The Kay Review of UK Equity Markets and Long-Term Decision Making - Business, Innovation and Skills Committee Contents

5   More work to be done?

80. We now consider some of the less-specific 'recommendations' and underlying principles of the Kay Review. In particular, the Stewardship Code, resourcing stewardship, using a Financial Transaction Tax to incentivise behaviour and the role of owners in the process of mergers and acquisitions.

The Stewardship Code: Content
Box 1: The UK Stewardship Code

    The UK Stewardship Code aims to enhance the quality of engagement between institutional investors and companies to help improve long-term returns to shareholders and the efficient exercise of governance responsibilities. The Code sets out good practice on engagement with investee companies to which the Financial Reporting Council believes institutional investors should aspire and operates on a 'comply or explain' basis. The Financial Standards Authority requires UK authorised asset managers to report on whether or not they apply the Code.

    First published in July 2010, the Code was revised in September 2012; the Financial Reporting Council encouraged all signatories to review their policy statements once the Code came in to effect from 1 October 2012.[142]

81. In its current form, the Stewardship Code is voluntary. It embodies seven principles for institutional investors to:

    1. Publicly disclose their policy on how they will discharge their stewardship responsibilities.

    2. Have a robust policy on managing conflicts of interest in relation to stewardship which should be publicly disclosed.

    3. Monitor their investee companies.

    4. Establish clear guidelines on when and how they will escalate their stewardship activities.

    5. Be willing to act collectively with other investors where appropriate.

    6. Have a clear policy on voting and disclosure of voting activity.

    7. Report periodically on their stewardship and voting activities.[143]

82. In his review, Professor Kay recommended that the Code be "developed to incorporate a more expansive form of stewardship, focussing on strategic issues as well as questions of corporate governance".[144] The Government noted the recommendation and highlighted the fact that the Financial Reporting Council (FRC) reviewed the implementation and impacts of its Codes, and would produce its next report on developments in Corporate Governance and Stewardship in December 2013.[145] The Government concluded that:

    In light of this and future exercises it will consider whether further changes to the Stewardship Code may be desirable in due course to reflect Professor Kay's recommendation.[146]

83. The Chartered Institute of Personnel and Development did not believe that the Code required reform as it already focussed on corporate governance:

    The revised UK Stewardship Code of September 2012 already includes strategy, corporate governance and culture within its definition of 'stewardship activities', on which institutional investors are encouraged to publicly disclose their activity with the aim of protecting value for their clients.

    It is also recommended that investors should consider intervening when they have concerns about the company's strategy, governance and approach to risks, including those that are social or environmental.[147]

Steve Waygood, Chief Responsible Investment Officer at Aviva Investors, thought that the current Code, while fit for purpose, could be improved:

    If I was rewriting the Stewardship Code, I would add a provision in there encouraging those people who sign up to the Stewardship Code to examine how they use their research commission to promote and finance stewardship.[148]

84. FairPensions (now ShareAction) proposed four specific improvements that should be included in an improved Code:

    ·  Articulate more explicitly that engagement can and should extend beyond immediate financial matters and encompass drivers of a company's long-term fundamental value, including environmental, social and governance (ESG) factors.

    ·  Address more explicitly the role of institutional investors, particularly 'universal owners' such as pension funds with holdings across the economy, in nurturing the wider economy and attending to potential systemic risks, rather than only engaging with risks to individual companies in their portfolio.

    ·  Be stronger and clearer in respect of conflicts of interest. [...] The recent amendments to the Code [...] do not seek to ensure that signatories explain how key conflicts of interest are managed in practice.

    ·  Articulate a clearer definition of 'stewardship'. [...] The Code still does not define the term 'stewardship' as such. In our experience, there is still confusion over what is being 'stewarded' (companies, savers' assets, or the economy and environment on which financial returns depend) and to whom stewardship obligations are owed (companies or savers).[149]

Blackrock told us it defined the term 'stewardship' as "protecting and enhancing the value of the assets entrusted to us by our clients. As shareholders, our stewardship responsibility is to our clients".[150] However, it warned us that good stewardship would not necessarily lead to more engagement with firms because asset managers must put their client first (rather than the long-term health of the companies that they hold):

    Sometimes fulfilling our stewardship responsibilities to clients will involve engagement with companies; other times it will necessitate selling or reducing a shareholding if we cannot protect our clients' interests through engagement, which should not be seen as a derogation of our duty, but a fulfilment of it.[151]

