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Are family firms immune from regulatory reform?

Hywel Lewis is a freelance financial journalist specialising in family business.

A spate of international financial scandals has forced governments to crack down on corporations, bringing corporate governance to the fore. But are the recommended steps to improve corporate behaviour fully applicable to family firms?

The corporate scandals that have monopolised the business headlines over the past few years have led many to reassess the opinion that terrorism or IT failure are the factors that pose the greatest threat to family and other enterprises. The collapse of Parmalat in the family arena, and of Enron and WorldCom in the wider picture, has led some experts to believe that corporate governance issues now pose the most real and persistent dangers to the fortunes of family businesses worldwide.

This accentuated focus upon corporate governance issues was most famously crystallised in the passing of the Sarbanes-Oxley Act of 2002 by US president George Bush. The law was intended to bolster public confidence in the American capital markets, imposing new duties and significant penalties for non-compliance on public companies and their executives, directors, auditors, attorneys and securities analysts. Sarbanes-Oxley has required public companies to tighten up auditing standards, with accountability to a newly-established Public Company Accounting Oversight Board, as well as imposing strict controls on those who serve in positions of responsibility in a public company, requiring improved corporate disclosure, and imposing greater pressure upon companies to detect and expose fraud.

In Europe, the collapse of Parmalat, a family business become international colossus, provoked calls for similar regulatory reform. The Parmalat scandal came to light in December 2003, when it emerged that €3.9bn ($3bn) in cash and securities the company claimed lay in a Bank of America account, did not exist. Charges including market-rigging, false auditing and regulatory obstruction have been levelled at executives of the multi­national firm and at several accountancy firms associated with the company. This meltdown seemed to prove that listed companies can hide problems in certain circumstances if the board is dominated by the founding family and its friends.

The collapse of Swiss conglomerate Erb heightened concerns about the lack of controls in Europe's family businesses. Founder Hugo Erb's refusal to listen to staff concerns about the company's rising investment in struggling German real estate business CBB, prompted by a hatred of retreating from investments led Erb into meltdown. Hugo Erb's lack of judgment found counterparts in the tales of Swiss financier Martin Ebner and German media tycoon Leo Kirch, who were both forced to break up their empires after borrowing too much from banks, and concealing much of their trouble from creditors.

To those who view the scandals as paradigm cases that show the weakness of family-dominated companies, Erb had some features that are suspiciously common in the European family-business sector. Founders of the business dominated its decisions and information, auditors were often close friends of the family, and the company lacked independent scrutiny from outside directors. On top of these weaknesses, the banks often did not press for transparency for fear of losing their business.

Such a surfeit of highly-publicised scandals has suggested to many family business analysts that there has come about a wholesale change in the market environment as regards attitudes towards corporate governance. Not all agree, however. What effect has one of the biggest business stories of the past decade really had upon family firms? And has the pressure exerted upon family firms really all been justified?

Many industry experts believe the new corporate governance legislation and the associated environment are in fact having a far more limited effect than might popularly be believed. John Ward, a family business expert at Kellogg University, is a proponent of this point of view. "Fundamentally, this new legislation affects only three types of family firms: those that are publicly-traded, those with publicly-traded debt, and those family businesses that have a philosophy of managing themselves as if they were publicly-traded."

The last group named wishes to operate by the same standards as publicly-traded businesses, as a kind of self-imposed benchmark. However, says Ward, the advent of Sarbanes-Oxley has imposed a whole new level of stricture, and as such some of its stipulations are entirely unreasonable and unrealistic for the vast majority of family businesses. "The costs of compliance have been seen as suffocating for medium- and small-sized companies," he says. "Family businesses will often pay for attempting compliance with the new laws as their accountants pick on details that have not previously been considered important. This leads to numerous new costs in terms of both money and time, such as board meetings that would not hitherto have been required."

This begs the question of whether these family businesses are indeed attempting compliance, says Ward. While some family businesses have boards with independent directors who are rabidly pro-Sarbanes-Oxley, thus putting a great deal of pressure upon the company in question, in general independent directors sitting on the boards of family firms have been understanding.

Jim Hutchinson, CEO at Regeneration Partners, family business consultants in Texas and Arizona, is in agreement that, despite the crisis in business governance caused by the collapse of various firms in the US and beyond, Sarbanes-Oxley and similar regulations have had little or no impact upon the vast majority of family businesses. "Metaphorically speaking, the new regulations are like laws against teenage drinking. They are generally acknowledged to be good and worthwhile, but this does not prevent the family busi­ness from carrying on as usual, albeit with an increased sensitivity to the situation."

Corporate governance analysts in Europe made a similar and striking point when calls for the reformation of Italy's regulatory structure followed the collapse of Parmalat. The institution of new laws would simply bypass the real issue, they argued. Adequate regulation already existed in the area of corporate governance pre-Parmalat, so the real problem of gross negligence would not be remedied with the introduction of a few new laws. It would require more competent and courageous accountants, "and a couple more staff in the regulators' office to do their job." Moreover, the reliance of the Parmalat auditors upon a crude forgery claiming the existence of €3.9bn euros in cash and securities hardly constituted a subtle subterfuge.

