The Effectiveness of Corporate Governanc PDF

The Effectiveness of Corporate Governance
in One-Tier and Two-Tier Board Systems

Evidence from the UK and Germany
by
Carsten Jungmann*
Germany and the UK are paradigms of systems in which the control of manag-
ing directors of companies either lies in the hand of a separate supervisory
board (two-tier system) or is an additional task of the board itself (one-tier
system). This paper provides for an empirical test of the effectiveness of both
systems of corporate governance. The analysis of the financial performance
and board turnover of the largest companies listed on the stock exchanges in
Frankfurt and London over a total of 400 financial years establishes that both
systems are effective means of control. Yet the analysis also demonstrates that
it is not possible to assign superiority to either of them. Therefore, the often
raised question as to whether one of the two systems will finally prevail
and whether there will be ultimate convergence of both systems, has to be
answered in the negative. As the discussion of the strengths and weaknesses
will show, however, there is still scope for improvements in each of the two
board models.
Table of Contents ECFR 2006, 426474
I. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 427
II. Forms of supervision of corporate management in the UK and in Germany . . . . . 432
1. The German system of corporate control (two-tier model) . . . . . . . . . . . . . 432
2. The British system of corporate control (one-tier model) . . . . . . . . . . . . . . 435
3. Groups of persons entrusted with monitoring tasks . . . . . . . . . . . . . . . . . 437
III. Analysis of the relationship between board turnover and financial performance . . . 438
1. Earlier comparative research . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 438
2. Earlier research with relation to the effectiveness of corporate control . . . . . . . 439
3. The uniqueness of the focus on different board systems . . . . . . . . . . . . . . . 440
4. Methodology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 441
* Dr. iur., LL.M. (Yale), M.Sc. in Finance (Leicester), Wissenschaftlicher Assistent,

Bucerius Law School in Hamburg. The author is grateful to Christian Bochmann for
his research assistance on this project.
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ECFR 4/2006 One-Tier and Two-Tier Board Systems 427
IV. Testing the hypotheses: data on financial performance and board turnover . . . . . . 446
V. Strengths and weaknesses of the concurring board models . . . . . . . . . . . . . . . 448
1. Advantages and disadvantages of the two-tier model . . . . . . . . . . . . . . . . . 449
2. Advantages and disadvantages of the one-tier model . . . . . . . . . . . . . . . . . 458
VI. Conclusion and recommendations for the improvement of corporate control . . . . 462
1. Recommendations for the improvement of corporate control in the two-tier
system . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 463
2. Recommendations for the improvement of corporate control in the one-tier
system . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 469
3. Reflection on the limits of corporate control . . . . . . . . . . . . . . . . . . . . . 473
VII. Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 473
I. Introduction
It is a well-known phenomenon that there are two main sets of legal rules on
the supervision of corporate management: one-tier boards and two-tier
boards. Within Europe, the United Kingdom is a prominent country with a
single board system, consisting of executive and non-executive directors;
other countries such as Ireland take the same approach. On the other hand,
Germany traditionally employs the dualism of a management board and a
separate supervisory board. This system is also found in the Netherlands,
Austria, Finland and Denmark 1. While some countries such as Sweden have
legal frameworks that cannot be classified as one-tier or two-tier systems,
other countries, such as Belgium, Portugal and Spain, allow corporations to
choose between the two systems 2. The same once held true for France, but
France has since introduced a third option through which more than one
organ can be entrusted with executive supervision 3. The European legislator
also took the approach of creating a mixed system when it created the
European Company, the Societas Europaea (SE). According to Article 38 of
the Council Regulation (EC) No. 2157/2001 of October 8, 2001 on the
Statute for a European company (SE), a SE shall be comprised of either a
supervisory organ and a management organ (two-tier system) or an adminis-
trative organ (one-tier system).
1 See Klaus J Hopt, The German Two-Tier Board: Experience, Theories, Reforms in
Klaus J Hopt and others (eds), Comparative Corporate Governance: The State of the Art
and Emerging Research (OUP, Oxford 1998) 227, 228; Udo C Brndle and Jrgen Noll,
The Power of Monitoring (2004) 5 German LJ 1349, 1353.
2 See Carsten Berrar, Die Entwicklung der Corporate Governance in Deutschland im
internationalen Vergleich (Nomos Verlagsgesellschaft, Baden-Baden 2001) 3641.
3 See Michel Storck, Corporate Governance la Franaise Current Trends (2004) 1
ECFR 36, 4153.

428 Carsten Jungmann ECFR 4/2006
There are strengths and weaknesses of the monistic as well as of the dualistic
systems with regard to nearly all aspects of the organisation of a companys
affairs. Many of these problems, however, lie outside the focal point of this paper.
This paper will instead concentrate on the question of effective corporate con-
trol, i.e. corporate governance as the system by which companies are directed
and controlled 4. Thus, the key questions are whether the German two-tier and
the British one-tier systems are effective, and whether it is possible to classify
one of them as the superior method of successful corporate governance?
Both questions have been regarded as fundamental to the lively comparative
debate on corporate governance 5. The relevance of the questions presented
and the necessity of analysis becomes apparent when we consider the recent
discussions concerning the reform of corporate governance rules in Germany
and the UK. One of the key criticisms of the erstwhile German rules concern-
ed the mandatory two-tier board system. Some fifteen years ago, the German
dualism of a management board and a supervisory board had been criticised
as inferior to the British one-tier board system with executive and non-exe-
cutive directors in a single board 6, but today, this view is no longer shared 7.
4 Committee on the Financial Aspects of Corporate Governance, Report (London 1992)

15 (para 2.5); Department of Trade and Industry, Modern Company Law For a Com-
petitive Economy (DTI, London 1998) para 3.5; see Reinhard H Schmidt and Gerald
Spindler, On the Convergence of National Corporate Governance Systems: A note on
Braendle and Noll (2006) 17 J. Interdisc. Econ. 83, 8485; cf. Rolf Birk, Germany in
Arthur R Pinto and Gustavo Visentini (eds), The Legal Basis of Corporate Governance
in Publicly Held Corporations A Comparative Approach (Kluwer Law International,
The Hague 1998) 53, 67 for the German interpretation of the expression. For the
broader implications inherent in the concept of corporate governance see Klaus J Hopt,
Common Principles of Corporate Governance in Europe? in Joseph A McCahery and
others (eds), Corporate Governance Regimes (OUP, Oxford 2002) 175, 176.
5 See Klaus J Hopt and Patrick C Leyens, Board Models in Europe Recent Deve-
lopments of Internal Corporate Governance Structures in Germany, the United King-
dom, France, and Italy (2004) 1 ECFR 135; Patrick C Leyens, Deutscher Aufsichtsrat
und U.S.-Board: ein- oder zweistufiges Verwaltungssystem? (2003) 67 RabelZ 57;
but see Udo C Brndle and Jrgen Noll, On the Convergence of National Corporate
Governance Systems (2006) 17 J. Interdisc. Econ. 57 (arguing that the question has
become obsolete due to the convergence process of corporate governance systems); cf.
Reinhard H Schmidt and Gerald Spindler (n. 4), 87 for a critical view on Brndles and
Nolls methodological concept.
6 Manuel R Theisen, Das Board-Modell: Lsungsanstze zur berwindung der ber-
wachungslcke in deutschen Aktiengesellschaften? (1989) 34 Die Aktiengesellschaft
161, 163165; see also Erich Potthoff, Board-System versus duales System der Unter-
nehmensverwaltung Vor- und Nachteile (1996) 48 Betriebswirtschaftliche Forschung
und Praxis 253 (highlighting the strengths of the board model).
7 But see Patrick C Leyens (n. 5) 97 (arguing that the one-tier system has a higher poten-
tial for development in the long term); cf Manuel R Theisen, Empirical Evidence and

Accordingly, the two-tier system has not been abolished under the new
German Corporate Governance Code adopted in 2002 (as amended in 2006).
A vital discussion of changes to the current system continues instead, which
is primarily concerned with ways to improve internal control. If, however,
there was to be a major reform to the German corporate governance system
in the future, it is likely that such a reform would converge the current
system to the British one 8.
In the UK, neither the reports on corporate governance nor the recent pro-
posals for a reform of company law called for changes to the unitary board
system 9. The British system has instead been regarded as being superior to
the German system 10. A decade ago, however, the advantages of the German
two-tier board system were at least sporadically highlighted, and its intro-
duction into British law was even postulated 11. However, this proposal never
found approval by a majority of commentators. Thus, it appears that the
one-tier system is favoured over the two-tier system, and the adoption of a
Economic Comments on Board Structure in Klaus J Hopt and others (eds), Compara-
tive Corporate Governance: The State of the Art and Emerging Research (OUP, Oxford
1998) 259.
8 See Reinhard H Schmidt, Stakeholderorientierung, Systemhaftigkeit und Stabilitt
der Corporate Governance in Deutschland (Working Paper No. 162, University of
Frankfurt Working Paper Series: Finance & Accounting, 2006) 2 <http://www.wiwi.
uni-frankfurt.de/schwerpunkte/finance/wp/1150.pdf> (accessed 26 October 2006); Tho-
mas Raiser, Unternehmensmitbestimmung vor dem Hintergrund europarechtlicher
Entwicklungen in Verhandlungen des sechsundsechzigsten Deutschen Juristentages
(Verlag C. H. Beck, Mnchen 2006) B 109110.
9 See Colin Mayer, Corporate Governance in the UK (2000) 8(1) Hume Papers on Pu-
blic Policy 1; Eva-Dsire Lembeck, UK Company Law Reform (2003) 6 Neue Zeit-
schrift fr Gesellschaftsrecht 956.
10 Committee on Corporate Governance, Final Report (London 1998) 2627 (para 3.12);
Paul L Davies, Board Structure in the UK and Germany: Convergence or Continuing
Divergence? (2000) 2 ICCLJ 435.
11 Thomas Sheridan and Nigel Kendall, Corporate Governance: An Action Plan for Pro-
fitability and Business Success (Pitman Publishing, London 1992) passim (especially at
161164); Lewis Robertson, Corporate Governance: The Lessons of Recent British
Experience (1995) 3(4) Hume Papers on Public Policy 1, 4; see also Robert Ian Tricker,
Corporate Governance: Practices, Procedures and Powers in British Companies and
their Boards of Directors (Gower, Oxford 1984) 242249 (proposing that all public
limited companies should have a Governing Body); for a review and discussion see
Geoffrey Owen, The Future of Britains Boards of Directors Two Tiers or One?
(Board for Chartered Accountants in Business, London 1995); see also Owen Green,
Why Cadbury Leaves a Bitter Taste Financial Times (London 9 June 1992) 19.

compulsory supervisory board into UK law is very unlikely to happen in the

foreseeable future 12.
In the ongoing discussion regarding corporate governance, arguments in
favour of either system were often based on theoretical approaches 13, rather
than on empirical research on their effectiveness 14. In addition, at the be-
ginning of the debate on reform, the proposals concentrated on the abolish-
ment of one system and its replacement by the other. However in the last years,
the idea of convergence although forecasted about twenty years ago 15
originated. Today there is a very significant discussion concerning con-
vergence versus continuing divergence in the field of corporate governance 16.
And the 2005 Recommendations of the EU concerning the roles of non-
executive directors and members of the supervisory board 17 may be regarded
as a preliminary result of this process 18. This discussion concerning the com-
parison of the board structure in the UK and Germany was led by Davies 19.
However, again, empirical research on the particular question is still missing.
12 Eils Ferran, Company Law and Corporate Finance (OUP, Oxford 1999) 219; Depart-
ment of Trade and Industry, Modern Company Law For a Competitive Economy:
Developing the Framework (DTI, London 2000) paras 3.1403.141.
13 For an overview see Udo C Brndle and Jrgen Noll (n 1) 13621363.
14 See Peter Hommelhoff and Daniela Mattheus, Corporate Governance nach dem
KonTraG (1998) 43 Die Aktiengesellschaft 249, 250251 (pointing out that empirical
evidence on the superiority of one of the models is missing).
15 Knut Bleicher and Herbert Paul, Das amerikanische Board-Modell im Vergleich zur
deutschen Vorstands-/Aufsichtsratsverfassung Stand und Entwicklungstendenzen
(1986) 46 Die Betriebswirtschaft 263.
16 See among the important contributions Paul L Davies (n 10); Lucian Bebchuk and Mark
J Roe, A Theory of Path Dependence in Corporate Ownership and Governance in
Jeffrey N Gordon and Mark J Roe (eds), Convergence and Persistence in Corporate
Governance (CUP, Cambridge 2004) 69; Wymeersch, Convergence or Divergence in
Corporate Governance Patters in Western Europe? in Joseph A McCahery and others
(eds), Corporate Governance Regimes (OUP, Oxford 2002) 230; John C Coffee Jr, The
Future as History: The Prospects for Global Convergence in Corporate Governance
and its Implications (1999) 93 Nw. U. L. Rev. 641; Henry Hansmann and Reinier
Kraakman, Toward a Single Model of Corporate Law? in Joseph A McCahery and
others (eds), Corporate Governance Regimes (OUP, Oxford 2002) 56.
17 Recommendations of the European Commission of 15 February 2005 on the Role of
Non-Executive or Supervisory Directors of Listed Companies and on the Committees
of the (Supervisory) Board, Official Journal of the European Union L 52 (25 February
2005) 51; for a discussion see Gerald Spindler, Die Empfehlungen der EU fr den Auf-
sichtsrat und ihre deutsche Umsetzung im Corporate Governance Kodex (2005) 26
Zeitschrift fr Wirtschaftsrecht 2033.
18 See Christian Frster, Europische Corporate Governance Tatschliche Konvergenz
der neuen Kodizes? (2006) 27 Zeitschrift fr Wirtschaftsrecht 162.
19 Paul L Davies (n 10).

