Business, Innovation and Skills Committee - Minutes of EvidenceHC 603

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Oral Evidence

Taken before the Business, Innovation and Skills Select Committee

on Tuesday 5 February 2013

Members present:

Mr Adrian Bailey (Chair)

Paul Blomfield

Rebecca Harris

Ann McKechin

Robin Walker


Examination of Witness

Witness: Professor John Kay, Chair of the Review of UK Equity Market and Long­Term Decision Making, gave evidence.

Q1 Chair: Can I thank you and welcome you, Professor Kay? Could we just start by letting you introduce yourself for voice transcription purposes?

Professor Kay: I am John Kay, author of the review of equity markets and long­term decision making.

Q2 Chair: I will start off with a fairly general question. In your analysis, you basically downgraded the role of equity finance in terms of business capital investment. However, there did seem to be some contradictory evidence from the Quoted Companies Alliance. Could you tell us whether equity markets remain an essential source of capital for new investment in British business? What are your thoughts? Coming from your perspective, and that of the Quoted Companies Alliance, what do you think is the right sort of balance of evidence?

Professor Kay: There are two ways of looking at it. One is to consider what has been raised over the last 20 years or so. We actually find that if we strip out the amounts that were subscribed in the rescue rights issues of British banks-most of it by the Government-then total new equity issuance has been negative, not positive. By that I mean that more shares have been bought back or removed from the market through people buying companies from cash than have been raised in new issues. In that sense, equity markets are not now a source of fundraising.

If I look at it from the other point of view, which is the question of where quoted companies actually get money from, the answer is that they are overwhelmingly now self­financing. If one examines British quoted business as a whole, it makes more cash flow from operations than it currently invests. We know that at the moment British companies, taken as a whole, are sitting on a large pile of cash, and that the vast majority of quoted companies are individually self­financing as well. When quoted companies go outside the company itself to raise new money in the markets, they have largely done it through debt, rather than through equity.

Q3 Chair: Could it be, though, that even though the overall figures indicate a diminishing role for equity finance, it is still, or has been, strategically very important for some companies?

Professor Kay: Rarely, I think. The other side of it, which causes me a lot of concern, was the observation that successful small and medium­sized companies less and less regard getting public market quotation as a natural part of their development. Another reason for that is that business is less capital intensive than it was. We think of knowledge businesses as being the future, and these businesses may incur operating losses in their start­up years, but they do not require huge quantities of physical investment. Equally, the kind of physical investment that we do need in business is now much more fungible than it was. It is property, computers, and that kind of thing, which can be provided through other ways than equity finance. I am not either applauding or deploring this. I am just describing what I think has happened.

Q4 Chair: I understand that. How did this affect your recommendations in the review?

Professor Kay: It took me to saying that "This is how things are, and, actually, I don’t think they are going to change very much." Equity markets are, in this sense, fundamentally secondary markets. In a way, the tail has come to be much larger than the dog. Therefore, corporate governance and issues around that are not a small part of the way in which equity markets relate to corporate performance. They are actually a very large part of it; in some ways, they are the main thing that we should be looking at. As far as investment and decision making in business is concerned, what equity markets are doing in effect is, they are a way of supervising the investment decisions and the strategic decisions that are made by company management. That is the way we should look at it, and it is the way that I did look at it.

Q5 Chair: Given your position on this-and I think you have touched on this already, but if you could just spell it out-how do you see the role of the equity market in future?

Professor Kay: As things are at the moment, I see it probably playing a diminishing role. We have said that it is not an important source of finance for new business. We have said that it does not seem to be the case that new British companies are coming to market. One of the striking things, if you look down the list of new listings on the London Stock Exchange over the last five to 10 years, is that although it is quite a long list you will not find many ordinary, non-financial British companies on it. This is not the way that British business now seems to be growing and developing. There are a lot of reasons for regretting that, but that seems to be the way that things are now.

We have put in place measures, partly through regulation and partly through other means, which mean that insurance companies and pension funds have a smaller proportion of their portfolios in equities than they used to. Of course, the pretty disappointing returns that savers have made from equity markets over the last 10 years have not made equity markets look exciting as a vehicle for savers in the way that they did in the 1980s and 1990s. At that time, just buying equities randomly was almost a way of making quite a lot of money.

Q6 Chair: This may perhaps be slightly beyond your terms of reference, but I have an observation arising from what you have just said, and I would be interested in your view on it. The larger companies are not turning to the equity market: they retain savings, and so on and so forth. Smaller businesses are finding it incredibly difficult to access capital from the banking service. Would you say that there is a structural failure in the market?

Professor Kay: Yes, I do. Our capital markets are not working well, in terms of their primary job of getting capital to businesses that need it. The critical requirement for small and medium­sized companies is to cover the operating losses of developing a business position, rather than, as I described, to buy plants and machinery and build factories, as was traditionally the case in the past. Banks never provided that much finance of that kind anyway, but we all know how little finance is now being provided for small and medium­sized companies.

As you say, this was not part of the terms of my review, but it is something about which I am very concerned, and plan to write about in what I am currently writing in terms of the financial services industry. It is one of the biggest problems we have in relation to the functioning of UK capital markets. What I would like to see would be the development of new specialist institutions that were more oriented to the provision of equity or near equity capital than the banks traditionally have been. They would perhaps be a bit like the venture capital industry used to be, before it rather lost its way and became private equity, and much more interested in buy­outs of established businesses.

Chair: I think it is likely that the Committee would love to pursue this line of questioning.

Professor Kay: Whether it is today is another matter.

Chair: It perhaps takes us rather beyond our remit. However, if you are writing about it, it is certainly quite possible that we will be doing a future inquiry into this, so we will invite you to expand further on that

Professor Kay: I would be happy to come back, I am sure.

Q7 Chair: In the meantime, I will watch the outcome of your deliberations with some interest. I would now like to move onto the international context and the market. Your analysis found that the owners of more than 40% of UK shares are based outside of the UK. How do you think that that has affected corporate governance and stewardship of UK companies?

Professor Kay: We have brought in a group of people who, for various reasons, are rather more reluctant than UK institutions used to be to involve themselves in the governance and strategy of UK companies. There is a term that I would rather not use in all of this, which is "share ownership," because, as I talk about in the report, exactly what we mean by "share ownership" is quite a difficult question. I have described critical players in this today as being "asset managers", and so our equity market is now dominated by large asset managers. Some of these are American firms like Fidelity, Capital, BlackRock and Vanguard. Some of them are British firms like Legal & General and M&G. Those are the biggest beasts in the equity market scene.

A lot of the funds that they manage are ultimately funds that originate outside of the UK. Many, although not all, of the funds that they are managing-whether they are American or British-are funds that originate within the UK. The picture is more complicated than the ONS statistics on share ownership, for instance, suggest. The basic element in this is that there are more foreign beneficial holders of UK equities, and there are more foreign­based asset managers in the market, than there were 20 years ago. There is also an element of sovereign wealth fund involvement in this, of which Norway and Singapore are the largest.

Many of these people are more reluctant to get involved in governance and strategy of UK companies than British institutions used to be. This is perhaps because that is not the way that Americans tend to operate; historically, Americans are more reluctant to work together than UK institutions. As with the sovereign wealth funds, they are a bit scared of getting involved in UK business. That is what led me to write that one of the things I would like to do would be for the British Government to say that, "For the people we are talking about, we would welcome greater involvement and collective involvement in British business on their part."

Q8 Chair: You have anticipated my next question.

Professor Kay: Sorry.

