Corporate Governance Codes have been largely focused on big public companies but what about the investing institutions that own them? How should we assess their Corporate Governance?
Our Applied Corporate Governance approach is to define the key stakeholders and ask them how they view the organisation concerned against our Five Golden Rules of good corporate governance. The Five Golden Rules are straightforward: an ethical approach, a clear goal shared by all key stakeholders, a strategic approach to management, an organisation fit to deliver the goal, and transparency and accountability by management to the stakeholders. However, defining the stakeholders and weighting their importance may not be as easy as at first might appear. This article is intended to explore the issues, expose some of the key risks and suggest some solutions.
UK Stewardship Code
The UK Stewardship Code was introduced in 2010 in an attempt to improve corporate governance by getting owners to engage more closely with their investee companies’ managements. This wasn’t wrong in principle, but still focused primarily on the governance of the investee company rather than that of the investing company. In talking about stewardship it was essentially referring to the role of the numerous fund managers employed by major institutions who invest many trillions of pounds, dollars, yen etc, belonging to billions of people via millions of corporations around the world. This didn’t really address the question of the quality of the governance of the investing institutions themselves except insofar as engagement with investee boards was judged to be a mark of good governance.
CG codes for investing institutions
There are, of course, Codes of Corporate Governance introduced by the governing bodies or trade associations of these investing institutions, such that issued by the Association of Investment Companies (AIC) for its members, the AIC Code of Corporate Governance. This is focused on the relationship between the investing institution and its manager, essentially through the behaviour of the Board, whose duty it is to look after the interests of the shareholders.
Who are the stakeholders?
It is worth quoting the words of the AIC Code:
Investment companies have special factors which have an impact on their governance arrangements. These special factors arise principally from two features. Firstly, the customers and shareholders of an investment company are the same, thus simplifying stakeholder considerations while magnifying the importance of this group’s concerns. Secondly, an investment company typically has no employees and the roles of CEO (unofficially), portfolio management, administration, accounting and company secretarial tend to be provided by a third party fund manager (or delegated by it to others) who may have created the company at the outset and have an important voice in the composition of the board.
These factors mean that the fund manager is a more important stakeholder than a typical supplier. Equally the fund manager can have a position of influence on board deliberations that can be disproportionate relative to the shareholders, whose combined interests dwarf those of the manager. Accordingly, most of the AIC Code deals with matters such as board independence and the review of management and other third party contracts. In practice, most of the time spent by a board of a well functioning investment company should be spent on matters of general corporate governance (e.g. investment strategy, performance monitoring, etc).
This, however, may be too limited an interpretation of the stakeholder group. Outsiders would surely hold the investing institutions at least partly responsible for the conduct of the companies in which they have invested. After all, they are the owners, are they not? So the stakeholders in the investee companies are likely to see themselves as fellow stakeholders with the owner/investors. Here is where the discussion becomes interesting.
Passive v Active investors
The investors in passively managed funds and in actively managed funds will probably be fairly clear in their views about how directly they can hold the fund managers responsible for the actions of their investee companies. Even so, they may have to take care. An interesting article by Dr Roger Barker, Director of Corporate Governance at the IOD, in the summer edition of the IOD’s Big Picture, considers the Bumi disaster [Update: see our 2016 article on Bumi, written after three more years of troubles]. Briefly, Nat Rothschild thought he could get emerging market stocks re-rated by introducing better corporate governance. A number of “sophisticated investors” believed him and invested. Sadly he failed and they lost a lot of money. The lesson Roger Barker draws is that investors should not be beguiled by apparent compliance with a set of rules into lazily avoiding proper due diligence. Rules don’t provide total protection for active investors. But can passive investors, relying on rules, avoid all responsibility for the actions of the companies in which they invest? If not, what should they do to protect their reputation for integrity?
Wide ownership versus concentrated ownership
It is often thought that wide ownership and equal shareholding rights is a “good thing” and that concentration of ownership and blockholder shareholders are a symptom of crony capitalism. Good governance would therefore favour boards with a majority of independent directors and no major shareholdings. However, widely dispersed ownership can create its own problems, including a lack of interest in governance by shareholders, a short term focus by management leading to excessive pay. RBOS wasn’t saved by its independent directors. By contrast, blockholder shareholders can take long term view. Examples are Dyson, still controlled by its founder and Amazon, still in practice controlled by Jeff Bezos. Perhaps investors in venture capital funds and private equity should ponder some of the issues this raises.
What investment company shareholders want
The AIC Code says that share holders want:
- The best possible share price total return with an acceptable level of risk consistent with the objectives of the company
- Clear objectives and transparent investment policies so that they can understand what they are buying and the risk:reward dynamics that apply
- A low expense ratio consistent with proper incentivisation for outstanding performance and quality service
- Good liquidity so that they can sell (or buy more) shares easily
- Good communication from the board and fund managers
If this is what the Code says good corporate governance should be delivering, how can the boards governing the investing institutions be assured that this is happening?
We would argue for a regular survey addressing the key elements of good governance as outlined in the opening paragraph. The AIC Code recommends that boards provide for an external view to support and add perspective, coupled with objective monitoring of fund manager performance and monitoring and responding to shareholder opinion. They recommend a regular review of the structure, objectives, target audience, fund manager and continuing existence of the fund. Their role includes maintaining proper internal control sand ensuring effective shareholder communications. Finally, they must ensure that the fund manager manages within the agreed parameters set by the board.
In earlier articles we have referred to our Applied Corporate Governance Research methodology, based on a Stakeholder Survey which can be devised to link customers, management, owners and other key stakeholders in a co-managed exercise, carried out at regular intervals.
There are now specialists who have built software tools to enable a tailored survey to be prepared quickly and economically and which will deliver results rapidly to flag up areas of concern. Such tools will make regular surveys economically and logistically practical and would seem to be a very good way to fulfil the expectations of the writers of the AIC Code.