Corporate governance crisis has been witnessed in the first years of the twenty-first century all over the world. In particular crisis like Polly Peck (UK), BCCI (UK), Maxwell (UK), Mirror Group (UK), Enron (US), World Com (US), Holzmann (Germany), Metallgesellschaft (Germany), Bayerische Hypo- und Vereinsbank (Germany), has affected the countries to make an effective regulation of corporate behaviour. As responses this kind of corporate scandals several laws implemented in many countries around the world. The flow of implementing corporate governance is global, however, it is a complex subject of company law because of the legal, cultural, ownership and other structural differences in countries. Related to these differences some of these responses are examples of soft law or hard law, besides each of them has a different theory behind it. For instance, corporate governance in the United States has become mandatory designated by regulation and law which is an example of hard law. SOX Act. carries, known as ‘obey the legal requirements or risk the penalties’ or ‘one size fits all’ approach which means unlimited fines and jail.
In the contrast to the United States, the United Kingdom has adopted principles based voluntary approach which is an example of soft law, instead of rules based approach, to the enforcement of the provision of corporate governance codes. Self-regulation is the main aspect of these codes and this approach has a long history in the United Kingdom, specifically in the City of London where the ‘code culture’ has started. Despite started in London, the approach of principles based, which deployed ‘comply with the code or explain why you have not’, corporate governance tendency has influenced all over the world. And this approach became very popular in many countries. Germany is one of them but slightly different from the United Kingdom, which Germany’s system is not entirely principles based voluntary code. This kind of code in the UK and in Germany has accepted to reach a good and respected corporate governance. But the critical question here is “what is the goal of the corporation? Is it profit and for whom? Social welfare more broadly defined?”. This paper will critically evaluate whether such a principles-based voluntary code is sufficient for achieving appropriate corporate governance outcomes in the United Kingdom and in Germany which has not totally voluntary code.
The concept of corporate governance appeared in 1932 with the book ‘The Modem Corporation and Private Property’ by Adolf Berle and Gardiner Means. Berle and Means have pointed that the separation of ownership and control in publicly held companies in the United States as a consequence of distinguished ownership and the great number of shareholder in public companies led to a special group of business people with full authority to run the corporation. Because of the problems appearing from the separation of ownership and control became a vital area of corporate governance. In other words, it is possible to describe corporate governance’s cause of existence as a ‘problematic separation of ownership and control’.
As a response this problematic separation of ownership and control, the first response of the United Kingdom is the Financial Aspects of Corporate Governance, as know Cadbury Report, of the Cadbury Committee in 1992 has been established by the London Stock Exchange and the UK Financial Reporting Council. The Cadbury Report included a set of rules administered to the boards of directors of all listed companies which are registered in the United Kingdom. Many of them still exist today in the United Kingdom Corporate Governance Code 2014, for instance, the role of non-executive directors. The latest United Kingdom Corporate Governance Code 2014 is based on 10 main principles of good governance covering five areas: (A) leadership, (B) effectiveness, (C) accountability, (D) remuneration, and (E) relations with shareholders. These principles of corporate governance on matters specifically relations with shareholders, the accountability of the directors for financial matters, directors’ remuneration and the composition of the board.
The main vein of codes in the United Kingdom is ‘comply or explain’ principle which eliminates ‘one size fits all’ approach. The explanation is being waited from the companies why the principles do not adopt if a company chooses not to comply under the comply or explain approach. Failure to comply or explain might lead to questions being asked by the capital markets about the company’s legitimacy. This approach is non-mandatory and it gives an opportunity for self-regulation, also encouraged by principles-based.
So, comply or explain approach provides flexibility in the application of the code. Financial Reporting Council emphasised ‘while it is expected that listed companies will comply with the Code’s provisions most of the time, it is recognised that departure from the provisions of the code may be justified in particular circumstances. Every company must review each provision carefully and give a considered explanation if it departs from the Code provisions’’. These point of comply or explain approach is reasonable because there is no correct or proper corporate governance standards for all public companies. Hereby, the aim of the code is to enable companies to establish their own governance policies in the lead of main and supporting principles. Because for some smaller companies may have difficulties in obeying the strict standard because of the costs of compliance like the example of the United States. This reflected in the Cadbury Report and the Cadbury Committee recognized that ‘smaller listed companies may initially have difficulty in complying with some aspects of the code. […] The boards of smaller listed companies who cannot, for the time being, comply with parts of the Code should note that they may instead give their reasons for non-compliance’.
