Europe's Old Ways Die Fast

In scandal's wake, boards are embracing the holy trinity: Shareholder rights, transparency, and accountability

All over Europe, shareholders have been clashing with corporate boards and management this spring. In early April, a dissident group succeeded in ousting the entire management of France's troubled Eurotunnel. Then, on Apr. 7, investors harshly criticized DaimlerChrysler's supervisory board and CEO Jürgen E. Schrempp at the company's annual meeting: The firestorm influenced the decision two weeks later to halt a costly rescue plan for Mitsubishi Motors. In Stockholm on Apr. 27, Atlas Copco Chairman Sune Carlsson told shareholders he was withdrawing a proposed executive stock-option plan, because they had complained that the grants weren't linked to performance. It was the fourth time this year that a company controlled by the Wallenberg dynasty -- owners of hefty chunks of Sweden Inc. -- succumbed to shareholder pressure and scrapped a controversial incentive plan.

Until recently, many European companies paid little more than lip service to the notion of shareholder rights, transparency, and board accountability -- the holy trinity of good corporate governance. Instead, boards, dominated by a clubby coterie of interlocking shareholders -- family members, friends, or banks with financial relationships with the company -- frequently ran roughshod over minority shareholders.

Now the triple whammy of dismal returns, the two-year bear market, and a slew of homegrown corporate scandals -- Elan, Vivendi (V ), ABB (ABB ), Skandia, Ahold (AHO ), Parmalat, and now Royal Dutch/Shell (RD ) -- is spurring shareholders to stand up for their rights. Boards have little choice but to react. "These crises have grabbed boards' attention and gotten them good and scared," says Stephen Davis, president of Davis Global Advisors Inc., an international corporate governance consultancy in Boston.

The old ways of doing business are no longer acceptable, and several forces are driving change. Institutional shareholders, led by Britain's National Association of Pension Funds, the Association of British Insurers, and a handful of major U.S. and European fund managers, are demanding more accountability and openness. They want management to disclose detailed information on everything from executive compensation to the board selection process to how auditors are chosen and how much they're paid. Shareholders also want to know whether board members are sufficiently independent to act as an effective check on management. "European boards are under huge pressure to raise their game," says Belinda Hudson, a principal at Mercer Delta consulting and a specialist in corporate governance in London. "There is a profound difference in Europe, compared with a decade ago," adds Stanley J. Dubiel, senior vice-president with the London office of Institutional Shareholder Services (ISS). "Most of the change is among blue-chip companies, which are very exposed to international capital markets." Last year, ISS began tracking close to 900 European companies in 16 countries, assigning each a "corporate governance quotient" so global institutional investors could assess the comparative merits of corporate boards.

Other agencies are getting into the act. The three major credit-rating agencies -- Moody's Investors Service (MCO ), Standard & Poor's (MHP ), and Fitch Ratings -- have incorporated governance measures in their credit-rating methods. Of the 30 largest European asset managers, 20 factor governance into their investments. "This is starting to change the dynamics of the investor side in the corporate governance game," says Stilpon Nestor, member of the European Corporate Governance Council and principle of Nestor Advisers Ltd. in London.

European governments are also acting as a catalyst for reform. They continue to introduce and tighten national codes of good governance -- a process that began with Britain but picked up on the Continent in recent years in response to corporate scandals. Currently, at least 21 European countries have governance codes in place. One of the newest is the Netherlands' Tabaksblat Code, named after its author, former Unilever CEO Morris Tabaksblat, and considered one of the best in the world. The code recommends that corporate boards disclose everything from board structure to the terms of top managers' contracts -- and that shareholders approve management compensation plans.

The code is voluntary, but companies must explain to regulators their reasons if they decide not to comply. When the proposed code was published last year, says Tabaksblat, "there was quite a lot of criticism from the business community, but that is over now. Most companies expect a high degree of compliance." Dutch grocery giant Ahold is using the code to rebuild its reputation among investors after its accounting scandal a year ago. In Germany, companies are finding it's easier to try to meet code requirements than to face angry shareholders demanding why they didn't. "The reaction [of companies] has been overwhelming," says Max Dietrich Kley, interim CEO of semiconductor maker Infineon Technologies and a member of the commission that wrote Germany's code.