85. In its current form, the Stewardship Code contains seven voluntary principles which represent the minimum benchmark for the relationship between owners and investment managers. Professor Kay recommended that the Code should be developed to take account of strategic issues as well as those around corporate governance. We recommend that this be implemented through a formal consultation by the Financial Reporting Council. It is essential that the Code is accepted by all players of the equity market, therefore all such participants must have a say in its development. Having considered the evidence and suggestions from many players in the market, we specifically recommend that the Code be enhanced:

·  To allow investment managers to focus on strategic issues facing companies within their policies on how they discharge their stewardship responsibilities (rather than the current focus on profit, which is inherently short-term).

·  To include the principle that engagement and corporate governance should extend beyond financial affairs and encompass more long-term value adding activities such as environmental, social and governance factors.

·  To include the provision that institutional investors and significant owners should be members of at least one Investor's Forum.

·  Related to the previous point, to include the role of institutional investors to engage in potential systemic risks to the UK equity market rather than only engaging with risks to individual companies in their portfolio.

·  To redefine a clearer explanation of conflicts of interest and in particular for asset management firms to publish how key conflicts of interest are managed in practice.

·  To provide one clear and authoritative definition of the term 'stewardship'.

The Stewardship Code: Sign-up

86. In its current form, 203 Asset Managers, 67 Asset Owners and 14 Service Providers have signed up to the Stewardship Code (although one organisation is listed as both an asset manager and a service provider).[152] The Financial Reporting Council (FRC), which administers the Code, gave us the latest figures in terms of how much of the UK equity market is covered by the Code, referring to an IMA survey:

    The IMA reported that the 103 respondents to this year's survey included 73 managers who are responsible for £702 Billion of UK equities representing 36% of the UK market.[153]

It went on to tell us, however, that because "not all signatories responded to the IMA survey", it was "reasonable to say the overall total is slightly higher than the IMA's figure".[154]

87. Although the rate of sign-up to the Code may have improved, the overall number of signatories remains low, particularly among owners (for example pension fund trustees). Penny Shepherd, Chief Executive of UKSIF hoped to see "considerably more asset owners signed up to the Stewardship Code".[155] The National Association of Pension Funds Limited confirmed that its owners (and pension funds in general) had been slow to sign up. It suggested that investment consultants should have responsibility for encouraging more owners to be involved:

    As key intermediaries between pension funds and asset managers, investment consultants could do more to encourage the take-up of the Code by explaining its relevance to their pension fund clients. We believe that this could help drive more pension funds to sign up to the Code.[156]

Anita Skipper, Corporate Governance Advisor to Aviva Investors agreed. She told us that:

    A lot of fund managers have already signed up. The disappointing bit is that the owners have not signed up. You want the owners to sign up so that the fund managers actually do the work for them. Fund managers do see the benefit of engagement, which is why [they] spend so much time engaging with companies, but it is very difficult to keep increasing that when nobody is asking you to do it and they do not even care. The focus must be on demand from our perspective.[157]

88. When we aired these concerns with the Secretary of State he assured us that "if your hearings [...] elicit quite a lot of evidence that this approach is failing, I would feel obliged to respond to it".[158] Our inquiry has raised concerns, and we look forward to his response.

89. Progress has been made in terms of the number of asset managers signing up to the Stewardship Code. However, sign-up among owners remains low. We recommend that the Government:

·  Outlines what it considers a minimum acceptable level of sign up to the Stewardship Code (making provision for the distinction between manager and owner).

·  Makes clear that it is government policy to encourage sign-up to the Code and publishes a clear target (and timescale) of success. This timescale should be no longer than two years.

·  Outlines clearly what action it will take if this target is not met by the market on a voluntary basis.

90. Finally, some witnesses pointed out that, at the time of our inquiry, the Parliamentary Contributory Pension Fund (PCPF) was not signed up to the Stewardship Code. Penny Shepherd, Chief Executive of UKSIF, told us that "one area in which this House can act to raise awareness is by acting as an exemplar of good practice".[159] We are pleased to take this opportunity to formally welcome the fact that the trustees of this fund have made the decision to sign up to the Stewardship Code in the near future. We will continue to monitor this.

