Governance and costs monitoring: an impossible marriage?

19/12/23

Initially published on AGEFI

Luxembourg’s economy is expected to face challenges in 2024, with weak investments and tighter financing conditions. The economy of the country is likely to experience a recession early 2024, leading to a gross domestic product contraction.

Luxembourg companies are suffering from this situation while at the same time facing a number of regulatory changes that require investment in order for them to comply, which they must. As an example, the Digital Operational Resilience Act (DORA) will introduce new obligations for most European financial firms in terms of cybersecurity and risk management. The Corporate Sustainability Reporting Directive (CSRD) covers sustainability matters including environmental, social, human rights and governance factors and will be required very soon. These are a few examples, on top of the existing and costly compliance requirements.

In parallel, Luxembourg companies must ensure that they have a sufficient level of substance in the country. Substance requirements and best practices involve several elements such as infrastructure, workforce, governance, legal and transfer pricing documentation and financing activities. These restrictions could be even more important in the future when new European Directives will be transposed into the domestic law (e.g., ATAD III).

Luxembourg entities therefore need to navigate a complex regulatory environment while balancing the need to maintain substance requirements and manage costs.

Given the current downward cycle, the first reaction would be to focus on core activities and cut less significant or value-added activities. Governance principles, being mainly best practices, are very often the first ones to be sacrificed. What may make sense from a pure economic standpoint can however become a real threat to companies: proper governance helps ensure that companies are operating in an effective, transparent and ethical manner. The challenge therefore lies in finding the right balance between cost-cutting measures and the preservation of proper and robust governance structures and principles.

Governance is instrumental to Luxembourg companies

Good practices can help companies build trust with their stakeholders, including investors, employees, and customers.

Far from being a mere regulatory requirement, proper governance is key in Luxembourg, for financial, tax and operational reasons. It contributes to its status of a transparent, trustworthy and reliable jurisdiction.

Neglecting the entire governance spectrum can have severe consequences:

The reduction of board meetings and documentation may appear as a pragmatic solution to cut costs, but its implications on decision-making processes are significant. Board meetings serve as critical places for strategic discussions, risk assessments, deliberations and decisions. A decrease in their frequency may lead to inadequate and delayed responses to external and internal changes or factors, harming the competitiveness of the company.

The financial sector is subject to significant and frequent regulatory requirements. Regular board meetings and resolutions are instrumental in ensuring compliance with these regulations. Supported by the compliance, risk management and internal audit functions, they will create awareness in the firms and allow them to adapt, organise and comply. Underestimating it may result in regulatory breaches, fines, sanctions and damages to the companies' reputation.

Investors, especially in the asset management sector, focus, among other criteria, on transparency and governance when choosing where to allocate their funds. Similar to ESG criteria, investors do not only make their decisions based on economics and financial factors. They want to ensure that their funds will be managed by transparent, ethical and reliable companies. Any cuts on governance principles may harm their confidence, potentially leading to capital outflows and a decrease in market shares.

The involvement of Luxembourg Directors is essential to demonstrate the ability of the Luxembourg entities to take decisions for themselves, based on their own interests, without naively replicating the decisions taken in the foreign headquarters. Similarly, the documentation (and the location!) of the decision-making process is key here, to accurately reflect the different elements of the deliberations. Luxembourg is under scrutiny and foreign tax administrations are very keen on assessing the tax substance of the foreign entities located in the Grand-Duchy. Neglecting it could have a serious impact: legally, operationally and commercially.

One of the strengths of the country is its reputation for reliability and integrity. A perceived laxity in governance may harm this image, impacting not only individual companies but also the jurisdiction. It is far easier to harm its reputation than to recover it. Therefore, reputational damages should not be underestimated.

What are the alternatives?

Whilst we cannot deny that proper governance implies additional costs for businesses, Luxembourg companies and asset managers can adopt strategic approaches to navigate this delicate balance:

Invest into technology to streamline processes: virtual board meetings, digital signatures, documents production can enhance efficiency without compromising on the quality of governance.

Evaluate existing governance practices to identify areas for efficiency improvement. This could mean optimising meeting agendas, prioritising key discussions, or leveraging the work done by the different committees. As an example, it is possible to decrease the length of the meetings by improving the internal communication (e.g. sharing internal committees' memos), improve the preparation of these meetings (supporting materials sent in advance to allow Directors to read and analyse), better highlight the key topics (with the help of the chairman) and go to the essentials during the meetings.

Invest into continuous training programmes for executive and non-executive directors to ensure they remain aware of the latest regulatory changes and best practices. Going forward, it will allow the organisation to spend less time during meetings (as the involvement of experts will be limited) and contribute to more effective deliberations and decisions.

“Do what you do best, and outsource the rest. (Peter Drucker)”. Consider outsourcing non-core functions to specialised service providers. Not everyone has the time, money or will to spend on tax substance, governance best practices and company secretary. This can help reduce operational costs without compromising on the essential aspects of governance.

In conclusion, the challenge between proper governance and cost optimisation is real and Luxembourg companies and asset managers must consider it diligently. While cost monitoring is imperative, it should not come at the expense of governance. Indeed, cost-cutting measures may bring short-term success but also negative long-term consequences. Alternatively, considering investments into technology and training, assessing the current processes and operations and the need for outsourcing may be an option to find the right equilibrium. By doing so, businesses in Luxembourg will not only resist to the current market challenges but also become stronger and more resilient in the long run.

Contact us

Florent Delory

Tax Partner, Entity Governance & Compliance, PwC Luxembourg

Tel: +352 621 332 667

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