The duties of share ownership

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Peter Butler and Paul Lee
Hermes Pensions Management Ltd

Pension fund trustees and other fiduciaries are increasingly concerned about the risk of being sued for damages. This tends to encourage a shorter-term timeframe within which they consider their investments, and closer consideration of the need to reassign the mandates awarded to fund managers who underperform for just one or two quarters. This in itself produces some unfortunate consequences: ‘short-termism’ in the discussions which fund managers have with investee companies, and thus shorter-termism in the planning by those companies. Neither will add value for long-term investors.

But this also misses a key way in which investors can add value. The marginal effect of trading shares around benchmarks may produce small incremental value for pension funds, but much more value can be added or maintained by being a good owner of investee companies. A few studies are considered later in this chapter, but it is worth thinking about where value has been added and where lost in the average pension fund investment over recent years.

Most funds will have seen the value of their stocks soar during the tech bubble, with considerable frictional costs paid to management and active fund managers who enjoyed the upside but did not face the same downside as fund investors when the bubble burst. And this destruction of value affected not just tech stocks, but also well-respected companies. Marconi is the classic example from the UK perspective, but most funds lost at least as much from the loss of value within Vodafone through its acquisitive expansionism at the height of the bubble.

A good owner of these businesses might have played a role in reining in executive ambitions, ensuring that pay incentives encouraged long-term value creation and discouraging expansionism. Had there been enough good owners, the system might have avoided significant losses.

So what makes a good owner? This is a key question for institutional shareholders from around the world. It has been raised in the United States, where many institutions have long been exhorted to vote by the logic behind the Employee Retirement Income Security Act requirement: that shareholder voting rights are an asset and must be used to the fullest extent possible to the beneficiaries’ best interests. In recent months, this duty to vote has effectively been expanded by the requirement for mutual funds to disclose voting records. There was a suspicion that voting by such funds was half-hearted, or indeed was influenced by conflicts of interest, so the light of transparency was shone onto them to ensure that votes are cast, and are only cast in investors’ best interests.

Beyond the vote

But good ownership goes beyond merely exercising voting rights, important though this is. This is the clear conclusion of work in the United Kingdom in recent years. First, “Institutional Investment in the United Kingdom: A Review”, a publication almost universally known as the Myners Report after its author, Paul Myners, identified the need for good long-term shareowners to intervene at underperforming companies and engage with their boards to improve them and enhance returns. Then, the Institutional Shareholders’ Committee (ISC) – an umbrella grouping for UK institutional investors, bringing together the Investment Management Association, the Association of British Insurers, the National Association of Pension Funds and the Association of Investment Trust Companies – produced a document in response, entitled “The Responsibilities of Institutional Shareholders and Agents – Statement of Principles”. This was a statement of intent from the industry as a whole to rise to the challenge set by the Myners Report (and intended to avert a government threat of legislation to enforce compliance).

The ISC Code was explicitly incorporated into the revised version of the UK’s Combined Code of Corporate Governance, published in mid-2003. This lays out for the first time an agreed framework of what institutional investors are expected to do in order to be good owners of UK companies. Institutions which are not prepared to play their part can expect to be excluded from the evolving debate on corporate governance, and from debates on the development of individual companies.

It is instructive to consider how the Combined Code of Corporate Governance came to consider guidelines for good institutional shareowners in more depth. The debate over the publication of the Higgs Review of the Role and Effectiveness of Non-executive Directors largely centred on the lack of confidence which many company directors had in the ability and willingness of institutional investors to engage properly in their half of the ‘comply or explain’ bargain. Each company is unique and may have good reasons for not fully complying with all the detailed guidelines of the new combined code, instead providing an explanation of such non-compliance in its annual report. However, there is no point in companies doing so if institutional investors are not prepared to invest the time and resources – and the professional staff – in understanding the individual circumstances of each company, and determining whether the structures in place in this context are appropriate and sufficient to give the institution confidence in the future of the company.

