Is the UK’s new Stewardship Code simply redundant bureaucracy?
In an article earlier this year, we looked at the draft of the proposed new version of the UK’s Stewardship Code and discussed some of the primary inputs and influences. We expressed our concern that it was drifting well away from stewardship per se, into prescribing detailed rules and operational procedures for the investment industry, which would be more appropriately dealt with by industry regulation. And we began to question whether the Corporate Governance Code and Companies Act already covered the broad principles addressed by the proposed new Code.
Note: while this is focused on the UK, our many international readers will note that most of the world has followed the UK model of corporate governance dating back to the first Cadbury Report in 1992; the message and lessons are therefore relevant to all those with an interest in corporate governance initiatives around the world.
In October 2019, the new Code was published, so we thought it would be timely to review it in the light of the concerns mentioned above.
To assess whether the new Code has resolved the issues that we raised, we need to look at four relevant pieces of legal guidance:
- The Companies Act 2006
- the Corporate Governance Code 2018
- the Association of Investment Companies (AIC) Code 2019
- the Stewardship Code 2020.
and see what conclusions we can draw.
At the risk of making this article overly long, but to drive home the messages coming out of the process, it is necessary to quote verbatim extracts from the original Act and Codes, which we do below, but in collapsible sections so you can ‘see the wood over the trees’. What we are displaying are the general objectives of each Code and the specific Principles which each Code puts forward, and the key section of the Companies Act relating to the duties of directors. We will then draw our own conclusions and readers can see how far they agree with us.
The relevant parts are Sections 170 -177. In brief, these state:
S 170 Scope and nature of general duties
The general duties specified in sections 171 to 177 are owed by a director of a company to the company.
S 171 Duty to act within powers
A director of a company must (a) act in accordance with the company’s constitution, and (b) only exercise powers for the purposes for which they are conferred.
S 172 Duty to promote the success of the company
A director of a company must act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole.
S 173 Duty to exercise independent judgment
A director of a company must exercise independent judgment.
S 174 Duty to exercise reasonable care, skill and diligence
A director of a company must exercise reasonable care, skill and diligence.
S 175 Duty to avoid conflicts of interest
A director of a company must avoid a situation in which he has, or can have, a direct or indirect interest that conflicts, or possibly may conflict, with the interests of the company.
S 176 Duty not to accept benefits from third parties
A director of a company must not accept a benefit from a third party conferred by reason of (a) his being a director, or (b) his doing (or not doing) anything as director.
S 177 Duty to declare interest in proposed transaction or arrangement
If a director of a company is in any way, directly or indirectly, interested in a proposed transaction or arrangement with the company, he must declare the nature and extent of that interest to the other directors.
The first version of the UK Corporate Governance Code (the Code) was published in 1992 by the Cadbury Committee. It defined corporate governance as ‘the system by which companies are directed and controlled. Boards of directors are responsible for the governance of their companies. The shareholders’ role in governance is to appoint the directors and the auditors and to satisfy themselves that an appropriate governance structure is in place.’ This remains true today, but the environment in which companies, their shareholders and wider stakeholders operate continues to develop rapidly.………………….
…………………Over the years the Code has been revised and expanded to take account of the increasing demands on the UK’s corporate governance framework……………….
…………….At the heart of this Code is an updated set of Principles that emphasise the value of good corporate governance to long-term sustainable success. By applying the Principles, following the more detailed Provisions and using the associated guidance, companies can demonstrate throughout their reporting how the governance of the company contributes to its long-term sustainable success and achieves wider objectives……………….
………………In line with their responsibilities under the UK Stewardship Code, investors should engage constructively and discuss with the company any departures from recommended practice. In their consideration of explanations, investors and their advisors should pay due regard to a company’s individual circumstances. While they have every right to challenge explanations if they are unconvincing, these must not be evaluated in a mechanistic way. Investors and their advisors should also give companies sufficient time to respond to enquiries about corporate governance…….
