Challenges in Corporate Governance

Learn about the most important challenges of corporate governance and how three major jurisdictions, Germany, Luxembourg, and the UK differ.

Dear Legal Ops!
Welcome to this week’s Let’s talk about Legal Ops, offered by NEWTON. We tackle corporate legal departments, speed up processes, and career growth. Please send us your questions; in return, we come back with real insights and actionable tips.
If you find this post valuable, don’t miss the chance to check out our latest posts.

• Maximizing Transparency and Compliance with Legal Entity Management: The Power of Automated Visual Charts
• Getting SOC2 and ISO27001 ready
• How to build a culture of compliance

Corporate governance can, in theory, seem a rather obscure and vague subject, especially when confused with the issue of a company’s ethical behaviour – or lack thereof. Many definitions have been given to the concept of governance. Quite simply, however, it can be summarised as the system by which companies are controlled and directed. It comprises the processes, rules and laws governing a company’s conduct, particularly concerning its shareholders and board. In the following article, we deep dive into the challenges of corporate governance with a brief comparison of the differences between Germany, Luxembourg and the UK.

In this article, we will cover the following:

Why is Corporate Governance so important?

The Wirecard fraud case currently being tried in Germany is one of the country’s greatest corporate frauds in its history and an embarrassment for its regulatory authorities. It raises significant questions about how this scandal could have been allowed to occur – especially given the importance that German regulation places on corporate governance.

https://youtu.be/1yhPtoqDkzo?t=19

In the 21st century, good corporate governance is considered so important due to the fundamental role it plays in ensuring that a company is run both effectively and efficiently, with appropriate regard to the interests of every relevant stakeholder, including employees, shareholders, and customers. Fundamentally, corporate governance plays a key role in both building and organising relationships within companies, and generating profits for shareholders and other stakeholders.

A vital component of corporate governance is the fact that it also tends to determine the ability of a company to cope with a crisis. in this way, a company’s stability and success can be largely attributed to its level of corporate governance, given the importance of a firm framework based on clear values such as honesty and accountability. The strength of these principles in an organisation will direct the way it is managed, its success and the extent of its attractiveness to investors.

As the Organisation for Economic Cooperation and Development (OECD) notes, corporate governance is the “structure by which business corporations are directed and governed.” Good corporate governance, in terms of transparency and compliance with key principles such as accountability in organizations, also has wider implications for business and society in general, on both a national and a global scale. It results in increases in shareholder value, the ability of businesses to weather difficult financial periods and environments, and the general improvement of the global economy.

Germany has been rocked by the Wirecard scandal. The company, which grew from a small and unknown payments company to become one of Europe’s largest fintech firms, had long been held up as an example of the opportunities that Germany’s digital economy offers companies for advancement. Yet the later discovery of Wirecard’s engagement in dishonest accounting procedures and the concealment of debt of billion of euros, culminating in its collapse in June 2020, has left investors and regulators in shock. Crucially, it has raised pertinent questions about the sufficiency of Germany’s regulation of companies and corporate governance.

Understanding the Challenges and Complexity of Corporate Governance

Corporate governance does not take place in a vacuum. It is the result of a nation’s legal, cultural, historic and economic development and landscape, and it is for these reasons that governance structures vary so differently between jurisdictions. Global corporate governance is a pipe dream; there is no alternative but to accept the often-wide international variations between nations and companies, and the legislative and regulatory bases upon which their corporate governance is based. This is in any case inevitable, given the fact that corporate governance may be said to be inextricably connected to the prevailing economic development of a country’s economy and the way in which this has determined organisational ownership and control structures.

Corporate Governance in the UK

This distinction is especially noticeable in the way in which European corporate ownership patterns differ so distinctively from UK ownership structures, and this has carried over into patterns of corporate governance. In Europe, share ownership tends to be concentrated much more significantly in the hands of a smaller group of shareholders and as such, is more orientated towards bank ownership rather than that of financial institutions. Whilst this results in a strong group of owners, it also means that other shareholders are weak and scattered and subject to the control of capital-owning blockholders that have the power to appoint managers. This is precisely the opposite of the UK, or the Anglo-Saxon system, where share ownership tends to be highly fragmented. This results in the ability of a company’s board to exert a significant amount of power over a company’s direction – something that is rarely seen in Europe, where many companies are tightly owned by wealthy families in possession of over 20% of shares.

