Internal Monitoring

One Tier- and Two Tier Boards

Continental European company laws traditionally rely upon statutory regulation with a two tier
board model, often including co-determination, whereas the Anglo-Saxon corporation relies on a
one tier board.

1. The European Way: Two Tier Boards
The two tier system is mandatory in Denmark, Finland, Germany, Sweden, Austria and large
companies in the Netherlands. In France, Portugal, Switzerland and Spain the companies can
choose between a one or two tier board. But non-statutory rules became a supplementing regime
soon after several corporate governance codes took effect. The new codes follow the self-
regulatory comply-or-explain- approach and distinguish between regulatory levels. The central
feature of internal corporate governance therefore lies in the organizational and personal division
of management and control by a two tier structure. Direction and control of the company, for that
reason, remain separated. Responsibilities and functions of the boards are theoretically quite
obvious and clear which is practically not true as the system rests on partially wrong
assumptions.

Running the business in the interest of the stakeholders could be one goal of the management
board. This responsibility, to some extent, is contradictory - as maximizing the utility of totally
different stakeholders always is. Essentially, this is the problem the principal-agent literature
deals with in many variations. However, the role of the supervisory board is even more difficult
and often misunderstood, but, its legal functions are clear regarding the appointment,
supervision, and removal of members of the management board.

To apprehend the resulting problems, one has to know the interactions of the bodies of the
companies and which are regulated within the company law. In short, the general assembly that
meets once a year, or extraordinarily in the case of emergency, relieves the management and
supervisory board and has the right to elect the latter. The supervisory board in turn elects the
management board, concludes the contracts with each of the members of the management board
and controls them. As the management board has the right to suggest part of the members for the
supervisory board, this system is often criticized and can lead to collusion between these two
bodies.

Generally, the members of one board cannot act as members in the other board and managerial
functions cannot be delegated to the supervisory board. In Germany, banks often hold large
blocks of companies and they make up large parts of the boards and consequently, have strong
influence in the general meetings. These German banks, in addition to the depository voting
rights of their customers, hold power as external monitors. But banks do not necessarily
represent the interests of the other shareholders.34

In corporations with concentrated ownership it is therefore quite impossible for the supervisory
board to protect the interest of the minority shareholders against both managing board and
blockholders. Committees, although legally permissible, are less common in two tier board
systems than in the UK or US. However, a strong tendency towards nomination, remuneration,
and audit committees can be observed, and the majority of the larger listed companies have
already installed them.35

Apart from the strong position of banks in supervisory boards, one might also view interlocking
directorships as a problem of the two-tier board system. These directorships are established if a
member of one supervisory board is also a member of one or more other supervisory or
management boards of another company.36

The strong emphasis on separation of management and control can lead to inefficiency as the
two bodies of the company should work together. Each control method has a trade-off between a
first-degree error where good management is qualified as insufficient, and a second degree error
where bad management is not disciplined.37 In this context, consequences like occasional
scandals are inevitable if one wants to avoid a second degree error where efficient management
would be hassled. This would harm the company, as managers tend to loose motivation and
initiative if they are controlled continuously. Since the publication of corporate governance
codes, the focus of the supervisory boards work within the two-tier board system has begun to
shift more and more towards advising and counseling the management board designing itself to
be a kind of continuous representative of the shareholders between their meetings.

2. The Anglo-Saxon Way: One Tier Boards
In contrast, the one tier board realizes management and control within one body, the board of
directors, which is vested with universal powers.38 To understand the control function, a pivotal
distinction has to be made between executive directors who are employed as managers parallel to
their directorate and non-executive directors who are not involved in the running of the day-to-
day business of the company. As all directors have the same power, non-executive directors can
also take the initiative in management decisions and they are not restricted to post-decision
approval.
The board is elected in the annual general meeting, typically for one year term. Due to the
dispersed ownership structure within Anglo-Saxon companies, a free rider problem for the
shareholders manifests itself and the voting rights are therefore exercised by a proxy assigned to
the management. The free riding occurs when shareholders only hold small fractions of shares
and therefore do not have enough incentives to engage in looking for the best independent
members. Consequently, the management safeguards its job in the end by choosing their favorite
supervisors. This resembles the problem of the two tier board in which the management board
has the right of proposal for the members of the supervisory board.
Concerning the independence of non-executive directors, the Combined Code, which is part of
the listing requirements at the London Stock Exchange, explicitly defines indicators where a
director, in principle, should not be deemed independent.
Examples of non-independence include: the existence of an employment contract with the
company within the last five years, a material business relationship within the last three years,
additional remuneration apart from the directors fee, close family ties, cross directorships,
representation of a significant shareholder, or a directorship for more than nine years.39
According to the Combined Code, at least half of the board should be comprised of independent
non-executive directors. 40 The rationale behind this regulation is that if directors are not
dependent on the CEO in some way then they are more likely to defend shareholders interests
without fear of consequences such as budget reductions for their departments. But it is not
difficult to find flaws in this logic. First, directors who are independent of the firm may lack the
knowledge or information to be effective monitors. Second, even unrelated directors are still
dependent on the CEO for reappointment.
Independence is also important for the composition of the board committees, which are very
common in one tier boards. An audit committee is part of the listing requirements on most stock
exchanges.41 audit committee is to set the scope and review the results of the yearly audit.42 It
also reviews the financial relationship between the company and auditors. The importance of an
audit committee has increased in the wake of the scandals of Enron, WorldCom, Parmalat, etc.,
where the independence of the auditor was not always clear.43 Unlike the board of directors,
which meet five to six times a year, committees meet, on average, three times a year.
Questions concerning human resources are the task of the nomination and compensation
committee. The latter is responsible for the evaluation of the management, which is intimately
connected with the appraisal of the adequacy of managements compensation.44 The nomination
committee deliberates on the planning of succession of the directors. These committees meet
several times a year and can only pronounce suggestions to the board members who finally
decide about the issues.
In sum, the separation of the positions of board chairman and chief executive officer (CEO), and
the recommendation to compose at least half the board with independent non-executives can be
seen as a functional distinction between management and control.

II. The Better Board System?
Now, of course, bearing in mind the specifics of the two types of board systems just described,
the question arises whether one system can be seen as superior to the other. One might ask,
which is the better system? This is problematic as normally every system has its strengths and
weaknesses. The one-tier board has the advantage that the common responsibility of its members
for management and control provides much more flexibility for board organization, as well as
ensuring that the necessary information will be available to all its members. But it lacks
independence of control, with board members too often dependent on the CEO. By contrast, the
two-tier German system, theoretically and historically, is based on the idea of a separate outside
board.45 Since its introduction, the supervisory board has been implemented to control the
management board (the other tier). The supervisory board has the right to approve certain
categories of management decisions with far reaching consequences (for example major
acquisitions). Day to day management is strictly reserved for the management board.46 In
practice, though, the supervisory board is also dependent on the management board. Former
members of the management board often become ordinary members or even president of the
supervisory board.47 The supervisory board collects the necessary information from the
management board, the body over which it should be exercising control.

But an assessment of the "better" system question is not necessary as we can observe a
convergence of both board structures.48 The revised Corporate Governance Code in the UK
(Combined Code)49 and the Principles of Corporate Governance recently adopted in France,50
strengthen the presence of independent directors on one-tier boards. Another advantage of the
two tier board seems to be the separation of the positions of CEO and chairman of the board,
which is nowadays a suggestion of all corporate governance codes. For the German two-tier
structure, the strengthening of the strategic role of the supervisory board by the new German
Corporate Governance Code51 of 2002 means an attempt to incorporate a key advantage of the
one-tier model.



Two tier



One Tier