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Economic reform working group - session 1

  • Date(s)
    14 April 2005
  • Location
    Brussels

Policy Network organised in cooperation with the European Policy Centre (EPC) a new meeting of its Economic reform working group on the 14th and 15th April 2005 in Brussels. The first working session was devoted to corporate governance, the second session addressed the issues of research and innovation.
 
The panel began the discussion with a presentation by David Phillips (PricewaterhouseCoopers) of his paper The Information Imperative. David Phillips’ focus over the past years has been to define more precisely what information needs reporting in order to understand value creation in a modern knowledge economy. In his new contribution, he proposes a model for reporting in the context of renewing corporate governance in Europe.

Today we face a critical window of opportunity to develop a high-level, principles based governance model which can accommodate the diversity of culture and business practices within the European Union. However, if the opportunity is not grasped, there is a risk that Europe import critical aspects of the existing US governance model, either knowingly or by stealth. This is a model predicated by rules, where the legal form often appears more important than the substance. Three areas are key to establishing a high performance economy:

Leveraging the power of the capital markets through an understanding of the civil economy model

Policy makers need to identify the key players, what their roles are, and how they interact with each other. This step requires an understanding, first, of the value institutional investors can bring if they act like owners and not traders, then, of the value other organisations can bring by monitoring business performance and influencing corporate behaviour, and, finally, of the value that can be achieved by making more visible the work of auditors.

If this model is understood, it can be harnessed to help deliver the objectives of the Lisbon agenda by making visible those areas of business performance critical to its success and can in the long run enhance overall economic performance and corporate responsibility. Furthermore, the corporate sector is uniquely placed to drive change in a variety of areas, including innovation and other components of the knowledge economy. But today, business leaders and those acting as owners (the fund managers) are not sufficiently aware of the European political agenda for economic growth, and cannot see how the policy objectives tie together.

Creating a European governance model

The first element of the model is board effectiveness. Experience shows this is where most corporate failure emanates from (Enron, Worldcom, Parmalat). One of the key issues here is what is the composition of the board, and how it operates and exercises its power and influence.

Second, the right reporting model must be adopted. The current model relies too much on financial reporting. It is considered too complex and technical. Most worrying, it has become remote from its key stakeholders - businesses, investors, and auditors. We have created an environment where the model is being created by technicians for technicians and it is certainly not providing investors what they want. The challenge is to simplify financial reporting and make sure it addresses the basis data needs of investors.

Moreover, the importance of non-financial and contextual information is still largely ignored by the current model - research shows this information accounts for approximately 75% of the information that truly matters to investors. It comprises the soft assets of the business, people, brands, customers, intellectual property and innovation, etc. If known, this information will be used to change corporate behaviour and enhance corporate performance.

This is why many governments have moved first in trying to address the issue (e.g. the UK Operating and Financial Review). Additionally, companies have to move away from a one-size fits all model. We need a framework in which management can report what information they routinely use to run the business - the reader can then evaluate for themselves the credibility and competence of management.

Finally, it should be emphasised that through better information, the civil economy model can be unleashed, allowing investors to act as owners and public interest bodies to question how companies are being run. Over time this should provide real benefits to the economy as a whole.

The third element of the model is to ensure sufficient focus on the effectiveness of control processes - but this focus has its limitations as systems of control are always subject to the vagaries of human behaviour. The Sarbanes Oxeley legislation in the US will create value in the long run, but Europe needs to carefully consider what the US learns from this legislation and the process of implementation, both in terms of making the US market attractive to new investors and the real value delivered to the capital markets.

Fourthly, the audit process should be optimised. While there is currently a lot of change taking place, it may be focused on the wrong issues - independence, scope of services, rotation. We know most corporate failures occur because management at the top act fraudulently. We also understand through academic research that auditor rotation does not improve audit quality. Therefore there is value to be found in thinking more radically about the role that assurance can play in fulfilling the needs of society in the 21st century. Can the current role of the auditors be sufficient if it is focused on the current financial reporting model which itself is broken and needs an overhaul? To whom should auditors be responsible - shareholders or all corporate stakeholders, particularly if most companies use the stakeholder model to run the business on a daily basis? How can the work and views of the auditors be made more visible - is a linear audit opinion sufficient - and can the expectation gap be closed?

Identifying the key points for creating the right environment

First, one such key point is liability reform. This is necessary for directors and auditors to embrace and drive a principles based model. Second, unified regulation is needed both across territories and within territories (e.g. the UK position on OFR and Turnbull).  Third, regulation should be “light touch” and focused on the key points of the civil economy model. Fourth, leveraging technology can help create the right environment: enhanced access to information and the ability to compare and contrast performance at the touch of a button will make the civil economy model a reality in a relatively short time frame.

So where is action needed by policy makers? Firstly, let’s ensure that Europe put in place a principles based governance model - focused on the high level issues of board effectiveness and corporate transparency, which demands judgement and attention, from management and auditors and which avoids a model based on rules and legal compliance.

Secondly, in relation to the current reporting model, we need to make important decisions in a number of critical areas (namely, re-engaging investors, enhancing the critical non financial information, moving towards a global standard without necessarily adopting the US “GAAP” model).

Thirdly in the area of business controls, the EU must determine what level of assurance is needed and learn from the experiences of SOX in the US, both in terms of its implementation and its impact in attracting companies.

Fourthly, in the area of assurance, we need to move beyond the issues which are currently being debated and ask more fundamental questions about the role of auditors in the 21 century - can the expectation gap be addressed, can the profession add more value, and if so for whom and how, etc.

