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Newsroom & speeches
21 April 2009
1. Good morning. I’d like to begin by thanking Daniel (Godfrey) and Carol (Ferguson) for the kind invitation to speak to you today – it’s a pleasure to be here and seeing such a large audience is testament to the strength of the industry.
2. As many of you will know, I previously had the honour of chairing theAITC and it is good to see many familiar faces here.
3. I would like to use this opportunity to say a few words on the subject of governance.
4. It won’t surprise you to hear that the AIC’s mission – to “work with members to add value for shareholders over the longer term” – is a cause that I strongly support.
5. I’d like to share some thoughts on how investment companies, and in particular their boards, can go further in achieving that objective.
6. Investment companies are in many ways unique in capital markets.
7. One of the features is the double layer of governance: investment company boards must ensure not only that they govern their company in the interests of investors, but also that their managers engage appropriately and exert proper discipline on investee companies.
8. This characteristic of Investment Companies makes it doubly important that they must be proponents of good governance. It also makes the job of an investment company director a very challenging one.
9. In preparing these words, I took a fresh look at the AIC’s Code of Corporate Governance.
10. I think the Code deserves to continue to be applauded. The Government challenges industry to come up with solutions and, in producing the code, the AIC has risen to the challenge admirably. And I know you have the support and endorsement of the FRC, as guardians of the Combined Code.
11. At the heart of an Investment Company are its directors, and it is their collective ability that will drive the failure or success of the company.
12. UK Investment Companies benefit from the wisdom and experience of hundreds of excellent investment company directors, and much of that talent can be found in this room today.
13. But, with the increasing complexity of some investment companies’ investment strategies, it is critical that boards have a full and proper understanding of what is being pursued by companies they represent.
14. It falls to Board members to ask searching questions about the business model of the company on whose Board they sit. Board members should at times play the role of “devil’s advocate”, questioning and testing, with some persistence, the core assumptions on which their company’s purpose rests.
15. It’s clear from the events of the past 18 months that our banks could well have done with more challenge of this kind from their board members.
To fulfil their duties effectively, directors must be able to dedicate sufficient time and focus to their role.
16. This time commitment debate is also being had in the context of the boards of our major financial institutions.
17. I’m sure you’ll be aware that the government has commissioned Sir David Walker to conduct a review of bank governance. His review will address fundamental questions about the operation and effectiveness of the boards of our major banks.
18. I am keen that Sir David should consider, amongst other things, whether there is a case for Non-Executive Directors to have dedicated support and resources to help them carry out their responsibilities and commission reports independent of management. I feel there is, for example, potentially scope for expanding, in this respect, the role of the company secretary. Investment companies have a particular interest in this respect, with both investment management and secretariat functions often contracted out. They must ask themselves- are they really making enough use of the secretariat function?
19. I also hope Sir David will look at how much time non-executive directors should be expected to spend performing their role and the right approach to compensating the value provided by independent directors. As far as I am aware, no one has really focused on building a zero base case for setting independent director fees, vis a vis the compensation of executive directors, or external advisers and consultants. In my experience, a very good independent director represents extraordinarily good value, especially for a FTSE 100 firm. Fees paid may seem high by comparison to, say, the national average salary, but can represent very good value when compared to the fees of consultants and investment banks. But there is more critical discussion to be had on the performance expectations we place on independent directors versus their reward.
20. And I’m pleased to be able to announce this morning that we are extending Sir David’s terms of reference so that the Review can also identify where its recommendations are applicable to other financial institutions.
21. I think this extension is an important step: the financial crisis provides lessons which we must be willing to apply wherever appropriate to help ensure that the mistakes of the past cannot be repeated.
22. Turning to the specifics of investment companies. Their boards should be clear over the division of responsibility between the board and the managers. Boards should define and fulfil their own responsibilities and enforce those they allocate to managers.
23. This clarity of role and the balance between delegation and accountability should be spelt out clearly to owners, investors and advisers.
24. It has been said before that ineffective boards – those that fail in their responsibilities – are those that allow themselves to be treated like mushrooms – being fed occasionally, but for the most part being kept in the dark.
25. To avoid becoming mushrooms, boards should be in control of setting the agenda for board meetings and AGMs – and they should drive the annual reporting process and lead on investor engagement. The board must demand from management the information it needs to do its job, rather than allowing itself to be spoon-fed from standard templates produced by the manager. Boards should, for instance, have an annual programme to cover important matters. They probably need to spend more time without their contracted manager present and ensure that they regularly access other sources of insight: broker analysts; specialist media; other managers.
