ENCOURAGING SHAREHOLDER ACTIVISM – ABI RESPONSE
TO DWP/HMT CONSULTATION DOCUMENT
INTRODUCTION
1.1 The Department for Work and Pensions and HM Treasury published, on 4 February 2002, three consultation documents relating to recommendations in the Myners Report on Institutional Investment in the UK. Responses were invited by 3 May 2002.
1.2 This paper represents the response of the Association of British Insurers to the consultation document on Encouraging Shareholder Activism. Separate responses are being made to the other consultation documents on pension scheme trustees’ familiarity with the issues, and on independent custodians.
1.3 The consultation document on Encouraging Shareholder Activism outlines plans to impose on all those involved in pension fund management, an express statutory duty to use shareholder powers to intervene in investee companies where this is in a pension scheme’s best interests. The proposals follow up on the recommendation contained in the Myners Report published in March 2001 that pension scheme trustees should incorporate the principle contained in the US Department of Labor Interpretative Bulletin into fund management mandates, and that this principle in due course be more clearly incorporated into UK law.
1.4 ABI members have a strong interest in the matters raised in the consultation document. As institutional investors, they are responsible for the fund management activities of insurance companies with over £1,000 billion of funds under management including some £350 billion invested in the shares of UK companies. Some £500 billion of these total assets represent the investments of insurance administered occupational and personal pension schemes. In addition substantial further funds back pension annuity business where in excess of £5 billion is paid out each year. ABI members also manage a significant volume of pension scheme funds on behalf of third parties.
1.5 In their specific capacity as institutional shareholders ABI members are concerned to ensure that pension provision by sponsoring employers
can be undertaken on a cost-effective and efficient basis without undue regulatory burden.
1.6 The consultation document also considers whether the principles proposed in respect of pension funds should extend more widely. ABI has an important interest in this respect. The Sandler Review is already considering to what extent and in what way the proposals of the Myners Report should be applied to retail financial products, including life assurance. The terms of reference of the Sandler Review indicate that the area of overlap between pensions and life insurance, i.e. insured pension schemes, are within the scope of its deliberations. 1.7 The special circumstances of insured schemes are already recognised
in that some obligations on pension schemes, such as the obligation to produce a Statement of Investment Principles do not apply for insured schemes. Given this and also the observation made in Paragraph 29 of the consultation document that disclosure of funds’ approach to activism might best be made through the Statement of Investment Principles, there would seem considerable sense in clarifying that the references to “investment of assets of a retirement benefits scheme” do not apply in respect of insured schemes. It should also be clarified that investment of assets backing pension annuities are excluded.
1.8 In any event, recommendations in the current consultation document, which appear not to discriminate between insured and non-insured pension scheme arrangements, should not be implemented in respect of insured schemes in advance of the Sandler Review reaching its final conclusions. More generally, application of activist duties to non-occupational pension schemes would also best await the conclusions of the Sandler Review.
GENERAL COMMENTS
2.1 The proposals are designed to apply to pension schemes. It is left unclear on what basis pension schemes are specifically identified for enhanced protection of beneficiaries. The importance of safeguarding retirement income may be of some qualitative significance, while the magnitude of sums involved represents a quantitative significance. That pension investment takes place within a particular fiscal framework has also been used by Government as justification for imposing some restrictions on freedom, as shown in the recent consultation on modernising the annuity framework.
2.2 From an asset management perspective, we see no obvious reason for making a distinction between pension and non-pension related investments as regards the appropriateness of activism and, in principle, we would look for a consistent framework to apply within institutional investment. There are strong practical arguments for this too. Effectiveness of activism on the part of investment houses
depends to a significant extent on value of relevant assets on behalf of which they are speaking. For pooled funds incorporating both pension and non-pension money, application of activist duties in respect of pension related investment alone would be impossible.
2.3 ERISA regulations in the US relate to the nature of the fiduciary relationship. In the UK context this points particularly at the role of the trustee of the pension scheme and we believe this is the right focus for any activism duties. In practice, trustees themselves will often recognise that corporate governance activities are best devolved to the fund manager. The role of the fund manager will depend on the terms of their engagement. It is to the trustees that the fund manager is accountable and it is the responsibility of the trustees to convey what the interests of the fund and its beneficiaries are.
