November 2014

SHAREHOLDER RIGHTS: Corporate governance

MicrophoneCompany restructuring in the face of heightened shareholder pressure is gathering momentum. Companies, as well as investors, can benefit, finds Fiona Rintoul.  If Europe once had the reputation of being a little sluggish in the corporate governance department, the financial crisis changed that. Not only did the crisis highlight the potentially disastrous consequences of poor corporate governance, it also laid bare institutional investors’ dereliction of duty as shareholders.  “There was a recognition that investors, especially institutional investors, were way too passive and way too focused on the short term,” says Lisa Beauvilain, who is responsible for environment, social and governance (ESG) analysis at Impax Asset Management. This led to a drive to make institutional investors more engaged with companies and to get them to take a long-term perspective. In Europe, this approach is now to be enshrined in the revised EU Shareholder Rights Directive.  A proposal for the revised directive, presented in April 2014, says it will tackle corporate governance shortcomings relating to listed companies and their boards, shareholders (institutional investors and asset managers), intermediaries and proxy advisers (ie, firms providing services to shareholders, notably voting advisers. Meanwhile, informal discussions between the commission and “stakeholders” (that’s you) on measures to increase shareholder engagement have been summarised in a moderately interesting paper that was published on the commission’s website. Beauvilain claims that it is an ambitious programme.  But the commission’s horizons are, as always, distant. The directive won’t be finalised until next year or 2016, and member states will have 18 months to implement it.  In the meantime, national codes, such as the UK Stewardship Code, promote change. Else, the arguments in favour of greater shareholder engagement are left to make themselves. For some, such as Impax, it’s a no-brainer.  “We give an ESG score to all companies,” says Beauvilain. “It’s quite remarkable that the companies that score well are the ones that perform better in the long term.” Others are less convinced. The commission’s summary of the informal discussions concerning the initiative on shareholder engagement notes: “Some [said] there might also be cases in which shareholder engagement turned out to be bad for the long-term perspective of a company. Others underlined that short-term investors do not always have a bad influence and that they are also crucial for the smooth functioning of the system.”  However, the momentum is in the direction of greater engagement, not least because, in the terrible aftermath of the crisis, that’s exactly what companies wanted.  “Companies are talking with shareholders more, not just about corporate governance but about non-financial factors in general,” comments Michael Herskovich, head of corporate governance in the socially responsible investment team at BNP Paribas Investment Partners.  And it’s what clients want. “Asset owners are pushing more and more for involvement,” says Herskovich. “There’s pressure from regulators but there’s also client pressure.” RESTRUCTURING
This, combined with financial pressures after the crisis, has meant that corporate restructuring has reached parts previously considered impregnable to such ideas.  During the crisis capital became scarcer, says Patrick Vermeulen, European equities fund manager at JP Morgan Asset Management (JPMAM). That has provoked companies to make rational decisions.  “Everyone says you can’t restructure in France but even there it is possible if you get the right management with the right attitude,” says Vermeulen. “Across Europe in general there is a much more rational approach to capital allocation.” Such restructuring creates opportunities. Vermeulen has made it his task to track down those opportunities. “It’s never a problem to find cheap companies,” he says. “The challenge is to find cheap companies where you see a change in management behaviour,” he adds. Examples of companies that have become better investments because of crisis-provoked restructuring include Alcatel, Airbus and WH Smith.  In the case of WH Smith, JPMAM was so impressed by the turnaround that former chief executive Kate Swann brought about, that it invested in the company she joined after WH Smith when it floated.  “Her involvement was a major factor in our decision to invest,” says Vermeulen.  Pay plays a big role in getting the right management with the right attitude.  Say on pay is a topic that has both hit the headlines over the past two to three years and exercised shareholders. Certainly, in the case of BNP, more time is spent now analysing executive pay than previously.  “The crisis showed there was a disconnection with remuneration,” says Herskovich at BNP.  The first step towards fixing this problem was to ensure there was greater transparency. “Whatever subject you want to raise with companies, you need to have the information available,” Herskovich says.  “Transparency is the first step not just for compensation but for lots of corporate governance subjects,” adds Herskovich. As is always the case when the tricky topic of pay comes up, fund managers are keen to emphasise that they don’t want to put a cap on executive pay; they just want it to be structured right.  “There is no problem with management being handsomely paid for good performance,” says JPMAM’s Vermeulen. “But it shouldn’t be free money and it should be largely share-based.” Share-based bonuses are effectively a transfer of wealth from existing shareholders to management on condition that they deliver. This creates alignment of interests, provided the targets are right.   “It’s not so much about growth in earnings per share,” says Vermeulen. “That’s easy to achieve. You can buy growth and get paid for it.  “What we want is an incentive scheme that drives management to allocate capital properly.” Progress has been made. “Larger companies have executive compensation structures that are better organised and long-term oriented,” says Herskovich.  But there is more to do. “In Europe, there is a clear improvement, but it’s not universal and there is still a lot of room for further improvement,” says Vermeulen. “The criteria [for bonuses] should be very clear. There should be more disclosure on that.” DIFFERENCE OF CULTURE
In due course, such disclosure may be enshrined in the Shareholder Rights Directive. However, there are differences of opinion as to the best approach with the UK approach broadly at odds with the current approach in mainland European. “It’s a difference of culture,” says Beauvilain. “The EU is generally more prescriptive, and the UK is more principle-driven. If the legislation is very lenient or principle-driven, it could be that some [mainland] European companies won’t do it, but the UK culture is probably fairer.” In any case, however important transparency may be, a lot of shareholder engagement happens behind closed doors.  This is another topic for the commission in drawing up its directive: should engagement be disclosed? “It’s something that’s under discussion from the regulatory perspective,” comments Herskovich.  “Dialogue and the success of the dialogue are also important. We are transparent with our clients, but if we enter a dialogue with a company and it knows we won’t disclose its name we can achieve more.” The kind of shareholder activism that doesn’t hit the newspapers is perhaps particularly effective in areas where there are no plans for change. These include the shareholder structure in certain countries. In Sweden, for example, there are two classes of share, one with more voting rights than the other.  Germany has preference shares and France has a system whereby shareholders that remain invested for more than three years get double voting rights.  Because of vested interests and protectionism, there is little prospect that this will change any time soon. But through activism, shareholders can effect change in other ways. “It’s highly unlikely that we will see substantial change in terms of voting rights,” says Vermeulen. “Because of the way Europe works, the official structures don’t push towards that. But what is changing is the dialogue between the management and the board.” In any case, shareholders can, of course, vote with their feet. “Equity investors only want to give money to well managed companies,” says Vermeulen. “Weak ones get locked out.” But in terms of end investors – the saver in the investment fund or pension scheme – there is also a whole other level to the discussion, and that is about investor governance.  “A lot of these reforms to corporate governance would be great ideas for the investment community as well,” says Catherine Howarth, chief executive of charity Share Action.  Investor governance topics that need to be addressed, in Howarth’s view, include fees, pay, accountability and management of conflicts of interest.  Progress in this area has thus far been desultory. “It’s a very underscrutinised problem,” says Howarth. “We don’t have a constituency of very well informed people. “It’s a much tougher agenda to get debated.” Institutional investors agree that they need to have leverage over companies. Ensuring that savers have leverage over the investment professionals who serve them should perhaps be the next topic on the reform agenda. ©2014 funds europe

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