Structure and Role of the Two Board System of Directors in Germany

Introduction
The two board system of directors theoretically presents a way for greater accountability and oversight in corporate governance. The system was developed in Germany with the idea being to have a supervisory board over the management board, the members of the former elected by shareholders. In functional terms, however, the supervisory board can be involved in long-term decisions that impact the corporation—so it is not entirely accurate to define this board as being focused on accountability and oversight (Proctor, 2002). This paper will discuss the structure and role of the two board system of directors, how the board has evolved and what the greatest challenges are facing it.
The Two Board System
The structure of the Board of Directors of the two-board system as used in Germany came about as result of that nation’s preference for a more inclusive form of governance that combined oversight with representation (Owen, 2003). The two-tiered board structure is comprised of one group of insiders who sit on the management board and another group of representatives of employees and shareholders making up the supervisory board. Thus, the two-tiered board system consists of one management board and one supervisory board that work together to oversee the company. The management board is filled with insiders, i.e., directors. The supervisory board is filled with shareholders and workers. The supervisory board oversees the management board. German banks play a major role in the boards of corporations in Germany, as Ewmi (2005) points out, since they are considered shareholders who have long-term stakes in these companies. For that reason, it is not uncommon to find German bank representatives sitting on the supervisory boards.
Another key aspect of the German board system is that voting rights are much more curtailed than in the US. Ewmi (2005) notes that “voting right restrictions are legal; these limit a shareholder to voting a certain percentage of the corporation’s total share capital, regardless of share ownership position” (p. 10). This is an important point because it indicates that there cannot be a monopoly of voting rights, held by a handful of people. Voting rights are meant to be more evenly distributed in the German two-tier system to prevent the kind of concentrated power one often sees in companies like Tesla, where the Board is essentially managed entirely by one man and his family (Cornell & Damodaran, 2014). However, as Siebert (2004) notes, the banks tend to have a dominating position in terms of voting rights and control over boards in Germany’s system. The reason the German system has not succeeded in avoiding monopolistic control over boards has to do with block holdings of shares: “block holding seems to dominate in Germany due to the fact that share owner representatives are more powerful in bargaining with employee representatives on the supervisory board than if they had dispersed votes” (Siebert, 2004, p. 43). The end result is that, although the two-tier system in Germany ostensibly was meant to democratize corporate boards, corporate control is still essentially in the hands of a small group of bankers.
The two tier structure is different than in the US where the separation of ownership of the corporation and control or management of the corporation is integral to the American idea of corporate governance (Zhao, 2010). This approach, however, has ushered in essentially a professional class of corporate board officers, whose career is characterized by sitting on various boards of corporations. It is the main reason one can look at publicly held companies from various sectors and find familiar names and faces throughout the respective boards. Overlapping boards of directorates prevail. The overlap facilitates the propagation of corporate governance throughout the wider corporate world (Bouwman, 2011). The situation in the US is aggravated, one could argue, by the concentration of wealth in the hands of a few large funds, such as Vanguard or BlackRock, which now controls over $7 trillion in assets and has significant holdings in major major corporations in the US and in Europe (Ahmed, 2020).
How the Board Has Evolved
Because of SEC regulations, companies now must demonstrate some of the characteristics of the two tier structure, if not in formal terms then at least in spirit. For example, the need for public companies to have an audit team that is made up of independent members who have no positions or ties to the firm is now standard practice (Bukhvalov & Bukhvalova, 2011). This evolution has come about as a result of various corporate governance failures, examples such as Enron, Worldcom, and numerous others over the decades. Yet questions remain as to how to evaluate board performance and whether there is any real accountability in the system.
When companies like Tesla are able to win board approval for a series of billion dollar payouts to its CEO, one must wonder if there is any significant oversight. Shareholders have not been quick to punish the company’s stock over the matter—on the contrary, the performance of the CEO and the rewarding of options valued in the billions has been directly tied to the stock price performance, thus incentivizing the CEO to pump the market and incentivizing investors to invest in the stock, as both mutually benefit from the stock price rising. On the face of it, it should appear that this is evidence of manipulation and conflict of interest—yet the SEC has essentially done nothing on the matter, thus tacitly approving the role of the board in handing billions to a CEO that has yet to lead the company towards a full year of profit, much less a year of profit based on actual sales of the company’s products instead of sales of carbon credits. The exclusion of Tesla from the S&P 500 Index was a sign that at least some have been paying attention.
Challenges Going Forward
One of the greatest challenges going forward for boards is the issue of share buybacks in an uncertain economy. Again, the problem of conflict of interest comes into play here. Would the two-tier structure reduce the risk of such conflict of interest? It is unlikely considering that prior to the 1980s, corporate share buybacks were illegal because it was viewed as market manipulation—and now they are legal and virtually every company engages in it (Reda, 2018). The conflict of interest here of course is that c-suite executives receive remuneration in the form of options, which can then be redeemed for big pay days so long as the company’s stock price goes up. Boards thus have a vested interested in authorizing share buybacks and allocating capital from the company to the repurchasing of shares in the open market. Rather than put existing capital into developing infrastructure or research and development, companies use funds to buyback shares and boost the value of the equity stake of executives and investors. It is essentially a way for executives to profit from their position, even though this is not the purpose of their appointment to the board.
