comparative corporate governance

Annual General Meeting Season….

noreply@blogger.com (Gerhard Schnyder) — Sun, 01 Apr 2007 13:59:00 +0000

The claim for efficient control mechanisms that help shareholders to ‘get their money back’ from opportunistic and self-interested managers is at the heart of the corporate governance debate...but what if shareholders don’t care about these rights?

In recent years, in virtually all countries around the world the level of minority shareholder protection (MSP) in law and in corporate practice has significantly increased: transparency and accounting rules have become stricter, legal venues for shareholders to challenge management and/or board decisions are more numerous, the liability of board members has increased. Shareholders have hence more control instruments available to them then say twenty years ago.

However, despite the increasing possibilities for shareholders to effectively control management, a trend is perceptible which shows that shareholders tend paradoxically to become increasingly unconcerned. One indicator of this trend can be seen in the shareholder behaviour during the Annual General Meetings (AGM). In Switzerland, four signs exist which clearly show that shareholders are not very keen on exercising their control rights.

Firstly, many shareholders who buy registered shares of Swiss companies do not bother to ask the company to be registered in the stock ledger – which is necessary in order for them being able to exercise their voting rights (Boemle 2003). Thus, for up to 40% of the shares issued by Swiss companies, the company does not know who the shareholder is since she does not announce herself to the company (one speaks of Dispo-Aktien).

Secondly, those shareholders who do ask to be registered do not usually attend the AGM and do not bother to send their voting instructions to the company or their bank – which both are legally enabled to exercise the proxy right – either (Boemle 2003). The proportions of represented shares are hence very low. As an example, in 2003 of the CS Group’s 797 million exercisable votes, only 316’000 were represented during the AGM (Boemle 2003)!

Thirdly, those shareholders who do not wish to attend the AGM, but do send back the proxy card to the company so that their votes are represented send them often back without any voting instructions. For these proxies, the board of directors (BoD) can exercise the votes in their own interest (NZZ May 03, 2003).

Finally, the reform of the Stock Corporation Law of 1991 has introduced the institution of “independent representative” which is a person that the company must appoint before the AGM in order to allow shareholders to have their voting rights exercised by an independent person rather than the company’s organs (i.e. a member of the BoD) themselves. However, most shareholders chose to send their proxy to the company directly rather than to the independent voting rights representative as is shown by different studies (cf. study von der Crone in NZZ Mai 03, 2003, Boemle 2003).

Overall it appears hence that a very small proportion of shareholders take the trouble to go physically to the AGM and exercise their control rights, and even the proxy option is only to a very limited extent used in order to control the management. Besides, the main reason for those shareholders that do go to the AGM seems to be linked to sociability rather than any wish to have their say in the company’s affairs. One telling anecdote is reported by Finanz und Wirtschaft, a Swiss financial news paper which published in 1993 an article entitled “No Snack, no Candies, no Interest”. In fact, when Merkur AG (a company specialist in chocolate and candies production) announced in the invitation to the 1993 AGM that due to a share split the previous year, the number of shareholders had considerably increased and that it would therefore not be possible anymore to offer snacks after the meeting and to give a chocolate box to every shareholder, the attendance decreased from 1624 shareholders in 1992 to 703 in 1993.

So, what is all the ‘shareholder-need-more-control-fuzz’ about if they seem to be perfectly happy without these rights? Well, for one thing, one could argue that if shareholders do not use their control rights in an actively, i.e. through ‘voice’, they might just use another strategy i.e. ‘exit’. In other words, if shareholders don’t bother going to the AGM, it may be that they follow the Wall Street rule and ‘sell out if they dislike management’. The question remains, however, if this type of control over management is really efficient enough to avoid managers’ opportunistic behaviour and especially outright fraud and mismanagement.

It should be noted however that exceptions exist from the rule that shareholders are passive in Switzerland. One example is the Ethos foundation – a foundation managing the money of several pension funds – which has started to oppose actively the proposals of that the BoD submits to the AGM if they are not happy with them. As an example, the proposal of Novartis CEO Daniel Vasella to renew his double-mandate during the AGM of March 7, 2007 as well as the amount of his compensation have been fiercely contested by Ethos…without success however.

Be that as it may, it is somewhat ironic to see that all the efforts to revive the so-called “shareholder democracy” which has been debated in politics at regular intervals since at least the 1970s have not yielded fruit. Especially, one argument to explain the notorious passivity of Swiss shareholders that came up in all debates about shareholder democracy was that due to the proxy votes represented by banks – which were as a rule exercised in favour of the BoD’s proposals – it was impossible for minority groups to influence the decisions of the AGM. The absence of active shareholders was hence attributed to a feeling of powerlessness by the shareholders. At the beginning of the 21^st century, proxy voting by banks has become virtually inexistent; however, the shareholders’ behaviour did not change. Obviously this argument neglected the fact that shares have become more and more a means to increase one’s personal wealth, losing more and more their concrete signification, i.e. to be a security giving right to a part of the control over the company. This is what Schumpeter meant by saying that property which is detached from the person and from matter does not generate any sentiment of loyalty. As long as the company – or rather the share price – is performing reasonably well, there is not much reason for a minority shareholder to care about the company of which she is – theoretically – a co-owner…

Organisational Control Structures and Integrity

noreply@blogger.com (Gerhard Schnyder) — Sat, 03 Feb 2007 10:56:00 +0000

I think it’s useful to discuss a bit more in detail Julien’s comment on my post on whistle-blowing. In fact, his very relevant point concerning the “capturing” of external control by the controlled makes me think of Arthur Andersen or the external auditing in general. In fact, audit companies are precisely supposed to perform an external control on their clients, making sure that the accounts are right. The problem however is precisely, that “outside” does not mean “independent”, “neutral”, or “without personal interest”. Any durable social relation implies some degree of mutual dependence. This is notably true for an auditing firm and its clients: the firm is dependent on revenues that are paid by the client and the client-firm is dependent on the auditor’s favourable report. This mutual dependence can eventually lead to a situation where the interest of both conflate or at least overlap in large parts, especially when confronted with interests of actors which are not involved in this relationship. When an auditing firm like Arthur Andersen makes large parts of its profits thanks to a mandate in one particular firm, it seems very likely that they do not want to upset this valuable client and may turn a blind eye on some practices that they would otherwise consider to be problematic.

The problem lies hence in the confusion of the term “outside” and “independent” and especially in the difficulty to establish social relations between the controller and the controlled that guarantee that this relationship will allow a genuinely independent control.

I guess that’s precisely what Alain Minc meant when stating that “the independence of directors is an alibi” (thanks Julien for sending me this link). In this interview Minc – chairman of the supervisory board of the French newspaper Le Monde and business consultant – states that the idea of “independent directors” is largely an illusion. In fact, ‘independent directors’ is often synonym with ‘incompetent directors’ since they don’t know the company which they are supposed to control. The trade-off he suggests is that the more a director is “independent”, the less well she knows the company and hence the less competences she has to play her role as controller and vice versa: better knowledge of the company implies necessarily closer personal or professional relations and hence less independence.

According to Minc, the claim for independent, non-executive directors serves mainly the managers to increase their power. I made a similar point in an earlier posting when talking about “structural holes” that may appear between the board and management when too many non-executive directors sit on the board, allowing the CEO to exploit his informational advantage. Minc is right when stressing that people that sit on a board do necessarily have some kind of personal or professional ties, since they are part of the same rather small social group, the business elite. These ties are not per se a problem. Or rather, since they are inevitable, we have to deal with them. The challenge is hence to create organisational structures that allow an efficient control despite these social ties. Minc states that the solution is transparency, i.e. each director has to openly declare her ties. I don’t think that this is enough. Minc who holds seats in different companies with sometimes conflicting interests states that he does not intervene in decisions that could imply a conflict of interests. This, however, cannot be legally enforced or controlled, but depends entirely on the integrity and the business ethics of the director in question. In such a situation, transparency without enforcement mechanisms does not allow for efficient control.

Efficient control might in fact be function of different dimensions that have to be efficiently combined: internal control, external control (by state agencies for instance), and market control. One could ad the dimensions peer-control, sectoral control by associations etc. (see Arndt Sorge’s recent book “The Global and The Local” pp.190f for a listing of different dimensions). The empowered third-party control, which Julien mentions in his comment, can indeed be seen as one possible combination of these instruments. But as he mentions as well, it looks like there will always be a part of the control structure which is contingent upon the actors’ integrity, and the risk of fraudulent behaviour cannot be entirely eliminated by organisational design. The efficiency of control mechanisms can be enhanced by the existence of a self-imposed “ethical code” among the business elite, and a social control among these elite guaranteeing the observation of this code. Without social norms within the elite condemning fraudulent behaviour and hence pushing managers to refrain from abusing their power, any control structure can ultimately be bypassed in one way or another…Unfortunately such social norms seem to have gone out of fashion in a more and more cynical society where hedonism and personal profits rank among the highest values…

What Links the “Hold”-Strategy to the Swissair case?

noreply@blogger.com (Gerhard Schnyder) — Wed, 17 Jan 2007 00:13:00 +0000

Last monday’s NZZ (January 8, 2007) ran a very interesting article on financial analysts in Switzerland. The article reports on a study carried out by StarMine concerning buy recommendations made by Swiss financial analysts. The study shows that Swiss financial analysts recommend more often than financial analysts in other countries to “hold” shares rather than “buy” or “sell”. In fact the hold strategy is the most common recommendation in Switzerland! A hold strategy implies, so the journalist argues, that the analyst recommends a shareholder who possesses already the share in question not to sell it, but other clients who do not have shares from the same company, not to buy them. Different clients get hence contrary advice from the same analyst, which shows that a hold strategy is theoretically not justifiable. Either a share can be expected to out-perform the market in the future, in which case the analyst should suggest a buy strategy, or it will under-perform, in which case the shareholders should sell out their stake.