Board leadership & company purpose
A a successful company is led by an effective & entrepreneurial board, whose role is to promote the long-term sustainable success of the company, generating value for shareholders and contributing to wider society
B The board should establish the company’s purpose, values & strategy, and satisfy itself that these and its culture are aligned. All directors must act with integrity, lead by example and promote the desired culture
C the board should ensure that the necessary resources are in place for the company to meet its objectives and measure performance against them. The board should also establish a framework of prudent and effective controls, which enable risk to be assessed and managed
D in order for the company to meet its responsibilities to shareholders & stakeholders, the board should ensure effective engagement with, and encourage participation from, these parties
E the board should ensure that workforce policies are consistent with the company’s values and support its long-term sustainable success. The workforce should be able to raise any matters of concern.
Division of responsibilities
Composition, succession & evaluation
Audit, risk & internal control
A framework of best practice for member companies
- Purpose of the AIC Code
The purpose of the AIC Code of Corporate Governance© (AIC Code) is to provide boards of our member companies with a framework of best practice in respect of the governance of investment companies………….
2 Endorsements and statements of support
2.1 Financial Reporting Council Endorsement…………..
3 Background to the AIC Code
Corporate governance does not exist in a vacuum and the AIC encourages shareholders to engage with boards where and when appropriate and to give careful consideration to boards’ proposals.
The AIC Code is built around an understanding of what shareholders want or expect to achieve by holding shares in investment companies and the role boards play in delivering these objectives…………….
4 Reporting on the Code
The following is an extract from the UK Code which also applies to the AIC Code……………….
5 Board leadership and purpose
- A successful company is led by an effective board, whose role is to promote the long-term sustainable success of the company, generating value for shareholders and contributing to wider society. (Incorporates relevant content from UK Code Principle A)
- The board should establish the company’s purpose, values and strategy, and satisfy itself that these and its culture are aligned. All directors must act with integrity, lead by example and promote the desired culture. (UK Code Principle B)
- The board should ensure that the necessary resources are in place for the company to meet its objectives and measure performance against them. The board should also establish a framework of prudent and effective controls, which enable risk to be assessed and managed. (UK Code Principle C)
- In order for the company to meet its responsibilities to shareholders and stakeholders, the board should ensure effective engagement with, and encourage participation from, these parties. (UK Code Principle D)
- [Intentionally left blank]
6 Division of responsibilities
7 Composition, succession & evaluation
8 Audit, risk & internal control
Stewardship is the responsible allocation, management and oversight of capital to create long-term value for clients and beneficiaries leading to sustainable benefits for the economy, the environment and society…………..
……………Environmental, particularly climate change, and social factors, in addition to governance, have become material issues for investors to consider when making investment decisions and undertaking stewardship. The Code also recognises that asset owners and asset managers play an important role as guardians of market integrity and in working to minimise systemic risks as well as being stewards of the investments in their portfolios.
How to report
All Principles are supported by reporting expectations. These indicate the information that organisations should include in their Stewardship Report and will form the basis of assessment of reporting quality.
When applying the Principles, signatories should consider the following, among other issues:
- the effective application of the UK Corporate Governance Code and other governance codes;
- directors’ duties, particularly those matters to which they should have regard under section 172 of the Companies Act 2006;
- capital structure, risk, strategy and performance
- diversity, remuneration and workforce interests;
- audit quality;
- environmental and social issues, including climate change; and
- compliance with covenants and contracts
Principles for asset owners and asset managers
Purpose & governance
Signatories’ purpose, investment beliefs, strategy, and culture enable stewardship that creates long-term value for clients and beneficiaries leading to sustainable benefits for the economy, the environment and society
- the purpose of the organisation and an outline of its culture, values, business model and strategy; and
- their investment beliefs, i.e. what factors they consider important for desired investment outcomes and why
Signatories’ governance, resources and incentives support stewardship
Signatories should explain how:
- their governance structures and processes have enabled oversight and accountability for effective stewardship within their organisation and the rationale for their chosen approach;
- they have appropriately resourced stewardship activities, including:
- their chosen organisational and workforce structures;
- their seniority, experience, qualifications, training and diversity;
- their investment in systems, processes, research and analysis;
- the extent to which service providers were used and the services they provided; and
- performance management or reward programmes have incentivised the workforce to integrate stewardship and investment decision-making
Signatories manage conflicts of interest to put the best interests of clients and beneficiaries first
Signatories should disclose their conflicts policy and how this has been applied to stewardship.