This study is a quantitative comparative assessment of the degree of managerial

discipline provided by both systems. It examines the financial performance of
companies in the UK and Germany and the reactions of the monitoring
bodies in cases of poor performance. Typically, there are various reasons for
poor performance, and there are numerous ways to control management 20. If
negative performance of a company appears to be related to mismanagement,
it is then the appropriate response to release management from its duties,
either by not re-electing the managers or by dismissing them 21. Although this
measure is frequently the last resort, it is the most meaningful task for those
who are entrusted with managerial control. Thus, the functioning of internal
control is a proper measure of the performance of a corporate governance
system 22 and consequently used in this paper. This leads to the two hypotheses
tested:
Hypothesis 1: Board turnover is inversely correlated to financial per-
formance, so that the non-executive directors (UK) and the members of the
supervisory board (Germany), respectively, exercise their power to (effec-
tively) unseat management.
Hypothesis 2: It is impossible to deduce the superiority of either of the two
systems from the degree of inverse correlation between the board turnover
and the financial performance.
The paper is structured as follows: in the subsequent part, the forms of super-
vision of corporate management in the UK and Germany are presented. This
includes a short analysis of the legal rules as well as practical observations.
Part III contains the description of the methodology used in this paper to
examine the relationship between board turnover and financial performance.
It explains the uniqueness of the approach taken here and gives definitions of
the relevant terms used. The empirical results of this study are then presented
in part IV, which also offers an answer to the question of whether the above
mentioned hypotheses have proven to be true. Part V addresses the relevant
theoretical explanations for the empirical results: the advantages and disadvan-
20 See Eugene F Fama, Agency Problems and the Theory of the Firm (1980) 88 J. Polit.
Economy 288.
21 Brian R Cheffins, Company Law: Theory, Structure and Operation (Clarendon Press,
Oxford 1997) 605; see Eils Ferran (n 12) 217223.
22 See Jonathan R Macey, Institutional Investors and Corporate Monitoring: A Demand-
Side Perspective in a Comparative View in Klaus J Hopt and others (eds), Comparative
Corporate Governance: The State of the Art and Emerging Research (OUP, Oxford
1998) 903, 908909; Rudi K F Bresser, Reynaldo Valle Thiele, Annette Biedermann and
Holger Ldeke, Entlassung des Vorstandsvorsitzenden und Unternehmenserfolg: Eine
empirische Untersuchung der grten deutschen Aktiengesellschaften (2005) 75 Zeit-
schrift fr Betriebswirtschaft 1165, 1166.

tages of the one-tier system and the two-tier system are contrasted. The dis-
cussion of these strengths and weaknesses leads to the conclusion in part VI,
which encompasses recommendations to enhance both of the systems of cor-
porate control.
II. Forms of supervision of corporate management in the UK

and in Germany
The purpose of this paper is to examine the effectiveness of corporate control.

As the extent of board turnover will be used to measure the exercise of power
of control, it is important to analyse who exactly is entrusted and empowered
with control in both jurisdictions.
1. The German system of corporate control (two-tier model)
According to the German Stock Corporation Act of 1965, it is mandatory for

all German stock corporations (Aktiengesellschaften) to have two boards: the
management board (Vorstand) and the supervisory board (Aufsichtsrat). The
supervisory board members are either shareholder representatives or labour
representatives 23. Simultaneous membership of the management board and
the supervisory board is not permitted.
The main tasks of the supervisory board are to appoint and dismiss the mem-
bers of the management board and to monitor them. The supervisory board
also represents the corporation in all affairs concerning the management
board, especially by initiating court actions against the board members. In
addition, the supervisory board must approve the annual accounts and can
intervene in cases where the companys interests are seriously affected. For
certain extensive and fundamental decisions, the by-laws must impose that
authorisation by the supervisory board is required 24. Finally, the supervisory
board also has some soft functions, such as networking with stakeholders 25.
Notwithstanding these numerous tasks, supervision remains the core func-
23 This composition of the supervisory board is due to the German laws of co-determina-
tion in companies with more than 500 employees: depending on the size and the busi-
ness of the corporation, up to 50 % of the members of the supervisory board are labour
representatives. They are elected in a rather complicated procedure governed by the
applicable co-determination act, while the representatives of the shareholders are
elected in the general meeting by the shareholders.
24 See Carsten Berrar, Die zustimmungspflichtigen Geschfte nach 111 Abs. 4 AktG im
Lichte der Corporate Governance-Diskussion (2001) 54 Der Betrieb 21812182.
25 Paul L Davies (n 10) 450453.

tion of the supervisory board, whereas all management issues are in principle
reserved for the management board, which acts autonomously and is not
bound by orders of the shareholders or the supervisory board. As mentioned
above, the members of the management board are appointed and can be
removed by the supervisory board. The management board does not only
manage the companys affairs, but also sets up long term goals and guidelines.
At least in principle, there is a clear separation between the tasks and respon-
sibilities of the two boards 26. However, case law in the last few years has
shown that the monitoring task of the supervisory board has become more
and more permanent and future-oriented, as the intended business policy
has also to be controlled by the supervisory board. Sec. 5.1.1 of the German
Corporate Governance Code expressly clarifies that it is the task of the
supervisory board to advise regularly and supervise the management board
in the management of the enterprise and that it must be involved in deci-
sions of fundamental importance to the enterprise. Thus, the members of
supervisory board act, to a certain extent, as consultants of the management
board which necessitates an ongoing and continuous discussion 27.
There are, in addition, shareholder control mechanisms, which are often
referred to as voice and exit 28. In small family companies and companies
with only a small number of shareholders, the shareholder influence is signi-
ficant, both practically and theoretically: few shareholders are able to co-
ordinate their activities and act efficiently 29; in particular, few shareholders
can effectively make use of their rights in the general meeting, which the
German Stock Corporation Act of 1965 regards as the highest corporate
organ. By contrast, in listed and publicly traded companies, which hold the
spotlight in the corporate governance debate and are the focal point of this
study, most investors have only a tiny proportion of the shares and are not in
a position to effectively exercise control in the general meeting. Furthermore,
monitoring costs exceed the benefit of being able to exert influence and non-
monitoring shareholders would gain the same advantages (free-rider problem).
Thus, the incentives for shareholders to exercise control are low.
Notwithstanding these general reflections on the role of shareholders in large
corporations, we need to make two remarks concerning distinct particular-
26 Knut Bleicher and Herbert Paul (n 15) 265.

27 For a review of the latest court decisions see Hartwig Henze, Neuere Rechtsprechung
zu Rechtsstellung und Aufgaben des Aufsichtsrats (2005) 58 Der Betrieb 165.
28 Albert O Hirshman, Exit, Voice, and Loyalty: Responses to Decline in Firms, Organiza-
tions, and States (Harvard University Press, Cambridge 1970); see also Reinhard H
Schmidt (n 8), 69.
29 See Rolf Birk (n 4) 65.

ities of the German stock market. The first concerns the ownership structure
of large companies. At least traditionally, institutional investors and espe-
cially banks have held large proportions of shares in Germany 30. This was
regarded as a major advantage for effective corporate control 31. However, in
Germany as well as in the UK, there is a now general tendency towards a less
dispersed ownership 32. Thus, the first phenomenon observed is becoming
less important; at least, it is no longer a German particularity 33. Secondly,
the threat of (hostile) takeovers helps to discipline the management in other
jurisdictions 34, but we have to recognise a lack of hostile public takeover bids
in Germany 35.
30 Theodor Baums, Corporate Governance in Germany: The Role of the Banks (1992) 40
Am. J. Comp. L. 503; Klaus J Hopt, Corporate Governance und deutsche Universal-
banken in Dieter Feddersen, Peter Hommelhoff and Uwe H Schneider (eds), Corpo-
rate Governance (Otto Schmidt-Verlag, Kln 1996) 243, 247248.
31 See Mark J Roe, A Political Theory of American Corporate Finance (1991) 91 Colum.
L. Rev. 10; Edward B Rock, Americas Fascination with German Corporate Gov-
ernance (1995) 40 Die Aktiengesellschaft 291; see more generally Stu Gillan and Laura
Starks, Corporate Governance Proposals and Shareholder Activism: The Role of
Institutional Investors (2000) 57 J. Finan. Econ. 275
32 See Office for National Statistics, Share Ownership: A Report on Ownership of Shares
as at 31st December 2004 (London 2005); Jean Tirole, The Theory of Corporate Finance
(Princeton University Press, Princeton/Oxford 2006), 39 (Figure 1.4); Deutsche Bun-
desbank, Ergebnisse der Gesamtwirtschaftlichen Finanzierungsrechnung fr Deutsch-
land 1991 bis 2004 (Frankfurt 2005).
33 Cf Paul L Davies (n 10) 455; see also Stefan Grundmann and Peter O Mlbert, Corpo-
rate Governance: European Perspectives (2000) 2 ICCLJ 415, 421 (noting converging
trends in Europe with regard to the role of shareholders in corporate governance).
34 See David Scharfstein, The Disciplinary Role of Takeovers (1988) 55 Rev. Econ. Stud.
185; John W Byrd and Kent A Hickman, Do Outside Directors Monitor Managers?
(1992) 32 J. Finan. Econ. 195; Jean Tirole (n 32), 4351; Klaus Gugler, Corporate
Governance and Performance: The Research Questions in Klaus Gugler (ed), Corpo-
rate Governance and Economic Performance (OUP, Oxford 2001) 3241.
35 Theodor Baums, Corporate Governance Systems in Europe Differences and Tenden-
cies of Convergence (Working Paper No 37, University of Osnabrck/University of
Frankfurt Working Paper Series, (1996) 9 <http://www.jura.uni-frankfurt.de/ifawz1/
baums/Bilder_und_Daten/Arbeitspapiere/a0896.pdf> (accessed 26 October 2006)); Ste-
phen Prowse, Corporate Governance in an International Perspective (Bank for Inter-
national Settlements, Basle 1994) 4650; Andreas Hackethal, Reinhard H Schmidt and
Marcel Tyrell, Banks and German Corporate Governance: On the Way to a Capital
Market-Based System? (2005) 13 Corporate Governance 397; see also Ekkehart Boeh-
mer, Germany in Klaus Gugler (ed), Corporate Governance and Economic Perform-
ance (OUP, Oxford 2001) 108 (stressing how little is known about hostile takeover bids
due to the lack of publication requirements for takeover negotiations).

Consequently, in Germany, the members of the supervisory board are the

predominant monitors of the corporate management 36. This also holds true
in the light of the remaining shareholder control mechanisms 37, since the
means by which the shareholders can exercise control are different from
those that the main bodies for corporate control can use. This study incorpo-
rates board turnover as an indicator of whether effective control is exercised.
The shareholders have no direct means of influencing the replacement of the
management. Thus, shareholder control mechanisms are not in the centre of
this study 38.
2. The British system of corporate control (one-tier model)
In the UK, only one single board exists 39. All board members, i.e. executive
directors as well as non-executive directors, are normally elected by the share-
holders. The shareholders also have the power to remove the directors from
office (Sec. 303 Companies Act 1985). However, this remedy would be the
last resort and is only used in cases of serious misconduct or extreme under-
performance. Usually, the board takes decisions to reorganise the manage-
36 This even holds true in the light of the latest judgments of the German Federal Supreme
Court, according to which the most important key decisions (eg, the sale of core busi-
ness units, the investment in highly risky projects or the acquisition of other firms) need
the approval of the shareholders in the general meeting; see BGHZ 83, 122 (Bundes-
gerichtshof, II ZR 174/80, 25 February 1983); BGHZ 159, 30 (Bundesgerichtshof, II ZR
155/02, 26 April 2004); for an overview see Holger Fleischer, Ungeschriebene Haupt-
versammlungszustndigkeiten im Aktienrecht (2004) 57 Neue Juristische Wochen-
schrift 2335.
37 See Paul L Davies, Institutional Investors as Corporate Monitors in the UK in Klaus J
Hopt and Eddy Wymeersch (eds), Comparative Corporate Governance: Essays and
Materials (Walter de Gruyter, Berlin 1997) 47; Alexander Mann, Corporate Governance
Systeme (Duncker & Humbolt, Berlin 2003); see also Colin Mayer (n 9) 67 for the
situation in the UK.
38 As this study concentrates on the largest companies only and as these companies are
not subsidiaries, the influence of parent companies being responsible for reviewing the
performance of directors can be disregarded. See Korn/Ferry International, European
Boards of Directors Study (London 1996) 32, for the monitoring role of parent compa-
nies in Germany.
39 See Paul L Davies, Gower and Davies Principles of Modern Company Law (7th edn
Sweet & Maxwell, London 2003) 316321 (also pointing out that the Companies Act
1985 does not explicitly address the question whether the board is to be a one-tier or a
two-tier board); but see Jonathan Rickford, Fundamentals, Developments and Trends
in British Company Law Some Wider Reflections; Second Part: Current British
Priorities and Wider Reflections (2005) 2 ECFR 63, 7378 (on the legal necessity of a
unitary board).

ment, and the shareholders, as well as the creditors, have only a limited capa-
city to exercise pressure on the board members and thereby indirectly affect
the board composition40. An increasing pressure to reorganise the board is a
reaction to the financial situation of the company, and demand to remove
directors only arises with regard to those who are managing the companys
affairs the board.
According to legal provisions, it is the board that manages the company.
Nowadays, however, virtually all boards consist of not only executive direc-
tors but also non-executive directors: according to the Combined Code on
Corporate Governance (as amended in 2006), it is best practice that half of
the board of larger companies should be comprised of non-executive direc-
tors. Therefore, the question arises as to how the role of an executive director
differs from the role of a non-executive director. Non-executive directors are
not employees of the company but rather members of the board and are,
accordingly, concerned with managerial problems. It is indeed one of their
functions to judge on strategy, key appointments and standards of conduct.
The Combined Code meanwhile expressly states in the supporting principles
to its Sec. A.1 that non-executive directors should constructively challenge
and help develop proposals on strategy. However, it has become apparent in
the corporate governance debate during the last years that there is a tendency
towards control becoming their most important task 41. It was only a logical
consequence of this development that not only the Cadbury Code but also
the Combined Code refers to this role of non-executive directors. Sec. A.1 of
the Combined Code assigns them, as becomes apparent in the supporting
principles of this section, with the duty to scrutinise the performance of
management in meeting agreed goals and objectives and monitor the reporting
of performance. The first studies subsequent to the adoption of the Cadbury
Code revealed that the disciplinary function of the board increases if the
monitoring role of non-executive directors is strengthened 42.
It is also apparent that even if managerial power is vested in the board, e.g.
by the articles of association, the day-to-day business of the company is
40 Eils Ferran (n 12) 118119.