The Stewardship Code and Professor Kay's good practice statements

91. As well as analysing the Stewardship Code, Professor Kay also produced three Good Practice Statements. These are outlined in full in the Annex to this report. His recommendation on the matter read:

    Company directors, asset managers and asset holders should adopt Good Practice Statements that promote stewardship and long-term decision making. Regulators and industry groups should takes steps to align existing standards, guidance and codes of practice with the Review's Good Practice Statements.[160]

The Government responded:

    The Government supports this recommendation. The development and promotion of good practice in the investment chain is central to achieving the culture shift that Professor Kay advocates. Professor Kay's suggested Good Practice Statements—aimed at company directors, asset managers and asset holders in turn—provide a starting point from which to achieve this.[161]

92. In his Review, Professor Kay outlined how he expected the Statements to sit alongside existing regulation:

    We do not believe the principles set out in these statements should be translated into specific regulatory requirements. However, we do envisage that Regulators will also endorse these principles, consider to what extent existing regulatory requirements may prevent their adoption, and seek to align existing guidance and codes of practice with them.[162]

He went on to explain that he expected his Good Practice Statements to "complement, and inform further development of the Corporate Governance Code and Stewardship Code".[163] Although this approach could add to the regulatory burden, Professor Kay was clear that this was one area where he was happy for the Government to force the market's hand:

    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.[164]

93. Russell Investments supported Professor Kay's Statements because they were "developed explicitly for the growing and diverse 'fiduciary management' segment, which may, in the future, be in control of substantial portions of asset owners' portfolios".[165] Dr Paul Woolley, Head of the Paul Woolley Centre for the Study of Capital Market Dysfunctionality, also supported the Statements and drew our attention to new recommendations of the Consultative Group on International Economic and Monetary Affairs Incorporated (G30) which recently made similar recommendations.[166] He believed that the industry was on the edge of change and that "there will be a very significant early mover advantage to funds" which adopted such statements first.[167]

94. Aviva plc, however, was less supportive of Kay's Statements. While it welcomed them in principle, it concluded that they "fail to cover all relevant players in the capital market".[168] They provided the diagram below to demonstrate the complex series of impacts and interactions across the market and outlined which were and which were not covered by the Statements:[169]

95. When we asked the Secretary of State how he saw Professor Kay's Good Practice Statements running alongside existing regulation and voluntary codes, he acknowledged that there was a "mixture of voluntary stewardship codes of practice, on the one hand, and legislation on the other".[170] However, he set out how Professor Kay's analysis could be incorporated into the Stewardship Code:

    We have just had a wholesale revision, which the FRC oversaw—you know the way the system works. Next year, we have asked them to go back to the stewardship code specifically to take into account the Kay recommendations.[171]

96. The Secretary of State concluded that reform was "a twin-track approach. There are key areas of corporate behaviour that have to be regulated, and are regulated, but for other areas, where subtle changes are involved, the voluntary approach works well, as it is the best solution and it works".[172]

97. We support Professor Kay's Good Practice Statements and agree that the industry, asset holders and company directors should be given the opportunity to formally embrace the principles that are contained within them. However, we are conscious that many individuals and firms are already signed up to the Stewardship Code and we are concerned that yet another voluntary compliance statement will be submerged by a rising tide of self-regulation and codes of best practice. The market requires clarity and certainty and we are concerned about over-burdening it with regulation and codes.

98. Professor Kay's Good Practice Statements should be the standard level of behaviour for the industry and all players in the UK equity market. We expect the Government, in its response to this Report, to outline its timetable for all companies to sign up to Professor Kay's Good Practice Statements. If this target is not met, the Government should be prepared to incorporate Professor Kay's Good Practice Statements into the already established Stewardship Code.

Resourcing stewardship

99. Lord Myners was clear in his mind that stewardship was an under-resourced activity in the investment chain:

    There is an inverted pyramid in investment management, in which the least important functions receive the greatest attention and the highest pay, and the most important function receives little attention and, frequently, no pay.[173]

Lord Myners set out where he saw the problem:

    The decision on asset allocation for a pension fund—which is about understanding what your optimal level of risk is, creating a risk budget, and then saying that you will invest [...] is taken by trustees who are often unpaid; who are generally not professionals, or particularly economically knowledgeable; and who are led by the nose by consultants.

