Investment managers should be more active on behalf of their clients in corporate governance of banks and other financial companies, according to recommendations in a U.K. report released Thursday.
The report, commissioned by Alistair Darling, U.K. chancellor of the exchequer, also said boards should encourage rigorous challenge to directors' oversight of risk and executive compensation practices.
But engagement on corporate governance doesn't necessarily represent a better approach for major shareholders and investment managers for complying with the best practice principle against selling or other ownership strategies can be effective, when they have deep concerns about long-term corporate performance. the report said.
The 184-page report is the final version — modified to reflect concerns expressed by institutional investors and other financial industry commenters — of a 142-page draft that was released in July. Both contain 39 recommendations (www.pionline.com, July 16).
Sir David Walker, senior adviser at Morgan Stanley and author of the report, developed the recommendations to strengthen corporate governance oversight of banks and other financial institutions to mitigate chances of a recurring financial crisis.
The final report changed draft recommendations that called for fund managers and other major shareholders to conform to the principle of engaging “more productively” with companies in which they invest to encourage improvement in long-term performance, or explain why they are not in compliance.
Some “fund manager respondents were concerned at what was seen” in the July draft calling active engagement the superior or best practice for major shareholders and fund managers as against other ownership or trading strategies, the final report said. “It was widely felt that the emphasis should be on disclosure of the business model being used by a fund manager, with the principles or code for stewardship seen as best practice for those whose business model embraced active engagement.”
The draft generated some 180 submissions from institutional investors and other members of the financial community, commenting on the preliminary recommendations.
Lindsay Tomlinson, vice chairman of Barclays Global Investors Ltd., London, in a 24-page comment letter Oct. 1, objected to the draft recommendation calling for compliance with shareholder engagement.
“As fiduciary manager of segregated assets it is not for BGI to decide upon matters of shareholder engagement, but rather to reflect the wishes of our clients,” Mr. Tomlinson wrote. “As such, we find ourselves automatically out of compliance with (the draft recommendation) requirement that fund managers should confirm that investment manager mandates include support of shareholder engagement activity.”
The final report reflecting such concern said, while “there is need for better engagement between fund managers acting on behalf of their clients as beneficial owners, and the boards of investee companies … this does not exclude business models that involve greater emphasis on active trading of stocks rather than active engagement on the basis of ownership on a longer-term basis. But there should be clear disclosure of the fund manager's business model, so that the beneficial shareholder is able to make an informed choice when placing a fund management mandate.”
The importance of shareholders' responsibility as owners “has been inadequately acknowledged in the past” to the detriment of the entire financial system, the report said. The financial crisis underscored that shareholders “enjoy the privilege of limited liability whereas taxpayers have ended up assuming unlimited liability in respect of the big banks. Early preventive medicine through shareholder engagement can save everyone substantial time and money later on.”
At the board level, Mr. Walker recommended a fundamental change “to make the boardroom a more challenging environment than it has often been in the past.” Among the changes, outside directors should have “to devote sufficient time … to assess (corporate) risk and ask tough questions about strategy.”
In conclusion, the report said, “better corporate governance of banks (and other financial companies) cannot guarantee that there will be no repetition of the recent highly negative experience for the economy and society as a whole. But it will make a rerun of these events materially less likely. The challenge will be to find the right balance with, on the one hand, materially enhanced supervision and regulation to ensure safety and soundness but without, on the other hand, so cramping enterprise in major financial institutions that they fail adequately to meet the needs of the wider economy. The desirable balance is more likely to be found (encouraging) the greater the confidence of government and regulators that corporate governance in these institutions is set to become dependably more robust.”
The report proposes that most of the recommendations be included by the Financial Reporting Council, a U.K. regulatory authority, into the combined code of corporate governance, which sets out standard of good practices, or in a separate stewardship code for institutional investors, both operating on a basis of requiring compliance with the rules or explanation of lack of compliance. The move would be the first time the FRC developed a corporate governance code for shareholders.
The Financial Services Authority, another U.K. regulator, is expected to consider how to apply recommendations related to financial institutions. The report suggests its recommendations on compensation disclosure be enforced through legislation in a financial services bill.