A two tier system would not alter this situation in the slightest because, first of all, buybacks are legal, and secondly it would make no difference to the supervisory board overseeing the management board because the supervisory board is made up of shareholders—all of whom would benefit from authorizing a buyback plan. To make matters worse, companies borrow funds to facilitate buybacks because the fee to borrow is so low and the potential profits from having a constant bid in the market are so much greater for investors (Light, 2019). To go into debt for the purpose of boosting share prices only makes sense from the perspective of shareholder theory. From the perspective of corporate governance one has to wonder why the practice is allowed at all, since the board is there to oversee operations--not the market price of stock.
Yet the evolution of the board is really just a small part in the more complex issue of the market and the role that corporations play in the lives of pension funds, mutual funds, sovereign wealth funds, and hedge funds. Public companies are essentially there to give investors a way to obtain a return on investment that theoretically outpaces the growth of inflation. Pension funds and insurance funds must invest in the market in order to get an ROI that allows them to make good on promises made. If the ROI is not provided by the market, the collapse in both pension funds and insurance funds would be catastrophic—and those are just two examples. In order for the ROI to appreciate year over year, there has to be a constant bid, and if liquidity is non-existent it has to be stoked, which is where companies come into play by authorizing buybacks. Boards are simply doing what they must to ensure the entire financial and economic system set into motion can continue on. It has very little to do with corporate governance and everything to do with a macrocosmic way of life. That board members sit on the boards of all the same companies (i.e., that there is now a professional class of individuals whose career is defined by sitting on boards) shows the extent to which individual companies no longer exist: they are all one members of one big socio-economic system and must do as they are told by firms like BlackRock, who essentially can destroy any company that refuses to go along with the socio-economic scheme by dumping their entire position in a matter of minutes.
Thus, on the face of it, corporate governance is little more than lip service paid to the idea of democratization, oversight and regulation. The situation is not really any different in Germany than in the US. In Germany, the two-tier structure gives the impression of accountability, but when the bankers are the ones sitting in the supervisory role one can imagine that it is little different from the foxes watching the hen house. In the US, there is less actual lip service paid to the idea of oversight. Tesla’s CEO gets away with open stock market manipulation and the company’s stock is sent into the stratosphere for new fundamentally good reason at all—and regulators and analysts do nothing more than tacitly approve of all this by their complicit silence.
Conclusion
The board structure within the two-board system originating in Germany was developed to help ensure oversight of management by having shareholders install representatives who would sit on a supervisory board overseeing the management board. The supervisory board, however, tends to be dominated by banks, who are considered shareholders and block shares give the monopolistic control. In the US, similar control is wielded although the board structure is slightly different, with the two board system prevailing in the sense of an independent audit team existing.
References
Ahmed, S. (2020). BlackRock profit beats estimates as assets top $7 trillion. Retrieved from https://www.reuters.com/article/us-blackrock-results/blackrock-profit-beats-estimates-as-assets-top-7-trillion-idUSKBN1ZE1E4?feedType=RSS&feedName=businessNews&utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+reuters%2FbusinessNews+%28Business+News%29
Bouwman, C. H. (2011). Corporate governance propagation through overlapping directors. The Review of Financial Studies, 24(7), 2358-2394.
Bukhvalov, A., & Bukhvalova, B. (2011). The principal role of the board of directors: the duty to say “no”. Corporate Governance: The international journal of business in society, 11(5), 629-640.
Cornell, B., & Damodaran, A. (2014). Tesla: Anatomy of a Run-up. The Journal of Portfolio Management, 41(1), 139-151.
Ewmi, P. F. (2005). Three models of Corporate Governance from developed capital markets. Lectures on Corporate Governance, December, 1-14.
Light, L. (2019). More than Half of All Stock Buybacks are Now Financed by Debt. Here’s Why That’s a Problem. Retrieved from https://fortune.com/2019/08/20/stock-buybacks-debt-financed/
Owen, C. J. (2003). Board Games: Germany's Monopoly on the Two-Tier System of Corporate Governance and Why the Post-Enron United States Would Benefit from Its Adoption. Penn St. Int'l L. Rev., 22, 167.
Proctor, M. (2002). Corporate Governance. Cavendish Publishing.
Reda, J. (2018). How Stock Buybacks Can Affect Executive Compensation. Retrieved from http://clsbluesky.law.columbia.edu/2018/08/03/how-stock-buybacks-can-affect-executive-compensation/
Siebert, H. (2004). Germany's capital market and corporate governance (No. 1206). Kiel Working Paper.