6.4 Governance Panel Discussion

Professor Stewart Myers, Dr. Rolf Breuer, and Dr. Victor Fung all commented on the factors driving greater interest in corporate governance. Aside from the obvious issue of U.S. corporate scandals, changes in Asia and Europe are highlighting the importance of corporate governance.

In particular, the rising use of equity financing and outside shareholders in both Europe and China bring up the issues of greater transparency and shareholder rights.

Dr. Rolf Breuer, chairman of Deutsche Bank, described the European view of corporate governance. In describing the current situation, he noted the troublesome issue of unifying the 35 different corporate codes of conduct and regulatory frameworks in the European Union. This is a microcosm of the larger global problem of unified standards and the thorny issue of balancing global needs against local needs. Breuer warned that the European Union should avoid choosing the lowest common denominator when creating a common framework. It is important to use the commonality among the 35 frameworks but also to keep local laws where they serve local purposes.

Looking at the world stage, Breuer lamented the lack of convergence between U.S. international accounting standards bodies. For example, when Deutsche Bank listed on the NYSE, the bank was forced to switch to U.S. GAAP. The switch caused much consternation and confusion among the bank's European and world shareholders. And, although Breuer had no qualms about signing the U.S.-mandated CEO and CFO certifications, some heads of dual-listed European companies have objected to this recently mandated practice because they see it as a sovereignty issue: whether American watchdogs should oversee European companies or vice versa. To improve communication with shareholders and provide greater transparency, Breuer recommended using scenarios when presenting issues to shareholders, analysts, and stakeholders. Too many corporate decisions are obfuscated by complex legalistic documents. Complex legal documents adhere to the letter of the law regarding reporting proposed actions to shareholders, but they create a lack of transparency that brings a host of ill-considered practices such as excessive executive compensation or Enron's infamous special-purpose entities. Instead, CEOs could explain proposed actions using a set of scenarios (worst-case outcomes, expected outcomes, and best-case outcomes). Such scenarios would help shareholders and stakeholders gain a clearer understanding of the real impacts of proposed management decisions.

Dr. Breuer also commented on the U.S. practice of allowing the CEO (head of management) to be chairman of the board (head of oversight). In contrast, the dual-board system is common in Europe. In the dualboard system, the heads of the two boards are purposefully distinct—the executive board is in charge of running the business, and the supervisory board performs a strategic oversight role and hires/fires those executives.

When asked about the recent closure of Germany's Neuer Markt, Breuer noted that this answer to America's NASDAQ failed because it tried to copy the public-listing practices that were appropriate for larger, more established companies. As Professor Myers had noted, different types of organizations require different types of governance and regulatory frameworks. Aside from cultural and regional differences, differences in the age, size, and history of a company affect how it should be run.

Dr. Victor Fung, chairman of Li & Fung, focused on the Asian view of corporate governance. The biggest story in Asia is the ongoing evolution of China from a communist-led command-and-control economy to one that tries to meld the energy of free markets with the values of socialism. The state-run enterprises have already shrunk from being 100 percent of the economy to being a mere 30 percent of the current economy.

During his introduction, Professor Myers noted the crucial goal of frictionless flow and efficient allocation of capital. In turn, Dr. Fung described the obstacles to this process in China. The obstacles are twofold: human resource issues at banks and the lack of sophistication of investors. Like many Asian countries, China enjoys a phenomenally high savings rate (some 40–50 percent). Most of this money flows into low-yield bank savings accounts. In the past, banks played more of a simple cashiering role, because the state made all the lending and investment decisions. In theory, the banks now have the responsibility for local lending decisions. Unfortunately, the banks have neither the personnel nor the expertise necessary to recycle all the capital socked away in savings accounts. Until the banks learn to lend—or consumers learn to invest in equities—China will suffer from inefficient allocation of capital.

Regarding his own company, Dr. Fung noted its efforts to promote ethical practices among Li & Fung's global network of trading partners. Although not mandated by any government edict, Li & Fung created a Compliance Officer position in the company. Li & Fung knows that its own reputation as a trading company is a function of the reputations of all the companies with which it does business. The Compliance Officer ensures that trading partners live up to high standards. Dr. Fung noted that although his company created this position simply because they believed in it, the practice has created a barrier to entry for Li & Fung competitors. Li & Fung can form tighter relationships with the better suppliers, leaving less ethical alternatives to its competitors.

