No one has come out of the various international reviews into the global banking crisis with much credit. Regulators have been shown to have been slow and ineffective, boards have demonstrated a poor awareness of risk, and audit committees have earned a reputation as the “rubber-stampers” of corporate greed. Yet even those that had a massive financial interest in the companies that have either taken a dive in value or are now in the hands of the tax-payer (or at least on paper) did little to act.
Institutional investors have been keen to pour scorn on directors and audit committees, but they have been reticent about their own voting records and engagement activities with boards. Armed with three mighty weapons – the vote at the AGM, the option to disinvest, and the ability to issue governance warnings, like the Association of British Insurers and its “red-top reports” – critics say that they are rarely used, and that pension funds are largely “toothless tigers” or “sleepy”.
According to the Trades Union Congress (TUC) annual survey of fund managers released at the end of June this year, the majority of institutional investors failed to challenge the remuneration reports of large financial groups in the run-up to the financial crisis. The report, which analyses the voting patterns of 20 leading fund managers for the period between July 2007 and July 2008, says every bank remuneration report voted on in the period received the support of 60 percent or more of the surveyed fund managers. The one bank that received less than 60 percent support was HSBC.
The TUC also takes institutional investors to task for their acquiescence in the merger of ABN Amro and Royal Bank of Scotland – largely regarded as disastrous – which was opposed by only one investor, Co-operative Insurance Society. “The fund managers who are meant to exercise ownership rights and responsibilities often fail to do so,” said Brendan Barber, TUC general-secretary. “What is worse is that many will not even tell the unions that represent thousands of pension fund savers whether or how those ownership responsibilities were exercised.”
“The tragedy is that this system has been tested, with the result being the near destruction of the global financial system. In practice, big banks were accountable to no one, their boards free to chase big bonuses without any regard to safeguarding the long-term interests of their shareholders,” he added.
Severe discrepancies
Although the majority of fund managers supported the banks’ remuneration reports, there were wide discrepancies within the survey group. Six of the surveyed fund managers supported every single remuneration report, while there were six who supported less than half. The TUC found strong overlap between the six managers who supported all remuneration reports and the eight managers who supported all management incentive schemes.
The head of the UK’s City watchdog has also slammed the inactivity of institutional investors. In a speech to the Securities & Investment Institute Conference on May 7, Hector Sants, the chief executive of the FSA, said that the current financial crisis “has demonstrated that we can no longer rely on senior management judgements” and that “there are some management decisions that have revealed a degree of incompetence, and at times a rather cavalier approach regarding risk management.”
Sants said that shareholders have a duty to raise objections. “Shareholders must take responsibility to be active individually and more importantly, in collaboration with other investors, to engage with senior management and non-executive directors in companies and question the effectiveness of the construct of their boards,” said Sants. “They should also challenge management to ensure business plans are credible,” he added.
Furthermore, investors’ have also been criticised for being slow to challenge “positive” financial data. Their over-reliance on the reports and ratings of credit ratings agencies such as Moody’s and Standard & Poor’s led to a burgeoning trade in high-risk investments, such as collateralised debt obligations. Arthur Levitt, a former chairman of the SEC, said in September 2007 as the scale of the crisis was dawning, that “we need investors to accept more responsibility for evaluating structured financial products.” He added: “Credit ratings agencies play a critical role in the capital markets, but their judgements are guides, not stamps of approval. Too often, institutional investors have been investing in sophisticated credit products on the basis solely of the credit rating and without fully understanding the inherent risks they are undertaking.”
Unsurprisingly, institutional investors have decided to fight back – by unleashing a new “voluntary” code. Hot on the heels of the current Walker Review of corporate governance into the UK’s beleaguered banking industry and its approach to risk management and the UK corporate governance watchdog the Financial Reporting Council’s review of the Combined Code on Corporate Governance, the UK’s most influential group of institutional investors has outlined its thoughts on what needs to be done to improve accountability in the boardroom.
