The theory and practice of corporate governance and capital markets suggest that certain organizational structures of listed companies are to be considered superior to others or even best practice. This article critically reviews the mainstream doctrine and reports on the results of my own empirical research on corporate governance of publicly-traded companies with access to capital markets in Switzerland.

By Valentin Jentsch (Reference: CapLaw-2019-30)

1) Introduction

Various corporate law and governance theories inform us that board independence, management ownership and blockholder ownership are important elements of the overall corporate governance system. It has been close to conventional wisdom among scholars and practitioners that both independent directors and separated CEO and chairman roles are to be considered “good” corporate governance. It is also often argued that non-executive directors as well as executive directors and officers are more effective monitors and more focused on maximizing shareholder value when they have a larger financial stake in the company. Standard theory further predicts that controlling shareholders and institutional investors are efficient monitors because they manage to overcome collective action problems and make better investment decisions, also because they more closely monitor the companies they invest in. The empirical evidence on the effectiveness of these elements is, however, mixed at best. Moreover, the results and conclusions of prior theoretical and empirical research are typically country-specific and often not universally applicable.

In a recent article, titled Board Composition, Ownership Structure and Firm Value: Empirical Evidence from Switzerland, which has just been published in issue 2 of volume 20 of the European Business Organization Law Review (June 2019), I analyze a panel data set consisting of 43 large listed companies over a time frame of 6 years in the context of the small and open economy of Switzerland. The results of this analysis suggest that a larger fraction of independent directors on the company board decreases firm value and that a combined leadership structure may also increase value. In addition, the results indicate that both the presence of current or former executive directors on the board and a chairman with executive functions or a CEO who sits on the board may increase firm value. Similarly, the results suggest that the presence of a controlling shareholder decreases firm value and that the presence of institutional investors as significant shareholders may also decrease value.

Based on these results, I hypothesize that modern corporate governance theory and public policy rule-making in this area should in particular focus on four patterns. First, a majority rule of independent directors seems to be sufficient and more efficient than a supermajority rule, the independence definition should include the representation of significant shareholders and soft law should provide for a certain minimum number or percentage of executive directors. Second, the CEO and chairman function should not by rule of law or recommendation be required to be separated and there should be enough room for top executives to engage with and ultimately join the company board. Third, the minority rights should be further strengthened, a majority of the minority vote should be introduced for certain key situations in which the entrenchment risk of the controlling shareholder is evident and whether controlling shareholders should be subject to a duty of loyalty towards the company and/or public shareholders has to be seriously considered. Fourth, the exercise of the participation and voting rights of such investors should be further enabled and facilitated as well as a legal basis for the issuance of loyalty shares to long-term investors should be created.

In this contribution, I will briefly summarize and highlight the main arguments made in my article mentioned above. I will do so by briefly outlining these four patterns on the role of independent directors, CEO and chairman, controlling shareholders and institutional investors in listed companies, with a particular focus on the corporate landscape in Switzerland, but also beyond.

2) Board Composition

a) Independent Directors

Several regression models of my study show a very high statistically significant negative correlation between the number of independent directors sitting on the board and firm value. These results, however, do not mean that independent directors are not important. Instead, given that at least 50% of the directors of all listed companies under examination were considered to be independent at all times, these results must be interpreted on the examined 0.5 to 1 scale so that, once the majority threshold is met, additional independent directors do not add, but diminish value. The corresponding policy implication of that finding is that a majority rule, requiring at least 50% independent directors on Swiss boards, should be more efficient than a supermajority rule, which, for example, requires a minimum of 66% or 75% of independent board members.

Moreover, how director independence is defined in the Swiss context is of crucial importance. One dimension that should definitely be considered to be included as an independence criterion in Switzerland is the relationship to a significant shareholder. In my view, directors who represent a significant shareholder can by definition not be qualified as independent since they are serving such a (controlling) shareholder, but not the company and/or the public shareholders, which would in fact be part of their role.

Other models of my study show a somewhat high statistically significant positive correlation between the presence of current executive directors and firm value, indicating that an executive has more accurate and timely information about the current state of the company, which can be of great importance to the board. In addition, these models suggest that former executive directors positively affect firm value, indicating that board members, who have recently served in an executive role, know the company and the industry better and are therefore in a position to create additional value for shareholders. Therefore, a potential policy implication would be to require that the board of a listed company includes at least one director, who currently or recently held an executive function in the company.

b) CEO and Chairman

Arguably the most meaningful regression model of my study suggests that there is some evidence that a combined CEO and chairman role may increase stock market performance. A possible interpretation of this finding is that the market actually undervalues such a combined leadership structure, which might potentially add value. It can further serve as a basis to argue that public policy should not prevent listed companies from appointing the same person as CEO and chairman.

