The role of the shareholder

And of course, when shareholders participate in pivotal decisions, the sense of ownership is much more real.

What happens in practice

As understanding of governance has grown over the years, so the shareholder community has sought to codify its own best practice. Part of the drive to do so reflects a belief that good governance does add to value and that collective pursuit of governance principles will therefore raise the general quality of investment returns over the longer term. Part responds to government and corporate pressure on institutions to show that their considerable power is being used responsibly and with consideration for both beneficiaries and the companies in which they invest. This came together in 2002 in the form of a statement of principles by the Institutional Shareholders Committee (ISC) which groups the main investor bodies: the Association of British Insurers, the Association of Investment Companies, the Investment Management Association and the National Association of Pension Funds.

The ISC statement1 was revised in September 2005 but its main points remained intact. It sets out best practice for institutional shareholders and/or their agents in relation to their responsibilities in respect of investee companies. It commits them to:

set out clearly their policy on how they will discharge these responsibilities

monitor the performance of investee companies and establish a dialogue with them where necessary

intervene where appropriate

evaluate the impact of their engagement

report back to their clients or to beneficial owners.

The statement makes clear that its exhortation to institutions to engage with companies constitutes not an obligation to micro-manage their affairs, but rather that they should institute procedures to ensure that shareholders derive value from their investments by dealing effectively with concerns over underperformance. Institutions should disclose their engagement policies to the public, preferably on their websites. The statement should cover arrangements for monitoring companies, strategy on intervention, an indication of the type of circumstances when action would be taken, and the institution’s policy on voting. Institutions should also disclose their policies for addressing and minimising conflicts of interest.

The ISC statement suggests a number of areas where intervention may be necessary. These include when there are concerns about:

1For text see the Guidelines Section of the ABI’s Institutional Voting Information Service website: www.ivis.co.uk.

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the company’s strategy or operational performance

its acquisition strategy

independent directors failing to hold management properly to account

internal controls failing

inadequate succession planning

unjustified failure to comply with the Combined Code

remuneration policy

the company’s approach to corporate social responsibility.

Where no constructive response is received, a range of additional approaches may be considered, up to the requisitioning of an extraordinary general meeting to change the board. There is, however, a particular emphasis on considered voting. The statement states that institutional shareholders and their agents should vote all shares held directly or on behalf of clients wherever practicable to do so. They should not automatically support the board but, where concerns have driven them to oppose or abstain on a resolution, they should inform the company in advance of their intention and the reasons why.

As with the Combined Code, the statement represents an ideal and, as with companies’ responses to the Combined Code, it is clear that not all large institutions comply with every aspect of the statement. However, the statement and the support accorded to it by member bodies of the ISC has undoubtedly helped raise awareness of the importance of good governance and raise the standards applied by institutions in practice. Evidence of this is provided by surveys carried out by the Investment Management Association, which are considered in greater detail below. It is also clear that dialogue between companies and institutions on governance matters has increased considerably in recent years.

Some companies hold regular meetings for their non-executive directors with shareholders at which any governance issue can be raised. Many institutions include their governance experts at meetings with companies. At the collective level both the ABI and the NAPF have been active in facilitating discussion. In 2003, the NAPF revived its case committee system, whereby members can propose an engagement with companies where problems are perceived to have arisen. The NAPF process is strictly private, but it is known that the organisation instituted dialogue with BSkyB at the time of the appointment of James Murdoch, son of Chairman Rupert, as Chief Executive. The NAPF also held a series of meetings with Shell after it revealed in 2004 that it had overstated its reserves. The ABI procedures are less formal than those of the NAPF, but the organisation also held a series of meetings with both companies. In the course of any year, it will facilitate discussions between institutions and around ten companies on governance subjects distinct from remuneration. Sometimes this helps both sides understand how to apply the Combined Code, as in the case of the discussions between ABI members and Barclays over the appointment of its Chief Executive Matt Barrett to be Chairman. Sometimes the dialogue helps create support for a succession process, as with the discussions leading

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up to the appointment of a new Chief Executive at Morrison, the supermarket concern, in 2006. Another large company, which was facing a simultaneous succession of both its Chairman and Chief Executive, canvassed the ABI and other shareholders well in advance of taking a decision to extend the tenure of the Chairman so that he could oversee the transition of Chief Executive.

