25 March 2010
ICGN Conference on Corporate Governance
Check against delivery
Good morning, I would like to thank Christy for her introduction and also the ICGN for the honour of being able to address this conference.
Those of you here today will know that I have been steadfast in my views on the importance of good governance, a subject on which I have focussed for close to twenty years.
Importance of governance
The recent past is littered with significant governance shortcomings.
These shortcomings have cost investors and savers dearly.
Irrespective of culpability, we all have a duty to rise to the challenge, because we all stand to gain from this.
I have been immensely encouraged by the steady improvements I have witnessed in corporate governance over the last two decades, including through the work of Sir David Walker.
But further changes and improvements are needed and I have to question the resistance to this in many quarters.
Is it born out of a fear of change? A belief that any changes to any part of the system leads them to question – much like the Argo – whether the system as a whole is still the same as the one they still hold on to?
And if this fear is preventing beneficial owners from taking the actions necessary to protect their ownership interests, I wonder who they expect to step in in loco parentis?
I find it difficult to comprehend why shareholders wouldn’t want to protect their own interests as much as possible, when recent events have shown the extent of the losses they can be exposed to if ownership is not performed effectively.
I approach these questions from the perspective of having been both an institutional investor and a corporate director, executive and a non-executive. My views are unashamedly pro-market.
They are also sincere and expressed with a genuine belief that reforms and improvements are essential if we are to secure the future health of the listed company sector, including banks, and, crucially, people’s faith in it.
Shortcomings of public company ownership
Having spent a great deal of my career studying and participating in the market, I have seen the best and the worst interpretations of public company ownership.
The benefits of this model are potentially massive - public markets unlock capital, create liquidity and provide access to resources that no other model of economic organisation could achieve.
But these are not being fully realised.
The value in us coming together today at ICGN is to ask why, and to seek to address the shortcomings we identify.
And the most profound shortcoming - which we and other developed economies with similar ownership models need to address, is one that Sir David observed and commented upon in his first class speech to you yesterday evening - the hidden cost of public ownership if it results in inadequate stewardship, and the consequential ‘ownerless corporation’.
This is not a recent epiphany - I first raised this issue publicly in 1996, in a report I was asked to produce for the DTI entitled ‘Developing a Winning Partnership’, at a time when Michael Heseltine was the Secretary of State.
And in the entire period since, I am yet to meet anyone who believes that the PLC model is functioning as well as it should.
Many fund managers privately express their frustration to me over what they see as a clear fault line in the governance landscape - the absence of engaged shareholder stewardship.
But while they say this privately, they publicly continue to argue that it is not feasible for them to enact change, because they only own a small percentage of the equity of the companies in which they invest; their clients do not demand ‘good governance’, and, moreover, would be unwilling to pay for it.
If we take this argument to its logical conclusion it implies a major flaw in our PLC model – that firms whose ownership is widely distributed, and held in diversified portfolios cannot be accountable to their owners in an effective way.
Let me be clear: the primary culpability for this state of affairs rests with the end investor – the pension fund, endowment or insurer – rather than the appointed investment manager. Investment management is, for the most part, a highly professional industry. Investment managers respond rationally to the incentives and goals expressed, both overtly and covertly, by their clients.
And these goals have been informed by a steady transformation of shareholders from ‘owners’ to ‘investors’ that has occurred over the last few decades, and an attenuation of ownership responsibilities.
And as much as many would prefer me to simply ignore this problem, I have to question why this is the case?
If you owned 100% of a company you would unequivocally be an owner and behave as such; not many self-employed business people make disinterested decisions.
But at lower percentages, the focus shifts to behaving as an investor.
From my experience, I am convinced that there is a real opportunity to add value through good governance – acting as an owner, in it for the long haul, and not an investor, looking to make a quick return in what too often is a zero sum game.
But the current approach to investment in listed equities vitiates the promotion of good governance. Investors are required to focus on relative, short-term price performance rather than absolute value performance. Little or no opportunity is provided to act in accordance with ‘the longer view’.
