Boards and shareholders in european listed companies facts, context and post crisis reforms

This volume analyses four main topics in the corporate governance ofEuropean listed firms: i board structure and composition and theirinteraction with ownership structure; ii board remune

E U R O P E A N L I S T E D C O M P A N I E S

With contributions by distinguished scholars from legal and financial backgrounds, this collection of essays analyses four main topics in the corporate governance of European listed firms: (i) board structure, com- position and functioning and their interaction with ownership structure; (ii) board remuneration; (iii) shareholder activism; and (iv) corporate governance disclosure based on the ‘comply or explain’ approach The authors provide new comparative evidence and analyse its impli- cations for the policy debate They challenge the conventional wisdom that corporate governance in European firms was systematically dysfunc- tional While proposals aimed at increasing disclosure and accountability are usually well grounded, caution is suggested when bringing forward regulatory changes with respect to proposals targeting specific gover- nance arrangements, especially in the fields of board composition and shareholder activism They argue that the ‘comply or explain’ principle should be retained and that further efforts should be exercised to enhance disclosure.

massimo belcredi is Professor of Corporate Finance at the Università Cattolica of Milan He has written numerous books and articles in the fields of corporate finance, corporate governance, ownership and board structure, law and economics.

g u i d o f e r r a r i n i is Professor of Business Law and Capital Markets Law at the University of Genoa, and Director of the Genoa Centre for Law and Finance Among other important roles, he was an adviser to the Corporate Governance Committee of the Italian Stock Exchange He has published widely on the topics of corporate governance, financial law, corporate law and business law.

m a r k e t r e g u l a t i o n

Corporate law and financial market regulation matter The global financial crisis has challenged many of the fundamental concepts underlying corporate law and financial regulation; but crisis and reform has long been a feature of these fields A burgeoning and sophisticated scholarship now challenges and contextualises the contested relationship between law, markets and compa- nies, domestically and internationally This Series informs and leads the scholarly and policy debate by publishing cutting-edge, timely and critical examinations of the most pressing and important questions in the field.

Series Editors Professor Eilìs Ferran, University of Cambridge

Professor Niamh Moloney, London School of Economics and Political

Science Professor Howell Jackson, Harvard Law School

Editorial Board Professor Marco Becht, Professor of Finance and Economics at Universite´ Libre de Bruxelles and Executive Director of the European Corporate

Governance Institute (ECGI) Professor Brian Chef fins, S.J Berwin Professor of Corporate Law at the

Faculty of Law, University of Cambridge

Professor Paul Davies, Allen & Overy Professor of Corporate Law and Professorial Fellow of Jesus College, University of Oxford Professor Luca Enriques, Visiting Professor, Harvard Law School Professor Guido Ferrarini, Professor of Business Law at the University of Genoa and Fellow of the European Corporate Governance Institute (ECGI) Professor Jennifer Hill, Professor of Corporate Law at Sydney Law School Professor Klaus J Hopt, Emeritus Scienti fic Member, Max Planck Institute of

Comparative and International Private Law, Hamburg

Professor Hideki Kanda, Professor of Law at the University of Tokyo Professor Colin Mayer, Peter Moores Professor of Management Studies at the Sạd Business School and Director of the Oxford Financial Research Centre

James Palmer, Partner of Herbert Smith, London

Professor Michel Tison, Professor at the Financial Law Institute of the

University of Ghent Andrew Whittaker, General Counsel to the Board at the UK Financial

Services Authority Professor Eddy Wymeersch, former Chairman of the Committee of European Securities Regulators (CESR); former Chairman of the IOSCO European Regional Committee, and Professor of Commercial Law,

University of Ghent.

B O A R D S A N D

S H A R E H O L D E R S I N

E U R O P E A N L I S T E D

C O M P A N I E S

Facts, context and post-crisis reforms

A research project promoted by Emittenti Titoli S.p.A.

Edited byMASSIMO BELCREDI

andGUIDO FERRARINI

Emittenti Titoli is a company promoted by Assonime and created in 1998 Its shareholders are some of the main non-financial Italian listed firms and their controlling holding companies Emittenti Titoli promotes the development of the securities market in the interest of Italian issuers After having acquired a 6.5% participation in Borsa Italiana, Emittenti Titoli contributed

to define both the governance of the Italian Stock Exchange and its listing rules, trying to counterbalance the influence of intermediaries Following the acquisition of Borsa Italiana by the London Stock Exchange Group, Emittenti Titoli is currently the first Italian shareholder of LSE, holding 1.6% of share capital Emittenti Titoli publishes, jointly with Assonime, an annual analysis on the corporate governance of Italian listed companies and on the state of implemen- tation of the Italian Governance Code Emittenti Titoli is led by a Board of Directors composed of

15 members, chaired (since 2012) by Luigi Abete.

Published in the United States of America by Cambridge University Press, New York Cambridge University Press is part of the University of Cambridge.

It furthers the University ’s mission by disseminating knowledge in the pursuit of education, learning, and research at the highest international levels of excellence.

www.cambridge.org

Information on this title: www.cambridge.org/9781107040564

© Emittenti Titoli S.p.A.

This publication is in copyright Subject to statutory exception

and to the provisions of relevant collective licensing agreements,

no reproduction of any part may take place without the written

permission of Cambridge University Press.

First published 2013 Printed in the United Kingdom by Clays, St Ives plc

A catalogue record for this publication is available from the British Library

ISBN 978-1-107-04056-4 Hardback Cambridge University Press has no responsibility for the persistence or accuracy of URLs for external or third-party internet websites referred to in this publication, and does not guarantee that any content on such websites is, or will remain,

accurate or appropriate.

The papers collected in this volume, written by a group of leadingEuropean scholars, are the result of a research project promoted byEmittenti Titoli.

In recent years, the academic debate focused on the relationshipbetween corporate governance and thefinancial crisis It is still unclearwhether, and to what extent, dysfunctional corporate governance hascontributed to the recent financial crisis Nonetheless, a number ofpolicy proposals have been put forward to redress the most obviousfailures In particular, the European Commission published two GreenPapers, in 2010 and 2011, respectively, targeting corporate governance infinancial institutions and remuneration policies and the EU corporategovernance framework In December 2012, on the basis of its reflectionand of the results of previous consultations, the European Commissionpublished an Action Plan outlining future initiatives in the areas ofEuropean company law and corporate governance

This volume analyses four main topics in the corporate governance ofEuropean listed firms: (i) board structure and composition and theirinteraction with ownership structure; (ii) board remuneration; (iii)shareholder activism; and (iv) corporate governance disclosure based

on the ‘comply or explain’ approach For each of them, the authorsprovide new evidence and analyse its implications for the policy debate

In the main, they challenge the conventional wisdom that corporategovernance in European firms was systematically dysfunctional and,therefore, they suggest caution in bringing forward regulatory changes.Basically, while proposals aimed at increasing disclosure and account-ability are usually well-grounded, caution is needed with respect toproposals targeting specific governance arrangements (especially in thefields of board composition and shareholder activism) Similarly, theyargue that the‘comply or explain’ principle should be retained, but thatfurther efforts should be exercised to enhance disclosure

v

Emittenti Titoli, a company promoted by Assonime, and whose capital

is held by the most important Italian non-financial companies, is happy tooffer the results of this research project to the international financialcommunity in order to further stimulate the debate on corporategovernance