Chair: That is fine. The question was to be whether this is good or bad. I would gather that, from your perspective, you think that greater involvement of such funds in British business would actually be a positive, rather than a negative, influence.

Professor Kay: I think that it would, if it is the right kind of involvement. A lot of people talked about the merits of greater shareholder involvement. One needs to be a little bit cautious about that, because we have had rather negative shareholder involvement in many ways. I talked, for example, in the report about some of the signature examples of things going badly wrong in large British companies: the disappearance, essentially, of ICI and GEC, for example. The truth is that the break­ups that led to the ultimate collapse and disappearance of these companies were encouraged by shareholders. Indeed, if these companies had not been as oriented towards equity markets as they were, it is unlikely that these developments would have occurred. The kind of shareholder involvement that is about making short­term gains from restructuring and refinancing, rather than promoting the long­term operating capabilities of the business, is negative, not positive. That is why I think that we have to look, at the same time, at the style of asset management that asset managers deploy.

Q9 Chair: You state that the "general direction of our recommendations to asset holders and asset managers should, overall, be helpful to smaller companies". Could you elaborate on this?

Professor Kay: What we would like to see is longer­term, more concentrated portfolios by asset managers who take a strong interest in the companies in which they invest. We were talking a few moments ago about small and medium­sized businesses, and their funding problems. In my view, that is exactly the kind of funding that the typical small and medium­sized business is in need of, and is the kind of funding that is not currently very well provided through public markets in many cases.

Q10 Paul Blomfield: I wonder if we could reflect a little on where we go now. In drawing your report to a conclusion, you talk about the challenge ahead and say that the task will be "long and difficult. But it is time to begin." Who do you think should be picking up the ball, and how well do you think they are doing it?

Professor Kay: There are a whole range of people who should be picking up the ball. Government should clearly be picking up the ball, but there are limitations to what the Government can do. There are two very fundamental ways in which Government can contribute. One is that Government, and you as politicians, have a huge effect in setting the tone of public debate. If we are trying to change the way that people think about markets and the relationship between markets and companies, the way in which we have a public dialogue about that is terribly important.

The second-and this is described a bit in the report-is that a lot of our regulation of financial markets has gone quite badly wrong. Let me make clear that I am not against financial market regulation. However, I think we have gone far too far down the specification of detailed rules. We have also tended to view financial markets through the eyes of people in financial markets. There is something extraordinarily self­referential about both the ways in which people in public markets talk and the ways in which we regulate them. We need to reverse that, and say that markets are for users and should be judged by how well they serve users, not by criteria that are essentially generated by the market itself. That, over the long run, is a big shift. At the moment, if anything, we are going in the wrong direction, rather than the right one, in relation to that issue.

Chair: The purpose of this inquiry is to develop that process.

Q11 Paul Blomfield: Giving that responsibility to Government, and recognising its limitations, how well do you feel that the Government have responded to the challenge that you have set?

Professor Kay: It is hard to say at this point. The tone of the Government response, in relation to the two issues that I have just described, was more positive than I had anticipated. I was fearful-and am still fearful-of more push-back from established, vested interests in the financial services industry.

Q12 Paul Blomfield: What about the response from other players?

Professor Kay: The response from asset managers and investment managers has been mixed, but, in the main, pretty positive. I got a strong sense during the work on the review-and it has been confirmed afterwards-that a high proportion of the asset management community would actually like to go down the directions that we are describing. They feel inhibited in doing it by the demands of their customers and by the whole regulatory and market environment in which they are operating. That is why we have to go about making a whole set of piecemeal changes-in tone and in regulation-to try and shift things in the directions that we want to go.

Q13 Paul Blomfield: As a different reflection on your report, you provided a fairly fundamental critique of markets. In response to the Chair earlier you talked about structural failure, or concurred with that view. In that context, there has been some criticism that the report is fairly timid; one commentator said that it whets the appetite for a further report that specifies more of what might be done. How do you respond to that?

Professor Kay: I can see a sense in which that is right, if one is talking about a 20year process of change and reform. The kinds of markets that we have today are the product of a long history. One can see the changes in the 1970s and 1980s that set the way for the financial services industry that we now have. If it is a long process, then it is probably right to say that we are starting to push in a different direction and creating a vision of where we would like to be. That is why I welcomed one aspect of the Government’s response, which was to say, "We will look at this issue again, and see whether we are starting to make progress in the right kind of ways". That is a sensible way to look at it. What I have said explains, in a way, why we did not do what a number of people would have liked us to do, which would be to set out a raft of detailed regulatory changes and recommendations. I really do not think that would have been helpful in setting the kind of change in tone and direction that I would be seeking.

Q14 Paul Blomfield: You make a strong critique in your report of the limitations of regulation, so I understand where you are coming from. However, one commentator in the FT said that, of your 17 recommendations, only four could really be described as substantial. In the comments you just made a moment ago, you seemed to suggest that you felt you could have gone further. Is that fair?

Professor Kay: Yes. Let me take a radical example: we are in a bit of a mess about insider trading rules. That is a subject where we have not quite thought about what we are doing, and is a classic case in which we are tending to view the issue through the eyes of market participants, rather than the ultimate users of markets. I could have said more about that, but I do not think that either financial market opinion or public opinion is yet ready to rethink the way in which we view these kind of issues. We have to move step by step.

Q15 Paul Blomfield: What would you see as future steps? Taking that one example, if public opinion was right, what else would you like to see?

Professor Kay: If one elaborates on that example, what we do at the moment is that we conflate together the kind of fraud involving a guy sitting in a boardroom, and ringing up his hedge fund friend to tell him what to buy and sell when he comes out of the boardroom-these kinds of people ought to be in prison, and we ought to be focusing on how we get tougher enforcement action so that we can get people who do these kinds of things behind bars where they ought to be-with a raft of regulatory and compliance issues that we have, which I think is a different matter. These are the issues that regulate the kinds of interactions that asset managers can have with the companies in which we invest. We are, in effect, saying at the moment that we really want asset managers to engage more forcefully with the companies in which they invest, but if they do, and gain any informational advantage, they may not trade on it. There is a paradox there. I do not believe it is either possible or desirable to say that we will have markets in which everyone is trading on the basis of uniform information.

Q16 Chair: Before I move on to Ann McKechin, could I just put it to you that you have outlined the problems, you have not made that many robust recommendations, but in your evidence to us today-and I hope I am summarising it fairly-you say that too often Government sees regulation through the eyes of the industry? Surely part of your role was to provide the Government with a counter­argument that it could use as a basis for introducing a greater degree of intervention. There does seem to be a lacking in your recommendations of the kind of detail that would enable them to do so. How would you respond to that?

Professor Kay: I see what you are saying. First of all, I do not want more regulation. I really want less, in fact, because we have gone down what I sometimes think is a Soviet Union­type road of introducing regulations and, when they do not work very well, making them more elaborate. We then go on, getting more and more frustrated at the fact that they do not work very well. In a way, I would like to see less regulation of financial services, rather than more.

However, what we ought to be aiming at are things that are the products of different kinds of behaviour. For example-and this is a very important one-a lot of the damage is being done by the way in which asset holders and retail savers are judging, and are being encouraged to judge, fund managers and asset managers on the basis of their very short­term performance. Everyone is going through the business of getting quarterly performance reporting, sometimes more often than that, and having the kind of discussions in which people say, "Why were you 1% behind the benchmark in the last three months?" and so on. I do not think I can introduce regulations that would stop people doing that. Just try and frame the regulation; you cannot do it. Indeed, there is an almost human tendency to try to look at performance terribly often. I know that, now I can press a button on my computer and get the value of my share portfolio at any moment of any day, I quite often do that, even though I know that it is not giving me any useful information.