The Institutional Shareholders Committee (ISC), which is made up of the Association of British Insurers, the Association of Investment Companies, the Investment Management Association, and National Association of Pension Funds, has issued a paper which sets out what changes could be made to encourage greater shareholder engagement with companies to enhance their corporate governance.
Improving institutional investors’ role in governance, the paper sets out a number of ideas where shareholders could be more active in encouraging boards to justify or change their strategies. Firstly, the ISC says that those responsible for appointing fund managers should specify in their mandates what type of commitment to corporate engagement, if any, they expect. Where shareholders delegate responsibility for such dialogue to third parties, they should agree a policy and, where appropriate, publish that policy and take steps to ensure it is followed.
Secondly, it says, there should be effective dialogue. Many institutional investors seek regular dialogue with companies on corporate governance matters. Mostly this is conducted on an individual basis, and works well. But when an individual approach fails, the ISC believes that a collective approach by several institutional investors may be useful to ensure that their message is heard. The ISC says that a broader network might include foreign investors and sovereign wealth funds with an interest in long-term value.
Clear sailing required
However, the group says that “it is important that there are no regulatory impediments, real or imagined, to the development of collective dialogue” as “uncertainty about the rules on acting in concert can be a deterrent to such initiatives”. The ISC says that the authorities should make it clear that collective dialogue is permitted and that it is possible for individuals to receive price sensitive information in the course of dialogue – provided there is appropriate ring-fencing.
While the ISC says that dialogue between investors and company boards is the preferred form of engagement, it also stresses that investors have a duty to use their “full range of powers”, such as voting against company resolutions at the AGM, where “dialogue fails to produce an appropriate response”. The ISC believes that investors have – on occasion – been too reluctant to act in this way.
The ISC is also keen to ensure that concerns that investors raise with company chairmen are shared with the rest of the board, as it believes that all board members have a duty to act in accordance with the best interests of the company and its shareholders. The ISC says that one way of making boards more accountable would be for the chairs of leading committees to stand for re-election each year. If support for any individual fell below 75 percent (including abstentions), the chairman of the board should be expected to stand for re-election the following year.
The ISC believes that this would be a powerful incentive to resolve concerns during the intervening period. Indeed, the requirement for chairs of committees to put themselves up for re-election would motivate them to keep abreast of investors’ views and ensure that concerns are addressed in a timely way, it says. The ISC adds that in practice it should lead to improved dialogue with investors about issues that might be controversial. It would also broaden the agenda beyond the remuneration issues that dominate dialogue at present, it says.
Lastly, the ISC has made a number of suggestions to amend the Combined Code on Corporate Governance which it feels could enhance the quality of the dialogue between companies and investors. The ISC suggests that chairmen should retain overall responsibility for communication with shareholders and/or their agents, and be encouraged, through amendment to the code, to inform the whole board of concerns expressed (whether directly or through brokers and advisers).
Both the chairman and the rest of the board should ensure that they understand the nature of the concerns and respond formally if appropriate.
The ISC also believes that the senior independent director should intervene when appropriate communication between board members and shareholders does not happen.
If warranted by the extent of the concerns, the code should also encourage him/her to take independent soundings with shareholders and/or their agents, and work with the chairman to ensure an appropriate response from the whole board.
The investors’ body also wants the Combined Code to emphasise the importance of succession planning more clearly, with chairmen reporting annually on the process being followed and progress made. Furthermore, it says that the audit committee’s terms of reference should be expanded to include oversight of the risk appetite and control framework of the company.
ISC chairman Keith Skeoch says that “we believe this paper is a useful contribution to the evolving debate. Institutional investors wish to be more effective and have an important role to play. The ideas set out in this paper are an important step in this direction and should make a real difference.”
