The European Commission (hereinafter ‘EC’) is speeding up the sustainability reform process to improve the EU regulatory framework on company law and corporate governance. The considered policy options are mostly based on a study performed by Ernst & Young (hereinafter ‘EY’) on behalf of the EC. This study—published in July 2020—was meant to ‘assess the root causes of short termism in corporate governance’ in order to ‘support the European Commission in identifying the need for a possible reform in corporate law and board duties to foster sustainable corporate governance’.
Compared to the ambitious mandate, the EY study appears to be rather lacking and its conclusions unconvincing.
To start with, the EY report builds on two main assumptions, which are revealing of its biased approach: first, corporate decision-makers focus on short-term results; second, this short-termism reduces the long-term economic, environmental and social sustainability of European businesses. While the latter assumption is not even tested empirically, the former one is based on an empirical analysis of companies’ pay-outs and capital and R&D investments over the last 30 years. Here the EY report infers EU companies’ pressure towards short-term results from the ratio between a company’s pay-outs and net income: the higher the ratio, the greater the short-termism. This simplistic view fails to recognise the role of capital markets in allocating and re-allocating resources; moreover, it is based on a rough data analysis.
The EY evaluation of the ‘pay-outs and net income ratio’ mimics Lazonick’s study (2016) on US companies but fails to consider the significant difference with the EU. While both studies find a growing trend in the ratio between total pay-outs and net income, the US and EU differ for at least two reasons. First, the absolute value of pay-out is significantly higher for US firms (around 90% in 2006-2015) than for the European ones (around 55% in the same period). Second, there is a clear difference in trends, as the EU firms’ ratio increased only in the first period (1992-2001), while the US firms experienced a constant increase. Following Lazonick’s approach, the EY considers only the gross value of pay-outs (ie total capital that flows out of the corporation through dividends and buybacks). The adoption of a more complete parameter, such as net pay-outs which consider also capital inflows that replace distributions, would have been more appropriate. In the US, for example, Fried and Wang (2018) find that, between 2007-2016, net pay-outs among S&P 500 firms constituted only 50% of net income, far less than the 90% found by Lazonick on gross pay-outs.
Moreover, the EY short-termism hypothesis neglects inward flows, namely capital increase and debt, overestimating actual net pay-out of the European companies. For example, the financial crisis and the low cost of traditional financing sources sensibly increased new corporate debt issuance that, in turn, powered corporate recapitalisation. As a matter of fact, this phenomenon has been already observed in the US market by Mark Roe (2018) and Elgouacem and Zago (2020), while the EY report on EU companies completely disregards it.
The EY report’s analysis of ‘business investment’ is also incomplete. Here the EY report further supports its short-termism hypothesis by observing the slowdown of the ratio of CAPEX and R&D investments to total revenues, corroborated by the decrease of the absolute value of business investments over the last ten years. But this slowdown may be interpreted differently: the decline in investments may not be the result of short-term pressure but rather of the global recession due to the financial crisis and the decrease in capacity utilisation which followed (as pointed out by Mark Roe (2018) for US companies). Moreover, data on CAPEX and R&D investments are a rough estimate of the actual long-term investments: they do not consider, for example, investments realized indirectly through M&A activities; more generally, the quality of information about R&D is far from homogenous and reliable, depending as it does on different accounting standards and disclosure rules across the EU (as clearly illustrated in the European Commission, EU R&D Scoreboard, p 109).
Even assuming that EY data are reliable, the different timing for EU firms in the increase in pay-outs (concentrated before the financial crisis) and in the decrease of investments (concentrated after the financial crisis) challenges the EY conclusions about their interconnection.
Furthermore, even the data sample of the EY report appears incomplete. Our main concerns are based on publicly available aggregate statistics, as we were denied access to the complete database due to confidentiality reasons.
First of all, the inclusion of UK companies appears inconsistent, as an impact analysis for future policy options should not consider the market features of a country that is no longer part of the EU. In fact, other parts of the study treat the UK as a ‘third country’. Moreover, because of the size of the UK market, its inclusion may well distort the sample representativeness.
Secondly, the selection of only 15 member countries out of 27 appears neither clear nor reasonably consistent: the inclusion of some very small economies and stock markets, such as Slovakia and Slovenia, and the exclusion of some larger economies and stock markets, such as Denmark and Ireland, has no justification and is potentially misleading, if not instrumental. As a matter of fact, Slovakia largely comes out as the most short-term oriented country.
In summary, the EY empirical analysis does not properly support its conclusions: first, the reported absolute level of pay-outs in the EU is much lower than in the US and it is significative only in the first decade examined, challenging the hypothesis about the pay-out level being a relevant and current issue in Europe; secondly, the EY report simply explains the decrease of companies’ investment as a consequence of the increase in pay-out, while actually the timing of the two phenomena is the other way round.
Furthermore, the EY report suffers significant methodological loopholes: neglecting inward capital flows, it overestimates the actual net pay-out of the European companies, on one hand; neglecting investment realized through M&A, it underestimates their actual long-term investments, on the other hand. Moreover, the data sample is built on unclear criteria, making it difficult to assess whether it can effectively represent EU companies (and we strongly suspect it does not, considering the post-Brexit EU).
Addressing these issues is, in our opinion, a preliminary and necessary step before any empirical, let alone policy, conclusion can be drawn. Therefore, the EU Commission’s enthusiastic endorsement of the EY study findings (‘The Study found a clear trend of short-termism in the focus of EU companies. It identified key drivers of this issue’) appears odd, or at least, premature.
Marcello Bianchi is Deputy Director General of Assonime (Association of the Italian joint stock companies) in charge of the Corporate Governance and Capital Markets Area, and Coordinator of the Technical Secretariat of the Italian Corporate Governance Committee.
Mateja Milič is senior analyst in the Corporate Governance and Capital Markets Area of Assonime and research staff to the Technical Secretariat of the Italian Corporate Governance Committee.
This post is part of the new OBLB Series: ‘European Commission Initiative on Directors' Duties and Sustainable Corporate Governance’.