Clients judge fund manager performance relative to peers over short time horizons. Thus the easiest way of being ‘right’ is simply to avoid being ‘wrong’ and a herd mentality rules.
And these judgements are overly obsessed with ‘market prices’. Such prices are, by their nature, defined at a particular moment in time based on a particular, and often small, transaction at the end of trading at the close of the valuation date.
The result is portfolios with high diversification and low exhibited stock conviction, designed to limit tracking error (or the risk of seeing things differently from other investment managers. In this world, it is fine to be wrong, even to lose money, as long as you do so in the company of others). A lack of consideration for the long-term is evidenced in portfolios being churned for little evident benefit, erosion of return through non-value adding trades and holding underweight positions in securities judged to be over-valued.
Indeed, if a fund manager perceives there to be a problem in a sector or company, say of strategy or management, rather than engaging with the company on the issue, the fund manager may quite logically decide to take an underweight position in the stock, protecting performance against the perceived risk, while limiting to a known extent the consequence of possibly being wrong.
Importantly though, this approach provides no incentive for the manager to work to address the underlying problem. Perversely, the fund manager is incentivised and rewarded for doing nothing – letting the flawed strategy or inadequate management go unchallenged. Can anyone in this hall explain why we regard that as acceptable? But it is a logical consequence of placing the focus of performance on relative returns.
This sits at odds with the reality that relative performance does not pay peoples’ pensions - that requires absolute returns.
This is often linked in argument to the ‘free rider’ problem, how can we do more, fund managers ask, when others will reap the rewards of our good work? But I’m afraid I see this as little more than a ‘convenient truth’ for some in the industry.
If an investor actively engages and delivers real value in terms of improving management, or by frustrating a flawed takeover or poorly thought through strategy, it makes no difference at all that other shareholders also benefit as a consequence - the important outcome is that the absolute position of the active investor has been improved.
If your sole focus is to nudge a few percentage points ahead of the pack of other Funds then such paranoia is understandable, if not defensible. But if you disregard these comparisons and seek absolute performance, then the Fund, or the clients of the engaged investment manager, are the ones to reap the rewards of successful work. So called ‘free riders’ become irrelevant.
So we need a shift in focus; the value created from stewardship is complicated, but that should not mean its benefits are ignored, for they are significant.
A strong, effective, credible board openly and honestly engaging with shareholders benefits the company in terms of access to wider sources of funding, a lower cost of capital, and greater commitment from long-term investors.
It is the failure to overcome problems of agency mismanagement, inappropriate portfolio goals and perceived free rider barriers to becoming actively and constructively involved that has placed value at risk for participants at all levels, from institutional shareholders to individual savers.
But if investors recognise that there is a problem and agree they want to do more, rather than saying ‘what can I do alone?’, part of the answer surely lies in them collaborating more, sharing some of the cost.
I am encouraged that work is being done through the Stewardship Code, but more needs to be done, and the onus is on the shareholders, as the ultimate owners to lead the process of continuous improvement.
Sir David Walker last night covered his views on the failings of governance, as well as his recommendations on the necessary actions needed to improve this. Let me explain where we are on implementation of the Walker Review, as well as some of the other actions we are taking in this area.
Chief amongst the recommendations was the suggestion that investors sign up to a best practice code of ownership principles – the Stewardship Code.
The Institutional Shareholder’s Committe Principles offer a very good starting point for this Code and the Financial Reporting Council is currently in consultation on how best to take ownership of this Code and what amendments, if any, are needed.
Sir David also concluded that compliance with the code should be disclosed, through a Financial Services Authority owned framework.
Disclosure of compliance with the Stewardship Code by fund managers should encourage trustees and those who appoint investment managers to consider engagement track records in their fund manager selection criteria, and be more probing of governance approaches, competencies and track records.
