6.2 European Corporate Governance: A Changing Landscape?

6.2 European Corporate Governance: A Changing Landscape?

Giovanni Carriere, Andrew Cowen, Jos Antonio Marco, Donald Monson, Federica Pievani, and Tienko Rasker

This paper focuses on the evolving landscape of European corporate governance. Effective governance supports the stability and efficiency of the corporate sector. Countries with clear, accurate, formal, and widely accepted business practices are more successful in attracting global capital flows and creating economic prosperity. Companies with greater transparency have better access to capital, and thereby obtain a competitive advantage.

There is an ongoing debate on governance in the major industrialized countries. This paper describes where the countries of continental Europe stand in this debate and identifies possible future developments. We do not judge any particular country's governance practices, nor do we advocate changes. We review recent developments, highlighting key issues for the future.

First, we look at the sources and flows of capital that fund companies. We examine three areas: stock markets, debt financing, and venture capital. We begin with a look at the London stock market, which is more liquid and provides better access to capital than its continental competitors. This does not mean, however, that "Anglo-Saxon" governance practices will—or should—prevail on the continent. Next, we look at debt financing, which plays a crucial role in capital allocation in Europe. European banks often lend on the basis of long-standing relationships and government influence. Banking reform measures are under discussion, but progress on banking reform may be slow. Finally, we examine venture capital. European entrepreneurs face a shortage of seed funding. Relatively few high net-worth individuals in Europe invest in start-ups, preferring safer investments. This is an important issue for Europe, since innovation and growth are often fueled by start-up companies.

Second, we look at corporate governance from the perspective of control, examining the role of boards, corporate takeovers, and institutional investors. European boards of directors are becoming more influential. The current power of the CEO over nominations and the influence of cross-shareholdings among companies may change. The failure of the European Commission's European Takeover Directive and the prevalence of defenses against hostile takeovers mean that the market for corporate control is not well developed in Europe. Finally, pension reform is increasing the importance of institutional investors in Europe. The professional managers of new funded pension plans will strengthen the role of institutional investors in corporate governance.

Stock Markets

The London Stock Exchange and the London-Continent Connection

The European corporate and investment community considers the U.K.—not the U.S.—as their model for capital markets. The U.S. and the U.K. markets are similar in many respects, including accounting, exchange reporting requirements, corporate structure, and laws surrounding events such as takeover. The U.K.'s membership in the EU, however, and its proximity to the rest of Europe move the U.K. closer to the continent and apart from the U.S., particularly with regard to laws, taxation, the recent move to deregulated/privatized national industries, and dual stock listings.

Although the U.K. is under common law and the continental law is based on Code, the regulations affecting securities create a similar environment. For example, violations of insider trading are subject to criminal—not civil—standards in the U.K. and in continental Europe. Therefore, prosecuting violators of insider trading laws is just as difficult in the U.K. as it is in continental Europe. Unlike in the U.S., corporate officers in the U.K. and Europe face little or no risk of monetary loss for breach of fiduciary duty.

Tax laws in the U.K. and in continental Europe are also similar, particularly regarding corporate compensation and capital gains. For example, in the U.K., taxes equal to 17 percent of the value of a stock option have to be paid upon issuance. While options haven't caught on as much on the continent, similar tax policies exist surrounding them.

Enforcement of governance laws is another shared trait between the U.K. and the continent. In the United States, although exchanges enforce certain requirements, the Securities and Exchange Commission (SEC) is the main watchdog of companies and their officers. In the U.K. and the continent, the exchanges themselves are the main watchdogs.^[1]

The Big Bang

Lack of liquidity and access to capital is what historically attracted European companies to dually list their shares domestically and in London. The U.K. had started a privatization move in the 1980s that had enormous implications for capital markets. When the largest companies in a country or region are not publicly traded, the affected capital markets lack liquidity. With reduced liquidity comes less investment and fewer investors, making it more difficult for other companies to access the capital markets. This situation characterized continental markets. In contrast, access to capital markets is a hallmark of the Anglo-Saxon (i.e., U.K. and U.S.) business model.

A 1986 law called the "Big Bang" opened up the London exchanges. The Bang had a massive effect. First, ownership of member firms by foreign companies became permissible. American and continental European investment banks established a beachhead. This development, along with more liberal commission schedules, increased the competition for brokerage business and caused a surge in trading volume.

The increased volume, along with the establishment of the Stock Exchange Automated Quotations (SEAQ) system, enhanced London's capital-drawing powers beyond what anyone anticipated. For example, over 60 percent of all Swedish stocks were traded in London at one point.

London has continued to draw trading volume. Daily trading grew to $24 billion by 2001.^[2] Just over $3.3 billion were traded daily at the Deutsche B rse, the next largest continental exchange.

London is also the world's largest center of equity assets under management. As of 2000, almost $2.5 trillion was managed from London. New York was second with just under $2.4 trillion. Paris ranked as the largest European center with less than $500 billion.^[3]

These developments were catalysts for the change of European corporate governance. First, companies who list their shares in London must comply with the U.K. reporting and accounting standards, regardless of the requirements in their home countries. This means quarterly reporting of operating income, balance sheets, and statements of cash flow. Second, dual-listed companies can expect to be plied for data and pushed in new ways by the English and American investment community. Many management teams got their first taste of Anglo-Saxon investment community requirements when they listed in London.

Addressing these requirements was the price of admission for access to the U.S. and U.K. capital pools, access which European companies looking to grow quickly wanted. Continental Europe was almost devoid of large equity pools until very recently. Governments on the continent controlled most of the largest companies and thus the largest pension funds. These pension funds usually invested a minority of their assets in equities. In Italy, for example, the pension laws almost entirely precluded pension investment in equities.

The London Stock Exchange still leads in overall trading, with over $4.5 trillion of annual volume compared to the Deutsche B rse's $2.1 trillion.^[4] In order to retain volume and compete against larger exchanges, the smaller and regional exchanges have either consolidated or gone public to raise their profile. For example, Paris, Belgium, and Amsterdam merged to form Euronext in the spring of 2000. Euronext had $1 trillion of annual volume in 2001.^[5]

Introduction of the Euro Brings Convergence

The euro's introduction has had major implications for reporting and capital markets. Total European securitization has surged from just under 40 billion euros in 1996 to almost 154 billion euros in 2001. Although the U.K. has historically accounted for the bulk of these issues, the market for new asset-backed and mortgage-backed securities is growing robustly in several countries on the continent.^[6] Naturally, a larger marketplace around a unified currency attracts capital. Companies have found it much more efficient to issue debt via these larger capital markets than from banks. Companies using the capital markets need to have better public disclosure of operating results and capitalization than companies using bank debt.

Accounting Standards

The European Union has issued a directive for the implementation of International Accounting Standards (IAS) by 2005 by companies in all member countries.

One reason why the IAS was favored over something closer to the U.K. Generally Accepted Accounting Principles (GAAP) is the lack of prescriptive requirements. Both U.K. and U.S. GAAP call for specific treatment of specific issues. IAS allows more flexibility in reporting methods. Investors need to guard against being forced into a false sense of security by companies that claim strict adherence to IAS.

A nonshareholder-friendly version of IAS emerges from tax policy. Most continental European countries do not allow companies to keep two sets of accounting books—one for the government tax authorities and one for the markets. Therefore, in situations where CEOs feel more pressure to pay the least in taxes rather than book the most earnings, the shareholders could lose out.^[7]

Summary

Recent developments on the continent suggest an apparent embracing of the Anglo-Saxon model of corporate disclosure and structure of capital markets. However, although there have been many changes—specifically in terms of reporting standards, capital mobility, and the role of outside shareholders—there are still many differences.

For example, the majority of continental countries have a history of universal banks, acting as holders of equity and providers of debt. Many of the largest banks—including Deutschebank, Societ General, BNP Paribas—have purchased U.S. and U.K. investment banks, and they appear to be evolving into more pure investment banks. But considerable equity ownership of borrowers by continental lenders continues. Given the structure of boards, the state of capital markets, the structure of tax laws, and the training of management, the continental country systems may be the most effective for those countries.

Each country also retains its own standards in almost every facet of capital markets, accounting, and disclosure. Differences can exist even within the newly consolidated exchanges. Euronext came out of a merger between the Paris, Brussels, and Amsterdam stock exchanges. However, French companies listed on Euronext have far weaker reporting standards than their Dutch counterparts. French companies do not have to report quarterly or even semi-annually. In another example, retroactive adjustments to earnings announcements are forbidden in London and Holland, but they are permissible in Germany (even though Germany is leading the move to IAS on the continent).^[8]

The relationship between London and the continent has a long and complicated history. All indications are that this relationship will continue to evolve with the nature of financial and operational disclosure and the structure of capital markets in both places. While it is impossible to predict exactly what will happen, all signs point to an increased alignment of systems both within continental Europe and between the U.S., the U.K., and the continent.

The Neuer Markt

Less than ten years ago, access to capital markets in Europe was restricted to well-established companies with real assets and reliable cash flows. The advent of new markets, formed in the image of NASDAQ across Europe, shifted the balance of power and fueled the technology boom of the late 1990s. In Germany, over 300 companies went public on the Neuer Markt between 1997 and 2000, compared to a mere 49 public offerings in the previous three years. The STET developed a platform for young, innovative companies to reach the public market, and many investors quickly realized extraordinary returns on the Neuer Markt during the Internet era.

