Financial Times, January 17, 2010 column

George Meredith might not have had institutional investors in mind when he wrote The Egoist. Yet this cynical aphorism in his comic novel from the high Victorian period applies very neatly to the widespread view that the shareholders of the last decade behaved like absentee owners when confronted with excessive risk-taking by banks.

UK shareholders make themselves heard

The UK version of shareholders’ say on pay, introduced in 2002, entails a non-binding advisory vote on all listed companies’ remuneration reports, which set out overall remuneration policy, boardroom pay and incentive structures. The aim was to permit shareholders to influence pay, securing a better alignment of interests between directors and investors.

A report last year by Railpen Investments, manager of UK rail industry pensions, and Pirc, the corporate governance consultancy, found that say on pay had strengthened the pay-for-performance culture, cut back rewards for failure and enhanced dialogue between institutional shareholders and management. In a handful of cases, there have been majority votes against remuneration reports, including at some large companies such as GlaxoSmithKline and Royal Dutch Shell. The level of No votes has increased markedly since the onset of the financial crisis.

Yet boardroom pay continues to rise remorselessly, often regardless of overall corporate performance, not least because most non-executive directors want their chief executives to receive rewards above the average. Bank bonuses in particular are perceived by public and politicians to be out of control, prompting moves in the US, UK and France to impose either levies on bank liabilities or bonus taxes to recoup some of the costs of the financial crisis. The UK Treasury select committee concluded last May that say on pay “has largely failed to promote enhanced scrutiny of, or provide an effective check on, remuneration policies within the [financial] sector”.

To strengthen say on pay in banking, Sir David Walker’s 2009 review of corporate governance in the UK financial sector proposed that chairmen of remuneration committees should be required to stand automatically for re-election where, of the votes cast, remuneration reports attract fewer than 75 per cent in favour.

There are also signs of greater institutional militancy. Some are beginning to vote against the reappointment of directors who have sat on remuneration committees that have done a poor job, implying that say on pay, while a non-binding vote, could be reinforced through the back door.

Sir David Walker, author of the recent UK government-sponsored review of corporate governance in the financial sector, argues for example that “board and director shortcomings ... would have been tackled more effectively had there been more vigorous scrutiny and engagement by major investors acting as owners”.

For Lord Myners, UK financial services secretary, shareholders should have paid closer attention to the strategies, motives and competence of the boards and chairmen of banks.

Lord Mandelson, the business secretary, speaking in the context of takeovers, told investors and industrialists last week that he wanted to “ask if London can set a new standard for high-quality, long-term engagement between investors and company owners”.

These views are echoed with a different nuance in the US, where a panel of industry and market experts told the Senate banking committee last month that the global financial crisis represented “a massive failure of oversight” but that “share owners currently have few ways to hold directors’ feet to the fire”.

In spite of the transatlantic focus on the need for greater shareholder engagement, the proposition that it could prevent a recurrence of the crisis is questionable. Is it possible that the expectations of investors are pitched too high?

In the light of the UK institutional investors’ inability to prevent banks passing on the cost of the new tax on bonuses to shareholders, the extent of big investors’ power over the companies in which they invest appears a moot point. An equally fundamental question is whether they have the competence to second-guess boardroom decisions and whether they would do so for better or worse.

What cannot be denied is that the scope for shareholder activism appears greater than ever. In the US, where federal regulation on corporate governance has focused more on the efficiency of securities markets than on the accountability of management to shareholders, there are the beginnings of a shift in the power balance. A number of companies have moved to give shareholders the right to propose nominees for the board.

At the same time, the drive for “say on pay” – whereby shareholders are granted a non-binding vote on compensation reports – finds increasing support among companies. For recipients of US government money under the troubled asset relief programme, providing a say on pay is obligatory. There is a good chance, too, that US legislation for financial reform under discussion in the Senate will make it easier for shareholders to influence directors’ appointments.

In Canada, the Toronto Stock Exchange last year joined other mainstream exchanges in requiring companies to seek shareholder approval for takeovers involving substantial issues of stock, after a tough battle between management and investors. A number of leading Canadian companies have also adopted say on pay.

In Europe, where the UK introduced legislation to require a say-on-pay vote in 2002, many countries have followed suit. The latest is Germany, where Gerhard Cromme, chairman of both Siemens, the engineering group, and steelmaker ThyssenKrupp, last week met leading shareholders to discuss boardroom pay before they cast their first votes on the issue.

The UK has the best claim to provide a laboratory to test the assertion that institutions can have a benign influence on board decisions. Institutional investor activism has a long history; as far back as the 1950s, Prudential Assurance led a shareholder putsch to unseat the free-spending Sir Bernard Docker from Birmingham Small Arms, an engineer. Much of the spending had been lavished on his exuberant spouse, who featured large and often in the tabloid press.

Many UK shareholders hold larger percentages of the companies in which they invest than their US counterparts, making it harder to perform the equivalent of the “Wall Street walk” – dumping the shares – because the holdings may be too large for the market to absorb. Yet these large stakes also give the institutions a more powerful voice in the dialogue with management.

In terms of their legal powers, it is relatively easy, as it is in much of continental Europe, for shareholders to throw out underperforming boards. This is in contrast to the US, where the so-called plurality voting system allows shareholders to vote for, but not against, nominees for the board, and where they cannot usually put forward their own candidates without a costly, full-blown election contest.

