Future directions for corporate governance in Europe

Karel Lannoo (*)

Discussing corporate governance in an issue which is devoted to financial structures might seem strange. In the strict sense of the word, corporate governance is defined as the way in which companies are directed and controlled, and refers thus to a legal regime. Yet the best way to get a feeling of the patterns in corporate governance in the member states is to compare the structure of financial markets and corporate finance. The revealed differences partly explain the difficulty of passing Community harmonising legislation in that area. National corporate legislation is grafted on economic conditions and social traditions, which differ widely in the Community.

There is however a clear trend for the market to play a bigger role in the exercise of corporate control. Not only do the effects of the liberalisation of the provision of financial services within the Community start to count, but also the increased globalisation of markets. Institutional investors act worldwide, and export the investment attitudes of their home market. Particularly the 'relationship investing' and the shareholder activism of US pension funds is of relevance for the corporate governance debate in Europe. This shareholder activism is likely to become more widespread in Europe and will influence European institutional investors and organised shareholder groups.

European corporations should be aware of this process and follow it with care. In view of the deadlock on further harmonisation of company law in the Community and the importance of good governance for their stock quotation, a recent CEPS working party has proposed that European corporations should adopt voluntary guidelines regarding corporate management and control.

This article will in a first part present a static pictures and examine some indicators of differences in corporate governance in the EU. A second part will look at the subject from a dynamic point of view and discuss some pressures for change at a global level. A final part outlines the proposals of a CEPS working party to respond at a European level to these developments.(1)


A. The Importance of Stock Markets

Despite increasing globalisation and the integration of European markets, the relative size of stock markets in EU member states still differs widely. By the end of 1993, stock market capitalisation as a percentage of GDP ranged from 132% of GDP in the UK and 61% in the Netherlands to 25% in Germany and only 13% in Italy. The number of domestic listed companies ranged from 1,927 in the UK to 664 in Germany, 726 in France and 242 in Italy.

Overall, the average stock market capitalisation in the EU, expressed as a percentage of GDP, falls far below the levels registered in Japan and the US. By the end of 1993, the EU 15 had a stock market capitalisation of only 44% of GDP, compared to 73% in Japan and 83% in the US (NYSE and NASDAQ). Excluding the UK, the average stock market capitalisation amounts to 29% of GDP or 30%, including the three new member states. Countries like Sweden and the Netherlands are notable exceptions. Neither is known to have especially transparent or open corporate governance mechanisms, but their stock market capitalisation is much higher than that of other continental European countries. This is even more the case in Switzerland.

Data for 1995, although still incomplete, confirm these levels of stock market capitalisation as a percentage of GDP for some countries, such as Germany, France, Italy and the UK, while strong increases are noticed in others, in particular the Netherlands, Sweden and Switzerland.

The number of domestic listed companies in the EU, especially when those of the new member states are added, comes closer to the figure for the US, NYSE and NASDAQ taken jointly. The difference within the EU, however, between the UK on the one hand and the other member states on the other is great.

B. Mergers and Acquisitions

One might expect that the more important are stock markets in the trading of control rights in a given country, the more important might be the takeover activity. This correlation does not seem evident, however, from data on the nationality of firms in mergers and acquisitions in the EU for the period 1991-94 (Table 2).

Table 1
Domestic Listed Companies by Country and Their Total Market Value at end of 1993

Country Capitalisation Domestic Listed Companies
in ECU mn % of GDP
B 69,526 38.6 165
DK 35,504 30.6 206
D 409,610 25.1 664
GR 10,738 17.1 130
F 404,926 37.9 726
IRL 15,259 38.9 53
I 128,056 15.1 242
L 17,170 195.1 56
NL 162,356 61.5 239
P 10,432 16.3 89
ESP 105,675 25.9 374
UK 1,065,515 132.4 1927
EU12 2,434,766 44.3 4871
AUS 25,178 16.3 111
SF 20,922 29.7 57
SWE 95,095 59.7 197
EU15 2,575,961 43.8 5236
CH 240,812 113.9 2115
N 24,332 27.8 120
JAPAN 2,672,638 73.8 1667
US-NYSE 3,752,446 70.3 1788
US-NASDAQ 703,827 13.2 4310

Note: Listed companies include main and parallel markets listed companies and market capitalisation do not include investment trusts, listed unit trusts and UCITS the market capitalisation data refer to the main market of the state mentioned, except for Germany, where it covers the Federation of German exchanges.

Sources: FIBV, Federation of European Stock Exchanges, and European Economy.