The "new market" renaissance that started with AIM in London (1995) and Nouveau Marche (1996) in Paris quickly spread across Europe to include, by the end of 1999, the Nuovo Mercato in Milan, Nuevo Mercado in Madrid, SWX New Market in Zurich, NMAX in Amsterdam, EURO.NM in Brussels, and pan-European EASDAQ. The Neuer Markt, with its pure growth and technology focus, transparent standards, wide analyst coverage, and ability to attract private investors, became the premier European growth market in terms of market capitalization, with about half of the total capitalization of all of Europe's new markets.

The Neuer Markt experienced phenomenal growth in the late 1990s as the technology sector blossomed and a cadre of venture-capital-backed start-ups gained access to the capital markets. Highprofile successes like MobilCom and EM.TV triggered widespread enthusiasm for equity investments in Germany. Private and institutional investors scrambled to accumulate shares of new public offerings. The Neuer Markt's early adoption of market regulations in adherence to international standards, coupled with corporate governance guidelines, made it an attractive platform for high-potential companies and international capital.

When the Internet bubble burst, the Neuer Markt suffered a severe market correction and lost 90 percent of its value. Without the cover of inflated returns, high-profile cases of insider trading, regulatory violations, and management negligence contributed to widespread erosion of investor confidence in Neuer Markt companies. Capital markets depend on corporate governance and market regulation to ensure efficiency and liquidity. Neuer Markt companies had to obey regulations in accordance with private law; but with no strong central regulatory body similar to SEC, the Deutsche B rse (a private institution) was left to create, monitor, and enforce market regulations.

One of the forefathers of German venture capitalists, Rolf Dienst of Wellington Partners admitted that lax enforcement of securities regulations contributed to the collapse of investor confidence. Insider trading and lock-up violations tarnished Neuer Markt IPOs. The six-month lock-up regulation, which restricts existing shareholders from selling their equity within six months of the public offering, was frequently broken. Intertainment, Buecher.de, and EM.TV are examples of companies whose founders faced charges for selling large blocks of personal shares, often with insider information, before lock-up periods expired.

The problem of the insider trading and lock-up violations stems from Germany's reliance on a private institution, the Deutsche B rse, to establish and enforce Neuer Markt regulation. In contrast, NASDAQ establishes listing requirements and market regulations subject to SEC laws and minimum requirements. In Germany, Neuer Markt companies adhere to regulations in accordance with private law.

Ultimately, the B rse announced plans to close the Neuer Markt, but as a European capital market innovation, the Neuer Markt provides some useful lessons.

Regulatory Alignment: The Need for Regulatory Body Consolidation

The NASDAQ has developed into the paragon for growth markets, and its regulatory oversight body, the SEC, deserves much of the credit. The SEC, a U.S. federal agency, serves NASDAQ at all levels—rule formation, monitoring, and enforcement. Thus, the SEC ensures the transparency and credibility of the exchange. One investment banker we interviewed contended that, given the Neuer Markt's youth in comparison with NASDAQ, it regularly explores new territory not wholly contained in its guidelines. Such was the case with early violations of insider trading and loopholes in lock-up period trading. The multiple institution involvement makes Germany's regulatory regime comparatively less responsive and often unprepared to handle emergent violations and ensure market efficiency.

The legal and regulatory framework of the Neuer Markt, like other European growth markets, was subject to a complex market surveillance regime that spanned private and public institutions. In contrast to the regulatory sovereignty of the SEC in the United States, the involvement of multiple institutions in rule formation, monitoring, and enforcement hindered the development of the Neuer Markt as a wholly transparent marketplace for international capital.

Germany has a three-tier supervisory system for monitoring German securities markets. The first layer for regulation is the Deutsche B rse AG, a private organization, which manages the Frankfurt Stock Exchange (FWB). The Deutsche B rse oversaw regulatory adherence on the Neuer Markt, where it set listing requirements, monitored trading regulation compliance, and imposed fines for rule violations. Much of the regulation was established in accordance with private law, legally equivalent to a private contract between a listed company and the Deutsche B rse.

The second layer of supervision came at a state level from public quasi-regulatory bodies, including the FWB, which monitored the various Deutsche B rse market segments, and from the stock trading authority of the Economics Ministry of the state of Hessen, which assumed further responsibility for legal and market supervision.

The third layer, the Federal Supervisory Office for Securities (BAWe),^[9] conducted overall surveillance of the German markets with a specific focus on public information disclosure and insider trading violations. Because the Neuer Markt regulation was largely a matter of private law, the role of the BAWe in the case of the Neuer Markt remained opaque.

Market transparency and liquidity are two crucial criteria that determine the success of a stock exchange. The Neuer Markt had ostensibly taken great measures to ensure transparency with stringent regulatory guidelines (RWNM)^[10] created in accordance with private law that are augmented with exchange laws and orders (B rsG and B rsO)^[11] established by the FWB as well as securities law (WpHG)^[12] set at a federal level.

Market Enforcement: Cracking Down on Securities Violations

A structural disconnect between monitoring and enforcement of securities laws in Germany had contributed to insider trading, sloppy reporting, and management negligence, which in poor market conditions exacerbated the Neuer Markt downturn. Until recently, disclosure of insiders' holdings (director's dealings) had not been required. Without one clearly defined body for securities law enforcement, insider trading grew from a couple of isolated cases to an epidemic in late 2000 and 2001.

Once considered a management perk in Germany, insider trading has dealt a severe blow to the perceived transparency of the Neuer Markt in the eyes of international investors. Case in point: EM.TV, an Internet start-up that went public in 1997 on the Neuer Markt, triggered concerns when they lowered 2000 earnings from $250 million to $24 million. EM.TV went on to lose more than 98 percent of its value. State market regulators accused founders Thomas and Florian Haffa of falsifying midyear reports in 2000. Further investigation into Thomas Haffa revealed that he sold $18 million worth of shares within six months of EM.TV's November 1999 capital increase, which appears to violate the Deutsche B rse lock-up guidelines. Haffa claimed he received clearance for the transaction from investment bankers and violated no criminal law. Prosecution of such cases in Germany is difficult because it is deemed a matter of private law and not a criminal offence.

The Deutsche B rse can threaten to delist violators and even levy penalties up to 100,000 euros, but ultimately the enforcement must carry criminal charges and as such must involve the Federal Supervisory Office for Securities (BAWe). The BAWe is an understaffed, weak federal office. To act on specific cases, the BAWe needs the cooperation of local authorities to seize documents and conduct an investigation. The result is that many violations fall through bureaucratic cracks and managers go unpunished. In fact, no one has ever gone to jail for insider trading in Germany.

Likewise, crime and punishment were not sufficiently aligned to deter reporting inconsistencies in companies. Until recently, the fine for publishing quarterly data late was 25,000 euros, a small sum for a company wanting to delay bad news on the market.

On May 1, 2002, the German parliament passed a law integrating three federal supervisory bodies—securities (Bundesaufsichtsamt f r Weltpapier, BAWe), credit (Bundesaufsichts mter f r das Kreditwesen, BAKred), and insurance (Bundesamt f r das Versicherungswesen, BAV)—under one federal financial services supervisory body, the Bundesanstalt f r Finanzdienstleistungsaufsicht (BAFin). The final step was to empower BAFin as a powerful government watchdog, which sends insider traders to jail and demands corporate governance guideline adherence.

On September 27, 2002, the German stock market council voted to restructure the German stock market, which will result in the abolition of the Neuer Markt by the end of 2003 at the latest.

Debt Financing

In Europe, where professional investors have long tended to avoid equity as an asset class, debt plays a crucial role in the capital allocation system. Bank managers offering credit to their customers channel scarce capital toward the best investment opportunities. Managers of bond portfolios make decisions guiding Europe's capital to where it can work the hardest. A number of recent incidents have raised serious doubts as to whether European financial institutions have the capabilities, and the desire, to perform these functions effectively.

Europe has too many banks, and banks sometimes issue debt on the basis of standing relationships and under government influence—often at the wrong interest rates to the wrong companies. A spectacular recent example of poor judgment was the failure of the Kirch Gruppe in Bavaria. German banks lent the company billions of euros to make dubious investments in a variety of media ventures, including Formula 1 motor racing. The company declared bankruptcy. Financial experts finally had publicly doubted Kirch's creditworthiness, and there were serious accusations of meddling in some of the bank's decisions by the prime minister of Bavaria, Edmund Stoiber. German banking regulators have subjected the transactions to review. A comparable lack of judgment can be perceived among investors in the fledgling high-yield bond markets in Europe, which are showing large negative returns. Experts comment that too many European debt investors lack duediligence skills.

