A decade ago, most shareholders showed little interest in matters such as corporate governance, environmental or ethical issues. However corporate scandals on both sides of the Atlantic - Ahold, Enron and WorldCom - have propelled shareholder engagement into the investment mainstream.
A dramatic shift in thinking has occurred, with the realisation that dialogue between shareholders and companies over governance matters is a vital part of the risk management process. The idea of investors acting like “absentee landlords” who turn a blind eye to poor governance rather than actively address deficiencies is no longer tenable.
The Tabaksblat code
There have also been significant changes in the regulatory and legal codes surrounding corporate governance. In contrast to the heavy-handed response in the United States expressed in the hastily introduced Sarbanes Oxley Act, European governance codes have been allowed to evolve following widespread discussion of the issues at stake.
The Netherlands leads the rest of the Continent with the Tabaksblat code, which has now been incorporated into Dutch corporate law. This code advocates an “apply or explain” approach to governance principles, in contrast to the absolutist approach of Sarbanes-Oxley. Tabaksblat wisely recognises that best practice goes beyond voting procedure and is about dialogue and flexibility. Take-up has been impressive, with 88% of companies complying in the first year and full compliance expected within three years.
Myths about engagement
Media coverage of showdowns at shareholder meetings and reports of confrontational polemics between investors and companies have created misconceptions and given shareholder engagement a sometimes controversial image.
Yet engagement is not about micro-managing businesses. Rather, it is recognition that at the heart of good governance lies an understanding that shareholders must satisfy themselves that company strategy genuinely takes a long-term focus on shareholder value through an understanding of the wider Environmental, Social and Governance factors that affect value. Constructive dialogue, not confrontation, is the name of the game.
Transparency of voting is on its way
Just as transparency from companies is a pre-requisite for constructive shareholder engagement, it is also important that institutional investors should not shy away from being transparent with their own customers in terms of how they vote. Moreover, indiscriminate data disclosure adds little and in fact can overwhelm and undermine the spirit of true transparency. Therefore, when shareholders are unable to support management through their votes, they should explain themselves in the interest of improved mutual understanding.
From our experience of voting on a global scale, sensible voting should take account of different legal and cultural legacies. Voting against management should be used sparingly. F&C routinely writes to all its holdings, well over 3,500 companies, to advise them of its voting policies – and voted against management in only 8% of cases worldwide in 2005.
Within the broad field of corporate governance, there are four core areas of interest to shareholders. Board effectiveness – typically addressed through board structure and composition; remuneration; internal controls and management systems; and capital structure.
Boards should have a balance of experience and strong representation by genuinely independent non-executive directors, as well as adequate representation from executives. The roles of Chairman and Chief Executive should be clearly separated, as without separation, the Chairman cannot objectively supervise and challenge the CEO about implementation of the corporate strategy set by the Board.
Executive pay is another contentious issue. The guiding principle should be an alignment of reward with performance, accompanied by full disclosure of remuneration. In the Netherlands, companies are improving their disclosure on remuneration and putting their policies to a shareholder vote, as advocated by Tabaksblat. Recognising that many companies are still finding their feet on these issues, F&C has abstained rather than vote against 15% of remuneration proposals from Dutch companies. But our stance on remuneration issues is likely to become tougher in the future.
Robust internal controls are vital to the mitigation of potential risks. A newly emerging concern is that of political donations and lobbying, where management systems should be in place to ensure transparency and clear policies to avoid accusations of buying influence.
Another area of interest is shareholder rights and capital structures. The principle of one-share/one-vote is a fundamental building block of sound governance, and serves to ensure that management is properly accountable for its strategy and performance. Furthermore, institutional shareholders should refuse to give companies a “blank cheque” to issue stock without pre-emptive rights or a specified price. Last year, F&C opposed such requests from a number of companies including ABN Amro, Ahold, Akzo Nobel, DSM, KPN and Unilever.
Bribery and corruption
Shareholders should ensure that effective systems are set up to counter corrupt practices, especially in developing markets. These would include confidential internal reporting procedures, aka, ‘whistle blowing systems’, to ensure that staff and others are encouraged to report wrongdoing as early as possible without fear of punishment.
The reputation of a company can be seriously affected by its policies and actions on environmental issues. It is therefore in the interest of shareholders to ensure that companies develop strategies to strengthen their environmental credentials.
Companies with poor labour standards risk their reputation and consequently shareholder capital.
In some fast-growing developing economies, workforce mortality through HIV and AIDS is a real problem. Shareholders are encouraging companies operating in these markets to assess these risks and consider solutions in the form of education and treatment programmes.
Shareholder engagement in the Netherlands
In the Netherlands, pension schemes have two broad options for incorporating good corporate governance practices in their communication with companies. First, is to implement a consistent approach of direct dialogue with companies. However, this requires a considerable resource commitment and will only be an option for the very largest schemes.
Alternatively, pension schemes can work with the Governance and Socially Responsible Investment departments of asset management houses, who are able to provide this service as part of their mandate.
But there is also a third approach which is particularly suitable for schemes which use multiple fund managers rather than a single balanced mandate. This is to use an external provider of shareholder engagement services, who can implement a consistent and coordinated approach across all the scheme’s portfolios. This ensures that whilst the scheme may seek to utilise numerous different investment capabilities, in terms of representing shareholder views and concerns to companies the scheme is seen to speak with ‘one voice’.
At F&C we have long offered the latter two of these approaches through our reo® (responsible engagement overlay) and shareholder voting service. On behalf of clients, including those who use other asset managers, we engage with investee companies on a wide range of issues, ensure that we cast votes whenever possible and on a global basis and then report back this activity to our clients. With recent developments in governance code, standards and expectations have been significantly raised and Dutch pension schemes need to meet the challenge of this new climate. At F&C we believe we can provide a series of solutions.