Board structure – The case for diversity
For decades the debate over the relative merits of the onetier versus the two-tier board structure has raged in academic papers, seminars, conferences and, yes, in boardrooms themselves. What is the answer to this dilemma? Corporate governance expert Dr YRK Reddy, who will be speaking in session one of the CGC 2012, believes we need a greater appreciation of diverse approaches to board structure since different models are suited to different markets.
Academics have sought to examine board structures mainly from a binary perspective – the one-tier/ unitary model and the two-tier one. Many have argued the merits of one over the other as eventual points of convergence. Some comparative studies have even sought to link the models with economic outcomes for the firm and for the economy. This debate continues even as countries known to represent these classic models themselves seem to be borrowing from each other and elsewhere. That should not be surprising as the management world in the US and UK has seen much learning from the Japanese and the Germans in earlier decades followed by the reversal apparent during the last decade.
The adaptations of the classical one-tier model
The one-tier model, which has been traditionally popular with the international investing community, is typified by boards in the UK and the US and is followed in almost all countries in the common law tradition. When the Cadbury Report – which generated a slew of codes all over the world – drew attention to the need for independent directors, independent audit committees and separation of the chairperson from the executive, there was understandable criticism from some quarters that it was superimposing the supervisory board idea. It implied that the supervisory role and control function of the board must dominate over its more strategic management role. Further, in many of the common law countries, regulatory codes define corporate governance as the manner in which companies are ‘directed and controlled’ – a supervisory function – even as their law treats non-executive directors as ‘officers at default’ along with executive directors and key managerial personnel!
Some believed, and in many countries they still do, that these changes to the one-tier board model induces bureaucracy, erodes competitiveness and imposes higher transaction costs in general. However, most felt that the opportunities provided by internationalisation and capital markets required that adjustment to bring in more investor confidence and their money. Further refinements, such as the introduction of lead independent directors and separate meetings of the independent directors, reinforce abundantly this disposition towards enhanced stewardship as against the managerial role.
Simultaneously, it has become the norm for all big corporations to have a formal management/ executive committee comprising the senior management which in many ways mimics the management board of the two-tier model but without a legal status, unless provided for in the articles of the company.
There is another manner in which the disposition of civil law countries with their two-tier boards has possibly seeped intothe one-tier system. The recent emphasis on corporate social responsibility; triple bottom-line and sustainability reporting; special statements regarding environmental compliance in respect of some types of industries; and even ethics (most exemplified by the King Committee III of South Africa); reflects the shift from the shareholder model to at least recognising the stakeholder idea. Further, despite the expected tradition of ‘comply/ apply or explain’, some aspects have slowly started creeping into legislation, regulatory directives and prudential standards. This is exemplified by SarbanesOxley in the US; the changes to listing agreements with securities exchange regulators in many countries; prudential standards relating to governance as issued by banking/ financial regulators; and the changing remits of statutory auditors in some countries.
One may recall that there were some in the UK who seriously argued in favour of a two-tier model during the 1970s, but the issue that stalled the move was that of providing space for labour a la Germany. Nevertheless, in many common law countries where state-owned enterprises are significant, it is not unusual to have a stakeholder representative on the board by law or on the state’s directive. Such representatives are often from the unions/ collectives, minority shareholder or depositors in the case of banks. The state’s intervention in board composition to represent public interest has also been evident intermittently in cases of major corporate failures or bailouts in these countries. This is most recently witnessed in the US and the UK, once again reflecting the stakeholder assertions witnessed in the civil law countries.
The changes to the classical two-tier board
Though the Dutch two-tier board has enjoyed a 400-year history, it is the German variety that has come to represent the model. According to German law, all public companies (Aktiengesellschaften) are required to have a management board (Vorstand) and supervisory board (Aufsichtsrat). The members of the supervisory board are normally representatives of shareholders and labour. By a separate labour-related law on codetermination, companies with more than 500 employees are required to have employee representatives (which could be up to 50% of the board where the company has more than 2,000 employees), elected through a highly-structured process. By law, the ‘labour director’ on the management board also may be required to be elected by the workers.
The duties of the supervisory board are distinct from those of the management board – and are mainly hiring and disciplining the management board; monitoring its performance; providing control; approving accounts, etc. The articles of the corporation may also supplement the defined duties with possibilities of delegation, approval procedures and appellate process in the case of disputes between the two. Though the division of duties and responsibilities appear to be clear and the management board acts independently, it is observed by some that the supervisory board has tended to be more hands-on in recent years compared to the past. This is especially so as the German code enjoins the supervisory board to ‘advise regularly’ and be involved in decisions ‘of fundamental importance to the enterprise’. The monitoring and disciplining role of the supervisory board is further enhanced in countries like Germany where it is not uncommon to have concentration of ownership and where the markets for control may not be very active.
