Submission from FairPensions (S014)
· Good corporate governance in banking institutions should promote sustainable wealth creation and effective management of risks, including systemic risks.
· Regulation and good corporate governance are complementary; comply or explain is effective if explanations are meaningful and properly scrutinised. There is now some recognition of a need for improvement in this respect.
· Debates about the role of shareholders in banks’ corporate governance have tended to focus on the problem of insufficient shareholder engagement. However, the wrong sort of engagement can equally be viewed as a contributing factor to a culture of risk-taking and short-termism. The encouragement of ‘stewardship’ is therefore not just about increasing engagement but about cultivating a responsible, long-termist ownership ethos among institutional investors.
· The Stewardship Code has been effective in gathering mainstream industry support for the concept of stewardship, but less so in translating this into meaningful behavioural change. This should be addressed, including through this year's review of the Code.
· As Ferdinand Mount has pointed out, the asset managers who exercise shareholder rights are not themselves the actual owners of companies but are merely another layer of agents. Getting shareholder oversight right therefore means paying attention not just to the relationship between shareholders and managers, but to the relationships between asset managers and asset owners, and between asset owners and their ultimate beneficiaries.
· Current problems with this chain of relationships include:
◦ Narrow interpretations of institutional investors' fiduciary duties to savers, which (a) assume that fiduciaries cannot have regard to anything which is not immediately monetisable, and (b) encourage fiduciaries to 'follow the herd'. FairPensions has proposed statutory clarification to create a more flexible and enabling environment in which a broader approach can be taken to beneficiaries' best interests, including their interest in management of systemic risks.
◦ Inconsistencies in the application of fiduciary duties to investment intermediaries, contributing to inadequate management of conflicts of interest, including in relation to the exercise of shareholder rights. This could be improved through greater oversight from institutional clients and by more consistent application of fiduciary standards by regulators.
◦ Lack of consumer demand due to the disconnect between 'ultimate owners' and the stewardship debate. Greater transparency and accountability to beneficiaries could help to generate market pressures for better shareholder oversight.
· Disclosure of remuneration in banks should include not just the quantum of pay but also the performance criteria on which variable pay is based. Without this it is difficult to see how shareholders can assess whether incentives are appropriate.
1. FairPensions is a registered charity that works to promote active share-ownership by institutional investors in the interests of their beneficiaries and of society as a whole. Our particular focus is on encouraging shareholder engagement with listed companies to ensure effective management of environmental, social and corporate governance (ESG) risks which may affect long-term financial returns. We work collaboratively with investors on issues where there is a strong business case for engagement. We also educate and facilitate individual pension savers to take an interest in their money, and advocate for greater transparency and accountability to beneficiaries about how shareholder rights are exercised on their behalf.
2. We are a member organisation. Our members include bodies representing pension savers, leading UK charities and thousands of individual pension fund members. We are independent of industry and are funded primarily by grants from charitable foundations and trusts.
3. Our experience and research on shareholder engagement applies to all listed companies, but we believe that many of the issues we have encountered are particularly relevant to the banking sector and therefore to the Commission’s remit. This submission draws on our evidence to the Treasury Select Committee’s enquiry on corporate governance and remuneration in financial institutions. It is most relevant to the Commission’s call for evidence on "the role of shareholders, and particularly institutional shareholders" in shaping the culture of UK banking, and how any weaknesses identified here might be addressed.
4. We are currently undertaking a research project analysing the character and impact of this year’s so-called ‘Shareholder Spring’. We are using a range of evidence, including voting records and investor responses to government consultations, to assess what has driven shareholders to intervene at particular companies, the extent to which this marks a fundamental shift in shareholder attitudes to engagement, and what further steps policymakers could take to encourage responsible shareholder oversight. We expect to publish a report in October and will share this with the Commission.
Regulation, governance and ‘comply or explain’
5. Good corporate governance in banking institutions should seek to promote:
· sustainable wealth creation (this may not coincide with the maximisation of short-run returns, as the 2008 crisis all too clearly demonstrated); and
· effective management of risk, including potential systemic risks posed by the institution’s activities.