Luigi AbeteChairman, Emittenti Titoli

7 Shareholder engagement at European general

4.1 Time trends in board characteristics: European Union, 2000–10 page 195

4.2 Time trends in board size: European Union, 2000–10, stable samples 196

4.3 Time trends in board independence: European Union, 2000–10, stable samples 197

4.4 Time trends in board gender diversity: European Union, 2000–10, stable samples 198

4.5 Time trends in board characteristics: United States, 2000–10 199

5.1 The Group lens 237

6.1(a) Compliance in 2007 Financial vs non-financial companies 283

6.1(b) Compliance in 2010 Financial vs non-financial companies 283

ix

3.1 Performance, family ownership and crisis (777 companies) page 160

3.2 Performance, family ownership and crisis (regressions) 167

3.3 Performance, family CEOs and crisis 171

3.4 Investments, downsizing and increase in size 175

3.5 Crises, wages and employment 180

4.1 Board size across countries (2010) 200

4.2 Board independence across countries (2010) 201

4.3 Board gender diversity across countries (2010) 202

4.4 One-tier versus two-tier board structures 205

4.5 Corporate board size in Europe: the impact of firm characteristics, industries and countries (2010) 207

4.6 Corporate board independence in Europe: the impact of firm

characteristics, industries and countries (2010) 210

4.7 Board gender diversity in Europe: the impact of firm characteristics, industries and countries (2010) 214

4.8 Board size in 2010 and firm characteristics in 2007 216

4.9 Board independence in 2010 and firm characteristics in 2007 218

4.10 Board gender diversity in 2010 and firm characteristics in 2007 219

5.1 Matrix of board interaction 241

6.1 Say-on-pay regulations in various jurisdictions 261

6.2 Remuneration characteristics and expected effect on European

6.7 Governance, disclosure variables and firms’ ownership

characteristics 290

6.8(a) Mean (median) total compensation of the board of directors 292

6.8(b) Mean (median) total compensation of the CEO 294

6.9(a) Composition of CEO mean and median pay and stock-based incentive portfolio: whole sample 297

6.9(b) Composition of CEO mean and median pay and stock-based incentive portfolio: sample of non-financial firms 298

6.9(c) Composition of CEO mean and median pay and stock-based incentive portfolio: sample of financial firms 299

6.10(a) Regression analysis of determinants of CEO total

compensation 300

6.10(b) Regression analysis of determinants of board total

compensation 301

7.1 The use of control-enhancing mechanisms 322

7.2 Statutory requirements with respect to general meetings 324

7.3 Number of management and shareholder proposals in Europe by country and year 330

7.4 Votes for management and shareholder proposals in Europe 332

7.5 Number of shareholder proposals and votes for the proposals in the

7.6 Financial performance and ownership characteristics of the sample firms 341

7.7 Country-level shareholder rights and corporate governance 342

7.8 Regressions explaining the votes for management proposals 345

7.9 Determinants of shareholder proposal submissions 350

7.10 Regressions explaining the votes for shareholder proposals 353

8.1 Descriptive statistics: firm characteristics 384

8.2(a) Descriptive statistics: ownership structure according to the identity of the ultimate shareholder 385

8.2(b) Descriptive statistics: ownership structure according to the identity of the ultimate shareholder 386

8.3(a) Descriptive statistics: board elections according to the identity of the ultimate shareholder 388

8.3(b) Descriptive statistics: board elections according to the identity of the ultimate shareholder 388

8.4 Determinants of the decision to submit a ‘minority’ slate (ownership defined in terms of concentration) 396

8.5 Determinants of the decision to submit a ‘minority’ slate (ownership defined in terms of ultimate shareholder identity) 398

8.6 Determinants of the decision to submit a ‘minority’ slate (ownership concentration and voting rules) 400

8.7 Determinants of the decision to submit a ‘mutual fund’ slate (ownership defined in terms of concentration) 405

8.8 Determinants of the decision to submit a ‘mutual fund’ slate (ownership defined in terms of ultimate shareholder identity) 407

8.9 Determinants of the decision to submit a ‘mutual fund’ slate (ownership concentration and voting rules) 409

c h r i s t i a n a n d r e sis Professor of Empirical Corporate Finance, OttoBeisheim School of Management, WHU.

r o b e r t o b a r o n t i n i is Professor of Corporate Finance, ScuolaSuperiore Sant’Anna in Pisa and Director of the Masters’ Course inInnovation, Management and Service Engineering (MAINS)

m a s s i m o b e l c r e d i is Professor of Corporate Finance, UniversitàCattolica of Milan and an independent director of Arca SGR and Erg

s t e f a n o b o z z i is Associate Professor of Corporate Finance, UniversitàCattolica of Milan

l o r e n z o c a p r i ois Professor of Corporate Finance, Università Cattolica

of Milan and an independent director of Sogefi

e t t o r e c r o c iis a Lecturer in Corporate Finance, Università Cattolica

d a n i e l f e r r e i r a is Professor of Finance at the London School ofEconomics, Director of the Ph.D Programme in Finance and ResearchFellow of CEPR and ECGI

t o m k i r c h m a i e ris a Lecturer in Business Economics and Strategy atManchester Business School and Fellow of the Financial Markets Group,London School of Economics

xiii

l u c r e n n e e b o o gis Professor of Corporate Finance, Tilburg Universityand Director of Graduate Studies, CentER for Economic Research.

p e t e r s z i l a g y i is a Lecturer in Finance at the Judge Business School,University of Cambridge

m a r i a c r i s t i n a u n g u r e a n u is Advisor Corporate Governance atSodalin, a global provider of corporate governance consulting, share-holder transactions and institutional investor relations She is also fellow

of the Genoa Centre for Law and Finance

e r i c v a n d e l o o is Professor of Leadership VU Amsterdam andTiasNimbas Tilburg, Visiting Clinical Professor of Leadership INSEADand Tun Ismail Ali Chair of Leadership in Kuala Lumpur

j a a p w i n t e r is Professor of Corporate Governance, DuisenbergSchool of Finance, Amsterdam, and Professor of International CompanyLaw in Amsterdam

e d d y w y m e e r s c his Chairman of the Public Interest Oversight Board

in Madrid and Board Member of Euroclear SA and of the Association forthe Financial Markets in Europe (AFME)

In this chapter, we offer an overview of the present volume, placing thesame in the context of recent European Union (EU) reforms and ofcorporate governance theory and summarising the main outcomes of thefollowing chapters In addition, we offer some policy perspectives– as toboards, incentive pay and shareholder activism– based on the theoret-ical and empirical outcomes of the research project of which this volume

is the product In drawing this broad picture, we underline larly that variances in ownership structures of listed companies and inthe adoption of either a shareholder value or a stakeholder approachhave pervasive implications for corporate governance issues For exam-ple, board composition criteria may reflect a stakeholder orientation,such as that found in the German codetermination system (Schmidt

particu-2004) Also the board’s function, the role of independent directors andincentive pay arrangements may vary depending on whether diffuseshareholders or blockholders own the company Similarly, diffuse own-ership companies represent the natural setting for shareholder activism,which may not be a cost-effective solution in controlled corporations.1

* The analysis across the volume refers to EU and Member State regulation as of 15 January 2013.

1

Within this context, it is debated whether additional reform, aimed at stimulating activism of institutional investors (such as, for instance, the adoption of cumulative, proportional or slate voting in corporate elections), may be useful (see Section 6.3.2.

below and Chapter 8 ).