I do not think we can regulate people to do that. However, what we can do is say to people that it is not good practice, and that hauling your fund manager over the coals every three months and asking why they underperformed last week is not you doing your job conscientiously. It is bad practice. It is not in the long­term interest of your beneficiaries to have that kind of inquiry, because it leads to fund manager behaviour that is short­term, inappropriate, and stimulates them to look at markets and the performance of markets, rather than the underlying performance of companies. That is why I thought that the right way of doing that is to try to tell people what good practice is, so that they can say to their asset managers-as I hope they ultimately would-"Here is some money. Come back after a period of years, and tell me how you have performed with it, because I cannot judge you except over that period of years." That is not negligent. It is what people ought to be doing.

Q17 Chair: It sounds a bit like the financial equivalent of motherhood and apple pie. Telling people what good practice is, and so on, is very different from actually getting an industry that, by and large, does not seem to put the adoption of good practice at the top of its agenda to do so. Surely there must be some means by which the Government could exercise a monitoring role that would not need a whole raft of detailed regulation.

Professor Kay: Let us look at the example of what has happened in this area, by putting more responsibility on pension fund trustees to monitor the performance of their asset managers and their underlying companies. We have done two things. One is that we have created this market for investment consultants, who are themselves the source of quite a lot of this short-termist behaviour, because they are typically making recommendations to trustees based on recent performance histories, rather than the future approach and strategy of the manager. In addition, we have encouraged trustees to think that they have to be going through this regular routine of performance management. By saying we are monitoring the performance of pension fund trustees more carefully and imposing more obligations on them, which sounds as if it is moving in the right direction, we have in fact done the opposite.

If we want to establish trust relationships as the basis of financial services-and I believe we do-we cannot regulate trust relationships very easily. We need to set up structures and environments in which people can develop them and in which they are encouraged to develop them, rather than the one we have at the moment in which people are going through large amounts of compliance­based form­filling and box­ticking.

Q18 Chair: Surely that is because the compliance criteria are wrong. If those were altered, then that could surely change.

Professor Kay: This is where I come back to wanting to set out these generalised statements of good practice. I do not see how I can enforce these. What we have ended up in large part doing-in the corporate governance sphere, for example-is that we have set out what everyone in the corporate sector calls "box-ticking", in which people are devoting lots of time to worrying about how long non-executive directors have been on the board. These things are not trivial, but they are not much to do with what has really gone wrong in those British companies where things have really gone wrong. GEC did not blow up because it did not have the right lengths of service or experience of non­executive directors. It blew up because of very fundamental misconceptions about the relationship between financial markets and business.

Q19 Chair: Can I just pick up one point that you made, in terms of directors’ remuneration and incentives? I will quote you: "Long­term performance incentives should be provided only in the form of company shares to be held at least until after the executive has retired from the business". I understand what you are trying to say there, but could that not be contradictory, insofar as it might provide an incentive for a higher turnover of directors who would basically take their cash and run when it suited them?

Professor Kay: That is possible. I do not think it would happen very much. Back in this area-as in the area that we have just been talking about-what we want is people running large companies who derive their main satisfaction from their sense of how they have built the company over a period of years. That is what British managers traditionally did, before we started an elaborate and counter-productive process of supposedly aligning their interests with those of shareholders through these complicated bonus and incentive schemes. The people who built the great British businesses of the past-the ICIs, the Shells, the Unilevers and so on-were motivated by the thought that they were building great businesses, and they were. These people did not really think about the share price much. I would like to get back to managers having much more of that kind of approach and attitude.

Q20 Mr Walker: On that point, and on the point about management incentives supposedly aligning with shareholders, do you think that change in culture has made managers of businesses more inclined to sell and take a profit when they can?

Professor Kay: It has certainly made them much more financially inclined, interested in M-and-A­type strategies and restructurings, and a whole variety of issues that are not very closely related to the underlying competitive strengths of the business.

Q21 Ann McKechin: Good morning, Professor Kay. I wonder if you could perhaps give me your opinion of whether there is any added value in having a non­enforceable stewardship code, which is what we currently have?

Professor Kay: Yes, I think there is. We can do a lot to tell people what we regard as good behaviour and put pressure on them to do it, without actually pushing that into formal regulations. There are two disadvantages of framing these things in terms of formal regulations. One is that they are inflexible-not all of these regulations will be applicable to all situations and all companies. The other is that people will be inclined to believe that, so long as they have complied in a formal sense, then they have done their job.

We have seen a lot of examples in the financial services industry of regulation that has worked badly in these respects. The worst example is the capital requirements that we imposed-and, indeed, are now strengthening-on banks. That had essentially the effects I have described: people believed that, so long as they formally complied with the capital requirements, they were managing their risk properly. We know that, in fact, they were not. It also meant that people devised instruments that, in effect, got around the intended effect of the capital requirements. These things encourage formal compliance, rather than substantive compliance.

Q22 Ann McKechin: Some of the evidence given to our Committee-for example, from Aviva-talked about a free-rider problem. They said that good stewardship is a public good, and therefore that if you have one set of asset managers who exercise the code in the right spirit, then basically other asset managers can simply piggyback on that and do not have to bother. In that sense, is there not then a greater need for some form of baseline, and there being consequences for not complying with this baseline? Otherwise, what is the incentive for companies as a whole to improve?

Professor Kay: The freerider problem concerned me quite a lot, and it is discussed at length. That is, in part, why I wanted to introduce measures that made it easier for people to act collectively. In terms of baseline involvement, there is something to be said for that, but, again, it is quite difficult to enforce a low baseline meaningfully. We want asset managers to engage more forcefully and effectively with the companies in which they invest. It is really quite difficult to define what we mean by engagement of a constructive kind.

Q23 Ann McKechin: Do you think the Government should rewrite the code? You have mentioned the fact that you think that the code should be more strategic in its purpose. To what degree do you think Government should be engaged in trying to set that?

Professor Kay: Yes, I do, and that was one of the things I was trying to encourage through statements of good practice. If the industries do not develop these kinds of concepts of good practice, I would like Government to intervene and try to do it for them. However, to me, that is a second best, because what we are really trying to do is to influence people to start changing the way in which they behave. The best way to do that is to take advantage of the fact that most of them want to do it. You talked about Aviva. Most fund managers would actually like to move towards the kind of regime that we are describing. It is not because they are recalcitrant; it is because the structure of the environment in which they are operating does not encourage that kind of behaviour. That is why we have to make all of these moves in changing the culture in a way that will bring about the kind of behaviours that we want.

Q24 Ann McKechin: You have mentioned the fact that many asset managers would want to have greater involvement in management of the company. However, surely part of the code should be designed for the general public and savers so that they actually know what it means, and what they can and should expect from the people who are responsible for their savings. FairPensions have indicated that there is really a need for a clearer definition of stewardship. You have mentioned that defining parts of the Code is quite difficult in some ways, but would you agree that greater clarity might be of assistance?

Professor Kay: Yes, I do. I think that the good practice, the stewardship code, and so on, are all things that we would want to evolve over time. That, in a sense, is another reason for not making it too rigid and too inflexible. We want it to be an evolving and developing process.

Q25 Ann McKechin: If I could turn now to the good practice statements, which you have also mentioned in your report, they said that they should prompt market participants to consider their current practice, but will not have the force of regulation or formal guidance. If that is the case, who will be responsible for monitoring the compliance between the asset managers, the asset holders, and the company directors?