6. Both of these objectives serve the long-term interests of shareholders whilst also protecting the public interest in stable and sustainable banks.
7. We regard regulation and good corporate governance as complementary. The 2008 crisis exposed failings in both regulation and corporate governance as mechanisms for ensuring that banks pursued sustainable business models and managed risks effectively. Regulation should set the parameters of acceptable behaviour (external accountability), while good corporate governance should ensure effective strategic decision-making and risk management within those parameters (internal accountability).
8. 'Comply or explain' is only as good as the quality of explanations offered for non-compliance by boards, and the degree of critical scrutiny of those explanations by shareholders. Evidence suggests there is much room for improvement in this respect. A 2005 study by the London School of Economics found that firms who did not comply with the Combined Code of Corporate Governance "often did a very poor job explaining themselves", with almost one in five cases of non-compliance not explaining themselves at all. Moreover, the study concluded that "shareholders seem to be indifferent to the quality of explanations".  Our recent research suggests this conclusion may still hold (see paragraph 16).
Shareholders and UK banking culture
9. There appears to be a growing consensus that the problems revealed by the 2008 banking crisis and by the recent LIBOR scandal can be traced in part to a flawed banking culture – one of excessive risk-taking, short-term profiteering and unchecked conflicts of interest. In the wake of the banking crisis, questions were asked about why shareholders had not done more to challenge this culture. Analysis of this issue focussed largely on the ‘absentee landlord’ problem, with the Walker Review recommending the introduction of a Stewardship Code to promote greater shareholder engagement.
10. In our view, this is clearly part of the problem, but it is not the whole story. As the recent report of the Kay Review noted, "Shareholder engagement is neither good nor bad in itself: it is the character and quality of that engagement that matters." Indeed, as Kay observes, many bad corporate decisions of recent years "were supported or even encouraged by a majority of the company’s shareholders". In our view this is particularly true of the banking sector in the run-up to the financial crisis. Shareholder demands were an active driver of greater leverage and more risky strategies in the pursuit of short-term returns. Only one major asset manager (The Co-operative Asset Management) voted against RBS' takeover of ABN-AMRO, with only one other (Royal London) abstaining.
11. In asking why this is, it is important to examine the culture of shareholders themselves as well as that of banks. Kay argues that the culture of City investment intermediaries has become too focussed on trading and transactions (exit) and insufficiently focussed on long-term relationships and engagement (voice). Of course, one consequence of this is that shareholders deprioritise engagement. But another important consequence is the measurement of company success (and, by extension, investment success) in terms of short-term share price movements rather than the fundamental value of the business. This means that when investors do engage, it may exacerbate rather than mitigate banks’ cultural problems.
12. Although we would by no means suggest that genuinely long-term engagement is non-existent, our experience broadly accords with Kay’s analysis. Surveys of both directors and investors support this picture of pressure to maximise short-term results, even amongst theoretically long-term investors such as pension funds. In one US study, 78% of financial executives interviewed said they would give up long-term economic value to maintain smooth earnings flows to their investors in the short-term.  In the recent FRC review of the Stewardship Code, many companies felt that "some shareholders still seemed to focus too much on specific issues of a short-term nature".  In a survey of ten large European pension funds, their ideal time horizon was estimated at 23 years and their actual time horizon at six years. Participants blamed short-term, benchmark-relative remuneration structures for the discrepancy. 
13. Similarly, Ferdinand Mount has argued that the shareholders we rely upon to oversee company managers are in fact part of the same managerial elite, sharing the same culture and the same incentives (i.e. the short-term maximisation of the share price).  If true, this is even more so in the case of banks, where the two groups are part of the same industry – and even in some cases, since the Big Bang, part of the same parent company. Moreover, the loss of public trust caused by incidents like the LIBOR scandal has not been confined to banks but has affected the entire finance industry. In the most recent survey by the National Association of Pension Funds, mistrust of industry was the number one reason given by people planning to opt out of enrolling into a pension scheme under the government’s workplace pension reforms.  The Commission should therefore ask itself what can be done to ensure that investment institutions (a) regain public trust and (b) effectively fulfil their role in the governance of the banks they own.