In general, we assume that boards are an essential mechanism fordirecting the company and monitoring the agency costs of management,while incentive pay is important to align the interests of professionalmanagers with those of shareholders Moreover, we assume that share-holder activism can work as a useful complement to these governancemechanisms by exercising pressure on boards and holding themaccountable for the performance of their monitoring functions.However, the effectiveness of similar mechanisms depends on a variety

of factors, including the quality of corporate law and its enforcement, thedegree to which private codes of best practice are complied with, andthe institutional context in which boards and shareholders operate Inparticular, ownership structures in a given system or company affect theequilibrium between the corporate governance mechanisms that weanalyse in this volume While mainstream global corporate governance

is heavily influenced by the model of the Berle and Means corporation,

an analysis of the European context requires a less biased approach inorder to catch the richness of governance models and diversified experi-ences (as particularly shown by the study of familyfirms inChapter 3)

In the remainder of this Chapter, we introduce recent reform tives and the variety of corporate governance systems in Europe, sketch-ing out the alternative between shareholder and stakeholder governanceand the specificities of bank governance In Section 2, we outline themain tools for controlling agency costs, including market mechanisms,corporate law, codes of best practice and the ‘comply or explain’approach, and bank prudential regulation In Section 3, we analyse theimpact of ownership structures on agency costs and comment onChapter 3on familyfirms in Europe InSection 4, we examine the theoryand practice of boards, in light of EU law and soft law and of the analysis

initia-in Chapters 4and5on board size, independence and gender diversityand also of the limitations inherent to a‘law and economics’ approach

InSection 5, we examine the theory and practice of incentive pay, in light

of EU soft law and banking regulation, and summarise the outcomes of

an empirical analysis on pay practices in large European listed ies included inChapter 6 InSection 6, we analyse shareholder activism

compan-in Europe and summarise the outcomes of two empirical contributions(one on activism in the EU and the United States (US), the other onactivism in Italian corporate elections) contained in Chapters 7and8

In Section 7, we outline some policy considerations on the topics sidered in the previous four sections Section 8 draws some generalconclusions

con-1.2 EU reform

In the present section, we review the legal reforms that have affected EUcorporate governance since the beginning of the current century Thesereforms addressed the main corporate governance failures which gov-ernments and legislators identified in the 2001–2 corporate scandals andthe 2008financial crisis (Enriques and Volpin2007; Bainbridge2012).Similar failures affected both the internal governance structures ofcorporations– including those relating to the audit of accounts – andthe essential mechanisms for capital market efficiency, such as securitiesunderwriters, financial analysts and rating agencies (Gilson andKraakman2003; Skeel2011) This chapter focuses mainly on corporateboards and shareholders, in line with the remainder of this volume.Indeed, boards have a key governance role and perform monitoringand advisory tasks with respect tofirms’ managers Shareholders havefundamental governance rights, including that of appointing the board,which derive from their function as residual risk-bearers In line withrecent Commission Green Papers, this chapter and the whole volumetake into consideration both shareholder activism (which occurs mainly

in diffuse ownership companies) and the protection of minority holders (which typically concerns controlled corporations)

share-1.2.1 After EnronThe ‘new economy’ bubble highlighted serious corporate governanceshortcomings, mainly related to internal controls, executive remunera-tion and external auditors (Coffee2005) Corporate frauds and account-ing failures had been made easier by lack of appropriate internal controlsfor which thefirms’ managers and directors were generally responsible.Moreover, stock options and other incentives were aggressively resorted

to, contributing to managers manipulating share prices through falseinformation relative to theirfirms’ financial performance The auditorsand other gatekeepers, such as investment bankers, business lawyers andrating agencies, largely contributed to thefirst crisis of this century (i.e.the corporate scandals era), by covering frauds and aiding insolventcompanies to conceal their true financial conditions (Coffee 2002;Gordon2002; Miller2004; Ferrarini and Giudici2006)

Wide reforms were sought both at EU and domestic levels, oftenmodelled along the US Sarbanes-Oxley Act, which had, however, beenenacted in a remarkably brief period, with minimal legislative processing(Bainbridge2012) The European response to thefinancial scandals was

relatively less hasty, given that the epicentre of the 2001–2 turmoil hadbeen the US, and also considering the more complex political process for

EU legislation Moreover, thefinal response in Europe was not as strongand pervasive as that in the US (Ferrarini et al 2004) The EU ActionPlan was out in the 2003 Communication from the Commission onModernising Company Law and Enhancing Corporate Governance in theEuropean Union,2which was prepared on the basis of a report by theHigh Level Group of company law experts appointed by CommissionerBolkestein and chaired by Jaap Winter (the Winter Report).3 TheCommission’s Action Plan envisaged four main pillars for corporategovernance reform

(i) The first referred to enhancing corporate governance disclosure,with the argument that more than forty corporate governancecodes had been adopted in Europe, their contents being widelyconvergent; however, ‘information barriers’ underminedshareholders’ ability to evaluate the governance of companies.The Commission proposed that companies be required to include

in their annual reports and accounts a comprehensive corporategovernance statement covering the key elements of their corporategovernance structures and practices This statement should carry areference to a code on corporate governance, designated for use atnational level that the company complies with, or in relation towhich it explains deviations This proposal led to the adoption in

2006 of the new Article 46a of Directive 78/660/EEC on the annualaccounts of certain types of companies, which required companieswith securities admitted to a regulated market to publish a corpor-ate governance statement in their annual report.4 The contentand implementation of the EU ‘comply or explain’ principle are

2 See Communication from the Commission to the Council and the European Parliament, Modernising Company Law and Enhancing Corporate Governance in the European Union – A Plan to Move Forward, Brussels, 21.5.2003, COM(2003) 284 final.

3 See the Report by the High Level Group of Company Law Experts, A Modern Regulatory Framework for Company Law in Europe, Brussels, 4 November 2002.

4

See Article 1, para 7 of Directive 2006/46/EC of the European Parliament and of the Council of 14 June 2006 amending Council Directives 78/660/EEC on the annual accounts of certain types of companies, 83/349/EEC on consolidated accounts, 86/635/ EEC on the annual accounts and consolidated accounts of banks and other financial institutions and 91/674/EEC on the annual accounts and consolidated accounts of insurance undertakings, O.J 16.8.2006, L 224/1.

analysed briefly in the following paragraph, and more extensively inChapter 2.

(ii) The second pillar contemplated strengthening shareholders’ rights

in terms of both electronic access to information and proceduralrights (to ask questions, table resolutions, vote in absentia, andparticipate in general meetings via electronic means) TheCommission proposed that the facilities relevant for the exercise

of similar rights should be offered to shareholders throughout the

EU, while specific problems related to cross-border voting should

be resolved urgently This led to the adoption of the ShareholderRights Directive,5 which is analysed briefly in Section 6 and inChapter 7

(iii) The third pillar involved modernising the board of directors First, as

to board composition, non-executive or supervisory directors who,

in the majority, are independent, should take decisions in key areaswhere executive directors have conflicts of interest – such as remu-neration and supervision of the audit of company accounts Second,the directors’ remuneration regime should require disclosure ofremuneration policy and remuneration details of individual direc-tors in the annual accounts; prior approval by the shareholdermeeting of share and share option schemes in which directorsparticipate; and proper recognition in the annual accounts of thecosts of such schemes for the company Third, the collectiveresponsibility of all board members for key financial and non-financial statements should be clearly recognised under nationallegal systems

The proposals relative to board composition found detailedspecification in the Commission Recommendation of 15 February

2005 on the role of non-executive or supervisory directors of listedcompanies and on the committees of the (supervisory) board6(commented upon briefly underSection 4.2.); the proposals relative

to directors’ remuneration found specification in the CommissionRecommendation of 14 December 2004 fostering an appropriateregime for the remuneration of directors of listed companies (seeSection 5.2 andChapter 6); and those on collective responsibility

were translated into Articles 50b and 50c of Directive 78/660/EEC

on the annual accounts of certain types of companies.7

(iv) The fourth pillar involved co-ordinating corporate governanceefforts of Member States, with reference both to the development

of national corporate governance codes and to the monitoring andenforcement of compliance and disclosure (a topic dealt with inChapter 2)