The Reform of Banking Regulations: "Basel 2"

Traumatic events, such as the near-collapse of Long-Term Capital Management in September 1998, highlighted the need for reexamination of current frameworks for risk management within the financial system. The international Basel Committee on Banking Supervision launched a review of banks' risk management and capital reserve requirements. It has published a detailed proposal for setting banking capital requirements, known as "Basel 2." Basel 2 will revolutionize the way capital requirements are set, adjusting them to the banks' own measures of the risks they run. The new rules were intended to come into effect everywhere in the EU in 2004 and to replace Basel 1, which has been in place since 1988. Progress on finalizing the proposals has been slow. At this time, commentators predict that the proposals will not come into effect before 2006.

The intention of Basel 2 has been to stimulate banks to put in place more sophisticated schemes for risk assessment by offering a reward in the form of reduced capital requirements. However, the rules must not give advanced banks too great a competitive advantage over less sophisticated, perhaps smaller, competitors, or else they will be perceived as unfair. Getting the balance right has been a serious challenge and has delayed the finalization of proposals.

Apart from the emphasis on improved internal risk management by banks, another novel aspect of the Basel 2 proposal is the intended use of market discipline—rather than regulatory supervision—as a means of enforcing good practice. As the Basel committee writes, "The new framework aims to bolster market discipline through enhanced disclosure by banks. Effective disclosure is essential to ensure that market participants can better understand banks' risk profiles and the adequacy of their capital positions."^[13]

Basel 2's focus on promoting good risk management through lower capital requirements and enhanced disclosure is designed to improve the economic rationality of banks. So far, it seems to have been reasonably successful. The Economist comments: "There is no doubt that the Basel 2 exercise has heightened awareness of risk among banks. It has prompted them to overhaul their credit-scoring methods and to tighten up their operations."^[14]

The Banks

Current lending practices in Europe have raised eyebrows. "Risk is underpriced," comments a London fund manager. "In a smaller German bank, a manager could get fired if he loses business from a company like DaimlerChrysler, even if the rate he has to offer is unattractive." In some countries, relationships between the banks and their clients have become so close that, rather than providing critical supervision, the financial institution starts to "go native." In Germany, longterm bank lending to large corporations is a crucial part of the funding system. Banks gradually grow together with their corporate clients. The proposed Basel 2 arrangements give incentives to promote shortterm rather than long-term lending. It is not surprising that Germany has lobbied for the removal of these incentives.

Political pressure to help certain companies, for example when job losses threaten, is another major source of bad credit decisions. This behavior is not financially irrational: a bank with strong backing from its government need not worry as much about possible losses because the government can bail it out. A common example of banks enjoying government backing, and acting accordingly, are the publicly owned German Landesbanken, which are backed by explicit state guarantees. Several of these banks were involved in the Kirch Gruppe debacle. The Bayerische Landesbank—50 percent owned by the Bavarian state government—injected more than 1 billion euros into Kirch in 2001. This funding decision was probably made by the bank, even if it was good politics for the Bavarian prime minister. The general perception is that the bank was routinely used to provide capital to companies favored by the government as part of Bavarian economic policy.

In 1999, competing European banks launched a formal complaint about the unfair advantage the German regional banks have in raising cheap funds. A deal has now been struck between the European Commission and the German government. The deal will lead to a dismantling of the guarantee system starting in 2005. Of course, the dismantling of state-backed banks also has disadvantages. A very large share of small-company lending in Germany comes from publicsector savings banks. It is feared that tighter credit controls will inevitably lead to decreased access to credit and higher interest rates for some. There may well be a significant number of bankruptcies and a wave of restructuring. This is the pain caused by the financial discipline being forced through the system. Regarding Basel 2, German chancellor Gerhard Schroeder said that only an accord that is friendly to small companies (the "Mittelstand") will win Germany's approval. Very tight Basel 2 rules on lending to small and mediumsized companies have already been relaxed through a variety of adjustments.

The Markets

The attempt to introduce greater market discipline on banks through better risk disclosure may lead to a more efficient economy in the long run. Whether the European markets are currently sophisticated enough to impose that discipline, however, is not known. For instance, in recent years the junk bond market in Europe has seen significant increases in liquidity. But early experiences suggest that investors have not done a very good job of valuing these securities. Average investor returns in some classes of high-yield debt have been negative in the double digits. A trader comments: "Of course everyone was suffering from irrational exuberance the last few years, but it is certainly fair to say that some European investors in high-yield securities have lacked the necessary due-diligence skills." Another trader mentioned: "Within half an hour of putting an issue, we get calls from buyers, without even looking at the prospectus. They just go by the credit rating and are not able to do any due diligence themselves."

It is ironic that European investors are ill-equipped to handle high-yield debt. Some believe that here lies the solution for some of the German Mittelstand. As one trader put it, "Corporate Europe is not yet issuing junk, even though this is the source of capital for middle America. Family businesses can use junk to raise capital without losing control." The negative returns on high-yield debt have scared many of the investors who were pioneering this market, and it will take time before they return.

Conclusion

In Europe, regulators wishing to reform the financial system are fighting a tradition of government interventionism and relationship-based banking. It is perhaps reasonable to expect reform in Europe to take substantially more time than it did in the United States following the savings and loan crisis.

Venture Capital

An important aspect to corporate finance is early-stage venture funding. Although the amounts of capital transacted are relatively small, the economic importance of funding start-ups is enormous. These new enterprises keep the economy young and create jobs. Over the last decades, the importance of early-stage financing has become widely accepted and the European business community—often with government support—has taken active steps toward creating a venture capital industry which can provide funding to small private companies, filling the so-called "equity gap." There is now a sense in most European countries that the availability of venture capital funding is adequate. This has highlighted two other weaknesses of European venture funding.

The Shortage of Seed Funding in Europe

It is often said that the hardest round of funding to get for a new company is the very first seed capital injection, which allows the business to grow from an idea into a proper business proposal. Would-be entrepreneurs, who are excited about setting up a new business, need to convince a family member, a friend, or a colleague to give them a small amount of money so they can quit their job, plan the new business, and assemble a founding team. A recent study by the Global Entrepreneurship Monitor (GEM)^[15] consortium—a large international consortium of academics collecting data on entrepreneurial activity in different countries for comparison—suggests that this kind of informal investment is a major engine of the economy. In the 29 countries included in the survey, informal investment made up as much as 1.1 percent of total GDP. This kind of informal funding normally exceeds funding from professional venture capitalists by a large margin.

Professional venture capitalists in Europe are selective investors. They will only invest in a business which has outstanding growth potential. Although they are willing to endure substantial risk, they will usually not consider a venture until its products are fully developed and the first customers have been won. The funding provided by informal investors in the very early stages of a company's development is therefore a key first step in the process of business creation.

It seems as if European entrepreneurs should have no trouble finding an informal "angel" investor to back their plans. A recent study published by Merrill Lynch and Cap Gemini Ernst & Young^[16] says that in 2000 there were 2.3 million high net worth individuals (HNWI) in Europe. Together, they held assets of $7.2 trillion, no less than 27 percent of all wealth held by HNWIs worldwide. This puts Europe only slightly behind the United States. Although one would think that a large chunk of this private capital is invested in would-be entrepreneurs, this does not appear to be the case. The European HNWI prefers conservative investments. Aggressive investment strategies such as private equity, venture capital, and hedge fund investments are left to the Americans, who invest roughly six times as much in these types of assets. The GEM report concluded that there is no mature businessangel culture in Germany. Across Europe, the pattern seems to be the same: the GEM study indicates that in most European countries, informal investors are far fewer in number than in the countries of the new world, namely New Zealand, Canada, the United States, and Australia. According to the GEM study, it was New Zealand that had the most angel investors in 2000, just over 6 percent of all adults, whereas the highest European country came in at less than 4 percent.

Recognizing the problem, European governments have sought to intervene through creative funding schemes. The U.K. government, for instance, created the University Challenge Fund, which allowed universities to compete for money to set up university seed funds. The initiative proved popular with the universities, and there are now dozens of university seed funds. However, the funds are rather small. In total, about 60 million was made available in the first round, with minor top-ups in later rounds. Total informal investment in the U.K. comes to many billions of pounds. Furthermore, the university funds can only invest up to 250,000 per deal, a very small amount for someone wanting to set up a laboratory. Therefore the initiative, though useful, can scarcely be considered a full solution to the problem.

Another very interesting attempt was made in the Netherlands. The Netherlands government created a government-backed incubator, Twinning, which aims to make funds available to entrepreneurs in the information and communications technology sector. Twinning not only offers seed funding, but it also makes available office facilities, provides counseling, and even participates in the first round of venture capital investment, though not as the lead investor. As part of its service, Twinning maintains intimate relationships with local venture capitalists, and Twinning also maintains a presence in Silicon Valley to allow their ventures to make the leap to the U.S. market. There has been serious concern that the Twinning is going the same way as the plethora of commercial incubators that rose with the Internet bubble and have now mostly disappeared. Recently, Twinning had to close one of its offices because they were simply unable to generate enough quality deals. Attempts by the Dutch government to privatize the unit have not been successful. In the current market, the model does not appear to be sustainable without continued government support.

Perhaps a more promising way in which governments are trying to stimulate seed investment is through tax relief. In the U.K., the Enterprise Investment Scheme gives HNWIs an attractive package of tax breaks if they invest directly in unquoted companies. Notably, the scheme gives the investor an exemption from the capital gains tax. However, the scheme can only be used for small investments, up to 150,000. Furthermore, the company has to trade in the U.K. This makes it difficult to use the scheme to finance technology companies, which want to trade internationally.