Professor Kay: Because they are good practice, I do not think that there is an issue of formal compliance. This is what we want people to do, and we are saying that many people want to do it. However, it is almost impossible to define the kind of engagement we want in terms of formal rules. It is almost impossible to define the kind of long­termist attitude that we want from company directors in terms of formal rules. If managers of large German companies typically have more long­term outlooks than managers of British companies, for example-and they do-it is not because there are different duties in German law to the ones in British law, or different regulations in the two countries. It is essentially because the structure of share ownership in Germany, and the attitudes of many of the large holders of stakes in German companies, are different from the equivalents in Britain. What brings about the difference is not a different regulatory structure or different company law, but a different set of attitudes to how businesses should develop. That is what we need to be focusing on.

Q26 Ann McKechin: We could say this about any business relationship, but, at the end of the day, what happens in the City has an impact on the savings, pensions and economic prosperity of every citizen of this country. Would you not reflect that there needs to be a degree of transparency? If somebody says, "We have a practice statement, and we believe that the outcomes will be X-this will be improved, and there will be some way in which we can give certain degrees of certainty about what we are aiming for, and we will report back to our shareholders or whoever on a regular basis about how we are achieving those outcomes in line with our good practice statement," then people can see a direct correlation. At the end of the day, this just seems to be a whole other set of words that somebody stores carefully in the shelf and brings out from time to time to say, "We’ve got a good practice statement." People want to find a way in which they can actually hold people to account for the way in which they are dealing with their money. This is what this is fundamentally about.

Professor Kay: That is right. However, we should then ask how, as savers, we are collectively going to do it. There are two things that we can do. One is, as savers, to place our money with people who adopt the right kind of practices in dealing with that money. That is both looking at what they say they do, and observing whether they actually do it. Secondly, we can develop intermediaries to do that. I think that, at the moment, intermediaries are in the main not being terribly helpful in bringing about the kind of objectives we want. Intermediaries are playing the game of being obsessed with short­term relative performance rankings. One of the positive developments in this area is the creation of NEST, and I think that people who bring to the industry and to business the kind of attitude that NEST has are capable of being more effective representatives of genuine shareholder interests than we have had up until now.

Q27 Ann McKechin: If people continue to ignore voluntary statements, how could the implementation of policing be firmed up to ensure that they abided by them? You have mentioned that you are not keen on simply having stark Government regulation, but surely the stock exchanges and other professional bodies have a part to play in terms of their own rules and regulations?

Professor Kay: We are not talking about the rules and regulations of the stock exchange very much. We are largely talking about the people whom I see as being key to this process, who are asset managers, and developing different kinds of relationships between asset managers and the savers or the representatives of the savers-who are the ultimate beneficiaries-and companies. You will notice that the way I am describing it is a way that downplays the role of the stock exchange and public markets. That is quite intentional. What I would like to do-and this is fundamentally what is underlying the whole direction of the recommendations-is to try to move towards a world in which financial intermediation is based much more on trust relationships, and much less on transactions and trading, than has been true in the past. We will only be able to develop a structure that gets the capital that British business needs, and the returns that savers and all of us need to pay our pensions from, if we do that.

Q28 Ann McKechin: What is the push towards that? We say this is what we would like to happen. If it does not happen, what do you think we should then try to do?

Professor Kay: The biggest push to it would be if we-both as individual savers and as people like pension fund trustees who are placing funds with asset managers-began saying, "We are looking for long­term, strong, absolute returns from the funds that you invest, and are not very interested in your performance relative to other people."

Q29 Ann McKechin: The pension fund managers are the key part, because the ability of individual shareholders is probably pretty limited.

Professor Kay: Yes, but the expectations of individual shareholders affect the attitudes of the asset managers and everyone else. At the moment, asset managers are very much concentrating on outperformance, relative to other asset managers. That outperformance is typically over quite short periods. That is the largest thing we need to fight against. We need to educate savers not to respond to advertisements that say, "Our fund beat 90% of the others over the last six months." We need to enable trustees to feel that, not only are they not required to monitor the performance of their asset managers every three months, but that they are actually not serving their members very well if they do so. We need to tell pension fund trustees that the real approach they ought to be taking is finding managers whom they trust and in whose strategies they have confidence. We also need to be saying to asset managers, "This is what we think is good practice as an asset manager, and we are not only going to stop putting obstacles in the way of your constructive engagement with companies, but we are actually going to facilitate it." There is a whole set of piecemeal changes. Some of them are regulations, but most of them are the attitudes that we need in order to get closer to where we want to be.

Q30 Chair: Can I just come on to investors’ forums, which is a concept that has been accepted by the Government. How do you think that the collective engagement of investors can bring about an alignment of the objectives of shareholders, investors, and business?

Professor Kay: This is what was just described in the last exchange-trying to offset what is described as the freerider problem. If by engagement you improve the performance of a company, but you own 3% of the company, you get 3% of the benefit from what it is you do. The more opportunity there is for people who collectively own 30%, 40% or 50% of the company to act together, the more offset we have against that particular freerider issue.

Q31 Chair: Some evidence that we have received actually challenges this, on the basis that it would "weaken the strength of the shareholder system, namely, that shareholders vote and act as individuals." How would you respond to that challenge?

Professor Kay: That is a good example of the issue, which I have described, of viewing markets through the eyes of market participants, rather than the interests of ultimate users. It is in the interests of everyone-savers taken as a whole and companies taken as a whole-that we should do as much as we can to encourage the better performance of British business.

Q32 Chair: Would it be fair to say that that view is based on a myth that shareholders do actually vote and act as individuals?

Professor Kay: They certainly do not vote and act as individuals, to some degree. Amongst the asset managers who control large voting blocks, there is some tendency for them to still act as individuals. It is not shareholders acting as individuals, but it is large institutions acting independently.

Q33 Chair: Consistent with what you said before, and looking at it through the eyes of the financial institutions, the pensions community has told us that this recommendation is not necessary, because "a significant amount of collaboration already takes place amongst UK investors" that is "not always visible." What consultation did you have with investors, and what was the evidence that led you to come to these conclusions?

Professor Kay: I talked a great deal about this to large asset managers. As I described earlier, I think it is the case that there is a degree of coordination and consultation between British­based institutions. I described my experience, which was that American­based firms were more reluctant to be involved in this process than British­based firms, and their role in the process is now much larger than it was. People talk to me almost endlessly about concert party rules. Although the Takeover Panel kept telling us that this was not, in fact, an obstacle to collective action, it was perceived as one by many of these firms. The sovereign wealth funds, whom I mentioned, keep their heads down, in the main. It is certainly true that there was more collective action amongst British institutions 20 years ago than there is now, and that is primarily because British institutions were a larger part of the total market 20 years ago than they are now.

Q34 Chair: As I said before, the recommendation has been accepted by the Government. However, the quote is that the Government would "like to see further progress across the investment industry". Who have you recommended should monitor progress in this area, and what do you think is the reason for the delay?

Professor Kay: Monitoring the process, and monitoring progress on most of the recommendations here, is very much a matter for Government. That is who should be monitoring this. I am not myself party to the discussions about setting up such a forum. That is not my job.

Q35 Chair: We will no doubt be talking to Ministers about this at some time. FairPensions argues that, to shift incentives for market players, some kind of external force is necessary. We do not seem to be getting very far at the moment. There is buck­passing. What do you think this external force should be? Do you think it might be applied to either the Government or the regulator?