These four pillars fundamentally marked two areas for corporate ance reform – boards and shareholder rights – which are intercon-nected to the extent that companies are run in the interest ofshareholders and the latter monitor board governance and appoint andremove directors The Commission further suggested two main paths for

govern-EU reform, which were subsequently implemented through directives orrecommendations: disclosure of corporate governance structures andfunctioning (including those concerning directors’ remuneration); andsetting of standards for board and remuneration practices, and forshareholders’ information and rights

1.2.2 The recentfinancial crisis

It is uncertain whether and to what extent corporate governance tributed to the recentfinancial crisis While policymakers generally offer

con-a positive con-answer (Kirkpcon-atrick 2009), the topic is still debated amongstacademics For sure, a distinction should be made between financialinstitutions– banks in particular – and other companies, given that theformer were at the epicentre of thefinancial crisis, both in the US and inEurope, while non-financial companies were affected by the crisis butdid not show risk-management or other governance failures similar tothose experienced by financial institutions (Cheffins2009) Moreover,empirical research has proven that banks which failed in the crisis hadadopted ‘good’ corporate governance standards (Beltratti and Stulz

2012) However, other research has shown that banks which fared better

in the crisis had better risk-management systems in place, suggestingthat the criteria defining ‘good’ governance need to be reconsidered(Ellul and Yerramilli 2012) The European Commission sided withgovernments and international organisations arguing that corporategovernance had failed in the crisis, but appropriately distinguished7

See Article 1, para 8 of Directive 2006/46/EC ( n 4 above), inserting a new Section 10A (Duty and liability for drawing up and publishing the annual accounts and the annual report) in the Directive on annual accounts.

between financial institutions and other firms Therefore, two GreenPapers were published, one in 2010 on Corporate Governance inFinancial Institutions and Remuneration policies8 and the other in

2011 on The EU Corporate Governance Framework.9

The 2010 Green Paper was part of a programme for reforming theregulatory and supervisory framework offinancial markets announced

in a Commission Communication of 4 March 2009,10which was based

on the conclusions of the de Larosière Report.11In the Green Paper’sintroduction, the Commission stated:

As highlighted by the de Larosière report, it is clear that boards of directors, like supervisory authorities, rarely comprehended either the nature or scale of the risks they were facing In many cases, the share- holders did not properly perform their role as owners of the companies Although corporate governance did not directly cause the crisis, the lack

of effective control mechanisms contributed significantly to excessive risk-taking on the part of financial institutions.

This statement helps understand the remaining contents of the GreenPaper, which include the role and composition of the (supervisory)board; risk management as a key aspect of corporate governance;and appropriate shareholder monitoring and the role of supervisoryauthorities with respect to the internal governance offinancial institu-tions We pay some attention to the specificities of bank governance inSection 1.3.2 and to the role of banking regulation and supervision inSection 2.4 However, the discussion found in the 2010 Green Paperlargely overlaps with the analysis developed in the 2011 Green Paper, sothat they can be bundled in our analysis

Indeed, the 2011 Green Paper extends the arguments applicable

to financial institutions to other firms, assuming that ‘corporategovernance is one means to curb harmful short-termism and excessiverisk-taking’ for firms in general and suggesting that the Green Papershould ‘assess the effectiveness of the current corporate governanceframework for European companies.’ Similar to the 2003 CommissionCommunication on Modernising Company Law, the 2011 Green Paperfocuses on the board of directors, emphasising that‘effective boards areneeded to challenge executive management’; on shareholders, arguing8

COM(2010) 284 final 9

COM(2011) 164 final 10

COM(2009) 114 final.

11

Report of the High-Level Group on Financial Supervision in the EU published on

25 February 2009, available at http://ec.europa.eu/internal_market/ finances/docs/ de_larosiere_report_en.pdf.

that they must‘engage with companies and hold management to accountfor its performance’; and on the ‘comply or explain’ approach, claimingthat the informative quality of explanations published by companies is

‘not satisfactory’ and the monitoring of the codes’ application is

‘insufficient’ We shall make specific references to the 2011 GreenPaper throughout the present chapter, highlighting some of its mainfeatures in connection with the individual topics touched upon in ouranalysis

1.3 Varieties of corporate governance

As anticipated, variances in European corporate governance are ant and depend mainly on the ownership structures of listed companiesand the national systems’ adherence to either a shareholder or a stake-holder approach (Hansmann and Kraakman 2001; Clarke and Chanlat

import-2009; Kraakman et al.2009) In this Section, we outline the key ences between shareholder and stakeholder governance, focusing onscholarly definitions and positions taken by EU policy documents Wealso present the core specificities of bank governance, which determinethe regulation and supervision of board structures and functions, and thereorientation of the relevant criteria for the protection of stakeholders(depositors) and thefinancial system (systemic risk) rather than for mereshareholder wealth maximisation

differ-1.3.1 Shareholder v stakeholder governance

There is no clear-cut, generally accepted definition of corporate ance Many definitions are found in the academic literature and incodes of best practice, but differences, though rarely spelled out, aresubstantial The dominant approach in the financial literature (Tirole

govern-2006) focuses on the relationship betweenfirms and suppliers of funds(debt and equity) An oft-cited work argues that‘corporate governancedeals with the ways in which suppliers offinance to corporations assurethemselves of getting a return to their investment’ (Shleifer and Vishny

1997) In other words, corporate governance concerns how corporateinsiders can credibly commit to return funds to investors, so as to attractoutsidefinancing Suppliers of debt and equity may benefit from severalcontrol mechanisms, based on either legal protection (through contractand/or regulation) or sheer power deriving from concentration of claims

A similar view is sometimes criticised as being too narrow, for otherstakeholders (employees, clients, local communities) have an interest in

how thefirm is run (Blair1995; Blair and Stout2001) Becht et al (2002)offer a broad definition under which ‘corporate governance is concernedwith the resolution of collective action problems among dispersedinvestors and the reconciliation of conflicts of interest between variouscorporate claimholders.’ These definitions imply that corporate govern-ance is a ‘common agency’ problem, involving an agent (the ChiefExecutive Officer, CEO) and multiple principals (shareholders, cred-itors, employees, clients) Since thefirm is a nexus of contracts (Jensenand Meckling1976) and contracts are incomplete, managerial discretionarises and governance mechanisms are needed to allocate power andcreate incentives However, the presence of multiple principals blurscorporate objectives and may ultimately compound agency problems,providing the management with an ad hoc rationale to explain anydecision whatsoever (Williamson1985; Tirole2006) In a similar setting,regulation may shift part of the discretionary powers to the regulator,who willfind a ‘political’ solution to these trade-offs.