26. A director’s critical responsibility is to ensure that the manager is providing a good service to investors at a good price. Day to day, directors can do this through oversight and challenge of the manager, but they should always keep in mind the option of replacing the manager if necessary and an idea of the circumstances under which this would be in investors’ interests and when such a decision-making process might be triggered.
27. A zero based approach would also regularly consider the option of internalising management or putting the contract out to tender. Maintaining maximum freedom to take decisions and action should be a critical feature of any management agreement that is signed.
28. One feature of management agreements that I have been critical of in this respect, although one that has been addressed recently by directors, is overly long notice periods for managers that are not in the interest of owners.
29. The incentives for the manager must be aligned with the interest of investors. I know that some are concerned, for example, about the potential for conflicts of interest where managers are paid on the basis of gross assets but still maintain some control over leverage or valuation. As a result some companies have already moved to alternative fee calculations based on market capitalisation.
30. I see merit in such an approach and would certainly encourage boards to ensure that they address the question of whether their company’s current approach to fee calculation is optimal or beset with the risk of unintended, or perceived, deficiencies.
31. Setting an appropriate benchmark is another key responsibility of board members. In a falling market, managers can lose money and still beat their benchmarks.
32. This can of course represent genuine out-performance and skill, which delivers value to investors over the longer term. But equally boards might wish to consider whether a relative rather than absolute benchmark is in fact necessarily consistent with the interests of shareholders.
33. A critical area that has been exposed by the financial crisis is the need for more committed and effective shareholder engagement. Boards of investment companies need to ask their manager to account for how they exert proper challenge and discipline on investee companies; and boards should, in turn, account in a similar manner to their shareholders. Over the weekend I looked at a number of investment company annual reports and found little explanation of how boards of investment companies discharge this important governance function.
I imagine that a high proportion of the investment companies represented here today lost material sums as a consequence of investment in banks. How many boards have asked their managers to account for how they exercised surveillance or how they voted their shares on critical matters such as acquisitions, or remuneration?
34. Encouraging shareholder engagement has long been a priority for this government and for me personally. The AIC’s code already assigns responsibilities to boards in this respect and that deserves recognition.
35. But I want to see investment company boards putting an even greater emphasis on ensuring managers are doing this job properly. And I would welcome the AIC giving consideration to whether the role of boards in this area in the AIC Code can be further strengthened.
36. Indeed there is a real opportunity for investment companies to emphasise the real value that the investment company model has over other investment product models as a consequence of the constitutional presence, via non-executive directors, of independent oversight of managers and management on behalf of shareholders.
37. I feel our governance codes need to accord shareholder engagement a higher priority and I’m sure Sir Christopher Hogg and his team at the FRC will be thinking about the subject. The Combined Code deals with the issue of institutional investors in only one and a half pages in a document of forty pages; therefore, we need to ask- do we have the right balance between the focus on board responsibilities and the focus on investor responsibilities?
38. I want to encourage responsible and engaged shareholders, not shareholders that act like absentee landlords. I want to address the risk of inadequate engagement leading to weakened accountability.
39. Shareholders need to think about how they engage with companies, with whom, and for what purpose. In this context they should probably separate out information-gathering, to enhance investment decision-making, which is essentially a one way process, from their role in ownership engagement which requires active dialogue, including with NEDs.
40. Another area where shareholders need to revisit their engagement is on remuneration, where the focus has tended to be on the remuneration of plc directors rather than the company's overall remuneration culture and the behaviours it seeks to encourage through remuneration. More engagement along these deeper lines might have lead to earlier questioning about the increasingly wide gap that has developed between rewards of most senior directors in our plcs and those of the rest of the company.
41. I am hoping Sir David Walker will also ask questions about the Remuneration Report to shareholders - should it continue to be advisory, or should it have some mandatory element? Should benefit consultants be solely accountable to the board, or perhaps have a duty to report to shareholders against a template agreed by shareholders that would identify critical scheme features, potential risks and provide an assessment of economic utility.
42. For shareholders there is an obvious self-interest in good corporate governance: it contributes to better company performance by helping a board discharge its duties in the best interests of shareholders, delivering better shareholder value over the longer term.
43. Whenever I raise this issue investors tell me that they agree and that they would like to do more, but that they only own a small percentage of the equity and are therefore relatively powerless.
44. This is an argument which is hard to dispute. But taken to its logical conclusion it would imply a major flaw in our PLC model – that firms where ownership is widely distributed cannot be accountable to their owners in an effective way. So I want to encourage a debate on how this issue can be addressed.