Europe cannot afford to allow this agenda to be determined in piecemeal or as a knee jerk reaction to the next corporate failure, the next economic down turn or by outside influences who see the world differently. Lets also recognise the upside potential, enormous value  can be gained both in economic and social terms from the development of a high level principles based governance model, an enhanced reporting model and a new progressive assurance model.

This debate intertwines two separate issues: on the one hand, accounting rules and the role of auditors, and on the other hand, the model of corporate governance. The various models of corporate governance available all require financial reporting rules. But should we focus on the broader issue of a change of paradigm of corporate governance, or just on improving financial reporting within the existing models?

Corporate governance models

The risk to import an American model of corporate governance is probably low in Europe, because of the diversity of existing corporate models. An example of this diversity is the existence of co-determination, although the German business community is now fighting against it. A one-size-fits-all model would not be possible in the European situation, and will probably never arise. Moreover, despite the fact that there is a single market, there is still an important diversity of company law in Europe.

Another question is whether good governance really fosters economic performance. This seems to be the case. But should we legislate about corporate governance, so as to raise the performance of corporations, or should one just let the markets deal with it?

The difference of businesses makes very hard to define a common framework (not only in legislative terms). The EU Commission has prepared a directive proposal that would require managers to tell the public whether they follow a corporate governance code, and if they do, whether they depart from that code, and why. This text, which indicates an objective, does not prescribe the kind of code that companies should follow, implying that the latter choice is left to the market. The work of the commission is about levelling up the good practices of different countries, not define a specific model.

Innovation structures represent a new challenge for governance and information alike. In a knowledge economy, the issues are, primarily, governance and management performance. You have many expectations, but do not know exactly where you are going. What is needed is a management system to build interactions. The problem is whether the performance management system meets the objectives.

Corporate social responsibility (CSR) is obviously important to the future of corporate governance in Europe. It is profitable to companies when it is driven by companies themselves. A communication by the EU Commission will soon be published, following a long preparatory debate involving all stakeholders. CSR is in fact more than “social” responsibility. It is about acknowledging the sustainability and the externalities of a business. However, forcing companies to think in terms of long term profitability remains difficult.

Information and reporting

How should we measure performance? Simply with profit or according to a wider notion? Looking back to the US management studies literature in the 1980s, one realises that dissatisfaction with financial information is not particularly new, and seems to regularly re-emerge. However, once several criteria have been introduced, it becomes more complicated to judge the performance. Moreover, whenever shareholders evaluate managers, it seems hard to deny thatprofit remains the main criterion. In terms of reporting, it makes sense to have more information than purely financial, especially because information is not only for the shareholders, but also for consumers, stakeholders, NGOs, etc. This helps foster corporate social responsibility.

There is some truth to the view that more information is good for democracy, for society, and for the economy. However, it depends on who receives it. Will those who receive it pay attention to it? Do they have an incentive for that? Shareholders, stakeholders and consumers are not interested in the same kind of information. And it is not certain whether all the information that these different people want to see can be gathered into a single framework.  One has to keep in mind that investors look for other information anyway, in a private fashion, although this is arguably more developed in the US than in Europe. Provided it is feasible, what is the value-added to mark that information publicly?

Ideally, investors should get the same information as managers, but this is very difficult to uphold in practice as there is understandable reluctance to this. Companies constantly hide or retain some information that they use, especially for innovation purposes, for fear of being overtaken by competitors. So the model proposed by David Phillips might be adapted to Unilever and Microsoft but not all kinds of companies.

It should be reminded that information already goes beyond financial statements. European law insists that non-financial information should be included, and this is already well-incurred in reality today. Now, how binding should the information model be? The EU provides tools which companies can use (through Commission recommendations), and does not consider there is a need for a blueprint. However, some countries, as Germany, are now opting for legislation. The UK legislation provides guidelines and asks companies disclose the information that they actually use for management purposes.

Changing the nature of information does have effects on investors, and therefore has an economic impact. Information can also determine the quality of staff that is hired, the relationships with providers, etc. Moreover, without the right information flowing, the quality of the wider corporate governance model diminishes. However, in favouring a principles based model rather than a model based on legal rules there is the risk that auditors become effectively strategy consultants. This link was, probably rightly, cut several years ago. There is undoubtedly a tension between the job of auditor and being an insider.

Finally, companies today ask for convergent rules on accounting, and also on the whole regulatory burden in general – as well as harmonised interpretation of the rules in Europe. The lesson we should learn from Enron and Parmalat is not that corporate executives are all crooks, but that the absence of check and balances has made the scandals possible. Then, there may be a case for revising the regulatory framework and the incentives that it creates.

Participants

Annalisa Barbagallo, account director, Gplus Europe
Philippe de Buck, secretary general, UNICE
Carlos Buhigas Schubert, policy analyst, the European Policy Centre
Antoine Colombani, associated researcher, Policy Network
Mireille Hijnen, government affairs manager, Microsoft, Brussels
Michiel van Hulten, vice-chair, Policy Network
Eivind Hoff, trade and investment advisor, WWF European Policy Office
Truus Huisman, European Public Affairs, Unilever
Göran Hultin, CEO, Caden Corporation S.A.
Francois Lafond, deputy director, Policy Network
Roger Liddle, member of the cabinet of Peter Mandelson, EU international trade commissioner
Philippe Pellé, deputy head of unit, DG-Internal market and services, European commission
David Phillips, senior audit partner, PricewaterhouseCoopers, London
Antoine Quéro Mussot, member of the cabinet of Joaquin Almunia, EU economic and monetary affairs commissioner
Alain Quévreux, chief of the Europe service, French National Agency for Technical Research (ANRT)
André Sapir, professor of economics, Universite Libre de Bruxelles
Stephen Yeo, CEO, Centre for Economic Policy Research (CEPR), London

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