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Sarah Jane Leake | Bloomberg Law Institutional investors represent an increasingly significant voice and these days hold the majority of shares in quoted companies. The Organisation for Economic Co-operation and Development (OECD) has reported that in 2009, for example, institutional investors in OECD-member jurisdictions1 managed approximately $52 trillion in assets, including some $22 trillion in equity.2 As institutional shareholders, they have a responsibility towards ensuring that the companies in which they invest have sound financial reporting and good corporate governance policies, practices, and procedures. The OECD Principles of Corporate Governance (Principles), first published in 1999, are widely used as a benchmark for achieving good corporate governance by OECD and non-OECD countries alike. In 2004, when the Principles were last revised, it was anticipated that institutional investors, as sophisticated, well-resourced shareholders, would make informed use of their rights and promote good governance in the companies in which they invest. Institutional shareholders, however, are not like ordinary shareholders; they have a very different and unique set of costs, benefits, and objectives. As such, they have "not always behaved as desired."3
The OECD PrinciplesThe OECD has explicitly addressed the issue of shareholder rights in the context of institutional investment through two particular principles. These recommend that institutional investors should: Disclose their overall corporate governance and voting policies with regard to their investments, including the nature of any procedures in place to decide on the use of their voting rights;4 and Be allowed to consult with each other, as well as ordinary shareholders, on issues concerning their basic shareholder rights, subject to exceptions to prevent abuse.5 Institutional investors across the globe are subject to varying degrees of regulation. Over the years, a number of jurisdictions, including the UK, have introduced professional codes of conduct designed to heighten standards. While many of these codes incorporate the OECD Principles, levels of compliance remain unknown. The OECD, however, has recently expressed concern that implementation of the Principles is "not robust" in many countries.6
The UK Stewardship CodeIn the UK, institutional investors' activities and responsibilities are governed by the Financial Reporting Council's (FRC) Stewardship Code, which came into force in 2010.7 The Code seeks to set standards of stewardship to which institutional investors should aspire and endeavours to encourage more effective engagement between investors and the boards of the companies in which they invest. Much like the Corporate Governance Code for listed companies, the Stewardship Code operates on a "comply or explain" basis. Firms regulated by the Financial Services Authority (FSA) are required, under the FSA's Conduct of Business Rules (COBS), to disclose the nature of their commitment to the Stewardship Code, and, where they do not commit to the Code, their alternative investment strategy (COBS 2.2.3R).8 In brief, the Stewardship Code sets out seven principles of best practice, which incorporate the OECD Principles referred to above. Specifically, it provides that institutional investors should: Publicly disclose their policy on how they will discharge their stewardship responsibilities; Monitor their investee companies; Act collectively, where appropriate, with other investors; and Have in place a clear policy on voting and the disclosure of voting policy.
VotingVoting is perhaps the most obvious form of engagement. It "is not an end in itself: it should actually be viewed as a form of stewardship which prompts engagement rather than a form of engagement itself."9 In most jurisdictions, institutional investors are under no obligation to vote. A few, such as Israel, however, require fund managers, pension funds, and insurance companies to vote if the resolution in question is likely to negatively affect the beneficial owners. Furthermore, an increasing number of jurisdictions, including the U.S., Australia, India, and Spain, are now requiring institutional investors to disclose how they have voted. While in the UK, the FRC has the authority to require an institutional investor to disclose how they have voted, this power has not to date been used as the FRC still places heavy reliance on the "comply or explain" doctrine. Despite the introduction of the Shareholder Rights Directive10 in 2009, which sought to facilitate cross-border voting, the average turnout across Europe is currently in the region of 62 percent.11 The lower voting presence of institutional investors across the EU is mainly caused by the difficulties associated with cross-border voting. Due to the long chain of intermediaries through which voting instructions must pass, the end investor ends up having little, if any, time left to vote. Moreover, the lack of certainty that their cross-border voting instructions are actually carried out at meetings, combined with the small stakes that they hold in foreign companies, produces some degree of apathy that inclines institutional investors against voting. In contrast, the U.S. has an estimated average turnout of 81 percent,12 despite having a similarly dispersed ownership and large foreign shareholding. The OECD puts forward two reasons for this: (1) brokers are allowed to vote "non-instructed" shares under their street name; and (2) the Employee Retirement Income Security Act of 1974, under which many institutional investors, particularly pension funds and mutual funds, consider it mandatory to vote. Surprisingly, there have been low levels of dissent across the globe, both at general and special shareholder meetings. The average dissent level in 2010 in OECD-member jurisdictions was only 3.5 percent over 16,000 resolutions, with a maximum of 6.2 percent in Israel. Dissenting levels in Europe are just above average at 3.7 percent.13 To the OECD, however, this could be caused by low levels of voting, as turnout levels "can be just as good an indicator of institutional engagement as the degree of 'dissent' expressed on resolutions."14 The OECD reports that many member countries have removed provisions that automatically allow custodian institutions to cast the votes of shareholders. Germany goes one step further, requiring custodian institutions to provide shareholders with information regarding their options in the use of their voting rights. In the U.S., the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, amending the Securities Exchange Act of 1934, requires the rules of each national securities exchange to be amended to disallow brokers from voting uninstructed shares on the election of directors, executive compensation, or any other issue determined material by the Securities and Exchange Commission. To the OECD, one of the biggest challenges to effective engagement is the fact that domestic investors do not vote their foreign equity. This is important as foreign investors comprise approximately 30 percent of ownership in many jurisdictions. Evidence shows that there is a lack of knowledge by institutional investors about foreign companies in their portfolios. While a practical solution to resolve this issue could be the use of proxy advisors, this would raise other concerns as the proxy voting industry is already considered too influential.