One weakness with all these attempts is that, arguably, government schemes are no substitute for a healthy angel investment climate. The best angel investor is an experienced entrepreneur who knows how to put together a solid business, with the right foundations for later growth. Tax breaks may make the affluent more interested in investing in start-ups, but it will not make them more skillful at guiding a startup through the early stages. As one veteran Bavarian angel investor remarked, "There have always been angel investors in Germany, but they invest in a person, not a business. Though lately things have become more professional."

It is rare for a business to get venture capital funding. According to GEM, fewer than 20,000 businesses received venture capital worldwide in 2000, while more than 150 million persons were involved in start-ups or new ventures. If the corporate structure put in place in a company in the seed stage is not sound, the company will struggle to attract venture capital later. Venture-capital-backed companies are a mayor source of wealth creation in the United States. A study by Wharton Econometric Forecasting Associates, supported by the National Venture Capital Association, concluded that in the United States, venture-capital-backed companies accounted for 3.3 percent of all jobs and 7.4 percent of GDP in 2000.

The Difficulties with Going Public in Europe

Suppose the hopeful European entrepreneur manages to secure seed capital, and suppose that he also manages to attract venture capital. He will now want to grow his business quickly. In Europe, that means that relatively soon he will have to start operating internationally. As the business grows, he will usually require ever-increasing amounts of capital, especially if he is to expand internationally aggressively, as he must. Where should this capital come from?

In the first instance, the company will go back to its original venture capital investors, who will provide additional capital and try to put the firm in touch with other venture capitalists who can join the backing syndicate. European venture capitalists quickly run out of steam, however. Few European venture capital houses can invest more than 10–20 million euros in any one company. In the United States, it is not unusual for a venture to attract funding of well over 100 million euros. To raise that much, European venture capitalists would have to invest in large syndicates, but complications increase rapidly with the numbers of different parties involved. There are few venture capital houses in Europe that can supply that much money out of their own pocket, and often these are large private equity funds that do start-ups on the side. A recent study by KPMG^[17] highlighted the fact that European Private Equity houses do relatively poorly when it comes to managerial support of their portfolio companies. Although many funds are addressing this need by hiring more staff with industry experience, they often lack the skills internally to react quickly to operational crises.

What else can a start-up needing a significant amount of growth capital do? One solution is to go public earlier. Recent years have seen the creation of a number of stock markets, including the Neuer Markt, NASDAQ Europe, and others, which will allow very new business to list their stock and gain access to the capital markets. However, a stock market listing constitutes a significant overhead for a company. The CFO of Morfosys, Germany's largest biotech start-up, told us: "The rules for [a public company] in Germany are a straightjacket." Regulations include the requirement to offer first refusal to current shareholders for major share offerings, which makes the process of raising capital that much more complicated. The rules also ban offering shares at a major discount to the market price, as is typically required for a PIPE, a process for selling publicly traded shares through private placement. One of the most frustrating rules is the requirement to hold a general shareholders meeting for almost every major decision. "Last year, we had to send 80,000 invitations to shareholders for the shareholder meeting. It cost us about DM 0.5 million. We hosted 700 guests. The rules disallowed us activities in the capital markets for months at the time of the meeting."

The raft of clumsy rules and regulations form a real problem: "The rules put you at a disadvantage with respect to your competitors." The CFO of Morfosys commented, "If I had to incorporate again, I would incorporate in the Netherlands." However, rules in the Netherlands are far from ideal. One Dutch venture capitalist told us that, although the law in the Netherlands is better than in most European countries, and many are deciding to incorporate there, the Dutch authorities are slow. "It takes months to create a Dutch corporation, especially if one of the founders is not Dutch….In Delaware the process is much faster." The European venture, as it grows, will have to deal with more of these kinds of complications earlier in its growth than its U.S. competitors. Will it be able to work with these regulations and beat more nimble U.S. competitors? Maybe, maybe not. In contrast to the problems with seed funding, these problems are not yet the topic of much public debate. Politicians give them little attention.

Conclusions

The financial infrastructure in Europe for supporting early-stage ventures is far from ideal. Start-ups face serious challenges when setting up and gaining seed funding. They face serious challenges again in the later stages, when they need large amounts of capital. Governments have tried to help the situation, but there have been few successes. It is hard to see what can be done about a perceived lack of skilled angel investors. A gradual cultural change may be required. Regarding the troubles European ventures have in the later stages, regulators should cut red-tape and streamline processes that are obstructive. Unfortunately, these issues are not widely debated, and there is little momentum behind the movement for change.

Boards of Directors

Within the different countries of Europe, companies' boards have special rules and structures which are hard for foreign investors to understand. A common perception is that directors are not always selected on the basis of how much value they can add to the company. Often, directors of listed European companies are not "independent." Individuals sitting on the board of large corporations routinely find themselves at the center of complicated webs of personal relationships and pressure groups that end up conditioning their behavior. Shareholder interests, especially minority shareholder interests, are not necessarily the first priority when making decisions.

Companies should have knowledgeable, well-informed, powerful boards because good boards create value for the company, the shareholders, the workers and, ultimately, for countries.

As is the case in all areas of the world, Europe does not lack examples of bad corporate governance. For example, a recent Economist article on French business^[18] reported: "French bosses are particularly cozy with each other…. There is the tendency for top managers to sit on each other's boards. Mr. Messier [CEO Vivendi] sits on Mr. Arnault's [chairman LVMH], and Mr. Arnault sits on Mr. Messier's. The Vivendi boss sits on Alcatel's board, while Mr. Tchuruk [CEO Alcatel] is a director of Vivendi and three other big firms." Given these crossrelationships, there are strong possibilities that personal relationships could win out over the best interests of shareholders.

Germany provides another example. Each company has two boards: supervisory and management. An important quota of the seats (between 33 and 50 percent) on the supervisory board is reserved for workers.^[19] The supervisory board can appoint and fire the members of the management board. There is no formal need to have a CEO: the chairman of the management board can be a strong leader. Often, however, the chairman is a mere spokesman. Value creation is, in the words of the chairman of a German company we interviewed in January 2002, "an academic goal" in such a complex environment. Shareholders who want to protect their interests cannot rely on independent board members to focus on value creation. Instead, they have to hold significant stakes. The phenomenon of "block shareholding" is much more common in Germany than in the Anglo-American economies.^[20]

More cases can be found in Italy and Spain. In Spain, recent research revealed that 50 percent of all listed banks of Ibex-30 do not comply with some or all of the provisions of the code of Good Corporate Governance (Codigo Olivencia) relating to boards' compensation. Banks do not frequently disclose the compensation of their directors, and they often fail to highlight the link between pay and performance. In the first months of 2002, a group of directors of BBVA (Spain's second largest bank) were found guilty of holding secret personal accounts in tax havens. The accounts were used to embezzle company funds.

Why Are Boards Relevant to Corporate Governance?

Boards are critical when a company seeks access to capital markets. Boards guarantee the protection of minority shareholders by supervising management and ensuring they do not fall into the temptations generated by the principal-agent problem.

There are many studies that prove that boards matter to public shareholders.^[21] At an academic level, it has been proven that investors are willing to pay a premium to own shares of companies run according to sound corporate governance principles. Having a good board is one of these sound governance principles. Furthermore, common sense tells us that the small investor giving his money to the managers of a corporation will sleep better at night if the managers have supervisors who make sure the money is put to good use. For this reason, it is worthwhile to worry about the effectiveness of the boards in Europe and their potential for improvement.

In our research, we performed a review of the economic literature to identify principles of practical relevance to identify what constitutes a "good board." Boards have been the object of extensive analysis in both the economic literature and the managerial literature. Although many questions remain unresolved, the studies point to some generally accepted principles with which boards should comply:

• Smaller boards will be more effective and create more value than boards with a large number of board members.

• Boards must be independent and members should be adequately compensated to create value.

• Practices of electing directors from lists prepared by the management have to be restrained.

• Boards have to include younger, active people, with time to spend in understanding the companies and their industries. Effective boards must be truly independent.

The results of our research show that true independence goes beyond what is usually required in most European governance codes.

Are European Boards Changing?

Despite some problems with continental European boards, one cannot say that the German two-tier system has proven ineffective or that the United Kingdom model has prevailed. No research has given obvious results on the greater "effectiveness" of either system. What is obvious, however, is that investors have started to put a great deal of emphasis on scrutinizing the corporate governance practices of companies and on the composition of the groups of people that represent their interests.

As a result, in the last two years, every European country seems to have issued some sort of Corporate Governance Code. In addition, in the last few months, the pace of change has accelerated. Deutsche Bank is undergoing one of the most important transformations of its history, shrinking the "management board" and creating an "executive group." BBVA has reduced the size of its board from 32 to 21 members, eliminating people with little experience in banking. A number of academic research institutions with a focus on corporate governance have been founded or revived in the last year. And Deminor Rating, a Belgian consultancy, created a website where investors can join a drive against the management and boards of European companies supposedly violating good corporate governance principles.