Professor Kay: The application of external force is clearly a matter for Government. We have talked earlier about the two ways in which that kind of Government external force can be applied. One is through Government setting the tone and terms of debate, and that is very important. The whole set of issues around saying that the purpose of finance is not to serve finance, but rather to serve savers and business, represents a big change from the tone of what Government has been saying about the financial system for quite some time.

The other is that we need to get regulation right. We are making some progress in that; there are signs that the new regime will be more user-focused than the old FSA structure was. However, we have an awfully long way to move in that direction, and to emphasise that the critical feature of our regulation should be what it does for companies and savers, not what it does for people in the market. In Europe, which is the driver of quite a lot of our financial regulation now, we are very far from being in the kind of position that I have been describing.

Q36 Chair: I am a layperson. I have never been involved in this particular industry at all. However, I think that my perspective is probably shared by the public at large, which is that just a change in tone is not likely to realise a change in habit, policy, and so on. Surely there needs to be something that will exercise more influence on the industry?

Professor Kay: I understand your desire, which, in large part, I share. If I could find regulatory provisions that would do the kind of job that we are describing, I would support them. I find it very difficult to see what these regulatory provisions are going to be. Indeed, the starting point should be withdrawing some of the regulatory provisions that are going in the opposite direction. We have, at the moment, a market abuse directive. Think about that phrase for a moment. It is not market abuse that we should be concerned with; it is customer abuse, and a customer abuse directive would look very different from a market abuse directive. Our concern is not with manipulating the market, except insofar as manipulating the market creates a worse deal for companies and savers. That is the kind of preoccupation we need.

I was quite struck, hearing an interview with the chief executive of one of the big execution­only share dealers acting for retail customers in the markets. He was asked what effect MiFID-the Markets in Financial Instruments Directive-had had on his customers. There was a pregnant pause for a moment, at the end of which he said, "I can’t think of any." We are proliferating this kind of regulation, which essentially entrenches the existing structure of the industry. That is why I want to be focusing on the interests of users and customers.

Chair: We will look at that in greater detail during the course of the inquiry.

Q37 Rebecca Harris: You recommend that companies should consult their major long­term investors over major board appointments. I was wondering if you could just clarify for the Committee what you mean by a "major investor", and also a "long­term investor"?

Professor Kay: We are really talking about, in general, the six to 10 large asset managers who are now speaking for a very large proportion of UK equities. Obviously, since they do not all hold the same proportions, they would be different people in relation to different companies. If we move to a world-which is the world I would like to see-in which there was more differentiation of asset manager portfolios than there is at the moment, so that you were not always finding the same six or 10 at the top of the shareholder register of companies, you would have much more specialist relations between companies and their investors. In that world, it would be natural and part of the ongoing engagement with the company that the company should consult the investor. That is what I have in mind. Obviously, companies cannot realistically consult shareholders at large. We have the essentially formal re­election at the annual general meetings that are part of current practice, but that is a formality, as we all know.

Q38 Rebecca Harris: Can you also define for us what you would consider to be a "major board appointment?"

Professor Kay: I think that, by "major board appointment", I probably mean any board appointment. We were thinking, in part, that for smaller companies it would probably be primarily about the chairman and chief executive.

Q39 Rebecca Harris: So it would depend on the company, rather than the board. How would you recommend that companies should balance consulting with their shareholders with the difficulty of confidentiality around information attached to the appointment?

Professor Kay: This goes back to the regulatory front. I would like to be much more relaxed about all of this. I am not sure that the raft of regulations that we have designed to control the flow of information to investors is actually serving the interests of either investors or companies. It is in large part there to protect the interests of short­term traders, so I am not that bothered about confidentiality. The sense in which I have to be bothered about the confidentiality front is that, at the moment, there are asset managers who will say that they are reluctant to be consulted by the companies on serious issues because that may make them insiders who are unable to deal in the company’s stock. That goes back to the issue that I am not really sure that the current, near­obsessive emphasis on uniformity of information is serving useful, desirable purposes.

Q40 Rebecca Harris: Did you go as far as considering that long­term substantial shareholders should have direct board representation?

Professor Kay: That is a matter between the investor and the company. At the moment, many asset managers would say that they did not really have the expertise to do this. I would hope, increasingly, that they would. That is probably more a matter for smaller companies, where the company has more difficulty finding non­executive directors with wide experience, than it is for larger companies. A particular asset manager would ideally have quite a strong relationship with such a company, if he decided to invest in one.

Q41 Rebecca Harris: You recommended that BIS should take a rather more sceptical attitude about the claimed benefits of foreign takeovers. I wondered how much we have to be careful there, given that many UK companies are also active in acquiring foreign businesses. I wondered if you could comment on that.

Professor Kay: One of my views on this is that we have too much merger and acquisition activity of all kinds, whether inward or outward. I understand the concerns about the inward takeover-the Cadbury issue-but in terms of terrible takeovers that have damaged British business in the last 20 years, RBS taking over ABN AMRO or GEC taking over rather curious US telecoms companies were not great successes. The damage done to British business by M and A activity is not just a matter of good British companies being taken over, although that is a problem; it is also British companies who, when you talk to them about strategy-and this is true when you talk to a lot of people in the City about what they mean by "strategies"-believe it means, "What businesses are you going to buy and sell?" That is not what I mean by strategy. It may sometimes be the right thing to do, but strategy is really about building up capabilities and operating businesses. That is the focus that I would like to see.

Q42 Rebecca Harris: So therefore, future success in this area for you would be fewer mergers and acquisitions, or fewer that fail?

Professor Kay: I think we can all vote for fewer that fail. Since, to be honest, none of us know which are going to be successful or unsuccessful, I would like for there to just be fewer. One of the things that one is bound to think about is whether we should have more powers for the Secretary of State, or the Competition Commission or its successors, to block mergers. I am stuck there with the difficulty that either the Secretary of State or the company itself has in knowing whether a merger will succeed or not, in the long run.

Q43 Rebecca Harris: How does that work? As we have said, we do not know which are going to succeed and which are going to fail.

Professor Kay: I know that there are too many, but I do not know which ones are the "too many". I would like to just have fewer. The real thing that we are trying to achieve is what I described earlier: persuading the senior executives that their job is to develop the capabilities of underlying businesses. They are not what I have described as "meta fund managers", who are juggling portfolios of businesses, rather in the way that fund managers are juggling portfolio stocks. That, frankly, is more or less how quite a lot of people have seen the chief executive role over the last decade or two.

Q44 Rebecca Harris: It is kind of a cultural change, basically, isn’t it?

Professor Kay: Yes, and it is another good example of the kind of thing where it is very difficult to see how it could be addressed through regulation, but where we can do an awful lot by tone.

Q45 Rebecca Harris: There have been comments about the Takeover Panel; there have some criticisms, saying that it is effectively a cartel of the investment banks with no statutory basis, which focuses solely and explicitly on price. What kind of role do you see for the Takeover Panel in implementing your recommendations, and how would it perhaps need to change?

Professor Kay: I am not sure that I want the Takeover Panel to be doing very different things from what it is doing now. When there is a contested bid, there is a job to be done in insuring against malpractice of various kinds. That is what the Takeover Panel has done over the decades it has been in existence, and it has done reasonably well, overall. However, it is a terribly limited function, and of course it is not its function-nor should it be-to say whether a bid is any good or not. It has been described as a cartel of investment banks. I think that is largely right, although not necessarily derogatory, if it has the narrow role that I am describing. However, there is an interest on the part of investment banks. We have had a relatively modest rate of takeover activity since the crisis of 2007-2008. That is probably a good thing, but I am not sure that it is here forever. There are fashions and cycles in merger and acquisition activity, and I expect that we will have another one some time in the next few years.