Impact of the UK Stewardship Code
14. The UK Stewardship Code has been effective in promoting the concept of stewardship (virtually the entire UK asset management industry, by assets under management, has signed up to the Code). What is less clear is its impact on the quality of stewardship in practice.
15. Examples such as the blocking of Prudential's planned takeover of the Asian arm of AIG in 2010, or the recent wave of rebellions over executive pay, might suggest a step up in shareholder oversight. However, the general picture is much more mixed. In the recent FT/ICSA Business Bellwether survey, 79% of responding FTSE 350 companies reported no increase in engagement since the introduction of the Code, with the remaining 21% reporting only a slight increase.  Similarly, the FRC's first review of the Code found that most companies "[had] noticed relatively little change in approach to engagement". 
16. Our own research  suggests that the decision to keep the Code high-level and principles-based has not prevented a 'tick-box' approach to disclosures, with many asset managers simply repeating the wording of the Code's Principles. This was particularly the case regarding management of conflicts of interest. Disclosures on investors’ approach to company 'explanations' for non-compliance with the Corporate Governance Code were also an area of weakness. For instance, one firm simply stated "We evaluate each deviation on its own merits" without giving any insight into the criteria on which explanations were judged. Such detail was a feature of the better statements we examined, but unfortunately these were the exception rather than the rule.  The recent attention given to the quality of explanations by the FRC and industry participants is welcome. This issue should continue to be monitored closely.
17. Disclosure of voting records under Principle 6 of the Code also remains poor. One study by PIRC found that just 21% of signatories disclose full records, and over half do not disclose any information at all.  The government has reserve powers to introduce mandatory voting disclosure if voluntary initiatives do not generate sufficient improvements (under section 1288 of the Companies Act 2006).
18. The FRC’s success in gathering signatories to the Code must now be built on with efforts to raise standards of behaviour and disclosure. The FRC’s present review of the Code offers an important opportunity to do this. However, there is also a need to examine the structural barriers to greater uptake of stewardship behaviour. The remainder of this submission explores what we believe are some key problems, along with possible solutions.
Structural problems - the investment chain
19. It is well established in economic theory that the relationship between shareholders and company managers creates ‘principal/agent’ problems. There is now general consensus that managing these problems requires active shareholder oversight. However, to achieve this there is a need to disaggregate what we mean by the term 'shareholder'. Institutional investment is itself a chain of principal/agent relationships: the asset managers who generally exercise shareholder rights are agents acting on behalf of asset owners (such as pension funds), who in turn are agents acting on behalf of individuals (such as pension savers). This 'triple agency problem' is the source of many key barriers to better shareholder oversight of banks and other listed companies.
20. For example, as the evidence discussed above shows, there is clearly a misalignment between the inherently long-term financial interests of pension savers and the short-term metrics used both by pension funds to assess fund manager performance, and by fund managers to assess company performance. It is unclear that the post-crisis focus on stewardship has done anything to alleviate this problem – and equally unclear that current norms of shareholder oversight would be effective in preventing a repeat of the 2008 crisis.
21. Fiduciary duties are the main legal mechanism used to deal with principal/agent problems in UK law. Those who act on behalf of others have a fiduciary duty to act in their best interests, and not to use their position to further their own interests or those of third parties. FairPensions has conducted extensive research on interpretations of fiduciary duty. This has helped to inform the Kay Review, whose final report included an extended discussion of fiduciary duty.  In our view, there are two key problems with the current situation: firstly, confusion over what fiduciary duties require, and secondly, inconsistencies in who is deemed to have fiduciary duties.
Problem 1: Narrow interpretations of fiduciary duty
22. Pension fund trustees’ fiduciary obligations are widely interpreted as a duty to maximise short-term returns and ignore other considerations, even if they might have a material impact on long-term outcomes for beneficiaries. This is a real barrier to stewardship: legal advice given to one large UK pension scheme even suggested that their policy of exercising voting rights could breach their fiduciary duties if they could not demonstrate that the costs incurred were justified by monetisable benefits to that individual scheme. Since the benefits of stewardship almost inevitably accrue to the market as a whole, this contributes to a 'free-rider' problem.