Recent EU policy documents are rather ambivalent and fluctuatebetween the two approaches The 2011 Green Paper remarks that cor-porate governance is traditionally defined (a) as the system by whichcompanies are directed and controlled and (b) as a set of relationshipsbetween a company’s management, its board, its shareholders and otherstakeholders The first part of the definition echoes the shareholderapproach already followed in the UK by the Cadbury Report, whichemphasises the respective roles and responsibilities of boards and share-holders The board should set the company’s strategic aims, provide theleadership to put them into effect, supervise the management of thebusiness and report to the shareholders Shareholders appoint (andpossibly remove) the directors Under this approach, corporate govern-ance centres on the agency relation between boards (agents) and share-holders (principals) Other stakeholders are protected by contracts and/

or regulation (concerning bankruptcy, competition, labour, etc.), ratherthan by traditional corporate governance institutions However, share-holder primacy has come under closer scrutiny in the last few years,particularly in financial institutions, where corporate governancearrangements have been criticised for distorting managerial incentivesand/or contributing to the financial crisis (Kirkpatrick 2009; Beltrattiand Stulz2012; Fahlenbrach and Stulz2011; Admati et al.2012; Becht

et al.2012)

The second part of the Green Paper’s definition reflects a stakeholderview, similar to that found in the Organization for Economic Co-operation

and Devolopment (OECD) Principles of Corporate Governance ThesePrinciples highlight that (a) different classes of shareholders may existand need to be treated in an equitable manner and (b) other stakeholdersmay possess rights established by law or through mutual agreements,which may also extend to corporate governance institutions (e.g.employees may obtain board representation and have a say in specificcorporate decisions) From a similar perspective, corporate governanceinstitutions do not exclusively concern the relationship between man-agers and (undifferentiated) shareholders Rather, they must solve thepotential trade-offs between different kinds of agency problems, whichmay justify regulating, for instance, the composition and role of theboard of directors.

The question therefore arises whether and to what extent the boardand/or shareholders’ powers should be regulated to reflect otherstakeholders’ interest From a comparative perspective, the answers tothis question are diverse, as shown by the fact that workers’ participation

in boards is required in some countries, while special rules have beenadopted internationally for the corporate governance offinancial insti-tutions In general, corporate governance institutions vary considerablyacross countries and types offirms, with differences that are persistentand largely dependent on specific institutional contexts (Bebchuk andRoe1999)

1.3.2 Bank governanceBanks are different from otherfirms for several reasons that matter from

a corporate governance perspective (Adams and Mehran 2003; Maceyand O’Hara2003; Mülbert2010; Ferrarini and Ungureanu2011) First,they are more influential than other firms, with the consequence that theconflict between shareholders and fixed claimants, which is present in allcorporations, is more acute Second, banks’ liabilities are largely issued asdemand deposits, while their assets, such as loans, have longer matur-ities The mismatch between liquid liabilities and illiquid assets maybecome a problem in a crisis situation, as we saw vividly in the recentfinancial turmoil, when bank runs took place at large institutions, threat-ening the stability of the whole financial system Third, despite contri-buting to the prevention of bank runs, deposit insurance generates moralhazard by incentivising shareholders and managers of insured institu-tions to engage in excessive risk taking (Corrigan 1982;2000) Moralhazard is exacerbated when a bank approaches insolvency, becauseshareholders do not internalise the losses from risky investments, but

instead benefit from potential gains (for example, by having an implicitput option at strike price zero) (Macey and Miller 1992; Polo 2007).While risk taking by non-bank corporations close to insolvency is con-strained by market forces and contractual undertakings, banks in asimilar condition can continue to attract liquidity, thanks to depositinsurance (Macey and O’Hara 2003; Sorkin 2009) Fourth, asset sub-stitution is easier in banks than in non-financial firms (Levine 2004).This allows for more rapid risk shifting, which further increases agencycosts between shareholders and stakeholders (and bondholders anddepositors in particular) In addition, banks are more opaque – it isdifficult to assess their risk profile and stability Information asymmet-ries, particularly for depositors, hamper market discipline and, in turn,increase managers’ moral hazard.

For all these reasons,‘good’ corporate governance (that is, aligning theinterests of managers and shareholders) may lead bank managers toengage in more risky activities (Laeven and Levine2009), since a majorpart of the losses would be externalised to stakeholders, while gainswould be internalised by shareholders and managers (if properly aligned

by the right incentives) Prudential regulation and supervision aim toreduce the excessive risk propensity of shareholders and managers inorder to guarantee the safety and soundness of banks An exogenousregulatory cost is allocated on excessively risky behaviour of bank man-agers, reducing agency costs between shareholders and stakeholders.Recent empirical research confirms that ‘good’ governance may not beenough for bank soundness Beltratti and Stulz (2012) investigatewhether banks’ poor performance in the recent crisis was the outcome

of afinancial tsunami that hit them unexpectedly, or of some banks beingmore inclined to experience large losses The authors analyse possibledeterminants (regulation, corporate governance, balance sheet andincome characteristics) of bank performance measured by stock returnsduring the crisis for a sample of ninety-eight large banks across theworld, of which nineteen are US banks Theyfind no evidence for thethesis advanced in a report by the OECD12that thefinancial crisis, to animportant extent, can be attributed to failures and weaknesses in corpor-ate governance arrangements (Kirkpatrick 2009) In particular, theyfind no evidence that banks with better governance performed better

12

OECD, ‘Corporate Governance and the Financial Crisis: Key Findings and Main Messages ’, June 2009.

during the crisis On the contrary, banks with more pro-shareholderboards performed worse.

Adams (2009) reaches similar results assessing to what extent the crisiscan be attributed to bad governance offinancial firms She shows that banksreceiving bailout money from the US government under the Troubled AssetRelief Program (TARP) had more independent boards, larger boards, moreoutside directorships for board members, and greater incentive pay forCEOs than non-TARP banks Except for thefinding of more independentboards, these results are consistent with the idea that TARP banks hadworse governance However, Adamsfinds it striking that TARP banks hadboards that were more independent One explanation could be that inde-pendent directors are less likely to have in-depth knowledge of their banksand thefinancial expertise to understand complex transactions like securi-tizations In other words, greater independence may be detrimental for abank board because a more independent board will not have sufficientexpertise to monitor the actions of the CEO

The criteria for examining corporate governance employed by thestudies mentioned above are open to debate For instance, independentdirectors are used as a proxy for good monitoring by the board, but thismonitoring depends on professional qualities and levels of engagement

in board activities that are not necessarily captured by current definitions

of independence (Ferrarini and Ungureanu 2011) Similarly, tional corporate governance indexes make reference to aspects such asinternal controls, which do not necessarily reflect the detailed require-ments for proper monitoring of complex risk-management processes by

interna-a binterna-ank bointerna-ard (Bhinterna-aginterna-at et interna-al.2008; Stulz2008) Thus, while establishing aprima facie case for excluding corporate governance as a main determin-ant of the crisis, the above studies cannot be used for asserting that whatappeared to be‘good’ governance at banks which failed was satisfactory

in practice and in no need of reform A similar statement calls for proofthat banks failed despite best monitoring efforts deployed by theirboards, a proof no doubt difficult to offer, particularly in light of theegregious risk-management failures seen in most troubled banks (SeniorSupervisors Group 2008; Stulz 2008) Moreover, recent empiricalresearch proves that banks that had strong risk-control systems inplace– as measured by the importance attached to the risk-managementfunction within the organisation and, in particular, by the existence androle of the Chief Risk Officer – were more judicious in their exposure toriskyfinancial instruments before the crisis and, generally, fared betterpost-crisis (Becht et al.2012; Ellul and Yerramilli2012)

2 Controlling agency costsAgency problems stem from the information asymmetries characterisingmodern business, which create an opportunity for principals to hirebetter-informed agents.13However, specialisation comes at a cost Thedelegation of discretionary powers, which are necessary to exploit theagents’ superior capabilities, carries conflicts of interest Agency costsinclude those of writing and enforcing contracts First, there are the costs

of structuring, monitoring and bonding contracts with conflicted agents.Second, output is lost whenever the costs of full enforcement wouldexceed the benefits (Fama and Jensen 1983) Several mechanisms andinstitutions keep agency problems under control In this Section weconsider the impact of product andfinancial markets; the role of corpor-ate law; soft law and the related‘comply or explain’ mechanism; and theimpact of prudential regulation on banks’ internal governance