British corporate governance is often described as a system of control by outsiders, rather than the insider control system; this reflects, among other things, the larger role played by the stock market in Britain and a different ownership structure. In the United Kingdom, the “comply or explain” technique is built on the idea of market enforcement. Consistent with this, there are two basic assumptions underlying the Cadbury Committee’s recommendations, first, self-regulation, rather than statutory regulation and enforcement, was the optimum way to improve corporate governance and financial markets, rather than independent regulators, provided the most appropriate means of dealing with those companies which fell below the acceptable standards of corporate governance. However, market control may not be sufficient. In this point, it is important to determine the outcomes of corporate governance which is designated in the UK. In the UK narrow perspective of corporate governance is adopted. The tendency has started with the Cadbury Report and it was entitled as The Financial Aspects of Corporate Governance, from this point it is easy to implicate that it stressed finance and focused the role of the board directors. The Cadbury Report and its predecessors have obtained this narrow perspective to maximise the profit and indented to solve financial problems to hinder corporate scandals. Because, scandals of Maxwell Corporation, Polly Peck, BCCI and Baring Bank in the United Kingdom has fraudulent activity relating to unrestrained profit maximisation. However, the issue of corporate governance is a much wider one than that suggested by the Cadbury Committee.
According to agency theory, corporate governance is a set of monitoring mechanisms that exist when the separation of ownership and control make it necessary for capital providers to set up means to safeguard and to achieve a return on their investment. Agency theory Jensen and Meckling (1976) identifies the agency relationship where one party delegates work to another party. The agency relationship can have a number of disadvantages relating to the opportunism or self-interest of an agent. Agents or managers may not always act in the best interest of shareholders when the control of a company is separate from its ownership. Agency costs include the costs of structuring, monitoring, and bonding a set of contracts among agents with conflicting interests. Related to this theory, the traditional Anglo-American model, which including the United Kingdom, of corporate governance is based on profit maximisation which claims to protect shareholders. Thus, the United Kingdom has the shareholder-oriented approach to achieve corporate governance outcome which is profit maximization.
Henry Hansmann and Reinier Kraakman, argue that ‘ultimate control over the corporation should rest with the shareholder class’ and that managers should manage in its interests. However, Berle-Dodd argue that after reviewed all these alternative theories to a shareholder-oriented model, ‘they’ have failed to be seen as a ”viable alternatives to the shareholder-oriented model‟. Parkinson and Kelly (1999) point out that the Code contributes very little to the stakeholder debate, i.e. the notion that managers should take into account a wider range of interests (employers, investors, suppliers, etc.) rather than those of only shareholders. The argument that companies should be required to maximise their profits because in this way best serve the public interest is open to objection because profit maximising policies are not always wealth maximising ones and even where they are wealth may not be the most desirable outcome.
To sum up, according to the shareholder view companies should be run in the interest of their shareholders, however, the stakeholder view emphasizes that managers should promote the interests of all stakeholders in the company. Herewith, profit-maximisation may not be all shareholders’ interest, they may have other objectives in investing. Such that corporate governance outcomes may not be only profit maximisation, there are broader outcomes of corporate governance as follows;
i) Fulfil the long-term strategic goal of the owners, which, after survival may consist of building shareholder value or establishing a dominant market share or maintaining a technical lead in chosen sphere, or something else, but will certainly not be the same for all organisations,
ii) Consider and care for the interests of employees, past, present and future, which we take to comprise the whole life-cycle including planning future needs, recruitment, training, working environment, severance and retirement procedures, through to looking after pensioners,
iii) Take account of the needs of the environment and the local community, both in terms of the physical effects of the company’s operations on the surroundings and the economic and cultural interaction with the local population,
iv) Work to maintain excellent relations with both customers and suppliers, in terms of such matters as quality of service provided, considerate ordering and account settlement procedures, etc.,
v) Maintain proper compliance with all the applicable legal and regulatory requirements under which the company is carrying out its activities.
German approach is closer to achieve these outcomes. The German Corporate Governance Code aims to address these issues within six subsections: shareholders and the general meeting, cooperation between management board and supervisory board, management board, supervisory board, transparency and reporting and auditing of the annual financial statements. With these solving issues, the German model can be characterised as long-term relationships between stakeholders in the firm. The German Corporate Governance Code is a mix of rules with different bases; part hard law, part soft principles of best practice which are only recommendations and part aspirations, for which neither conformance nor explanation is required. In relation to the recommendations, which are regarded as the core of the German Code, a comply-or-explain approach like in the United Kingdom. Notably, in contrast to the United Kingdom, the code was officially set up by the Ministry of Justice as a ‘Governmental Commission’ and the code was also published by the Ministry in the official part of the Bundesanzeiger where also laws are made public.
