Vince Cable, the UK Business Secretary, will sit down later this year to consider the findings of the review he commissioned by John Kay, the economist, on UK Equity Markets and Long-Term Decision Making and formulate the government’s response. RI takes a look over the report’s major recommendations to point up where the Kay Review might be well received, and where it could fall short or hit resistance:
The Kay Review has made 17 headline recommendations. Here is RI’s point-by-point analysis:
1. The Stewardship Code should be developed to incorporate a more expansive form of stewardship, focusing on strategic issues as well as questions of corporate governance.
- This seems a reasonable objective, but how does it in fact differ from the existing Code? Surely any investor who is an active steward of a company will already be interested in broader strategic issues. Or is this stretching the remit of the Code too far? Kay doesn’t say how he envisages increasing participation in the Stewardship Code, where take-up has already been muted, nor how to give it social visibility and value.
2. Company directors, asset managers and asset holders should adopt Good Practice Statements that promote stewardship and long-term decision making.
- Drill down and you find some good ideas in each of the multi-point statements but the worry is they will get lost within the 17 headline recommendations. All told, the Review makes 46 separate recommendations; this may be too many to be assimilated by the parties targeted.3. An investors’ forum should be established to facilitate collective engagement by investors in UK companies.
- This is a good idea in itself, but such a forum, the Institutional Investor Committee (IIC) already exists in the UK (indeed it has done in various forms to underwhelming effect since 2001’s Myners Review), not to mention similar initiatives such as the PRI Clearinghouse. What’s to make this forum different? How will the make up of its directors/management differ from the IIC, and how will it be internationalised to reflect broad UK share ownership (the IIC made overtures on this without action). The new forum could benefit from official government backing to kick start it. But, as ever, it is all about outcomes: will it result in companies that are better run over the long-term? Another issue is, how will investor engagement be disclosed? If there is no openness here it defeats the object.
4. The scale and effectiveness of merger activity of and by UK companies should be kept under careful review by BIS (UK Department for Business, Innovation and Skills) and by companies themselves.
- This seems less “laissez-faire” than might be expected, asking the government to oversee corporate M&A activity. The role of shareholders in keeping tabs on poor M&A should be more explicit here given the lessons of disastrous recent takeovers. The remit of the UK Takeover Panel should be examined. Might there also be a discussion around an M&A test on national interest?
5. Companies should consult their major long-term investors over major board appointments.
- Fine in principle, but what is the mechanism by which this occurs? How are shareholders to be consulted and how are decisions to be made? Would this undermine the AGM format even further, just when governance (pay) issues are gaining prominence. And what is the role of advisors to investors, given the scrutiny proxy firms are already under? The US pension funds’ Diverse Director DataSource initiative could be a useful reference point here.
6. Companies should seek to disengage from the process of managing short-term earnings expectations and announcements.
- This is a good suggestion and should go some way to addressing short-termism, although how many companies act on it will be interesting to see. It is right that the market as a whole gets away from its fixation with quarterly numbers, and this seems a good way of encouraging that. Its corollary is recommendation 11 to end quarterly reporting.
7. Regulatory authorities at EU and domestic level should apply fiduciary standards to all relationships in the investment chain which involve discretion over the investments of others, or advice on investment decisions.
- This could be difficult to encourage/implement given the different legal structures and cultures across the EU. The recent call by Fair Pensions for a clarification of fiduciary duty, along with relevant suggestions, is a useful guide here. That said, while UK ‘soft’ regulation has often been an influence on EU regulatory direction, whether that remains true post financial crisis is questionable. The EU’s Corporate Governance Directive expected in October will be instructive.
8. Asset managers should make full disclosure of all costs, including actual or estimated transaction costs, and performance fees charged to the fund.
- This is one way to address ‘rent extraction’ and as such is a key proposal. Kay complains of information overload, but this could result in even more info for asset owners to digest. Managers who do this will need their efforts to be recognised by clients in some way to offset competitive pressure. Asset owners should push hard for this though in the interest of their members.9. The Law Commission should be asked to review the legal concept of fiduciary duty as applied to investment to address uncertainties and misunderstandings on the part of trustees and their advisers.
- Any review of fiduciary duty is welcome, and another will do no harm. But is the problem really one of “uncertainties and misunderstandings” on the part of trustees and advisors, as Kay says, or the inability inability/experience of some trustees to act as qualified fiduciaries because of lay status or resource constraints? Only bigger asset owners have to date been able to exert stronger influence on their providers on cost and service. Kay rightly says that fiduciary standards require the client’s interests to be put first and foremost along the investment chain, that transparency on costs and conflicts of interest is paramount and that ‘caveat emptor’ is not compatible with fiduciary responsibility. All true. He’s also right that the core fiduciary duties are “loyalty and prudence”; it’s what many in the RI world have argued for in terms of a more rounded concept of long-term, financially and socially relevant prudential investment. But who will foster that culture, or police it? Where is the incentive to sanitise the current corrupted intermediation chain that Kay so deftly points up? Can we really rely on a few good men and women to step up, eat their own lunch and do the right thing on behalf of the end saver? A government review of fiduciary duty in 2008 gave trustees latitude to revisit the concept:
What will be different this time, and when will we have a firm outline of what proactive fiduciary duties or expectations might actually be, and which pension funds could tailor to their own requirements?
