In Light of Market Crisis, EU Commissioner McCreevy Questions Efficacy of Voluntary Corporate Governance Codes

With the unfolding debacle in global financial markets, European Commissioner for the Internal Market Charlie McCreevy has questioned the role of corporate governance, particularly as it applies to credit rating agencies. He also wondered if self-regulatory voluntary comply or explain corporate governance codes are getting the job done, and if binding rules may be needed. Similarly, in remarks at the recent European Corporate Governance seminar, he questioned if simply mandating a specific number of independent directors is enough after the meltdown we have witnessed.

Comply or explain corporate governace codes are popular in the EU, with the UK's Combined Code being of this variety. Voluntary corporate governance codes have served EU companies well, Comm. McCreevy said, and will remain important instruments of sound corporate governance. However, that does not mean that codes are always the right solution. In certain circumstances, he noted, binding rules may be necessary. The current financial crisis has pushed systems of corporate and internal governance across the global financial system to the limit and, he lamented, these systems have unfortunately been found wanting.

One area in which self-regulation will no longer be permitted is that of credit rating agencies. In the commissioner’s view, credit rating agencies played a major role in the market turmoil by greatly underestimating the credit risk of structured credit products. The Commission can no longer leave it to the rating agencies themselves to deal with this, he emphasized, since the ratings business is much too important for the stability of the financial markets. He intends to propose in the next few weeks a legally binding registration and external oversight regime whereby European regulators will supervise the policies and procedures followed by the credit ratings agencies, which will include reforms to the corporate governance of rating agencies.

Another issue which the current turbulence has highlighted is the matter of executive compensation. Serious questions are being asked about remuneration structures in financial institutions and the perverse incentives that are in place. In his view, compensation incentives should not only focus on short term gains but overall shareholder interest and long-term, firm-wide, profitability. It has become clear that some incentive schemes have led to excessive risk taking.

While addressing these perverse incentives has traditionally been the responsibility of the financial institutions themselves, he noted, clearer guidance may be needed from policy makers. He noted that only about a third of Member States followed the Commission's 2004 recommendation that shareholders should be able to vote on the remuneration criteria applying to board members. Shareholders must have a say on executive compensation, he emphasized, and they must be more engaged. The issue of executive compensation now figures in some of the emergency measures that some Member States have taken in response to the financial crisis.

In 2004, the Commission also recommended the use of independent directors, in particular to mitigate conflict of interests. It now appears that the availability of independent board members alone is not a guarantee for a well functioning board. Indeed, he observed, the current turmoil has led many to question the usefulness of simply requiring independent board members. The whole of the board and the individual board members must not only be competent in relation to their tasks, he said, they must also exercise a collective responsibility and due diligence with respect to the company.

There must also be improved dialogue between shareholders and issuers. Shareholders must have sufficient and adequate information about what is going on in the company so that they can form an opinion and take the necessary action. The commissioner is not referring to information overload, but rather to targeted and relevant information. The effective exercise of shareholder rights was the main reason for the Shareholders Rights Directive. This directive, which must be implemented by mid-2009, reduces the effort for shareholders to exercise their voting rights, but also ensures that they will be better informed by the company.

Shareholders will receive certain information from the company prior to general meetings and they may ask questions of the company. While Comm. McCreevy believes that this will lead to improved dialogue between shareholders and issuers, he cautioned that it is not only a matter of tools. Shareholders must be in a position to monitor the actions of the company carefully.