You could feel the tension in the air when Manuel Conthe, president of [Spain’s] National Stock Market Commission (CNMV) presented the outlines of a new code of good government last March at the Madrid stock exchange. A line-up of executives, consultants, investors, shareholders’ representatives and investment fund managers surrounded the group of experts who had prepared the documents. By then, the controversy had already begun.


News of the code had been leaked in the press, and a considerable group of business executives had expressed their unhappiness both in public and in private. Some of the recommendations that raised concern in the business community included the following: Conceding all possible power to the independents; eliminating armor plating and restrictions in principle on “one share, one vote”; expanding the presence of women; creating the position of an independent vice-president that is similar to the Anglo-American “lead director”; publicizing the reasons behind the dismissal of a board member; preventing independents from resigning en masse when the largest shareholder changes; limiting publicly traded companies, like others, from issuing stock of their subsidiaries on the stock market; submitting a board member’s compensation to the consultative vote of the board; and making it as easy as possible for minority shareholders to exercise their rights.


After a tough battle aimed at breaking Manuel Conthe and the group of experts, the definitive code was presented on May 22. Although some concessions watered down the initial proposal, there were very few changes.


Conthe and his team stood their ground on such controversial points as restrictions on voting rights and protecting women. They also made small concessions on other points, such as the independent vice-president. That figure has essentially been preserved (as leader of the independents, with power to convoke the board), although the actual post has been eliminated. In other cases, such as publicly traded subsidiaries, they have wound up by giving in. However, the principal crack in the code is the possibility for an independent to possess up to 5% of the company’s capital.


Many observers believe that the main achievement of the code is that it has narrowed its realm of activity to abuses of power by executives and by large shareholders of publicly traded companies. One reason for some executives’ criticism of the code is that they are afraid they will lose their current status.


Nevertheless, some observers are not confident that minority shareholders will be active when it comes time to playing their hand. In other words, although there may be more transparency and there may be new mechanisms for exercising their rights, many small shareholders will continue to have a passive attitude because their main interest lies only in receiving the highest possible dividend.


Defenders and Detractors


Juan Antonio Maroto, professor at the Complutense University in Madrid, recognizes that “in order to exercise their new rights, minority shareholders need information and, most of all, that information must be provided in such a way that they know what topics are to be clarified.” Nevertheless, he is not confident that “they are going to get involved in management to the point that they are able to refute the arguments of the largest shareholders. What’s more, will they be able to provide an effective force to the syndication of shares, which typically happens a lot between main shareholders who are also represented on the board?”


Maroto’s argument stems from his conception of minority shareholders: “Small shareholders, either because of their vocation or because of the facts, don’t rise to become ‘outstanding bondholders’ in Latin countries. That means that even ‘to comply’ or ‘to explain’ can be an incentive for them to tolerate something less than good governance in exchange for getting a higher return on their shares. Their reasoning is narrowly economic, although it is almost never considered that way. It is based on the feeling that the requirements of good governance involve a cost that companies must bear. What would shareholders elect if the alternative to not complying is ‘getting paid for being good?” he wonders.


Sergio R. Torassa, professor of finance at the European University, does not share that view. “The voluntarism implicit in the new code has the advantage of permitting the structures of governance to adapt to the particular conditions in each enterprise, depending on its size, sector and number of shareholders. It can do that without incurring excessive costs, unlike the Sarbanes-Oxley legal provisions in the United States.” On the contrary, he argues that these recommendations will lead to the natural selection of the best companies. “You’ll always be able to have companies that manage to apply cosmetic changes to their board and their governance practices. Nevertheless, like the old aphorism says, ‘You can’t fool all the people all the time,’ and the marketplace will take care of separating the wheat from the chaff.”


In addition, he argues that good governance is not incompatible with making money on the stock exchange. To demonstrate that, he offers some interesting data:



  • Risk: Those companies that are rated in the top 10% (evaluated for Good Governance) had volatility of between 1.7% and 2.9%.


  • Those companies that are rated in the lowest 10% had volatility of between 4.9% and 5.8%.


  • ROI (Return on Investment): Companies that are in the top 10% (rated for Good Governance) have ROI of between 4% and 8%, while those that are in the lowest 10% have negative ROI
  • ROE (Return on Equity): Companies in the top 10% (rated for Good Governance) have profitability of between 8% and 14.6%, while those in bottom 10% have negative ROE.


  • ROA (Return on Assets): Companies in top 10% (rated for Good Governance) have profits of between 2.75% and 9.75%, while those in the bottom 10% have negative ROA.


  • EBITDA/Sales: Companies that comply with [Good Governance] best practices have an EBITDA/sales ratio of between 12.1% and 20%, while those in the bottom 10% have negative margins.