This finding is further confirmed by other models of my study, according to which there is some evidence that a CEO sitting on the board and a chairman with executive functions might add value. These results thus suggest that a combined or overlapping leadership structure can be superior to strictly separated functions. This implies that public policy should not prohibit such organizational structures and calls for a policy building upon the freedom of organization.

3) Ownership Structure

a) Controlling Shareholders

Almost all regression models of my study show a very high statistically significant negative correlation between the presence of a controlling shareholder and firm value. Given these unambiguous results, it is quite straightforward to conclude that controlling shareholders are not good monitors and in fact decrease firm value. According to the literature, this is arguably because such shareholders are not in a position to effectively police management, but because they are more likely to use their power in order to extract private benefits from the company. This discussion has been reframed as the controlling shareholder tradeoff. Referring to this framework highlights that the shareholder rights of the majority and the minority cannot be considered adequate and well balanced in Switzerland and calls for a public policy focusing on the protection of minority shareholders.

One approach would be to strengthen certain minority rights in Swiss corporate law. This has, to a certain extent, already been proposed in the course of the ongoing revision of Swiss corporate law. These policy proposals thus have to be assessed favorably.

Another measure of minority protection, which has been suggested more recently, is the introduction of a majority of the minority vote as a default rule for all companies listed in Switzerland. My take on this controversially discussed issue would be that the majority of the minority vote does in fact have a legitimate scope of application, namely when the minority rights are endangered. Typical examples for such a situation would include the introduction of an opting-out clause in relation to the obligation to submit a public tender offer or the ex post introduction of a share transfer restriction regime.

Another possible alternative for providing a more balanced protection of minorities would be to impose a duty of loyalty on the controlling shareholder (vis-à-vis the company and/or the other shareholders). In this framework, it would further be conceivable that a controlling shareholder could be held responsible and liable for the damage it causes to the company and/or other shareholders.

b) Institutional Investors

A few regression models of my study, arguably the most meaningful models, suggest that there is some evidence that the presence of institutional investors may decrease stock market performance, leading to the conclusion that institutional investors are not good corporate governance monitors. One explanation might be that the market actually overvalues an ownership structure with a large part of institutional investors as minorities, which indicates that such company should eventually be traded at a discount. This discussion can however be reframed as the institutional investor tradeoff. Using this framework, it can be argued that shareholders are still generally perceived to be too passive and often seem to be focused on short-term results, which calls for a public policy that promotes active involvement and engagement of all sorts of institutional investors in the company and encourages a long-term investment horizon among all types of institutional investors.

One way to promote an active involvement and engagement of all sorts of institutional investors in the company would be to enable and facilitate the exercise of their participation and voting rights. Many of the policies, which have been introduced more recently, thus have to be assessed favorably.

An instrument that encourages a long-term orientation of institutional investors would be the issuance of loyalty shares (i.e., shares with multiple voting or dividend rights) to long-term shareholders. It is up to the Swiss legislator to consider, whether or not to introduce this instrument into the law.

4) Conclusion

The new evidence of my country study casts doubt on several generally accepted good corporate governance principles and highlights the need for a reconsideration of public policy towards board governance and blockholder governance, not only in Switzerland, but also at the international level. The findings and conclusions of my article essentially cast doubt on and point to the need for fundamental revision of generally accepted international understandings of what constitutes “good” corporate governance norms today, in particular with regard to listed companies with access to capital markets. This is especially true for the concept of independent directors, which was long believed to be the panacea in corporate governance, notably in controlled companies, and gives rise to further research on blockholder governance, in particular to a systematic and thorough analysis of companies with a controlling shareholder. Since the times are changing and the allocation of power between management and shareholders is currently being readjusted, at least and in particular in listed companies, we also have to rethink the corporate governance and public policy particularities relating to board composition and ownership structure of publicly-traded companies.

The complete article (including tables and footnotes), which has been discussed in this contribution, can be found at https://doi.org/10.1007/s40804-018-00128-6.

Valentin Jentsch (valentin.jentsch@rwi.uzh.ch)