Biggest contrast of German Code with the British Code is German Code has stakeholder systems power is shared between shareholders and other groups especially employees with an interest in the company. Thus, the formal position of management is that it is under a duty to promote the interests of ‘the company as a whole’, which is taken to include employees, lenders, suppliers and costumers. Stakeholder theory is in juxtaposition to agency theory. Stakeholder theory takes account of a wider group of constituents rather than focusing on shareholders. A consequence of focusing on shareholder is that the maintenance or enhancement of shareholder value is paramount, whereas when a wider stakeholder group such as employees, providers of credit, customers, suppliers, government, and the local community is taken into account, the overriding focus on shareholder value becomes less self-evident. The stakeholder theory rejects the idea of profit maximisation as a single outcome.
Failure to adopt principles of the UK code may also indicate a breach of a director’s duties under ss. 172-175 of the Companies Act 2006. For the first time, the parts relating to the corporate governance especially the function of the board of directors to promote the success of the company have codified in part 10, subsection 172 of Companies Act 2006. It states that ‘promote the success of the company for the benefit of its members as a whole’. It requires directors to have regard to a range of interests in discharging their duty to promote the success of their company. Thus, it is possible to say the Companies Act 2006 brought a broader approach to companies with subsection 172. However, although the provision seems to ground on stakeholder-oriented, this is not to say the United Kingdom company law transformed from a shareholder-orientated to a stakeholder-orientated system, to decide what is the benefit for the shareholder is up to the directors, not the courts. Lord Eldon LC in Carlen v. Drury addressed that ‘court is not required on every occasion to take the management of every playhouse and Brewhouse in the Kingdom’. Consistent to this Jonathan Parker J In Regentcrest Plc v. Cohen expressed that ‘the question is whether the director honestly believed that his act or omission was in the interests of the company. The issue, therefore, relates to the director’s state of mind’. But, it shows that effective protection of the interests of various stakeholder groups has long been integrated into the UK approach to regulating the conduct of directors.
As mentioned above, the United Kingdom’s system based on the market for control, however in internal monitoring is in the forefront in Germany. Besides, at least in theory, internal monitoring ought to be able to respond more quickly to managerial failure, and be better able to recognise it than the market. To promote the interests of all stakeholders, in other words, to promote the interests of ‘the company as a whole, in the company Germany has the two-tier board, a management board (Vorstand) and a supervisory board (Aufsichtsrat), system. The function of the supervisory board which consists both shareholders and employees are representatives is to oversee the company’s management. The important aspect about the two-tier board is mandatory despite taking part of the German Corporate Governance Code and the size of the supervisory board is set by law and cannot be changed by shareholders. However, corporate governance is structured on a one-tier model in the United Kingdom, the management runs daily activities while some executives are also members of the board of directors. The German equivalent of non-executives, which has an important role in the United Kingdom corporate governance, are segregated from their executives and they have an independent board which is supervisory board. Contrast this with the UK where non-executives sit together executives on a single board.
The discussion of one-tier boards in the United Kingdom is increasingly focused on strengthening the role of non-executive directors. The role and effectiveness of non-executive directors have tried to be more effective with the Higgs Review. The Higgs Review was an independent review of the role and effectiveness of non-executive directors led by Derek Higgs, on behalf of the United Kingdom government. The aspects of non-executive directors can be defined as part-time, external, and independent. Provisions about non-executives still exist in the United Kingdom Corporate Governance Code. The main point of these provisions is to ensure that the executive directors are acting consistently with shareholders’ interests. In other words to create a balance between executive power and non-executive power. The Higgs Review recommended that one of the non-executive directors needs to be appointed as a senior independent director and a senior independent director should attend the meeting with several times. The main idea of the senior independent director is to make a connection between shareholders and the board and it is a significant role in the corporate body because shareholders sometimes have a difficulty in reaching the board. Moreover, this is the one important reason of the failure of Maxwell and Poly Peck. The appointment of non-executives should be impartial for the best protection of shareholder’s right. Regrettably, according to a subsequent survey to the Cadbury Report, 70 per cent of non-executive directors were selected by the way of ‘old school tie’. It is not clear whether non-executive directors can play a fully effective role in ensuring accountability.
The shareholder-elected supervisory board members differ from British non-executive directors in two ways. First, they do not owe their positions to management, a situation which is surely a pre-condition for effective monitoring. Secondly, not only are the supervisory directors independent of management but also, they are usually representatives of powerful shareholders. The shareholders’ role is important here in that they are prepared to assume the function of selecting and supplying a pool of suitably qualified candidates to serve as directors. The close connection between supervisory directors and shareholders ensures as well that the directors have access to valuable support services.
