For many years, investors have lauded Germany’s two-tier board structure. Indeed, following the 2008 financial crisis, some US companies suggested moving from a single to a dual board. However, the recent collapse of the German payment processor Wirecard has brought the two-tier board structure under scrutiny. Which raises the question: is this two-tier arrangement still fit for purpose?
A quick recap
German companies were the first to adopt the two-tier board structure, which became law after World War II. Since then, Austria, the Netherlands, Finland, Poland, China and Indonesia have followed suit.
A two-tier board consists of a Supervisory Board and a Management Board. The former is responsible for the strategy and supervision of the latter. Its members are non-executives and are elected by the shareholders. The composition varies across jurisdictions, but in Germany the Supervisory Board includes employee representatives. The Management Board is responsible for daily management of the company. It works closely together with the Supervisory Board on strategy matters. The Supervisory Board appoints the senior executives. Meanwhile, shareholders as well as stakeholders advise the members of the Supervisory Board. This ensures that Board members represent the best interests of the company and its staff.
In Germany, the Corporate Governance Code, or Kodex, dictates the structure of the Supervisory Board. It contains essential statutory regulations for the management and supervision of German-listed businesses. The Germany government formulates the recommendations and reviews the code once a year in order for it to comply with best practice of good corporate governance.
What are the benefits?
In an ideal world, within a two-tier board structure there is a clear line of responsibility and accountability between the Supervisory Board and Management Board. Communication between the two boards is essential on risk management, business development, and strategy. The head of the Supervisory Board, or Chair, has double voting rights in case of a draw during internal elections. This gives the Chair a unique and, at times, powerful role. As the Chair provides the link between the two boards, they must use their position wisely.
A well-functioning two-tier board structure offers greater independence, as the roles of executive and non-executive directors are clearly defined. There is also a clear line of responsibility and accountability between the Supervisory and Management Board.
Wirecard
So, what went wrong with Wirecard? Pressure on the financial technology company had been mounting for some time, led by a Financial Times investigation and a moves by number of short sellers. Then, on 18 June, the firm admitted that auditors could not find €1.9 billion in cash.
Fingers were immediately pointed at the Board. Critics highlighted that some Management Board members, including Markus Braun and Jan Marsalek, lacked financial and governance experience. This perhaps prevented them from identifying issues when they first appeared. Investors also criticised auditors for failing to discover inconsistencies in the company’s accounts. Many accused banking regulator Bafin of failing in its supervision duties.
Of course, Wirecard is not Germany’s first corporate scandal. Over the past few years the country has seen Bayer’s ill-fated takeover of Monsanto, the VW ‘Dieselgate’, and the Siemens bribery case. All of these companies had a dual board structure.
So, what can we do?
There are certainly things two-tier board companies can do to improve operations. At present, there is no legal limits in terms of board tenure for employee representatives. By comparison, board tenure for non-executive directors (NEDs) on the Supervisory Board is currently 4-5 years. Perhaps, then, companies should consider refreshing employee reps with the same frequency as NEDs.
Although defined by law, the size of the Supervisory Board might also be an issue. For example, a Supervisory Board of 20 members should have 10 independent non-executive members. They should have the necessary experience to contribute to the strategy of the company and supervision of the Management Board. As we highlighted, the Supervisory Board oversees the Management Board. So, it is important to have the right mix of expertise and diversity on the Board to hold the Management Board to account. But can a 20 members board really be that efficient? From our experience, we would argue for smaller boards in general.
The G in ESG
Investors also have a vital role to play. By fully embedding environmental, social and governance (ESG) considerations into the investment process, we believe investors can better understand the risks and opportunities of any investment.
We believe it is essential that portfolio managers regularly talk with management teams or decision-makers before, during and after they invest
As part of this, we believe it is essential that portfolio managers regularly talk with management teams or decision-makers before, during and after they invest. This is because active stewardship and open interaction should help them fully get to know their assets: who they are, what they do and how they hope to achieve their future goals.
But companies don't operate in a vacuum. It is therefore important to engage with a variety of stakeholders. This includes regulators, policymakers, suppliers, customers, third-party analysts, academics and non-government organisations. It’s about generating the most detailed picture possible. This includes identifying where companies are failing in their governance.
However, as the Wirecard situation demonstrates, fraud can often be difficult to spot, irrespective of board structure. This is especially true when the fraud is “elaborate and sophisticated”, as EY, Wirecard’s auditor, called it. We must all therefore continue to improve our ESG activities and place company engagement at the heart of the investment process.