The guidelines set out for institutional investors are thus a form of quid pro quo for the additional expectations of corporate boards. They acknowledge that both sides of the corporate governance debate must apply intelligence and thought for the structure to work, and to provide the best possible context for companies to create long-term value for their shareholders. Those company directors who raised concerns about these issues in the context of the Higgs Review consultation may be expected to ensure that their own companies’ pension funds fulfil their half of this bargain in full.

The developments in the United States and particularly the United Kingdom have been reflected by events elsewhere, including progress towards change at an EU level and the introduction of specific country codes of corporate governance such as the recent Tabaksblatt Code in the Netherlands. There have also been initiatives such as the Malaysian government’s creation of the Minority Shareholders Watchdog Group – comprising three leading domestic pension funds – to ensure that there is independent outside oversight of local companies, with the expectation that this will ensure better long-term performance of individual companies and the economy as a whole.

What good ownership means

The growing understanding that good companies need good owners, and that good ownership includes voting but extends well beyond it, has its clearest expression on the international stage in a document produced by the International Corporate Governance Network (ICGN), its Statement on Institutional Shareholder Responsibilities. The document makes the following statement:

“Improving the corporate governance of companies is increasingly understood as an important means of enhancing the long-term value of equity investments. As a result, many institutional shareholders, along with the ICGN itself, have taken steps to outline best practices for the governance of such companies. However, institutional shareholders as a class have an equal responsibility to address their own roles as fiduciaries and owners of equity on behalf of savers.”

The ICGN lists actions which may be appropriate ways of giving effect to ownership responsibilities, depending on the specific circumstances of the investee company. These are as follows:

•  voting;

•  supporting the company in respect of good governance;

•  maintaining constructive communication with the board on governance policies and practices in general;

•  incorporating corporate governance analysis in the investment process;

•  stimulating independent buy-side research;

•  expressing specific concerns to the board, either directly or at a shareholders’ meeting;

•  making a public statement;

•  submitting proposals for the agenda of a shareholders’ meeting;

•  submitting one or more nominees for election to the board, as appropriate;

•  convening a shareholders’ meeting;

•  teaming up with other investors and local investment associations, either in general or in specific cases;

•  taking legal actions, such as legal investigations and class actions;

•  outsourcing any or all of these powers to specialised agents, for instance where the institutional shareholder concludes that it does not have the ability to muster necessary skills in-house;

•  lobbying governmental bodies and other authoritative organisations; and

•  making appropriate statements concerning public policies affecting shareholder rights and corporate governance.

The statement says:

“Institutions risk failing to meet their responsibilities as fiduciaries if they disregard serious corporate governance concerns that may affect the long-term value of their investment. They should follow up on these concerns and assume their responsibility to deal with them properly.”

This is not an end in itself, according to the ICGN. Rather:

“The ICGN believes that if institutional shareholders take their responsibilities seriously then this can contribute significantly to the creation of an environment suited for solid long-term investment. Therefore, all institutional shareholders are encouraged to establish an action plan working towards full implementation of the statement’s recommendations as soon as possible.”

Why good owners matter

This is not a moral crusade. The ICGN is not an organisation driven to promote good corporate governance for its own sake. Corporate governance is worth pursuing because it adds value to companies over the long term. As such, it not only fits with the fiduciary responsibilities of pension fund trustees and their agents (and other investment institutions), it is also something which they have a duty to pursue in order to preserve and enhance the economic wellbeing of their beneficiaries.

While there are numerous examples where value has been lost through poor corporate governance – Enron, Parmalat, Tyco, Barings, WorldCom, Maxwell, Adelphia and so on – there is also increasing evidence of the value which good governance can add. Hermes recently compiled a document pulling together all these pieces of research, entitled “The Value of Corporate Governance”. This survey of the growing body of research suggests that the best evidence in this regard comes not from studies which examine board structures in a mechanical way, but rather from those studies which consider ‘focus lists’ and the like – processes through which investment institutions focus their involvement on what they perceive as problem companies and seek to initiate change at them. This tends to support the contention of many of those concerned about the Higgs Report that box-ticking, compliance-based governance (the cheapest and easiest form for investment institutions to carry out) adds no value, and that only close involvement of professional and experienced staff in a labour-intensive way actually improves governance in any practical sense, thereby creating better companies in the long run and ultimately improving investment returns.