What is interesting is the explanation the journalist gives for this phenomenon: “Switzerland is a small country, and the smaller a market is, the stronger are personal ties. The probability that a financial institution in a small country that recommends selling a given share is at the same time a creditor of the company in question is much higher than in a large market. […] The fact that in a small country like Switzerland everyone knows each other is enough to result in a situation where none wants to put the other’s nose out of joint” (my translation). Hence, a tendency of Swiss analysts to recommend – following an age-old Swiss penchant for compromises – the “hold”-strategy.

The “hold”-strategy phenomenon is indeed an excellent example of how the Swiss business system works. It shows a central feature of the Swiss economy, i.e. the existence of the “Filz” (“sleaze”). This term designates the multiple interweavements of the members of the Swiss business elite among each other and their connexions to other sub-spheres of the society such as politics and – in the past – the army. Switzerland seems in fact to illustrate very well the concept of the “power elite” – a term coined in 1956 by C. Wright Mills – which controls not only the economy but also other sub-systems of society. This phenomenon, i.e. the same people are influential in different spheres, is not necessarily a conscious strategy – although it can – but the simple fact that the elite is very concentrated in this country leads to situations where close personal ties become inevitable. This becomes particularly clear when looking on board overlaps between companies. Philippe de Weck, former CEO of the Swiss Bank Corporation once stated:

“[i]t is correct that there is in human nature a certain tendency to form clubs and that this tendency is maybe stronger in Switzerland than elsewhere. […] And we also have clubs of boards of directors. This tendency is maybe more pronounced in the German part of Switzerland than in the French-speaking part. In several parts of German-speaking Switzerland, the mentality of the population is still very much affected by the corporations. One can feel that there has been an age-long tradition of trade guilds. And the natural tendency of clubs is to be somewhat closed. In my opinion, this is the reason why, during the years of the economic boom between 1950 and 1970, a certain club mentality developed – certainly without deliberateness - concerning board of directors. I meet you here, so why don’t you come there; I know you, I know how you think; if we take someone else, I don’t know him, maybe it won’t work out with him, etc.” (de Weck 1983: 93; my own translation)

Regarding this “club mentality” and the fact that the board of directors of Swiss companies overlapped – until recently – very strongly, the role of banks is usually considered being particularly important. In fact, due to the importance of banks for non financial companies banks are regularly suspected to take profit of industrial companies in order to satisfy their own, purely financial interests. Thus, Rudolf Hilferding criticised in 1910 already the power of banks and their influence on other companies through their presence on the board of other companies and through their role as capital provider (later on, in 1928 more precisely, however, he started to consider the concentration of capital as a step towards an organised form of capitalism and towards the Stamokap (Staatsmonopolkapitalisum) (see for the question of the socialist criticism of the concentration of economic power since the late 19^th century the excellent essay by Martin Höpner). Louis Brandeis criticised in 1914 how US investment bankers used “other people’s money” in their own interest. Sergei Illitsch Ulianow was enthusiastic with both Hilferding’s and Brandeis’ analyses and argued – in a book called “Imperialism: the Highest State of Capitalism” published in 1916 – that the situation in Germany was not much different from the one described by Brandeis. This debate reached eventually also Switzerland. The socialist author Fritz Giovanoli analysed and critisised in his book from 1937 “Libre Suisse, voici tes maîtres” (“Free Switzerland, here are your masters”) board overlaps and the concentration of power in the Swiss business elite. Since then, the debate about the power of banks re-emerges periodically.

Be that as it may, several facts show that the “power of banks” is not as complete as political propaganda suggests. In fact, Swiss banks seem at least as useful to industrial companies as the other way round. To name but one example, Swiss banks controlled usually large amounts of votes during the Annual shareholder meeting of industrial companies because the bank clients who held shares in the company in question could delegate the voting right to a bank representative. This gave banks a considerable potential power of non financial companies. However, as a rule, banks always cast their votes in favour of the board of directors’ propositions to the AGM. During long time, they did so even if the bank client wished that her votes be cast against the board! This shows that banks were loyal to the management of the company and clearly not acting in their own interests. This is of course by no means a self-forgetful behaviour of the banks, but shows that banks – or rather bankers – conceive of themselves as part of a very cohesive business elite.

This cohesion has actually once again made it to the front pages of Swiss newspapers. In fact, this morning started the process against the former directors of the national airline Swissair. In the graph below, I try to illustrate this cohesion. In fact, I took the former directors of Swissair who will appear in court starting from today. Based on a data base on the board compositions of the 100 largest Swiss firms, I looked what board overlaps between Swissair and other large Swiss companies the accused former directors created. (The data base was actually created at the Universtiy of Lausanne in relation with a research project funded by the Swiss National Science Foundation in which participated prof. Thomas David, Dr. André Mach, and lic hist Martin Lüpold).

The people whose board seats I took into account were the following defendants: Philippe Bruggiser, Mario Corti, Gerhard W. Fischer, Jacqualyn Fouse, Bénédict Hentsch, Antoine Höfliger, Eric Honegger, Andreas F. Leuenberger, Lukas Mühlemann, Thomas Schmidheiny, Georges Schorderet, Verena Spoerry, Gaudenz Stählin, , Andreas Simmen, Andreas Länzlinger, Scott Cormack, and Karin Anderegg Bigger. The snapshot takes into account board positions in 2000, i.e. just one year before the debacle. The lines symbolise ties that are created by a director sitting at the same time in two companies. Thicker lines indicate that the companies in question shared several directors:

What does the graph show? Well, it certainly shows that the people that appear in court starting from this morning are not some strange outsiders with dodgy business practices….these people are the very core of Swiss business. This is no big surprise since it has been repeated over and over again since the grounding of Swissair in October 2001. However, what the graph shows visually is how delicate this corporate failure is for the Swiss economy as a whole. In fact, at least ten major companies are directly linked to one of the accused. Hence the dilemma linked to this case: if the accused – or some of them – are guilty, the integrity of the whole business elite will be put into question. If they are not guilty, however, the failure of Swissair is not due to criminal behaviour but to… incompetence, which of course puts the whole business elite not less into question. Maybe, this explains why one of the few things that Gerhard W. Fischer said to the judge this morning was that the debacle would not have occurred without 9/11! Someone has to be guilty after all!

Be that as it may, all this very much confirms what Peter Katzenstein said in 1985 about small states in world markets: The elites in small countries seem to close ranks in order to face threats from outside…

Helping the State: The Role of the Press and Whistleblowers in Fighting White-Collar Crime

noreply@blogger.com (Gerhard Schnyder) — Sun, 12 Nov 2006 23:21:00 +0000

Yesterday’s Tages Anzeiger (November 11, 2006, print edition) revealed a new „corporate scandal“ in Switzerland. This time, however, the scandal is somewhat special. In fact, no law was broken, no regulation by-passed, and no company went bankrupt. What happened? According to the newspaper, 40 mangers of Cablecom, a non-listed telecom company, had acquired during the takeover of the company by American institutional investors in the fall of 2003 a 8% stake in their own company for CHF2.8m. two years later, when the company was sold to the US group Liberty, the same 8% stake was sold by these same mangers for CHF144m. This is of course not shocking in itself. However, what the popular Swiss newspaper Blick decries as being outrageous is the fact that the same year, i.e. in the fall of 2005, the management of Cablecom announced the layoff of 260 staff. Once more, the unlimited greed of the managing elite seems to contrast starkly with the hardship that the “normal” employees have to endure.

Be that as it may, what is interesting in this case is the way in which this issue was made public. In fact, Cablecom, as non-listed company, does not publish any annual report or accounts. Hence, no information about the value of the company and the shareholdings of its executives is available. In fact, the above-mentioned facts and financial figures where made public by an employee who got hold of a copy of the “confidential” annual report and informed the press.

Even though this particular case is, at most, a case of reprehensible moral behaviour (realising a benefit of 5000% on one’s investment and at the same time laying-off 260 staff in order to reduce costs), the mechanism that was at work is very important. Several academics in the field of finance have expressed the view that a functioning (financial) press – i.e. one that is precisely capable of revealing this kind of incidents – can serve as a functional equivalent for legal protection of investors and other stakeholders that do not control the companies decision-making process. In other words, in countries where minority shareholders and other minorities in the firm are not well protected in company law, the public denunciation of “crooks” in newspapers can have a deterring effect on other potential crooks and can permit to punish crimes that otherwise would go unpunished. This at least is the thesis defended by Alexander Dyck and Luigi Zingales in their study on private benefits of control.