Stepping back from the daily flurry of news and opinions, we can see the big picture: the nature of boards in Europe is changing. In our research, we have found that changes across different countries and industries exhibit at least three patterns:

1. European CEOs are acquiring more power in their boards. There seems to be a shift to a more "American" style and status. Individuals are making an international name for themselves by rejecting the stuffiness of old-style business, prioritizing value creation, and speaking openly about it in and outside board meetings. CEOs like Jean Marie Messier, Francois Pinault (CEO Pinault Printemps-Redoute), Josef Ackerman (CEO Deutsche bank), and many more are reshaping the landscape of European boards and European capitalism in general.

2. Boards are becoming more independent. Among the most notable examples: In Germany, the private sector adopted two codes on Corporate Governance in 2001. One of the codes, adopted by a panel led by a former influential managing director of DSW (the asset management unit of Deutsche Bank), recommends that each board have a sufficient number of independent directors on the supervisory boards^[22] and that boards have at least six board committees. In France, the National Assembly and the Senate are rumored to be close to approving a bill that would separate the solitary post of pr sident directeur g n ral (equivalent to the chairman and CEO position) into two posts, unless shareholders explicitly vote for a different solution. In the U.K. in March 2000, the Department of Trade and Industry issued a Report on Company Law Reform with many recommendations aimed at strengthening the independence of the board and the chairman. In Italy, a new segment of the stock market, called "Star," was created. Companies that want to be listed in Star must comply with a set of guidelines, most of which relate to matters of board independence.

3. Boards are becoming more "accountable." The rise of an "equity culture" across continental Europe has led to an increase in shareholder activism. Shareholders, both individuals and institutions, are becoming able to bypass boards and voice their own interest. Board members are being called on more often to give reasons why they approved transactions that negatively affect minority shareholders. In 2001, minority shareholders: blocked the takeover of Legrand by Schneider Electric because it did not respect some preference rights attached to their shares; sued Deutsche Telekom because it wrote off some assets, implying that some of its acquisitions had been grossly overpaid; and blocked the board and management of Telecom Italia from converting all saving shares into ordinary shares at an unfair price.

Institutional owners cannot sell their shares without depressing market prices; and they prefer to increase their returns by fighting with management and replacing board members with their representatives. Financiers like the Swiss Martin Ebner and the American Wyser-Pratte spend their time looking for underpriced companies, buying minority stakes, vying for board seats, and fighting current board members and management. Board members can no longer sleep through presentations and cash their attendance check at the end. They are being called on for involvement.

Summary: Three Issues to Address

First, in our research and interviews, we found that CEOs in Europe are still the ones who choose the candidates to directorships that are presented to shareholders.

Second, CEOs and chairmen are the same person in most European corporations in many countries. If we add this feature and the fact that star European CEOs have become more vocal, we get situations close to "one-man corporations," which are often detrimental to shareholders.

Third, the main problem seems to be that European boards belong to a restricted "elite," defined by personal relationships and a web of cross-shareholdings among the major companies. Most students of European corporations would find it easy to identify who the most influential people are. The cadre of names from which to choose appears small. Also, changes in legislation can help eliminate the most obvious conflicts of interest As long as public European corporations are run by a lucky minority, the debate on independence will be largely moot. Instead, the debate should be about how new firms in Europe are created and how true meritocracy can be introduced across the business world.

Corporate Takeovers

There is increasing pressure on European managers to maximize shareholder value. This comes from three major sources.^[23]

1. Intense pressure from international capital markets to generate sustainable, above-average returns. Growth and globalization have increased the demand and supply of equity worldwide. The shift to a savings culture based on equity, the change in demographics, and the increase in the volume managed by institutional investors (especially pension funds) have significantly increased the potential supply of funds to capital markets. On the demand side, an increase in the number of public companies (around 30 percent during the last decade) means more opportunities for investment. Furthermore, the intense pressure for high returns has increased trading volume (a 130 percent increase during the last decade). This higher trading volume, whether caused by an increase in the number of public stocks or by a decrease in the length of time of stock holding, shows that companies are more exposed to investor scrutiny. Private companies that went public are now compared against the stock market performance of their competitors. Investors looking for returns can get in and out of stocks easily.

2. Activism and professionalism of shareholders; institutional investor ownership. During the last decade, institutional investor ownership has increased significantly in Europe. Institutional investors focus on maximizing value because, unlike banks, they do not have conflicting incentives. While pension funds focus on generating future cash flows to pay pensions, banks also consider the credit business they maintain with companies. CEOs consider institutional investors to be the most important investor class because institutional investors can significantly influence the market value of the firm.

3. The winner-takes-all economy. Hyper-mobile pools of capital search for firms with best practice in governance rules and super-normal returns. Today's winner-takes-all capital market signals a new era. Across sectors, a few players are creating most of the new shareholder value. A McKinsey study^[24] highlights that 5 to 10 per cent of companies in a given industry create all of the shareholder value in that industry. Given these facts, investors are trading in and out of firms in continuous search of super-normal returns. In fact, McKinsey and Institutional Investor research^[25] show that institutional investors would be willing to pay an 18 percent premium for the shares of a well-governed company^[26] in the United States or the United Kingdom and a 20 percent and 22 percent premium for the shares of well-governed companies in Germany and Italy, respectively.

These three sources of pressure on corporate executives suggest that CEOs should give top priority to the design and monitoring of corporate governance systems, especially those related to defensive measures, because they have a direct and visible impact on shareholder value.

A Change in the European Way of Business: Telecom Italia's Takeover

One of the takeovers that greatly influenced the market for corporate control in Europe is the Telecom Italia (TI) takeover. Olivetti, with revenues one-seventh of TI's $30 billion and a market capitalization one-quarter of its target, created a turning point in the European way of business.

Legal reform in Italy made this takeover possible. The "Draghi" law, first proposed by and named after the former general director of the Italian treasury, introduced two major changes that facilitated an active market for corporate control. First, it suppressed the rights of the Italian government to veto any acquisition of more than 3 percent of ordinary, voting shares if a formal offer was made for 100 percent of those shares. Second, once the formal offer was submitted to the Italian market regulator (Consob), no change in the capital structure of the target and no issue of new debt could be made without the approval of 30 percent of the capital. These two actions significantly limited the number of defensive actions that the target could take. Managers of undervalued or poorly performing companies were no longer secure in their jobs. Their companies could be bought from under their control.

The fight was very intense. Many international investment banks and the powerful Italian investment bank, Mediobanca, backed Olivetti. The takeover took the shape of an LBO in which Olivetti planned to use the cash flow of the target to pay the debt. A syndicated loan of 22.5 billion euros was arranged from 20 banks in three weeks, showing the corporate finance capabilities that had been developed in Europe. The number of banks, speed, and amount of the loan showed that European financial markets and bankers were prepared to facilitate an active European market for changes in corporate control.

Telecom Italia hired many investment banks as defense advisors, who presented many strategic, financial, and legal defenses, including a "white knight" takeover and a "pacman" defense. However, Franco Bernabe, CEO of Telecom Italia at the time, fought without considering the influence and power of capital markets: "I am not going to do anything I would not have considered in the normal course of business. I want to make a distinction between this highly leveraged, speculative bid, and a solid commercial strategy. Our defense will be our industrial plan." The CEO of Olivetti at the time, Roberto Colaninno, presented the acquisition as an opportunity to cut costs, create cell-phone alliances, invest in new services, and improve the domestic network.

The takeover resulted in a new paradigm for the European market of corporate control. Governance provisions protecting interests other than those of shareholders were fewer; now, the focus of the law was on preserving shareholder interests.

The Telecom Italia deal spurred similar transactions on the continent. In 1999, Vodafone completed the largest hostile takeover ever when it bought Mannesmann. One U.K. analyst qualified the logic of the deal as "impeccable, and… the value to be gained by both sets of shareholders of bringing these assets together is enormous."

For all of the progress from an investor perspective, there are still some barriers to mergers and to enhancing the majority of shareholders' interests. One high-profile case was the failed merger between the Spanish telecom operator, Telefonica, and the Dutch telecom operator, KPN. The discussions were not strictly focused on the shareholder value creation but on the degree of liberalization of the economy of both countries. On the one hand, Telefonica had already been privatized and the only right that the government had on it was a golden-share option. KPN was not privatized and its privatization process, according to the Spanish Finance Minister, was not starting immediately and did not have concrete milestones. Telefonica's board—directly influenced by the Spanish government—opposed the deal because Telefonica would have a state-owned partner, the Dutch government, while the Spanish government was actively liberalizing its economy.

Status of the European Market for Corporate Control

Presence of Takeover Defenses

A Corporate Governance Survey (2001) by Deminor, a consulting firm on corporate governance, analyzes the corporate governance behavior of companies included in the Euro STOXX 50. One area of analysis focuses on the presence and strength of takeover defenses. The results show that even the most internationalized companies maintain a significant number of takeover defenses. What are the major structural and capital defense mechanisms used by European companies in a hostile takeover?

1. Capital structure: because the voting power of the majority shareholder is very high (20 percent) compared to the second and third ones (6 percent and 3 percent, respectively), the majority shareholder can influence the balance of power in the shareholder base, thus being a significant takeover defense. Fourteen percent of the companies in this index have a majority shareholder.