And some studies are beginning to suggest that different sorts of shareholders can have a dramatic impact on the performance of investee companies, not only in terms of share price, which might be expected, but also in terms of underlying corporate performance. This effect is seen not only where traditional institutional ownership is compared with new highly short-term investors such as hedge funds, but even between different members of the traditional institutional investment community. The first such study is “Institutional Investors and Firm Innovation: A Test of Competing Hypotheses”, by Kochhar and Parthiban, published in the Strategic Management Journal in 1996. This study created the concepts of ‘pressure-sensitive’ institutions (largely, insurers and banks) and ‘pressure-resistant’ institutions (largely, public pension funds). It examined the differential impacts on companies of having a preponderance of one or the other sort of institutions among their shareholder bases. The study found that companies with more pressure-resistant institutional investors tend to be more innovative than those with more pressure-sensitive ones, and therefore perform better in the long term.

A second such study, “Entrepreneurship in Medium-Size Companies: Exploring the Effects of Ownership and Governance Systems”, by Zahra, Neubaum and Huse, was published in the Journal of Management in 2000. This largely replicates the results of the first study. It again discusses the differential impact of having different shareholder bases, finding that companies whose shareholder base is predominantly pressure-resistant outperform those with predominantly pressure-sensitive investors.

One further study identifies a difference between the effects of pension fund ownership and ownership by investment funds. “Institutional Ownership Differences and International Diversification: The Effects of Boards of Directors and Technological Opportunity”, by Tihanyi, Johnson, Hoskisson and Hitt, was published in the Academy of Management Journal in 2003. It finds that where pension fund investors predominate over investment fund shareholders, the long-term attitudes of pension funds as shareholders allow innovative research and development (R&D) companies the time to make investments and expand overseas, so that they can then fully exploit the value created by their R&D investments for the long term. Without the scale afforded by this international expansion, many of these firms could not be profitable in the long run, the study finds.

Rising to the challenge

So what does this mean for investment institutions? And what does it mean for the companies they invest in?

The second question is perhaps the easier to answer. Simply put, good companies have nothing to fear from the governance debate and everything to gain from having stable long-term owners. As institutions increasingly target their limited resources at those companies where engagement and good ownership can add value, companies which are operating effectively and performing sustainably well for their investors are likely to be supported and allowed to continue ploughing their successful furrows. If they need the outside perspective of an interested long-term owner, they should expect to have individuals whom they can contact, and institutions may seek the occasional clarification about structures or explanations of non-compliance; but otherwise such companies can expect to be left to perform.

However, companies which are not performing well, and which fail to communicate effectively the reasons for that underperformance and to articulate a practical strategy for reversing it, should expect institutional investors to pay close attention and seek meetings with board members on a more frequent basis than usual.

Institutions have a duty to their beneficiaries to protect the value of their investment, and as good fiduciaries must expend necessary time and resources in order to do all they can to do so. If they do not believe it will be cost effective for them to carry through the necessary engagement with companies themselves, they need to seek other ways in which they can do so, such as outsourcing the work to a service provider. And this goes beyond voting, important though this is: it extends to engaging more actively with companies where this will preserve or enhance value for beneficiaries. Studies suggest that this will often be the case, as more involved and active owners lead to better and more successful companies.

This is a daunting task, and a major step up for all institutional investors. But those who railed at Higgs were right: corporate governance is not a one-sided activity. It is time for the other side of the bargain – the investment institutions – to begin to play their part in ensuring that economic value is created and preserved in the companies in which they invest their beneficiaries’ money.