However, two preliminary remarks are necessary with reference tocorporate law and its impact on European corporate governance Thefirst is that the EU dimension of the topic adds an additional complexity,

to the extent that not all cases in which corporate law has a role to playare also cases in which EU intervention is appropriate Under the sub-sidiarity principle (Article 5 Treaty on European Union (TEU), legalharmonisation should only occur when national legislation is unfit toaddress existing cross-border externalities (ECLE 2011) This explainswhy the role of European corporate law is rather limited and its impact

on corporate governance overall modest with respect to the role played

by national legislation and case law (Enriques and Volpin2007) Thesecond remark is that EU law acknowledges the importance of soft law

in corporate governance and attempts, particularly through disclosure(‘comply or explain’), to enhance the role of private codes This reflects ageneral trend in Europe, given that codes of best practice are widelyemployed to address corporate governance issues in Member States; onthe other hand, it may also be seen as a reflection of the inherent limits of

13 Agency problems come in many guises Tirole ( 2006 ) offers the following classi fication: (a) insuf ficient effort, such as leisure on the job and inefficient allocation of work time to various tasks; (b) extravagant investments, like suboptimal allocation of capital – i.e negative NPV decisions – due to conflicts of interest; (c) entrenchment strategies, including actions taken by the managers to secure their own position, without regard

to the impact of the same on company value; and (d) self-dealing, ranging from benign

to illegal activities, such as consumption of perquisites, tunnelling and other behaviours including thievery Roe ( 2005 ) groups agency costs in two main categories: ‘stealing and shirking ’, i.e expropriation and waste of resources.

EU powers in this area, since EU legislation can easily cover disclosure byEuropean listed issuers, but wouldfind it more problematic directly toaddress the typical agency issues affecting internal corporate govern-ance The recourse by the Commission to non-binding instruments,such as the 2004, 2005 and 2009 Recommendations examined in thischapter, confirms this approach (Armour and Ringe2011).

2.1 Market solutionsCompetition in the product and factor markets may reduce the mostserious agency costs, to the extent that inefficient firms do not survive Inother words, competition has a disciplinary function, pushingfirms andmanagerial teams to seek efficient performance (Fama1980).14Financialmarkets also play a role in reducing agency costs A firm tapping themarket for new resources is subject to the scrutiny of potential investors.Therefore, it issues new information about its current management andperspectives and possibly about corporate governance arrangements Inaddition, market prices generate incentives to value maximisation Ifagency costs are perceived as low by investors, the price of the firm’ssecurities will be enhanced Furthermore, well-developedfinancial mar-kets allow re-packaging expected cash-flows and restructuring the set offinancing contracts, so as to minimise agency costs (Barnea et al.1981).15The market for corporate control concurs to reduce agency costs Boththeory and evidence support the idea that hostile takeovers may solvegovernance problems (Manne 1965; Jensen 1988; Scharfstein 1988)

14

The true extent to which agency costs are limited by product markets is disputed Jensen and Meckling ( 1976 ) argue that: ‘If my competitors all incur agency costs equal to or greater than mine I will not be eliminated from the market by their competition ’ Jagannathan and Srinivasan ( 2000 ) produce evidence consistent with a disciplinary role of competition in product markets.

15 Financial structure decisions may re flect the relative pros and cons of debt and equity in controlling con flicts of interest: debt is more appropriate where free cash flow produc- tion is high, since it forces management to seek approval (and re- financing) for new investment projects; on the opposite, equity financing is more appropriate where free cash flow production is lower (and/or unstable), since the risk of leniency in corporate decisions is naturally lower and lower leverage allows to reduce the risk of costly bankruptcy An inef ficient financial structure (implying higher than necessary agency costs) may be easily restructured by the firm’s management or by a large investor buying out – at market prices – all the securities issued by the firm, which could then switch to the most ef ficient solution.

Takeover targets are often poorly performingfirms, and their managersare removed once the takeover succeeds A different view, focusing onthe UK, argues that hostile takeovers are not so much about correctingpoor performance, but changing the strategy of middle-of-the-roadperformers, so that they become top performers (Franks and Mayer

1996; Mayer 2013) In general, unfriendly takeovers are widely seen as

a corporate governance mechanism directed to control managerial cretion where ownership is dispersed (Easterbrook and Fischel1991) Atthe same time, bidder decisions may also be affected by agency problems(Masulis et al.2007), while hostile takeovers may transfer wealth fromstakeholders to shareholders of target firms (Shleifer and Summers

dis-1988) However, in corporate systems like those prevalent in continentalEurope, where controlling shareholders are often the norm in listedcompanies, the role of hostile takeovers is naturally limited, while man-datory bids contribute to protecting minority investors by grantingthe same a right of exit in change of control situations (Ferrarini andMiller2010)

The market for managerial labour may also play an important role, forindividual managers are disciplined by competition from within andoutside thefirm Compensation packages for managers, both incumbentand recruited on the job market, represent a market price for theirservices If remuneration fully reflected a manager’s past/expected per-formance, including possible misbehaviour, the value of human capitalwould be adjusted accordingly and the moral hazard problem woulddisappear (Jensen and Meckling1976) However, the managerial labourmarket does not exert this disciplinary role perfectly, especially whenmanagers have a short residual work life (Fama 1980) Moreover, theidea that remuneration is the result of arm’s length contracting has beencriticised recently, to the extent that the setting of pay may be influenced

by the executives through capturing the board or as a result of tion asymmetry (Bebchuk et al.2002; Bebchuk and Fried2004), espe-cially where shareholders are weak and dispersed (seeSections 3and5below)

informa-2.2 Corporate lawMarket solutions do not eliminate agency problems altogether in the realworld becausefinancial, product and labour markets are not perfectlyinformation-efficient If prices do not incorporate the information avail-able to individual agents in a timely and correct manner, they will not

provide a complete solution to agency problems (Barnea et al 1981).Indeed, distorted prices produce a distorted set of incentives, aggravatingthe agency problems that the relevant markets would otherwise reduce.

As we shall see inSection 5, for instance, CEO incentive pay packagesmay give rise to agency problems rather than reducing the ones that theywere intended to cure

Similar market failures explain why corporate law affords protection

to outside investors, such as shareholders and creditors In general,corporate law sets the requirements and limits to contracts that may beentered into by private parties State powers are also available to the sameparties for enforcing contractual performance and/or the collection ofdamages for non-performance All of this affects both the kinds ofcontracts that are executed and the extent to which contracting is reliedupon (Jensen and Meckling 1976) Of course, this mechanism is moreeffective to the extent that the contracts at issue are‘complete.’