    The most important decisions are taken by the people with least economic incentive and interest in the outcome, little reward, and little experience. On the other hand, the decision that adds no added value at all is hugely rewarded.[174]

Harlan Zimmerman, Senior Partner at Cevian Capital, agreed that resourcing the roles of stewardship and governance was a problem across all types of funds. He told us that as a fund manager "you do the minimum that you can to protect your investments" because "there is a general issue that proper stewardship and engagement is a cost centre".[175] He went on to explain that managers did the minimum that they needed to maintain appearances as a responsible investor:

    You focus only on the greatest transgressions and react in a defensive way, and you do the minimum that society imposes upon you.[176]

100. USS Investment Management Limited argued that it was a matter of scale and that stewardship was under-resourced in the relatively smaller UK pension funds when compared to larger funds globally. It told us that this was because funds were "too small to adequately resource their stewardship operations".[177] It went on to explain that this had contributed to the lengthening of the investment chain and the subsequent distancing of the owner from the company.[178] Russell Investments told us that larger asset owners tended to have stronger governance because they:

·  Have better access to expert resource and advice: taking together the number of finance or investment professionals on the trustee body or the investment committee, as well as any full-time in-house investment staff.

·  Are more likely to have an investment committee.

·  Spend more time in absolute terms on investment issues: trustee boards and their investment committees spend.

·  Are more likely to have a more ambitious investment strategy.[179]

It argued that consolidation was a practical solution to the problem of smaller funds not having the resources to effect good stewardship, pointing out that "current UK legislation makes it possible for smaller [pension] plans to join together, but there has been very little movement in that direction".[180] Simon Wong agreed, noting that Canada already ran a similar system:

    At present Canada has an interesting proposal, which is to mandate the transfer of assets from smaller pension funds to a new vehicle as a way to build scale. [...] You have a collective vehicle that hopefully will give you better scale and so reduce costs.[181]

101. Aviva plc also offered a solution to the cost of effective stewardship. It argued that, under the current regulation, equity commissions which are earned on all trades made by an asset manager may be used to "buy research from any type of provider and this global research spend amounts to $22bn per year".[182] It explained:

    A few fund managers—including Aviva Investors—are directing this research commission towards brokers and independent research providers of long-term investment research, voting advice and stewardship work. We are clear that such investment in stewardship adds value to investment decisions and is in the long-term interests of our clients.[183]

102. However, this approach remains uncommon and that "those fund managers that do utilise this mechanism tend to spend only a few percentage points of their research commission in this way" because it was not actively encouraged by any official department or regulator.[184] When we asked how this could be encouraged in other firms. Aviva plc responded with four actions for the Financial Conduct Authority (FCA) to consider:

·  The FCA could clarify that long-term investment research that is orientated towards good stewardship behaviour by investors can be paid for in this way.

·  The FCA could suggest as a guide that it is good practice for a material proportion of the commission research (say 10-25%) to be spent in this way.

·  The FCA could say that it is good practice for fund managers to be transparent to their clients that this was taking place.

·  The FCA could say that it is good practice for clients to be allowed to opt out of this, as long as they are clear to their beneficial owners what their rationale is for so doing.[185]

103. The Secretary of State was clear that he would like to see more resources allocated to stewardship.[186] We asked him about Aviva plc's proposal and he appeared receptive, telling us that he agreed that better stewardship would "involve a certain amount of investment and the obvious way for the industry to invest would be to make a contribution from its own coffers".[187]

104. The attitude of 'do the minimum possible' found in many of our institutional investment firms has hindered the development of good stewardship. Asset managers are currently allowed to use commissions to pay for long-term research, including long-term stewardship, but it appears that few are aware of this. We therefore recommend that the Financial Conduct Authority contacts all major institutional investors highlighting that long-term investment research that is orientated towards good stewardship could (and should) be paid for using a proportion of equity commissions reserved for research. Furthermore, we recommend that the FCA sets and publishes an appropriate minimum proportion of a firm's commission allocated to research that should be used towards such activities and an annual list of those firms which do not achieve that level. Those firms will be expected to comply or explain why they have not dedicated the recommended proportion of resources on good long-term stewardship.