The merits of activism
2.4 The Association’s members as long-term institutional investors fully recognise the importance of activism, both individually through their own fund management activities and collectively through the ABI.
2.5 The consultation document identifies a number of important principles. One is that intervention in companies should not be made compulsory regardless of circumstances – for example, by creating a duty to intervene even where the costs would exceed the benefits. We agree that this principle is well founded.
2.6 However, it must be recognised that precise quantification of the prospective benefits will be very difficult to measure. To impose a legal requirement to assess these potential benefits relative to the actual costs incurred in activism, both in terms of resources devoted to the corporate governance activities generally and when action is undertaken in specific corporate circumstances, will create genuine uncertainty. We do not agree with the view expressed in the consultation document that the cost of intervention is not high.
2.7 The principle must be carefully defined to ensure that activism takes place to the extent that benefits in respect of the investments might be expected to exceed the costs, whether it is the fund or fund manager that bears these in the first instance. Ultimately, it must be the funds themselves that bear these costs and, where actual costs exceed expected costs, an appropriate market response will be a variation in prevailing fund management fee levels. However, in the shorter term it would not be unreasonable for pension scheme trustees to be able to expect that an appropriate degree of corporate governance activity on the part of the fund manager forms a part of the service for which they are paying.
2.8 Where trustees of pension schemes are of the opinion that more resources could usefully be devoted to activism, they should act on this
belief and engage fund managers who are able to manage funds on such a mandate. Of course, the fees for such fund management will be higher than otherwise, and it should be for the trustees to decide whether the benefits would exceed the cost. In practical terms, approach to activism is an important component of the marketing proposition for fund managers seeking mandates.
The rights of shareholders
2.9 These derive from the Memorandum and Articles of the company, from company law and, in certain respects, from the UKLA’s Listing Rules. The key rights in law are to receive the Annual Report and Accounts, to vote at and to attend company general meetings, and, subject to certain criteria, to requisition EGMs and sponsor resolutions. These are the formal rights that attach to the holders of equity shares. In reality, institutional investors are able to exercise much greater influence through ad hoc and structured dialogue. However, this relies on the constructive attitude of both institutional investors as major shareholders and the directors of the company concerned.
The legal position
2.10 The consultation document suggests that an obligation of activism is already embodied in the common law duties owed by fund managers, as well as in financial services legislation. This would seem of itself to provide a sufficient and reasonable legal reflection of obligations implicit in the stewardship of funds. We are, however, extremely concerned at the prospect of explicit codification of duties in statute and creation of a provision, expressly, that breach of this duty may be the subject of civil litigation in the same manner as a claim in tort. In summary, intruding statutory legal duties in this area creates legal risks and will require considerable compliance costs with no obvious benefits.
2.11 More generally, it is very questionable whether there are public interest considerations justifying legislation, over and above ensuring that shareholder rights are protected and duties are owed to beneficiaries of funds being invested. We agree that it is an important and legitimate issue for Government to ensure that the legal and regulatory framework supports shareholders in scrutinising the efficiency and effectiveness of company management and their strategies. In most respects this framework already exists though we believe that progress on facilitating electronic voting would be the most useful practical advance that should currently be pursued.
2.12 It is for shareholders themselves to exercise the rights attaching to their ownership of the equity of the companies they have invested in. Where the ultimate investors have delegated the management of their investments including responsibilities of activism, it is for those investors, the trustees in the case of pension schemes on behalf of the
ultimate beneficiaries, to ensure that these responsibilities are being discharged. It is through the contracts agreed between trustees and fund manager that this accountability should lie.
Is more activism required?
2.13 The case for greater activism seems predicated on the notion that there is insufficient evidence (absence of evidence) that it is done rather than that it is not done (evidence of absence). This fails to recognise that the bulk of such activity needs to be undertaken in a confidential manner and some of it is highly sensitive. We are unaware of any studies or research realistically measuring the volume and extent of such activity.
