Corporate governance: European Commission green paper on corporate governance framework

Practical Law UK Legal Update 7-505-5767 (Approx. 8 pages)

Corporate governance: European Commission green paper on corporate governance framework

by��PLC Corporate

Background

On 14 January 2010, the Commission published a study on monitoring and enforcement practices in corporate governance in the member states. The study concluded that, despite deficiencies in the application of the "comply or explain" regime and in light of support for the regime, it should be strengthened, not abandoned (see Legal update, European Commission study on the monitoring and enforcement of corporate governance codes in member states).

On 2 June 2010, the Commission published a green paper on corporate governance in financial institutions and remuneration policies (the June 2010 green paper), which set out the Commission's proposals for dealing with issues, including:

How to improve the functioning and composition of boards of financial institutions in order to enhance their supervision of senior management.
How to establish a risk culture at all levels of a financial institution in order to ensure that long-term interests of the business are taken into account.
How to enhance the involvement of shareholders, financial supervisors and external auditors in corporate governance matters.
How to ensure corporate governance principles are implemented effectively and efficiently.

On 12 November 2010, the Commission published its feedback statement on the consultation (see Legal update, European Commission feedback statement on corporate governance in financial institutions), and on 20 December 2010, it published a roadmap on the follow-up work to its June 2010 green paper. The roadmap indicated that the expected date of adoption of any Commission proposals in response to that consultation would be May 2011.

On 1 March 2011, the Commission called on publicly listed EU companies to sign a pledge to increase the presence of women on corporate boards to 30% by 2015 and 40% by 2020, by actively recruiting qualified women to replace outgoing male board members. The "Women on the Board Pledge for Europe" is to be signed and sent to the Commission. The pledge is a voluntary commitment and on 8 March 2012, the Commission will assess whether this self-regulatory initiative has worked and decide on any further course of action.

For further background on recent European developments in the area of corporate governance that have shaped the existing UK corporate governance environment, see Practice note, Corporate governance: global, EU and UK influences.

The green paper

The Commission's stated aim for the April 2011 green paper is that it leads to a broad debate on the effectiveness of the corporate governance framework for European companies. Certain of the solutions put forward in the June 2010 green paper are specific to the circumstances of financial institutions and may not therefore be relevant to companies more generally. The April 2011 green paper therefore focuses on listed companies rather than on financial institutions.

The green paper addresses three main areas: boards of directors, shareholders and monitoring and enforcement of national corporate governance codes.

Boards of directors

The Commission makes a number of suggestions in relation to the composition of the board of directors:

Separation of the functions of the chairperson and the CEO. The Commission considers that it could be helpful to more clearly define the position and responsibilities of the chairperson, and asks whether, at EU level, it should ensure that the functions and duties of the chairperson and chief executive officer are clearly divided.
Board diversity. The Commission considers that a diversity of board members' expertise and backgrounds is key to efficient board work. It cites a variety of professional backgrounds, national or regional backgrounds and gender diversity as key factors that may help to tackle "group-think".
A board may be able to improve in its effective monitoring of the company if it has recruitment policies in place to identify the skills and expertise that the board needs. The Commission asks whether listed companies should be required:
- to disclose whether they have a diversity policy and, if so, to describe its objectives and report at regular intervals on progress against the policy; and
- to ensure a better gender balance on the board, and, if so, how this might be achieved.
Limiting the number of mandates a non-executive director may hold. The Commission is seeking views on whether to introduce a requirement at EU level to limit the number of mandates that a non-executive director may hold to ensure that non-executive directors devote sufficient time to their companies.
External board evaluation. The Commission refers to evidence it has collated that suggests that, especially in times of crisis, or when there has been a breakdown in communication between board members, an external reviewer can add significant value to a board evaluation. It asks whether listed companies should be encouraged to carry out an external evaluation of the board at regular intervals, for example every three years and, if so, how this might be achieved.
Directors' remuneration. The Commission reports that a number of member states have failed to address adequately the Commission's recommendations relating to directors' remuneration and disclosure (for background on the Commission's recommendations, see Legal update, Corporate governance: further Commission recommendation on directors' remuneration). The Commission also consulted on the issue of directors' remuneration in its June 2010 green paper. Certain respondents to that consultation indicated that they would welcome greater transparency of remuneration policies of listed company directors and a shareholder vote.
In the April 2011 green paper, the Commission is seeking views on whether:
- disclosure of the remuneration policy, the annual remuneration report and individual remuneration of executive and non-executive directors should be mandatory;
- the remuneration policy and the remuneration report should be required to be put to a vote by shareholders.
Risk management. The Commission does not consider it would be appropriate to propose a "one size fits all" risk management model for companies, given the diverse and specific sectors in which different companies operate. However, it considers that, to be effective, any risk policy needs to be clearly set by the board of the directors for the whole organisation. It also stresses the importance of clearly defining the roles and responsibilities of all parties involved in the risk management process. The Commission asks whether:
- the board should report the company's risk policy meaningfully to shareholders, and whether such disclosure should also include key societal risks;
- the board should ensure that the company's risk management arrangements are effective and commensurate with the company's risk profile.