Chair: Can I bring in Robin Walker on Cadbury, derivatives, futures and short­selling?

Q46 Mr Walker: Before we move on to that, I just wanted to pick up on a couple of points relating to foreign takeovers in my personal experience. I should probably refer to the register of interests the fact that, prior to coming here, I used to work in financial communications in the City. I actually worked on a number of takeover defences, both hostile and friendly, of UK PLCs. In my experience, when an approach was first made, in every case management set out to continue running the company, to defend the company, and to drive up the value of the company. However, there was then a process in which they drove up the value of the company, showed what a good job they were doing and won shareholders over, and then the shareholders ended up putting pressure on the management to sell at a higher price. In, I think, five out of the six of those types of situations that I worked in, the companies ended up being taken over. It comes back to this thing about the culture change of shareholders. Are shareholders just too ready to take cash when it is offered, and what can be done to make them appreciate the long­term value that can be created if they hold on?

Professor Kay: The most constructive thing that we can do is divert attention away from short­term performance. If you are being judged by your relative performance over a three­month period, and you are being offered a substantial premium for your shares over what they were selling at three months ago, the pressures to accept are really quite great. It is once you get into the business of looking at the portfolio over three or five years that it starts to be less obviously attractive to accept the kind of bids you describe.

Q47 Mr Walker: One of the problems there-and this comes into the whole Cadbury­Kraft thing and the argument about shortselling and short­term shareholders-is that not everyone holds their shares for five or six years. You have got the long­term investors, who are there and who form a rump, but often during the course of the takeover you will have more and more short­term investors-hedge funds-moving in and taking a greater proportion of the register.

Professor Kay: As you know, one of the things that was put to us-and there was quite a lot of discussion about this-was whether short­term holders of that kind should be disenfranchised in some way in these cases. It seemed to me that one reason for not going down that route was that if you asked, "Where did the arbitrageurs get their shares from?" the answer was, in most cases, "From the long-term holders." That suggests that the real issue we have to address relates to the long­term holders, rather than to the arbitrageurs.

Q48 Mr Walker: The Cadbury­Kraft situation was described at the time as a disaster for Cadbury and the country by interested parties. Traditionally, only 5% of the stock of Cadbury was held by short­term owners. At the time of the sale, the figure had risen to 30%. I suppose it comes to that question: why should those short-term holders not have their influence reduced-although not be necessarily disenfranchised-in a situation such as that?

Professor Kay: I do not see any harm in that. However, if, as we are saying, that 25% came from these long­term holders taking the higher price in the market, then that is the source of the problem. We would not change the outcome significantly. We might change it a bit, because some of these holders might be more reluctant to be publicly identified with growing their 8% stake, but it would, in a sense, be marginal.

Q49 Mr Walker: Overall, if all your recommendations were adopted by the industry and the Government, do you think there would have been any difference in the outcome of something like the Cadbury takeover attempt?

Professor Kay: We might just start with Government being less relaxed than it historically has been about takeovers in general. If one looks at examples of takeovers that one really does wish in retrospect had been stopped, the examples would be the Ferrovial bid for BAA in terms of inward takeovers and the RBS bid for ABN AMRO in terms of outward takeovers. Powers already existed to stop these bids; they were just not actually used. In terms of generally reducing the incidence of these, we should just move away from where we have historically been, namely having more or less the most liberal regime in the world in terms of attitudes to takeovers of, or by, British companies.

Q50 Mr Walker: Going back to my previous experience, one of the non­UK situations that I worked on was the defence of Arcelor against Mittal. That was one in which Governments tried to play quite a substantial role in stopping the company getting taken over, but that eventually got effectively brushed aside by shareholder power and by the weight of hedge funds pushing for a deal. I suppose that there are limitations on what Governments can do.

Professor Kay: There are limitations. If we have a policy objective of reducing the pace of takeover activity, which is certainly one that I would like to have-as I said a few moments ago, it has happened of its own accord for the moment, but one might ask how permanent that is going to be-we can gradually ratchet up the degree of hostility to see what level is necessary to get, at least in that sense, a level playing field with other countries. One of the problems that we have is that there is a sense in the investment banking community that Britain is for sale, which is not true in the same way in many other countries.

Q51 Mr Walker: One thing that other countries are looking at, and that was not touched on in great detail in the report, was the impact of derivatives and futures and practices such as short­selling. Do you think that there is anything that we should be looking at in that respect?

Professor Kay: Quite a lot was said to us about short­selling. I came to the view that, while it could be the case that you had good companies that were being destroyed by short­sellers, one could not find examples of that happening, certainly not in Britain. However, one could find cases where bad companies, whose management either did not know or were not telling the truth about how bad the company was, had their company management damaged by short­sellers and were in some cases brought down by them. That kind of short­selling does not seem undesirable to me. It could rise to a degree at which it was undesirable, but I am not sure that we are there yet.

Q52 Mr Walker: That is interesting. You say firstly that short­selling is incompatible with the concept of stewardship, but you then go on to set out your reasons for defending it. How far do you think your recommendation that income from stock lending should be disclosed and rebated to investors would go to address the public distrust and concern about short­selling?

Professor Kay: I do not think it would address the public distrust of short­selling. One can understand the public suspicion of shortselling, because it is not a very nice activity, fundamentally. I think the rebate and disclose activity is just a matter of straightforward transparency about what the costs and charges of financial intermediation actually are. What we have at the moment is a situation in which some of these costs are, in effect, being concealed from the beneficiaries. Beneficiaries are potentially being exposed to risks that they may not know about, and the rewards relating to the risks are actually being taken by other people, rather than by the beneficiaries. I do not think that situation is acceptable.

Q53 Mr Walker: Speaking of intermediaries and beneficiaries, I just want to come back to your exchange with Ann earlier, where you were talking about the culture and attitudes of shareholders, and trying to change the culture in order to take a long­term approach. Intermediaries came up. One observation that I would make is that the biggest culture change of all has been in the intermediaries. Even during my relatively brief time in the City, I saw gradual decline of long­term corporate broking relationships, and of corporate broking houses that had based their whole approach on having long-term relationships with their clients. These have been replaced by a much more M and A, investment banking­focused approach. Do you think that there is anything that could be done to change that, and to reverse that direction of travel? From what I can see, that process is very much continuing.

Professor Kay: For me, that absolutely gets to the heart of the issue, that the largest cause of almost all the issues that we are describing has been the replacement in financial intermediation of a relationship­based culture with a transactions and trading­based one. How do we reverse that? To repeat the kind of approach that I have been saying over and over again, firstly it is a matter of tone and culture. We can do a lot to set the tone. The tone has almost been that the relationship­based way of doing business in this sector is a terrible, old­fashioned way of doing things that the benighted Germans are still immersed in, but that we Brits and Americans have got over. Instead, we need to be moving in the opposite direction and confronting the reality, which is that the Germans have actually done pretty well in building great companies for the long term.

There is the tone issue, and then there is the regulatory issue. As I have suggested at several points, regulation has in large part been about making life safer for traders. What we ought to be doing is not making life safer for traders, but rather making life easier for long­term investors. That is a very big change of philosophy.

