As we approach the 10-year anniversary of the UK’s Stewardship Code, Dr Dionysia Katelouzou, Lecturer in Law at King’s College London, asks whether institutional shareholders are part of the problem or part of the solution towards more sustainable companies.
Shareholder engagement is key to good corporate governance as it enhances a company’s accountability and performance. The focus of shareholder engagement expectations and requirements used to be on the responsibility of companies to maintain an appropriate level of disclosure and to ensure that channels of communication were available to shareholders wishing to engage with the company. Following the global financial crisis of 2007 and 2008, there has been an increasing recognition that it takes both parties to the dialogue to ensure that there is genuine engagement and focus on long-term rather than short-term corporate performance. Along with other regulatory reforms to prevent future financial crises over the last decade, we have seen an increased push from regulators globally to ensure that shareholders, in particular institutional investors, adhere to basic principles of stewardship and responsible ownership.
This trend started with the publication of the UK’s Stewardship Code in 2010. The code, which was revised in 2012, introduces seven soft law principles for UK-based institutions and asset managers aimed at improving their relationships with investee companies whilst largely adhering to shareholders’ interests. The code applies to asset owners and asset managers (and by extension to service providers) on a comply-or-explain basis. Institutions can choose whether or not to sign up to the code and, if they do, they should state publicly whether they comply or else explain why they deviate from the code’s principles. Even though the code does not constitute an obligation for institutional investors to micromanage corporate affairs, it emphasises for example that stewardship is more than just voting at the Annual General Meeting (AGM), and ideally institutional shareholders should be monitoring and engaging with companies on matters such as strategy, performance, risk, capital structure and corporate governance through a ‘purposeful dialogue’ which can be escalated where necessary.
Since 2010, the concepts of stewardship and responsible ownership have gained ground around the world. We have seen stewardship codes published in a number of different jurisdictions, including: Australia, Italy, Japan, Hong Kong, Kenya, Malaysia, the Netherlands, Switzerland, Singapore, South Africa and Taiwan. More recently, with the publication of the amended EU Shareholder Rights Directive in 2017, the trend seems to be entering a new phase where the soft law approach may be replaced by semi-mandatory requirements.
Should all investors have a stewardship role?
One of the key issues in shareholder stewardship is the question of to whom these new code principles are supposed to apply. While in theory all shareholders, irrespective of the size of their shareholdings, have a role in the accountability chain of command – directors hold managers accountable and shareholders hold the board accountable for the fulfillment of its responsibilities – it is generally only institutional investors who have the scale and the resources to engage with investee companies beyond attending the AGM.
This issue was debated in Hong Kong when its stewardship code – Principles of Responsible Ownership – was released by the Securities and Futures Commission (SFC) for consultation in 2015. The SFC intended the code to apply to all shareholders, but submissions during the consultation process argued that most of the principles are only really relevant to institutional investors. For example, the concept of reporting to stakeholders on how they have discharged their ownership responsibilities, or the need to manage conflicts of interests when investing on behalf of clients, would not be useful to small individual or retail shareholders.
As a result of the consultation, the SFC abandoned the attempt to have the principles apply to all shareholders. Nevertheless, it has retained some elements which are targeted at non-institutional shareholders, in particular the need to take responsibility for how the shares are voted. ‘Ownership of shares brings with it important responsibilities, particularly the right to speak and vote on matters that can influence the way in which a business is conducted. Owners of company equity should not blindly delegate these responsibilities. Even when they employ agents, directly or indirectly, to act on their behalf, owners should ensure that their ownership responsibilities are appropriately discharged by those agents,’ the principles state.
At the same time, it is important to note that the spread of electronic voting platforms over the last decade has made it easier for all investors, including non-institutional investors, to vote at AGMs and thereby engage with investee companies, especially when shares are held through complex chains of intermediaries at a cross-border level. More recently, the emergence of blockchain and smart contracting technology can further facilitate remote voting and restructure old-fashioned AGMs. Whether electronic or blockchain shareholder voting will be sufficiently picked up by all investors and catalyse responsible ownership remains to be seen.
The corporate governance role of institutional shareholders
As discussed above, most stewardship codes around the world are specifically targeted at institutional investors. This is not only because they have the resources to engage with investee companies, it is also because they represent a hefty and growing slice of the market. In the UK, the proportion of equity held by institutional investors has been rising in recent decades (see Figure 1: Increasing institutionalisation of UK public equity).
This pattern is also visible in other markets globally – institutional investors have become significant global equity owners (see Figure 2: Financial assets of institutional investors 1995–2014 as a percentage of GDP). The big question, however, remains: are institutional shareholders part of the problem or part of the solution towards more sustainable companies?
In some ways, institutional shareholders would seem to be part of the solution. Two major challenges for capital markets around the world are the effects of short-termism and shareholder passivity. Institutional investors would appear to mitigate both of these risks. Pension funds, for example, tend to hold equity for the long term, and institutional investors generally, including activist hedge funds and similarly active asset managers, have been at the forefront of engagement activities globally.
On the other hand, institutional investors may have interests that differ materially from those of other shareholders and stakeholders. For instance, it is still highly debatable whether activist hedge funds can act like real owners and hold directors and managers to account, or whether they serve a self-interested, short-term agenda at the expense of other long-term shareholders and stakeholders.
While the existing evidence in relation to the role that institutional shareholders can play in the corporate governance of publicly listed firms remains largely inconclusive, it is clear that the public trust in institutional investors and public companies more generally cannot be restored in the 21st century unless the dysfunctionality of institutional shareholders’ accountability is addressed. Ultimately, this is what shareholder stewardship aims for.
Are stewardship codes effective?
While the intention of stewardship codes around the world – namely to promote a purposeful dialogue between investees and with investee companies – is certainly laudable, do they actually make much difference?
Hong Kong’s Principles of Responsible Ownership, like most stewardship codes, is voluntary and non-binding. The code sets out basic principles for responsible ownership in Hong Kong – for example, investors should monitor and engage with their investee companies, they should have clear policies on voting and they should report to their stakeholders on how they have discharged their ownership responsibilities.
The vulnerability with this voluntary model is that the code can be safely ignored. Even where comply-or-explain elements are added to a stewardship code, there arises the question of who is going to monitor compliance? The local regulator is unlikely to have jurisdiction over the majority of institutional investors since they are usually multinational institutions. In the UK, for example, more than 50% of the institutional equity stake is held by overseas institutions.
Is there any evidence that the slew of stewardship codes around the world is having an effect? As we approach the 10-year anniversary of the UK’s Stewardship Code, is there any evidence that these codes have actually changed the behaviour of institutional investors? Is there any evidence of higher voting levels or higher transparency among institutional investors? Are institutional investors more willing to disclose their voting activity, their management of conflicts of interest, or how they have escalated their activities? Are they more ready to act collectively with other investors where appropriate?
Given the limitation of voluntary stewardship codes, will we see a trend towards a hardening of the soft law of stewardship? The EU’s new stewardship regime – the Amended Shareholder Rights Directive (SRD) 2017 – has taken a step in that direction. Arguably, the SRD reflects a broader public interest in making institutional shareholders accountable to a wider range of corporate constituents in the exercise of their engagement powers, and is not far short of imposing a duty on institutional investors and asset managers to demonstrate engagement. The SRD can therefore be viewed as the beginning of the hardening of shareholder responsibilities and obligations, and in time, duties.
Dr Dionysia Katelouzou
Lecturer in Law
King’s College London