Enhancing shareholders' involvement

The June 2010 green paper also examined the role of shareholders in corporate governance (see Background above). The Commission considers that responses to the June 2010 green paper on the lack of shareholder engagement are, to a large extent, also relevant to shareholder engagement in listed companies with "dispersed ownership".

In the April 2011 green paper, the Commission addresses a number of issues, including:

The possible introduction of a framework for transparency in voting policies of institutional investors. The Commission notes that respondents to its June 2010 green paper were largely in favour of such a requirement.
Short-termism. The Commission asks respondents to highlight any existing EU legal rules which might be considered to contribute to "inappropriate short-termism among investors" and to suggest how such rules might be changed to prevent this.
The Commission considers that short-term incentives in asset management contracts may be part of what leads to asset managers' short-termism, and asks respondents to suggest measures relating to the incentive structures for, and performance evaluation of, asset managers managing long-term institutional investors' portfolios.
Greater transparency about the performance of asset managers' fiduciary duties. The Commission considers that greater transparency about asset managers' investment strategies, the cost of portfolio turnover and the level and scope of engagement with investee companies could give more of an indication of whether or not such activities benefit long-term institutional investors and long-term value creation. In turn, the increased transparency would assist institutional investors in monitoring their asset manager and being more involved in the investment process.
Facilitating shareholder cooperation. The Commission acknowledges the suggestion by respondents to the June 2010 green paper that more uniform rules on acting in concert would help to facilitate shareholder cooperation, which may assist individual investors in engaging more effectively. The Commission is seeking views from respondents as to the best way for the EU to facilitate shareholder cooperation.
The Commission also confirms that it will be looking into issues that investors have highlighted as problematic in the area of cross-border voting as part of its work on harmonising securities law.
Proxy advisors. The Commission notes the concerns raised by interested parties that proxy advisors (who provide services to institutional investors such as voting advice, proxy voting and corporate governance ratings) are not sufficiently transparent about the methods they use when preparing their advice, and may also be subject to conflicts of interest. The Commission asks whether:
- EU law should be introduced to impose more transparency requirements on proxy advisers;
- respondents consider any other legislative measures to be required, for example to introduce restrictions on the ability of proxy advisors to provide consulting services to investee companies.
Shareholder identification. The Commission is considering whether there needs to be a European mechanism to help issuers to identify their shareholders so that issuers can engage with them on corporate governance matters. It asks respondents whether they see a need for this and, if so, how such mechanism might operate.
Minority shareholder protection. The Commission is seeking views on whether the existing EU rules are sufficient to protect minority shareholders' interests in companies which have controlling or dominant shareholders, or whether minority shareholders need additional rights in such cases. The Commission cites the example of Italy, where some of the board seats are specifically reserved for minority shareholders.
Some investors have suggested that, in order to better protect the interests of minority shareholders where a company enters into a related party transaction, the board should appoint an independent expert to give an opinion on the terms and conditions of a related party transaction to the minority shareholders where the transaction is above a specified threshold. The Commission asks for views on whether minority shareholders need more protection against related party transactions and, if so, asks for suggestions of measures that could be taken.
Employee share ownership. The Commission is seeking views on whether (and, if so, what) measures could be taken at EU level to promote employee share ownership.

Applying the "comply or explain" approach

Under the "comply or explain" approach, a company that departs from a recommendation in a corporate governance code must give detailed reasons for that departure. The Commission considers that some adjustments may be needed to improve the application of national corporate governance codes, as a recent study has highlighted some shortcomings in applying the "comply or explain" principle (see Background above). It confirms that any proposals are not intended to change the basic "comply or explain" approach but are rather aimed at "improving the informative quality of the reports".

The study highlighted by the Commission showed that, in over 60% of cases where companies chose not to apply the recommendations of a corporate governance code, they did not provide a sufficient explanation for the departure. The Commission considers that it would be reasonable to require that companies disclose both the reasons for the departure from the recommendation, and also a detailed description of the solution they have adopted instead.

The Commission is also asking respondents whether they agree with its suggestion that monitoring bodies, such as securities regulators, stock exchanges or other authorities, should be authorised to check whether the information given, especially the explanations, is sufficiently informative. It also envisages the possibility of formal sanctions for the most serious cases of non-compliance.

Other issues considered

The Commission raises two other issues for consideration:

Should the EU rules distinguish between different sizes of listed company in the same way as certain member states' corporate governance codes include recommendations which take account of company size and structure and, if so, how might this be done?
Is any action needed at EU level in relation to corporate governance in unlisted companies, for example the promotion of voluntary codes for non-listed companies?

Next steps

The deadline for responses to the consultation is 22 July 2011 and the Commission has said that it will issue a feedback statement summarising the results of the consultation in Autumn 2011. It will then be in a position to determine whether legislative or non-legislative proposals are required, although any such proposals will be accompanied by a detailed impact assessment which will take account of the need to avoid undue administrative burdens for companies.

The Commission has also confirmed that it intends to publish a new framework initiative on corporate social responsibility later in 2011.

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