41 See generally Brian R Cheffins (n 21) 602652. See also Paul L Davies, Board of
Directors: the European Perspective in Geoffrey Owen, Tom Kirchmaier and Jeremy
Grant (eds), Corporate Governance in the US and Europe Where Are We Now?
(Palgrave MacMillan, New York 2006) 42 (arguing that the Combined Code is to push
the UK towards a de facto two-tier board system).
42 See Jay Dahya, John J McConnell and Nickolaos G Travlos, The Cadbury Committee,
Corporate Performance, and Top Management Turnover (2002) 57 J. Finance 461; for a
theoretical evaluation see, eg, Brian R Cheffins (n 21) 642652.

managed by individuals, not by the board as a whole, which meets once a

month or even less frequently. Thus, most of the tasks required to run the
business are executed by senior managers 43. They do not necessarily need to
be board members, but in practice, this is often the case among the most
senior members. It is, in any case, not the function of the non-executive
directors to get involved in the day-to-day management of the company. In
this respect, it is possible to differentiate non-executive directors from execu-
tive directors. Nonetheless, in contrast to the two-tier board system, there is
no black or white distinction between the functions, neither between the
separate organs nor within an organ of the company itself.
3. Groups of persons entrusted with monitoring tasks
This final aspect will be significant to the discussion of the advantages and
disadvantages of the British one-tier system. Since the management of the
daily business affairs of the company does not fall within the responsibilities
of the non-executive directors, it is the role of executive directors in the UK.
This distinction is mirrored in Germany with the role of the members of the
management board being identical to that of the executive directors, whilst
the members of the supervisory board are the counterparts of the non-exe-
cutive directors 44.
Accordingly, this study concentrates, as far as board turnover is concerned,
on the members of the management board and the executive directors, res-
pectively. This is in accordance with the results of previous studies, which
have demonstrated that supervisory board turnover or replacement of the
non-executive directors cannot be regarded as being related to financial
performance 45, with the exception of cases after periods of persistently poor
performance, where there is some reaction 46. This reaction of the share-
holders, however, does not concern the monitoring institution itself, but
rather concerns a problem arising from the failure of the individuals who are
entrusted with the monitoring tasks. Accordingly, turnover of non-executive
directors and members of the supervisory board is not examined in this
paper.
43 See Brian R Cheffins (n 21) 603604.

44 For a sound discussion of other internal and external mechanisms of corporate gov-
ernance in the UK, see Alexander Mann (n 37).
45 Julian Franks, Colin Mayer and Luc Renneboog, Who Disciplines Management in
Poorly Performing Companies? (2001) 10 J. Finan. Intermediation 209.
46 Julian Franks and Colin Mayer, Ownership and Control of German Corporations
(2001) 14 Rev. Finan. Stud. 943, 965.

III. Analysis of the relationship between board turnover

and financial performance
Empirical studies on the relationship between board turnover and financial

performance have been conducted in the past 47, but none have focused on the
distinction between one-tier and two-tier systems. Hence, this paper is an
attempt to fill the gap in available literature. Most of the former studies either
failed to take Germany into account, or concentrated on the shareholder
structure and differentiated between insider and outsider systems.
1. Earlier comparative research
In the few existing comparative studies, Germany has been regarded as the
prototype of an insider system 48, i.e. a system with a small number of quoted
stock companies and concentrated share ownership, while the UK has been
taken as a clear example of an outsider system 49, i.e. a system with large equity
markets and dispersed ownership 50. Typically, this approach was taken to
verify the theoretical explanation given by Shleifer and Vishny 51 who hypo-
thesized that concentrated share ownership mitigates free-rider problems and
is thus superior to dispersed ownership, as far as questions of effective corpo-
rate control are concerned. Goergen 52 was one of the first to undertake a
quantitative study with regard to the markets in Germany and the UK. How-
ever, he concentrated his study on ownership and control in initial public
offerings (IPOs), which makes his findings hard to generalise.
About ten to fifteen years ago, the differences in the ownership structure be-
tween the UK and Germany, in terms of the concentration of shares owned by
banks, non-financial corporations, and households, were significant 53. Several
47 For an overview see Udo C Brndle and Jrgen Noll (n 1) 13631365. Important infor-
mation concerning board size, structure, composition and remuneration with regard to
Germany and the UK can be found in Korn/Ferry International (n 38).
48 See Klaus Gugler, Dennis C Mller and B Burcin Yurtoglu, Corporate Governance and
Globalization (2004) 20 Oxford Rev. Econ. Pol. 129, 130134.
49 See Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer and Robert W Vishny,
Law and Finance (1998) 106 J. Polit. Economy 1113, 1145-1148; see also Jean Tirole
(n 32), 5356.
50 These differences are sometimes still stressed today, see Udo C Brndle and Jrgen Noll
(n 5).
51 Andrei Shleifer and Robert W Vishny, Large Shareholders and Corporate Control
(1986) 94 J. Polit. Economy 461; see also Harold Demsetz and Kenneth Lehn, Large
Shareholders and Corporate Control (1985) 93 J. Polit. Economy 1155.
52 Marc Goergen, Corporate Governance and Financial Performance A Study of German
and UK Initial Public Offerings (Edward Elgar Publishing, Cheltenham 1998).
53 See, eg, Stephen Prowse (n 35) 3339; Julian Franks and Colin Mayer (n 46) 946952.

more recent studies have taken this approach: Franks, Mayer and Renneboog
examined the relation between board turnover and, inter alia, corporate per-
formance and addressed the question of how the UK system of corporate
ownership relates to control 54. Franks and Mayer undertook a similar approach
with regard to the ownership and control of German corporations 55. The
results of these studies might have been diluted in the meantime. The remaining
differences notwithstanding 56, the latest statistics clearly show a recent trend
that the ownership structure in the UK is no longer as dispersed as it once
was 57. Consequently, whilst a couple of years ago the differences in the
shareholder structures might have been a valid explanation for the results of
comparative studies on the effectiveness of corporate control, with respect to
recent data for the UK and Germany, this is no longer the case 58.
2. Earlier research with relation to the effectiveness of corporate control
Most of the other studies on the effectiveness of corporate control have been
conducted solely based on the US market. Therefore, they analysed the
Anglo-American one-tier system but did not contrast it with the dualistic
model. Some used Tobins Q as a performance measure 59, whilst others more
traditional means 60. However, they all focused on the composition of the
54 Julian Franks, Colin Mayer and Luc Renneboog (n 45).

55 Julian Franks and Colin Mayer (n 46).
56 See Luis Correia Da Silva, Marc Goergen and Luc Renneboog, Dividend Policy and
Corporate Governance (OUP, Oxford 2004), 915; Colin Mayer (n 9) 14; Rafael La
Porta, Florencio Lopez-de-Silanes and Andrei Shleifer, Corporate Ownership Around
the World (1999) 54 J. Finance 471; Ekkehart Boehmer, Who Controls German Cor-
porations? in Joseph A McCahery and others (eds), Corporate Governance Regimes
(OUP, Oxford 2002) 268.
57 The percentage of UK shares owned by individuals/households dropped from 37.5 % in
1975 to 14.1 % in 2004 (Office for National Statistics (n 32) para 3.8), whereas between
70 % and 80 % of shares in UK listed companies are today held by institutional
investors (Jonathan Rickford, Fundamentals, Developments and Trends in British
Company Law Some Wider Reflections; First Part: Overview and the British
Approach (2004) 1 ECFR 391, 411).
58 See also Andreas Hackethal, Reinhard H Schmidt and Marcel Tyrell (n 35); Reinhard H
Schmidt, Corporate Governance in Germany: An Economic Perspective in Jan Pieter
Krahnen and Reinhard H Schmidt (eds), The German Financial System (OUP, Oxford
2004) 386.
59 Robert Morck, Andrei Shleifer and Robert W Vishny, Management Ownership and
Market Valuation: An Empirical Analysis (1988) 20 J. Finan. Econ. 293; Sanjai Bhagat
and Bernard Black, The Uncertain Relationship between Board Composition and Firm
Performance (1999) 54 Bus. Law. 921.
60 Benjamin E Hermalin and Michaels S Weisbach, The Effects of Board Composition
and Direct Incentives on Firm Performance (1991) 20 Financial Management 101;

board and on the compensation of the board members. These studies could
not find a significant relationship between the board composition and finan-
cial performance. These results can be contrasted with a study by Byrd and
Hickman 61, who concluded the opposite. Indeed, in the American studies of
the 1980s and the early 1990s, there is no clear line of evidence to verify
whether outside directors are valuable or whether market forces have made
them superfluous.
With regard to the previously mentioned studies concerning the UK and
Germany, we arrive at the widely accepted conclusion that a strong relation-
ship exists between board turnover and corporate performance. This result is
supported by earlier research by Coughlan and Schmidt 62, Warner, Watts and
Wruck 63, Weisbach 64 and, very recently, Bresser, Valle Thiele, Biedermann and
Ldeke 64a. These studies notwithstanding, Hypothesis 1, with its emphasis on
the inverse correlation between board turnover and financial performance,
can be afforded stronger supporting evidence.
3. The uniqueness of the focus on different board systems
The above-mentioned studies comparing the UK and Germany are of limited

use with regard to the key question examined in this paper, namely whether
the monistic or the dualistic system is superior (Hypothesis 2). One of the
reasons is that these studies stand in contrast to earlier theoretical approaches,
which state that there is little association between concentration of owner-
ship and managerial disciplining 65. This problem, however, can be dismissed
in this paper, as due to the significant changes in the ownership structure
mentioned above, ownership structure should no longer be the focus of
research. Current studies should instead illustrate the advantages of the corpo-
rate governance systems and must therefore focus on the distinction between
one-tier and two-tier systems. It is the concentration on this distinction here
which makes the approach a novel one.
Hamid Mehran, Executive Compensation Structure, Ownership, and Firm Perform-

ance (1995) 38 J. Finan. Econ. 163.
61 John W Byrd and Kent A Hickman (n 34).
62 Anne T Coughlan and Ronald M Schmidt, Executive Compensation, Management
Turnover, and Firm Performance (1985) 7 J. Acc. Econ. 43.
63 Jerold B Warner, Roll L Watts and Karen H Wruck, Stock Prices and Top Management
Changes (1988) 20 J. Finan. Econ. 461.
64 Michael S Weisbach, Outside Directors and CEO Turnover (1988) 20 J.Finan. Econ. 431.
64a Rudi K F Bresser, Reynaldo Valle Thiele, Annette Biedermann and Holger Ldeke (n 22).
65 See Andrei Shleifer and Robert W Vishny (n 51).

One other recent study Lucier, Schuyt and Tse 66 is worth mentioning. This
study compared the percentage of performance-related and total CEO
succession rates in, inter alia, Germany and the UK. While a study concen-
trating solely on the CEO has various conceptual weaknesses, it did prove
that the performance-related successions in both countries increased in the
last three to four years 66a. However, since the study shows no evidence of the
number of poorly performing companies, the increase of performance-
related successions does not, by itself, prove the effectiveness of the means of
corporate control in question.
4. Methodology
This paper examines the relationship between the board turnover and the
financial performance of companies listed on the stock exchange in the
United Kingdom and in Germany in the years 1994 to 2003. In each country,
a sample of 25 companies was randomly chosen from those listed on the
London Stock Exchange (FTSE 100) and on the Deutsche Brse (German
Stock Exchange in Frankfurt) (DAX or M-DAX). Companies that were only
temporarily listed during the examined period (except during the first years)
were excluded from the sample, as were companies that were party to a major
merger, since board restructuring in these companies was likely to be based
on reasons other than financial performance. In addition, some companies
were excluded due to a lack of information on composition of the board or
on financial performance. This amounted to a total of 397 financial years
under review. For each of these years, board turnover and financial per-
formance were analysed. As board members need time to digest financial
news, board changes that are related to prior performance take place in the
following year. Thus, this study concentrates on board turnover following a
year of poor financial performance.
a) Board turnover
Board turnover is defined as the number of executive directors who leave

the board during the financial year, divided by the total number of board
members at the beginning of the financial year. If the resignation of a board
member was due to death or retirement, it was not included in this total.
66 Chuck Lucier, Rob Schuyt and Edward Tse, CEO Succession 2004: The Worlds Most
Prominent Temp Workers (Report) (2005) <http://www.strategy-business.com/
media/file/sb39_05204.pdf> (accessed 26 October 2006).
66a But see Rudi K F Bresser, Reynaldo Valle Thiele, Annette Biedermann and Holger L-
deke (n 22) for the contrary result on the German market.

Ideally, this would ensure the measurement of only forced resignations.