23. Institutional investors' fiduciary duty to invest prudently has also been interpreted by UK and US courts as being relative to the behaviour of other investors.  This encourages herding behaviour, sometimes characterised as 'reckless caution', and potentially exacerbates systemic risk. For instance, we have been told privately that, before the dot-com bubble burst, some managers who recognised the bubble and avoided tech stocks were sacked by pension fund clients for underperforming their peers in the short-term.
24. In combination, these widely held perceptions of the law contribute to a focus on chasing short-term outperformance (alpha) rather than improving the performance of the market itself (beta) through stewardship activities. This is one driver of the short-term, benchmark-relative remuneration structures which incentivise fund managers to demand that their investee companies prioritise short-term returns. It also has no place for the wider interest of pension fund beneficiaries in the management of systemic risk: market volatility and systemic crises have a far greater impact on pension savers than the degree to which their individual fund outperforms the market, yet current interpretations of the law require their agents to relentlessly prioritise the latter.
25. FairPensions has proposed statutory clarification to remove these perceived legal barriers to better shareholder oversight. The aim would be to create a more flexible and enabling environment by clarifying that fiduciary investors may consider factors beyond quarterly results, and to encourage a focus on sustainable wealth creation. We have published draft legislation which suggests, among other things, that investors should be explicitly permitted to have regard to "the impact of [their] investment activities on the financial system and the economy".  This is intended to help resolve the problems outlined above, and should create space for better shareholder oversight of systemically important financial institutions. The Kay Report essentially endorsed this recommendation, concluding that "there is a need to clarify how these duties should be applied in the context of investment, given the widespread concerns about how these standards are interpreted." 
Problem 2: Inconsistent application of fiduciary duties
26. One less frequently invoked aspect of fiduciary duty is the duty to avoid conflicts of interest. There is considerable anecdotal evidence that conflicts of interest among fund managers are one barrier to more robust shareholder engagement. For example, one recent paper cites an instance where "the company secretary of a UK manufacturer reminded a fund manager who was intending to vote against the company’s remuneration report that his firm was bidding for an investment mandate from the corporation’s pension plan".  In financial conglomerates, conflicts may arise between asset management arms and investment banking arms. When we surveyed asset managers' disclosures under the Stewardship Code, we found that many gave little or no insight into how these conflicts were managed. The FRC has also identified this as an area for improvement.
27. Asset owners should be more attentive to how conflicts are managed by their investment agents; greater clarity is also needed about asset managers' own fiduciary responsibilities. The Law Commission has concluded that asset managers, and indeed anyone engaged in discretionary asset management or investment advice, have fiduciary duties.  This appears to be accepted by the Investment Management Association, for example in Richard Saunders’ oral evidence to the Treasury Select Committee.  However, it is unclear that these duties are genuinely accepted or applied by the industry as a whole. The position is even less clear with regard to contract-based pension providers like insurance companies. The Kay Report recommended that regulators "should apply fiduciary standards to all relationships in the investment chain which involve discretion over the investments of others, or advice on investment decisions."  FairPensions supports this recommendation (although it is vital that any such measures go hand in hand with steps to clarify the content of fiduciary duties, as discussed above).
Problem 3: Lack of transparency / market pressures
28. An analysis of the chain of principal/agent relationships between saver and company also highlights the absence of market pressures from those whose money is ultimately at stake. Beneficiaries have been virtually absent from the stewardship debate: indeed, there is often some intellectual confusion about whether investors' 'stewardship responsibilities' are owed to companies or to savers (in law, it is clearly the latter). Ferdinand Mount, in his book ‘The New Few’, speaks of a ‘double disconnect’: shareholders are disconnected from management of the companies they own, but the ultimate owners of shares are equally disconnected from the intermediaries who manage their investments. Most savers have no voice or visibility on decisions made about their money and many do not even realise that it is being invested in stocks and shares.