Although today most countries have corporate governance codes, such as the UK’s Combined Code on Corporate Governance, these are generally soft law that is not legally binding but is rather intended to influence behaviour and set standards. Whilst the UK Combined Code is certainly sophisticated, it is essentially a guide for company self-regulation. The overriding principle in the UK is that of “comply or explain”, by which a compromise is intended to be achieved through the allowance to companies of some flexibility whilst ensuring that reporting and governance requirements are met.

Yet this soft law has no overarching ability actually to improve director accountability and company transparency. Although the UK Code might initially appear strict, it can be criticized for its broadness as well as being open to interpretation. Many companies consider that they have complied with their duties by issuing generic policy statements.

Corporate Governance in Germany

In contrast to the UK, Germany may be said to have one of the tightest regulatory structures for corporate governance. In addition to this, in contrast to the UK, German boards are comprised of two-tier organisations, which is intended to ensure a separation between management and control. Yet, in reality, the functions assigned to the management board and supervisory board are divided differently depending on the specific industry, company size, tradition, and, especially, if one board or the other has strong leaders.

A vital reason for the mandatory policy of the two-tier board in Germany is the politically entrenched policy of labour co-determination. This powerful instrument of corporate governance enables workers to enjoy rights that allow them to actively shape their working environment. This is hardly something that a one-tier board would be likely to tolerate. In contrast to Germany, the reason for the existence of the one-tier board in the UK is likely historically due to the emergency of entrepreneurial activity and resistance to any state or trade union attempts to oversee company structures and introduce labour co-determination. Although labour codetermination is a feature in many European countries, German regulation is significant for its regulatory mandate that there must be an equal shareholder and employee membership at the supervisory board level.

Corporate Governance in Luxembourg

Luxembourg, in contrast, is a rather more complex case; public limited liability companies, for example, have the choice between a two-tier or a one-tier board structure. It is certainly curious that the overwhelmingly preferred option in Luxembourg is the one-tier structure, suggesting that in the absence of regulatory force, companies prefer the freedom of a mixed board that does not separate supervisory and management functions.  Perhaps Germany too would not embrace two-tier boards and labour codetermination were its companies provided with such a choice. That’s not to say, however, that Germany is without fault. Local emphasis on employee representation has blocked companies from making necessary redundancies, whilst the evolving door that exists between the two tiers of a board has resulted in problematic conflicts of interest.

As an international financial centre, Luxembourg’s corporate governance principles should objectively be stricter, and yet there is no single corporate governance code that is applicable to all companies. Furthermore, the risks of short-termism have been recognised and there is a need to improve board governance structures and improve the focus on reporting requirements. Indeed, there have been various rumbles over the years regarding violations of good corporate governance principles, especially in relation to the close relationships and overlapping interests that exist between the political class, the business community, and its regulators.

Conclusion

Regardless of the differences in corporate governance between the UK, Luxembourg and Germany, rules are only as good as their enforcement. Each nation has developed its own systems and rules in the context of its historical, cultural, economic and legal features, and corporate governance is also inevitably shaped by the economic and political landscape. Regulation and the monitoring of corporate governance is a complex endeavour, and whilst the aim is ultimately to ensure accountability, an accommodation must also be made with the practicalities of business.

About this article

Sources

Financial Times (2019). German governance must be fit for purpose Recent scandals have exposed shortcomings in the corporate model
Kelleher, E. (2013). Luxembourg faces fresh criticism over good governance
European Journal of Business & Management Research (2021). Corporate Governance and Financial Fraud of Wirecard
Mondaq (2022). Luxembourg: Corporate Governance Comparative Guide
No. 13 Hans-Böckler-Stiftung, Dusseldorf (2018). Co-determination in Germany: A Beginner’s Guide
Reuters (2022). Wirecard bosses’ fraud trial begins after scandal that rocked Germany
Deakin Law Review. Vol. 23: 177-208 (2018). Are Corporate Governance Code Disclosure and Engagement Principles Effective Vehicles for Corporate Accountability? The United Kingdom as a Case Study
The Organisation for Economic Cooperation and Development (OECD) (2023). The OECD Principles of Corporate Governance OECD Publication Service
Thomson Reuters. Practical Law (2022). Corporate governance and directors’ duties in Luxembourg: overview
United Kingdom (2018). The Combined Code on Corporate Governance

Images

Featured Image: Photo by airfocus on Unsplash
Featured CTA blog post: Photo by Jurica Koletić on Unsplash / Photo by Christina @ wocintechchat.com on Unsplash