Moreover, many have pointed out that the adoption of a code on a ‘comply or explain’ basis in Germany is indicative of the influence of the common law countries. It is said that German corporations are more accustomed to following law, regulations and directives rather than self-regulatory codes of best practice as introduced prominently by the UK and followed by many others.
Is diversity a bad thing?
If one looks at the board structures adopted around the world, particularly in Asia, one is struck by the enormous differences. There are similar differences in board models among the BRIC countries. Some researchers take an optimistic view of the forces for convergence, such as institutional investors, major auditing/ consulting firms and international accounting standards. But then, one must also take into account several other forces and factors that will ensure diversity in both form and substance.
1. Economic structures.
The economic structures of countries vary vastly, especially in relation to the size of their capital markets; the need for foreign investment versus domestic capital; the size and importance of publicly-traded companies in economic development; ownership structures/ concentration; the extent and size of state-ownership; etc. Consequently, despite the meticulously stated ‘business case’ for a unitary corporate governance framework under assumed market conditions, many countries may be slow to warm to the idea. The one-tier board corporate governance framework may have been dominant over the last two decades – riding on the buoyancy of many Western economies, the promise of financial flows and the growth prospects of capital markets – but all these have taken a severe knock in recent years following the global financial and economic crises. The appetite for market-driven policies has also been tempered around the world though none disputes their logic per se. Perhaps, there is a measured and muted pause now to understand how other types of economic policies and management have continued to be resilient – and perhaps greater appreciation of diverse approaches.
2. Political structures.
Many countries, especially in Asia and Latin America, have diverse political structures, governance models and legal frameworks that are in transition in some manner or other. They may not be mindlessly bound by legal traditions and be path dependent/ persistent to the extent assumed by some writers. Board structures and corporate governance reforms are contingent on the larger changes and cannot race ahead or be in contradiction. Many of these countries seem to favour incremental changes and regulatory forbearance/ tolerance for differences in the pace of progress. This is especially so in the absence of evidence-based categorical solutions to corporate governance-related issues that seems to haunt both models.
3. Regulatory philosophy.
International standards, such as those arising from the OECD principles, are themselves inclusive and accommodative of diverse board structures, ownership structures and legal forms.
4. Competitive advantages.
Even if there are signs of convergence in some aspects, there is a strong likelihood of variance in operations/ substance that may not necessarily be undesirable. Drawing from the world of management, corporations in different countries in the same product/ market segments have similar organisation designs, technological processes, accounting standards, information systems, operations, and supply and distribution chains – yet they are vastly different in the manner in which they function. They derive competitive advantage mainly out of the softer aspects in the organisation. Thus, when comparing British, Japanese, Korean and Indian management styles, one finds overwhelming apparent similarities and yet many differences. The same should be true of board structures.
In the light of the above It would be hard to predict convergence to, or divergence from, any one model, but instead of being frustrated by a world of diverse models and practices, wise policy makers and institutional investors should welcome the prospect as it only increases the alternatives for investments, depending on what works best in the given socio-cultural-political-economiclegal transitory conditions. This diversity ensures different markets for different types of finance/ investors, spreads the risks and promises greater value. It is already evident that, even as many countries in the West with either of the board models are tottering amidst crises, there are other countries and models that are thriving – no doubt investors are already finding great value in them.
Dr YRK Reddy
Dr YRK Reddy is an international advisor, speaker and commentator on corporate governance policy and practice. He will be speaking in session one of the CGC 2012.
SIDEBAR: The EU experiment
The EU is a perfect example of how one-tier and two-tier board structures can happily live alongside each other. The EU sought initially to impose standardisation on board structures, but over the last three decades this project has increasingly been seen as futile – there is no conclusive proof that one model is superior to the other.
Many countries in Europe now provide alternatives to companies (mostly by way of shareholder resolutions or articles of incorporation) to follow either one-tier or two-tier boards. The Netherlands, France, Italy and Portugal are prominent examples in this respect. Some like Denmark reportedly have an even more distinguishing system of a compulsory executive board and an optional supervisory board.
Moreover, since 2004 the EU has established the option of the ‘Societas Europaea’ (SE). A survey of these in 2009 indicated that there were 369 SEs registered, of which nearly 38% were shell/ shelf entities. They seem to be concentrated in countries where the two-tier system is compulsory with employee involvement. Most have opted for the single-tier board in these territories.