However, the annual reports state often that a board member has retired
without it being apparent whether retirement was indeed the reason or
whether it was a euphemistic expression. In this context, financial news-
papers are normally also ineffective means of distinguishing between forced
and unforced retirements 67. Thus, in this paper, resignation due to retirement
is only excluded if the director is at least 65 years of age at the time he leaves
the board. Choosing the age of 65 means that a more conservative approach is
taken here in comparison with other studies which used 62 as the relevant
age68. It is, however, consistent with the results of the empirical research by
Warner, Watts and Wruck 69, according to which the average age of resigna-
tions from the board which were declared as retirements was 65 years. Weis-
bach 70 also chose 65 years as the relevant limit.
It is pertinent to note that the data on board turnover was collected from the
annual reports, which detail the number and the names of board members. In
Germany, only changes in the members of the management board were
examined, and with respect to the UK, the study concentrated solely on the
turnover of executive directors.
b) Poor financial performance
There are numerous ways to measure financial performance, and it is thus

difficult to form a decision as to whether the performance was good or poor
in a particular year. Consequently, it is not surprising that past studies have
concentrated on different performance measures: Warner, Watts and Wruck 71
report on an inverse relationship between the probability of board turnover
and a firms share price performance. Weisbach 72 concentrated on stock returns
and earnings changes as measures of US firms performance. Kaplan 73, in his
67 See Michael S Weisbach (n 64); but see Chuck Lucier, Rob Schuyt and Edward Tse
(n 66) as well as Rudi K F Bresser, Reynaldo Valle Thiele, Annette Biedermann and
Holger Ldeke (n 22) in contrast.
68 Julian Franks, Colin Mayer and Luc Renneboog (n 45) 213.
69 Jerold B Warner, Roll L Watts and Karen H Wruck (n 63).
70 Michael S Weisbach (n 64).
71 Jerold B Warner, Roll L Watts and Karen H Wruck (n 63).
72 Michael S Weisbach (n 64).
73 Steven N Kaplan, Top Executive Rewards and Firm Performance: A Comparison of
Japan and the United States (1994) 102 J. Polit. Economy 510; Steven N Kaplan, Cor-
porate Governance and Corporate Performance: A Comparison of Germany, Japan and
the U.S. in Klaus J Hopt and Eddy Wymeersch (eds), Comparative Corporate Govern-
ance: Essays and Materials (Walter de Gruyter, Berlin 1997) 195 [hereinafter Corporate
Governance and Corporate Performance].

studies on the Japanese and the US market, also examined earnings and stock
returns, but added sales performance as an additional measure. According to
Marsh 74, dividend cuts are powerful signals of bad news, both in respect to
the current situation and future prospects. This is also the conclusion of a
study on 6,000 UK dividend announcements in the years 1989 and 1992;
Franks, Mayer and Renneboog report that the same result holds true for
the US market 75. However, they also examined abnormal share price returns,
earning losses, after-tax cash flow margins, and after tax rates of return on
book equity. Franks and Mayer 76 chose earning losses, dividend cuts and ab-
normal returns as indicators for poor financial performance. Finally, Bresser,
Valle Thiele, Biedermann and Ldeke 76a favoured a keep it simple ap-
proach and utilised three accounting measures of performance (earnings be-
fore interest and taxes to total assets, return on assets, and sales growth) and
one market measure (total return to the firms shareholders).
aa) Data for the measurement of financial performance
In this study, four measures were taken as means of evidence for poor per-
formance: loss for the financial year, loss of profits, abnormal negative share
price performance and a dividend cut or omission. With regard to all of the
above, the data collected refers to the financial years of the companies, i.e. not
necessarily to the legal year ending December 31st.
Whether there was a loss for the financial year was decided on the basis of the
figures on net income for the financial year (i.e. profit after taxation and
equity minority interests) provided in the annual reports. The loss of profits
was calculated by a comparison of the net income in two consecutive years.
During the time analysed in this study, new financial reporting standards
were adopted. In addition, a number of the companies changed their account-
ing principles (e.g. from UK-GAAP to IAS) between 1999 and 2002. Further-
more, in some very rare circumstances, it became obvious that losses or
losses of profits were only book losses, i.e. solely due to changing legal or
accounting requirements (such as the activation of good will, patents, etc.)
but not due to operational business. In all of these cases, the losses were not
taken as an indicator for a year of poor performance. Finally, with regard to
74 Paul Marsh, Why Dividend Cuts are a Last Resort Financial Times (London
12 August 1992) 16; for a detailed analysis see Luis Correia Da Silva, Marc Goergen
and Luc Renneboog (n 56).
75 Julian Franks, Colin Mayer and Luc Renneboog (n 45) 213.
76 Julian Franks and Colin Mayer (n 46) 959.
76a Rudi K F Bresser, Reynaldo Valle Thiele, Annette Biedermann and Holger Ldeke
(n 22).

Germany, all data was expressed in EURO, i.e. converted from Deutsche
Mark (DM) to EURO in the years prior to 1999.
Share prices and dividend payments were also converted into EURO. In
addition, conversions of the numbers printed in the annual reports were
made: some of them were due to rights issues of equity shares, some due to
changes in the nominal value of shares (frequently from 50 DM to 5 DM
and/or to 1 EURO). In most cases, information concerning the dividends
paid and the share price at the end of the financial year was contained in the
annual reports. Alternatively, the Financial Times London and the Handels-
blatt were used as data origins. A share price performance was considered to
be abnormally negative if the change in the share price was less than 15 % of
the change of the relevant sector index. Figures for the indices (normally
sub-indices of the FTSE 350 or the M-DAX) were available in the Financial
Times London (UK) and in the OnVista/IS Teledata database (Germany).
bb) Definition of poor financial performance
As Table 1 shows, the four measures chosen show different frequencies: a loss
for the financial year occurred only in 3.52 %/5.88 % (Germany/UK) of the
years, and there was a dividend cut or omission in 7.49 %/2.94 % of the years.
By contrast, the incidence of a loss of profits and an abnormal negative share
price performance was much higher, i.e. 27.31 %/38.82 % and 46.70 %/42.94 %.
Jurisdiction Loss for the Loss of Abnormal Dividend Poor

Financial Profits Negative Cut or Performance
Year Share Price Omission
Performance
Germany
Total 8 62 106 17 44
Percentage 3.52 % 27.31% 46.70 % 7.49% 19.38 %
United Kingdom
Total 10 66 73 5 36
Percentage 5.88 % 38.82 % 42.94 % 2.94 % 21.18 %
Table 1: Measures of poor financial performance
For the purposes of this study, however, poor performance is defined as

a financial year in which two out of the four indicators were positive, as
opposed to one out of the four indicators. The reasons for this particularly
restrictive approach are two-fold: firstly, it reconciles differences resulting
from varying accounting and legal requirements as well as differences in

business behaviour. For example, Da Silva 77 found that dividend cuts are far
more likely to occur in Germany than in the UK or the US. This is likely to
be related to different business cultures, since the signalling role of a dividend
cut in Germany is less strong than in the Anglo-American market. At the
same time, German companies build up and reduce hidden reserves in order
to smooth earnings figures 78, which is due to more liberal legal rules con-
cerning the reporting of earnings. These observations are consistent with the
data in Table 1: dividend cuts or omissions are more frequent in Germany
(7.49 % compared to 2.94 %) whereas losses for the financial year and losses
of profits occur more often in the UK (5.88 % compared to 3.52 %, and
38.82 % compared to 27.31 %, respectively).
Secondly, the removal of directors is a severe form of exercising control and is
in most cases the last resort. As the reason for the removal of a board member
is rarely clearly stated, the restrictive approach taken in this study increases
the probability that, in years of poor financial performance, the reasons
underlying the board turnover rate are indeed related to poor performance.
At the same time, this reduces the probability that reasons unrelated to poor
performance had an influence on the turnover rate. This necessarily leads to a
higher board turnover percentage in years of good performance, since board
turnover figures which should actually be included in the statistics for years
of poor financial performance, are, due to the restrictive approach of defining
years of poor performance, erroneously included in the statistics for years of
good performance. If, however, the data shows that the board turnover
remains significantly higher in years of poor performance, despite the extra
restriction, the results are even more convincing.
Given the fact that it is a widely accepted view amongst commentators that
a loss in a financial year and a dividend cut or omission are regarded as
the most important indicators of poor performance, and notwithstanding
different legal und cultural backgrounds, it is worth mentioning that the de-
finition of poor performance used here does not diminish the importance of
these two indicators: in the UK, 100 % of the years with a dividend cut or
omission and 80 % of the years with a loss of profits are years of poor finan-
cial performance as defined in this study, and the corresponding numbers for
Germany are 82 % and 100 %, respectively. Consequently, the two out of
four approach used here respects the theoretically well-founded importance
77 Luis Correia Da Silva, Corporate Control and Financial Policy: An Investigation of the
Dividend Policy of German Firms (PhD thesis, University of Oxford 1996); see also
Luis Correia Da Silva, Marc Goergen and Luc Renneboog (n 56) 113123.
78 See Ray Ball, S P Kothari and Ashok Robin, The Effect of International Institutional
Factors on Properties of Accounting Earnings (2000) 29 J. Acc. Econ. 1, 1516.

of losses and dividend cuts as performance measures but, at the same time,
prevents loss of profits and abnormal share price performance from influencing
the results beyond a legitimate degree.
IV. Testing the hypotheses: data on financial performance

and board turnover
In this part, the results of the study are presented. The first apparent difference
between the board structure in Germany and the UK concerns the average
board size.
Germany United Kingdom

Total Board Management Supervisory Board Size
Size (Average) Board (Average) Board (Average) (Average)
1994 24.33 6.77 17.56 12.00

1995 24.56 7.00 17.56 12.44
1996 24.87 6.96 17.91 12.50
1997 25.17 6.91 18.26 12.22
1998 25.26 6.65 18.61 12.17
1999 19.47 6.90 18.78 11.44
2000 19.38 6.02 18.78 11.78
2001 25.17 6.39 18.78 11.50
2002 24.95 6.17 18.78 11.83
2003 24.51 5.73 18.78 11.40
Average 23.77 6.55 18.38 11.93
Table 2: Board size in Germany and the UK (19942003)
To test Hypothesis 1, i.e. the inverse correlation of board turnover and financial
performance, the average board turnover in years following a year that did
not fall into the definition of poor performance had to be compared to years
following a year that did. As can be seen from Table 3, there were 44 years
characterized by poor performance in Germany and 36 years in the UK.
Jurisdiction Years of Poor Other Years Total

Performance
Germany 44 183 227
UK 36 134 170
Total 80 317 397
Table 3: Years with and without poor financial performance in
Germany and the UK (19942003)

In Table 4, the average board turnover percentage in years following a year of

poor financial performance is contrasted with the board turnover percentage
in other years. In the years that did not fall within the definition of a year of
poor performance, in Germany, 8.88 % members on average left the manage-
ment board for reasons other than death or retirement, and in the UK an
average of 11.71 % of the executive directors abandoned the board. In both
countries, there was an increase in the average board turnover in years of
poor performance: in Germany, it rose by 3.30 percentage points to 12.18 %,
and in the UK, there was an increase by 3.73 percentage points to 15.44 %.
Jurisdiction Performance in the Board Turnover s s

Financial Year n
Germany Not Poor 8.88 % 11.81 0.87

Poor 12.18 %
United Kingdom Not Poor 11.71 % 13.90 1.21

Poor 15.44 %
Table 4: Relation of board turnover and financial performance in Germany and the UK
(19942003)
The sample size for the years that did not fall into the category of poor
performance is nGermany = 183 and nUK = 134, respectively. That means that
the sample size is large enough so that the sampling distribution of the mean
can be approximated by the normal distribution. As the standard deviation of
the sampling distribution is sGermany = 11.81 and sUK = 13.90, respectively,
the increase is statistically significant at the 99 % level of confidence in both
countries. Thus, the board turnover was substantially higher in years follow-
ing a year of poor performance than in other years, and accordingly, the data
supports Hypothesis 1, underscoring the notion that board turnover is in-
versely correlated with financial performance. Hence, both systems, the one-
tier and the two-tier system, are effective means of control, and non-execu-
tive directors, as well as the members of the supervisory board, attend to their
duty of removing incompetent directors. This result stands in contrast to
other papers 79 and consequently offers significant new evidence capable of
influencing the discussion on questions of corporate governance and the
reforms of the relevant statutory provisions.
79 See, eg, Stefan Grundmann and Peter O Mlbert (n 33) 421 (arguing that in both
systems the control function is deficient); cf n 62 to n 64.

The comparison of the differences in the board turnover between the years
following a year of poor performance and other years allows us to comment
on the validity of Hypothesis 2: this hypothesis has also to be accepted as the
data contained in Table 4 does not allow us to judge the superiority of either the
monistic or the dualistic system. Both systems show an inverse correlation
between the financial performance and board turnover; however, this correla-
tion is so statistically significant that it is impossible to come to the con-
clusion that one system would be more effective than the other. This is due to
the fact that the difference between the degrees of effectiveness between the
two systems is too small.
V. Strengths and weaknesses of the concurring board models
According to the data presented in the last part, it is hardly possible to deem
one board system superior to the other. This result is, intuitively, not very
surprising as both systems have existed for more than one hundred years 80.
Metallgesellschaft or Philipp Holzmann on the one hand and Bank of Com-
merce and Credit International (BCCI), Eurotunnel or Barings Bank on the
other are well known examples of financial scandals and cases of evident
failures of corporate control in Germany and in the UK. Surprisingly, the
changes made in the statutes governing company law were rather conser-
vative in both countries and, indeed, one of the concurring board models was
never replaced by the other.
However, this fact alone does not prove the equal adequacy of the systems.
According to economic logic we should expect the more effective system to
prevail over time and thus we should see tendencies to converge. But the
development of statutory provisions is always driven by structure (path
dependence) 81. Accordingly, the strengths and weaknesses of a system must
always be seen in the context of both business and legal environments. Legal
systems develop in accordance with their historical, societal and even cultural
roots82. This view is not limited to models of corporate governance but is
80 Cf Jonathan Charkham, Keeping Good Company: A Study of Corporate Governance in

Five Countries (OUP, Oxford 1995) 349366; Udo C Brndle and Jrgen Noll (n 5) 1.
81 Lucian Bebchuk and Mark J Roe (n 16); Reinhard H Schmidt and Gerald Spindler, Path
Dependence, Corporate Governance and Complementarity (2002) 5 International
Finance 311; Mark J Roe, Path Dependence, Political Options, and Governance
Systems in Klaus J Hopt and Eddy Wymeersch (eds), Comparative Corporate Gover-
nance: Essays and Materials (Walter de Gruyter, Berlin 1997) 165.
82 Klaus J Hopt (n 4) 183184; Klaus J Hopt and Patrick C Leyens (n 5) 161162; see also
Reinhard H. Schmidt and Gerald Spindler (n 4) 93.