Commenting on the Bank of China, Dr. Fung described how going public brings greater discipline to a company. Many believe that privately held companies have an advantage in being able to make better strategic decisions than do their publicly traded counterparts. Yet going public in Hong Kong forced the Bank of China to create better governance and reporting structures for the Hong Kong side of the bank. The bank learned much from the process and intends to transfer that learning back to the mainland and then take the remainder of the bank public.

Another issue being debated in Asia is whether companies should move to quarterly reporting. (Currently, companies report semiannually.) Dr. Fung pointed out that the practice of quarterly reporting can actually reduce transparency. This view is in contrast to the argument that the longer reporting cycles of companies in places like Europe and Hong Kong mean a lack of transparency—that investors lack timely updates on affairs of the company. First, he pointed out that shorter reporting cycles tend to amplify the normal noise of business, having fewer months over which to average the ebb and flow of revenue and cost events. Thus, companies on shorter reporting cycles have more incentive to manage earnings, shifting costs and revenues using accounting sleight-of-hand to reach the magical "1 cent over expected earnings" target. Second, shorter reporting cycles can actually delay the reporting of material events. If a material event occurs two months into a six-month reporting cycle, the company is likely to report it immediately. In contrast, a company on a three-month cycle might delay the news for one month to coincide with the next routine quarterly announcement.

The speakers also referred to the role of crises in bringing about corporate governance reforms. Dr. Fung said that the state of corporate governance in Asia was not good before the financial crisis of 1997. The crisis raised awareness, however, and Asian countries have made much progress since them. Singapore and Hong Kong are the farthest along. The United States, currently in the midst of crisis, is trying to create reasonable reforms to prevent any future repeat of the recent corporate scandals and to restore confidence in U.S. financial markets. Dr. Breuer said that the events in the United States were eye-opening for Europe. Europe is currently working hard to avoid being the next financial crisis.

The speakers also discussed one of the differences between American stock exchanges and those in Asia and Europe, namely the size of companies listed on the exchanges. For example, more than 50 percent of the market cap of the Hong Kong Stock Exchange is made up of companies that are family-controlled, Dr. Fung said. Dr. Breuer, likewise, commented on the large and vibrant role of small and midsize companies in Europe. This difference in corporate size requires a corresponding difference in corporate governance. Although some have argued that family ownership is a poor form of governance, Fung disagreed with this view. Family ownership creates extremely strong incentives and alignment that other "professionally managed" companies must try to create using cruder mechanisms such as salary, bonuses, and stock-options. Although family ownership can be abused, Hong Kong regulations focus on those potential abuses (e.g., self dealing and connected transactions). The point is that no single form of governance is superior to all others. Each form of governance has advantages and each needs regulations that address the potential weaknesses or abuses inherent in that form of governance.

Finally, the speakers discussed the topic of strong independent boards of directors and the challenges to creating these boards. Most pressing is the shortage of qualified candidates. In China, the newness of private enterprise implies a shortage of experienced business executives for boards, Dr. Fung said. In a country in which no one can claim decades of for-profit management experience, finding board members is difficult. Fung also noted the low pay scales for board members and a tendency for the same people to appear on multiple boards.

Likewise, in the United States, the drumbeat for accountability will likely frighten potential board members. Increasing the responsibilities and liabilities of board members will shrink the pool of applicants. In her presentation, HP CEO Carly Fiorina cautioned that overregulation could make boards and management too risk-averse, which would threaten the innovation and experimentation that form the basis for value creation.

Even the definition of "independent" varies across countries. Dr. Breuer noted that U.S. regulators see European boards as lacking independence owing to the presence of employee representatives. At the same time, European regulators see U.S. boards as lacking independence owing to prevalence of stock ownership by members of U.S. boards. At issue is the role of the board in representing various constituencies during the boards' oversight of management. European boards have more alignment with employees; U.S. boards have greater alignment with shareholders. Board members can represent constituencies such as shareholders, employees, debt-holders (banks), the local community, governments (i.e., golden shares), and even the general public.

Aligning the board with any of these constituencies can make the board indirectly dependent on the company and management. With the fates of so many all connected in different ways to the fate of the company, no one is truly unbiased and independent. This is the prime driver for the need for ethics. In an interconnected world in which everyone is dependent on everyone else, ethics may be the only practical substitute for the ideal of independence.