45. How can we help owners behave like owners, as assumed in classical economic literature? Many institutional investors have been nervous about addressing this question, possibly because they are uncomfortable with answers which strike at the heart of portfolio construction methods, the choice of performance benchmarks and the legal duties of professional managers. Some might even have some difficulty reconciling situations where Boards doing the right thing for the company in terms of creating long term sustainable value may come in to conflict with the immediate impact on the share price. Over the last few years, situations have arisen where companies that appear strong in operational terms are suffering from inappropriate capital structures “forced” on to them by the threat of private equity. In the period of easy credit, decisions often looked to be taken in the interest of the short-term share price, not in the interest of creating long-term value.
46. Coalitions of shareholders often have more influence than single organisations acting alone. Investors therefore need to think about what barriers there are to effective co-operation and what needs to de done to remove those barriers. Government is more than willing to hear constructive proposals on these matters.
47. I would have thought this is something the Institutional Shareholders' Committee (the ISC) should be thinking about. It is after all designed to be the forum which allows the UK’s institutional shareholding community [the Association of Investment Companies, the Association of British Insurers, the Investment Management Association and the National Association of Pension Funds] to exchange views and coordinate their activities in support of the interests of UK investors.
48. But some might say that it appears the ISC has sunk beneath the surface just when it is needed most. The body’s website shows that it has not published anything since June 2008. It appears to meet sporadically at best. It gives no public sign of being seized by the challenge of the moment.
49. Not a single stakeholder from either the institutional investor or corporate communities has once mentioned the ISC to me over the last six months. This leads me to conclude that those supporting the ISC, which, I repeat, includes the AIC, need to ask themselves serious questions about how it operates, including whether it can be taken seriously without its own secretariat and research capability. I have today asked the four members of the ISC to meet with me over the coming weeks to discuss these issues.
50. I think there is a particular role here for the AIC, in that it clearly represents investors and is pure in the sense that it speaks for investor interests alone. It may be poorer than some of the other bodies in terms of financial and other resource available to it, although it is phenomenal what Daniel, Carol and their team of 19 achieve. But the clarity and purity of purpose of the AIC as an investor voice, rather than product provider or manager, should make it a key intellectual force in getting the ISC to fulfil its role.
51. It will not have escaped your notice that I have spent most of this speech talking about the responsibilities I would like you – the directors and managers of investment companies – to fulfil. I have said little about the responsibilities of government.
52. Government bears a major responsibility for creating an environment in which well-run investment companies can flourish. And I believe that we have listened when you have told us that change is necessary.
53. A long-standing issue has been the relative tax inefficiency of bond investments for investment companies. So, in response to the AIC’s report on this issue, Budget 2008 announced the government’s intention to act.
54. We consulted in July 2008 on a framework to allow UK based investment companies to invest tax-efficiently in bonds and other interest producing assets and ensure that UK investors continue to choose their investments for commercial rather than tax reasons. I’m grateful for the engagement of the AIC and its members on this consultation.
55. Of course, I can't pre-empt Budget announcements, but the consultation document stated that, subject to the responses, the Government intends to include powers in the Finance Bill 2009 to legislate for the draft regulations and for these to take effect as soon as possible after the Bill is granted Royal Assent.
56. We will continue to listen to you and to take action where appropriate. I am keen to know what else you believe Government can reasonably be expected to do to promote an effective and efficient investment company sector.
57. I quite sincerely believe that if investment companies can meet major challenges of efficiency and effectiveness and continue to develop and improve its governance, the sector will continue to play a vital role in financial markets.
58. And there are currently a number of opportunities the sector can exploit – in a low inflation, low return environment, the cost advantage which some investment companies hold over their open ended equivalents becomes more telling.
59. The sector needs to identify and articulate what its unique selling point is for investors – I firmly believe a superior governance and oversight model is a competitive advantage that firms can exploit and which they have in the past not promoted with sufficient vigour.
60. And to the extent that investment company sales to retail have been held back by the difficulty of paying commission to intermediaries, the FSA’s proposals under the Retail Distribution Review should help level the playing field.
61. But these opportunities will only be fully exploited if boards maintain an unswerving focus on discharging their responsibilities to investors.
62. Let me finish by saying that one of the clearest lessons from the events in the global economy of the past 18 months is that robust systems of governance cannot be sidelined. The responsibility must be shared between boards, managers and investors.
63. Directors must have the resources and time to analyse proposals from management. And they must not act passively, but challenge actively, and evidence at all times the capacity for independent thought.
64. Managers must welcome the scrutiny of directors and keep boards appropriately informed. They must also communicate effectively with investors- a duty for both managers and directors
65. And as shareholders investment companies have a duty to engage with investee companies and to overcome obstacles that prevent their voices being heard.
66. The global financial crisis has shown the importance of good governance and created the will for change. The challenge for you now is to take the necessary action to make a lasting difference.
67. Thank you.