This brings us back to a point, which I’ve made in several previous posts. In fact, I have pointed out the limits of public regulation for preventing “misbehaviour” by corporate insiders. The financial press is in fact a mechanism that can denounce criminal or unethical behaviour, push the corporate elite to justify their actions, and put certain issues on the political agenda by creating a public pressure. Even though such mechanisms can of course be (ab)used for populist goals, the financial press can exercise a certain control over corporations in ways that the state cannot.

This is especially the case, where there is no immediate clearly identifiable victim of the insiders’ actions. Most legal offences of corruption are such cases: none is immediately harmed and none is hence going to file a law suit against the delinquent. In such cases, the denunciation of crimes – or supposed crimes – to the press by another corporate insider can prove to be the only way to stop this kind of wrongdoings.

The legislators in different countries seem to have understood this and have adopted legislation that aims at protecting the so called “whistleblowers”, i.e. employees of a company that denounce the fraudulent and criminal behaviour of their collaborators or superiors. In the US, the Sarbanes-Oxley Act reinforces the protection of “whistleblowers”. In Switzerland, following the initiative of a social democratic and a radical democratic MP (Remo Gysin and Dick Marty), the Parliament has asked the Federal Government to elaborate a proposition in order to legally protect whistleblowers. Also, the Swiss branch of Transparency International has established in April 2005, in collaboration with the Federal Government, a hotline for whistleblowers (cf. NZZ Online, October 5, 2006). Once a week, people who detect criminal or unethical behaviour within their company can call this hotline in order to denounce their colleagues. What may appear at first glance as disloyal behaviour towards once company is in fact an important mechanism of corporate control.

All countries, however, do not seem to adhere to this view. Thus, in May 2005, the French commission on the protection of data privacy (Commission nationale de l’informatique et des libertés, CNIL) has prohibited two companies to establish such “ethical lines” for whistleblowers, fearing that such hotlines could lead to an “organised system of professional denunciation”. The risk of some whistleblowers being motivated by personal motives rather than a genuine will to knock criminal behaviour in their company on the head can of course not be completely excluded. However, such hotlines do constitute an instrument for fighting crime, in a place where the state has no chance to do so.

Manager Compensations: A Populist Fight with Windmills?

noreply@blogger.com (Gerhard Schnyder) — Tue, 31 Oct 2006 09:33:00 +0000

Yesterday’s Swiss newspapers reported the launching of a popular initiative against corporate “rip-off”. A popular initiative is an instrument that allows Swiss citizens to submit a proposal for a constitutional amendment to a popular vote if they manage to collect 100’000 signatures. This “anti-rip-off initiative” proposes, in a nutshell, that the “shareholder democracy” should be strengthened by granting the annual general shareholder meeting (AGM) the right do decide about the total wage bill, bonuses, and other forms of remuneration for mangers and board members. Moreover, executives that occupy a full-time position in the company, but hold other mandates (such as board seats on the boards of other companies) should be obliged to pay a part of this additional income to their principal employer. (NZZ online, October 30, 2006).

What were the reasons for the launching of this initiative? The originator of the initiative Thomas Minder, owner of a small-sized company called Trybol AG, states in an article published in NZZ online october 30, 2006 that he has always been annoyed with the fact that managers pocketed millions in indemnities and compensations, wheras their company announced losses. The immediate reason for the launching, however, Minder says, was the Swissair debacle.

These arguments may seem somewhat bizarre. In fact, excessive executive remunerations are a real problem of corporate governance. However, they concern mainly the shareholders (whose money is paid in excessive salaries) and the other employees of the company (who can consider that it is not justified that they should earn as much as 500 times less than their boss). Hence, the corporate governance problem with excessive remuneration is one of expropriation and agency costs and of distribution of value added. In other words, if a manager of a company is paid too much, this is the problem of the shareholders of that company and of other employees.

So, what has the Swiss citizen to do in this? What is her interest in granting shareholders more control over executive remuneration? Of course, one could argue that most Swiss citizens are now shareholders since a part of their pension fund assets are invested in shares, but the real reason is arguably another. In fact, the whole problem boils down to a question of “social justice” or, to put it in a slightly more polemic way, to envy. In fact, people who have troubles to make ends meet (1m persons in Switzerland have a net income of less than 2450.- CHF a month, whereof approximately 200’000 are “working poor”) can just not understand why some people should earn as much whereas the same economic system seems not to be able to pay them a decent salary.

Also, since the 1980s, like in many industrialized countries, the citizens have become used to hear the litany of the importance of saving costs. Not only in the corporate world, but especially in the public sector: social benefits are continuingly reduced in all sectors with the arguments of budgetary discipline and reducing of public debt. The same is true in corporate life: real salaries of “normal” workers have stagnated or even decreased during the largest part of the 1990s. In such a situation, it is hard to understand for John Doe why management salaries should increase by 18% a year and where this money comes from. Since the end of the postwar boom, the sentiment that economics is a zero sum game has been reinforced: if someone gets a larger part of the cake, someone else has to lose. Hence, an increasing ressentiment against excessive salaries.

As understandable as such feelings may be two questions suggest themselves: firstly, how problematic are the current levels of executive remunerations really? Are they really excessive or do they reflect extraordinary achievements? Or in other words: what are “objective” criteria to assess if managers earn too much? The answer the initiative suggests is that the only ones that can tell are the shareholders, which seems a fairly reasonable approach.

Secondly, is a popular initiative the right means to tackle the problem – if there is one – of executive remunerations? In fact, it is of course not very difficult to find support for such an initiative among the voters, since most of them do not earn salaries of several millions a year. Notoriously populist actors such as the tabloid newspaper Blick – which is worldwide one of the only left-wing tabloid newspapers – are of course very eager to support this initiative. So is such a populist strategy the right answer to a real problem of corporate governance?

Concerning this latter point, one argument of Minder for his initiative is that the new reform proposal of the Stock Corporation Law, which will be debated by the Parliament sometime next year, does not contain any proposal concerning management remuneration. According to Minder, this is due to the fact that the majority of MPs are themselves part of the Wirtschaftsfilz (literally: the “economic sleaze”) and do not wish to curtail their own power and material benefits (NZZ online, October 30, 2006). And he’s probably not completely wrong. In that sense, the popular initiative may be a good means to put on the agenda issues that the political elite – which are of course very close to the business elite notably because of the non-professional Parliament in Switzerland (Milizsystem) – would refuse to address.

What is very interesting, however, is that the initiative does not originate from left-wing parties or trade unions but from the milieu of the SME. In fact, many owners of a SME seem to be sympathetic with Minder’s initiative (see the article in today's Blick) despite the fact that they are on the same side of the class divide as the managers that are aimed. According to the comments one could read in the press, their aim seems to be to fight the greed of the execs of the top firms in the name of economic integrity and of a now bygone way of doing business, where the boss and owner of a company (the “patron”) was preoccupied with the well-being of his employees and not just with his personal benefits. This reflects very well the divide between two parts of the Swiss economy, i.e. the large multinational companies oriented towards international markets and the vast majority of SME who produce mainly for the domestic market, which have different needs and interests and different views on corporate culture and values in general. In a way, the ‘anti-rip-off initiative’ is but a new episode in a conflict that has opposed the two parts of the Swiss economy for a long time.

Skilling and the Dark Side of the System: Temptations, Laws, and the Importance of a Systemic View on Corporate Scandals

noreply@blogger.com (Gerhard Schnyder) — Thu, 26 Oct 2006 23:41:00 +0000

Earlier this week, Jeffrey Skilling, former CEO of Enron, was sentenced to 24 years and 4 month in jail for his role in what has become to be known as the one of the biggest cases of fraud in the history of the

economy.

Coincidentally, I watched the excellent documentary on Enron “Enron: The Smartest Guys in the Room” just a couple of days before. This movie sets out in a very entertaining but still highly substantial way the history of Enron from its beginnings in the 1980s until its collapse. It is really highly recommendable!

There was just one thing that kind of bothered me: the whole film focused very much on the personality of the people that were involved in the fraud. At some point, the filmmakers suggest that the criminal activities of the Enron execs were somehow linked to their need to prove their manliness (they loved to show-off with scars they got during motorbike races etc.).