Sir David also recommended that the FRC's Stewardship Code should be used as a means of improving institutional investor voting disclosure.
We announced in yesterday’s Budget, that as part of the development of the Stewardship Code, we will consider whether the existing institutional investor voting disclosure regime should remain voluntary, or whether it should become mandatory and the form that this could take.
This has the potential to improve the overall transparency framework, and ensure that institutional shareholders – as is only right - be accountable for the voting decisions they take.
Taxpayer investment in Lloyds Banking Group and Royal Bank of Scotland are held through UK Financial Investments. This keeps them one step removed from ministers and politicians, placing the day-to-day management of investments in the hands of UKFI’s accomplished professionals and independent board of directors.
UKFI, with my encouragement, is already leading the way by publishing all votes and providing an explanation of their voting decisions; I have asked them to ensure that they are as transparent as possible when explaining final decisions.
As part of the Financial Services Bill, we have also published draft regulations to require enhanced disclosure on remuneration by the largest UK and overseas banks operating in the UK.
Banks covered will be required to publish information on the number of people that have total annual remuneration packages falling within bands of £500,000, starting from £500,000 going up to £5million, and in bands of £1million thereafter.
After careful consideration, we have used a lower starting point and smaller steps than suggested by Sir David Walker, as we believe this granularity will afford even better opportunities for informed shareholder engagement.
And we will also require a breakdown of that remuneration into its constituent components and further detailed narrative to report the link between pay and risk management.
We believe greater transparency will serve to enhance shareholders' ability to exercise effective governance over remuneration policies followed and decisions made in the companies they own.
It is quite clear that shareholders are responsible for the terms under which directors are remunerated in their firms and should be accountable for their decisions. This is not a matter in which Government should need to become involved.
We also announced in the Budget that the Government will consult on possible changes to facilitate the approval by owners of executive remuneration in the financial services sector. We intend to ask questions about the limitations of ex- post votes on "say on pay" and to explore ex-ante options which could, for instance, require prior approval from owners; getting input from owners to remuneration and nomination committees in certain circumstances; and putting compensation consultants under a clear liability to the owners.
There is one further announcement made in the Budget that I would like to cover – the establishment of a Treasury-led working party to clarify the benefits of the possible dematerialisation of paper share certificates.
This reflects the fact that while the interests of institutional shareholders are well represented in the UK, through bodies such as the ISC, it appears that this is not the case for retail shareholders.
And if retail shareholders are to be encouraged to have an interest in the corporate governance of the companies in which they hold shares, it is vital that they can find a way in which they can retain their shareholder rights in a cost-efficient and user-friendly way.
If firms are to truly embrace good governance, I believe private investors are exactly the type of people Chairmen should be looking to reach out to. They are likely to take a much longer-term view and many of them will also be customers and so be able provide meaningful insights into how a company is really seen by its most important constituency. Examples of such engagement could be ensuring AGMs do not unnecessarily clash with those of other similar companies, considering holding them outside of London, and, importantly, the Chairman and CEO getting out to meet private shareholders in a programme of country-wide Town Hall Meetings.
The private investor and his/her valuable contribution has tended to be overlooked, although they often see issues of performance and governance with considerable clarity.
This working party will report to Ministers. I urge you to input into this process and I look forward to reviewing the findings in due course.
This brings me on to the topic that has arguably been the zeitgeist of the global financial crisis – remuneration.
The levels of pay we have seen in the past are a clear illustration of the governance failings that I have already discussed.
They were both a symptom and a contributor to the crisis and they have rightly divided public opinion and dominated the press.
Let me be clear on four points.
First, excessive executive pay did not cause the global financial crisis.
Second, government intervention in market mechanisms that determine pay can only go so far.
Third, Directors and the owners who elect them are responsible for remuneration decisions.
Fourth, owners are not evidencing sufficient engagement or challenge – they have and continue to let some executives get away with too much and are failing to demand of CEOs and remuneration committees that they find better ways of managing senior executives than simply throwing ever more money at them; they have failed to find satisfactory explanations for why the pay of the most senior executives and traders has become so detached from that of their middle and junior colleagues.
