Assonime Companies As Citizens: the Role of Corporate Governance

NOTE E STUDI

Assonime – Companies as Citizens: The role of corporate governance

1. Introduction

In the wake of Enron, the rules designed to ensure good governance of corporations and market transparency have come under scrutiny in the US and Europe.

Information flows (both accounting and non-accounting) to the market seemingly had an important role in the 1999-2000 bubble and in the recent wave of corporate scandals. The possible need for major changes in the rule-books is currently debated.

I will focus on the issue of communications between companies and investors, and discuss some recent initiatives in Milan’s Stock Exchange, notably the new “Guide to corporate information”, recently adopted by a Forum of market participants, including Assonime, Assogestioni, Assosim, AIAF, together with Borsaitalia.

2. Recent problems in the firm-to-investors communication system

2.1 The background

In the last ten years we have witnessed an apparent increase in short-termism in corporate management decisions; its main root-causes probably are in the massive recourse to incentive systems based on share prices. This system has produced remarkable results in terms of growth rate, and is indeed good in principle, as it tries to align managers’ interests with those of shareholders.

However, no one really knows what is the optimal level of option grants, and we now understand that private incentives may not lead to an efficient amount, notably because the cost of stock options to the company are not clearly recorded and communicated to shareholders and the market. Manipulation of the stock market price has emerged as a widespread short-cut by managers to pocket immediately huge compensations to the detriment of companies’ long-term ability to produce real value.

2.2 The consequences on firms’ disclosure policy

Robert Shiller recently wrote (WSJ, June 27, 2002) that the bubble years preceding the market peak in 2000 were a period when the nature of management changed fundamentally: the US apparently has moved from “managerial” capitalism to “investor” capitalism. Control of firms has shifted away from management teams who worked together over long periods, to “charismatic visionaries”, often with little specific knowledge of the business but capable of inflaming the share price with their grand science-fiction visions of companies’ prospects and acrobatic acquisition strategies.

Accounting and non-accounting information has been used increasingly to deliver a steady flow of announcements to the markets in order to prop up the share price: communicating ever-growing expectations to the market has often become the focus of value enhancement strategies.

Analysts have compounded the problem by providing the loud-speaker and the benchmarks for playing this type of game. Conflicts of interest have been ignored, and analysts have been rewarded for their ability to feed frenzies on stocks rather than their ability to analyse companies’ long term prospects. Their analyses have provided the earnings profile – ever more unrealistic -- that the market expected to inflate stock prices; earnings management by cynical managers has taken the place of corporate management.

2.3 The need for new rules

In the US there is now a discussion on whether it is sufficient to strengthen the punishment of illegal behaviours, or instead it is necessary to change the rule-books. European regulators and market participants are following the debate with anxious attention, since in many way in recent years they had been trying to adapt their market rules and practices to the US example. And yet, for many reasons it is clear that European stock markets are less exposed to the same type of dangers, for the very reasons why our stock markets had sometimes been criticised as less flexible and responsive to companies’ needs in the past: concentrated control, less organized securities markets, a slower pace of financial innovation, conservative accounting practices.

In this connection, let me emphasize two features of European accounting systems, including the IAS system that will be adopted throughout the Union starting in 2005. First, our accounting systems generally require a prevalence of substance over form. Accounting regulation is based on respect of general principles (first of all the “true and fair view” principle) and the Board of directors is liable for the veracity of corporate accounts.

A second feature of the European systems is the existence of formal ties between “official” financial statements and taxation. This may make aggressive accounting and income-boosting strategies very costly. Such strategies are more likely to be adopted in situations of financial distress (where, however, they could become a criminal offence in case of bankruptcy) or in start-up companies suffering huge losses (and therefore paying no taxes).

3. The interplay of regulation and best practices

A good regulation system is based on three complementary pillars: a legislative framework; regulation by the competent national authorities (e.g. the national Securities and exchange commissions) and the Stock Exchanges themselves; self-regulation by market participants.

The general framework on information regulation does not seem to require dramatic measures in the wake of Enron. More stringent rules have already been adopted in Union member states, including Italy, on inside dealing and market abuse.

Self-regulation can still play a useful role in improving regulation and lending it flexibility and adaptability to changing market circumstances. The border line between regulation and self-regulation lies in the difference between what is perceived to be “best” practice and what is a minimal standard of business behavior; this line moves slowly over time, and what is best practice now can become in ten years’ time a minimal standard embedded in the law.

4. Basic principles of disclosure regulation

Regulation of the communication between companies and investors should be based on some basic principles, which have been formalised by CESR (former FESCO) in their document on “Measures to promote market integrity”.

The first principle is prompt disclosure of all relevant information to the market, in order to give investors a true and fair view of the economic and financial conditions of the firm. Disclosing the relevant information to the market means, inter alia, to disclose information at the “right” time; companies should not be forced to deliver communications to the market until “information” has reached the “material” status of price-sensitive information. Companies should avoid using the release of financial and non-financial information as a mere marketing tool. The forthcoming EU Directive on market abuse requires companies to disclose all “inside” (or privileged) information as soon as possible; they may postpone disclosure at their own risk.