This completely blinds out the more systemic aspect of the Enron scandal. Maybe this criticism is not justified, because there are scenes in the movie that suggest that it was not just the problem of one isolated firm, but that the whole scandal implied more people then just the nerdy Enron execs. Thus, the involvement of all major US (and some Swiss) banks, of law firms, and of Arthur Andersen are discussed. This shows that such behaviour is not necessarily linked to a particularly evil and ruthless CEO, but is rather the result of the system as a whole. From the simple employee to the CEO of any industrial corporation, bank, or any other type of business enterprise, every single one has first and foremost to live up to the expectations that are set in her in order to keep her job. This creates pressures from a various sides – your boss, your colleagues, the stock market, creditors, clients etc. – and leads to situations where cheating can appear appealing. Especially the expectations of stock markets press more and more down on listed companies. Will the quarterly report satisfy the investors or will it lead to a decrease in the share price, exposing the company to the threat of hostile takeover or to me losing my job? In such a situation, it doesn’t take a Jeff Skilling to be tempted to find a way to satisfy these expectations…In the movie this is best expressed, I find, in the recordings of the taped telephone conversations between Enron traders during the Californian Energy Crisis of 2000 (the tapes can be down loaded on the movie web page). The cynicism of these conversations is just outrageous…but at the same time not very surprising.
At least since Hanna Arendt’s book on the Eichmann trial in Jerusalem, we know that anybody has to some degree the potential to “act evil” when the circumstances are favourable to such behaviour. In a highly competitive business environment where the stakes are very high for each cog in the machinery, the circumstances are ideal to put aside ethical and legal considerations. What I’m saying here is not meant to excuse such criminal – or even “just” unethical – behaviour. My point is that it’s too easy to say that Enron collapsed because Jeff Skilling is a particular ruthless person. That was also Sheron Watkins’ – former executive of Enron – point, I believe, when she said in one scene in the movie that Enron is not an isolated case – except for the extent of the fraud maybe – but that this can happen in any company. And apparently it happens more and more often, not just in the US but all over the world. White-collar crime is on the rise...

In yesterdays’ Echo der Zeit – a Swiss radio show on DRS 1 – a study on white-collar crime in Switzerland that was carried out by PWC was quoted. It states that in 2003 25% of the Swiss companies were affected by some sort of white-collar crime (mostly though embezzlement and fraud). One year later, this proportion had risen to 33%. Another study, carried out by, KPMG finds even higher proportions.

The trend seems to be towards even more white-collar criminality in the future. Thus, the Swiss Federal Police Office identifies in its Report on Homeland Security 2005 – still according to Echo der Zeit – a particular risk of criminality in the hedge fund industry.

Recent examples of supposedly criminal behaviour by managers (most of them have not been sentenced yet) are many in Switzerland and I have alluded to several of them in previous postings (Swissair and Swissfirst notably, but others can be cited such as OZ Bank, the SUVA scandal etc.).

Again the legislator has undertaken steps in order to counter this development: A reform proposal of the Stock Corporation Law has been elaborated by the Federal Administration, a public supervisory agency on audit companies will take up its activities in 2007 and legal responsibilities concerning corporate fraud have been newly defined: since 2003, the company as a legal entity can be held responsible for crimes committed by its employees.

However, and that’s the point I want to get at, it seems that the problem – in Switzerland – is not so much the legal framework than its implementation. In fact, in yesterday’s Echo der Zeit, Christof Müller – a lawyer and specialist in white-collar crime – stated that Switzerland lacks behind other countries not so much concerning the legal framework, but concerning the implementation of these rules. As an example he compared Enron, the Parmalat case in Italy to the Swissair case. All three scandals happen approximately at the same time. However, whereas the in the Enron case the trial court has rendered its judgement and the Parmalat case is well undeway as well, the Swissair case has barely begun. This is precisely what Julien was suggesting in one of his comments on my previous post on corporate scandals: rather than talking about the number of legal rules that exist, we should talk about the resources that are provided for the achievement of a certain goal. In Switzerland, the judicial system seems to lake the necessary resources in order to implement the laws that already exist. What good could new laws do in such a situation? The problem is not just one of efficiency but touches the question of justice directly. In the Swissair case for instance several of the accused are almost sure that there crimes will be prescribed by the time the process will begin. Again, this suggests that talking about new laws may not be the decisive issue after all…

Corporate Scandals, Economic Crises, and the State

noreply@blogger.com (Gerhard Schnyder) — Sat, 07 Oct 2006 00:40:00 +0000

Karl Marx predicted that the successive economic crises, which are inherent to the capitalist system, would eventually lead to revolution and to the downfall of capitalism. Max Weber contradicted this view in a speech held in Vienna in July 1918. Not revolution, but increased regulation of economic activity – either through economic actors themselves or through state action – would be the consequence of economic crisis. Hence, each crisis would lead to an increase in economic organisation, i.e. to a development away from the original liberal (or savage) capitalism towards a regulated form of capitalism.

This latter view is highly relevant to the contemporary debate on corporate governance. In fact, an analogy can be made between economic crisis and corporate scandals. Of course one could object that a corporate scandal, involving only one company, cannot be compared to a full-scale economic crisis that can menace the wealth of an entire population. Right…but still, if we look at the size of modern companies, the analogy does not seem that far-fetched after all. Multinational companies (MNCs) have annual sales that exceed the GDP of not just some poor sub-Saharan states but of quite large European countries (e.g. the sales of Ford exceeded the GDP of the Czech Republic in 2005 by far). Hence, corporations have become enormous economic entities and the failure of such a company, one could argue, have an economic impact that can be compared to an economy crisis.

Be that as it may, Max Weber’s prediction has been supported by evidence from many crises and scandals throughout the 20^th century. From the ‘Kreuger Crash’ triggered by the suicide of the Swedish ‘Match King’ Ivar Kreuger on March 12, 1932 in Paris, to the failures of Enron and WorldCom, corporate failures have often had as a consequence an increased activism by policy makers and major changes in the legal framework governing the economy. And there are certainly good reasons to do so. In fact, corporate failures and economic crises are bad for those involved, but good for people who are interested in understanding the functioning of the economy. In fact, crises and scandals reveal the functioning of the economy much better than any other economic phenomenon. They reveal loopholes in the existing legislation, and allow us to learn a great deal about economic practices that develop in between the lines of the legal text. This can be profitable to policy makers. In fact, policy making is of course much easier with the benefit of hindsight. So, why should the state not learn from past mistakes and integrate the new insights in new laws?

Well, many examples show that the scurried adoption of legislation subsequent to a scandal might not always lead to the best results. Take the Sarbanes-Oxley Act of 2002, which was adopted right after the Enron and WorldCom disasters when the gun was still smoking. Of course, this piece of legislation brought about some improvements notably concerning accounting rules. However it was adopted – under the pressure of the popular outrage – first and foremost in order to show that politicians are capable of effective crisis management. The result was a not so well thought-out law that introduced arguably unrealistic dispositions implying enormous costs for companies. The compliance costs with the SOA were especially for smaller companies completely out of scale so that the Securities and Exchange Commission (SEC) eventually proposed to exempt them from compliance at least with section 404 of the SOA (Report of management on internal control over financial reporting).

A similar precipitous law could be adopted in Switzerland in the near future following the Swissfirst scandal that I wrote about in an earlier posting on this blog. The alleged corruption scandal around the merger of Swissfirst and Bank am Bellevue, implying several pension funds, has opened a breach for all sorts of regulatory moods. Politicians agreed quickly on the source of the problem, i.e. the so called “parallel trading”, which designates the fact that the administrators of pension fund assets buy privately the same shares as they buy for their fund. In the online edition of the NZZ of October 4, 2006, one could read that politicians of all political orientations attacked this ‘new’ evil. The administrators of pension assets, so they argue, should be prohibited by law to trade with the same shares as they buy for the fund. One Social Democrat in the lower house described the ideal pension fund administrator as “a eunuch in a harem” (NZZ October 4, 2006)!

Such a rule may seem sensible at first glance. Especially if one thinks of another – minor – recent scandal that implied one of the investment companies belonging to Bank am Bellevue, BB Medtec. This investment company published, in August 2006, a report for its customers recommending buying shares of Nobel Biocare. At the same time, BB Medtech had reduced its own stake in Nobel Biocare from 10.2% in December 2005 to 9.6% in June 2006. It probably even further reduced that stake after that date since BB Medtech refuses to disclose its current stake in that company (NZZ, September 24, 2006). This kind of behaviour is of course unacceptable. Yet, what the Swiss Parliament is actually aiming at are – consciously or unconsciously – not such very problematic contradictions between one’s own trading strategy and recommendations to ones costumers. The discussions turned explicitely around parallel trading, which does of course not do any harm to whosoever. In fact, prohibiting these kinds of activities would even contradict a central principal of good corporate governance as it is advocated by many corporate governance specialists, i.e. the fact that the management of a company should hold stock (or stock options) of the company they manage. This permits to link the managers personal wealth to the company’s success, creating thus necessary incentives. Similarly, a pension fund administrators who buy the shares they also buy for their fund is a sign of the conviction that the fund’s investment strategy is a good strategy and will potentially make administrators more attentive to the evolution of these shares.

