undermines the role of the board to work in the broader company's interest" by focusing them on the narrower interest of shareholders. "For banks, it is more pernicious, as greater alignment of management with equity holders is associated with greater bank losses," it said.

Director turnover: The study also shows that directors of banks that did badly did lose their jobs, against the conventional wisdom that boards are not accountable to shareholders. But that raises another problem: "That shareholders were not in a position to raise red flags before the failings should not come as a surprise. As shareholders are not insiders, will they ever be able to do so?" the report states. The remedy for greater accountability promoted in the UK and now spreading to European is to have annual election of directors. To Nestor Advisors, that seems to be a medicine for an imaginary disease.

Source document: The report "Bank boards after the flood: The changing governance of the 25 largest European banks," by Catherine Lawton and Stilpon Nestor, is a 26-page pdf file.

Governing the professional service firm

Professional service firms – lawyers, accountants and the like – are a special kind of beast, but one with interesting parallels in other occupations. Moves to make these firms – traditionally partnerships – into something more like a joint-stock company have changed the ethos of firms to some extent. But they are still of a different character to normal companies. Professional service firms can draw less on hierarchical structures to create control. The allegiances of the professionals themselves are to clients, other professionals and to the profession itself. In the days now largely departed of unlimited liability for professions, adhering to standards was of profound importance, making these firms impediments to change even as they were the upholders of standards. Laura Empson at Cass Business School in London has written a brief note that describes the model of the tensions a professional service firm faces. It helps to understand how the governance of such organisations must be different. But it's useful beyond the professions. What she describes is a model of a knowledge-based business, too, where the means of production is firmly in the hands (and brains) of the workers. As other businesses become more knowledge-based those tensions will arise there as well. While the professionalism of the professions may be under threat from taking on more corporate-like approaches to their business, corporations may need to foster more a profession-like ethos to ensure quality.

Source document: The discussion note, A summary of "Beyond the firm: a new way of looking at professional service firms" by Laura Empson, is a three-page pdf file.