2.14 ABI members themselves undertake significant amounts of activism outside of the ABI framework, both regularly structured and otherwise, as an integral part of their fund management activities. ABI itself carries out significant engagement with companies within the broad scope of activism. Although most press comment tends to focus on engagements of a remuneration-related nature, this fails to reflect the real spread of activity, though as explained above, by its very nature other contacts usually are, and remain, confidential in nature. During the past year, we can indicate that our Association has undertaken some eight major non-remuneration related engagements with companies where our members considered it appropriate to do initiate matters under ABI auspices. On many other occasions, dialogue on various aspects of corporate governance takes place.
2.15 It might also be noted in passing that increasing linkage between share incentive schemes and performance means that dialogue on remuneration issues focuses more than in the past on the real core substantive issues that are of relevance to corporate performance which is identified as being the essential locus of the public interest. Thus the increasing emphasis on performance within the ABI’s guidelines on share incentive arrangements has itself contributed to a broadening and enhancement of activism as undertaken by the Association.
ABI monitoring service
2.16 The Association, through its IVIS share monitoring service, also analyses the AGM and EGM documentation of all companies in the FTSE All Share Index plus certain others, to assess compliance with ABI guidelines and corporate governance best practice generally.
2.17 Engagement with companies through the auspices of ABI can be desirable where, arising out of this analysis, there are more deep-seated problems of a corporate governance or general structural or thematic nature. Combination of the chairman and chief executive roles, and circumstances in which auditors obtain high levels of
non-audit consultancy income from their client companies are two subjects on which the Association has written to major listed companies to explain the expectations of investors and, where appropriate, to invite responses.
2.18 The Monitoring Service has in recent years been enhanced to reflect evolving best practice as regards internal controls reporting following the recommendations of the Turnbull Committee and, previous to this, the publication of the Combined Code following the deliberations of the Hampel Committee.
2.19 In advance of the current company reporting season, the Association has focused in particular on enhancing disclosure relating to socially, ethically, and environmentally responsible investment and has produced guidance on this. This has helped facilitate good quality reporting by companies which our members find valuable as a basis for their own activism and for informing their investment decisions. Where companies fail to provide sufficient disclosure, they are contacted and, where appropriate, meetings will be held.
Approaches to activism
2.20 Combined approaches by investors, especially through representative associations such as ABI, can be a particularly suitable means of conducting at least some aspects of activism and corporate governance because benefits accrue to investors being active only pro rata to their shareholdings (not generally more than 5% even for large investors) whereas they incur 100% of the costs. Whether undertaken individually or collectively, a strategy of activism will be easiest to justify as regards costs and benefits if it is understood that other institutional investors are similarly committed. There is much to commend, therefore, in ensuring the existence of market best practice.
Analysis of effectiveness
2.21 We believe that academic literature which uses dismissal of, or length of tenure of, CEOs and measures this as a proxy for shareholder activism, is very much misguided. Termination of the contracts of CEOs, if at all a measure of the achievements of shareholder engagement with companies, is a sign of failure not of success. In the US, it will generally be Boards themselves that initiate terminations. We know of no evidence that activism as such is prevalent in the US. Rather, this is concentrated on isolated examples of high profile proxy fights, therefore essentially of reactive nature to general meeting resolutions, or on class action litigation and therefore a phenomenon of the litigious environment. Genuine activism in the US, if undertaken without assurance of success, would run considerable legal risk of being sued by fund trustees. It is unsurprising that activism of a genuine kind is largely concentrated amongst a handful of very sizable public sector schemes.
2.22 Activism by institutional investors in the UK takes a variety of forms. Some is pro-active, some reactive, but the best arises out of continuing dialogue with companies.
2.23 The proposals focus on under-performing companies. Activism should also exist when companies are performing well in order to help maintain that performance. Institutional investors in the UK therefore seek to maintain on-going dialogue and this will generally be structured around the company’s reporting timetable and contact will be with the principal executives of the companies and, as appropriate, the Chairman. At other times, contact may be sought with non-executive directors.
Higgs review
2.24 The Government has announced recently the appointment of Derek Higgs to undertake a review of the role of non-executive directors. This review will no doubt wish to examine the relative roles of NEDs and shareholders and the interaction between them and we shall welcome the opportunity to input to the review.