Hence, ‘parallel trading’ is clearly not the most urgent problem – if it is a problem in the first place – that the legislator should tackle. In fact, Here, policy makers propose – under the pressure of public opinion and because an opportunity window for new regulation was opened by the scandal – to regulate a question, which is not even remotely responsible for the actual scandal. The question is if politicians are aware of the fact that they are off the mark concerning this question, but just don’t care, or if this the result of overhasty policy making. Be that as it may, rather than firing a snapshot in the heat of the battle, what the Swiss Parliament should do in this situation is continue the reform of pension fund surveillance that was commenced by the Federal Government before the Swissfirst scandal. Maybe for once the proverbial slowness of the Swiss decision making process can have a positive effect in the sense that in a couple of weeks factual and dispassionate problem-solving could be possible again …

The Great Transformation of Corporate Finance and its Impact on the Economy

noreply@blogger.com (Gerhard Schnyder) — Thu, 28 Sep 2006 12:11:00 +0000

I just came across a very interesting special report on corporate finance in yesterday’s Financial Times. In the leader, Gillian Tett shows that a variety of new instruments for debt financing has emerged in recent years. This evolution changes profoundly corporate finance and constitutes one of the most important driving forces behind the current changes in European corporate governance. In several earlier postings on this blog I touched on this subject, but I never actually discussed it more in depth.

So, how does the increasing resourcefulness of financial institutions affect the functioning of corporate governance? Well, in many ways as I will show. But let’s start with the cause of this evolution: the increasing variety of financial instruments, that is.

People that are familiar with the Swiss economy might remember the uproar that was created by Martin Ebner, when he first introduced a new equity instrument in Switzerland, which he got to know during is stay in the US. The so called Stillhalteroptionen allowed Ebner to issue options on shares of Swiss companies in his possession, which he blocked in a depot. The advantage was that these very expensive shares could be split into smaller parts, which were affordable for the small saver. This was a first step in Ebner’s quest to transform the Swiss into a people of shareholders…but that is another story.

What is important for the question of corporate governance, is the fact that the introduction of this instrument had an important impact on the evolution of the financial markets in Switzerland and that this kind of innovation of financial instruments seems more and more to reach not only equity but also debt markets. In fact, the functioning of Stillhalteroptionen resembles what is usually called securitisation of loans. This latter development means that banks grant loans to corporations and issue, then, themselves bonds on this loan portfolio. This allows them – among other things – to transfer the risk of the loans to the purchasers of the bonds. The same can be done with bonds, or in general with any kind of debt. This kind of securitisised loans are usually called Collateral Debt Obligations (CDO).

A multiplicity of very complex instruments and ways of financing debt has been created recently. What is important for my purpose is that the issuing of this kind of debt instruments is less and less the exclusive hunting ground of commercial (or universal) banks. In fact hedge funds, who are often ready to take considerable risks, have become important actors on this market.

This evolution has, according to Gillian Tett, lead to an increased accessibility of finance notably for companies that are in financial trouble. One remembers the negotiations between ‘financially challenged’ companies and banks for new loans (e.g. Swissair). This situation has, according to Tett, considerably changed in recent years: “[W]hereas these companies would have once been forced to turn to commercial banks [in order to obtain new loans], there is now a growing tendency for troubled companies to use hedge funds or other sources of capital […] (FT September 27, 2006).

Now, what does this mean for the functioning of corporate governance? One important consequence is of course that the role of banks changes in important ways. Banks used to play a central role in the functioning of the economy especially in countries with strong universal banks – i.e. banks that are active both as commercial banks (loans) and investment banks (equity issuing etc.) - such as Switzerland and Germany. Universal banks grant loans to corporations, they issue equity for corporations, advise them in merger and acquisition activities and controlled, moreover, important portions of voting rights during the Annual General Meeting of these companies through a proxy voting system that allows them to vote for bank clients that did not wish to attend the AGM. This is why Continental European Corporate Governance Systems are usually called ‘bank-centred’ systems.

The central role of banks and their multiple channels of influence on industrial companies gave periodically rise to criticism of the power of banks and their damaging influence on industrial development. The most extreme theories postulated that banks consciously accepted the bankruptcy of a company that was under their controlled in order to get the maximum out of the company’s assets.

In Switzerland, the Anti-Trust Commission was mandated in the 1970s to elaborate a report on the power of banks (Oddly enough, the report of 1977 concludes that – despite the multiple channels of influence that are shown by the report – the banks actual influence on industrial companies is very limited).

Be that as it may, the recent evolution of corporate finance led to a situation where industrial companies do not seem to rely so much on banks anymore, but they take out loans from other financial institutions or rise capital directly on equity markets (in the latter case, one speaks of disintermediarisation). Consequently, industrial companies are more and more independent from banks.

Yet, banks are not just the victim of this evolution, but they reorient themselves voluntarily their activities towards more profitable activities than loans. This becomes apparent when we consider that small- and medium-sized enterprises, who cannot raise funds on capital markets as easily as large companies, complain about the “credit crunch” that results from banks reluctance to grant loans. A glance at the composition of the balance sheet of Swiss banks illustrates the decreasing importance of loans for bank income (see graph below): If in 1955 more than 70% of the income of Swiss banks came from interests (i.e. from loans granted to corporations and individuals), by 2003 this proportion had fallen to about 40%. At the same time commission and fee income, from M&A advising and issuing activities for industrial corporations, has increased to reach about 40%, the rest stemming from trading activities.

Source: Swiss National Bank, Annual reports, various years

One important consequence of the disintermediarisation and the strategic reorientation of banks away from the loan business, which goes together with the increasing independence of industrial companies, is the anonymisation of relations between banks and industrial companies. In fact, credit activities are usually considered to be relationship-based activities, implying close personal ties between borrower and lender and an active monitoring by lenders of their loans. This was a central feature of Continental European corporate governance systems and limited the strength of market forces. Corporate finance through investment in equity, on the other hand, is market-based and does not necessitate any particularly close relationship between investor and issuer. This brings us to the downside of the increased independence of industrial companies from banks. By using more and more securitised finance instruments – as well for debt as for equity – companies become more dependent on financial markets. And this is precisely why we find so much change in corporate strategies in countries like Switzerland.

In fact, many of the recent evolutions in corporate governance in Switzerland and other European countries can be explained by this increasing dependence on financial markets. Thus, the abolition of discriminating voting right distortions (giving more voting rights for the same capital investment to traditional blockholders than to minority shareholders), the increasing transparency of annual accounts (use of international accounting standards) and more generally a better communication and protection of minority shareholders are all expression of this evolution. Maximising the value of the firm – i.e. the price of its shares – and its profitability are more fundamental trends that can be – in part – explained by the change in corporate finance.

‘So what?’ could one say, ‘why is this important?’ In fact, as technical and far away from everyday life these evolutions of the corporate governance system might seem at first glance, they can have a very concrete meaning to many people…as is shown, for instance, by PSA Peugeot Citroën’s announcement of a plan to layoff 10’000 in order to increase the company’s profitability (NZZ, September 27, 2006).

Boards of directors in the UK: structure, behaviour and competence. Or the limits of rules

noreply@blogger.com (Gerhard Schnyder) — Fri, 22 Sep 2006 09:57:00 +0000

Yesterday evening I was at a Round Table on Corporate Governance organised by the Centre for Research in Corporate Governance of the Cass Business School, London. Professor Terry McNulty gave a talk about a very interesting research he carried out with Andrew Pettigrew during the second half of the 1990s. The study consisted in a survey of board members of the 500 largest UK FTSE companies. The idea was to find out how the structure of the board influences the behaviour of board members and, more precisely, the relation between the Chairman and the CEO.

McNulty and Pettigrew show that after the Cadbury and Greenbury reports on corporate governance (and subsequent reports), boards of UK companies underwent considerable changes in structure. Already the Cadbury and Greenbury reports, but also the governance codes of 1998 (the Combined code elaborated by Hampel) and the revised version based on the Higgs report of January 2003, all ask that the chair of the board and the CEO be two different persons. They also claim that a certain number of board members should be non-executive directors (NEDs). Consequently, the most important evolution in board structure was the separation of the function of chairman of the board and CEO. This evolution led during the 1990s to the emergence of five types of board structures:

1. The traditional system of cumulation between the positions of chairman and CEO (only 8.7% of the firms in their sample still had this board structure in 1997. Since then, this ratio has further decreased and is today probably about 2%)

2. A board with a full-time, executive chair who has formerly been CEO of the firm (20.6%)

3. A full-time, executive chair who has not been CEO of the firm (6.2%)

4. A part-time, non-executive chair who was formerly CEO of the company (10.6%)

5. A part-time non-executive chair who has never been CEO of the firm (53.7%)

The figures show that compliance with the governance codes is high since approximately 64% of the UK companies have non executive chairs.

Yet, McNulty argued convincingly that this compliance with the structure does not necessarily imply compliance with substance. In fact, the separation of the role of the Chair and the CEO aims at creating an independent board, which is supposedly able to effectively monitor the company’s management. However, McNulty and Pettigrew show that some of these models weaken, rather than strengthen, the position of the chairman and of the other NEDs on the board. Thus, their survey shows that only in models 1 through 3 the chair sets the agenda for the board meeting, whereas in models 4 and 5, i.e. the models that notably the Higgs report preaches, the CEO sets himself the agenda. The most likely explanation is that since the chair is a non-executive, he has not enough information about what is going on in the company in order to set the agenda.