Another difference, which is maybe the most important one, between two systems is German’s board system is not voluntary as different the United Kingdom’s board system which is voluntary to comply. For sure that, in German model the rights of the shareholders will protect better than the UK model. Related to this, the Economic Co-operation and Development has suggested re-examining the adequacy of its corporate governance principles in key areas relating to risk management by company boards. However, even if in the UK model, protection ensures, it is voluntary to comply and the outcome which is being pursued is narrow. XXX In order other groups to have an effective influence, mandatory rules will be required because they have less bargaining power, and market forces alone are unlikely to protect them adequately. Such as the German model which has a broader approach and is mandatory to comply has been effective and has worked for years. Generally, German companies are profitable, well managed and, over the long-term, have served their shareholders well. It is not surprising that Germany is the third largest exporter in the world.
Contrast to the developments in Germany, in 2008 the Royal Bank of Scotland together with a number of other large UK banks was caught up in the toxic asset scandal that saw mortgage-backed securities tumble in value, along with a concomitant fall in the value of banks’ shares. One of them is Northern Rock Plc and related to this failure the Treasury Committee noted ‘the non-executive members of the Board, and in particular the Chairman of the Board, the Chairman of the Risk Committee and the Senior non-executive director, failed in the case of Northern Rock to ensure that it remained liquid as well as solvent, to provide against the risks that it was taking and to act as an effective restraining force on the strategy of the executive members.’ It clearly shows that non-executive directors are not sufficient in the United Kingdom.
In the United States which has another Anglo-American model, after the corporate scandals especially Enron, the United States has chosen a heavy regulated approach for avoiding future Enrons. The first government response to corporate scandals was the Sarbanes-Oxley Act 2002 (Sarbox) which was called ‘the most significant change to American corporate governance since the Securities Act of 1933 and the Securities and Exchange Act of 1934’. The United States listed companies are required to comply Sarbox provisions. By complying these provisions may be very expensive because of accountants and management consultants. As mentioned above, there is no one system for every company. The numerous requirements and regulations imposed by Sarbanes-Oxley Act is contrasted with the principles-based approach because there is no flexibility. Thus, a hard law which is rules-based and tick the box may not be the best solution for any company. Because it was unlikely to be able to set more than minimum standards. Companies will be stuck these minimum standards, however, companies might have built their own standards in the light of minimum standards in the principles-based system. In the light of these aspects, it would not be wrong to address that Sarbanes-Oxley Act was an overreaction to Enron and related problems and it was ineffective and unnecessary.
Corporate governance is, or should be, one of the most effective tools in the fight against corruption which leads corporate scandals. Generally, the purpose of the hard law or soft law has been to improve good governance practice by increasing management’s responsibility and promoting openness and transparency of business and to give confidence to investors. Companies typically comply to governance codes in order to sustain their legitimacy. And companies need to comply with the spirit of the code, not the letter. In the field of soft or hard law, it should be emphasized that nobody argues that all corporate governance rules should be mandatory. As the experience of the controversial Sarbanes-Oxley legislation in the United States has illustrated, there are no guarantees that such a step will be conducive in the long run either to a more attractive investment environment, or to more accountable or responsible corporate management. This is partly: (i) because there is no single model of effective corporate governance or obvious best practices; (ii) because the UK and US systems are continually evolving in reaction to market developments; and (iii) because corporate governance reflects the history and culture of corporate management in any given country.
As mentioned above that in corporate governance one rule does not fit all. So, the most effective type of corporate governance which is imposed consensually like the United Kingdom and partly German approach. In contrast, the UK model accords a high priority to shareholders’ interests, with less consideration to another stakeholder. The United Kingdom’s present system of corporate governance, self-regulation, entirely voluntary and the monitoring and control of corporate affairs is inadequate and unsatisfactory to protect the interests of shareholders, creditors and other stakeholder of the corporation. Contrast with the Germany. It comes front the another problem which is the theory behind it. Principles based voluntary code is not sufficient to achieve neither broader or narrow corporate governance outcomes. Some of them need to be mandatory, which proper to achieve broader outcomes of corporate governance and some of them need to be voluntary to establish according to companies’ characteristic. The danger with “comply or explain” is that to the extent that directors do not comply and they do not explain, or they explain, but they do not do so clearly, accurately or in detail, they fail to be accountable. The Germans have this saying: “Vertrauen ist gut, Kontrolle ist besser!” (“Trust is good but control is better”), it is better to control some provision, it should not be totally voluntary. Finally, structures alone will never solve all the problems of corporate governance. Nonetheless, up to date structures provide the best insurance we can obtain against another Polly Peck, Holzmann or Enron.