Q54 Chair: Before I move on to fiduciary duty, could I just go back again to the Cadbury­Kraft situation? In response to Robin’s question, you pointed out-quite accurately, I believe-that it was actually the long­term investors in Cadbury that eventually agreed to sell. I cannot remember the exact figure, but the majority of the shareholding certainly would have been composed of long­term investors. However, would it not be true to say that it was the activities of the short­term investors that drove the share price up to a point that the long­term investors were prepared to sell at, and if those short­term investors had been disenfranchised, that would have been unlikely to happen?

Professor Kay: I am not sure that is right. What drove the price up was how much Kraft was, in the end, willing to pay to get it. I do not see that the role of the hedge funds played a large part in that.

Q55 Chair: So you don’t think that was a significant factor in the eventual share price at which it was sold?

Professor Kay: No. I think that the board pushed to the limits of Kraft’s willingness to pay.

Q56 Chair: Can I come on to the fiduciary duty issue? What do you consider to be the minimum fiduciary standards that a regulator should enforce?

Professor Kay: The minimum is that anyone who is engaged, either in advice or in discretionary activity of some kind, accepts the obligation to put the client’s interests first, ahead of his or her own. The second is that conflicts of interest should be avoided, and should be disclosed where they are not avoided. There should be a requirement not to profit as a result of the existence of the conflict of interest. I think that these are the minimum standards, and in my view, I do not want to distinguish between wholesale and retail markets in the application of these.

Q57 Chair: That is an interesting reply. I was under the impression that you had highlighted loyalty and prudence as being core fiduciary duties, but you have not actually mentioned those, at least not directly. Why is that?

Professor Kay: Loyalty and prudence are the core fiduciary principles. I was translating them into specifics for the purposes of financial services regulation, but it is loyalty and prudence that lead you to these principles. Loyalty means putting the client’s interest first, and prudence, which relates to both clients’ interest and conflict, is essentially about doing what you would do yourself if you were in the position of the client.

Q58 Chair: You recommended that the Law Commission be asked to review the legal concept of fiduciary duty, which has been accepted. What do you think the key areas of focus should be, and why?

Professor Kay: There are two parts to the issues on fiduciary duty. The part that we have just been talking about is whether the FSA’s or its successor’s rulebooks correspond to standards of fiduciary duty. To my mind, they have historically fallen significantly below these kinds of standards. It seems to me that imposing these kinds of standards is essential to the creation of the trust relationships that we have all talked about. Then there is a specific problem of fiduciary duty in relation to pension fund trustees and similar trusteeships. I think you will all have received material from FairPensions, who have particularly developed that issue. It is apparent that there is legal advice around that interprets fiduciary duty in an extremely restrictive and narrow way.

What I discovered in discussion with lawyers in the course of the review was that many lawyers took the view that that restrictive interpretation is not a correct statement of the law. However, it seemed to me that that was something that ought to be discussed and resolved in order to clarify what fiduciary duty was. As a matter as fact, in a personal sense, I have a role as trustee in relation to managing the affairs of my Oxford college, and I thought I knew what my obligations in respect of that were when I began the review. I have found myself much less clear at the end than at the beginning. I do not think that is a very satisfactory situation.

Q59 Chair: You have done an awful lot of analysis and consultation on this. Why have you delegated it to the Law Commission, rather than make a recommendation yourself?

Professor Kay: I have spelled out where I would like to be. What I think we ought to have in terms of pension fund trustee obligations is, really, what we talked about earlier. You ought to be required to do what you yourself would do if you were in the shoes of the beneficiaries. That, it seems to me, means that you do not have to behave monstrously and unethically in order to make more money for your beneficiaries, which-to caricature a bit-is one suggestion of how the law is interpreted. Equally, you may not pursue your own particular moral, ethical or political purposes with the beneficiaries’ money. We want to define the middle ground between the two: that is, that the morality and ethics that you apply should essentially be those that would be appropriate to the beneficiary.

Q60 Rebecca Harris: One of your recommendations was that asset managers should fully disclose costs, whether estimated or actual transaction costs, and performance fees charged. How disappointed are you that the Government has not decided to make this compulsory?

Professor Kay: That is one of the areas in which I think we should have regulation that could be effective in doing this.

Q61 Rebecca Harris: So when it comes to the Government bringing its progress report forward, you would like to see that there has been substantial progress in this area.

Professor Kay: Yes, on proper disclosure of charges and costs of asset managers, because we don’t really know in aggregate what they are.

Q62 Rebecca Harris: How detrimental do you think it is that we don’t have this now? How much damage does that do?

Professor Kay: If people knew how much they were paying for intermediary services at the moment, there would be significantly more effective pressure to get that done. There is quite a lot of damage.

Q63 Ann McKechin: Could we just turn to this issue about reporting by companies? You say that much of the information is simply noise. Some people might argue that one person’s noise is another person’s data. What, in your mind, is too much information, or is it badly presented information that is at the core?

Professor Kay: It is a bit of each. If you look at the report and accounts of large financial institutions like banks or insurance companies, you get hundreds of pages, and you don’t learn very much, even if you go through the hundreds of pages. What is the answer to that? We could make it thousands of pages. Perhaps, to some degree, we should, but I think that if it moves to thousands of pages it will be all the more difficult to go through, and I am not sure that we will be that much better informed when we do it. So, where do we go? There are two directions. One, which is rather outside of my terms of reference-although it something about which I feel strongly-is that these institutions should be made a lot simpler than they currently are. The second is that there should be much more negotiation between users of accounts-the important ones, for our purposes today, are asset managers-and the companies that disclose them.

Q64 Ann McKechin: Do you think that there is a role for the investors’ forums in this?

Professor Kay: That could be a positive one in relation to this. Also, the kind of information you need about a company is very much specific to the sector, and even to the company. What you need to know about a bank is rather different from what you need to know about a retailer, and so on. It goes back to this favouring of transactions and trading over relationships. What we have tried to do is to block the provision of information through the relationships and say that companies have to provide a standardised mass of information for everyone. That has created the world that we see, where we get lots and lots of information that is not terribly useful.

Q65 Ann McKechin: You made a clear recommendation about quarterly reporting obligations, and the Government has supported your recommendation. Some people might argue, "How can less information be better?" Is it simply just that you are trying to change behaviour, rather than trying to block information coming out at a particular time?

Professor Kay: The argument that says that more information is always better is tempting, except that we all know that it really is not true. It is very difficult to ignore information, even if it is essentially irrelevant.

Q66 Ann McKechin: The problem is the way it is used, rather than the information itself.

Professor Kay: Yes, and that it is then manipulated. That has been part of the problem with quarterly reporting, which has reached extremes in the US. Companies produce steady streams of reported quarterly earnings. In many cases, they produce steady streams of these quarterly increases, until one quarter they do not because reality has finally broken through. It really has been part of a process of earnings guidance, earnings management: a kind of dysfunctional cycle of relationships between analysts and companies. I think we would like to just get rid of that cycle and have it replaced by, typically, more qualitative relationships between the company and the asset manager.

Q67 Ann McKechin: We are moving away from the crack cocaine of quarterly reporting, and you have talked about high­quality, succinct narratives. How would you define such a narrative?

Professor Kay: That is difficult. We can invoke certain elements of common sense and audit in this. What we want to avoid, obviously-and what it is very easy to see that we might get-is long narrative reports that are written by PR consultants, which are statements of motherhood and apple pie that do not get into anything substantive about the company. It is quite hard to set a rule saying that what you write has to be substantive.

Ann McKechin: "Avoid the flannel and get to the facts."

Professor Kay: We would probably transform Parliament, as well, if there was a "no flannel" rule.

Q68 Ann McKechin: Presumably, perhaps, codes of practice should try to give some indication to people about how good reporting could actually be achieved?