Remuneration must align executive and employee rewards with risk and contribution – to encourage behaviours consistent with the long-term health and prosperity of the corporation and the best interests of owners. This should be at the heart of firms’ corporate values.
The FSA remuneration code, which includes principles and guidance on sound remuneration practices, is in place and firms have been receptive to the idea that their compensation policies need to be structured over the long-term and not focus on short-term payouts.
I personally wrote to Chief Investment Officers at leading fund management firms, to ascertain what actions they have taken to promote the interests of their clients, in the matter of pay and incentives principles in banking. The responses will shortly be available on the HM Treasury website.
I am pleased to see increasing evidence that shareholders are engaging with Boards and making their views known. But more can and must be done and I hope we are moving towards a world where this happens in all public companies, on an ongoing basis.
One final area that I would like to cover is equity underwriting – an area of clear potential benefit for both investment managers and their clients. Three factors are apparent.
Firstly, investment banks have enjoyed large increases in the profit margins on trading and capital market activities - as evidenced by recent profit announcements. The rents attracted for intermediation appear on the face of it to be high for the value added of the risk taken.
Secondly, primary underwriting fees for equity issues have increased substantially, and, at the same time as a significant widening of the discount at which new shares are issued to the market price.
And, thirdly, investment bankers have made increasing use of pre-marketing to prepare investors and the market for issues.
These factors taken together, all things being equal, should lead to lower risk for the underwriter and have resulted in a significant increase per unit of risk.
Some institutional investors have complained to me about these developments and asked for a Government review, but they have done little or nothing about it themselves – they have, for the most part, acquiesced.
The OFT have said very recently that they are keen to find out more about competition in investment banking services, in order to help establish whether further work in this area is warranted.
I welcome this focus from the OFT, but I believe that this is an area where investors and shareholders should also take the lead.
I recently attended the tremendously successful Which! Future of Banking Commission, comprising well-informed, probing panellists, holding Ministers, industry and regulators to account. I would commend this model as one that should be taken into serious consideration by investment managers and/or their clients.
By launching a similar initiative on equity underwriting, institutional investors would send a powerful message and head off the charge that some investment managers are unwilling to challenge existing practices or pricing, because their relationship with investment banks is too cosy. It would also allow investors to openly engage with senior chairmen and investment bankers on this issue, through public evidence sessions and published submissions, pressing to test whether this vital capital raising activity is the product of sufficient competitive intensity.
I have no doubt that the Institutional Shareholders Committee, or one of its constituent bodies, could launch a successful public enquiry and, in so doing, garner real credit for being seen to bring client and members’ interests to the fore. I have very real doubts about whether investors and fund managers have the appetite to launch such an initiative. I hope to be proven wrong.
Shareholders have duties as owners; and they should fulfill them.
They need to think of solutions rather than looking for inhibitions that prevent them from doing so.
In some cases we have observed the problems that Adam Smith identified in ‘joint-stock companies’, when he expressed a warning that ‘Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company.’
We should have moved on by now.
I realise that my views on this topic have not always been welcomed, and I have been characterised in some quarters of the media as ‘the most unpopular man in the City’ (and I’m sure as much worse in private) – but my views are sincere, they are not party political and they are motivated by a real desire to avoid a repeat of the recent crisis and to enhance the effectiveness of the public company model to allow it to meet and beat competition from private equity, state capitalism and other less market-dependent ownership structures.
And if we are to do this, we will all need to make sound judgements in the months and years to come. Good governance is a fundamental mechanism for delivering better decision-making and I make no apology for continuing to champion its paramount importance.
Some developments in the City have been described as ‘socially useless’. That cannot be said of fund managers and their clients, where the effective performance of their role in capital allocation and oversight is absolutely critical to a successful economy and society.
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