The UK Stewardship Code: A missed opportunity for higher standards

Earlier this month, the UK ushered in the landmark Stewardship Code for institutional investors. Sadly, the Financial Reporting Council passed up an historic opportunity to strengthen the Institutional Shareholders’ Committee-developed code that has now become the Stewardship Code. There are compelling reasons to toughen the ISC code, foremost among them is that it was developed by institutions possessing widely disparate conceptions of, and commitment to, stewardship. This has resulted in a document that appears to reflect lowest common denominator compromises. Consider the modest changes of the ISC code from its predecessor ISC Statement of Principles, even though examinations into the causes of the global financial crisis found serious deficiencies in institutional investor oversight of investee companies. As highlighted by the FRC, the notable changes in the ISC code encompassed only 1) a new recommendation on disclosure by investors on the use of proxy voting advisory services, 2) encouragement that investors consider explanations made rather than compliance by listed companies against the UK Corporate Governance Code, and 3) greater prominence on managing conflictsof interest. In the latter area, the Stewardship Code has actually taken a step backward. Whereas the 2007 ISC Statement of Principles called for institutional investors to have a policy addressing how “situations where institutional shareholders and/or agents have a conflict of interest will be minimised or dealt with,” the Stewardship Code focuses only on “managing” conflicts, with no requirement to minimise or avoid them. Conflicts of interest are pervasive in the investment industry and, without stronger checks, they will pose a grave threat to good stewardship.
Furthermore, there are significant gaps in the Stewardship Code that should be addressed at its inception. Matters deserving elaboration and attention include the responsibilities of the highly influential proxy research providers and investment consultants, disclosure by institutional investors of their policies on lending securities and recalling lent shares, and consideration by investors of risks beyond “social and environmental matters” to all sources of material risks.
Lastly, the UK Stewardship Code should be comprehensive and of a high standard because – as the first “official” code for institutional investors – it will be
emulated by other countries. The current Code, with most provisions dating from the original 2002 ISC Statement of Principles, fails this threshold test, especially in light of acknowledged shortcomings in institutional shareholder monitoring. While there is some merit to the FRC endeavouring to maintain reform momentum by enacting the Stewardship Code expeditiously, this approach presents a substantial risk that once a standard is established, inertia will set in and future reforms will be much more incremental. Beyond the contents of the Stewardship Code, policymakers,asset owners, and the investment industry must also tackle investment management practices that impede good stewardship, such as financial arrangements that excessively encourage trading and attainment of short-term returns and increasing intermediation in the share ownership chain, which tends to weaken an “ownership” mindset. The FRC has decided to defer consideration of these further issues until the first review of the Stewardship Code, likely to be in late 2011. The debate on a stronger Code should start now.
Simon C.Y. Wong is a Partner at Governance for Owners and Adjunct Professor of Law, Northwestern University School of Law