Different strokes: Jaap Winter says Sarbanes-Oxley is wrong for Europe, but it may be just what the United States needs.

A LOT OF INTERNAL AUDITORS owe Jaap Winter a debt of gratitude, although they might not know it. In 2002 the European Commission (EC), the executive arm of the European Union (EU), asked Winter, a Dutch lawyer, to write a report on the policy implications of the Enron collapse. In November of that year, he made a series of recommendations that set the agenda for a program of corporate governance reforms that continues to this day. Winter and the other members of his committee made it clear what changes Europe needed to make in areas such as governance disclosures, the role of independent directors, and directors' pay.

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So why the debt of gratitude? Winter's work helped to steer Europe away from tough legislation like The U.S. Sarbanes-Oxley Act of 2002, which looked inevitable. The result is that European internal auditors are not spending all their time checking and documenting controls, unlike many of their U.S. peers.

Does that mean the United States got it wrong? Winter, a partner at law firm De Brauw Blackstone Westbroek, is in an interesting position to answer: He lectures on corporate law on both sides of the Atlantic--at the University of Amsterdam and Columbia Law School in New York--and is a member of a high-level EU advisory committee. The Sarbanes-Oxley approach would be wrong for Europe, he says, but could be just what the United States needs.

Q. Can you encapsulate what you recommended in the Winter Report?

A key message was that in Europe we should not have a uniform corporate governance code. The underlying company law systems in the EU member states--the 25 that we have today, and the 15 that we had in 2002--are so diverse that it would be impossible to impose a European code on them. You would have to have a code that was very general and did not say anything specifically on corporate governance practices, which would not add much. Or you would have a code that would try to be much more specific, but then it would have to include all sorts of exceptions for different member states. We thought that would not help either. So to accommodate the different systems in member states, we said the member states themselves should take the lead in developing their national corporate governance codes.

This led to a fundamental change. Now in most, if not all, member states there is one established national code. It might be linked to listing rules or to corporate law, or it might be voluntary, but listed companies are expected to comply or to explain why they have not.

Our report also said that corporate governance is wider than financial reporting on internal control, which is the basis of Sarbanes-Oxley. The report encompasses the relationship between the board and the shareholders, the functioning of the board, and the remuneration of board members.

We also stressed the value of a code, rather than mandatory legislation. In many areas of corporate governance, you cannot force companies--not even within one member state--into a fixed set of rules. One of the criticisms of Sarbanes-Oxley is that by imposing rules in a mandatory fashion, you take away the responsibility of boards to figure out for themselves what would be the best corporate governance practices for their particular companies. They simply have to follow the rules. The European comply or explain system, the fact that you need to explain what you do, makes boards accountable for their corporate governance choices. That is important.

Q. When Enron failed there was a great clamoring in Europe to have a tough legislative response. To what extent did your report steer Europe away from that course?

To some extent it did. But there was also a sense in Europe when Sarbanes-Oxley came out that it was an overreaction. It was explicable from the U.S. point of view, as there were large numbers of companies that had to restate their financial statements. But that seemed to be just one element of corporate governance.

To be honest, in those days, there was also a sense in Europe that these problems are not our problems--they are particularly American problems, fueled by the short-term requirements of quarterly reporting and a stock market driven by short-term interest. I never believed that this was only a U.S. problem.

Actually, since our report came out, we've seen scandals in several European member states that are not fundamentally different from the Enron problems. The underlying governance issues are very similar.

Q. The EC adopted almost all of your report as the basis for its corporate governance action plan. How successfully do you think that plan has been implemented?

We suggested that national member states make their own national codes, and that has happened. We asked for guidance at an EU level on governance, and the Commission has published recommendations on the role of independent directors and the remuneration of directors. We suggested a legal directive on shareholder rights, which is now on the table as a draft. [Once the EU agrees on a directive, member states have to incorporate it into their national laws.] It seeks to improve the ability of shareholders to exercise their voting rights, particularly across borders. The draft doesn't go all the way to create a real solution, but at least there is a draft on the table.

Other issues have been dealt with in a separate track. The issues about the role of audit committees, disclosure about internal control systems, and the regulation of statutory auditors have been dealt with through an amendment of the EU 8th Directive, which was never part of our remit.

Q. Do you think the European response to corporate financial scandals has been more effective than the U.S. approach?

The difficulty with both the European and U.S. approaches is that it is very hard to establish what the real effect is. Since the introduction of Sarbanes-Oxley, there have been, for example, more than 3,000 instances where companies have reported material weaknesses in their internal control systems. You could call this a benefit, in the sense that organizations are more straightforward about whether their systems work or not. I'm not sure if it's saying very much, actually. You also have to take into account the costs incurred to get that benefit. Documenting all internal control systems and all business processes is a huge cost.

The key question for Sarbanes-Oxley, and one that needs to be answered before we can make any judgment about the legislation, is are the huge costs a one-off, or will they recur to some extent annually, and do they outweigh the benefits of making sure that fewer companies have material weaknesses in their control systems?

With the European approach, we have not imposed this level of cost. We have basically gambled that boards will look at their own governance systems, will be criticized by shareholders and the media if they get it wrong, and will make changes where the court of public opinion has pressured them. My feeling is that this approach works. Boards have taken the governance of their companies much more seriously, and there is stronger involvement of shareholders. We will only find out later whether the increased focus on improving governance has actually led to better-run companies that are more successful in the long run.

Q. People complain that the renewed emphasis on governance has increased the burden of directors' responsibilities. But you argue that they're simply being asked to do work they should have been doing anyway.