Whereas governments are having extreme problems in forcing family firms to take up the new regulations, might there be secondary consequences that ultimately prove more persuasive? Any family company looking to raise capital it does not already have must approach a lending institution, whether this be a bank or a venture capital firm. Evidently if corporate governance is not exemplary in the firm, then the terms imposed will be more difficult than for a firm boasting an excellent governance standing. As Jim Hutchinson says, this does not mean that capital will not be forthcoming – no lending institution can afford to turn away business by imposing unreasonable restrictions upon its customers.

Whether or not they have been followed in detail, it is certain the new regulations and recommendations with respect to corporate governance have raised exponen­tially the profile of such issues in the world of family business. But, crucially, are the recommended steps to improve corporate governance fully applicable to family firms? Here opinion is most certainly divided.

Joachim Schwass, professor of family business at IMD, a business school in Lausanne, says that not having corporate governance burdens can be viewed as an advantage by family firms. "Public companies are struggling with growing corporate governance burdens, which are more and more about policing rather than about adding value." Schwass views a case such as Erb as an extreme one.

The letter of the Sarbanes-Oxley laws suggests that family members should not be permitted to serve on the company board, even where the family shareholders concerned do not serve any other function in the company. While on first reflection this sounds like a sensible idea, especially given certain of the business meltdowns in Europe discussed earlier, there is no convincing argument to suggest that the involvement of family members on the board should automatically be vetoed.

Indeed, a rigorous analysis of the relationship between family ownership and corporate performance of companies in the Standard & Poors 500 index, carried out by Ronald Anderson of American University and David Reeb of Temple University, has suggested just the opposite. Not only did their study find that family firms performed better than the non-family ones; more crucially it discovered that the outperformance was even more striking when a family member was the CEO, rather than an independent.

Interestingly, BusinessWeek magazine, carrying out separate research of its own, came to much the same conclusion, and suggested that the superiority of family firms stacked with family members was not simply an accident. Rather, if a Rupert Murdoch or a Kerry Packer pays a top executive multi-million dollar salary, then a substantial portion of that money will come out of the CEO's own pocket. Furthermore, if the executive in question underperforms, then the subsequent downturn in the company's fortunes will directly cost the family. Performance will be monitored very closely, and there are unlikely to be any huge packages handed out responsibility-free by 'independent' boards, which do nothing to encourage good business perfor­mance but everything to encourage stasis.

All of these thoughts run directly counter to one of the major current trends in promoting 'good' corporate governance – the feeling that every board member should stand more or less annually for his or her position, and that non-executive directors should ultimately not be permitted to maintain their position on a company's board for any longer than a decade. This is exactly opposite to the implicit conclusion of the studies – that long-term superior performance is founded upon longevity in the boardroom. John Ward argues that "family members on the board representing ownership interests also have a place on audit committees, compensation committees, and so forth."

Many feel that, on the contrary, excessive family participation on the board can be extremely detrimental to efficiency. Regeneration Partners' Jim Hutchinson argues that multiple family members on the board bring merely one set of ideologies or skills with them, rather than the broad range of skills an independent board would offer. "If company strategy is to acquire new businesses, then a mergers and acquisitions expert on the board will unquestionably be of help. If family members monopolise the board, then it will neither be possible to sack a member for poor performance, nor to prevent family arguments from resurfacing at board level."

Hutchinson does, however, suggest that as long as there are no more than two such members, the presence of family on the board need not be a disaster. He recommends that the other board members could be nominated, one by each branch of the family. As the arguments both for and against family-dominated boards carry a great deal of weight, theoretical and practical, such a compromise may be a wise move for family firms trying to achieve the board composition for opti­mum corporate governance. It also seems difficult to judge family-composed boards vis-à-vis independent board structures: not every family-dominated business needs to end up like the Erb conglomerate or Parmalat. Equally, some dictatorial non-family CEOs have done a splendid job of plundering their companies for personal gain.

We can conclude that for most small- and medium-sized family companies, the new atmosphere surrounding corporate governance has persuaded firms to look fleetingly at the constitution of boards and committees, the quality of auditing techni­ques and appropriateness of comp­ens­ation levels. But ultimately it has simply been a distraction. Neither, says Hutchinson, has there been any increased vigilance regarding anti-terrorism measures or the background of potential business partners.

The situations in which the recent corporate governance focus has had a strong impact upon family business are certainly the exception rather than the rule. Large public companies have had to make dramatic changes at board level, but this simply does not apply to 85-90% of family firms. "The vast majority of family firms will only move towards the ethic of indepen­dent directors when they get burned," says Hutchinson. "I hope that my words, and those of others, will encourage family businesses to move towards appropriate governance sooner rather than later."

John Ward is pessimistic that the situation will change in the years to come. "There is going to continue to be government activism in the area of corporate governance, and for publicly-traded companies there will continue to be new issues and concerns to deal with, one example being the recent debate over whether shareholder votes should be advisory or mandatory to the board. But I simply do not believe that the crescendo surrounding the issue we have witnessed will be repeated in the future."

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