The Financial Reporting Council (FRC) last week released the names of the asset management groups that have backed its Stewardship Code.
The list features 48 asset managers, 12 asset owners and eight service providers, and includes some of the largest names in the investment industry: BlackRock, Fidelity, HSBC and L&G.
Trade bodies and investor associations welcomed the move. It was heralded as an historic step in changing the dialogue between companies and their investors, but will it require significant change in practice on the part of asset managers?
The Stewardship Code was finalised in July and set out good practice guidelines for investors engaging with companies. It aims to improve long-term returns to shareholders and ensure investors manage their governance responsibility effectively. The code followed on from the statement of principles set up by the institutional shareholder committee, but putting it in the hands of the FRC, calling it a “code”. Pushing asset managers to state public compliance has given it more formality. It means that anyone can examine institutional investor practice on good governance.
The code was designed to address governance problems exposed by the financial crisis. Thomas O’Malley, a corporate governance analyst at HSBC Global Asset Management, says: “There is a view that investors should have been doing more to ensure good governance. The Stewardship code is about identifying good practice and encouraging investors to be clear about their approach. It is also about how they will monitor firms, engage with them and what they will do if it doesn’t work.”
Legal & General has suggested that as well as shortcomings in the incentive systems, risk management and internal control systems of many companies, the crisis highlighted cultural issues where short-term risk taking was promoted over long-term value creation. However, the greatest errors in governance came from a weakness in internal procedures – where a board assumed it did not need to challenge the executive, for example, nor understand business models or higher-risk activities and products.
The various reviews that have been put in place since the crisis suggest the system is not broken – it simply needs to work more effectively. O’Malley adds: “The findings of the review of the corporate governance code found that the system was the right system, it just needed the structures to work better. The revised corporate governance code more clearly defined the role of the chairman and directors and their accountability. The Stewardship Code is more clearly defining the role of investors.”
Some investors were already following the guidelines, and several asset managers have well-established credentials in shareholder engagement. Shareholders also voiced their disapproval of company behaviour, even before the FRC named the code’s supporters. For example, this year, Prudential found its Asian expansion plans derailed by shareholder activists, and Tesco has faced disagreements over remuneration for its directors. This has resulted less from signing up to the code and more from the need to address controversial corporate practice that had crept in during the boom years and in some cases eroded shareholder returns. (article continues below)
However, Karina Litvack, the head of governance & sustainable investment at F&C, says only a small proportion of asset managers had previously acted on such guidelines and investors needed to work hard to prevent best practice from slipping.
“There is a real risk that as we shift from crisis mode to ’business as usual’, we fail to change the culture of the investor and company dialogue. It is an entrenched process. We had been talking about systemic problems for some time, but did not foresee that it could plunge us into such complete chaos,” she says.
The code brings about some important initiatives with regards to existing practice. One of these is the encouragement of collaboration between shareholders. This aims to reduce the ability of companies to “divide and rule” when confronted by investors pressing for management changes. Andy Banks, the head of corporate governance at Legal & General Investment Management, says: “This is moving on from one-to-one discussions to collective engagement. Investors can identify common concerns and demonstrate to companies that it is an issue. The more investors that discuss a problem with a company, the bigger the impact.”
Litvack describes this move as “essential”. “There has to be transparent debate about what is the right outcome. In most cases investors know what it takes to avoid problems, but we are programmed to act on things that we can measure. Proper engagement requires investors to act on things over which they have only partial control. Investors are prone to saying that they will only put pressure on a firm if someone else is doing the same thing. It is rational, but it needs to be addressed,” she says.
In practice, shareholder platforms have always been available through industry bodies such as the Association of Britain Insurers (ABI), Association of Investment Companies and the Investment Management Association. However, there is a drive to expand these platforms to include some of the large international shareholders such as sovereign wealth funds. Banks says: “There is scope for widening these forums. Sovereign wealth funds, for example, would not be members of the ABI, but are relevant to particular firms. Funds such as Norges in Norway are already active.”
The code also helps establish the lines of responsibility between companies and investors. Banks says: “The code is all about holding management to account for their performance and actions. If a firm is working well and nothing exciting is happening, it may require little engagement. There is likely to be more engagement where companies need to raise capital or are changing management. But it should stop at the point of micro-management…where shareholders are starting to take a role in what the executive should be doing.”
The code also sets a precedent. Few fund managers now invest solely in Britain, and the code may become a benchmark for global investing practice. The European Commission is consulting with institutional shareholders on a similar code, which will give them a more concrete definition of stewardship.
The United Nations also established its Principles of Responsible Investment (PRI) in September, aimed at encouraging fund managers, asset owners and advisory firms around the world to incorporate environmental, social and governance (ESG) factors into their investment analysis and develop engagement capacities. In complying with the Stewardship code, British investment managers are one step ahead.
In many parts of the world, regulation looms in the background if investors fail to hold companies to account in future. O’Malley says: “There is a danger that if the code does not work, the regulators would seek to reduce the role of institutional investors in corporate governance. Most UK shareholders would resist this. The advantage of the ’comply or explain’ model in the UK is that companies can do things in their own way and then explain. The owners can then agree or disagree.”
The threat of regulation as an alternative to the code partly explains the enthusiasm of the asset management companies for the initiative. In Britain, almost all major asset managers have signed up. They are also coming under pressure from their own clients. In Penrose Financial’s second annual survey on the future of the pensions and investment industry in August, two thirds of the 100 senior figures in the European investment industry surveyed said greater expectation from clients would compel fund managers to increase levels of shareholder engagement.
Signing up to the code will entail more work, though this may be on the compliance side rather than the investment management side, as asset managers will have to state publicly what actions they are taking to comply to the code. On the investment management side, some active managers will have been examining these issues as part of their due diligence process and will be aware of many potential problems in companies. The large passive managers have become strong exponents of the principles underlying the code because anything that benefits the whole market benefits them.
Most would agree that compliance is less onerous than regulation or regulators taking control of corporate governance. Banks says the leading players have proved change is possible. “If the best firms can adapt, it is reasonable to ask the question of other companies. It is reasonable to require them to say how they are managing risk and how they justify that against best practice in their sector.”
The Stewardship Code will require changes on the part of asset managers, but ones which would have resulted in any case from pressure from clients or the threat of regulation.
The principles enshrined in it were already an integral part of asset managers improving their risk management after the financial crisis. Plenty of groups were in the process of stepping up shareholder engagement, and the code provides a formal structure for doing so. Far from being high-handed regulation, most see it as an important step to protect shareholder returns.