also true with regard to, e.g., accounting standards, taxation principles,
etc. Hence, only exceptional circumstances will lead to the adoption of a
completely different model83. Thus, it will often be more advantageous to
explore ways to make each system optimal within its own legal, historic and
cultural constraints 84. As this is also the more realistic way to reach an
enhanced level of corporate control, it is worthwhile to examine the advan-
tages and disadvantages of the two systems. Consequently, a comparison will
allow for an analysis of the possibilities to improve each system individually
as a means of corporate control, by adopting new measures and by system-
atically eliminating structural weaknesses. The conclusion drawn in part VI
depends therefore on the discussion of the strengths and weaknesses of both
systems in this part.
1. Advantages and disadvantages of the two-tier model
This discussion of the advantages and disadvantages of the dualistic system

with two separate boards refers to the present state of legal rules applicable to
corporate control. The key advantage of the two-tier system, however, needs
to be seen in the context of its historic origins.
a) Separation of control and management as the key advantage
Historically, the core idea behind the two-tier model was to strictly separate
the controlling institution from the managing institution. When implementing
the laws governing the stock corporation in Germany in the late 19 th century,
it was the legislators intention to protect both shareholders and the public
interest 85. This strict separation of control and managerial tasks was regarded
as one of the major advantages of the two-tier system 86, and this argument
83 Mark J Roe, Chaos and Evolution in Law and Economics (1996) 109 Harv. L. Rev. 641,
663665; see also Reinhard H Schmidt and Gerald Spindler, Path Dependence and
Complementarity in Corporate Governance in Jeffrey N Gordon and Mark J Roe
(eds), Convergence and Persistence in Corporate Governance (CUP, Cambridge 2004)
114, 116.
84 See Stephen Prowse (n 35) 5556; but cf. Reinhard H. Schmidt and Gerald Spindler
(n 4) 90.
85 Klaus J Hopt (n 1) 230231.
86 See, eg, Udo C Brndle and Jrgen Noll (n 1) 13591360; Uwe H Schneider, Die
Revision der OECD Principles of Corporate Governance 2004 (2004) 49 Die Aktien-
gesellschaft 429, 432; cf Paul L Davies (n 10) 436.

has also been highlighted in the recent British discussions on the reform of
company law 87. While this statement still appears to be true in general, one
has to observe the impact that case law had in the last ten years on the func-
tions of the supervisory board. As mentioned above, at present, control is not
purely backward-oriented but requires an open discussion between the
supervisory board and management board and also their close and trustful
cooperation. Notwithstanding this development, at least theoretically, con-
flicts of interests between the members of the two boards should not arise:
members of the supervisory board are elected by the shareholders in the
general meeting. Accordingly, supervisory board members increase the likeli-
hood of getting re-elected by fulfilling their most important task, i.e. to
monitor the management board adequately and thoroughly. At the same
time, the members of the management board are elected by the supervisory
board and will remain in office only if the company performs well.
In practice, however, the members of the supervisory board are chosen by the
management board and are only formally elected in the general meeting. It is
unusual for persons to become members of the supervisory board who have not
been pre-selected by the management board 88. This has two consequences:
only persons that are adequate in the opinion of the management board
become elected as members of the supervisory board, and only those who
adequately control in the eyes of the management board remain in office.
In both cases, the definition of adequacy by the management board does
not necessarily correspond with the shareholders definition of adequacy.
Consequently, the members of the supervisory board are not completely
independent when they exercise control. This becomes strikingly evident in
the cases in which members of the management board (often the chairman)
switch to the supervisory board (and often become chairman of this organ)
after retirement 89, which was, and sometimes still is, usual in practice.
While the separation of management and control the key advantage of the
two-tier system somewhat dilutes the independence of the members of
the supervisory board, this separation remains a strength with respect to the
87 Department of Trade and Industry (n 12) paras 3.1373.141.

88 Klaus J Hopt (n 1) 250; Patrick C Leyens (n 5) 81; see Rolf Birk (n 4) 65.
89 Bundesverband der deutschen Industrie eV and PwC Deutsche Revision AG, Corpo-
rate Governance in Germany (BDI-Drucksache No 322, August 2002) 33; Klaus J
Hopt (n 1) 243244; Patrick C Leyens (n 5) 81; Udo C Brndle and Jrgen Noll (n 1)
1358. According to Korn/Ferry International (n 38) 12, 43 % of the members of the
supervisory board are former members of the management board.

management board 90. Each member of the management board has the same
task, namely to run the business in a way that allows further development
and financial prosperity. In order to perform this task, every information is
shared among all board members and is not to the exclusive knowledge of
some board members. Accordingly, the decision-making process within the
management board is swift and efficient.
b) The need to distinguish between structural weaknesses

and problems arising from co-determination
There are also a number of disadvantages to the two-tier system. With regard
to Germany, a thorough review must distinguish between those weaknesses
derived from the mere fact of having two separate organs of the company
(structural weaknesses) and those owed to a German particularity, namely
its co-determination statutes 91. The latter strongly influences the composi-
tion of the supervisory board: the circle of eligible persons, the responsibili-
ties and the primary interests of its members, possible expert knowledge
requirements, etc. clearly depend upon the co-determination laws. The
distinction between structural weaknesses and problems arising from co-
determination is not only necessary for a sound analysis of the strengths and
weaknesses of the two-tier model, but it also helps to objectively assess the
value of the two-tier model and also its potential in countries that are not
governed by co-determination laws. For example, even European Companies
(SE) based in the UK might opt for the two-tier system. For these companies,
only the arguments regarding the structural weaknesses of the two-tier system
will be relevant. Finally, the above-mentioned distinction is important for
the discussion of potential improvements to the one-tier system which could
adopt single features of the two-tier system.
90 Cf Klaus J Hopt (n 4) 178 (mentioning that the German understanding of independ-

ence differs slightly from the British as it is common for members of the supervisory
board to be representatives of large shareholders); Alice Belcher and Till Naruisch, The
Evolution of Business Knowledge in the Context of Unitary and Two-tier Board
Structures [2005] JBL 443 (concluding that the German two-tier structure is likely to
encourage more teamwork and thus more likely to create a competitive advantage than
the UK one-tier structure).
91 See Peter Bckli, Konvergenz: Annherung des monistischen und des dualistischen
Fhrungs- und Aufsichtssystems in Hommelhoff and others (eds), Handbuch Corporate
Governance (Otto Schmidt-Verlag, Kln 2003) 201, 205208; Patrick C Leyens (n 5) 98;
Lewis Robertson (n 11) 4.

aa) Structural weaknesses
The key advantage of the two-tier system, i.e. the independence of the
members of the supervisory board due to the separation of the control and
management, is at the same time the reason for a number of structural weak-
nesses. At least traditionally, the members of the supervisory board, by
definition, do not make strategic management decisions of their own, and
with the exception that decisions of the management board need the ap-
proval of the supervisory board they are not involved in the decision-
making process at all 92. They are not informed at the outset, nor are they
asked for their opinion or advice. Instead, their role is limited to evaluating
measures already taken by the management board. Consequently, the way in
which the supervisory board exercises its control is always reactive and never
active 93. This necessarily leads to a decrease of the quality of control: at the
outset, there are normally a number of possible solutions to a strategic
management problem. In a two-tier system, the supervisory board is restrict-
ed to commenting on the chosen solution in hindsight 94. It might criticise the
choice and even go so far as to remove management. However, this does not
enhance the current status of the company, but rather only reduces the pos-
sibility that the same mistake will be made again. If, on the contrary, the
supervisory board had had the opportunity to exert influence on the decision
ex ante, a better solution may have been found.
The amendments to the German company law provisions by the Control and
Transparency in the Corporate Sector Act of 1998 95 and by the Transparency
and Publicity Act of 2002 96 were a step in the right direction. Since then, it
has become an additional task of the management board to inform the super-
visory board on intended business policy and corporate planning. As the
words intended and planning indicate, the supervisory board should
increase its involvement in strategic decisions. German courts have high-
lighted this additional tasks 97 and have, as mentioned above, thus initiated the
process of transforming the supervisory board from a pure review body to a
consultant of the management.
92 Marcus Lutter, Das dualistische System der Unternehmensverwaltung in Eberhard

Scheffler (ed), Corporate Governance (Gabler Verlag, Wiesbaden 1995) 5, 18.
93 See Peter Bckli (n 91) 213214.
94 See Patrick C Leyens (n 5) 9394; Carsten Berrar (n 24) 21812183.
95 Gesetz zur Kontrolle und Transparenz im Unternehmensbereich (KonTraG) (27 April
1998, BGBl I 786).
96 Transparenz- und Publizittsgesetz (TransPuG) (19 July 2002, BGBl I 2010).
97 See Hartwig Henze, Neuere Rechtsprechung zu Rechtsstellung und Aufgaben des
Aufsichtsrats (2005) 58 Der Betrieb 165.

The need for information is another weak point in the two-tier system of
control. This stems from the supervisory boards non-involvement in the
decision-making process and the fact that its members are not present at
the meetings of the management board. In order to be able to judge on
the performance of the management board, the supervisory board needs
adequate disclosure of information. However, there is a strong information
asymmetry between the two boards 98, since all information concerning
questions of strategy, future projects, business opportunities, budgetary
questions, etc. lies in the hands of the management board. The members
of the management board are in direct contact with employees and junior
management. They obtain all information unaltered and unfiltered. By con-
trast, the members of the supervisory board receive all their information from
the management board. They are not permitted to collect information on
their own 99, and employees are not obligated to report to the supervisory
board directly. Thus, the access of the members of the supervisory board to
sensitive information is limited 100.
Theoretically, the situation described above should not contribute to infor-
mation asymmetry since, according to Sec. 90 of the German Stock Corpora-
tion Act of 1965, the management board must regularly report to the super-
visory board. This provision was changed by the Control and Transparency
in the Corporate Sector Act of 1998, which led to an improvement in the flow
of information 101: disclosure must be comprehensive and punctual, and the
reports must contain all information needed to evaluate the work of the
management board, meaning that they must include information concerning
future projects and strategy. In addition, the management board must not
withhold information from members of the supervisory board which is
deemed to be delicate.
In reality, however, we must note that the supervisory board would not be
able to perform its tasks if the relevant files were not prepared, the infor-
mation was not processed and the data was not conceptualised prior to the
meetings of the supervisory board. This becomes evident if we consider
98 Bundesverband der deutschen Industrie eV and PwC Deutsche Revision AG (n 89) 17;
Department of Trade and Industry (n 12) paras 3.1403.141; Brian R Cheffins (n 21)
619.
99 Dieter Feddersen, berwachung durch den Aufsichtsrat in Hommelhoff and others
(eds), Handbuch Corporate Governance (Otto Schmidt-Verlag, Kln 2003) 441, 458
460.
100 See Geoffrey Owen (n 11) 17.
101 See Marcus Lutter, Comparative Corporate Governance: A German Perspective
(2000) 2 ICCLJ 423, 426427.

the average working hours of the supervisory board: prior to 1998, it was
common for the supervisory board to meet only 3.8 times a year on average.
Each meeting lasted less than four hours, namely 3.74 hours on average 102.
This amounted to a total working time of 14 hours and 13 minutes per year.
Since the amendment of the statutory provisions in 1998, it has become
mandatory for the supervisory board to meet at least two times in each half
of the year. This sets a minimum standard, but can not be regarded as a major
increase in the frequency of meetings 103. Hence, it is still impossible to reach
decisions in such a short time if the members of the supervisory board are not
provided with the data that is already processed. Consequently, the members
of the supervisory board rely on reports which contain all information con-
cerning the company and the managements strategy. As these reports are
prepared on behalf of the management board, the information is necessarily
filtered. The aspects that appear to be important in the eyes of the manage-
ment board are stressed, while others are deemphasised or even left out 104.
This has the following consequence: the management board members make
decisions based on information which they themselves regard as important.
However, a thorough control requires full transparency in order for one to be
able to properly evaluate the quality of the managements decision-making
process. In a two-tier system, with its typical flow of information, there is a
danger that the supervisory board cannot discover deficiencies due to a lack
of information. In evaluating the decisions of the management board, the
supervisory board might, consequently, repeat the management boards mis-
takes. This is not a question of bad faith or that a management board was not
willing to provide relevant information. It is rather due to the fact that the
management transfers only the information that it relied upon itself 105.
Furthermore, a meeting frequency of about four times a year confines the
supervisory board to its traditional but weak position, in which it exercises
mere ex post control. More continual monitoring and more frequent meetings
are needed in order to adequately process the high amount of data 106.
102 Klaus J Hopt, The German Two-Tier Board (Aufsichtsrat): A German View on
Corporate Governance in Klaus J Hopt and Eddy Wymeersch (eds), Comparative
Corporate Governance: Essays and Materials (Walter de Gruyter, Berlin 1997) 9; for
older data see Knut Bleicher and Herbert Paul (n 15) 273274.
103 More recent studies on the duration and the frequency of meetings of the supervisory
board are not available.
105 Cf Brian R Cheffins (n 21) 619.
106 See Marcus Lutter (n 101) 428; Peter Bckli (n 91) 214218; see also Erich Potthoff
(n 6) 265.

bb) Problems arising from co-determination
In addition to the structural deficiencies of the two-tier system, there are

problems originating solely from the German laws of co-determination 107.
As mentioned above, up to 50 % of the members of the supervisory board are
labour representatives. According to the Co-Determination Act of 1976, as
amended, one-half of the supervisory board must, in companies with 2,000 or
more employees, be composed of labour representatives, and this 50 % rule
was applicable to all companies under review in this study.
In the supervisory board, the labour representatives and the shareholder
representatives have equal rights and duties with the exception that the vote
of the chairman, who is never a labour representative, counts twice (casting
vote) in the event of a deadlock in the supervisory board. Before turning
to the disadvantages of labour co-determination with regard to corporate
governance and the ability of the supervisory board to control management,
it is worth glancing at the historical roots and the benefits of co-determina-
tion. The first laws governing co-determination were reactions to the eco-
nomically and socially difficult times after the wars in the first half of the
twentieth century and reflected the significant role of the coal and steel
industry in Germany at that time. As todays working environment is much
more developed and governed by other laws, co-determination does not
appear to be as crucial now as it was sixty or eighty years ago. It still has its
merits, however, especially as an early warning system for social conflicts,
thereby reducing the probability of strikes 108. Furthermore, management
accommodated co-determination, which is capable of shielding companies
from hostile takeovers, somewhat gratefully 109. One must keep all these
aspects in mind when evaluating the German two-tier system and when
subsequently mentioning the disadvantages of co-determination with respect
to corporate governance.
The first of the weaknesses is related to the information asymmetry mentioned
above. It is apparent that the shareholder representatives on the supervisory
board are reluctant to discuss certain highly confidential issues with labour
representatives. In countries with co-determined supervisory boards, this has
the practical consequence that certain issues are not discussed with the super-
visory board as a whole, although the laws provide for the contrary.
107 See Thomas Raiser (n 8) for a fundamental review and for an analysis of the future of
co-determination laws.
108 See Klaus J Hopt and Patrick C Leyens (n 5) 145.
109 Theodor Baums (n 35) 12; see Thomas Raiser (n 8) B 4957.