The key lever that shareholders control is their ability to vote at general meetings. For this reason, large institutions usually seek to vote actively and are concerned that the voting system works properly. The average voting turnout at UK general meetings is around 55 per cent and has been moving gently upwards in recent years. Given the extent of overseas and short-term ownership of UK equities by hedge funds and other non-traditional institutions, this suggests that long-term institutions such as pension funds and insurance companies generally use their voting power as the ISC statement urges them to do.

However, serious concern developed in 2003 over whether the voting system was working properly when a number of shareholders and companies reported that votes appeared to have gone astray. One problem was that voting instructions had been delivered late by a courier. Another was that a large intermediary in the voting chain had failed to carry out instructions. In response, the ISC led the revitalisation of a technical cross-industry group, the Shareholder Voting Working Group, under the chairmanship of Paul Myners to consider ways of improving the system. This group included senior practitioners from the investment industry, registrars, custodians and companies.

Myners produced a series of reports which developed the principle that those at the ownership end of the investment chain need to drive and control the voting process so as to ensure that it works properly on their behalf. His report also pushed strongly for the use of electronic voting systems by companies and shareholders in the belief that this would reduce errors that result from the transmission of paper instructions up and down the sometimes complex voting chain. It also made a point of urging investors to recall stock that had been loaned when they wished to vote. The result has been an improvement in the reliability of the voting process, although there remains no guarantee of its robustness and further work will be required with custodians and others involved in the investment chain to improve the effectiveness of the system.

The international dimension

While much of the focus on shareholder activity has concentrated on the UK, international developments have also come to the fore as institutions have diversified their portfolios. This is a more difficult area because UK institutions will normally comprise only a small minority of holdings in foreign companies in contrast to the large collective stakes they tend to enjoy at home. At a practical level, however, they can and do occasionally seek to make their influence felt by striking alliances with other shareholders. This was the case, for example, with a 2004 resolution at Nestle, the Swiss food-processing multinational, by

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which the Chief Executive was also to assume the role of Chairman. A number of UK institutions became involved in a coalition, promoted by a Swiss corporate governance group, which was urging shareholders to vote against the resolution. Similarly, institutions from a number of countries worked together to persuade Shell to reform its corporate governance after its admission that it had overstated its reserves.

Institutional shareholders have also been active in the policy debate, especially with regard to European Directives. In 2005, the European Commission launched a Directive on Shareholder Rights aimed at facilitating cross-border voting by shareholders at general meetings. Among other provisions, the proposed Directive allowed for voting in absentia and established a right for shareholders to appoint proxies to speak and vote on their behalf at meetings. The Directive also set minimum notice periods for general meetings so that shareholders would have sufficient time to prepare and register their votes. In a popular move with investors, it also formally outlawed the practice of shareblocking whereby shareholders who wished to vote were unable to trade their shares during the notice of meeting period. The Directive attracted support from shareholder bodies including the Association of British Insurers in the UK and the International Corporate Governance Network.

At the same time Charles McCreevy, the Commissioner responsible for company law matters, made a series of public statements promoting the concept of one-share-one-vote. This reflected disappointment in the Commission at the way in which member states had chosen to opt out of a key requirement in the Takeovers Directive which provided for voting distortions (such as multiple voting rights and voting ceilings) to be overridden at key moments in a bid. The Commissioner’s remarks were highly controversial, especially in countries such as Sweden, the Netherlands and France, where managements have traditionally been protected by limits on the ability of minority shareholders to register a vote proportional to their share of the capital. In 2006 the Commission commissioned a study on the issue, however, indicating that it was likely to remain a subject of discussion. The study found no economic evidence of a causal link between deviations from the so-called ‘proportionality principle’ and the economic performance of companies. In October 2007, Commissioner McCreevy announced that he had decided there was no need for action at EU level but urged shareholders to use their voting rights to push for more transparency on the need for and use of the so-called ‘control enhancing mechanisms’ such as one-share-one-vote.