2.25 The subject matter of the Higgs Review is of obvious relevance to the activism debate and we believe that it is inappropriate at the present time to seek to formulate a specific new duty of activism ahead of the deliberations of the Review.
The role of markets and investor preferences
2.26 Myners is too dismissive of concerns regarding insider dealing/ market abuse legislation and Takeover Panel regulations, and of “if we don’t like a company we just sell the shares”. It is also erroneous to suppose that selling shares is an impractical strategy. Genuine impediments of this nature are the exception rather than the rule.
2.27 Selling shares sends the correct signals to the market, leading to reduction in price to book ratios for such companies’ assets. This helps allocate fresh capital to companies which make best use of this. In extremis, companies become takeover targets. But it is the potential threat of takeover rather than the actuality that provides the discipline. Share price underperformance also diminishes the value of management’s share incentive arrangements and their personal shareholdings in the company.
2.28 Myners is also unreasonably dismissive of the argument that it is not the job of institutional investors to second-guess management. The skill-sets of fund managers are different than company management. It is precisely the things which Myners identifies as the skills of fund managers, essentially judging the soundness of company strategies rather than indulging in micro-management, which make decisions to
buy and sell shares the predominant and primary response to changing perceptions of investee companies. By contrast NEDs’ predominant response should be to influence and if necessary intervene and not to pursue an exit strategy for themselves.
2.29 Activism as an overt investment style is a specialised pursuit that is distinct from conventional portfolio management. The activist specialist is likely to buy rather than sell shares of companies which are earning sub-optimal returns on assets. For such funds, a duty of activism is superfluous. They will be buying shares from others who are selling. This is a market process. Discouraging institutions from selling detracts from the viability of the activist fund manager’s commercial strategy.
2.30 If specific public interest duties are to be imposed on a particular class of capital, i.e. equity, which does not apply to other classes, there will be a distortion of capital structures in favour of debt. This will produce incentives towards higher gearing of company balance sheets and greater emphasis on short-termism as cash will need to be generated to meet finance costs on debt capital.
2.31 The consultation document proposes that low cost fund management mandates, typically of an indexed variety, could have the ability to disapply the activism requirement. Although it is right that trustees, and indeed consumers generally, should have access to fund management on such terms, it is surely bizarre to prevent parties to other types of mandate from having similar choices. There is in any case a cogent argument for index trackers to devote more resources to activism as this is the most obvious means by which the fund manager can add to absolute returns i.e. where the cost of intervention is outweighed by the benefits. Where this is the case, what is the rationale for non-intervention?
Further adverse implications of proposed legislation
2.32 Imposing a public interest duty on investors in equity capital will artificially induce a switch from equity to debt investment. This change would adversely impact on the nature of the shareholder/company relationship including the willingness, or indeed ability, to consider the long-term perspective, as ensuring shorter-term solvency becomes the dominant consideration to a company with a highly geared balance sheet.
2.33 The proposals will also be likely to lead to considerable uncertainty as regards asset allocation decisions between UK and overseas equities. On the one hand, the exercise of rights in overseas jurisdictions will be considerably more difficult to achieve full compliance in respect of. On the other, investors may seek to take refuge overseas investment on the grounds that the costs of activism could be more easily demonstrated to outweigh the potential benefits.
2.34 Imposing a potential legal duty on investors will, rationally, lead to them seeking to avoid allowing this to become a reality. They will become more likely to sell down an overweight position in order to establish that the cost of activism relative to benefits is proportionately higher. This is surely the precise converse of the objective of combating the “if we don’t like a company, we sell our shares” philosophy. It will also further encourage the benchmark-tracking approach that Myners specifically objects to.
2.35 The proposed changes therefore run a serious risk of producing the precise opposite to the intentions behind the proposals, while also increasing the risks and therefore the costs of fund management.