10. All income from stock lending should be disclosed and rebated to investors.
- Kay’s position can be summarised as follows: stock lending provides liquidity, but end investors (asset owners) aren’t getting paid enough for the risk they take.
Fair enough, but the question obviously needs answering as to why not? It is also worth asking if institutional investing time horizons have shortened so much, should they really be facilitating shorting of many of those same companies. Kay said he had little evidence to make the case; investors themselves, however, should at least investigate! They should also ask what the impact of stock lending could mean for the enhanced engagement activities that Kay strongly advocates.
11. Mandatory IMS (quarterly reporting) obligations should be removed.
- There will be few grumbles on this recommendation: many companies dislike it and many investors, particularly those with a long-term focus see quarterly reports as excessive, with bi-annual or even annual reporting considered sufficient. As Kay notes, the noise in short-term data suggests that assessments outside of annual financial reporting should be discursive rather than statistical and that form and frequency should be company specific rather than imposed. Its worth noting that in its notes on this recommendation, the Kay report reiterates that institutional investors “acting in the best interest of their clients” should consider the environmental and social impact of companies’ activities and associated risks among a range of factors which might impact on the performance of a company, or the wider interests of savers, in the long-term.
12. High quality, succinct narrative reporting should be strongly encouraged.
- No arguments here, although to-the-point narrative reporting that supports actual material issues (as opposed to meaningless narrative that doesn’t) for companies is likely to be something of a problem, and perhaps a legal minefield. We should also be careful of ‘narrative fallacy’. The work being done by the International Integrated Reporting Council (IIRC) should be instructive here because investors need to lay down the narrative parameters they want to see companies use without creating a reporting straitjacket: Link*13. The Government and relevant regulators should commission an independent review of metrics and models employed in the investment chain to highlight their uses and limitations.*
- Triple AAA rated Mortgage Backed Security anyone? Libor-fixed swap contract for sale? Portfolio of uncorrelated assets for all market conditions, sir?
A review of this kind is long overdue: many aspects of the investment pipeline are considered fail-safe – even sacrosanct – until they fail, sometimes with horribly spectacular consequences! Investors, in tandem with properly independent specialists, governments and regulators should be constantly reviewing the safety of the financial ‘system’ that dictates all of the investment decisions that they take. Kay also skewers the white elephant of benchmark-related performance and risk comparison, calling instead for practices based on the risk to “savers”, not “market participants”. This has been happening in the investment world with a shift to individually or collectively-tailored absolute returns, but it needs to be speeded up, especially in a world shifting to market risk based, defined contribution plans.
14. Regulators should avoid the implicit or explicit prescription of a specific model in valuation or risk assessment and instead encourage the exercise of informed judgment.
- Kay acknowledges that there are significant problems but no easy solutions to the problems of mark-to-market accounting and fund valuation in noisy, volatile markets. The former has created paranoia in pension provision (shrill media coverage of deficits, companies deserting their pension plans) and the latter has shifted investors away from a quest for fundamental, long-term corporate value as their feet are held to the fire by concerned clients. The direction of the recommendation is good. It’s a shame, however, that Kay did not devote his considerable intelligence and review resources to outlining some guiding posts for a path forward to enlightened informed judgement.
15. Companies should structure directors’ remuneration to relate incentives to sustainable long-term business performance. Long-term performance incentives should be provided only in the form of company shares to be held at least until after the executive has retired from the business.
- Kay identifies succinctly all the assymetries and potential gaming outcomes of the bonus system (in short: upside payment, no downside risk) to reach the conclusion that only skin-in the-game (shares), held until career end will end the gravy train. Kay has done well to target areas where responsibility can be shifted towards “would I do this with my own money” questions. There is, of course, a problematic international dimension here, if bonus payment in shares is not the norm globally, could the much discussed brain drain for management become a flight to cash?
16. Asset management firms should similarly structure managers’ remuneration so as to align the interests of asset managers with the interests and timescales of their clients. Pay should therefore not be related to short-term performance of the investment fund or asset management firm. Rather a long-term performance incentive should be provided in the form of an interest in the fund (either directly or via the firm) to be held at least until the manager is no longer responsible for that fund.
- Another skin-in-the-game recommendation that if adopted would change the nature of asset management. There will be difficulty identifying the ‘long-term’ timeframe for bonuses and fund manager responsibility for a fund does not in itself have to be long-term and performance could be pumped over the short-term up to meet a cash interest (say if a manager plans to leave). It’s a challenge to the existing status quo and especially to asset owners to redesign the remuneration of their service providers based on value creation and participation over a reasonable time period….expect the investment industry to ignore or squeal vigorously. But public opinion on bonuses has crossed a rubicon.17. The Government should explore the most cost effective means for individual investors to hold shares directly on an electronic register.
- It’s true that equity markets have become somewhat divorced from individuals taking an active interest in local national companies, economic growth and investing in that. Updating equity markets for the internet age is a good idea, and the government should also look at on-line share-voting participation as well as ways for individual fund members to have a proportional voice in the investments they make via retail funds or pension plans. If the concept of ‘public’ equity markets is to have any meaning for the future, the ‘public’ rationale has to be revitalised.