Professor Kay: Yes. There is a role, as I have described, for the auditors, and there is a role for an asset manager of a large company, who can say, "This stuff is just not good enough."

Q69 Paul Blomfield: Clearly, the issue of levels of corporate pay is an issue on which there is lots of public focus. I was actually interested that, although you looked at the structure of pay, you did not feel tempted to comment on the levels of pay.

Professor Kay: I certainly felt tempted to comment, but since there was another BIS exercise looking at levels of pay while I was doing this piece of work, I was encouraged in the view that it was not my business. I received further encouragement from being told, especially at the interim report stage, that if I wrote about levels of executive remuneration, nobody would take any interest in anything else I said.

Q70 Paul Blomfield: I understand that entirely. I guess there might have been wider public interest, and I am reading into what you are saying that you would share the wider public concern about the excesses of corporate pay and their impact.

Professor Kay: Both the structure and the levels of executive remuneration are wrong, yes.

Q71 Paul Blomfield: You did then talk about-in terms of structure- linking more to long-term performance, but you also acknowledged in your report that that was what most companies said they were doing anyway.

Professor Kay: They said they were doing that, but a three­year long­term incentive plan does not seem to me long­term, in terms of building great British businesses.

Q72 Paul Blomfield: So recognising that, you then came out, trying to move things forward, with the specific recommendation that incentives should only be provided in the form of company shares to be held at least until after the executive had retired. Were you then disappointed by the Government response, which just said that the structure of remuneration should be determined by individual companies in consultation with their shareholders? That does not move things forward at all.

Professor Kay: It does not move things forward anything like enough. As I indicated earlier in the discussion, I think that the pursuit of particularly elaborate bonus schemes for executives has just been a serious mistake. It has been damaging, both to individual companies and to public perceptions of business. What I want to see is people running large British companies whose primary motivation is that they want to build great British businesses.

Q73 Paul Blomfield: As such, the Government response really fails to address one of your most substantive recommendations. I wonder, therefore, whether you felt that that recommendation should be made compulsory, notwithstanding your antipathy to regulation. In your report, you develop a very effective critique of self­serving circles of remuneration consultants. I am also minded of the report in the last few days, regarding the way that the chair of the remuneration committee of Barclays was heavily disregarded by the chairman of the bank when she made recommendations on remuneration there. Therefore, have things got to the stage at which we need to look at your recommendation being made compulsory?

Professor Kay: I think that there is an argument for that.

Q74 Chair: We are nearing the end now. I just had one or two questions. The first is relevant to long-term thinking. Aviva provided us with evidence that the average holding period for UK equities had fallen from eight years in the 1960s to just seven and a half months in 2007. Do you think that there is a case for reconsidering a financial transactions tax, not so much to raise revenue, but potentially to reverse this trend?

Professor Kay: Yes, there is. If we could have a financial transactions tax that worked, it would seem to me to be a very attractive way of discouraging that trading activity in favour of long­term investment. It is clearly very difficult to structure a financial transactions tax that works, and I have two large worries about this. One is that I have observed the financial transactions tax that we have at the moment, which, far from discouraging trading, is actually solely a tax on long­term investors. Someone described it to me as a tax on UK pension funds and private individuals, and that is essentially what it is. We have been very unsuccessful so far.

There are clearly a lot of things that, if we introduce a simple financial transactions tax here, could be done to avoid it. The danger is that we simply shift a great deal of equity trading into other-possibly less regulated and probably offshore-forms, and into more complicated instruments of various kinds. We have to be reasonably sure that we can structure a tax that will not do more harm than good, but if we could, I would support it.

Q75 Chair: That is an interesting response. You are an expert in this area; could you do it? I am not trying to give you a job; I am just interested to know.

Professor Kay: I have, and I have discussed with other people, ideas about how one might structure this. It is genuinely quite hard. There only have to be a few large loopholes-I am going to mix my metaphors-and people will drive a coach and horses through them. We know, for example, that a very large amount of short­term trading in UK equities already takes the form of contracts for difference, rather than direct purchase in sale of shares. We can do things about that, but then we have to look at things that would be done to evade or avoid the impact of that. It is complicated. I am not sure that it is impossible, but it is not easy.

Q76 Chair: That is interesting, and we may want to pursue that a little further with other speakers. Could I move on to high­frequency trading? You did not make any recommendations about this. Why not?

Professor Kay: There were two reasons. One was that there was another BIS exercise on high­frequency trading being conducted at the time. The other was that, although the existence of high­frequency trading is not something that one could say is very supportive of long­term decision making in British business, I concluded quite quickly that it is not the principal issue and problem, which is to do with the behaviour of the long­term holders. You quoted the Aviva figure for the average holding period. Of course, that is greatly affected by large amounts of very short­term trading, but it is not surprising when you think about it. If you look at the numbers, although much of the turnover is accounted for by very short­term traders, that does not mean that very short­term traders own a very large proportion of British business. They do not. Most shares are actually held by rather longer­term investors, so that leads one to the perspective that the issue that we need to tackle is getting the incentives and approaches of the long­term investors right.

Q77 Chair: I will accept what you say as being probably correct. However, it is equally true that it has precipitated stock market volatility in some countries. I believe that the German Government intends to introduce a law to clamp down on it, because of this market turbulence. Do you think that is the right approach?

Professor Kay: It goes back to the discussion that we have just had about a financial transactions tax. It might be a good idea if you could introduce something that you were confident would work. I rather fear that, if the German Government introduced it, it would just mean that trading would not take place in the environments where the German Government’s jurisdiction ran.

Q78 Chair: So do you think that it might help the British environment?

Professor Kay: Possibly, but I think that we should not feel very proud of that.

Q79 Chair: Could I just go back again to the Cadbury situation? As a West Midlands MP, it is obviously a little bit of a preoccupation of mine. Earlier, I asked you about the role of short-term investors in the company, and you said that basically the final share price was determined by the commitment of Kraft to pay that. That probably is the case. Do you think, therefore, that short­term investment or speculation on this scale is irrelevant to mergers and acquisitions in this country?

Professor Kay: I do not think it is irrelevant, because you made a point a moment ago about the volatility of markets. One of the effects of a rise in the volume of trading across financial services has been to create greater market volatility. Merger and acquisition activity is in part a function of market volatility. It creates more opportunity, and that feeds back on itself.

Q80 Chair: Do you think that there is a case for disenfranchising short­term investors of the nature that invested in Cadbury?

Professor Kay: When I talked about short­term investors there, I meant short­term investors in a much broader sense. As we were describing, I do not think that the result in the Kraft­Cadbury case was basically fixed by the existence of arbitrageurs and other short­term investors.

Q81 Chair: I accept that, but do you think there is a case? Would it impact on the level of mergers and acquisitions activity?

Professor Kay: If there was less short-term trading, I think it would.

Q82 Chair: That is interesting. Could I just conclude with another one? One of the policies that has been introduced, and is proving slightly controversial, is the 28­day "put up or shut up" conditions that arose very much out of the Cadbury situation. Have you any views on that?

Professor Kay: From what I have said earlier, you will see that almost anything that puts a bit more sand in the wheels of the merger and acquisition machine is something that I would welcome.

Chair: On that note, can I thank you for your contribution? It is a very useful opening. Obviously, we will be talking to a whole range of representatives from the industry, Government, and lobbyists on this, and we will come to our conclusions in due course. At the moment, can I just thank you for your contribution? It is a very helpful start to this particular review process.

Professor Kay: Good. I am glad that I have provoked your interest.

Prepared 24th July 2013