Meanwhile, the U.S. Sarbanes-Oxley Act of 2002, written after America's spate of corporate scandals, is also ratcheting up the pressure. Sarbanes-Oxley required companies with U.S. listings to improve disclosure and tighten financial reporting. But even companies without U.S. listings are starting to follow suit, recognizing that access to capital markets depends on meeting global standards of good governance.

Perhaps the latest motivation for company boards, however, is fear. European managers and board members such as those at Vivendi, Parmalat, Ahold, and Shell are increasingly exposed to liability in U.S. courts through class actions, including those launched by European shareholder associations such as France's Association de Défense des Actionnaires Minoritaires (ADAM) against former Vivendi CEO Jean-Marie Messier in New York. The panic is mounting. The key question chief executives are asking these days is: "'What is my liability?"' says Nestor. "People are really starting to be afraid about their U.S. liability."

HOPPING MAD. Soon they'll have to worry about their liability at home as well. Shareholder suits against management and directors are not as common as in the U.S., but this may be changing. In Germany, Ekkehard Wenger, a professor of finance at the University of Würzburg and a shareholder activist, plans to file a lawsuit against DaimlerChrysler's supervisory board for failure of fiduciary duty in prolonging CEO Schrempp's contract for three years. Shareholders are hopping mad about the failure of Schrempp's Asia strategy and the destruction of $40 billion in shareholder value since the merger of Daimler and Chrysler. "To renew the contract of someone so incompetent in the middle of a management crisis is inexcusable," says Wenger. Daimler defends the independence of its board and points to improvements in Chrysler as evidence that Schrempp's long-term strategy will work out. "The allegation is baseless," says a DaimlerChrysler spokesman.

Of course, many boards still resist change -- until a crisis forces it upon them. Take Shell, which garnered a 12.1 score from ISS. That means it performed better than only 12.1% of the 1,785 companies on the ISS list. The reason: poor disclosure, lack of board independence, and its convoluted dual company structure with boards and managers in Britain and the Netherlands. Until recently, Shell "had a culture of grand isolation from the investor," says Davis. But the shock announcement in January that the company was cutting its proven oil and natural-gas reserves by 20% led to the resignation of Sir Philip Watts as a managing director and chairman of Shell and of Walter van de Vijver, who had been in charge of Shell's exploration and production business.

Faced with class actions and a U.S. Securities & Exchange Commission investigation, Shell swiftly announced a series of corporate governance reforms aimed at improving its internal controls. The company will now comply with the Sarbanes-Oxley Act, the new Dutch Tabaksblat Code, and the revised Combined Code in Britain. A nonexecutive chairman will be appointed to the British company, Shell Transport & Trading, and there will be greater transparency in compensation policies. Still, governance experts say the company could open up more by ditching its dual corporate structure.

Contrast Shell's performance with rival British oil giant BP PLC (BP ), which ranks 84.4 on the ISS list. Beginning next year all BP directors will be subject to annual elections, even though this is not required under British regulations. And the board itself has its own staff, which helps members keep better tabs on compliance and management issues. Indeed, British companies have long led their Continental counterparts on corporate governance, as evidenced in the ISS rankings, where 78 of the 206 British companies in the index scored above 90. That's partly because Britain has a much more deeply ingrained equity culture. But it's also because Britain went through its own corporate crises back in the early 1990s, which led to a slew of governance reforms. Publishing company Emap earns a 99 score from ISS for its independent board, term limits for directors, and shareholders' having a vote on the selection of auditor.

A number of companies on the Continent were early believers in the benefits of good governance. Swiss pharmaceutical giant Novartis (NVS ) is going the extra mile to ensure that its board is not only independent but also high-performing. According to ISS, the Basel-based drugmaker scores 99.1. More than 75% of the board members are independent, as is the company's compensation committee, and directors are subject to term limits. CEO Daniel Vasella is a big believer in the benefits of transparency.

Unlike Roche (RHHVF ), its crosstown drug rival, Novartis gives investors detailed information on executive compensation. According to British pension fund manager Hermes, Roche discloses only the cash component of CEO Franz Humer's compensation. Novartis lists the value of all stock options and shares owned by Vasella. "Transparency forces management to be disciplined in everything we do," he says.

