Fidelio Board Breakfast – “Employee Representation – What Government & Shareholders Expect” with Hans-Christoph Hirt, Executive Director, Hermes EO

On the steps of Downing Street and again at the October 2016 Conservative Party Conference, UK Prime Minister Theresa May commended worker representation on company Boards and linked this to better governance. The theme also came up, albeit somewhat diluted, in the UK government’s recent Green Paper on Corporate Governance. What does this mean for UK companies? Does the German two-tier Board system represent an alternative model?

As a Board Development and Search firm that is active in both the UK and Germany, Fidelio has a keen focus on Board effectiveness. We were therefore delighted to welcome Hans-Christoph Hirt, Executive Director of Hermes EOS, with his distinctive investment and governance expertise, at a recent Fidelio Board breakfast to shed light on the merits but also the weaknesses of German corporate governance. Hans has been the scourge of many a DAX 30 Board and is a familiar figure at German AGMs. Moreover, as an international expert on investor stewardship and corporate governance, Hans is well placed to debate the relative merits of employee representation in the Boardroom.

In Fidelio’s customary style, we asked Hans to address three topics over breakfast:

  • The investor view on employee representation in Germany and more generally
  • Board composition and the two-tier Board system
  • Board trends, in particular regarding Supervisory Board engagement with shareholders

At our breakfast we were joined by Chairs, Non-Executive and Executive Directors from a range of sectors, including financial services, technology, aviation and professional services. We were also joined by a number of Directors with extensive experience of German Boards and German employee representation.

Crisis of Trust

Hans prefaced his remarks by putting the government’s employee representation proposals (which have already been through a couple of iterations) in the broader context of public discontent with big business. With Brexit in the UK and Trump’s election in the US, we are increasingly seeing waves of anti-business sentiment, and a general crisis of trust that undermines the position of business. A lightning rod for this anger is public dissatisfaction with executive remuneration packages. Hans suggested that this is in fact symptomatic of a broader corporate governance issue – short-termism. In order to restore faith in business, corporate governance needs to emphasise stakeholder engagement, and a shift to focus on more sustainable, long-term value.

Hermes sees a clear role for investors in encouraging this shift to longer-termism and Hans mentioned the role of pension funds in particular having a stronger voice in issues that matter to their members, the underlying beneficiaries. This may well include topics that are unlikely to affect the short-term share price and cannot be measured in financial terms, such as the environment, wider society and the welfare of key stakeholders. Hermes thus focuses on holistic rather than just financial returns and regards executive pay as one way to encourage appropriate behaviours.

The importance of this perspective was borne out by the fact that Hans left the Fidelio breakfast to speak with a Parliamentary Select Committee on the very same themes.

What does Employee Representation mean?

The government clearly sees employee representation as a panacea which will promote better governance. Before debating the strength of this argument at Fidelio’s Board breakfast, we clarified terms. What does employee representation look like?

Employee representation takes different forms across Europe. The most established and prominent example is the German Co-Determination model. For larger German companies half of the Supervisory Board, which can be up to 20 strong, will comprise employees or their representatives. The remainder represent shareholders with the Chairman being appointed by the shareholders and holding the casting vote.

We were fortunate to also be joined by Bob Bischof, Chairman of the German-British Forum, who argued that the German model of Employee Representation was embedded in German governance and corporate law. It saw its roots in the socially and economically polarised 1920s and was reintroduced during the economic reconstruction that followed WWII. This was a product of the post-war consensus, at a historical turning point where politicians were seeking a solution to tensions between employees and corporates, in light of the failings of both capitalist and communist structures. The Co-Determination initiative was led by the Christian Democrats, and benefited from a widespread consensus on the need to move towards a more sustainable system. Some of our guests questioned whether Brexit could provide such a catalyst for change in the UK.

Both our speaker and our guests were unequivocal that, while there are significant advantages to the German system, there are also some disadvantages relating to the particular form of employee representation found among large German companies.

Advantages of Employee Representation

Among the advantages of employee representation on Boards were:

  • Valuable employee insights for the Board into the company. Employee representatives can add substantial value by providing a diverse and practical perspective to the Board room discussion, particularly if employees continue to work in their day job (not always the case).
  • Improved decision-making and greater alignment of interests. Employee representatives bring the concerns and perspectives of the workers into the decision-making process and generally have a more long-term focus than the providers of capital.
  • A stronger culture of employee satisfaction. Businesses with worker representatives on the Board may exhibit higher investment in employee development, and a greater level of employee engagement and identification with the goals of the company.
  • Shareholder and stakeholder perspective. Many German quoted companies have created share option schemes which are available to the entire (German) workforce so that they can benefit as employees and shareholders in the company’s success.
  • A more long-term focus. It was suggested that the presence of worker representatives on Boards helps Directors shift their focus to long-term, sustainable value. A Fidelio guest with extensive experience in major M&A transactions commented that Boards with worker representatives were frequently more inclined to move cautiously on M&A deals, and scrutinise them more closely with a view to the company’s long-term well-being.