The agenda setting is but one out of 34 issues of McNulty and Pettigrew’s research for which the respective power of the CEO and the chairman was analysed. All the results tend to show that board structures with non-executive chairmen reduce rather than increase the power of the chairman.

This result is actually confirmed by structural analyses of organisations. In fact, the claim that a large portion of board members should be NEDs may lead to an organisational structure, where the CEO is the only person to bridge the “structural hole” between the board and the operative management of the company. This of course gives him considerable brokerage power concerning the control of information flows between the board and the company as such. Whereas if other executive directors are on the board there is at least a theoretical possibility that the information the CEO gives to the board is verified by these executives. Hence, the complete independence of the board – i.e. 100% of NEDs – does not maximise the boards influence over management’s decisions.

This result makes intuitively sense. However, the corporate governance reality does not pay much attention to this issue. In fact, corporate governance policy-makers put very much importance on the question of board independence from management, which should be achieved through rules concerning board structure and composition. As McNulty shows, these rules can be counterproductive. What misses in these reform efforts is a deeper understanding of how boards work in actual fact and the insight that at the end of the day boards are composed of people.

Related to this, one issue that was brought up yesterday during the discussion, was the question of competence. In fact, the competence of board members is probably the most important factor, which can guarantee that a chairman, or any other NED, is able to effectively control the management’s decisions. Competence however can not be guaranteed with rules concerning the composition or the structure of the board but only with recruitment procedures for board members; and such procedures are difficult to define. How can one make sure that the shareholder meeting elects the “most able” candidate on the board? In most countries board composition is ruled by other criteria than competence. Thus in some countries legal rules prescribe board representation for certain constituencies of the firm (such as employees’ representation in Germany). This limits of course the choice of people available for that job, which may further limit competence.

The link between competence of board members and effective control is an issue, which is virtually never addressed in discussions on good governance and does not appear as such in corporate governance codes or company laws. Of course finding a solution to this issue would greatly increase the quality of control mechanisms within the firm. However, as prof. McNulty pointed out last night, sometimes we can create as many new rules as we want, the outcome will always depend on how actors apply these rules and how they behave within the regulatory framework. This is a fundamental limitation to all efforts aiming at regulating the economy and making sure that things like Enron, Parmalat or Swissair do not happen again.

Princess Saurer, the Evil Hedge Fund, and the (Foreign) White Knight. Of how a Company Resists all Attacks…but Gets Eaten anyway.

noreply@blogger.com (Gerhard Schnyder) — Fri, 08 Sep 2006 19:28:00 +0000

Textile machinery and transmission system maker Saurer is used to fight – more or less successful – battles against potentially hostile investors. But the last one was particularly nasty! Since Laxey Partners, a UK hedge-fund, announced in July 2005 that it held a considerable position in the tradition Swiss company Saurer, a fierce battle between the investor and the Saurer management set in. This episode shows in an extremely clear way how two different economic principles clash: the Anglo-Saxon shareholder-oriented way of managing a company, and the European industrialist’s way. This struggle has started in Europe somewhere during the 1980s but especially during the 1990s when more and more investors started to adhere to the idea of shareholder value, which was at that time mainly propagandized by American pundits such as Alfred Rappaport. Due to the liberalisation of capital and product markets during the 1980s and 1990s and the increasing competition between companies all around the world, many observers predicted the fast decline of the European way of doing business. In fact, the Anglo-Saxon approach, based on the supremacy of the owners (i.e. shareholders) was considered to be the most efficient way of managing a company. Hence, less efficient approaches would soon disappear. The fundamental difference between the Anglo-Saxon approach and the European approach is the respective position of the shareholder and other stakeholders: in Anglo-Saxon countries, managers are considered to be trustees who administer “other people’s money”, the company being nothing more than a way for owners to increase their wealth. The mission of the management is hence to maximise shareholders returns on investment, i.e. creating shareholder value through the maximisation of the company’s market value. In Europe, on the other hand, the company is traditionally seen as being more than the sum of its parts. The company is a quasi-public entity with multiple interests and responsibilities. Sometimes it is even seen as an organic entity with an interest of its own (e.g. in the German theory of the Unternehmen an sich). This multiple interests give a large leeway to the mangers (and other insiders) in deciding what interests should be privileged: should the companies exceeding cash flow be reinvested in the production, used in order to increase salaries or be distributed to shareholders? In European corporate governance systems, this decision is often not made by shareholders during the Annual general meeting, but by the management or the board who has enough power to retain earnings for instance through the creation of hidden reserves.

The fight between Saurer and Laxey Partners illustrates in an impressive manner the clash between these two conceptions of the stock company and shows that the shareholder value idea does not yet prevail in certain parts of the Continent. Industrialists – despite political discourse that indicate the contrary (cf. Franz Müntefering’s last year’s speech on the plague of locusts in Germany and the ensuing debate on capitalism) – still seem to have the means to defend themselves against the evil force of globalised capital (and especially its spearhead the hedge-funds)!

The story begins on July 15 2005. That day, Laxey Partners Ltd. announces that it holds 7.61 % of the capital (which corresponds to 7.61% of votes since Saurer introduced in 1994 a single share). One month later, Laxey had increased its participation to 15.02%. Already at that point Laxey made clear that it considered the company – and more precisely its transmission system branch – as being fundamentally undervalued (NZZ August 12 2005).

From this date on, Laxey started to exert pressure on the Saurer management. The main contentious issue is very revealing of what I called the clash of two different economic mindsets. Thus, the chairman of Laxey, Preston Rabl, argued that, even though the Saurer management did a good job, the company was undervalued on the stock exchange, which was – according to Rabl, due to the fact that the management retained to much cash for its investment projects (NZZ March 18, 2006). The remedy was hence to distribute this money to shareholders, to increase transparency concerning its acquisition policy, and possibly to review the structure of the company. Concretely, Laxey attacked the fact that Saurer was built around two pillars, which did not generate any synergies, i.e. a textile machinery and a transmission systems division.

Also, Rabl reproached the Saurer management with being inclined to engage into ‘empire building’, i.e. to acquire new companies in order to increase the company’s size without consideration for its value or profitability. This is of course a real danger in any company that works well and generates good money (as was impressively illustrated by Swissair’s McKinsey-made ‘hunter strategy’ during the 1990s). However convincing Laxey’s argumentation may appear from a shareholder’s perspective, the management of Saurer has compelling arguments as well. In fact, the management put forward that the two divisions – textile machinery and transmission systems – constitute a very good combination for the company’s stability. In fact, the textile machinery branch generates a lot of cash with only little investment. In the transmission technology branch, on the other hand, profit margins are higher, but more investment is needed (NZZ March 5, 2006). The combination of the two branches constitutes, therefore, a good complementarity, allowing the company to operate successfully in both branches.

This argumentation, in turn, is compelling from an industrialist’s point of view. However, shareholder value textbooks clearly state that diversification is not the role of the company, but of investors. Or in other words, by diversifying its activities in order to achieve a more stable course of business, Saurer reduces the profitability of the investors stake, who themselves have already diversified their portfolio.

Before the Annual general meeting of May 2006, Laxey increased the pressure by putting several points on the agenda for the AGM. Firstly, Rabl demanded a seat on the board of Saurer. Secondly, CHF 140m should be paid back to shareholders (through a capital repayment), and, thirdly, the company’s strategy concerning its internal and external growth strategy should be reviewed by external experts. The Saurer management rejected especially the second point of this agenda. In fact, according to them, the spare cash was needed for investments (i.e. acquisitions) in different parts of the world in order to consolidate Saurer’s position in these markets. Also the amount of CHF 140m was, according to the management, more than the company had in surplus, implying that the level of debt would have to be increased if this proposition was accepted by the AGM.

Who was right? Does the company’s management have the right to use profits in order to pursue growth strategies or does the undervaluation of the company constitute an expropriation of its owners? Hard to tell of course. Especially because this question is very much steeped with ideological considerations.

Be that as it may, on May 11 2006, Laxey – who had meanwhile increased its stake to 20% – got in part what it wanted: Preston Rabl is elected (with 50.7% of the votes) on the Saurer board despite the opposition by the Saurer management. (This was in fact not the first time that a hostile investor acceded to the board of Saurer. In 1988, Tito Tettamanti bought an important participation in Saurer and acceded to the board where he staid until 1994). This move of Laxey was condemned even by pro-shareholder actors such as the company Institutional shareholder services (ISS), which considered that Rabl’s presence on the board of Saurer could constitute a source of conflict of interests (NZZ, May 5 2006). Also, it was in principle agreed upon the mandating of an external expert with a strategic review concerning Saurer’s acquisition strategy. The repayment of capital, however, was not voted during the AGM because Laxey finally renounced putting this point on the agenda.

However, despite Rabl’s election, the tensions between Saurer and Laxey did not decrease during the following months. In fact, it seems that the communication among the board members was very difficult. Thus, Rabl stated later that several important decisions were taken without even being discussed during board meetings (NZZ, August 30, 2006). Consequently, Laxey started a new attack during the summer 2006: on July 5, 2006 it announced that it had now a stake of 25%, which increased further to attain 25.94% on August 25, 2006. The following day, a new charge was undertaken: Laxey demands the holding of an extraordinary AGM during which four out of eight board members of Saurer should be replaced by representatives of Laxey. Together with Rabl’s seat, this would have meant a majority for Laxey. The justification of this move was that, despite the AGM’s decision of May 11, no strategic review had been order by the company’s management.