Yet in spite of these advantages, serious weaknesses in UK governance and shareholder accountability have been exposed by the banking crisis.

Exhibit one is Royal Bank of Scotland’s takeover of ABN Amro in 2007. Here many leading UK investment institutions had long been worried that Sir Fred Goodwin, RBS chief executive, was bent on expansion regardless of shareholder value. Their fears were borne out when he led a consortium bid for the Dutch bank. Not only did many analysts think the €71bn bid too high but, in addition, ABN Amro sold its crown jewel – the LaSalle subsidiary in the US, which Sir Fred had initially said was his main objective – to Bank of America in the course of the bid battle.

Worried UK shareholders did at least have the chance to vote on the transaction. Given the onset of the credit crunch, they could also point out to RBS management that the change in circumstance provided a respectable excuse to back down. Yet when it came to the vote, most of the big institutions, with one or two exceptions such as the fund management arm of the Co-operative Group, backed the board.

As much as anything, that reflects the difficulty of second-guessing ambitious, articulate managers of complex businesses engaged in complex transactions – both for non-executives performing their monitoring role with less information than executives, and for shareholders, who stand at an even further remove.

It requires expertise, judgment and courage for shareholders to say no on big strategic issues. That is given to the likes of Warren Buffett, the investment guru and Kraft shareholder – who has expressed a pungent view on the US company’s bid for Cadbury, the UK chocolate maker – or to the more aggressive hedge funds, but not to many managers of conventional institutional money.

Exhibit two concerns bankers’ bonuses, which Barack Obama, US president, last week branded as obscene. Bank shareholders have lost huge sums as a result of collapsing stock prices since the crisis began. They have pumped unprecedented amounts of capital back into the sector. Yet the increase in earnings now coming through courtesy of central banks’ exceptionally low interest rates is expected chiefly to fatten managers’ bonuses when announcements are made this month and next, leaving shareholders under-rewarded.

Takeover trap

●In 2007 Royal Bank of Scotland led a consortium in a hostile €71bn bid for ABN Amro of the Netherlands, one of many value-destroying mega-acquisitions to which UK institutional investors failed to mount serious opposition. Others include:
●Lloyds TSB’s paper acquisition in 2008 of HBOS, valued initially at £12bn. HBOS’s overdependence on wholesale funding and exposure to commercial and residential property proved catastrophic for Lloyds.
●Vodafone’s £112bn bid for Germany’s Mannesmann in 2000. Overpayment led to huge goodwill write-offs.
●The US high-technology acquisitions in the late 1990s that brought Marconi to its knees, inflicting losses of more than £5bn on the telecommunications group when the tech bubble collapsed.
●ICI’s £4.8bn purchase of Unilever’s speciality chemicals business in 1997, which caused Britain’s former leading manufacturer to plunge into technical insolvency.

In this instance, the question is less about shareholder competence than impotence. The managers are clearly running the banks in their own interest, not the shareholders’. Short of selling the shares, which larger institutions and passive funds cannot do, shareholders have not been able to impose restraint because using their voting power against a united board could result in an empty boardroom. Governments are an exception to this rule, since they can afford to be assertive over bonuses at banks in which they have taken large equity stakes.

Exhibit three concerns the structure of bank boards. The institutions unquestionably have the power to influence board composition. In spite of this, the two biggest casualties of the crisis, RBS and HBOS, the UK bank taken over by Lloyds TSB, were chaired by non-bankers – and, as Lord Myners has argued, their boards were deficient in understanding of risk and complex financial plumbing.

Moreover, the investment institutions are as much part of the problem as the solution because they are as prone to faddish thinking and bubble euphoria as are corporate or financial managers. Before the crisis, most institutions on both sides of the Atlantic were relaxed about the banks’ pursuit of high returns on equity regardless of the resulting dramatic reduction in the capital base of the banking system. Like the regulators, they underestimated the importance of liquidity to the banks.

The institutions also applied considerable pressure for high dividends and share buy-backs that depleted capital. Many derided cautious management. Lloyds TSB was criticised before its takeover of HBOS for failing to be more adventurous. In the technology bubble of the 1990s, the shareholders in Marconi notoriously egged on the UK company in its catastrophic US telecommunications acquisitions.

In part this reflects what Ira Millstein, a US corporate governance pioneer, calls “a relentlessly short-term investment focus”, often founded on performance measured over periods as short as three months.

Where institutions have been reluctant to address corporate underperformance, they are often influenced by conflicts of interest. Fund managers, for example, are reluctant to alienate company management from which they hope to win pension fund investment business. Lord Myners sees a failure by those such as trustees who speak for end-investors, including pension beneficiaries. They must ask, he says, “whether they are fully fulfilling their fiduciary responsibility to hold assets in good care if they do not pay proper regard for stewardship and governance”.

This is not to say there are no responsible institutional investors or that shareholder engagement has had no successes. Yet all too often there is a flawed chain of accountability from management to the institutions’ ultimate beneficiaries. This means looking to a shareholder bill of rights as the answer to governance weaknesses revealed by the financial crisis is not enough. As Mr Millstein says: “If corporate law or other public policy mechanisms are to give institutional investors even more clout, it is vital that these institutions are focused on the interests of their ultimate investors and of society as a whole in promoting sustainable, long-term growth.

“There is little point to fixing executive short-termism,” he adds, “if we don’t fix shareholder short-termism first – we need better incentives to turn investor heads in the desired direction.”