That statement is certainly unfair to a number of people who did their best and worked hard, particularly when companies had difficulties and crises. But overall I think it is probably true. For a long period, we ignored the question of what we expected of them. We were comfortable that just having meetings a few times a year, and raising interesting and challenging questions, was probably the right sort of thing, and that nothing much more would be needed.

Independent, outside directors need to do what we always thought they were doing, which is supervising what the executives are up to. There's a lot of scope for many boards to improve their performance. Compared to what they did before 2002 or 2003, they might complain that their new role is no longer fun--that the world is expecting from them something they cannot deliver. To be fair, I think one consequence of this will be that nonexecutive directors will ask for, and will be rewarded with, more money to fulfill a more intensive and committed role.

Q. Would Corporate America be in better shape if the country had adopted the recommendations of the Winter Report, instead of introducing Sarbanes-Oxley?

That's a very difficult question. I think the U.S. corporate system works on very different drivers. The U.S. thinking, in terms of being successful by making as much money as possible, is very different from what many people in Europe believe to be appropriate. If you have a culture where someone's reputation and performance are measured by the money he makes for himself, by his personal income, you should expect that people will go to the limit, and sometimes beyond. They have great incentive to get there and make money in very extreme ways.

I'm not criticizing the system. It's just that U.S. society is much more driven by that sort of incentive than European society is. Where people have strong incentives to gather personal wealth, there is a higher risk that they will go over the limit. So you may need tougher sanctions, and tougher enforcement mechanisms to stop them, or at least to punish them, if they do. In that sense, Sarbanes-Oxley may have been precisely the right sort of legislation for the United States.

Would a more nuanced approach, perhaps in the European style, be as effective in the United States as Sarbanes-Oxley, or perhaps even more effective? I'm not so sure about that. I'm sure that Sarbanes-Oxley would have been devastating for European companies.

Q. So is it your view that the U.S. corporate system actually encourages greed, and it encourages directors to bend the rules?

Some people argue that the creativity of American business people and the lawyers that work for them is invested in how to get around the rules--not how to apply the rules, or how to make the best of them, but how to get around them. I'm not an expert on the United States or Europe, but I feel Sarbanes-Oxley may have been the right approach for the United States, although it comes with a huge cost. It is difficult for us in Europe to say, "Well clearly the Americans did it wrong." It is interesting to see that regardless of Sarbanes-Oxley, the U.S. economy is still growing much stronger than the European economy. Sarbanes-Oxley did not stop that.

Does the U.S. corporate system act as an incentive to greed? Greed is such a negative word, but there are huge incentives in the United States. A director who runs a company, and runs it well, can, through performance shares, stock options, and bonuses, gather huge personal wealth. The amounts of money involved are unheard of anywhere in Europe. It is completely different. There are examples where, even in the United States, people are starting to feel that this is no longer appropriate.

Q. Why don't those incentives exist in Europe to the same extent?

In Europe, there was always a strong focus on solidarity, making sure that everybody is doing reasonably well, and the community invests in systems to ensure everybody keeps their head above water. As a result, there are not such high rewards for individual performance. It has changed over the years, but we remember the days when member states imposed high taxes on people with high incomes. In the Netherlands, I remember my father, who was a general practitioner, simply a doctor, paid income tax at 72 percent. So whatever you did, the state would take away almost three quarters of your income. That solidarity does not give much incentive for people individually to perform to the best of their abilities. In Europe, we have different expectations of what people should do, and when people are successful. Success is not measured by gathering enormous wealth; or, at least, less so than in the United States.

Q. If there are these fundamental cultural differences between the U.S. and European corporate environments, do organizations need to be aware of them when they think about risk and internal control?

It should be a relevant question, I fully agree with you. I'm not sure audit firms are very sensitive to it. I haven't heard much discussion about it. I've worked in a Dutch multinational company that had a long-standing U.S. presence, and I've talked with many people in Dutch multinational companies that have U.S. subsidiaries. The feeling is you need to have tougher controls on your U.S. business, otherwise the greed factor may get the company in trouble. These cultural aspects should probably play a role in the management of companies and, therefore, one could expect that they would also be reflected in internal control systems. But this is very anecdotal. I'm certainly not saying that the business sense of propriety in the United States is less than in Europe; it is simply different. The personal incentives for employees are different.

Q. Some of your views, for example on shareholder rights, bring you into opposition with some powerful interest groups. Does your high-profile stance on contentious governance issues ever affect your legal work?

I've certainly had debates with some of my clients about these issues. I take an independent view on what I think is an appropriate corporate governance system. I don't claim to have the full truth and the best view; others will have different views. I just try to participate in the debate and try to be completely independent. I'm not a shareholder activist, but I'm also not a company activist, and as a lawyer in private practice, I act on both sides.

Q. As captain of the Dutch lawyers soccer team that became world champion, your favored position was sweeper: sitting as the last line of defense, reading the game to anticipate attacks. Is there a metaphor between your soccer career and your legal work?

I was Dutch champion in the 200 and 400 meter sprint, so I was fast. I probably wasn't that good as a football player, but I used my speed: Every attacker who thought he'd got through the defense still had to beat me, and that was sometimes very difficult. And as sweeper, part of my job was to tell all the defenders and the people in midfield where to run and to make sure they were taking up the right positions, without making much of the play myself. I had to organize things and solve any crises that occurred. Is there a parallel with my legal work? Possibly!

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BY NEIL BAKER

EDITOR, INTERNAL AUDITING & BUSINESS RISK

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