Coupled with concern in a number of European countries about the behaviour of short-term shareholders, this means that the role of the shareholder has become a subject of hot political debate. In the aftermath of Deutsche Boerse’s abortive bid for the London Stock Exchange, which resulted in the resignation of both its Chairman and Chief Executive in 2005, a leading German politician described hedge funds that had opposed the deal as ‘locusts’. In the European Parliament debate on the Shareholder Rights Directive, Michel

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Rocard, the former French prime minister, described certain types of shareholders as delinquent. European corporate chiefs, as well as politicians, were increasingly concerned that some short-term shareholders were acquiring voting rights through derivative positions and other financial devices which meant they had obtained control without paying for economic ownership. On the other side of the debate, investors and liberally minded economists and politicians were expressing anxiety about economic nationalism which was leading European companies to exploit weaknesses in legislation such as the Takeovers Directive to fend off foreign bids. A clear example of this was the determined opposition by Arcelor, the Luxemburg-incorporated steel concern, to a bid launched by Mittal, which is controlled by an Indian entrepreneur.

If Arcelor and other similar transactions encouraged shareholders to defend their legal rights of ownership, the course of the debate also made it clear that a claim to rights needed to be met by a recognition of responsibility. An important step forward in this regard came in 2006 with publication by the International Corporate Governance Network of a draft Statement of Principles on the Responsibilities of Institutional Shareholders.2

The ICGN statement was designed to build on and replace an earlier statement which had focused on the responsibility of shareholders to the companies in which they had invested. While the new statement retained this aspect of responsibility, it also focused on the internal governance of institutions, and in particular on the need for them to have governance arrangements that enabled them to deliver on their overriding obligation to act in the interest of their beneficiaries. The requirement for a responsible approach thus extended in two directions: to the beneficiaries whose savings the institutions were deploying, and to the companies in which the funds were invested.

Where responsibilities towards investee companies are concerned, the ICGN statement covers similar ground to the ISC statement. It argues that high standards of corporate governance will help companies deliver sustainable value over time, and urges that governance activity should become an integral part of the investment process. Shareholder rights should always be applied with the objective of value creation and not in a formulaic, box-ticking way. Shareholders should act in a proactive way to address governance concerns and have consistent policies for engagement with companies, which should include a clearly defined approach to situations when dialogue is failing. They should vote in a considered way and on the basis of a policy which is disclosed to both beneficiaries and companies in which they hold stakes.

The section on internal governance is mainly addressed to those bodies such as pension fund trustee boards which represent the interests of the beneficial

2The ICGN is a network of over 400 members from over thirty-five countries with an interest in corporate governance. As investors its members control some $10 trillion of assets. Further details on the orgnisation and the text of its statement on shareholder responsibilities can be found on its website: www.icgn.org.

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owners, but it also sets standards for other intermediaries, particularly asset managers. It confirms that the overarching responsibility is to act at all times in the interest of beneficiaries. This means addressing four main principles:

transparency, which enables beneficiaries to satisfy themselves that their funds are being handled appropriately

disclosure and management of conflicts of interest

expertise, which enables institutions to make sound decisions on beneficiaries’ behalf

oversight structures that are suitably balanced so that decisions are taken in the interests of beneficiaries.

The need to deal with conflicts of interest is regarded as particularly important. The statement acknowledges that these will arise from time to time – for example, if the plan sponsor is also influential as a trustee of the relevant scheme, or if an asset manager faces a controversial vote on the affairs of a company from whose pension fund it has separately obtained a fund management mandate. However institutions must have a clear policy for disclosing and managing such conflicts. It follows also that they need to have an internal governance structure and ensure that they are in a position to deliver on the overarching requirement to act in the interests of beneficiaries.

The way in which individuals are appointed to serve on the governing body should be disclosed as well as the criteria that are applied to such appointments. A most important factor will be the behaviour of those who sit on the governing body. It is essential that the oversight structure provides for independent decision-making so that investment and voting decisions are taken in the interest of the beneficiaries and do not reflect other objectives of those involved.

The structure of such bodies will vary from market to market and may be determined by regulation or legislation. Whatever the structure, it is important that every individual who participates acts in an independent manner and in line with the overarching objective of safeguarding the interests of beneficiaries. Such expectations should be set out clearly in the constitution of the governing body.

Independent decision-making is easier to achieve if the structure of the governing body is balanced with all relevant interests represented. In particular it is not desirable that the plan sponsor or employer dominates the governing body. Where this is the case, consideration should be given to the representation of individuals accountable to beneficiaries even if this is not mandatory.

In another new step, the ICGN statement emphasises the serious conflict of interest which may also arise where the plan sponsor is a government or other public authority which may take voting and investment decisions that reflect their public policy objectives rather than the interests of the beneficiaries. Where this is the case, there is an additional need to ensure a majority of independent participants on the governing body.

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