The second principle is that the company is responsible for deciding when to disclose, with a number of important implications. First, the company has the responsibility to decide when is the “right” moment to disclose, and could sometimes decide not to disclose relevant information in order to protect its legitimate interests, provided it can ensure confidentiality.

The third principle is proper internal organization: prior to disclosure, issuers should take all reasonable measures to ensure confidentiality and to avoid the potential for market abuse by their “relevant persons” and by other people connected to the firm. This requires that issuers should set up an appropriate internal organization to handle information. When it is no longer possible to ensure confidentiality, disclosure should be made without delay.

The fourth principle is personal liability in case of misdeeds. As recently stated by US judge Henry J. Friendly, this liability “should hold even if the firm is in literal compliance with accounting regulations but the financial statements still create a materially misleading impression in the minds of shareholders”. I would go further and say that legislation should provide definitions and general principles, and the rest could often be left to self-regulation and market practices, provided a violation of the general principles (e.g. the “true and fair view”) is promptly and severely sanctioned.

5. Some recent developments in Italy

Prompt disclosure of relevant information should be completed by clear and equitable practices for information disclosure by companies, analysts and investors at large. Market participants may take a prominent role in defining these practices, within a regulatory framework defined by public authorities and the stock exchange.

In Italy, the obligation to disclose price-sensitive information to the market stems from the law (art.114 TUF). When and how to disclose is defined by Regulations and stock market listing rules and instructions. Disclosure must take place through the Network Information System of the Stock Exchange, which grants equal access to investors.

Primary and secondary law inevitably leaves some “grey areas” and cannot solve all the problems which continuously emerge from everyday’s practice. Therefore, the definition of best practice standards by market participants is important. The “Guide to corporate information”, issued in June by a Forum promoted by Assonime (the Association of Italian Limited Liability Corporations), the Italian Stock Exchange and other Associations, fits into this framework.

The preparation of the Guide started in the first months of 2001, when the shares of Enron, Worldcom and the like were still flying high on the world financial markets. Representatives of Italian issuers, commercial and investment banks, financial analysts, of the Italian Stock Exchange regularly met to define standards of best practice in the field of communication with the market. Experts of the Consob (the Italian Securities and Exchange Commission) took an advisory role in the preparation of the standards, which took slightly more than one year.

The Guide sets standards of best practice which complement current primary and secondary regulation on corporate information to the market in some important respects:

(a) the definition of price-sensitive information and of the right time to disclose. Only events of a precise nature that may be price-sensitive have to be disclosed; a list of events which are usually price-sensitive is enclosed; in particular, projects and negotiations over important deals should be disclosed only if they are likely to be successful and if confidentiality cannot be maintained, despite the definition of appropriate procedures. Rumours should be commented upon by issuers whenever possible before financial markets open.

(b) The law mandates that price-sensitive (including forward looking) information can be communicated in meetings with analysts and other market participants only if already disclosed to investors at large through the Network Information System of the Italian Stock Exchange. The Guide adds that companies should send in advance to the Securities and Exchange Commission and to the Stock Exchange the documents to be distributed at the meetings. These documents should be made available to the general public at the time the meeting takes place; if the meeting is open to market participants, media representatives should be invited as well; if price-sensitive information is unintentionally disclosed, managers should publicly disclose the same information without delay.

(c) Issuers who decide to disseminate forward-looking statements should disclose the nature of the information (i.e. true forecast vs. management goals) and the basic assumptions on which their forecasts rest; they should also restate previously disclosed statements as soon as the original forecasts or goals prove impossible to reach;

(d) Issuers should monitor consensus estimates by analysts and comment upon any relevant differences between consensus and their own forward-looking statements (if publicly disclosed). This principle may have a deep and pervasive impact on the organization of listed companies. On the other hand, no positive, general obligation exists to provide “earnings guidance”: this is intendedly so, and is a positive contribution to the definition of a well-balanced relationship between issuers and financial analysts.

(e) A lot of documents and information (e.g. annual, semi-annual and quarterly financial statements, articles of association, communications of potentially price-sensitive events, presentations to analysts) should be made available to the public on the company websites (possibly also in English).

Of course, the present version of the Guide is only a starting point. In our opinion, the Guide itslef could become a sort of a loose-leaf book, which could collect more principles to tackle the everchanging problems emerging in everyday’s practice.

To sum up, the events of last year have led market participants to realize a close relationship between companies and other market participants may imply some risks, which had been previously overlooked. The market recognized information flows can sometimes be used as marketing devices and that a more arm’s length relationship has to be built (or re-built). Such risks are inherently less prononunced in Europe; however, though current regulation needn’t be overhauled, a few precautionary measures may be useful. Issuers, banks, financial analysts and other market participants may take a leading role in the definition of standards of best practice. In this regard, the recent experience of the Guide to Corporate Information issued in Italy may be an interesting example even for international operators.