Know your role
However, not all investors are convinced. Colin Melvin, chief executive of Hermes Equity Ownership Services, which provides governance services for investors with £50bn of assets, says that the ISC should not be in charge of checking whether its members stick to its proposed new code. Instead, Melvin has suggested that the monitoring role should be transferred to an independent body, saying that the current investment governance framework, “is equivalent to giving the Confederation of British Industry responsibility for the Combined Code on corporate governance”.
Melvin’s call follows a damning critique of the ISC by Lord Myners. The City minister accused the investor body of making little progress in reviewing compliance or revisiting its core principles in the light of experience. He also attacked pension fund trustees for failing to incorporate the ISC’s principles on corporate engagement in fund manager contracts.
The ISC’s proposal for a new voluntary code would not, says Melvin, be enough to address the lack of accountability revealed by the financial crisis. He added that too many investment institutions were absentee owners who failed to engage actively with companies in which they invested.
Melvin says that there is a need for a strong “comply or explain” regime policed by a body similar to the Financial Reporting Council, which monitors the workings of the Combined Code. The Hermes chief has also called for a redefinition of institutional shareholders’ fiduciary obligations to discharge the duties of ownership and promote good governance. This echoes a longstanding proposal by Lord Myners.
When the City minister first suggested that the duties of pension fund trustees and their agents should be redefined in his review of institutional investment for the Treasury in 2001, the fund management industry resisted the move and persuaded the Treasury to support the creation of a new set of principles by the ISC. It is these principles that the ISC now wants to turn into a new, revised code in response to pressure from the government. However, Lord Myners has questioned whether a body controlled and funded by industry trade groups constitutes the best model to focus on investor interests and responsibilities.
Some investors have accepted a degree of blame for their failure to vote against boardroom decisions more robustly –or at all. Peter Chambers, chief executive of Legal & General Investment Management, which owns about 4.5 percent of the UK stock market, has conceded that shareholders could have done more in the past, particularly where boards had appeared deaf to their concerns, and said that shareholders need to look at how to sharpen their relationships with boards. Nonetheless, he maintains that most of the blame still lays with boards and regulators. “It is difficult to conclude that bank boards did their job effectively, but the regulation also failed,” he said.
Power to the people
The US has decided to put more power into the hands of shareholders to hold boards to account. Let’s hope they use it. On July 1, SEC scrapped a controversial 72-year-old rule that allowed broker-dealers to vote in corporate director elections on behalf of their clients without specific instructions. The change, first proposed by the New York Stock Exchange three years ago, comes amid public anger over lax oversight of companies taking on excessive risk. Activist investors and unions have long blamed the broker vote for making it difficult to oust directors and for skewing election results in favour of candidates backed by management. The change would in effect apply to director elections held by public companies after January 1. The change on broker voting came as the SEC proposed a series of sweeping proposals aimed at improving corporate governance and disclosure. The regulator is considering requiring companies to disclose more information about company directors, why they have chosen to combine or separate the chief executive and chairman positions, and what the board’s role is in risk management. Mary Schapiro, SEC chairman, said the proposals were aimed at “enhancing the quality of the system through which shareholders exercise their franchise”.
But the vote to eliminate the rule was close, with the two Republican commissioners making up the five-member SEC dissenting. Kathleen Casey, one of the Republican commissioners, said she was concerned that the change would undermine retail investors in favour of institutional investors. The US Chamber of Commerce, which represents more than three million businesses, echoed those concerns, saying the change “dramatically shifts’’ additional voting power to activist investors and unregulated entities such as proxy advisory services. “The SEC has . . . allowed certain investors to jump to the head of the line,’’ said Tom Quaadman, an executive director at the chamber.
However, Ann Yerger, executive director of the Council of Institutional Investors, which represents pension funds, said: “Eliminating discretionary broker votes will ensure that director elections are no longer tainted by phantom votes. Counting uninstructed broker votes is akin to stuffing the ballot box for management, as broker votes almost always are cast in favour of management’s candidates for board seats.’’