A second major disadvantage arising solely from co-determination laws is the

size of the supervisory board. As can be seen from Table 2, the average size of
the supervisory board of the companies examined in this study was 18.38
members. These numbers are not surprising, as the Co-Determination Act of
1976 stipulates that it is a requirement for the supervisory board of compa-
nies with more than 20,000 employees to have 20 seats. The prevalence of
these larger seat numbers becomes even less surprising in light of the fact that
the relevant provision of the Co-Determination Act of 1976 setting the seat
requirement was permanently applicable for 69.56 % of the companies under
review in this study 110.
It is common knowledge that a supervisory organ of this size must be ineffi-
cient 111. Nevertheless, the proposal to lower the size to a maximum of twelve
seats which was discussed prior to the enactment of the Control and Trans-
parency in the Corporate Sector Act of 1998 never became law 112. Assuming
that the average time of a supervisory board meeting is 3.74 hours, each mem-
ber of a supervisory board with 20 members has the theoretical opportunity
to speak for less than 12 minutes in a single meeting. In practice, however, the
presentation of reports and other formalities are time consuming 113 and, the
chairman will speak most of the remaining time. Accordingly, most members
of the supervisory board do not have the opportunity to speak.
There exists a third shortcoming to the two-tier system governed by co-
determination laws: co-determination requirements complicate the introduc-
tion of mandatory qualification standards for all members of the supervisory
board 114. The installation of such standards is suggested in the OECD Prin-
110 Cf Korn/Ferry International (n 38) 10 (reporting an average of 13.25 members for a

sample of 59 companies, which, however, also includes smaller companies than in this
study).
111 See, eg, Bundesverband der deutschen Industrie eV and PwC Deutsche Revision AG
(n 89) 3334; Thomas Raiser (n 8) B 5960; Steven N Kaplan, Corporate Governance
and Corporate Performance (n 73) 198; Martin Lipton and Jay W Lorsch, A Modest
Proposal for Corporate Governance (1992) 48 Bus. Law. 59, 65; Eberhard Schwark,
Corporate Governance: Vorstand und Aufsichtsrat in Peter Hommelhoff and others
(eds), Corporate Governance (Verlag Recht und Wirtschaft, Heidelberg 2002), 75, 102
103; Manuel R Theisen (n 7) 261262; Patrick C Leyens (n 5) 8182; see also Erich
Potthoff (n 6) 261; see finally Korn/Ferry International (n 38) 8 (reporting on the
self-assessment of German supervisory boards).
112 See Klaus J Hopt (n 4) 177.
113 Martin Lipton and Jay W Lorsch (n 111) 64.
114 Klaus J Hopt, Unternehmensfhrung, Unternehmenskontrolle, Modernisierung des
Aktienrechts Zum Bericht der Regierungskommission Corporate Governance in
Peter Hommelhoff and others (eds), Corporate Governance (Verlag Recht und Wirt-
schaft, Heidelberg 2002), 27, 4445.

ciples on Corporate Governance of 2004 115, and recent studies highlight the
importance of qualification and experience for the choice of the members
of the supervisory board 116. In contrast, Point 11.1 of the 2005 Recommenda-
tions of the EU 117 as well as the German Corporate Governance Code take a
rather diffident approach. Sec. 5.4.1 of the German Corporate Governance
Code states that members need to have the required knowledge, abilities and
expert experience to properly complete their tasks. At least every individual
member of the supervisory board needs to have a certain degree of know-
ledge, whereas the corresponding provisions of the German Stock Corpo-
ration Act of 1965, as interpreted by the courts, only require that the super-
visory board as a whole has this level of knowledge 118.
The introduction of even advanced mandatory qualification standards would
certainly not bar shareholders from finding adequately qualified representa-
tives. Such standards would instead be regarded as a hindrance to employees
which prevent them from freely choosing their representatives. Without
common standards concerning qualification and professional experience,
however, it is extremely difficult to ensure the quality of work performed by
the members of the supervisory board. The ex post review of decisions by the
management board is already a difficult task. It is unlikely, however, that an
organ consisting of members with little or no expertise in economics, finance,
corporate strategy, etc. would be able to enhance the quality of the decisions
made by the highly paid, carefully selected and well-educated members of the
management board. Thus, it is even more challenging to involve the super-
visory board more deeply in the decision-making process.
cc) Other uniquely German characteristics
The consequences of the German co-determination laws and the influence

of labour representatives are not the only particularities influencing the
standards of corporate governance and the effectiveness of the control by the
supervisory board. The tight-knit relationship between investors and lenders
also affects the manner in which control is exercised over the company and its
managers. The influence of German banks on the composition of the super-
115 For an overview see Uwe H Schneider (n 86).

116 See Rdiger von Rosen (ed), Wertorientierte berwachung durch den Aufsichtsrat
(Deutsches Aktieninstitut, Frankfurt 2005).
117 See n 17.
118 See Uwe Hffer, Die Unabhngigkeit von Aufsichtsratsmitgliedern nach Ziffer 5.4.2
DCGK (2006) 27 Zeitschrift fr Wirtschaftsrecht 637, 638.

visory board is immense 119. About 12 % of the shareholder seats in super-

visory boards are taken by members of private banks 120. At first glance, this
number might not appear to be terribly significant. However, this 12 %
represents only part of the influence that private banks have. Their total
influence is derived from the aforementioned seats in the supervisory boards,
from bank proxy votes 121, and notwithstanding a slight trend to the con-
trary from their still significant blocks of shares of the largest German stock
corporations 122.
The role of financial institutions in Germany is certainly not the sole expla-
nation for the quality of corporate control. Neither is it directly linked to the
two-tier system. However, any evaluation of the two-tier system as a means
of effective corporate governance and control must take this German feature
into account. This means that the adoption of this system in other countries,
or the introduction of elements of this system by way of converging the
one-tier system and the two-tier system, might lead to other results than in
Germany.
2. Advantages and disadvantages of the one-tier model
A number of the advantages of the one-tier model corresponds with the

weaknesses of the two-tier model and vice versa. The one-tier model in the
United Kingdom does not face comparable national particularities, the way
119 Klaus J Hopt (n 4) 186188; for details see Stefan Prigge, A Survey of German Cor-
porate Governance in Klaus J Hopt and others (eds), Comparative Corporate
Governance: The State of the Art and Emerging Research (OUP, Oxford 1998) 943;
Jeremy Edwards and Klaus Fischer, Banks, Finance and Investment in Germany
(CUP, Cambridge 1994).
120 Klaus J Hopt (n 102) 11 (citing a study of 1995); see also Jeremy Edwards and Klaus
Fischer (n 119) 207210 (analysing the relationship between proxy voting power and
supervisory board representation).
121 See Theodor Baums (n 30) 505-508; Theodor Baums, Corporate Governance in
Germany System and Current Developments (Working Paper No 70, University of
Osnabrck/University of Frankfurt Working Paper Series, 1999) 12 <http://www
jura.uni-frankfurt.de/ifawz1/baums/Bilder_und_Daten/Arbeitspapiere/paper70.pdf>
(accessed 26 October 2006); Oliver Rieckers and Gerald Spindler, Corporate Govern-
ance: Legal Aspects in Jan Pieter Krahnen and Reinhard H Schmidt (eds), The
German Financial System (OUP, Oxford 2004) 350, 377379; Luis Correia Da Silva,
Marc Goergen and Luc Renneboog (n 56) 13; for empirical evidence see Marco Brecht
and Ekkehart Boehmer, Ownership and Voting Power in Germany in Fabrizio Barca
and Marco Brecht (eds), The Control of Corporate Europe (OUP, Oxford 2001) 128.
122 For recent data, see Deutsche Bundesbank (n 32).

that the two-tier model in Germany does. Thus, the arguments made in
favour of and against the British one-tier model might appear to be more
universal than the remarks on Germanys system of corporate governance.
Nevertheless, the following comments refer to the United Kingdom, unless
the contrary is explicitly stated.
a) Structural strengths of the one-tier model
It is the board that leads and controls the company. Thus, all members of
the board are entrusted with the same tasks and are obliged to perform the
same duties 123. Consequently, both the responsibilities of monitoring and
strategy-setting are incorporated into the same body 124. Despite the fact that
some members of the board are executive directors, while others are non-
executive directors, they all have direct access to the same information. At
least in theory, the flow of information is a vast improvement to that of
the two-tier model 125. As the non-executive directors are involved in the
decision-making process, they have more incentives to supply themselves
with all relevant information, since they cannot argue afterwards that they
were limited to an ex post control of decisions made by other persons.
At the same time, the decision-making process is swifter with regard to far-
reaching questions. In a two-tier system, there is typically, but not neces-
sarily, the need for the management board to receive the approval of the
supervisory board. This approval can often be obtained only after a couple of
weeks, due to the low frequency of meetings of the supervisory board. By
contrast, in the one-tier system, board meetings take place more regularly 126.
This higher frequency of meetings has, simultaneously, an impact on the
understanding of the board members of the business, as it increases their
knowledge of day-to-day business 127. Meanwhile, the knowledge of the non-
executive directors helps the board as a whole, which demonstrates the po-
tential for better informed decisions in one-tier systems. This holds especially
true with regard to strategy formation 128.
123 Committee on the Financial Aspects of Corporate Governance (n 4) 20 (para 4.3); for
a critical view see Owen Green (n 11) 19.
124 See Jonathan Rickford (n 39) 75.
125 Paul L Davies (n 10) 448; Udo C Brndle and Jrgen Noll (n 1) 1358; Brian R Cheffins
(n 21) 615 (pointing out other ways for non-executive directors to obtain information);
but see Eils Ferran (n 12) 221223 (discussing the remaining difficulties with regard to
access to management information).
126 See Knut Bleicher and Herbert Paul (n 15) 273.
127 Geoffrey Owen (n 11) 16; see also Martin Lipton and Jay W Lorsch (n 111) 65.
128 See Department of Trade and Industry (n 12) para 3.140.

These advantages are certainly typical for the one-tier model with its unitary
board. In practice, however, it is doubtful whether the flow of information is
as perfect as in theory. It can be observed that the information available to the
non-executive directors is prepared by the management 129. Consequently,
non-executive directors face the problems of obtaining independent and
unfiltered information that are comparable to those of the members of the
supervisory board in the two-tier system. In the two-tier system, this leads to
an information asymmetry between the two boards; in the one-tier system,
there is an information asymmetry within the board. The non-executive
directors might not ask for additional facts, numbers, figures, etc. if they are
confronted with the well-informed executive directors in the board meeting,
while in the meetings of the supervisory board, all board members face the
problem of insufficient or lacking information. A single non-executive direc-
tor or a group of non-executive directors in a meeting of the board may
therefore be reluctant to ask for further information 130, whereas the members
of the supervisory board might, collectively, be less reluctant.
These observations notwithstanding, non-executive directors have, contrary
to members of the supervisory board, direct access to information. This is a
clear advantage of the unitary system. In this system it is, in fact, rather more
a question of filling the board with capable non-executive directors than a
structural problem of guaranteeing an adequate flow of information 131.
b) Weaknesses of the one-tier model
In this paper, it was argued that the separation of control and management is
the key advantage of the two-tier system. By contrast, the members of the
unitary board fulfil both managerial and supervisory roles. Thus, they face a
dilemma: they should make decisions and, at the same time, monitor these
decisions. While this problem does not exist in the two-tier system due to the
inherent formal separation of control and management, it is necessary to
obtain this separation artificially in the one-tier system. The mere fact that
there are executive and non-executive directors is not sufficient to guarantee
the adequate execution of the monitoring role of the board. Non-executive
directors are, as a survey confirms, well aware of their strategic role but less
129 Shann Turnbull, Why Unitary Boards Are Not Best Practice: A Case for Compound
Boards (2000) 34 <http://ssrn.com/abstract=253803> (accessed 26 October 2006).
130 See Martin Lipton and Jay W Lorsch (n 111) 6566.
131 See Patrick C Leyens (n 5) 9193.

so of their monitoring role 132. It has also been stated that non-executive
directors are not active in disciplining mismanagement in the UK 133. The
results of this study, however, cast a shadow of doubt over the accuracy of the
previous statements.
Nonetheless, there is a need for some board members to be neutral and to
concentrate their efforts primarily on the monitoring task. This has led to
a further class of board members: within the group of the non-executive
directors, only some are deemed independent. Emphasising the importance
of having independent directors on the board and narrowing the definition of
independence were core elements of the debate on the reform of corporate
governance in the UK 134. According to Sec. A.3.1 of the Combined Code, a
director is considered to be independent if there exist no relationships or
circumstances which are likely to affect, or could appear to affect, the direc-
tors judgment. Independence is deemed to be a necessary precondition
for the ability to handle the combination of two tasks in practice. It thus
remains a problem of the one-tier system to find ways to guarantee that a
certain number of board members are independent and to name criteria for
independence.
The independent non-executive directors face the dilemma of being col-
leagues with the other board members but also having to monitor them at the
same time 135. This monitor-colleague-dilemma could be diminished, how-
ever, by clarifying the roles and responsibilities of each director. It is mainly
the responsibility of the chairman to hold meetings in an environment in
which there is a clear understanding of the different tasks of the board
members and in which problems and questions can be discussed frankly and
openly. In addition, it is the task of the shareholders to find suitable persons
to fill the board 136. The non-executive directors must have a breadth of ex-
perience in order to understand the business and the sufficient confidence
132 See Department of Trade and Industry (n 12) para 3.134; but cf Brian R Cheffins (n 21)
604605; Jonathan Rickford (n 39) 75 (stating that the great majority of board activity
in typical British public company boards is taken up with supervising and monitoring
individual executive members and more junior managers); see also Korn/Ferry Inter-
national (n 38) 26.
133 Colin Mayer (n 9) 8; see also Julian Franks, Colin Mayer and Luc Renneboog (n 45)
(stating that non-executive directors have an advisory role rather than a disciplinary
role in the UK); but cf Brian R Cheffins (n 21) 604605.
134 Klaus J Hopt and Patrick C Leyens (n 5) 152164; see also Eva-Dsire Lembeck (n 9)
958960.
135 See Brian R Cheffins (n 21) 622623; Geoffrey Owen (n 11) 16.
136 But see Brian R Cheffins (n 21) 9899, 609 and 632633 (stressing that shareholders
select directors only in theory but in practice still ratify a list of candidates pre-selected
by the management).

to hinder the other board members from making mistakes 137. In addition,
shareholders must bear in mind the fact that they need persons on the board
that represent their interests 138. If these requirements are met, it is possible for
the independent non-executive directors to simultaneously act as colleagues
in matters of strategy-setting and decision-making, as well as supervisors.
This double function was traditionally integrated into the one-tier system
and it has been, with a focus on non-executive directors, highlighted in the
recent debate: non-executive directors participate in setting the corporate
strategy and in monitoring the management. If necessary, they are obliged to
seek the removal of the executive directors from office 139.
What remains, however, is the structural weakness of the one-tier system, in
which the effectiveness of corporate control depends not only on the per-
sonality of the non-executive directors, but foremost on the personality
of the chairman. Thus, a minimum formal requirement should be that the
chairman is not also the CEO and that he is independent. Both are recom-
mended in Sec. A.2.1 and Sec. A.2.2 of the Combined Code. These require-
ments are key elements of effective corporate control in the one-tier system,
as there is otherwise a danger that too strong an individual, possessing the
double title of chairman and CEO, would dominate the board, constraining
the boards monitoring function and restricting the representation of share-
holders interests.
VI. Conclusion and recommendations for the improvement

of corporate control
The empirical part of this study led to the conclusion that it is impossible to
consider one of the two concurring systems for corporate control as being
superior to the other. This is consistent with a view broadly (but not unani-
mously) shared amongst the academic commentators 140. The purpose of the
analysis of the advantages and disadvantages of the two systems in the last
part was two-fold: firstly, it brought the theoretical explanation in line with
the empirical results, as there exist sound arguments in favour of both
systems. Secondly, and more importantly, the last part formed the basis
137 See Geoffrey Owen (n 11) 16 and 19.