Table 2
Average Share of Cross-Border Mergers and Takeovers by Member State, 1991-1994 (in number of occurences as % of total of the EU)

Target 5.1 4.2 29.7 0.5 9.2 14.8 1.0 7.2 0.7 8.0 1.0 18.7
Purchaser 3.3 5.6 17.6 0.1 1.4 21.5 3.4 5.3 1.5 10.5 0.2 29.8
Balance -1.8 1.4 -12.1 -0.4 -7.8 6.7 2.4 -1.9 0.8 2.5 -0.8 11.1

Source : European Economy, March 1995.

C. The Financing of Industry

Although a certain convergence can be discerned over time, patterns of corporate financing show substantial differences in the EU. Figure 1 compares the own-funds ratios of six EU member states, on the basis of consolidated balance-sheet data of the non-financial industry states (BACH data). Generally speaking, it reveals the differences between countries where industry predominantly finances itself through the issue of equity securities, with high own-funds ratios and by other means, such as debt or internal reserves. Generalisations about differences between continental versus Anglo-American systems, however, are not justified. Not only does the UK have a high own-funds ratio, but so does the Netherlands and in recent years, Spain. Overall, the differences between low and highly leveraged countries are becoming less pronounced.

Furthermore, although BACH data are processed according to harmonised procedures, they should be considered with care.

The Deutsche Bundesbank investigated the reason for the persistently low own-fund ratios of West German enterprises, as revealed in their consolidated corporate balance-sheet statistics, and found that they do not differ significantly once some important methodological discrepancies are eliminated. In a comparison of four EU countries (France, Germany, Italy and Spain), it found that the national balance-sheet data, used for the BACH data bank, differed considerably in legal form, total amount and sectoral distribution of enterprises covered, the own-funds definition used, and in the accounting principles employed. These differences generally have the effect of presenting a weakened German capital base, compared to the other countries. The form of enterprises covered for France, Italy and Spain includes almost 100% limited-liability corporations, whereas in Germany, one-half of the data consists of partnerships and one-person companies. Accounting rules also show major national differences, diluting the own-funds in the German case. If the data are adjusted and methodological differences eliminated, the average German own-funds ratio amounts to 30% for the period 1981-92 &emdash; a result that is comparable to the other countries of the sample. The Deutsche Bundesbank argued that the result would be similar if other european states were included in the analysis, for example the UK, and, it particularly noted, if the German method of accounting for occupational pension provisions (the book reserves) were to be adapted to the English method. Occupational pensions in Germany are invested in the sponsoring enterprise and are shown as provisions on the liability side of a company's balance sheet, whereas they are kept in a separate fund and capitalised in the UK. In our example, taking provisions out of liabilities increases the own-funds ratio of German companies by 7 to 8 percentage points &emdash; to a level of 32% in 1991. Balance sheet provisions are on average four times higher in Germany than in the other countries studied.

D. Shareholding Structure

Fundamental differences in the shareholding structure in European countries are the key to explaining the variations in the importance of their stock markets. Table 3 shows that the largest share owners of quoted companies in the UK are the institutional investors (pension funds, insurance companies, banks and unit trusts), which possess an average equity of 59%. Households are the second largest group in the UK with 19%, and industry (including investment trusts) owns 4%.

Table 3
The Structure of Shareholding in Selected Countries, (percentage of total)

(as at end of year) 1990 1992 1993 1993 1992 1992
Institutional Investors 22 23 11.3 59.3 31.2 48


10 9.9 0.6 0.3 26.7

Pension Funds/Insurers

12 0.8 51.5 23.9 17.2

Others (Unit trusts)

0.6 7.2 7 4.1
Households 17 34 33.9 19.3 48.1 22.6
Private Companies 42 21 23 4 14.1 24.8
Public Authorities 5 2 27 1.3 0.7
Foreign Investors 14 20 4.8 16.3 6.6 3.9

Note : The figures do not necessarily add up to 100. Differences in regulatory setructures should also be kept in mind: a bank is a universal bank in Germany and a high-street bank in the UK.

Source : CREP-France, Central Statistical Office-UK Deutsche Bundesbank and OECD.

In Germany, on the other hand, the situation is rather the reverse: industry is the largest owner of quoted companies with 42%, institutional investors possess a much smaller part with only 15% (of which banks hold 10%) and households possess 17%. Households &emdash; in this case families &emdash; are the most important owners of quoted stock in France and Italy. Government is the second most important shareholder of quoted companies in Italy with 27%. No reliable data exist for the other EU member states not shown in the table. Only Sweden has a system in which ownership data are constantly followed by the stock exchange authorities.

Seen in comparison with the US and Japan, the dominating role of institutional investors in the UK is fairly exceptional. Foreign investors, on the other hand, are of minor importance in the US and Japan.

Over time, a strong growth can be noticed in the shareholding by institutional investors in several European countries.


