Sunday, 1 November 2009

If you want a vision of the future...

Right, now I've got the attention of George Orwell fans... I've been thinking a bit lately about what direction corporate governance and shareholder engagement is likely to take in the future. I think there are some obvious trends already emerging, along with the re-emergence of older ideas, and a few potential opportunities that don't (yet) seem to have been developed. Bear in mind I'm cutting a few corners and making some big assumptions in all this, and basing my comments purely on the UK, but here you go...

First up, I think that arguably more damage has been done in this crisis to the reputation of institutional shareholders as owners than to the UK's corporate governance regime. Think about it, no-one is seriously arguing that we move away from 'comply or explain' (even though others are), and you can find plenty of statements from companies, investors and others in responses to Walker, the FRC etc boldly stating that the UK's governance is not broken.

In marked contrast there seems to be a fairly solid consensus that institutional shareholders collectively have not covered themselves in glory (and by extension that something needs to change as a result). The reasons given for this vary - shareholders aren't really interested, they are inherently conflicted, clients don't ask them to do it, when they do engage it's at a superficial 'box-ticking' level, the information asymmetry undermines effective engagement, etc - and as a result the point behind the various critiques is often quite different. But a consensus there does seem to be, which is why the outgoing NAPF chair (to my surprise) actually seems to have hit entirely the wrong note, even according the Association's members.

Notably therefore we are very likely to see some sort of formal code for investors themselves to sign up to or explain why not. It also seems very likely that this will fall under the remit of the FRC rather than the ISC (a body which itself has suffered potentially fatal reputational damage as a result of Paul Myners' trenchant criticisms of it). Depending on what finally comes out of the Walker Review there may even be a small role for the FSA here, something which has the fund managers hopping mad.

But, second point, how likely is this process to lead to a change in the level and nature of engagement? This year there has been an uptick in voting - a fairly basic yardstick for measuring activism admittedly, but a vital one IMO - but it has not ben a fundamental shift. I suspect you'll struggle to find an RBS investor who backed the bank's remuneration report, for example. But actually go back just one year - and the annual report which made crystal clear that enhanced pensions were available to directors - and the remuneration report sailed through. In addition, there are fund managers out there who are still voting in favour of god-awful remuneration policies, just not the headline-grabbing ones. Therefore next season will actually tell us a lot more than this about how much things have changed. I have a suspicion that there is a substantial element of, for want of a better word, marketing in some institutions' voting this year.

Which leads on to point three - if we don't see a step-change on the part of institutional shareholders then what happens? In terms of high politics it won't necessarily matter because the Tories will be in power and their policy interest in this area is not obvious. A few examples - the Tories slagged off the FSA remuneration code when it appeared, but didn't talk the FSA about it during the consultation period. They don't seem to have put anything in to the Walker Review or commented on the FRC review of the Code. And their own 'White Paper' on financial reform had I think one or two paragraphs in it on corporate governance, and that said 'we don't know what we think yet'. So I suspect politically savvy fund managers are thinking they only need to make it until May and all this governance stuff will calm down again. (Incidentally, I suspect a change of government is going to be something of a rude awakening for those progressive types in this bit of the world who seem to think there is no real difference between the parties.)

But in public policy generally in this area, a return to pre-crisis behaviour by institutional shareholders could do a lot of damage. As I've banged on regularly in the past, if the owners - for whatever reason - repeatedly show no inclination to act like economic theory would suggest they ought, then people will question a shareholder-focused governance regime. If companies and their investors wish to avoid a situation where there is a greater statutory element to governance they need to recognise this. In a sense then Paul Myners is really giving institutions an opportunity to make the system work on a market basis. Again, I've said this before, but I think fund managers arguing against being encouraged to play the ownership role risk a lot as a result, though I'm not clear that they recognise this.

Which leads me on to point four - what might emerge instead? Well actually re-emerge - a stakeholder approach to governance. And funnily enough this is something that I don't really know much about, as I've always worked within the shareholder-focused governance framework. But it strikes me that if institutional shareholders effectively formally abdicate as owners in a meaningful sense, then other ideas about who is involved in governance come back into play. (And if you go back to Berle and Means they end up asking these sorts of questions - ie in whose interest should the corporation be run - which is part of their legacy that often seems to get forgotten.) For my part I would - no surprise here! - favour some sort of employee involvement. Not only for the Blairist reason that actually employees have a pretty good claim on the company compared to shareholders, but also because I think it could help discourage group think (see the Cass Sunstein point), and because I think it's right in principle.

Obviously this is a battle that is yet to even be fought, and there is no inevitability either about this happening, or that it would be successful. But it does strike me that the policy positioning the fund management industry seems to be adopting makes such a development more likely. Incidentally I'm genuinely not clear whether the position the industry is adopting is well thought out and aware of the possible impact on the governance debate, or simply short-termist arse-covering. Either way though possibilities are opening up.

There are two further potential trends that may emerge from this. First, those institutional investors which do have an interest in social, environmental and governance (ESG) issues may well start thinking much more about other ways to make an impact. If acting like an owner in the public equity market seems ineffective (because too few others will join you and you can't do it alone) I think they will a) start looking at influencing public policy directly and b) start looking at other asset classes (and the UNPRI is already doing a lot around private equity). Second, it's possible that civil society interest in using 'ownership', which has only recently started to emerge in some places, tails off again. Speaking personally, having been involved in shareholder campaigns that were not supported by one or two large asset managers that make a lot of noise about ESG issues has raised some big questions. I can't believe I am alone in this.

This leads on to point five - remuneration. First up a bit of politics. I'm not convinced by the Compass High Pay Commission, but I do think there is an open goal facing them - the failure of shareholders to police executive pay effectively, or link it too performance. I think if they just drew on some of the data already out there they could make a strong case that the current system is not working. Now that could lead you to try and make it work - and that might require a proper focus on how how shareholders look at pay (my next point) - or you could argue that it's inherently flawed, and therefore we need a rethink. I tend to the former because I think shareholders could make a difference, but you can see how a case can be made for latter. But curiously no-one on the Left has really taken a good look at the operation of the existing system (ie how shareholders act) other than just pointing at the outcomes (continual increases in exec pay).

So, point six. It strikes me that there is an opportunity to have a much more interesting debate about pay, and that shareholders are in a position to start this if they choose to. They could be asking questions like is executive pay working for shareholders, does remuneration act as a motivator, is a reasonable proportion being spent on remuneration (investment banks the obvious ones to look at here), and what about the split between execs and other employees in the same businesses? This ought really be simple self-interest. If shareholders aren't convinced that they are getting the return on their investment in remuneration, why don't they do something about it? And this is an area where some think shareholders can contribute something useful.

Point seven - this could also be a way to start thinking about whether stuff from behavioural economics and social psychology can be applied to governance. There seems to be an increasingly strong view that politics can learn something here. It would seem odd if the governance world (where the point is made so often that good structures aren't synonymous with good behaviours) did not do likewise. Again it seems like an opportunity waiting to be exploited if some investors would only show a bit of willing. There are even a few books out there that provide a jumping off point.

And finally - pressure on fees. Surely there must be some sort of backlash from pension funds against the increasing fees they are charged even though they get no better returns as a result. A focus on costs in the investment chain could lead to a) an attempt to reduce the links in the chain b) closer scrutiny of what actually takes place at each stage and c) a re-considering of the merits of long-termism. For whatever reason, pension funds and other institutions appear to be repelled by the idea that they should act like owners because it's a desirable end in its own right. Fair enough. So let's approach from the point of view that it is also costing them money, and an increasing amount. If they still don't bite then we know we have a political problem, rather than a market failure.

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