The ERISA context
2.36 The remedy proposed by DWP/HMT/Myners is to import duties required under US ERISA legislation and the US Department of Labour Interpretative Bulletin. The essential objections to this, and to the way in which those duties are proposed to be expressed, are:
1) There is little support for the view amongst practitioners in UK and US fund management that effective intervention in the US is more prevalent and effective – rather the reverse in fact. In the US the requirement to be active therefore focuses primarily on voting. In the UK, voting levels are, institutions believe, high and have risen in recent years and, because it is not a legal duty, is more effective than it would otherwise be if compliance were to subsist in voting rather than considered voting.
2) The UK Government seems to endorse the belief that the evidence of effectiveness in activism is a high turnover of chief executives. UK investors would argue the reverse.
3) The US requirements need to be seen in their context i.e. a litigious environment in which a major concern for fund managers is that they may be sued for allocating resources to activism without clear and unambiguous evidence of the economic benefits to clients outweighing the cost.
4) The US requirements do not exist in law as such but are based on interpretation by a US government department. It is difficult to see why they should exist in legislation in the UK.
5) The UK environment, with somewhat greater concentration of holdings with institutional investors and of institutions geographically, makes activism more likely to be effective without explicit duties being imposed.
6) The consultation document identifies that a duty of activism already exists in common law. Given the inevitable difficulties in defining activism, its aims and success criteria, this is not a problem since it will be susceptible to common sense interpretation. By contrast, the formulation proposed in the consultation document expressing the duties in broad terms creates very considerable uncertainty in legal
compliance – it is not the aim of the proposals that is objected to: it is the consequences of its legal formulation.
THE ABI’S ALTERNATIVE APPROACH
3.1 As outlined above, we consider that the right way to regulate the relationship between fund managers and scheme trustees and members/ beneficiaries is through contract. Breaches of the agreed terms can then be dealt with in the appropriate manner. Our key recommendation is that this route rather than one of statutory legislation be pursued and that the expectations of trustees be reflected in fund contracts.
3.2 To facilitate this, appropriate wording could be incorporated into model terms issued by representative associations. This could be closely modelled on the wording contained in paragraph 3 of the consultation document which identifies a duty, broadly, “to actively monitor and communicate with the management of investee companies and to exercise shareholder votes where, after taking into account the costs of any action, there is a reasonable expectation that such activities are likely to enhance the value of an investment”. This definition has the merit of providing considerable clarity, in contrast to the very open-ended duty which the consultation document proposes be defined in statute.
3.3 The ABI is currently examining the proposal, in conjunction IMA and NAPF, to take matters forward and in due course expects to be able to recommend to the Institutional Shareholders’ Committee that the paper on the Responsibilities of Institutional Shareholders be updated and reissued. This would seem to us to be the most useful approach to encapsulating and promulgating accepted good practice as regards activist duties.
SPECIFIC COMMENTS ON CONSULTATION QUESTIONS
Q1 The Government is minded that the activism duty should apply to trustees as well as fund managers, but would welcome views on this approach and any other impressions
We consider that the trustees are the appropriate focus of duties and responsibilities in respect of their pension schemes. In practice, the trustees of many schemes will seek to devolve relevant duties to the fund managers they have engaged. The fund managers will in turn be accountable to the trustees for exercising these duties but this should not alter where responsibility resides.
Q2 The Government would be interested in the view of respondents on an appropriate approach as to which funds are included in the duty
Consistent with our response outlined earlier, we do not believe that legal duties should be applied in respect of funds. In respect of occupational pension schemes, any duties ought to relate to the trustees. Any such duties should not come into operation in respect of insured occupational pension schemes until the Sandler Review, to which the Association intends to respond in due course, has considered the matter. In respect of non-occupational pension schemes, we believe the regime in respect of these would best be devised to reflect the approach adopted for retail investment products and life insurance products which, again, is to be dealt with as part of the Sandler Review.
Q3 The Government would welcome views on how best to disclose compliance with the new law
Fund managers report periodically to their clients, whether the client is the end-investor or, as in the case of occupational schemes, the scheme trustees. Trustees should, in most cases, be well positioned to require disclosure and reporting in the form which they would find most useful. A similar reporting process should apply whether legal duties as such are introduced or if duties are specified pursuant to fund management mandates.
03/05/2002
