SPEECH/02/459
Speech by Frits Bolkestein
Member of the European Commission in charge of the Internal Market and Taxation
Financial markets - a matter of trust
Annual meeting of World Federation of Equities at Euronext
Amsterdam, 6th October 2002
For a long time a politician was regarded as having the riskiest profession on earth. Although politics is often described as the 'art of the possible', professional politicians are exposed to the heat of the public debate, to the cynical smirks of the media and to the unexpected manoeuvres of their opponents. For politicians the future is uncertain and a stumbling block never far away. As former Prime Minister Wim Kok used to say: "In politics the royal box and the emergency exit are never far away".
In the past few years politicians may find consolation in a new phenomenon: professional prospects for many CEO's appear to be worse. Every day I open the Financial Times, gloss over the headlines and read that yet another CEO is on the way out or on the way in. The current woefully high speed of rotation even exceeds what politicians are used to.
The reason for the seismic wave which continues to rip through boardrooms is lack of confidence. Investors and shareholders were promised huge profits but learned through newspapers that promises and forecasts were unsustainable because balance sheets did not match reality. The collapse of Enron triggered a crisis of confidence in capital markets which were driven by a relentless hunt for double-digit earnings growth.
It became obvious that Enron, once the envy of many boardrooms, arrived at high profit rates by fiddling the figures and cooking the books. After Enron other companies had to confess that their much vaunted figures were also achieved by transactions off the books that contained large financial risks and eventually losses. As a result the crisis of confidence spread and affected stock exchange dealings all over the world.
In my view the nub of the problem goes beyond figures. A company is an economic entity where various interests are brought together in order to promote the advancement of the company as a whole. Sustainability is the keyword, but precisely here CEO's face a perilous dilemma.
On the one hand entrepreneurial activity requires the ability to work toward a long-term goal. But on the other hand financial reporting has generated a short-term focus. Financial results used to be published once a year. Then it changed to once in six months and now it occurs every three months. One may argue that frequent reporting is needed to assure investors and shareholders. This is perfectly true. But the unintended consequence of this good intention is that the CEO is under tremendous pressure either to present high profits or to look for another job. Therefore all attention is on a short-term expansion by acquisition and the presentation of double digit profit rates whereas long term sustainability drops out of sight.
Success sustains a company. But not all success is sustainable.
One may think that these thorny questions are recent but if one scratches the surface and jogs one's memory one learns that they are in fact rather old. The first multinational in the world, the Dutch East India Company, was confronted with these issues ever since it was founded on the 20th of March 1602. It was the first organisation in the world in which private investors participated on a wide scale and a long-term basis. The Dutch East India Company laid the basis for global trading in shares and thereby for modern capitalism, often described as rapacious. But in reality global share trading provided a foundation for the wealth of nations.
In December 1603 the first fleet, which consisted of 12 heavily armed ships, set sail for Asia. The expectations of shareholders were high and large profits appeared to be looming on the horizon. However, during the first years of the company results were stunningly disappointing because the commanders of the fleet had to keep Portuguese competitors at bay. They were instructed not to trade but to destroy Portuguese strongholds. Shareholders had to be patient. The first dividend was distributed only in April 1610, seven years after the Company was founded. Adding insult to injury dividend was paid in spices, not in cash.
If a current CEO would inform his shareholders that they would have to wait seven years for their first dividend, he would probably not survive the day of his announcement. However, the 'Heren Zeventien', the "Lords Seventeen", the board of directors of the company, remained in office unopposed.
The Dutch East India Company also introduced an important innovation. There was a strict segregation between the providers of capital and the 'Heren Zeventien', which met several times a year to set general policy. Shareholders were supposed to have confidence in the 'Heren Zeventien'.
Another innovation was the limitation of shareholder's liability. The first shareholders invested their capital for a period not longer than ten years after which they were free to have their capital refunded or reinvest it for another ten years. Shareholders were promised a dividend as soon as 5 percent of the invested capital had been recouped. So the first multinational realised that investor relations were pivotal for the sustainability of the company.
