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Regulatory trends and their impact on corporate governance

S T I L P O N N E S T O R

Introduction and overarching market trends

This chapter reviews recent regulatory developments in corporate governance, identifies emerging trends and offers thoughts as to the possible impact of these trends on the behaviour of market participants.1 The second part of the chapter discusses key regulatory trends at EU level and their impact on the European corporate governance landscape. The third part turns to a discussion of US regulatory trends while the chapter closes with some brief concluding remarks. The analysis of EU and US trends is organised around the two most important governance principles: transparency and accountability of agents to principals.

Since the 1980s, privatisation and technological change have fuelled the development of equity markets around the world. In the context of these developments, institutional investors have become by far the dominant owners of securities in the largest equity markets in the world, as Figure 9.1 shows. There is a fundamental challenge for regulators from institutional dominance: in view of the changing ownership and control environment, they need to revisit regulatory assumptions about market failures and question some of the basic objectives of investor protection.

The US regulatory model for the financial markets, the 1930s blueprint for securities regulation worldwide, may be losing its relevance. The US model is predicated on a market dominated by small retail investors who cannot fend for themselves: insurmountable information asymmetries exacerbated by the high cost of collective action mean investors cannot effectively exercise voice. Their only power is to buy and sell securities. Hence, all they need is adequate, timely and reliable information, and a liquid market. All the rest is taken care of by professional managers who run the large, listed corporations.

As ownership of equity by institutional investors in US (and continental European) public markets has increased, these assumptions are no longer totally valid. The owners of a company are fewer and large enough to be able to shoulder the costs of being true owners. A Chairman of a large US company recently told me ‘the critical mass of our shareholders is nowadays fifteen phone calls away’. Moreover, many institutions have limited exit opportunities. A large part of their

1The author would like to thank Cynthia Mike-Eze, analyst at Nestor Advisors, for background research for this chapter.

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$9,982,108 million under management,

$758,398 million,

62% of top 20 asset managers

46% of top 20 funds

20 institutions $10,740,506 million 21.5% of all assets

Source: Nestor Advisors Ltd, based on Pensions and Investments data

Figure 9.1 Corporate governance requirements of large institutional investors

holdings is indexed, meaning that they have to own certain stocks in order to maintain a risk profile that mirrors that of the market; or their positions on specific stocks are so large that they cannot significantly modify them without incurring substantial losses. A rebalancing between the availability of exit and accountability to shareholders might be the order of the day.

In addition to becoming an increasingly dominant force in their domestic equity markets, institutional investors are also becoming more international. Until recently, institutional portfolios were surprisingly local. The percentage of foreign equities in the portfolios of institutional investors is now considerable, having more than doubled over the last decade to more than 25 per cent in the UK and more than 15 per cent in the US. At the end of 2005, foreign investors owned 33 per cent of listed shares in European exchanges.2

But home bias is still there. In a 2005 report,3 the IMF calculated that there is still a considerable divergence from optimum allocation between domestic and international holdings. From a continental European (or, for that matter, Asian) issuer perspective, this means that the invasion of foreign institutional barbarians has barely started.

Whether because of regulatory pressures, as in the US, or because of the discovery of value in governance, institutional investors are adopting a much

2Figure compiled by Nestor Advisors, based on FESE 2005 and OECD data from twenty-one markets representing 97 per cent of the capitalisation of European exchanges at the end of 2005.

3International Monetary Fund, Global Financial Stability Report – Market Developments and Issues, September 2005, Chapter III.

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more active stance in addressing their own governance and that of investee companies. According to a representative of a large UK institutional investor organisation, institutions ‘must be equipped to manage conflicts of interest, set high standards of transparency, command the right levels of expertise and resource and have a balanced organisational structure, which permits them to carry out their obligations’.4

As regards the governance of investee companies, Figure 9.1 suggests that more than two-thirds of the world’s largest asset managers and 40 per cent of the largest pension funds, all in all institutions representing more than 20 per cent of global institutional assets, have adopted governance guidelines. These guidelines require institutions to vote, whenever that is not impossible or too risky, and, in voting, to follow certain principles on the way investee companies should be governed. To implement these guidelines, some institutions have built teams that are becoming increasingly vocal in challenging corporate management.

And, of course, there are the ‘locusts’, as private equity and activist hedge funds have been called by German politicians. The shareowning power of these institutions has grown immensely since the mid-1990s, largely due to growing asset allocations by large institutions. Their emergence has exacerbated the ‘great reversal’ of ownership dispersion in public corporations, which had been the predominant trend for much of the twentieth century. Hedge funds are becoming bolder by the day in pushing their agenda onto listed companies. They sit on boards, form alliances with other shareholders and pressure companies to change their capital structure and strategy. Hedge funds and private equity seem to have an overall beneficial effect on market efficiency and capital allocation. Their interventions often align management incentives with shareholder interests on the governance side and address inefficiencies in the capital structure, such as under-leverage, a legacy of a bygone era of high inflation and interest rates.5 What is probably the most objectionable issue with these market players is their secretive ways. This is especially so given the main reason for their prosperity is the amount and quality of public information about companies available as a result of regulatory reform. Transparency of ownership and control by such sophisticated buy-side operations is moving high on the regulatory agenda, as we shall discuss in the next part of this chapter.6

4Peter Montagnon, Chairman of the ICGN’s Shareholder Responsibility Committee and Investment Affairs Director of the Association of British Insurers, in ICGN News Issue 4, June 2006, p. 1.

5See The Role of Private Pools of Capital in Corporate Governance: Summary and Main Findings about the Role of Private Equity and ‘Activist’ Hedge Funds, OECD, May 2007, p. 2.

6For a detailed discussion of what is an appropriate regulatory response to hedge funds see Henry Hu and Bernard Black, ‘Hedge Funds, Insiders, and the Decoupling of Economic and Voting Ownership: Empty Voting and Hidden (Morphable) Ownership’. Available at Social Science Research Network electronic library, 2007 (http://papers.ssrn.com/abstract=874098).

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