In the beginning of September, Laxey finally informs the public of its plans for Saurer. The most likely option that was considered was splitting Saurer into two, and selling one of the divisions (probably the transmission system business), and concentrating all the efforts on the other (NZZ, September 4, 2006). A second option would have been to raise more capital and develop both branches. However, this latter strategy was clearly not Laxey’s first choice.

However, on September 6, 2006, many there was somewhat of a commotion when, Laxey announced that it had sold its 25% stake and that Rabl resigned immediately from the board. The buyer of this stake was Unaxis (which has recently renamed into Oerlikon) – a formerly Swiss company now controlled by the Austrian Investors Georg Stumpf and Ronny Pecik through their company Victory. Unaxis/Oerlikon held an additional 20.94% in Saurer in the form of stock options, and Oerlikon announced the same day that it intention was to launch a public takeover bid in order to acquire a majority stake.

Several observations can be made: Firstly, it is interesting to see that a supposedly so powerful hedge-fund did not achieve its goals despite the fact that Saurer constitutes – for Swiss standards – a rather open company respecting important corporate governance principles. Thus, Saurer applies since the early 1990s international accounting standards, it has a single share without restrictions to the exercise of voting rights or their transferability and it was not controlled by any large historical blockholder. Yet, the Saurer management still managed to repel the attacks. It is difficult to say what was decisive in this battle. In fact, the reasons for Laxey’s decision to stop the tug-of-war with the Saurer management and to sell its stake at a moment where it was about to obtain an extraordinary shareholder meeting are not completely clear yet.

A second observation is that Unaxis/Oerlikon – which made the headlines when it was taken over by the Austrian investors and when an additional considerable stake was acquired by a Russian investor – is welcomed by the Saurer management as “white knight”. Contrary to what usually happens in situations when Swiss companies are acquired by foreigners (cf. my previous post on this blog from August 1, 2006), this time, the nationality of the owners does not seem to play a role. In fact, more important than the nationality seems to be the strategy of the investor: Stumpf and Pecik are – despite what one could read in newspapers before their takeover of Unaxis – considered to be investors that pursue industrial goals, i.e. that aim at the company’s development in the long run and not short-term financial benefits to shareholders. Thus, a formerly dreaded foreign institutional investor became the saviour of a Swiss company that was threatened by an even eviler foreign investor. Globalisation sometimes really seems to blur national frontiers…

The Power of Institutional Investors: What the Swissfirst – Bellevue Scandal Tells us about Corporate Governance in Switzerland

noreply@blogger.com (Gerhard Schnyder) — Sun, 03 Sep 2006 12:42:00 +0000

A new full-scale corporate scandal has emerged in Switzerland a couple of weeks ago. This scandal around the merger between the Swissfirst Bank and the Bank am Bellevue touches some of the most central questions in the debate about good corporate governance: equal treatment of shareholders, insider trading, and the role of pension funds and their managers.

In fact, just before the merger of the two investment companies in September 2005, five large pension funds and two insurance companies sold their stakes in Swissfirst to this bank (NZZ, no 175, July 31, 2006). This allowed the Swissfirst to conclude the deal with Bellevue without capital increase, which led to a 50% increase in the Swissfirst share price after the announcement of the deal. At the same time, this implied that the future pensioners that were affiliated to the pension funds in question faced a loss of profits of about 20m CHF (the NZZ am Sonntag, July 30, 2006, estimates the loss of profits even at 33m CHF). This raises of course an important question: why were the managers of the pension funds ready to abstain from realising these considerable profits? The answer that the press gives is that the management of Swissfirst created incentives in order to convince the pension fund managers to sell their shares. In other words, some newspapers hold the view that the fund managers were bribed. Most likely, however, the incentives took simply the form of in-advance information about the merger (which is as illegal as bribing). Thus, several fund managers, while selling the stake of the pension funds they managed, bought privately Swissfirst shares and options just before the deal was concluded.

The suspicion of insider trading is supported by the fact that during the month preceding the announcement of the merger the price of stock-options of Swissfirst evolved independently from the price of the underlying share. In fact, from the beginning of August 2005 through September 9, 2005, the price of the option raised from CHF .21 to CHF .65 even though the share price remained fairly stable (NZZ am Sonntag, August 27, 2006). This hints of course at insider trading, since people who new about the imminent merger were ready to pay more for the stock options than what they were worth at the time. It is proved that mangers of Swissfirst – but also pension fund mangers – were among the buyers of stock options before September 9, 2005, the last trading day before the announcement of the merger.

One of the fund mangers appears to have increased hundredfold his personal fortune between 2001 and 2002. Following these revelations, the largest Swiss newspaper – the tabloid Blick – started a campaign against this fund manager. Front-page pictures showing the villa of the manager with headlines reading “That’s how the perkiest Swiss pension-fund manger lives” were published the following days and the integrity of the Swiss business elite as a whole was once more put into question.

But what does this episode tell us about corporate governance in Switzerland independently from the polemic it triggered? As any corporate scandal, this episode allows us to better understand the functioning of the Swiss economy. A very interesting question in this respect is the question of the role of institutional investors – and more precisely pension funds – in corporate governance.

In the US pension funds are mainly seen as powerful and active shareholders with considerable monitoring power over the management. This does not seem to be the case in Switzerland. In the US, CalPERS and other pension funds make headlines with their very active policy in proxy fights and during annual shareholder meetings. In Switzerland, on the other hand, there is not much ‘shareholder activism’ by pension funds, not even by public ones (one of the pension funds, which was involved in the scandal was Publica, the pension fund of federal civil servants). Except for the Ethos foundation, which explicitly pursues an active investment strategy and tries to exercise a certain influence on the management, most Swiss pension funds are very complaisant, follow buy-and-hold strategies and do not actively monitor companies’ management. A recent study by the Federal Office of Social Insurances shows that most Swiss pension funds do not exercise their voting rights during the AGM. Thus, during the period 1998 and 2000, only 5% of the interviewed pension funds said that they exercised their voting rights systematically. 50% answered that they exercised them never (Bulletin de la prévoyance professionnelle No 59, OFAS, 10.12.2001).

Two reasons explain this complaisance of Swiss pension funds towards companies’ management. Firstly, there is a built-in lack of independence of private pension funds from companies’ management. In fact, the foundation board of a private fund is composed of representatives of the employees and of managers of the company it belongs to, which makes a critical stance towards the management of course unlikely. Yet there is a second reason why critical voices are rare in Switzerland, i.e. the country’s small size. The small size of the country implies that the business elite is also small, which entails a situation where everybody knows everybody. Hence, ties between members of the business elite are very narrow. These close social ties render control by pension funds and other institutional investors difficult. This can be illustrated by the close personal ties that existed between the main actors of the Swissfirst – Bellevue scandal: the father of the CEO of Swissfirst was during long time manager of one of the pension funds, which sold its stake before the merger (NZZ am Sonntag July 30, 2006). A manager of another pension fund that was involved in the scandal was himself member of the Swissfirst board of directors until approximately one year before the merger. The chief investment officers of two of the pension funds sat together on the board of Cat Group, an investment company in which one of them held privately a considerable stake. The Cat Group, in turn, managed the savings of the pension fund in which its director was chief officer. Finally, one of the external investment advisors of another pension fund that sold its stake in Swissfirst, – a Member of Parliament from the Swiss People’s Party – was until May 2006 board member of Swissfirst and, at the same time, member of the investment board of another investment foundation that was involved in the scandal.

These multiple personal ties between the actors in the Swissfirst scandal are typical for the very coherent Swiss business elite. It reminds also the Swissair debacle, where the board of directors was composed of the most illustrious personalities from business and politics, which met in different places of sociability. Such ties are one of the reasons why critical voices are very rare and why it is difficult for individual members of the elite to denounce wrong-doings. In fact, due to this coherence social control is strong, imposing a set of common values – such as loyalty – on the members of the business elite. This is of course not new in Switzerland. The ‘sleaze’ composed of people close to the Swiss Radical Democratic Party was often held responsible for malfunctions in the Swiss economy. Notably the People’s party accused the radical democrats of nepotism and cronyism. What is new, however, is that this time it seems rather to be the People’s party, which is at the centre of the scandal.

August 1 – the National Holiday and Economic Nationalism in Switzerland

noreply@blogger.com (Gerhard Schnyder) — Tue, 01 Aug 2006 10:49:00 +0000

Just before August 1, the Swiss national holiday, an economic event put, once again, strain on Swiss patriotism. “Oerlikon becomes Russian,” read the headline in the NZZ am Sonntag of July 16, 2006 (p.25). This headline referred to the acquisition of 10.25% of the Unaxis Group (which was formerly known as Oerlikon-Bührle Holding, a tradition Swiss company active in the machinery industry) by the Russian Viktor Vekselberg through his investment company Renova. What the NZZ did not say in its headline is that Unaxis was at the moment of the Russian entry not Swiss anymore. In fact, in May 2005, Unaxis was taken over by the Austrian investment company Victory.