2. Board insulation: in 42 percent of the companies that the report analyzes, shareholders have difficulties in removing board members. This takeover defense goes against some of the basic shareholder rights and breaks the most elemental principles of the agency theory: shareholders (principals) have the right to name and dismiss board members, including top management (agents) who run a business.

3. Voting right distortions: 60 percent of the companies have at least one voting right distortion. Voting right ceilings that cannot be waived represent an important takeover defense. For instance, Nokia and BBVA do not have this provision while TotalFina-Elf and KPN do have right distortions. The basic principle of "one common share, one vote" must be respected to ensure that shareholder interests are preserved.

4. Authorized capital: 35 percent of boards can authorize equity issues, waiving the preemptive rights during a takeover.

5. Repurchases of own shares: 65 percent of the Euro STOXX 50 companies can repurchase their shares during a hostile takeover.

6. Targeted stock placement: Other conversion instruments such as convertible bonds or warrants can be used for a capital increase during a takeover. About 14 percent of the studied firms are allowed to do so.

7. Other takeover defenses: 33 percent of firms can use golden shares and golden parachutes to avoid a takeover.

Recent Failure of the European Takeover Directive

On July 4, 2001, after 12 years of negotiations, the European Parliament rejected the proposed European Takeover Directive ("the directive"). Klaus-Heiner Lehne, a German member of the delegation who opposed the directive, felt that it would leave companies unprotected and open to hostile bids from, for example, U.S. companies.

The rejected directive aimed to preserve the following general principles (article 3):

• Equal treatment: all shareholders of an offeree company of the same class must receive equal treatment. This principle tries to preserve minority shareholders' rights.

• Sufficient time and information: shareholders need to know the views of the board and have time to make an informed decision.

• Preservation of the interest of all shareholders: shareholders of the offeree should be able to decide based on the merits of the bid. This principle tries to avoid defense provisions adopted by the board or by some shareholders.

• No creation of false markets: share price of the offeree should not be distorted for the purpose of the takeover.

• Credibility of the takeover: the offeror should ensure a minimum of guarantees required to execute the takeover (e.g., cash availability).

Investors had hoped that the directive would harmonize the rules on the conduct of takeovers across Europe. However,

• The directive aimed at setting the minimum standards and did not attempt to harmonize European takeover law except in limited areas.

• Each state had the legal power to implement this directive within a chosen timeframe.

• Very little detail was given in the directive. For instance, no principles were defined for determining the equitable price that must be paid if there is a mandatory bid.

Although it did not impose strict rules, the directive was not approved. The main opposition was to its defense provisions, the so-called "frustrating actions" provision in article 9. The directive, as a minimum requirement, required that after the announcement of the bid and until the bid has been made public, the board of the offeree should not take any action which may result in the frustration of the offer. The offeree could take some defensive actions if the shareholders in a general meeting authorized them.

Those who rejected the directive probably thought that undervalued companies in their country would receive hostile takeover bids by foreign companies. However, the directive left room for some flexibility on defensive actions. For instance, the board of the offeree company could increase its share capital during the period of the acceptance of the bid if prior authorization had been received at a general meeting of shareholders no earlier than 18 months before the beginning of the period of acceptance.

Finance practitioners reacted to the opposition of Germany to the new European directive and the new German takeover law. The new German law will probably not promote a focus on shareholder value. As a partner of the German law firm CMS Hasche Sigle put it, "The management board and the supervisory board of a company together can take whatever frustrating action they want as long as it falls under the normal running of the company." Furthermore, penalties from international capital markets to German companies owing to their poor governance would increase. One German investment banker said, "capital markets will punish Germany and we will learn the lesson. Germany will find it difficult to attract institutional investors."

The process and time that it took to reach a political agreement, more than 12 years, highlights the cultural obstacles that lie in the way of EU harmonization of legal issues, especially when national interests are at stake. A harmonized European market for corporate control will take longer than expected. Nonetheless, a new proposed directive is under revision now, and a number of factors continue to influence the market for corporate control in Europe: the increase in capital needs and the internationalization of the shareholder base are some of them.

Conclusion

Corporate governance systems in firms are more important than ever to facilitate shareholder value creation. In fact, defensive measures against changes in the control of a company are not well perceived by shareholders. Punishments to highly protected firms against changes in control have increased enormously during the last years. Furthermore, institutional investors are more professional and active than ever, and the volume of hyper-mobile pools of investors in search of aboveaverage returns all over the world is increasing.

The Corporate Governance Survey (2001) shows that there is still a significant presence of defensive measures in firms within the European Union. Moreover, the European Commission's efforts to develop a common takeover law in Europe have not been fruitful. After 12 years of work on the European takeover directive, the directive was not approved because of opposition to the so-called "frustrating actions" provision.

Europe should meet two major future challenges. First, in the regulatory arena, financial regulators should develop takeover rules, at a European level, with high minimum standards. A homogeneous takeover law throughout Europe will help to develop a common shareholder focus such as that of the United States. If only a few countries adopt a takeover law favorable to shareholders, there will probably be significant differences in shareholder value creation among nations. In a winner-takes-all economy, with mobile pools of capital, nations that favor shareholder corporate governance systems will attract more capital, as the U.K. does compared to continental Europe. Second, in the corporate arena, top management and shareholders should work together to find an optimum in the separation of ownership and control through increased institutional shareholders—less concentration—and through an adequate equity-based compensation for top management.

Institutional Investors

Institutional investors (in particular life insurance companies, mutual funds and pension funds) own an increasing amount of equity. More and more firms are entering capital markets. As a result, a greater fraction of the economic base of a company is coming under the purview of institutional investors.

The volume of total financial assets relative to GDP (an indicator of the financial market dimension) has grown over the last 20 years, with a parallel increase in the proportion of assets held by institutional investors.^[27] The high level of "institutional assets" as a proportion of the total financial assets has accompanied a decline in deposits held in household portfolios, a lower level of corporate loans, and a higher level of corporate equity. These trends are observed in all G-7 countries, with institutional investors growing in relative importance.

The emergence of large shareholders able to channel the investments of a large number of individual investors could offer a possible solution to the principal-agent problem in equity finance. Through the strategy of diversification, institutional investors would seek an optimal size of shareholding that justifies the costs of exerting their rights and of monitoring managers, without overriding the interest of minority shareholders.^[28] The growing dominance of equity holdings by institutional investors, both in the Anglo-Saxon countries and in continental Europe, would lead to a new corporate governance model (the direct control via equity or shareholder value model). This new model would break down the traditional separation of the "Anglo-Saxon paradigm," in which the threat of hostile takeovers acts as a market disciplinary device against incompetent or fraudulent managers, from the "Continental paradigm" in which credit institutions are both the more important shareholders and the main providers of debt.

The Rise of Institutional Investors in Europe: The Role of Pension Reform

Institutional investors are likely to become even more influential in continental Europe, and the reason is developments in retirement financing.

Demographic Trends and Public Pension Spending

Demographics will impact Europe's pension system and might cause corresponding changes in capital markets and corporate governance. Continental Europe, in particular France, Germany, and Italy, has the largest pure pay-as-you-go pension system in the industrialized world. Under these systems, payments to pensioners are funded by taxes on the working populations. These systems work at high, but sustainable, tax rates when the Old-Age Dependency (OAD) ratio (the ratio of people 65 and older versus those aged 20 to 64) is low enough to ensure a fully funded program. According to the ECOFIN Group, however, the German OAD ratio will increase from 26 percent in 2000 to 54.7 percent in 2040. The Italian OAD ratio will similarly increase from 28.8 percent to 63.9 percent.^[29] As the population ages, the pay-as-you-go system (under which payments to pensioners are funded by taxes on the working population's incomes) automatically creates imbalance. The International Monetary Fund estimates that public pension spending in the countries listed above will increase to over 20 percent of GDP between 1995 and 2030. If this estimate is true, French, German, and Italian workers will pay, respectively, 38 percent, 41 percent, and 62 percent of their wages to the pension systems.^[30]

Although the pay-as-you-go system also depends on the development in labor productivity, the high proportion of government spending on pensions relative to GDP suggests that the state pay-as-you-go models are already overstrained and have become a drag on economic growth. Indeed, in all the countries mentioned above, there have been pension reform proposals and reforms in recent years. These changes have not slowed system membership, however, nor have they stabilized contribution requirements. Academic research, particularly Boersch-Supan and Winter's advancement of Gruber, Wise, and Schnabel's studies on the negative incentive effects of public pension systems on labor supply,^[31] suggests that workers who have grown up in a generous pay-as-you-go system tend to prefer early retirement or to take jobs that avoid social security taxation.