Shareholders were not loyal slaves for the 'Heren Zeventien'; they were demanding and their patience was limited. After 1610 the dividends still remained meagre. Shareholders became utterly disappointed and demanded a thorough financial report from the directors. But the 'Heren Zeventien' refused to open up the balance sheets which were meticulously put together by accountants, meeting in Amsterdam every year. Shareholders got angry. In 1622 a series of pamphlets appeared in which the directors were accused of self enrichment. The pamphlets were forbidden but the Dutch government was sensitive to popular resentment and promised shareholders influence over policy and better financial information. The government acted in that way because it realised that a strategic private company with rebelling shareholders was risky.
Some measures may sound familiar in the ears of current securities regulators. The mandated term of office of directors was limited to three years and for the appointment of new directors an electoral board of directors and chief shareholders had to choose three candidates from among the main shareholders. Furthermore the possibilities for directors to benefit financially were curbed. They were no longer entitled to buy spices privately from company stocks but could only do so at public auctions under the same conditions as other buyers.
In this way the Dutch East India Company took the first steps to shareholder democracy and corporate governance. So there is nothing new under the sun in the public debate about Enron. We do not have to reinvent the wheel. We have to make sure that management sticks to the time-tested principles of corporate governance. We must return to the principles that assured the success of the Dutch East India Company four centuries ago. Nowadays shareholders are just as demanding in wanting to know what happens with their investments as the shareholders of the Dutch East India Company in 1622. They have the right of know, the right to influence policy and the right to replace failing management that saps the health of the company by putting own interests first.
The European Commission tries to assure the guiding principles of corporate governance.
The first rule of corporate governance is that the figures must be accurate. Central to fair financial reporting are high quality standards and the European Union addressed this need by adopting of the International Accounting Standards Regulation. In 2005 more than 7000 listed EU companies will be required to prepare consolidated accounts, according to the IAS.
The second element is that there should be a proper system of checks and balances. This rule is broken when outside advisers like accountants are torn between their consulting fee and their auditing responsibility. The independence of auditors is pivotal to assure accurate accounting. The Commission recently issued a recommendation on auditor independence. It requires that they shall not engage in any work, including non-audit services, which is likely to threaten their objectivity and independence in carrying out statutory audit. It requires disclosure of audit and non audit fees, mandatory rotation of partners in audit firms every seven years, and a two year cooling off period for partners before they can start working for their audit clients.
A third aspect is an efficient framework of monitoring and supervision. Rules become obsolete if they are not consistently applied. In the proposals of the Commission securities regulators also have a part to play in the proper application of accounting standards. In this respect the Commission is working with the Committee of European Securities Regulators to develop an adequate enforcement infrastructure.
It is obvious that a law, even European laws, may never be adequate to assure fair practise and proper behaviour in all boardrooms. A few years ago some CEO's were portrayed as captains of glitter, hopping from one city to another while anointing a successor. As we all know, entrepreneurial excellence requires a degree of modesty, dedication and self-restraint. It also requires the ability to listen, in particular to bad news, and to cope with criticism from employees. Self-congratulatory group thinking in boardrooms is tantamount to slow but deadly poison.
The American government aims at restoring confidence in corporate governance by adopting the Sarbanes Oxley Act. The senior executives of all 14.000 firms listed in the US will have to swear in front of a notary that, to the best of their knowledge'' the latest financial reports contain no untrue information. Sinners may face punishments of which a jail sentence of 20 years is the biggest stick in store.
I share the American concerns over the need to re-establish confidence in the capital markets. But I am worried about the implementation of some provisions of the Sarbanes-Oxley Act which may have undesirable extraterritorial consequences and create unnecessary difficulties for European companies with a secondary listing in the US. Recently, I expressed my concerns in a letter to Harvey Pitt, Chairman of the US Securities and Exchange Commission.
I am confident that we shall restore confidence in capital markets by returning to the principles which led the Dutch East India Company into long lasting success. The problems are old, the solutions are well known. We simply must apply time-tested rules and we should focus on sustainability rather than on widely noticed but short-lived success. Our common belief in the blessings of modern capitalism and global share trading is first and foremost a matter of trust.
Source: European Commission