29. FairPensions works to change this through consumer engagement – the most recent example being our online tool enabling individual savers to contact their pension fund or stocks-and-shares ISA provider asking about their voting intentions on remuneration. We believe that greater transparency to these 'ultimate owners' could help to ensure that demand for stewardship is transmitted along the chain. If the Stewardship Code continues to produce poor levels of voting disclosure (see paragraph 1 7), consideration should be given to the exercise of reserve powers in the Companies Act 2006 to make disclosure mandatory.
30. In our submission to the Treasury's recent consultation on bank executive remuneration disclosure, we supported the extension of disclosure to significant risk-taking decision-makers below board level. However, we were concerned that the government's proposed requirements related only to the quantum of remuneration, and did not cover the performance criteria on which variable components were based. It is difficult to see how this meets the government’s stated objective of addressing the problem of "poorly designed remuneration structures [which incentivise] excessive risk taking",
since it does not provide information about the behaviours which remuneration is incentivising or disincentivising.
31. We also suggested that a disconnect exists between the role HM Treasury appears to envisage for institutional investors in making use of remuneration disclosures, and the way in which shareholders view their own responsibilities. The key objective of the reforms appears to be to facilitate oversight of systemically important actors. Institutional investors such as pension funds tend to be ‘universal owners’ (i.e. they have holdings across the economy), and therefore do have an interest in the long-term stability and sustainability of the economy as a whole, which may not coincide with their interest in maximising short-term profits at individual firms (see paragraph 2
4). In practice however, shareholders appear to evaluate executive pay precisely in the context of the recent performance of the individual firm in question. HM Treasury should work with the FRC in developing the UK Stewardship Code to ensure that it meets this challenge head-on, by encouraging institutional investors who are 'universal owners' to engage with systemically important companies in this spirit.
24 August 2012
 Arcot, Bruno & Grimaud, 2005, 'Corporate Governance in the UK: Is the comply-or-explain approach working?'
 Graham et al, 2005, 'The Economic Implications of Corporate Financial Reporting',
 http://pa p ers.ssrn.com/sol3/papers.cfm?abstract_id=491627
 See footnote 4
 Hesse, 2008, ‘Long-term and sustainable pension investments: A study of leading European pension funds’ . See
 http://bit.ly/u a PQdd
 Ferdinand Mount, 2012, ‘The New Few: Or, A Very British Oligarchy’, Simon & Schuster
 NAPF, 2012, ‘Workplace pensions survey’, http://www.napf.co.uk/PolicyandResearch/~/media/Policy/Documents/0220_NAPF_workplace_pensions_survey_-_March_2012.ashx
 See http://www.ft.com/cms/s/0/9ec5594c-6f8f-11e1-b368-00144feab49a.html
 FRC, December 2011, ‘Developments in Corporate Governance 2011: The impact and implementation of the UK Corporate Governance and Stewardship Codes’. Available at http://www.frc.org.uk/images/uploaded/documents/Developments%20in%20Corporate%20Governance%2020116.pdf
 See footnote 2
 FairPensions, 2010, 'Stewardship in the Spotlight', p9, http://www.fairpensions.org.uk/sites/default/files/uploaded_files/whatwedo/StewardshipintheSpotlightReport.pdf
 See http://www.pirc.co.uk/news/voting-disclosure-revisited
 Final Report of the Kay Review, 2012, Chapter 9 ‘Fiduciary duty’
 See FairPensions, 2012, 'The Enlightened Shareholder', p7-8
 Ibid, Appendix A
 Final Report of the Kay Review, 2012, para 9.22
 Wong, S., ‘How conflicts of interest thwart institutional investor stewardship’, Butterworths Journal of International Banking and Financial Law, Sept 2011.
 Law Commission, 1992, ‘Consultation Paper No. 124: Fiduciary Duties and Regulatory Rules’ (HMSO), para 2.47
 19 June 2012, Q163
 Final Report of the Kay Review, 2012, Recommendation 7 (p69)
 HMT, 2011, Bank Executive Remuneration Disclosure: Consultation on Draft Regulations, p5