Signatories identify and respond to market-wide and systemic risks to promote a well-functioning financial system.
Signatories should explain
- how they have identified and responded to market-wide and systemic risk(s), as appropriate;
- how they have worked with other stakeholders to promote continued improvement of the functioning of financial markets;
- the role they played in any relevant industry initiatives in which they have participated, the extent of their contribution and an assessment of their effectiveness, with examples; and
- how they have aligned their investments accordingly
Signatories review their policies, assure their processes and assess the effectiveness of their activities
Signatories should explain
- how they have reviewed their policies to ensure they enable effective stewardship;
- what internal or external assurance they have received in relation to stewardship (undertaken directly or on their behalf) and the rationale for their chosen approach; and
- how they have ensured their stewardship reporting is fair, balanced and understandable.
Signatories take account of client and beneficiary needs and communicate the activities and outcomes of their stewardship and investment to them
Signatories should disclose:
- the approximate breakdown of:
- the scheme(s) structure, for example, whether the scheme is a master trust, occupational pension fund, defined benefit or defined contribution, etc;
- the size and profile of their membership, including number of members in the scheme and the average age of members;
- their client base, for example, institutional versus retail, and geographic distribution;
- assets under management across asset classes and geographies;
- the length of the investment time horizon they have considered appropriate to deliver to the needs of clients and/or beneficiaries and why
Signatories systematically integrate stewardship and investment, including material environmental, social and governance issues, and climate change, to fulfil their responsibilities.
Signatories should explain:
- how integration of stewardship and investment has differed for funds, asset classes and geographies;
- how they have ensured:
- tenders have included a requirement to integrate stewardship and investment, including material ESG issues; and
- the design and award of mandates include requirements to integrate stewardship and investment to align with the investment time horizons of clients and beneficiaries
- the processes they have used to:
- integrate stewardship and investment, including material ESG issues, to align with the investment time horizons of clients and/or beneficiaries; and
- ensure service providers have received clear and actionable criteria to support integration of stewardship and investment, including material ESG issues
Signatories monitor and hold to account managers and/or service providers.
Signatories should explain how they have monitored service providers to ensure services have been delivered to meet their needs.
Signatories engage with issuers to maintain or enhance the value of assets
Signatories should explain:
- the expectations they have set for others that engage on their behalf and how;
- how they have selected and prioritised engagement (for example, key issues and/or size of holding);
- how they have developed well-informed and precise objectives for engagement with examples;
- what methods of engagement and the extent to which they have been used;
- the reasons for their chosen approach, with reference to their disclosure under Context for Principle 1 and 6; and
- how engagement has differed for funds, assets or geographies
Signatories, where necessary, participate in collaborative engagement to influence issuers.
Signatories should disclose what collaborative engagement they have participated in and why, including those undertaken directly or by others on their behalf
Signatories, where necessary, escalate stewardship activities to influence issuers
Signatories should explain:
- the expectations they have set for asset managers that escalate stewardship activities on their behalf;
- how they have selected and prioritised issues, and developed well-informed objectives for escalation;
- when they have chosen to escalate their engagement, including the issue(s) and the reasons for their chosen approach, using examples; and
- how escalation has differed for funds, assets or geographies
Exercising rights & responsibilities
Signatories actively exercise their rights and responsibilities.
Reporting expectations for listed equity and fixed income investments are below. In addition, signatories should report on how they have exercised their rights and responsibilities across other asset classes they are invested in, where they have the ability to do so, as disclosed in their reporting against Principle 6.
- state the expectations they have set for asset managers that exercise rights and responsibilities on their behalf;
- explain how they exercise their rights and responsibilities, and how their approach has differed for funds, assets or geographies. In addition, for listed equity assets, signatories should:
- disclose their voting policy, including any house policies and the extent to which funds set their own policies;
- state the extent to which they use default recommendations of proxy advisors
- report the extent to which clients may override a house policy;
- disclose their policy on allowing clients to direct voting in segregated and pooled accounts; and
- state what approach they have taken to stock lending, recalling lent stock for voting and how they seek to mitigate ‘empty voting’.