2005 was in fact a very tough year for economic patriots in Switzerland. In fact, last year already the Swiss national day was spoiled by a similar incident. Saia-Burgess a Swiss mid cap company manufacturing switches, sensors and other electronic parts for the automotive and industrial sectors, became the target of a hostile takeover bid by the Japanese Investment Company Sumida. The reaction of the people concerned – and even of those not so much concerned – were boisterous. The management of the target company published just before August 1, 2005 ads in several major Swiss newspapers asking its shareholders not to sell its shares to a foreign company. The ad read (among other things): “More and more […] successful Swiss companies become the target of foreign carpetbaggers. Nowadays, long-term investment faces the fast buck. Should our Swiss companies in the near future be exclusively controlled from abroad?” (See e.g. Neue Mittelland Zeitung, July 30, 2005, p.12)

Most of the politicians of the concerned region, but also John Doe, clearly answered ‘No’ and asked even for the intervention of the cantonal government in order to protect Saia-Burgess from the takeover attempt. Most people feared of course layoffs and the loss of tax money following the takeover and a possible delocalization and restructuring of the company and its production.

Obviously, the answer of the management was 'No' as well…for a while at least! In fact, in the beginning of September 2005, the board of directors recommended the SAIA-Burgess shareholders to accept a tender counter offer by the Chinese group Johnson Electric Holdings. The offer was 110.- CHF per share higher than the Japanese one and suddenly nationality was not that important anymore for the management. Of course, there might have been good reasons for accepting the Johnson offer rather than the one from Sumida (the management underscored notably that Johnson was ready to give SAIA-Burgess more independence than what Sumida was ready to concede).

Be that as it may, the nationalist tone of the ad from July and the vehemence of the reactions in the civil society might seem surprising in the context of globalization and increasing internationalization of economic activity. Many Swiss companies adopt very expansive strategies abroad mainly through mergers and acquisitions. In this context, it may indeed be surprising to see how nationalist arguments are – at the beginning of the 21st century – still acceptable in order to defend a Swiss company against foreign influence.

However, economic nationalism has a longstanding tradition in Switzerland and obviously it is not about to disappear. In fact, the small size of the domestic market and the high degree of internationalization of the Swiss economy might be a reason for such defensive behavior. In Switzerland, the orientation of the most successful firms towards exports and foreign markets went together, at least since the early 20th century, with a very nationalistic stance concerning the control of the companies. Speaking of Switzerland foreign financial analysts often used the term “the fortress of the alps” in order to characterize the closeness of its economy towards foreign investors. Different mechanisms of corporate governance allowed the management and the board of Swiss firms, and still allow them to a certain extent, to keep control over “their” company despite a high degree of internationalization.
The history of Swiss companies throughout the 20th century was marked by the fear of foreign influence on the Swiss economy. The term “Überfremdung” was coined in the early 20th century designating the fact to be infested with foreign capital or workforce. It was an important element of the construction of the Swiss corporate governance system throughout the 20th century. At different points in time, “Überfremdung” was the motif for the introduction of ‘selective protectionist measures’, which finally became characteristic of Swiss corporate governance. The most important of this measures was the so called “Vinkulierung”, which is a procedure by which the board and the management of a Swiss company could refuse any buyer of registered stock to exercise the voting rights. This instrument was mainly used against foreign investors and allowed the Swiss business elite to keep a grip on the companies even without controlling the majority of the capital.

Of course, at times, there were good reasons for the introduction of such mechanisms of selective protectionism. During both World Wars, Swiss companies faced problems of blacklisting because they were accused, due to the very strong presence of German capital and businessmen in Switzerland, of “trading with the enemy” or of being in reality German firms. Some companies saw their assets in the US and the UK confiscated. Thus, during and after both conflicts, “Vinkulierung” allowed Swiss companies to prove that they were really Swiss. Not only concerning the head quarters but also concerning the ‘ultimate beneficial ownership’, which was the criterion used in the US in order to determinate who controlled the firm.
Hence, the debate about “Überfremdung” gained importance during these conflicts and registered stock that allowed for ‘Vinkulierung’ was introduced in many companies during these periods.

During the 1970s, however, the reasons for excluding foreign investors got a new dimension. The influx of petrodollars from the Arabic countries lead several companies, among which also major banks, to introduce registered stock with the possibility of “Vinkulierung”. The slogan that went together with these measures and which justified also monetary policy against the appreciation of the Swiss Frank was “stop the sold out of the country!”. This shows that the debates during the 1970s were much more based on purely nationalistic arguments. Even though the fundamental reason for these measures was of course for the Swiss business elite not to lose control over the Swiss companies.

During long time, the Swiss corporate governance system proved very successful in avoiding foreign influence. Thanks to complex capital structures, with the existence of non-voting shares and registered shares that could be ‘vinkuliert’, it was possible to attract foreign capital without losing control. Despite a very marked under-evaluation of Swiss companies on the stock market, hostile takeovers were nearly impossible and were in deed very rare until recently.
This changed during the second half of the 1980s when a new kind of (Swiss) investors started to shake up the establishment with hostile takeover attempts. Thus, Werner K. Rey, Titto Tettamanti, Karl Schweri, René Braginsky and the young Martin Ebner stared to attack traditional Swiss firms such as Georg Fischer, Sulzer, Bank Leu and Usego-Trimerco Holding to name but a few. Werner K. Rey managed already in 1977 to take control of the shoe producer Bally. He emptied the company of a good deal of its assets and sold it one year later with tremendous profits. This kind of behavior of a new generation of “corporate raiders”, which was a completely unknown kind of investor until then, was harshly criticized by the Swiss business elite. Takeovers were all the more problematic, as no rules existed: there was no obligation to publish significant participations (which made “sneak attacks”, i.e. the secret buying of bearer shares, possible). No rule of equal treatment of shareholders existed either. Hence partial offers with special OTC deals were also allow. In the face of this new danger, ‘Vinkulierung’ started to show its limits: by buying registered stock, for which he did not get any voting rights, a raider could block a large number of votes during the shareholder meeting, which could allow him to obtain a majority of votes through bearer shares, which could not be ‘vinkuliert’. Also, the use of front men and the formation of alliances allowed raiders to short-circuit the Vinkulierung.
This situation where ‘anything goes’ during a takeover battle also met in peril the credibility of Switzerland as finance center. In reaction, the Swiss Stock Markets Association adopted a takeover code in 1989, which contained a clause obliging an investor to make a public offer on the totality of shares if the investor held more than 50%. This clause made the control of a company of course very costly and hostile takeover bids declined considerably after its adoption.

In parallel to the emergence of a new kind of investors, Swiss companies came increasingly under pressure by the international business community for their paradoxical behavior: aggressive strategies of expansion abroad and extremely protectionist and discriminatory behavior at home. Hence, already during the 1980s, some companies showed signs of a more liberal stance towards foreign investors. Thus, Nestlé opened its registered share capital to foreign investors in 1986, after it had been exposed to harsh criticisms in the UK the takeover of Rowntree for its ambiguous behavior. During the 1990s, more and more companies introduced a single share replacing, thus, complex capital structures most often with a registered share that could not be “vinkuliert”. (In parallel however voting caps were often introduced, which were, at least, not discriminatory). Gradually, Swiss companies became hence more open to foreign capital. This is explained by need for capital but also by pressures stemming from standards such as listing requirements of the LSE or NYSE and from international standards such as EU legislation, which influenced Swiss companies that had subsidiaries in EU countries. For these companies, most of which are among the largest in Switzerland, nationality was not so important anymore.

Yet, smaller companies, and especially mid-caps that were less exposed to the ‘international rules of the game’, changed their ways at a much slower pace. The case of SAIA-Burgess shows that nationalist arguments still seem to be acceptable. However, even here a certain change in attitudes can be observed. Several Swiss managers criticized the approach adopted by the SAIA-Burgess management as being contrary to the rules of the game (see the article “SAIA-Burgess: la voie patriotique divise” in Le Temps, August 4, 2005, p.17). André Kudelsky, CEO of the Kudelsky Group, stated that it was a paradox to have a capital structure with a single share, to raise capital on the equity market but not accepting the ‘laws of the market’ by introducing golden parachutes – which SAIA-Burgess did in August 2005. Other managers joined this criticism underscoring that ‘nationalism’ has no place in a functioning market economy.

Anyway, the Swiss might have to get used to the idea that foreigners control their companies. The quite impressive takeover wave of 2005 (SAIA-Burgess became Chinese, Unaxis became Austrian, Leica-Geosystems became Swedish etc.), at least, leads one to believe that the days are gone when Swiss companies could reap the benefits of their participation in international markets without paying the price.

Yet, Swiss citizens and patriots should take comfort in the fact that foreign investors do not seem to do much harm to the Swiss economy; quite at the contrary, as we could realize after the takeover of our national airline “Swiss International Air Lines” by Lufthansa.