However, legal protection may go far beyond guaranteeing ance with contractual clauses explicitly stipulated by the parties (Armour

compli-et al 2009b) Mandatory rules requiring or prohibiting some types ofagents’ behaviour may be dictated (Coffee 1989; Gordon 1989) As aresult, agents and principals do not need to negotiate detailed provisions

in their contracts, and transaction costs are minimised Furthermore,when discretion is given to an agent, the law offers standards (rather thanrules) against which the agents’ behaviour will be adjudicated ex post(Kaplow 1992) Fiduciary duties – like the duty of care and that ofloyalty, as specified by the courts – provide a set of incentives even inthe absence of a contractual clause (Easterbrook and Fischel1991).16Nonetheless, there are limits to corporate law as a mechanism forcontrolling agency costs other than‘stealing.’ No doubt, well-structured(and thoroughly enforced) corporate law provisions may deter control-ling shareholders from diverting value to themselves and managers fromputtingfirm assets into their own pockets However, corporate law is lesseffective in preventing the sheer mismanagement of corporate resources(‘shirking’) (Roe2002) The US business judgment rule and its equiva-lents in European jurisdictions typically insulate directors and manag-ers from courts’ interference, absent fraud or conflict of interest,

16

The protection afforded by legal standards of conduct is lower than that offered by rules Since standards are general, their enforcement is problematic Their aggressive enforce- ment may discourage risk taking and favour conformism, ultimately damaging the principles.

exempting them from ex post legal scrutiny (Hopt 2011).17 Indeed,courts regularly second-guessing managers would be a cure worse thanthe disease, for judges are generally less informed than managers andlack the incentives to take business decisions Furthermore, judges may

be affected by hindsight bias,finding reckless ex post managerial conductwhich was perfectly reasonable when performed As a result, if system-atic review of business decisions by the courts were permitted, theincentives inherent to agency relationships would inevitably be distorted(Rock and Wachter2001)

2.3 ‘Comply or explain’

Since informational asymmetry characterises agency relationships, closure is crucial for controlling the related costs Ex ante disclosureallows prospective principals to select agents on the basis of their intrin-sic qualities and to better decide on which terms the agency relationshipshould be entered into Ex post disclosure is crucial for enforcement, asprincipals can better detect contract violations, or deviations from theexpected standards of conduct Even in the absence of a breach, informedprincipals can revise their expectations about the risks and rewards of theagency relationship and take appropriate actions (Mahoney1995).The‘comply-or-explain’ principle – which is widely applied in Europeand was harmonised under the 2006 Directive cited above (Section1.2.1.) – reflects this ‘governance’ function of disclosure (Kraakman

dis-2004) Listed companies must state whether they apply a corporategovernance code, specify if they comply with its provisions and, in case

of non-compliance, explain the reason for their choice The need fordisclosure, combined with obvious reputational concerns– most firmswant to appear good at corporate governance, or at least do not want toappear non-compliant with best practices– push companies to complywith a code that, however, remains voluntary in nature Therefore,disclosure performs a ‘legislative’ function by lending support to softlaw and its enforcement (ibid.) At the same time, theflexibility of soft law

is protected, to the extent that a code can be easily displaced, provided

that a motivation is given for non-compliance with one or more of itsprovisions.

These and other key issues of corporate governance codes are analysed

by Wymeersch inChapter 2 Corporate governance codes are usually theoutcome of ‘private’ initiatives At the same time, they respond to thepublic interest and are considered as an alternative to public regulation.However, codes reflect mainly the concerns of business leaders, address-ing issues confronted by the same as board members or vis-à-vis share-holders Their business bias may explain the declining trust in corporategovernance codes by the political world, save for cases in which the codesare promoted by securities regulators or under the aegis of governments

In a few jurisdictions, two layers of recommendations or codes have beenadopted for boards and shareholders, respectively, the latter referringparticularly to institutional investors (an issue that will be further con-sidered atSection 6.2.3below)

The‘comply or explain’ principle is ambiguous and has stirred debatewith respect to its place in the legal system Wymeersch favours a broadinterpretation, arguing that a company should explain if and how itcomplies with a corporate governance code and, in the case of non-compliance, give the reasons for this and the solutions adopted as analternative The principle at issue caters to the private autonomy ofcompanies As a result, some of the main pillars of today’s corporategovernance– such as independent directors, audit committees and leaddirectors– derive from corporate governance best practices rather thanregulation However, the same freedom makes the code system fragile.Much depends on what explanation is deemed as ‘proper’ in a givensystem Company reports frequently include boilerplate explanations,carried over from year to year; however, a similar practice should berejected In several jurisdictions guidelines exist about the appropriate-ness of an explanation

In most countries, certain entities systematically analyse corporategovernance statements The nature of these monitoring bodies andthe scope of their action differ considerably Usually the substance ofdisclosure and explanations are not verified, as this would require ques-tioning corporate boards and analysing the reasons given for non-compliance As a result, monitoring is generally limited to statisticalanalysis and comments Moreover, individual breaches and thecompany’s identity are kept confidential, generally for fear of commit-ting libel and slander Moreover, publication of the breaches per se could

be considered as a sanction, triggering human rights concerns On the

other side, public authorities are reluctant to lend their assistance toenforcement of the codes, which are private in nature.

Wymeersch concludes that further Europe-wide harmonisation isproblematic Different ownership and governance structures, as well asdifferent legal regimes, counsel avoiding a uniform approach to corpor-ate governance issues Rather, corporate governance commissionsshould better explore how they can learn from each other and possiblyalign their recommendations and terminology At the same time, com-panies should streamline their governance practices and disclosures.European business associations could usefully support the convergence

of best practices High-level principles, reflecting the common inator amongst best practices, might then be developed, but the nationalstandard setters should remain free to adopt only those whichfit best totheir legal order

denom-2.4 Bank prudential regulation

As already noted, banks are different from other enterprises to the extentthat even‘good’ corporate governance (that is, aligning the interests ofmanagers and shareholders) may lead bank managers to engage in morerisky activities Given high leverage and other special features of banks, amajor part of the losses would be externalised to stakeholders, whilegains would be fully internalised by shareholders and managers (ifproperly aligned by the right incentives) As a result, prudential regu-lation and supervision aim to reduce the excessive risk propensity ofshareholders and managers in view of guaranteeing the safety andsoundness of banks In a similar framework, corporate governanceworks as a complement to prudential regulation by contributing tokeep risk management under control This explains why banking super-visors have become so interested in corporate governance in the lastdecade (Basel Committee2010)

Byfixing the standards under which bank boards should operate intheir monitoring activities vis-à-vis the managers and by supervisingtheir implementation in practice, bank regulators indirectly control risktaking by banks and assure their safety and soundness As a result, thecorporate governance of banks (andfinancial institutions in general) isclearly directed not only to maximise shareholders’ wealth, but also toprotect the interests of depositors (and other stakeholders) and to pre-vent systemic risk in all cases in which these could materialise (largeinstitutions, interconnected ones, etc.) (Becht et al.2012) As underlined

by the 2010 Green Paper,‘it is therefore the responsibility of the board ofdirectors, under the supervision of the shareholders, to set the tone and

in particular to define the strategy, risk profile and appetite for risk of theinstitutions it is governing’

‘minority shareholder engagement is difficult in companies with trolling shareholders, which remain the predominant governance model

con-in European companies’ The Commission also comments that similardifficulties may make the ‘comply or explain’ mechanism much lesseffective, hypothesising that legal rules may be needed for either reserv-ing some of the board seats to minority shareholders (a theme analysed

inChapter 8) or controlling related party transactions

In this Section, after sketching the different types of agency problemsderiving from the two main ownership structures, we consider thespecial case of family companies, which show interesting dissimilaritiesfrom other companies controlled by non-family blockholders

3.1 Dispersed v concentrated ownership

Agency problems may arise either between managers and shareholders(as a class) or between controlling shareholders (as agents) and minorityshareholders (as principals) When shareholders are dispersed, anappropriate set of constraints is required to guarantee that self-interestedmanagers – who have discretion over the allocation of the company’sresources– act primarily in the shareholders’ interest Alternatively, one

or more investors may acquire a large equity stake (Shleifer and Vishny

1997) The ensuing concentration of claims makes concerted action

amongst investors easier, given that transaction costs are reduced, whileblockholders are entitled to a higher (proportionate) share of theexpected benefits However, the interests of blockholders are not alwaysaligned with those of the remaining investors Indeed, the dominantshareholders (and the managers appointed by the same) may use theirdiscretion to expropriate minority investors and get a disproportionateshare of thefirm’s benefits.