Principles for service providers
1 Purpose, strategy & culture
2 Governance, resources & incentives
3 Conflicts of interest
4 Promoting well-functioning markets
5 Supporting client’s stewardship
6 Review & assurance
The final version of the new Stewardship Code has a much more straightforward layout than the earlier draft, and is easy to read and follow. Setting out Principles, with Context, Activities and Outcomes for each, makes it clear what is being aimed at.
However, the corollary is that that clarity makes it even easier to identify the fundamental concerns we expressed earlier in regard to the draft version of the new Code. Here we present some basic thoughts about regulatory control of the corporate sector generally, which therefore apply to the investment industry in particular.
The behaviour of companies should be regulated by the Companies Act, and that of their boards by the Corporate Governance Code. The behaviour of companies in a particular sector, such as investment, should be controlled in such detail as is necessary for that sector, by specific rules and regulations for authorised players in that industry sector.
If we look at a simplified statement of the Principles of the Stewardship Code 2020, and assess the extent to which they are addressed in the Companies Act 2006, the Corporate Governance Code 2018 and the AIC Code 2019, we see that pretty well everything is addressed in these three Codes. The only thing clearly missing is the exhortation, in Principles 10 and 11, to collaborate with other shareholders to bring pressure on investee companies.
The Table below summarises this comparison, and readers can look at our extract from the Codes, above, and make their own assessments.
||CG Code||AIC Code|
|Purpose & governance|
|Culture delivers sustainable benefits for economy & ESG||x||x||x|
|Governance, resources, incentives support stewardship||x||x|
|Conflicts of interest||x|
|Manage risks & promote well-functioning market||x||x|
|Review policies, processes to assure effectiveness||x||x|
|Take account of client needs and report back||x||x|
|Integrate stewardship, investment, ESG||x||x|
|Monitor and control managers and service providers||x||x|
|Engage with issuers||x||x|
|Collaborate engagement to influence issuers|
|Escalate activities to influence issuers|
|Actively exercise rights and responsibilities||x||x|
So why is the Stewardship Code necessary at all?
The sceptic would say that regulatory bureaucracy is getting out of control, and that Stewardship should now be absorbed into the Corporate Governance Code and Industry regulation. More specifically, Stewardship is surely one of the most important duties of the directors of a company created to look after investors’ funds. So it should be simply part of the duties covered by Corporate Governance and the Companies Act. Moreover, to include in Stewardship duties the task of furthering particular societal responsibilities, for instance, under the ESG heading, is to assume that investors have given their funds to that investment company with those specific aims in mind, which is not necessarily the case. These state-wide policies should not be included in a set of rules which are supposed to ensure that the agents of investors carry out the wishes of those investors. Why stop here? Climate change, alcohol, tobacco, weapons, the list is endless, and has nothing to do with Stewardship unless the terms of the fund specify this.
Worse, the Stewardship Code gets down to the level of telling companies to have appropriate organisations and staffing levels, and to look after their clients’ interests, and behave with integrity. If anything is going to produce boilerplate reporting and box-ticking, this surely will. And any company which fails to look after clients’ interests or has an unsuitable organisation or staffing, will not survive long. Similarly, holding managers and agents to account is simply good management. And if there are (justified) concerns about a well-functioning financial services industry, the Stewardship Code is not the place to deal with them holistically.
The difficulties of investment funds engaging in a useful way with hundreds of, often short term, investments present practical problems that we have referred to on many occasions, and to which the Code offers no acknowledgement, let alone solution. And as for prescribing collaboration and escalation of pressure, the expression “teaching grandmother to suck eggs” comes to mind.
Finally, reporting on exercising rights is likely to produce self-justifying boilerplate.
What to do about it
In brief: integrate the Stewardship Code into the Corporate Governance Code to the extent necessary, and similarly amend the AIC Code. Review the detailed regulations that apply to the financial service industry and the investment institutions in particular to see whether there is anything in the Stewardship Code that isn’t already covered, and ought to be, and remedy the omissions. Then scrap the Stewardship Code.