Slowly but surely, insular and long-secretive boards are opening up. At France's Air Liquide, a manufacturer of industrial gases, discussion of compensation "used to be limited to a very narrow group of people and rarely even uttered in the boardroom," says Chairman Alain Joly. "Today it's discussed openly, not just in the remuneration committee but on the board." Air Liquide scored 90.7 in the ISS ranking. Nine out of 11 directors are independent, and the company sets a mandatory retirement age for directors, while limiting the number of other board seats they can hold. To improve communication with shareholders, Air Liquide set up a committee of 12 shareholders who meet three times a year with management.

QUANTUM LEAP AHEAD. Even in Italy, where rankings trail the rest of Europe, companies are finally making progress. The main catalyst is the $18 billion fraud at dairy goods multinational Parmalat, which revealed endemic weaknesses in regulatory oversight, accounting standards, and governance. Parmalat is ranked a low 2.7 by ISS. Italy's center-right government is drafting a new law on financial regulation that will overhaul both institutions and laws, forcing greater disclosure, granting regulators more investigative powers, and tightening control over accounting practices.

Leading proponents of corporate governance in Italy agree it's still early days. But they insist the attitude toward self-compliance with the country's code, once lax, has changed dramatically in the wake of Parmalat. "The fear today about sanctions and companies being taken to court is much higher than before," says Vittorio Merloni, chairman of the $3.6 billion white-goods maker Merloni Elettrodomestici and member of Italy's corporate governance committee. Pushing the laggards along is the Italian Stock Exchange. It already publishes 300 listed companies' explanations of noncompliance with the country's corporate governance code, and it now plans to highlight individual cases that stand out as examples of poor governance. "Italy has to make a quantum leap in corporate governance," says Silvio Scaglia, chief executive at e.Biscom.

And the bar is being raised by Italian companies that have decided to meet Sarbanes-Oxley standards for board structures, transparency, and audit procedures. Merloni bolstered internal governance structures and practices after the Enron Corp. debacle in the U.S., and has instituted a blocking period 15 days before financial results are published, preventing insiders from trading shares. At Telecom Italia (TI ), Chairman Marco Tronchetti Provera is proposing a new list of board members for approval at a May 6 board election, the majority of which will be certified by outsiders as independent. Other leaders in corporate governance in Italy are ex-state-owned companies, which adhere to a tough set of controls, including mandatory audit committees. Privatized oil-and-gas giant ENI received a 92.4 score from ISS, to rank No. 1 among Italian companies. ENI is one of the few Italian companies with a majority of independent board members. "The best corporate governance rules don't serve any purpose if the people who exercise them fail," says ENI CEO Vittorio Mincato.

Progress, yes. But much more remains to be done in Italy and across the rest of Europe. Family-run companies in Italy, Spain, and Switzerland are still too secretive, and voting rights are stacked heavily in the founding families' favor. In Germany, experts say the system of co-determination -- where half of the supervisory board is appointed by shareholders and the other half by employees -- is an obstacle to good corporate governance. The heavy employee representation on the board is often an impediment to badly needed restructuring. And the system thwarts open debate among board members, who are reluctant to discuss strategy in front of employee representatives who might block change. In Spain, there's still not much of a shareholder culture, so investors aren't yet standing up for their rights. "Too often, the president of a company is still seen as an authority," says Carlos Moreno, a lawyer at investor relations firm Solero-Padró.

All these issues should matter not just to shareholders but to Europe Inc. more broadly. Roger Abravanel, a partner at management consultancy McKinsey & Co. in Milan, believes there is a direct link between a company's competitiveness and the effectiveness of its corporate governance practices. "What should good corporate governance do? It should procure capital and grow the company," he says. "It is about ensuring that a company has the best leadership in place to stay competitive and not only about preventing fraud." For the growth and competitiveness of Europe's economy, investors need to stay the course.

By Kerry Capell in London, with Gail Edmondson in Berlin, Carol Matlack in Paris, Ariane Sains in Stockholm, Jack Ewing in Frankfurt, and Juliane von Reppert-Bismarck in Madrid

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