Four developments are increasingly having the effect of reducing the specificities of systems, opening national markets to international competition and augmenting the importance of stock markets:

A. The Growing Role of Institutional Investors

The trend in which institutional investors have increased their share of listed companies over time in several European countries is likely to continue, above all in continental Europe, due to developments in retirement financing and health care. The aging of the European population will lead to increasing dependency on funded schemes in the financing of retirement provisions. European countries currently rely to a large extent on publicly operated pay-as-you-go financed pension schemes, in which contributions from the active working population pay for the pensions of the retired. Growing pensioner-to-worker ratios and the restraints on public spending will make these schemes more and more untenable, and a larger share of pension contributions will have to be financed by privately managed funded labour-market and/or individual pension schemes. Similar changes might also occur in the sector of health care, where parts of the tasks that are now carried out by the public sector will be divested and handed over to the private sector.

These developments will lead to an increase in the demand for equity and dis-intermediated finance by institutional investors, acting as the depositors of pension funds. They will push companies to adjust their financing methods and may well result in a reduction of the debt-to-equity ratios of European industry. The role of purely commercial banks (as opposed to investment or universal banks) might diminish in favour of securities markets. Governments might have to reconsider the preferential tax treatment of debt as compared to equity financing.

The growing importance of institutional investors in the European capital markets will push corporate governance towards the British/American model. Information to shareholders, the one-share/one-vote principle, dividend policy, executive pay and the assembly of shareholders will all become increasingly important. Institutional investors will be on the demanding side for equal treatment in takeovers and for restrictions on insider trading and dual classes of shares or capped voting arrangements. They can be expected to introduce a more active form of shareholding and pose a direct threat to lax or incompetent management. The growing competition amongst them will only intensify this process.

American pension funds, which possess in volume terms the most assets of all Western countries, are increasingly investing outside the US and bringing their corporate governance standards with them. Overseas equity holdings of US pension funds increased from $117 billion in 1992 to $202 billion in 1993. In percentage terms, the foreign stock of an average US pension fund portfolio was less than 4% in 1986, but rose to 7% in 1993, and is expected to reach 10% in 1996. American pension funds are required by law under the Employee Retirement Income Security Act (ERISA) to actively monitor investments and communicate with corporate management. The US Labor Department declared the proxy vote an asset that must be exercised to comply with ERISA legislation and required the companies managing the funds to develop voting guidelines aimed solely at member interests. This requirement applies to foreign stock as well. In the UK, the Cadbury report has called upon institutional investors to make positive use of their voting rights. The two major British institutional investors' associations &emdash; the Association of British Insurers (ABI) and the National Association of Pension Funds (NAPF) &emdash; both stress active corporate governance and adequate information to shareholders.

B. The Integration of Capital Markets

The former should be seen in connection with the developments in the EU to create an integrated capital market. The EU's third life and non-life insurance directives, which came into force in July 1994, reduce investment restrictions and lift localisation requirements for the investments of insurance companies throughout the EU. Although a draft directive liberalising restrictions in pension funds investment had to be withdrawn, increasing integration of markets and competition between institutional investors will further liberalise the investment climate for institutional investors. At the moment, Ireland, the Netherlands and the UK, which represent over 80% of all pension funds assets in the EU, have no limits on the portfolio distribution of pension funds, the sole exception being the Dutch civil servant pension fund ABP. Foreign asset holdings are limited in Germany, Belgium and Denmark. German insurance companies and pension funds may invest 30% of their stock in shares, but the traditionally risk-averse fund managers have up to now not been constrained by this limit. They are on average at a much lower level of 18%.

Globally, the worldwide integration of capital markets will lead to more convergence in portfolio distribution of institutional investors. Institutional investors in continental Europe have traditionally overinvested in bonds, whereas equity holdings are under-represented. The latter form a much more important part of the portfolio of British and US firms. They are more volatile but give a better return in the long run.

C. Shareholder Activism

Another development that has opened up the control of corporations is the increased activism of shareholders (3). The trend is clear in the US and the UK, where shareholders are joining forces to have a stronger position vis-à-vis management. Voting services inform shareholders of their rights and encourage them to exercise their proxy. They notify shareholders of the issues that will come up for voting at the annual general meeting and give background information on the different resolutions. They advise shareholders on which issues are contentious and which are not.

The legal requirement for US pension funds under ERISA to actively vote their shares has already been mentioned. On 29 July 1994, the US Department of Labor reaffirmed its position in guidelines for responsible ownership by pension funds, which call for proxy vote decisions to enhance the value of the shares and active monitoring and communication with corporate management. The latter includes not only the selection of candidates for the board, but also consideration of executive compensation, the corporation's mergers and acquisitions policy, the extent of debt financing and capitalisation, long-term business plans, work force training and practices, and other financial and non-financial measures of corporate performance.