Ownership structures vary across countries andfirms In the UK, USand other common law countries, ownership is typically dispersed andseparate from control (La Porta et al.1999) In the rest of the world, largeshareholdings of some kind are the norm: ownership is typically con-centrated in the hands of families and the State (Claessens et al.2000;Becht and Mayer2001; Faccio and Lang2002).18Consequently, differentcountries generally witness different kinds of agency problems (Roe

2005)

A third category of agency costs may be identified with regard to therelationship between the controllers of a company (as agents) and non-shareholder stakeholders (Armour et al.2009b; ECLE2011) However,not all relationships of this kind are easily defined in terms of agency.19

While debt contractsfit an agency perspective, the same cannot be saidfor other relationships such as those with the firm’s clients or localcommunities Nonetheless, contracts with stakeholders and the applic-able regulatory framework may have an impact on corporate governance

to the extent that the relevant prohibitions and/or obligations directly

or indirectly affect the firm’s directors and shareholders (Braithwaite

2008)

The interaction between ownership structures and total agency costs iswidely discussed in the economic literature According to some scholars (LaPorta et al.1997;1998;2000), ownership concentration leads to suboptimaldiversification When a firm goes public, the founder should thereforerelinquish control altogether, provided that institutions are available for

18 Precise numbers may vary according to sample size, reference years and methodology of analysis However, a clear distinction may be traced between the UK, US and a handful

of other countries, on one hand, where the average (or median) largest shareholding block is below the conventional 10% threshold, and continental European (and Asian) countries, where the average (or median) largest block is much higher (between 25% and 50%) and allows control of the decisions of the general meeting.

19

Jensen and Meckling ( 1976 ) de fine an agency relationship ‘as a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority

to the agent ’.

keeping managerial agency costs under control Consequently, goodinvestor protection leads to both ownership dispersion and higher firmvalues This‘law matters’ theory of corporate governance has been criticisedfrom different perspectives First, the underlying legal analysis and themeasures of investor protection adopted are not always accurate (Cools

2005; Armour et al 2009a) Second, the theory at issue does not fit theevidence available for a number of countries (Cheffins2001; Coffee2001;Dyck and Zingales2002; Gilson2006) Third, it is unclear whether share-holding blocks persist in some institutional contexts because minorityshareholders fear the controlling ones or because they fear the managers,who might dissipate shareholder value if the controlling shareholders dis-appeared (Roe2002)

Briefly, an optimal ownership structure is not easily found, which may

be due to the complexities of the‘common agency’ problem It has alsobeen argued that ownership structures, as well as corporate governanceinstitutions in general, are path-dependent (Bebchuk and Roe1999), i.e.their pros and cons may depend on a country’s existing pattern ofcorporate structures and institutions.20Therefore, the optimal solution

to the ‘common agency’ problem may be country-specific, when notspecific to the individual firm

In all cases, ownership structure decisions involve a choice betweenalternative sets of agency problems The same is true for institutionsaimed at keeping these problems under control A given mechanism maymitigate one type of agency problem, but reinforce another: for instance,entitling shareholders to remove the managers may mitigate the agencyproblems of shareholders as a class, but reinforce those of minorityshareholders (ECLE2011)

3.2 The case of familyfirms

InChapter 3, Andres, Caprio and Croci analyse how family-controlledfirms compare with non-family firms in responding to crises On oneside, they confirm what has already been acknowledged, i.e that familyfirms in Europe generally outperform non-family firms (Barontini andCaprio2006; Maury2006; Sraer and Thesmar2007; Andres2008; Franks

et al.2012) On the other, they provide new information on the ways inwhich family firms behave in booms and busts Their findings are in20

Which may also include historical accidents, due to non-CG factors, such as wars, upheavals and other less dramatic ‘political’ influences (Morck and Steier 2005 ).

stark contrast with the private benefits hypothesis, which assumes thatownership remains concentrated in the hands of families where lowinvestor protection allows the same to extract higher private benefits.Andres, Caprio and Croci show that family firms react to downturnsmore efficiently than non-family firms, as the former adjust their invest-ment decisions more quickly They also show that the engagement oflong-term investors does not necessarily produce more stable perform-ance and investments, contrary to what is assumed by most literature.The better performance of familyfirms derives from their more efficientinvestment policy, which includes rapid downsizing in crises Moreover,familyfirms apparently do not take advantage from a crisis to expro-priate minority investors.

Andres, Caprio and Crocifind evidence that family firms reacted tothe credit crisis by reducing their workforce and wages This could implythe break-up of long-term implicit contracts with employees and apossible wealth transfer from labour to shareholders (Shleifer andSummers 1988) Similar adjustments would be more difficult to carryout quickly if employees owned a significant fraction of the equity capitaland/or if they were represented on the board of directors Employees’ownership and/or board membership, despite being deeply rooted insome Member States, may work as a double-edged sword during crises

On one hand, they could lead to a smoother transition; on the other, theycould prevent or slow down the restructuring of ailingfirms

These results suggest that ownership structures in different countriesmay be determined by causes other than by the degree of investorprotection prevalent in each country The complexity of corporate gov-ernance arrangements can scarcely be captured by a simple measure ofinvestor protection or a‘governance index’ Moreover, similar arrange-ments, in order to be effective, should fit the underlying legal andinstitutional structure, rather than be dictated by the same The simpletransplant of corporate governance solutions may be ineffective andcould even backfire, where the regulatory and institutional contexts arenot receptive

Whatever thefirm’s ownership structure, both the markets and ate law provide incomplete solutions to agency problems, which are toocomplex to be solved solely through ex ante mechanisms Discretionarypowers, which are the essence of agency relationships, survive in a world

corpor-of incomplete contracts This leaves room for governance mechanismsallocating decisional powers ex post, i.e after the contract has beenstipulated, in a state-contingent manner These governance mechanismsare characterised byflexibility, for they allow new information generatedafter the making of the corporate contract to be exploited in the manage-ment of thefirm (Williamson1988) Thefirst mechanism of this type isthe board of directors which, in the two-tier system of governanceforeseen in some European countries,finds its equivalent in the super-visory board.

4.1 TheoryGiven contractual incompleteness, the (supervisory) board is entrustedwith the required discretion to take the core business decisions andmonitor the managers on behalf of the shareholders (and possiblyother stakeholders) Boards are found in all jurisdictions and all types

of organisations (profit and non-profit), and were generally developedbefore specific legal provisions were introduced to regulate them Boardscan therefore be regarded as a market solution to agency problems, i.e anendogenously determined institution that helps keep agency costs undercontrol (Hermalin and Weisbach2003)

Board discretion covers the monitoring of managerial actions and thetaking of high-profile decisions, which should not be left to the managersalone In Williamson’s (2008) words, boards are meant to ‘serve asvigilant monitors and as active participants in the management of thecorporation’ Their monitoring regards corporate organisation andmanagement performance It also includes the‘hiring and firing’ of theCEO and other key executives and the setting of their incentives andcompensation packages The monitoring extends to the informationflows to investors, such as financial statements, event-related price-sensitive information, etc The board’s management role mainly relates

to fundamental corporate actions, such as the approval of major businesstransactions and of corporate strategy and relevant plans Other boardroles are the offering of advice to the managers and networking withotherfirms and institutions

The board’s appointment gives rise to a discrete agency relationshipunder which agents (directors) monitor other agents (managers) and tothe ensuing conflicts of interest Nonetheless, the board is usually con-sidered a successful governance mechanism because of its collegialnature, which increases the information set collectively available to the