  • Price/Book value: Companies in the top 10% [rated for Good Governance] have price/book value ratios of between 2.4 and 2.9, while those in the bottom 10% have ratios of between 1.6 and 2.5.
  • Price/Cash flow: Companies in the top 10% [ranked for Good Governance] have price/cash flow ratios of between 10 and 12.7, while those in the bottom 10% have ratios of between 7.5 and 9.8.
  • Price-Earnings Ratio: Companies in the top 10% [ranked for Good Governance] have Price/Earnings ratios of between 15.7 and 20.1, while those in the bottom 10% have ratios of between 10.2 and 14.9.



Anglo-Saxons and Latinos


Maroto’s emphasis on Latin minority owners reflects the peculiar structure of capital in Spain, where many companies have one major shareholder who controls most of the capital. Giants such as Ferrovial, the construction firm that just acquired the largest airport operator in the world, are dominated by a single family, which owns more than half of the shares. Other companies, such as Union Fenosa, the electric utility, have one great investor (in this case, ACS) that, although it owns less than 50% of the capital, has demonstrated it can impose its criteria on the board of administrators.


This special reality differentiates the Spanish market from other more advanced markets such as those in the U.K. and the U.S. In those countries, there is a balance of power between independents and executives. In contrast, in Spain, regulators try to defend the rights of minority shareholders when they deal with the big shareholders and executives.


In fact, one of the main criticisms of the Conthe Code is that it is trying to bring to Spain the same norms that are in effect in the Anglo-American world, although the Code is dealing with a different reality. According to Maroto, “the mistake is to think that imitating ‘Anglo-Saxon’ codes can resolve differences among Latinos when it comes to protecting the rights of inventors; or banking institutions’ ownership of shares in other companies; or concentration of ownership; or the distribution of shares among small savers. It is like placing a sports car on the chassis of a compact car, and adding the engine. Try that, and it’s clear what your new car model will look like.”


In contrast, Altina Sebastián, professor of finance at the Complutense University in Madrid, argues that “globalization of the economy and the integration of financial markets will act as catalysts for the process of convergence toward best practices in governance. Spain will not be an exception, and the European Union will attempt to homogenize a Code of Best Governance that can be applied in all of its member countries.”


This much is clear: Markets are becoming more and more interrelated, and big investors are extending their tentacles throughout the world. This situation has led to the fact that the Conthe Code, like the rest of the codes, will require institutional investors to play a greater role. It will require them to watch carefully and be in compliance with the best practices. Sebastián applauds such measures.


“The fact that the new code includes principles that give a greater role to minority shareholders fits perfectly with the trend in those countries that are most advanced in governance, such as the United Kingdom and the United States. Nowadays, the logic that moves investors is not local, but global. That means that, sooner or later, the same principles will arrive in our country. In this process, the role of institutional investors is going to be decisive,” says Sebastián. One example is CALPERS, the retirement fund for public-sector employees in California. “It constitutes a paradigm of exemplary shareholder activism. To assure the prudent – but profitable – management of the savings of its members, the fund closely follows the behavior of the management teams of companies in which it invests. Faced with its first disagreement with management, it requests a meeting with the members of the board of directors and tries to get them to introduce specific changes in policy. If, despite everything, the situation does not improve, then the company winds up fattening the list of companies that cannot count on the support of CALPERS, which is something that no board member wishes.”


Comply and Explain … and Penalize?


Whether you are in favor of the Conthe Code or against it, the same question inevitably comes up: Will the Code be effective? Will companies wind up following its recommendations? And, above all, what will happen to those companies that turn a deaf ear to the Code? Will they be penalized? In the United States, Ken Lay and Jeffrey Skilling, Enron’s former chairman and president, face 20 years in prison because of the collapse of that firm, and it played a major role in the chain of business scandals that shook the entire business world. In Spain, similar penalties would be hard to imagine, nevertheless. As a result, Conthe and his team have proposed that the [Spanish] government toughen penalties for this kind of crime.


Maroto considers this measure incomplete. In his opinion, it also needs to require administrators to compensate for the damage that was caused. “When it comes to mistakes, betrayals, and crimes of an economic nature, the most effective penalty is compensation for the resulting damage, and for any lost profits that may have been caused. If toughening the penalties is not accompanied by financial compensation, these penalties will be very limited in their effectiveness.”


For his part, Torassa says that “generally speaking, people do not stop perpetrating punishable crimes unless they consider those crimes to be moral errors or they perceive that the costs – including the possibility of going to jail – exceed the gains. For example, if the benefits you get from altering accounting records are substantial and the possibility of being punished is almost non-existent, then cooking the books would appear to be a rational decision.” Torassa believes that “applying very strong fines and sanctions does not produce any result in itself; on the contrary, it only contributes to increasing the size of the manipulation. In 2002, the U.S. Congress doubled the prison term for financial fraud to 20 years. This punishment has been applied in only an extremely small number of cases, so it has barely had any dissuasive impact on crime. On the contrary, it appears that the more complex the ruse that is used, the lower the probability that the perpetrators will be punished.”


To avoid these kinds of situations, Sebastián proposes that the law be strictly applied. It is not only a question of expanding the penalties, but of carrying them out. “Unless they increase the probability of punishment for those people who are breaking the current law, there won’t be any decline in the number of scandals,” he concludes.