The Cadbury report in the UK has also called upon institutional investors to make positive use of their voting rights and to disclose their policies of voting. The UK pension funds association NAPF and the insurers federation ABI organise a voting issues service to allow their members to exercise their proxy votes. It monitors the largest UK companies, analyses their annual reports and assesses each company's position in relation to the corporate governance criteria of the Cadbury Code. The organisation reports on resolutions requiring shareholder approval at general meetings and dispatches reports on issues on the ballot in time for proxies to be lodged. NAPF feels that these measures can assist fund managers to improve the value of investments. This trend is gradually spreading in continental Europe, not only through the shareholdings of American and British investors, but also through increasing awareness of shareholder rights and the potential benefits of activism.

D. Privatisations

Several continental European countries have launched important privatisation rounds of state assets. Banks, telecommunications, energy and other enterprises are up for sale to the public in Belgium, France, Germany, Italy, the Netherlands and Spain. These moves will increase the importance of stock markets and augment their capitalisation. The prime example is Italy, where the stock market capitalisation in percentage of GDP is the lowest in the EU (see Table 1) and where the share of government ownership of listed companies amounted to 27% in 1993. Having an overall view of the importance of government ownership is difficult, however, since publicly owned corporations in general are not quoted on the stock exchange.

Nevertheless, the member states' desire to keep privatised corporations nationally "anchored", in order to retain a strong shareholding in the hands of nationals and to control national assets, might as well play a role in preventing corporate governance from becoming harmonised and transparent. In several European member states, privatisations are placed with local companies and investors. In France, a core shareholding of the privatised companies is in general placed with French institutional investors and corporations ("les noyaux durs"). Local individual residents came in second place, but not much was left for foreign investors. The same strategy is followed in other European countries, such as Spain and Belgium. Clearly, however, such policies are irreconcilable with membership of an integrated European market.


How should European corporations and authorities react to these developments? As shown in part I, the needs in the member states are different, while there are some common challenges. Should this be a case for Community legislation on the power and control of boards of large corporations, the level of disclosure and transparency. It might be difficult to argue. National authorities will refer to the wide differences among the member states, and to the differing needs and problems. Or they could argue that the issue is already well tackled in national legislation, and that the differences do not pose any problems of distortion of competition in the single market. The subsidiarity principle is not without importance to this debate.

The core proposals for harmonising corporate legislation in the member states have faced that problem. The draft fifth company law directive on the structure of public limited companies (plc), the draft tenth directive on mergers between plc's in the EU, the draft 13th company law directive on takeover bids and the proposal for a European company statute have all known many problems in the decision process, nor will they be adopted soon.

A recent CEPS working party has therefore come up with a proposal for European corporations to take the initiative in this area and to adopt self-regulatory Guidelines on corporate governance among publicly listed European corporations. These Guidelines would function as a minimum framework for good corporate governance practices in the Community. The group suggested that all listed corporations should comply with these Guidelines; other companies, especially those in which there is a high degree of public interest, should attempt to meet the requirements to the extent possible.

To launch the initiative, the CEPS working party has recommended that an industry federation should constitute a group of some 15-20 European blue-chip companies that would be willing to subscribe to commonly accepted Guidelines of good corporate governance and give the necessary publicity to the initiative. The effect on the market and investors would attract attention, and other companies would soon follow suit in subscribing to the Guidelines. Observance of the Guidelines should be monitored by an independent body, such as the stock exchange authorities or the chartered auditors of the company. As with the Cadbury Code, companies should indicate their level of compliance and explain any deviations in their annual reports.

Draft Guidelines were set by the CEPS working party. They cover basic shareholder rights, general principles for board structure and procedures, and rules on reporting and control. They include:

It is not intended that these guidelines would replace national legislation or codes. Rather, they would set minimum rules for the operation and control of corporations in the EU. Nor should they be seen as a counter-measure against the Commission proposals to harmonise company law in the member states. On the contrary, they would serve as an intermediate and probably faster way to reach convergence in corporate governance standards in Europe. Due to the complexities of governance mechanisms in the member states and the present difficulties in adopting far-reaching harmonising legislation in that area, this proposed form of self-regulation appears to offer a more appropriate way forward.


(*) Centre for European Policy Studies (CEPS), Place du Congrès 1 - B-1000 Brussels.

(1) See Corporate Governance in Europe, CEPS Working Party Report No 12, June 1995 for further information on the subject.

(2) Deutsche Bundesbank (1994). "A Comparison of Own Funds of Enterprises in Selected EC Countries", Monthly Report, October.

(3) The term shareholder activism refers here only to the professional, investment-oriented behaviour and not the other forms of activism based on moral, ethical or ecological considerations.