138 However, the Combined Code states in Sec. A.3.1 that being a representative of a signi-
ficant shareholder is a relevant factor to determine whether a director is independent.
139 Paul L Davies (n 10) 446447; Department of Trade and Industry (n 12) para 1.133.
140 See Bundesverband der deutschen Industrie eV and PwC Deutsche Revision AG
(n 89) 16.

for the following conclusion, which contains recommendations for the

improvement of corporate control in both systems. Keeping the limitations
due to path dependence in mind, every endeavour should be made to enhance
the systems by implementing single features of each that have proved to be an
important element of effective monitoring. Consequently, positive elements
have to be stressed and weak features have to be abolished. This approach
will necessarily lead to a convergence of the systems. However, convergence
remains a concept that leads to an enhanced standard as opposed to simply
creating minimum standards. Both systems will keep their uniqueness and
their fundamental difference: separation of managerial and control functions
in the two-tier system and the combination of the two in the one-tier system.
Thus, convergence and continuing divergence are not mutually exclusive 141.
The recommendations given in this part keep in mind that the Combined
Code in the UK as well as the German Corporate Governance Code are
valuable means of enhancing the standard of corporate governance in both
jurisdictions. Rule 9.8.6 of the Listing Rules of the UK Financial Services
Authority and Sec. 161 of the German Stock Corporation Act of 1965,
respectively, require each listed company to include in its annual reports a
narrative statement of how it has applied the principles of the relevant code
and a statement as to whether or not it has complied with the code provisions
throughout the accounting period covered by the annual report (comply or
explain philosophy) 142. Although the provisions of the codes are accord-
ingly not binding, any non-compliance appears to seek justification. Thus,
any code provision should be as accurate as possible and it is very worthwhile
to propose amendments, notwithstanding the soft law character of the code
provisions.
1. Recommendations for the improvement of corporate control

in the two-tier system
In countries with two-tier systems of corporate control such as Germany,

being a member of the supervisory board was, for many years, considered to
be merely an honorary position. Decisions were normally let through on the
141 See also Lucian Bebchuk and Mark J Roe (n 81) 72 (highlighting that corporate rules
can very well be path dependent and efficient).
142 For an exhaustive description and comparison see Tom Kirschbaum, Entsprechens-
erklrungen zum englischen Combined Code und zum Deutschen Corporate Gov-
ernance Kodex (Carl Heymanns Verlag, Kln 2006); see also Simon Goulding, Lilian
Miles and Alexander Schall Judicial Enforcement of Extra-legal Codes in UK and
German Company Law (2005) 2 ECFR 20.

nod, and there was often a lack of real effort toward effective control. How-
ever, this study shows that the control mechanisms were, at least in the ten
years under review in this study, nevertheless effective. Nonetheless, in the
current changing economic environment and with regard to businesses that
are becoming ever more international and complex, the time of regarding
supervisory boards as social circles to meet old friends and cement old rela-
tionships is over. A couple of years ago, it was not uncommon to be a member
of more than twenty supervisory boards. The number of mandates is now
limited to ten by Sec. 100 of the German Stock Corporation Act of 1965, and
being the chairman of a supervisory board counts as holding two seats.
Furthermore, the amended German accounting standards provide for the
publication of all seats held by members of the supervisory board in super-
visory boards of other corporations.
a) Strengthening the position of the chairman of the supervisory board
The introduction of these new rules can be regarded as the first step in
the right direction. What is necessary, however, is the strengthening of the
chairmans role. He plays the key role in the supervisory board, as he is
normally the only member dealing with the management on a more per-
manent basis. Being the chairman of a supervisory board should therefore
become a full-time job143, at least with regard to publicly listed corporations.
This should be accompanied by an adequate compensation. Nonetheless, the
chairman should remain strictly independent. Independence in this sense
means, inter alia, that the chairman should not have had a business relation-
ship with the company for the three to five years prior to his appointment 144.
Thus, the normal practice of retiring from the management board and
switching to the supervisory board as its chairman 145 should be abolished
an approach which can be found in Point 3.2 of 2005 Recommendations of
the EU 146. Meanwhile, Sec. 5.4.4 of the German Corporate Governance Code
contains a similar, though not too rigid, provision 147. As an accompanying
measure, a compulsory upper limit for his term of office should be intro-
143 See Marcus Lutter, Der Aufsichtsrat: Konstruktionsfehler, Inkompetenz seiner Mit-
glieder oder normales Risiko? (1994) 39 Die Aktiengesellschaft 176, 177; but see Eber-
hard Schwark (n 111) 104105.
144 See Uwe Hffer (n 118), 643 (favouring a period of two years as the maximum in order
to avoid negative discontinuity effects).
145 See n 89 and accompanying text.
146 See n 17.
147 See Uwe Hffer (n 118), 642.

duced 148. After about five years, the danger of the chairman losing his inde-
pendence becomes too large 149. Furthermore, a chairman should not hold
seats on other supervisory and management boards.
At the same time, the chairman of the supervisory board should have infor-
mational rights that go beyond the present status 150 and beyond the rights
which the supervisory board are presently allowed. It should be ensured that
the chairman has unlimited access to all sources of information. He should
also independently gather the information and should not rely on informa-
tion provided by the management. Proposals of this kind, made with regard
to other jurisdictions, have been heavily criticised in Germany 151. However,
this criticism must be seen in the context of the existing German statutory
provisions 152. There is no convincing reason to delay changing these rules.
The advantage of a strong chairman as proposed in this paper is obvious:
within a short time, he will gain a sound knowledge of the corporation. Even
if his term of office is limited and he is not eligible for re-appointment, he has
a strong incentive to fulfil his tasks thoroughly: as he is appointed by the
shareholders and not by the management board, it is important for him to
build a reputation. If he becomes renowned for his work as a monitor he is
likely to be appointed as chairman in another company. Thus, being the
chairman of a supervisory board would become a profession in its own
rights.
b) Professionalising the role of the other members of the supervisory board
The roles of the other members of the supervisory board also need to become
more professionalised 153. As their task is clearly defined and limited to the
control of the company, it is not necessary for them to have the same
degree of independence as the non-executive directors on the British board.
148 There is no upper limit in the Recommendations of the EU (see n 17) or in the German
Corporate Governance Code. See also Gerald Spindler (n 17) 2043 (questioning the
sense of an upper limit).
149 The Combined Code is less restrictive: According to Sec. A.2.2 and Sec. A.3.1, serving
for more than nine years on the boards affects the status of independence of a director.
150 See Christian Schlitt, Der aktive Aufsichtsratsvorsitzende (2005) 58 Der Betrieb 2007,
2008.
151 See Dieter Feddersen (n 99) 461464.
152 See Christian Schlitt (n 150) for a review.
153 Walter Oechsler, Qualifikation und personelle Besetzung des Vorstands und des Auf-
sichtsrats in Hommelhoff and others (eds), Handbuch Corporate Governance (Otto
Schmidt-Verlag, Kln 2003) 305, 310317.

Nonetheless, it is a step into the right direction that Sec. 5.4.2 of the German
Corporate Governance Code refers to an adequate number of independent
members of the supervisory board 154. Unless a conflict of interests becomes
apparent, the other members also do not have to be as independent as the
chairman. On the contrary, it might be an advantage for the supervisory
board as a whole if these members have special expertise and experience due
to a former position in the company or due to former or present jobs in the
same sector of the economy.
aa) Increasing the frequency of meetings
It is necessary to further increase the frequency of meetings 155. Nothing

hinders the supervisory board from meeting on a monthly basis. This would
have a number of positive consequences: even though being a normal mem-
ber of the supervisory board would not become a full-time job, work load
and time pressure would prevent individuals from holding too many seats in
supervisory boards. Thus, it is not necessary to further reduce the maximum
number of seats by law. At the same time, monthly meetings would allow the
supervisory board to monitor management on a more continual basis. This is
of crucial importance with regard to the involvement of the supervisory
board in strategic or fundamental decisions by the management board. If the
list of decisions requiring the approval of the supervisory board grows, it will
become increasingly necessary for the supervisory board to react in appro-
priate time.
bb) Installation of committees
Some exceptions notwithstanding, the German Stock Corporation Act of

1965 allows for the formation of committees, and Sec. 5.3 of the German
Corporate Governance Code expressly recommends such formations. Never-
theless, German corporations still do not make regular use of this right 156.
Audit committees, personnel committees, finance committees, etc. should be
154 Due to the role of the supervisory board in a two-tier system and due to German
co-determination rules, the adequate number of independent members is not
necessarily very high. In large companies with 20 members of the supervisory board,
for example, two or three independent members of the supervisory board are sufficient
according to Uwe Hffer (n 118) 641.
155 See Knut Bleicher and Herbert Paul (n 15) 284.
156 See Patrick C Leyens (n 5) 8284; but see Manuel R Theisen (n 7) 261262.

set up in large companies 157. Committees allow for the utilisation of a number
of the above-mentioned advantages, as members gain special expertise in
certain areas of the company. Meetings can be organised more easily and
meeting times can be flexibly adapted to the companys needs. As the size of
each committee is smaller by definition, the work can be performed more
efficiently. However with the exception of audit committees 158 there
should be no mandatory list of committees for each company 159. The question
of whether to install committees depends upon the nature and size of the
company. Some have a high fluctuation of staff, some rely on the highly
specialised technical expertise of the decision-makers, some invest and produce
in exotic countries and need decision-makers on site, etc. Accordingly, some
types of committees appear to be vital for some companies but not for others.
To a certain extend, this view is reflected in the approach taken by the 2005
Recommendations of the EU 160. According to Point 5 of the Recommenda-
tions, nomination, remuneration and audit committees should be created
within the supervisory board. However, Point 7.1 grants some flexibility in
setting up these committees, as it states that companies may group the func-
tions as they see fit and create fewer than three committees.
One should bear in mind that the installation of committees is hardly the uni-
versal remedy to overcome structural weaknesses in the control process. Some
issues are, however specific they may be, reserved for the board as a whole.
The board cannot delegate all of its responsibilities to committees. Committees
can sometimes be final decision-makers but should normally engage instead
in preparing board meetings 161. In this context, their role is important in that
they contribute to a more flexible approach and allow for a more efficient use
of the time available to the members of the supervisory board.
cc) Liability and mandatory qualification standards
Members of the supervisory board have a demanding and important respon-

sibility. In large corporations, especially in those listed on the stock exchange,
numerous anonymous shareholders rely on their work, as the shareholders
157 Peter Hommelhoff and Daniela Mattheus (n 14) 254255; see also Eberhard Schwark
(n 111) 110112 (discussing advantages and disadvantages of committees).
158 But see Owen Green (n 11) 19.
159 But see Marcus Lutter (n 101) 427428; Marcus Lutter, Defizite fr eine effiziente
Aufsichtsratsttigkeit und gesetzliche Mglichkeiten der Verbesserung (1995) 159
Zeitschrift fr das gesamte Handels- und Wirtschaftsrecht 287, 298299 (proposing
three mandatory committees).
160 See n 17.
161 See Klaus J Hopt (n 1) 261262.

do not have the ability to efficiently monitor the management themselves.