Structural Reforms of the Public Pension System

Many studies have been conducted on the structural remedies to the instability of the pay-as-you-go system. A common thread is the necessity of a funded component to augment the existing public system, in particular by encouraging occupational pension schemes that have the advantages to achieve a well-balanced risk mix, cost efficiency, and wide reach. Currently, the occupational pension component is underdeveloped in many European countries. In Germany, 82 percent of retirement income is paid from state resources, while occupational schemes account for 5 percent and personal provision 15 percent. Within Europe, only the Netherlands and Switzerland have a more balanced three-pillar pension system. Switzerland has 42 percent, 32 percent, and 26 percent of retirement income generated, respectively, by state contributions, occupational schemes, and personal savings. The European market per pension funds (meaning all pension products excluding life insurance, financed outside the sponsoring firm) was worth about US$2,750 billion in 1999, with the U.K. alone accounting for 50 percent. In contrast, Germany, the most powerful and most populous economy in Europe, accounts for just 5 percent of the European market.^[32]

Germany has recently taken action to stabilize its pension system. According to a new law, the Altersverm gensgesetz (AvmG), all employees now have a legal right to ask for employee-financed occupational pension plans. Moreover, the new law introduces a new German-style pension fund (Pensionsfonds) as a new occupational scheme. These pension funds invest the assets outside the sponsoring firm, are financed by both employer and employees, and can offer either defined-benefits schemes or defined-contribution schemes with guaranteed minimum benefits. Italy now allows new pension plans only as externally funded, defined-contribution schemes. The contributions made by employers—and, in some cases, by the employees—are channeled into a legally independent pension fund organization, which calls on an investment fund to manage or invest them. Spain has taken a similar step. Since 1995, only external funding has been permitted as an occupational scheme. Companies must decide by mid-October 2002 whether to write back their book reserves and pay them out in cash or convert them into certified pension funds.

Essentially, we are witnessing the development of the private pension system in Europe. According to Deloitte Research and Goldman Sachs,^[33] the impending shift from public to private retirement provision will create a private retirement market worth 4 trillion euros ($3.6 trillion) by 2010, rising to 11 trillion euros by 2030. Overall, the study estimates the market for long-term savings in Europe to be worth around 26 trillion euros by the end of 2010, up significantly from around 12 trillion euros in 1999.

The Forms and Effectiveness of Institutional Activism in Anglo-Saxon Countries

The empirical evidence from the Anglo-Saxon countries that institutional investors can improve the performance of the targeted firms can be useful to understanding the economic effects of an increase of the European private pension market.

Evidence from the United States

In the United States, institutional investors own 50 percent of the top fifty companies, and the top twenty pension funds own 8 percent of the stocks of the ten largest companies.

When U.S. institutional investors are dissatisfied with firm performance, they can choose to:

1. Follow the "Wall Street Rule" ("vote with their feet") by selling shares.

2. Take an active role in the corporate decision-making process through shareholder proposals and proxy fights.

3. Negotiate directly with management and, when a compromise can't be reached, sell shares with a public explanation of the reasons underlying the selling decision.

According to recent work by Parrino, Sias, and Starks (2000), "voting with their feet" by U.S. institutional investors significantly affects board decisions, and can force CEO turnovers, often replacing the CEO with an outsider.

The second alternative is often mentioned in the academic research as the only form of institutional activism. The definition is too narrow because it applies to just a small set of U.S. public pension funds, led by CalPERS. The U.S. Department of Labor's 1989 "Proxy Project Report" requires pension fund managers (but not mutual fund managers) to regard proxy voting as part of their fiduciary responsibility.

Moreover, how effective this form of activism is in improving the financial performance of the portfolio companies is ambiguous. Wahal^[34] analyzes activism by nine public pension funds over the period 1987–1993 and concludes that there is no significant evidence of increase in the long-term stock performance of targeted firms. On the other hand, Smith (1996, p. 251)^[35] analyzes activism (proxy fights) sponsored by CalPERS from 1987 to 1993 and concludes that "there is a significant positive stock price reaction for successful targeting events and a significant negative reaction for unsuccessful events. Overall, the evidence indicates that shareholder activism is largely successful in changing governance structure and, when successful, results in a statistically significant increase in the shareholder wealth" (251).

The third way of activism is more "vocal" than the mere sell-off of shareholdings, and it is precisely what has been observed in recent years within the wide community of private funds. For example, the stock price of GE's dropped almost by half between October 2000 and May 2002 because of the strong sell-off by institutional investors. This sell-off raised valid concerns over disclosure and over GE's ability to pump out future profits.^[36] GE's CEO, Jeffrey Immelt, was forced to take visible initiatives to regain investors' trust. The work of Wahal (1996) confirms that efforts by institutions to promote organizational change via negotiation with management are associated with abnormally high stock returns.

Institutional Activism in Europe

The Leading Role of Domestic Institutional Investors

The developments in the European pension market will gradually lead to an increase in the demand for equity by domestic (European) institutional investors, who will be acting as the depositors of occupational pension schemes. In this changing environment, domestic institutional investors could play a leading role in pushing companies toward better corporate governance standards. In turn, a greater transparency in providing information and the direct threat to poorly performing management would attract new foreign capital.

Together with the crisis of the public model of social security, the reform of stock market exchanges and the advent of a single currency have led domestic institutional investors to change how they approach corporate governance issues. European investors are increasingly looking outside their national borders for higher returns, making comparisons on a pan-European basis. Until now, their performance was largely measured against that of other managers in the same country. Now that institutional investors have to compete internationally for investment capital, they are far more eager to make the most out of their assets. They put pressure on the managements of their portfolio companies to increase the shareholder value orientation.

Forms of Institutional Activism

1. Collaborative investigations and public focus lists. In a dramatic shift from the past, European fund managers have started to publicly voice doubts about bad corporate practices. They are joining forces to push change. For example, in March 1998, 15 Dutch pension funds with $42 billion worth of holdings in Dutch companies teamed up to investigate the corporate-governance practices of all the companies on the Amsterdam market index. At the top of their hit list was Royal Philips Electronics. Fund managers at the company's annual meeting openly protested a juicy options scheme (then worth $175 million) that Philips had put in place without fully disclosing its details to investors.

2. Exerting voting rights. Sometimes the decisions made by institutional investors at shareholders' meetings have led to formal investigations. For example, the Oslo Stock Exchange and the Norwegian securities started investigating insider trading in the stock of Kvaerner, an Anglo-Norwegian engineering and shipbuilding company, after the Norwegian investment company Odin Forvaltning asked for and got the resignation of Kvaerner's CEO, who had been responsible for the highly leveraged acquisition of Trafalgar House, a British conglomerate several times the size of the company.^[37]

3. New investment styles. Besides public criticism and active participation in shareholders' meetings, European fund managers have started to approach corporate governance issues under a different perspective as well. For example, France's ABF Euro VA invests in European stocks and benchmarks itself against the FT Europe Index, but it favors holdings in companies that it expects will take actions to enhance shareholder value through good corporate governance practices. The strategy has turned out to be a winning strategy. The fund outperformed the market by 7.4 percent against a tracking error of 1.7 percent since its inception in 1998. This form of institutional activism disciplines management through markets, by timed buying and selling of target firms and by exerting voting rights when there are undervalued assets.

The Italian Case: Strengths and Weaknesses of the Investment Management Industry

The Italian system of institutional investing provides a representative example of the role of institutional investors in a continental corporate governance system. Analyzing the Italian case reveals positive signals as well as some limits of the current role of institutional investors. The case can be easily extended to other continental cases.

In the Italian financial system, the most common type of institutional investor is the investment fund (fondo comune di investimento), where the funds are invested in different financial activities and managed by a company (societ di gestione del risparmio). In Italy, about 90 percent of money managers are affiliated with banking or insurance groups. Different oversight authorities regulate money managers according to the specific kind of client whose assets are under management (individuals, high-net-worth individuals, pension funds, or insurance companies).

With shareholdings amounting to about 35 percent of the Italian stock market capitalization, the Italian money managers system is ranked third after the United States and France. At the beginning of 1990 it ranked twelfth. The percentage of assets invested in corporate equities has moved from 12 percent in 1990 to 38 percent in 2001.^[38]

According to some financial authorities,^[39] Italian money managers have started to show a more active form of shareholding than foreign investors, who are more inclined "to vote by feet" in the Italian companies where they invest. The increasing awareness of corporate governance by Italian money managers is confirmed by the important role that they played in issuing the "Draghi" law (Testo Unico della Finanza, 1998). In particular, they directly proposed the rule under which the board of directors cannot do anything to prevent takeovers unless two-thirds of the General Assembly approves the defense action. Assogestioni, the trade group for the Italian asset management industry, has recently started to take public actions against badly managed firms, thereby making it increasingly expensive (in terms of reputation costs) for firms to resist market forces. For example, in July 2001, through a formal communication to CONSOB, Assogestioni opposed SAI's acquisition of the insurance company Fondiaria because of the lack of information about the action and the inconsistency of the acquisition with respect to the expected development strategy of SAI.^[40]

Despite these favorable signals, the evidence about the activism of Italian institutional investors is still sporadic. A study of Italian mutual funds by Bianchi and Enriques (2001) is useful for understanding the problems that might prevent the expected pension reform system from being an effective driver for corporate governance. Bianchi and Enriques's empirical analysis shows that Italian money managers could potentially play a more significant role in the corporate governance of Italian listed companies. Other factors limit the activism. Examining the number of shareholdings larger than 1 percent, among 221 holdings, about 60 percent is concentrated in the hands of five Italian fund managers, with an average of 25 relevant holdings each. However, ownership concentration in the targeted firms, dependence on banking groups, and competitive disadvantage with respect to occupational schemes are the main factors that tend to reduce the incentives for activism.

