The role of the shareholder

Progress to date

Perhaps the most authoritative statement of how UK institutions have responded to their increased responsibilities comes from the regular survey carried out by the Investment Management Association. The latest of these covers the situation at mid-2006 and was published in June 2007.3 This covered thirty-three fund managers responsible for 68 per cent of the equities managed in the UK. It showed a steady trend towards more openness in the governance process and towards integration of governance activity in the investment process.

Highlights of the findings were that twenty-six out of the thirty-three managers surveyed had made their policies on engagement public compared with only fourteen three years earlier. All managers surveyed reported to clients on their voting activity or posted their voting record on their website on a regular basis. Altogether, fifteen institutions disclosed their voting decisions publicly on their website compared with just two when the first survey was carried out in 2003. As at June 2006, the fund managers surveyed employed 217 people working full time on engagement, an increase of more than 25 per cent in three years. The twenty-seven managers who provided details cast over 185,000 votes at over 17,000 annual meetings in the year to end June 2006.

What is also gratifying in the light of the ICGN statement is that twenty-six of the managers surveyed provided statements on the management of conflicts of interest. This is an increase from twenty-three recorded in the previous year. Also, eighteen out of those surveyed said voting decisions on controversial issues were taken at senior level whereas fourteen others portfolio managers are actively involved. A further sign that governance is being integrated with the investment process came from the finding that, in the majority of cases, corporate governance specialists sit in on company meetings with the portfolio managers and analysts when there is a relevant issue to be addressed.

The challenges ahead

The need to join up the governance and the investment process has, however, still some way to go. In some institutions there is still a sense that this is merely an overlay on the investment process. There are still problems in some houses integrating governance with the investment process. There is still a need to raise the quality of dialogue between shareholders and companies to ensure that it is properly informed, and there is still a need to move away from a short-term focus on the company’s financial results and share price performance. When these are favourable, fund managers may be reluctant to address governance

3Survey of fund managers’ engagement with companies, published by the Investment Management Association: www.investmentuk.org.

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issues even though these may contain the seeds of future value destruction. As part of the communications process between companies and shareholders, some shareholders need to do more to explain unfavourable voting decisions to companies in advance. Here, sheer pressure of work often means it is difficult to live up to a commitment to communicate such decisions in a timely way.

Communication also needs to be better coordinated on both sides of the relationship. While there is a lot more dialogue between companies and shareholders these days, it still tends to be compartmentalised. Thus the Chief Executive and Chief Financial Officer talk to analysts and fund managers about financial results. This rarely involves discussion about governance matters. Corporate governance specialists talk to the independent Chairman or relevant directors, such as the remuneration committee chairman, but these conversations rarely involve executives. On the company side, the relations with analysts and fund managers are handled by the Investor Relations Department, while on the governance side the Company Secretary handles relations with institutions. Finally, those responsible for socially responsible investment may be having lengthy discussions with corporate responsibility executives in the companies. There is too little interface between these parties, either within investment institutions and companies or across the divide. The result is a fragmented relationship.

A particular need is to fold the approach to corporate responsibility more effectively into the overall relationship. While specialised investors in this area are sometimes seen as reflecting the interests of particular stakeholders rather than the company as a whole, there is also recognition among mainstream investors that the way in which companies approach social responsibility may have a material impact on their franchise and thus on their business prospects. Corporate responsibility issues therefore belong in the area of risk management. Where they are germane to the business, they are a legitimate subject for all shareholders to address. The challenge, however, is to ensure that they are addressed in the right way. The development of narrative reporting offers an important opportunity because it should help focus attention on factors affecting the company in the long term and therefore allow corporate responsibility issues to be debated in an appropriate context.

Finally, the market itself is changing. The share of UK companies held by traditional long-only investors has fallen, partly as a result of regulatory pressures on pension funds and insurance companies, partly because of the overall tendency of markets to globalise, and partly because of new investment techniques involving the use of derivatives, which may involve the separation of control from economic ownership. The result is that control may have shifted to overseas investors or to hedge funds with a shorter-term time horizon who are less predictable and with whom it is harder for companies to build up a significant relationship.

What will be the contribution of hedge funds to the process remains to be seen. Some of them are very well informed about companies in which they

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take stakes and can engage very effectively with the management. Some of them recognise, too, that corporate governance is connected to value. Thus one hedge fund, Knight Vinke Asset Management, played an important role in helping Shell restructure in the wake of its reserves scandal and benefited as a result from the return of a ‘governance premium’ once the restructuring was complete. The influence is thus not all negative, but companies sometimes say they are confused about who to talk to, and the way in which some investors hold their stakes through derivatives such as contracts for difference means companies may not be sure exactly who owns them. In these circumstances, there is clearly an advantage in maintaining a good relationship with known long-term holders who will provide a form of anchor.

Another factor is the influence of the bond markets, in which investment has grown substantially, particularly at critical moments in a company’s history. Shareholders have ultimately, for example, had very little say in the affairs of a debt-ridden company such as Eurotunnel.

In short, just as the traditional institutions have begun to get better at exercising the responsibilities of ownership, their influence is diminishing as a result of changing market structures. Finding a way of ensuring that shareholders can continue to exert a positive influence on companies in these new circumstances is the biggest challenge of all.

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