Co-operationWhile it is difficult to document the degree of co-operation between shareholders, the OECD reports that co-operation by institutional investors is generally "quite advanced."15 Private associations of pension funds, especially in the Netherlands, Chile, Switzerland, and the UK, have proven effective in spreading the costs of monitoring by developing guides and background research (e.g., Ethos in Switzerland). Public pension funds in the U.S. (e.g., Investor Responsibility Research Center Institute) and in the UK (the Institutional Shareholders Council) have similar arrangements and can, on request, execute proxy votes for their members. While co-operation between fund managers and mutual funds is less popular, some fund managers, such as Hermes, are particularly active in this field. Co-operation is primarily facilitated across the globe by the United Nations' PRI Engagement Clearinghouse, which provides signatories with a forum in which to share information about engagement activities they are conducting, or would like to conduct. From July 2009 to July 2010, some 223 signatories were involved in collaborative engagements promoted through this platform. Although this number is still small, progress, albeit slow, is being made.16 In many jurisdictions, shareholders are cautious about collective engagement, fearing that it may violate concert party regulations. While Principle II.G seeks to encourage institutional investors to consult with each other, and with ordinary shareholders, this is firmly "subject to exceptions to prevent market abuse." According to the OECD, there is significant uncertainty, especially in Germany and Austria, as to where to draw the line. In Germany, for example, investors are prohibited from discussing any strategy that is not considered to legally fall within their competence. This, in effect, limits investor co-operation. The UK has sought to establish greater clarity as to when acting in co-operation can be seen as acting in concert and can trigger key takeover rules. The main issue here is whether the shareholders in question are attempting to "obtain or consolidate control . . . of a company or to frustrate the successful outcome of an offer for a company."17 In the UK, discussing business strategy would not constitute acting in concert, unlike in Germany. In contrast, shareholders in the U.S., which does not have takeover legislation, are generally at greater liberty to consult with each other in a more meaningful fashion, and to exercise their rights of share ownership. In the OECD's view, "a lot might be gained by pursuing a more relaxed approach to acting in concert."18
The Stewardship Code: A Satisfactory Compromise?Institutional investors are clearly well-positioned to play an important role in improving corporate governance within the institutions in which they invest. Regulation in many jurisdictions, however, does not sufficiently facilitate effective engagement. While the Stewardship Code has enhanced the quality of company-investor dialogue in the UK to some degree, the OECD is concerned that its self-regulatory "comply or explain" nature is inadvertently restrictive in practice. It reports concerns that the Code is "an unsatisfactory compromise between institutions with disparate conceptions of, and commitment to, stewardship."19 In its view, the FRC needs to strengthen its commitment to minimising conflicts of interest, and clearly set out its policy regarding proxy advisors and investment consultants, increased intermediation, and investment management practices that encourage excessive trading in the pursuit of short-term profit. In view of the criticisms levelled its way by the OECD's latest report, particularly in comparison to the Chilean regime,20 it is hoped that the FRC will, in its revision of the Stewardship Code later this year, facilitate more meaningful, and transparent, engagement in practice, not only in theory. -------------------------------------------------------------------------------- 1 These are: Australia, Austria, Belgium, Canada, Chile, the Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Israel, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, New Zealand, Norway, Poland, Portugal, the Slovak Republic, Slovenia, Spain, Sweden, Switzerland, Turkey, the UK, and the U.S. 2 The Role of Institutional Investors in Promoting Good Corporate Governance – OECD Report, Dec. 2011 (Report) at 20. 3 Id. at 9. 4 Principle II.F.1. 5 Principle II.G. 6 Supra note 2 at 13. 7 The Stewardship Code developed out of the Institutional Shareholders' Committee's Code on the Responsibilities of Institutional Investors, pursuant to the Recommendations made by Sir David Walker in November 2009. 8 Venture capital firms that manage investments for professional clients are exempt from this requirement. 9 Supra note 2 at 52. 10 Directive 2007/36/EC. 11 Supra note 2 at 55. 12 Id. at 56. 13 Id. at 57. 14 Supra note 12. 15 Id. at 38. 16 In the same period, signatories posted 85 new proposals, representing an approximate increase of approximately 8 percent from the previous year. 17 See Rule C of the City Code on Takeovers and Mergers. 18 Supra note 2 at 39. 19 S. Wong, cited in the Report at 37. 20 The OECD reports that "a specific feature of Chilean capital markets is the existence of well-developed institutional investors." See the Report at 90. DisclaimerThis document and any discussions set forth herein are for informational purposes only, and should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Review or use of the document and any discussions does not create an attorney-client relationship with the author or publisher. To the extent that this document may contain suggested provisions, they will require modification to suit a particular transaction, jurisdiction or situation. Please consult with an attorney with the appropriate level of experience if you have any questions. Any tax information contained in the document or discussions is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. Any opinions expressed are those of the author. The Bureau of National Affairs, Inc. and its affiliated entities do not take responsibility for the content in this document or discussions and do not make any representation or warranty as to their completeness or accuracy.©2014 The Bureau of National Affairs, Inc. All rights reserved. Bloomberg Law Reports ® is a registered trademark and service mark of The Bureau of National Affairs, Inc.
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