According to Sec. 116 of the German Stock Corporation Act of 1965, mem-
bers of the supervisory board are held liable to the corporation for any breach
of their duties. Recent legislation 162 introduced the possibility for share-
holders to take legal action against the members of the supervisory board,
however, numerous requirements have to be met. In addition, the action of
the shareholders is a derivative action 163. It would be even more advantageous
if the shareholders themselves were able to hold members of the supervisory
board responsible for ineffective control of the company. In such a regime,
the company would not necessarily have to suffer a loss; the loss suffered by
the shareholders would be sufficient. This would mean that a decrease of the
share price would be regarded as a loss, and the members of the supervisory
board would be liable if such a decrease was due to a failure on their part to
properly monitor business operations.
An additional method of increasing the quality of corporate control by the
supervisory board would be the introduction of mandatory qualification
standards 164. Such requirements should be applicable for all members of the
supervisory board in order to guarantee a uniform level of effectiveness. In any
case, diversity of experience and knowledge is beneficial for the work of the
supervisory board. Thus, it is neither necessary nor desirable for the super-
visory board to consist solely of experts in business administration, corporate
finance or the like. Expertise in the relevant industrial sector, technical know-
ledge, access to important external information, good business relations, etc.
would also serve as evidence of qualification. Only a board consisting of
persons who, on the whole, have the expertise to fulfil the necessary level of
supervision over the company, serves as an effective means of control.
Qualification standards, in this sense, would also minimise the potential
conflicts with co-determination rules. It was already mentioned above that
162 Corporate Integrity and Modernisation of the Right of Contestation Act of 2005
(Gesetz zur Unternehmensintegritt und Modernisierung des Anfechtungsrechts
(UMAG) (22 September 2005, BGBl I 2802).
163 For details see Gerald Spindler, Haftung und Aktionrsklage nach dem neuen
UMAG (2005) 8 Neue Zeitschrift fr Gesellschaftsrecht 865.
164 See Peter Hommelhoff and Daniela Mattheus (n 14) 255256; Peter O Mlbert, Die
Stellung der Aufsichtsratsmitglieder in Dieter Feddersen, Peter Hommelhoff and
Uwe H Schneider (eds), Corporate Governance (Otto Schmidt-Verlag, Kln 1996) 99,
122123; Thomas Raiser (n 8) B 104; Theodor Baums (ed), Bericht der Regierungs-
kommission Corporate Governance: Unternehmensfhrung, Unternehmenskontrolle,
Modernisierung des Aktienrechts (Otto Schmidt-Verlag, Kln 2001) 94 and 317319;
Frank Wardenbach, Interessenkonflikte und mangelnde Sachkunde als Bestellungs-
hindernisse zum Aufsichtsrat der AG (Otto Schmidt-Verlag, Kln 1996) 178183.

co-determination law might hinder mandatory qualification requirements,

and the same might hold true with respect to liability rules. But labour re-
presentatives typically have a sound knowledge of the company and can thus
help the supervisory board to control management with regard to a number
of questions that are unique to that company. The liability of the labour
representatives might also be restricted to cases of gross negligence. This
appears to be consistent with co-determination rules and labour law, accord-
ing to which no employee is permitted to act recklessly.
c) Involvement of the supervisory board in management decisions
Finally, the supervisory board should become more involved in management

decisions. This does not mean that the separation of management and control
in the two-tier system should be abolished. Day-to-day management should
remain the responsibility of the management board. Indeed, there are very
significant differences between the daily responsibility of the members of the
management board and the periodic responsibility of the members of the
supervisory board to evaluate plans, decisions and results.
The supervisory board should not be completely limited to an ex post
control. Consequently, all fundamental decisions and especially those that
set or change the corporate strategy should require the approval of the
supervisory board 165. This is an expansion of the present statutory provisions
and of the rules already existing in the by-laws of some companies, since the
current law only requires the by-laws to provide a list of decisions that need
approval. This, however, is merely a formal requirement, as the form of the
list and its content are not prescribed. The proposed mandatory approval list
is more than a mere expansion of the existing legal rules: it should be seen in
the context of the above-mentioned professionalisation of the supervisory
board as an organ consisting of experts permanently monitoring the company.
In such a reformed supervisory board the flow of information is more
complete and timely, and due to the higher frequency of meetings, decisions
can obtain the necessary approval in a reasonable time.
2. Recommendations for the improvement of corporate control

in the one-tier system
Some of the recommendations made with respect to the two-tier system are
of equal importance to one-tier systems and need not be repeated. This holds
true especially with regard to the installation of committees and liability
165 Theodor Baums (ed) (n 164) 7677; but see Carsten Berrar (n 24) 21842185.

rules 166. Subsequently, this paper concentrates on the proposed changes that
are essential for the unitary board.
It has been stressed that the central issue in each unitary board is, firstly, the
lack of separation of management and control and, secondly, as a conse-
quence thereof, the monitor-colleague-dilemma, which the non-executive
directors are facing. Hence, the key to successful control of the management
of the company is to reduce the potential conflict inherent in this dilemma.
As was proposed, particularly in the American literature on corporate gov-
ernance 167, this can effectively be done by choosing independent non-execu-
tive directors. Thus, the recent reforms in the UK to strengthen the role of
independent directors were necessary and essential. While this is a widely
accepted view, we should bear in mind that independence does not only have
its merits but also its downfalls. There are fewer incentives for a person
who had not previously had and does not currently have a relationship to the
company to spend an adequate amount of time controlling the companys
affairs 168. Moreover, it is questionable whether such a person has the relevant
knowledge of the particularities of the firm, which is a disadvantage for both
tasks.
a) Frequency and duration of board meetings
Information concerning the company is complex. This is true especially

with regard to data about long-term trends relating to financial performance,
competitive position and organisational structure. Consequently, directors
need time to evaluate the information and consider decisions and choices of
the past. It is thus worthwhile to further increase the frequency of board
meetings and to make board meetings last longer 169. Monthly board meetings
166 Derek Higgs, Review of the Role and Effectiveness of Non-Executive Directors
(Department of Trade and Industry, London 2003) 5965; Brian R Cheffins (n 21)
621624.
167 See Ronald J Gilson and Reinier Kraakman, Reinventing the Outside Director: An
Agenda for Institutional Investors (1991) 43 Stan. L. Rev. 863; Reinier Kraakman, Die
Professionalisierung des Board in Dieter Feddersen, Peter Hommelhoff and Uwe H
Schneider (eds), Corporate Governance (Otto Schmidt-Verlag, Kln 1996) 129, 135
136; see also Stuart Rosenstein and Jeffrey G Wyatt, Outside Directors, Board Inde-
pendence and Shareholder Wealth (1990) 26 J. Finan. Econ. 175.
169 Otto Graf Lambsdorff, berwachungsttigkeit des Aufsichtsrats Verbesserungs-
mglichkeiten de lege lata und de lege ferenda in Dieter Feddersen, Peter Hommel-
hoff and Uwe H Schneider (eds), Corporate Governance (Otto Schmidt-Verlag, Kln
1996) 217, 224.

are essential for continual supervision and for giving every board member
the possibility to promptly ask questions. The emphasis is on the continual
possibility of initiating discussions and addressing all areas of concern. Once
such a culture of continual supervision has been established, the preparation
of board meetings does not require the same amount of time as it does if
meetings take place only every third or fourth month. Thus the counter-
argument that monthly meetings lead to an inefficient allocation of directors
attention is diluted. At the same time, and in contrast to a minimum fre-
quency, it does not appear to be sensible to postulate a minimum duration of
a meeting. Each meeting should last until all issues are discussed. It is then a
question of the particular circumstances as to how much time is indeed
necessary.
One exception to this last point should be mentioned: at least once per
financial year, a board meeting should take place over two or three consecu-
tive days. In the absence of a tight time schedule, but rather with an extended
period including coffee breaks, lunches and one or two evenings spent
together, thoughts would be shared more openly and frankly, and non-exe-
cutive directors would have a better chance of getting involved in the work of
the board, even if they are not as well prepared as the executive directors. In
such a meeting, the long-term corporate strategy should be on the agenda 170.
b) Meetings of the non-executive directors
Having meetings of the board which last several days is a way of better inte-
grating the non-executive directors into the board. At first glance, it may
seem contradictory to also propose that the non-executive directors convene
in additional sessions without the management. However, in meetings of this
kind, it is again very likely that cohesive bonds develop among the non-
executive directors and that questions are discussed that might not be other-
wise brought up 171. They also strengthen the position of the non-executive
directors in the next regular board meetings, as the non-executive directors
might feel more competent when convening later with the executive direc-
tors. As only questions of corporate control are on the agenda of the exclu-
sive meetings, the monitor-colleague-dilemma is not as apparent as in the
board meeting, since the non-executive directors are able to concentrate their
efforts solely on questions of control.
170 Martin Lipton and Jay W Lorsch (n 111) 6970.

171 See Derek Higgs (n 166) 3334.

c) Composition of the board
The smaller the number of directors, the more likely it is that each director
can play an active and vital role. As a rule of thumb, in boards with more than
ten or twelve members, at least some directors will feel superfluous and con-
sequently stop preparing board meetings themselves but rather rely on the
work of the others. In addition, sufficiently thorough discussions will not
take place in groups that are too large 172. In a board consisting of eight to ten
directors in total, there is enough diversity and a sufficient range of view-
points in the boardroom and an exchange of thoughts is still possible 173.
The Combined Code states in Sec. A.3.2 that at least half the board, excluding
the chairman, should comprise non-executive directors determined by the
board to be independent but does not stipulate a maximum number of seats
in total. In some large companies, there might be practical need for six or
eight executive directors. It is doubtful whether this legitimises a board
consisting of twelve, sixteen or even more persons in total in order to meet the
requirement of the Combined Code 174 and whether this could be inconsistent
with the supporting principle in Sec. A.3, according to which the board should
not be so large as to be unwieldy. In contrast, the 2005 Recommendations of
the EU 175 take a more sensible approach, as they forbear from prescribing
fixed numbers but refer in Point 4 to a sufficient number of independent non-
executive directors that ensures that any material conflict of interest involving
directors will be properly dealt with. Indeed, it seems sensible to provide for
a flexible rule and to regard a maximum board size as the superior criterion. It
should be guaranteed, however, that a minimum number of independent
non-executive directors exists, and that they have effective voting rights 176.
172 See Klaus J Hopt (n 1) 255256; for a quantitative analysis see David Yermack, Higher
Market Valuation of Companies with a Small Board of Directors (1996) 40 J. Finan.
Econ. 185.
173 Cf Korn/Ferry International (n 38) 9 (arguing that the optimal size lies between six
and eight).
174 See also Derek Higgs (n 166) 33 (recommending a strong executive representation on
the board in order to ensure that the board as a whole is well informed).
175 See n 17; in this context, see also Jan Lieder, Das unabhngige Aufsichtsratsmitglied
(2005) 8 Neue Zeitschrift fr Gesellschaftsrecht 569.
176 At present, it is likely that the majority of executive directors prevails too often, even
with regard to issues raised by non-executive directors (see Brian R Cheffins (n 21)
609610). Cumulative voting rights for non-executive directors might overcome this
problem.

3. Reflection on the limits of corporate control
Effective corporate control means that there is an institutionalised, formal

process of monitoring and reviewing the actions of the decision-makers in
a company. Tasks should be clearly defined, and all stakeholders of the
company should know about the responsibilities of those in charge of moni-
toring the management. However, every system of corporate control has its
limits, and it can be made more effective if structural weaknesses are elimi-
nated. Yet, this does not mean that the possibility that mistakes are made
by the relevant people in the company can be eliminated, and mistakes can
be made at both levels, at the managerial level as well as at the control
level. Of course, we can hardly say that outsider directors, non-executive
directors, independent directors, etc. or competent, well paid, full-time
working members of the supervisory board have a degree of foresight and
wisdom that makes them, in any case, superior to the executive directors
or members of the management board. Both groups can be wrong in their
decisions; both might take too many risks and thus lead the company into a
period of financial distress. Thus, neither integrating the monitors into the
decision-making process nor strengthening the role of those involved in the
decision-making process as monitors would automatically bring an end to
business failures. However, an enhanced level of control would reduce the
probability of mistakes that occur at the managerial level remaining undetected.
Consequently, there is an increased chance that wrong or harmful decisions
can be corrected and that injury to creditors, shareholders, employees and the
general public can be reduced.
VII. Summary
In the last decade, corporate governance and questions of effective corporate

control have become one of the core topics in finance, business administra-
tion and law. The UK and Germany represent prototypes of two competing
systems. This study has shown that the British one-tier system, with its
unitary board, and the German two-tier system, with a management board
and a supervisory board, are both effective means of control. In addition, the
empirical results showed that it is not possible to deem one board system
superior to the other. This finding is consistent with theoretical approaches,
which have highlighted the strengths and weaknesses of both systems.
Although both regimes are demonstrably effective, it was argued in this paper
that there is room for improvement. It was concluded that single features of
one system can be introduced into the other, and vice versa. This must be

done carefully, however, as each system has its peculiarities which do not
allow for a fundamental change. Consequently, the amendments proposed
here would lead to a certain degree of convergence of the British and the
German system, but would not eliminate the diverging key features. As a
result, the standard of corporate governance would be enhanced and the
likelihood of corporate failures and financial crises would be reduced.


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The Effectiveness of Corporate Governanc PDF

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The Effectiveness of Corporate Governance

in One-Tier and Two-Tier Board Systems

Table of Contents ECFR 2006, 426474

* Dr. iur., LL.M. (Yale), M.Sc. in Finance (Leicester), Wissenschaftlicher Assistent,

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4 Committee on the Financial Aspects of Corporate Governance, Report (London 1992)

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compulsory supervisory board into UK law is very unlikely to happen in the

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This study is a quantitative comparative assessment of the degree of managerial

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II. Forms of supervision of corporate management in the UK

The purpose of this paper is to examine the effectiveness of corporate control.

1. The German system of corporate control (two-tier model)

According to the German Stock Corporation Act of 1965, it is mandatory for

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26 Knut Bleicher and Herbert Paul (n 15) 265.

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Consequently, in Germany, the members of the supervisory board are the

2. The British system of corporate control (one-tier model)

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40 Eils Ferran (n 12) 118119.

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managed by individuals, not by the board as a whole, which meets once a

3. Groups of persons entrusted with monitoring tasks

43 See Brian R Cheffins (n 21) 603604.

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III. Analysis of the relationship between board turnover

Empirical studies on the relationship between board turnover and financial

1. Earlier comparative research

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2. Earlier research with relation to the effectiveness of corporate control

54 Julian Franks, Colin Mayer and Luc Renneboog (n 45).

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3. The uniqueness of the focus on different board systems

The above-mentioned studies comparing the UK and Germany are of limited

Hamid Mehran, Executive Compensation Structure, Ownership, and Firm Perform-

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Board turnover is defined as the number of executive directors who leave

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Ideally, this would ensure the measurement of only forced resignations.

b) Poor financial performance

There are numerous ways to measure financial performance, and it is thus

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aa) Data for the measurement of financial performance

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bb) Definition of poor financial performance

Jurisdiction Loss for the Loss of Abnormal Dividend Poor

Table 1: Measures of poor financial performance

For the purposes of this study, however, poor performance is defined as

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IV. Testing the hypotheses: data on financial performance

Germany United Kingdom

1994 24.33 6.77 17.56 12.00

Average 23.77 6.55 18.38 11.93

Table 2: Board size in Germany and the UK (19942003)

Jurisdiction Years of Poor Other Years Total

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In Table 4, the average board turnover percentage in years following a year of