Conclusions and Open Issues

In Europe, the importance and number of institutional investors is expected to rise in the near future due to ongoing pension system reform. The development of the funded component of the pension system will lead to an increase in the demand for equity by domestic institutional investors, acting as professional money managers of the pension plans.

The discussion of the role of institutional investors as effective agents for change in Europe should address two issues:

1. What is the optimal internal structure that new European pension funds should adopt? The extent to which a plan is of defined-benefit or definedcontribution may affect the pension fund's investment horizon, thereby affecting the fund managers' interest in active corporate governance. Most of the U.K. pension funds are run according to defined-benefit plans, where individuals don't bear the investment risk. In Germany, even under the new law, full defined-contribution schemes are not permitted, and pension funds are obligated to be members of the insolvency insurance association.

   Quantitative investment restrictions could have a direct impact on the extent to which pension funds can play a role in corporate governance. In Italy, the holding of shares of closed-end funds is limited to 25 percent of the closed-end fund's assets. In Germany, pension funds cannot invest more than 35 percent of their assets in equities. Even under the new law, the government is authorized to issue detailed quantitative investment rules on pension funds. The European Commission has calculated that funds placing emphasis on quality management generated higher returns from the mid-1980s to the mid-1990s than those operating under quantitative rules.^[41]

2. What is the relationship between fiduciary responsibility and institutional responsibility? Should European institutional investors have a duty to exercise their voting rights diligently as part of their fiduciary responsibility? Or should institutional shareholders exert greatest influence through the market? In each of the two cases, what should the government's role be in promoting institutional activism? After starting to exert their voting rights at shareholders' meetings and making some public actions, will European institutional investors start to gain a powerful bargaining power in negotiating directly with a company's management?

The U.K. government has decided to adopt the first alternative to increase the activism of occupational pension schemes, despite the ambiguous empirical evidence from the U.S., where public pension funds have the statutory duty to use shareholder powers to intervene in investee companies.

Even without imposing the exercise of shareholder rights, European governments would have much room to maneuver:

• By introducing adequate regulations of conflicts of interest or several restrictive measures (e.g., limits to participation in managing companies) to reduce the influence of banking groups on money managers.

• By equalizing the treatment of all different occupational schemes (Italy).

• By simplifying the way of voting at annual meetings (Italy, Spain).

• By reforming the system of cumulative voting in order to ensure that the director designated with the vote of the institutional shareholders cannot be removed by the decision of the majority (Spain).

Although institutional activism has made significant progress in Europe, it seems that domestic investment funds still lack the power exercised by U.S. money managers, who vote "noisily" with their feet by directing harsh comments to managers, either privately or via the press.

Acknowledgments

We thank Professor Stewart C. Myers for his support of our research and for his coordination work. Special thanks also go to his assistant, Gretchen Slemmons, a "behind the scenes" leader.

This work would not be the same without the opinions and suggestions of all the inspiring people whom we have interviewed over the past year. Our sincere acknowledgments go to: Karl-Hermann Baumann, Siemens; Lori Belcastro, The Carlyle Group; Ilja Bobbert, Prime Technology Ventures; Professor Richard Brealey, London Business School; Albrecht Crux, Roland Berger; Rolf Dienst, Wellington Partners; Peter Englander, APAX Partners; Massimo Ferrari, Romagest (BancaRoma Group); Professor Julian Franks, London Business School; Arno Fuchs, Viscardi; Fabio Galli, Assogestioni; Anne Glover, Amadeus Capital; Professor Dietmar Harhoff, Odeon; Damien Horth, ABN Amro; Professor Simon Johnson, MIT Sloan School of Management; Professor Peter Joos, MIT Sloan School of Management; Dave Lemus, Morphosys; Professor Donald Lessard, MIT Sloan School of Management; Professor Richard Locke, MIT Sloan School of Management; Dirk Lupberger, Polytechnos Venture Partners; Marc Malan, Zouk Ventures; Professor Gordon Murray, London Business School; Sven-Christer Nilsson, Startup Factory; Julia Otto, Cinven Ltd.; Andrew Phillips, Intermediate Capital Managers; Maria Pierdicchi and her team, Borsa Italiana Spa; Professor Malcolm Salter, Harvard Business School; Rene Savelsberg, Philips International; Raffaele Savi, Romagest (BancaRoma Group); Dario Scannapieco, Italian Treasury Ministry; Professor David Scharfstein, MIT Sloan School of Management; Professor Antoinette Schoar, MIT Sloan School of Management; Professor Lester Thurow, MIT Sloan School of Management; Roberto Ulissi, Italian Treasury Ministry; Professor Jiang Wang, MIT Sloan School of Management.

^[1]This situation might change in the U.K., however, with the establishment of the Financial Services Agency (FSA) in September 2001. The FSA is the result of the combination of all of the governmental agencies with securities industry oversight. It is still too early to gauge the FSA's effectiveness, but increased governmental vigilance in enforcing securities laws may result.

^[2]London Stock Exchange Historical Statistics.

^[3]Thomson Financial, International Target Cities, Report 2000.

^[4]"The Battle of the Bourses," Economist, May 3, 2001.

^[5]Ibid.

^[6]ESF Securitisation Report (Spring 2002), pp. 1–3.

^[7]Peter Joos, professor of finance and accounting, MIT Sloan School of Management.

^[8]Communication from Damien Horth, European airline analyst, ABN-Amro, London.

^[9]Bundesaufsichtsamt f r den Wertpapierhandel (BAWe).

^[10]Regelwerke Neuer Markt (RWNM).

^[11]B rsengestz and B rsenordnung (B rsG and B rsO).

^[12]Wertpapierhandelsgestz (WpHG).

^[13]Secretariat of the Basel Committee on Banking Supervision, "The New Basel Capital Accord: an Explanatory Note," Bank for International Settlements, 2001.

^[14]"The Good Tailors of Basel," Economist, February 21, 2002.

^[15]P. Reynolds, S. Camp, W. Bygrave, E. Autio, and M. Hay (2001), "Global Entrepeneurship Monitor—2001 Executive Report," available at http://www.gemconsortium.org

^[16]Merrill Lynch/Cap Gemini Ernst & Young (2001), "World Wealth Report 2001," http://www.cgey.com, http://www.ml.com

^[17]KPMG, Manchester Business School (2002), "Insight into Portfolio Management—Private Equity Research Programme," http://www.kpmg.co.uk

^[18]Economist, March 21, 2002.

^[19]In companies with more than 500 employees. This practice is called "codetermination."

^[20]Gary Gorton and Frank Schmid, "Universal Banking and the Performance of German Firms," Journal of Financial Economics, 2000, 86–114.

^[21]Edward E. Lawler III, David Finegold, George Benson, and Jay Conger, "Adding Value in the Boardroom," MIT Sloan Management Review, Winter 2001, 15–23.

^[22]In Germany, retired members of the management boards usually move up to the supervisory board.

^[23]M. Salter, "A Note on Governance and Corporate Control," Harvard Business School Working Paper no. 01-090, 2001.

^[24]D. Campbell and R. Hulme, "The Winner Takes All Economy," McKinsey Quarterly, November 2001.

^[25]P. Combes and M. Watson, "Three Surveys on Corporate Governance," McKinsey Quarterly, November 2001.

^[26]A well-governed company was defined as "one that has a majority of outside directors with no management ties on its board, undertakes formal evaluation of directors, and is responsive to requests from investors for information on governance issues."

^[27]E. Philip Davis, Institutional Investors and Corporate Governance (West London: Brunel University), 1995.

^[28]Ibid.

^[29]Axel Boersch-Supan and Joachim Winter, Population Aging, Savings Behavior and Capital Markets, "Working Paper 8561" (October 2001).

^[30]Chand and Jaeger, IMF Occasional Papers 147, "Aging Populations and Public Pension Schemes."

^[31]Boersch-Supan and Winter, Population Aging.

^[32]Deutsche Bank Research, Special Study: Europe on the Road to Pension Funds? June 15, 2001.

^[33]Retail Banker International, January 15, 2002, p. 12.

^[34]S. Wahal, "Pension Fund Activism and Firm Performance," Journal of Financial and Quantitative Analysis 31, no. 1 (1996) 1–23.

^[35]M. Smith, "Shareholder Activism by Institutional Investors: Evidence from CalPERS," Journal of Finance 51, no. 1 (1996): 227–252.

^[36]Diane Brady, "The Education of Jeff Immelt," Business Week, April 29, 2002.

^[37]"Bosses under Fire," BusinessWeek, November 30, 1998.

^[38]Mr. Fabio Galli, secretary-general of Assogestioni.

^[39]Ms. Maria Pierdicchi, head of Nuovo Mercato and Mr. Fabio Galli, secretary-general of Assogestioni.

^[40]Assogestioni, Corporate Governance Committee. Acquisition of Fondiaria by SAI, Report published at http://www.assogestioni.it/novita/novita.asp

^[41]Communication by the Commission, Towards a single market for supplementary pensions, 1999, Annex, as quoted by Deutsche Bank Research, Pension Funds for Europe. See http://www.deam-europe.com/pension_reforms