Disadvantages of Employee Representation

However, Fidelio’s guests also identified some of the drawbacks of employee representation:

  • Conflicts of interest. The UK Companies Act clearly states that directors are accountable to shareholders and stakeholders for the interests of the company. The Act does not envisage classes of Directors that are narrowly representing one constituency, however important that constituency may be. Examples were provided where interests of the employee representatives may diverge from that of the company: strike action; corporate restructuring; or a bricks and mortar retailer investing in online distribution.
  • Confidentiality. Directors of quoted companies are very obviously privy to confidential, price sensitive information. Employee representatives may find themselves in an invidious position with access to information and a decision-making authority on sensitive issues such as job-losses and of course remuneration structures. To get around putting employee representatives in this position effective decision making may shift – formally or informally -to a smaller group thereby undermining the importance of the Board as the most important governance body.
  • Diversity and competency. Our guest were in unanimous agreement that employee representatives could bring diversity to the Board room which is welcome. Like any other Board Member, employee representatives also needed the bandwidth to contribute to all aspects of the Board’s work. In larger companies the employee representatives could be from the union, or employees who had effectively given up the day job to become a professional representative. Our guests were less certain that this form of employee representation served the objectives of enhancing Board effectiveness and Board diversity.
  • Stakeholder representation. Should other stakeholder groups be represented? If employees are represented at Board level, there is a question of whether other significant stakeholder groups such as suppliers or creditors should be represented.

What’s Preventing Long-Termism?

The debate about the pros and cons of employee representation led inevitably to a broader discussion of the perceived short-termism blighting UK companies, which in turn has given rise to a crisis of trust in business. Two challenges were highlighted in this context: remuneration structures and the role of Private Equity.

With regard to executive pay, some Fidelio guests suggested that introduction of Long-term incentive plans had brought about unintended consequences: frequently the structure of the LTIP was in fact a barrier to companies re-aligning around long-term and sustainable value. The LTIP may encourage senior management to take decisions that are not in the best long-term interest of the company. Hence the preference in the UK for Independent Non-Executive Directors to receive fixed remuneration. In this context the interests of the broader workforce are typically geared towards job retention which arguably is best served by the sustainable health of the company. Employees as shareholders are frequently a source of patient capital.

Our guests also debated the contribution of Private Equity to short termism. It was agreed that Private Equity typically has very defined investment horizons which at a given point will become short-term. Also Private Equity is often charged with saddling portfolio companies with a high level of debt. On the other hand, Fidelio’s breakfast guests provided examples of major PE firms that accounted for the creation of a significant number of jobs in the UK on a net basis.

Promoting Long-Term Thinking at Board Level

Drawing to a close, our guests concluded that employee representation was not in itself the panacea that the government hoped it would be. To re-build trust companies need to be seen to be aligned with broader public interests. With this end in mind Fidelio’s guests had three areas of focus in encouraging a more long-term, multi-stakeholder approach to governance:

  • Culture – the importance of creating the right culture to engage with employees and promote trust should not be underestimated. Businesses with the greatest success in implementing employee representation models are those where they have gone beyond compliance and box-ticking, to create a culture where employees feel valued. John Lewis in the UK was cited by our guests as an example of a strong corporate culture; while John Lewis employees lack the formal Board level representation enshrined in German governance, the partnership has created a culture in which employees know that their views are heard and respected. They also share in the success of the company.
  • Diversity – Fidelio is a strong proponent of Board diversity, and has long suggested that a lack of diversity of skills, perspectives and backgrounds at Board level has contributed to the crisis of trust in business. While the percentage of women on Boards has risen in the FTSE 100 and the DAX 30, there remains a long way to go to ensure real diversity of background, experience and perspective around the Board table, as evidenced by the recent Parker Review, A Report into the Ethnic Diversity of UK Boards.
  • Stewardship code and the role of investors – Our speaker, Hans Hirt, was unequivocal that investors have a clear role to play in encouraging companies to move to a more long-term outlook. While the Stewardship Code has over 200 signatories, it is doubtful that all of these are fulfilling their obligations with respect to scrutinising Boards and encouraging improved behaviours and governance. The very sizeable pools of pension funds have the opportunity to be an economic force wielding great influence on issues that are important to their beneficiaries. Arguably investors as capital providers have a critical role to play in encouraging good governance but also sanctioning poor governance

Conclusion

The UK government’s focus on governance is unsurprising against the Brexit backdrop. As Fidelio’s breakfast discussion highlighted employee representation is not a panacea. In Germany, for example, it is embedded into societal values and the legal framework; it has strengths but also weaknesses. The goal of creating companies that are clearly acting for the long-term benefit of the company and conscious of the public interest is surely a valid one. We see UK Boards exploring this challenge from a number of angles including Board composition. Fidelio thanks Hans-Christoph Hirt of Hermes, for his thoughtful contribution on this critical topic. And as a Board Development and Executive Search firm we are pleased to be contributing to the goal of trusted, better Boards in our daily work with clients, as well as through events like the recent Board breakfast.

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