The Financial Transaction Tax

105. High Frequency Trading (HFT) is often cited as an example how technological progress has been damaging rather than beneficial to the economy and there have been several attempts to analyse its impact on markets. The Bank of England reported that "HFTs contribute a large amount of both 'good' and 'excessive' volatility" and concluded that the "welfare implications of HFT are unclear".[188] In 2011, the Government Office for Science produced a report which sought to answer the question: can high frequency trading lead to financial crashes? It concluded that "it has in the past, and it can be expected to do so more and more in the future".[189] That Report concluded "the central question of the economic gains (and losses) provided by HFT" should be "considered seriously" and that the Government should:

    Use regulations and tax incentives constitute the standard tools of policy makers at their disposal within an economic context to maximize global welfare (in contrast with private welfare of certain players who promote HFT for their private gains).[190]

106. A recent report, commissioned by the Department for Business, Innovation and Skills and published by the Government Office for Science, concluded that:

    The key message is mixed. The Project has found that some of the commonly held negative perceptions surrounding HFT are not supported by the available evidence and, indeed, that HFT may have modestly improved the functioning of markets in some respects.[191]

It concluded, however, that "policy makers are justified in being concerned about the possible effects of HFT on instability in financial markets" and recommended that: [192]

    European authorities, working together, and with financial practitioners and academics, should assess (using evidence-based analysis) and introduce mechanisms for managing and modifying the potential adverse side-effects of Computer based Trading (CBT) and HFT.[193]


    Coordination of regulatory measures between markets is important and needs to take place at two levels:

    ·  Regulatory constraints [involving computer based trading] in particular need to be introduced in a coordinated manner across all markets where there are strong linkages.

    ·  Regulatory measures for market control must also be undertaken in a systematic global fashion to achieve in full the objectives they are directed at.[194]

107. We asked Professor Kay whether the Government should introduce a tax on this activity, not to raise revenue, but to influence behaviour. He was clear that:

    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 long-term investment.[195]

108. However, he went on to explain that it was "very difficult to structure a financial transactions tax that works".[196] When we spoke to Chris Hitchen, who was a member of Professor Kay's Advisory Board Team, he told us that this was an area where the team "feared to tread" and had anyway not had time to investigate fully:

    Around the table we were reasonably well disposed towards a financial transaction tax, which might help to mitigate that. We did not pursue that, but it is something we definitely picked up.[197]

He described the structural problems that Professor Kay had referred to as stemming from the global nature of transactions, summarising that "there are problems with imposing any sort of tax on a partial basis in a global market".[198] He emphasised that, from his perspective as the Chief Executive of RailPen, he supported a Financial Transaction Tax:

    It could potentially take a lot of unnecessary trading out of the system. Who pays for the profits of traders? Ultimately it seems to me it is the end investors; it is my members. Even if we end up paying a small tax on the trades that we do, if it stops us paying for a lot of profits on other peoples' activities, then we are still better off, net-net.[199]

109. Lord Myners told us that, from his experience of more than a decade analysing the market that he was "drawn towards a financial transaction tax: ideally, one that is established globally".[200] He suggested a solution to the 'global problem' that hindered progress during the Kay Review:

    We should not allow any bank in a developed country to establish a branch or a subsidiary in an offshore centre that does not comply with the OECD's white list of financially compliant economies. You could do something similar in terms of transactions.[201]

110. While some representatives from industry agreed that an FTT could be beneficial to the market, they did so with heavy caveats. For example, Steve Waygood from Aviva Investors told us that "we only agree that the financial transaction tax is a good idea if it could be done simultaneously in all key financial jurisdictions".[202] However, he was not confident that this was possible:

    Unfortunately the political practicalities of that mean that it might be an academically good idea for Tobin 30 years ago, but the current manifestation of it is not something that we would support.[203]

111. Anne Richards, Global Chief Investment Officer of Aberdeen Asset Management told us that HFT should be more closely monitored and linked to the tax system:

    There is another subset of market behaviours that have become technologically possible in a way that they were not before and I do not necessarily think that the market processes around the control of that or the taxation rules have kept up with the changes that technology has allowed.[204]

She conceded that a more consistent tax regime across the wide range of financial instruments (including HFT) could "get around some of these behaviours", but reached the conclusion that it was "a difficult area to see how you would implement a financial transactions tax in a really beneficial way to the end customer".[205]

112. Dominic Rossi, Global Chief Investment Officer at Fidelity Worldwide, did not believe that a FTT would work if its objective was to change behaviour. However, he did say that it would be successful at raising money.[206] This ran in direct conflict with the evidence put forward by the Secretary of State:

    Countries like Hungary, France and elsewhere were getting in a fifth or a quarter of the revenue that they thought they would get, because it is so very, very difficult to pin down these transactions and tax them in a sensible way.[207]

However, when we asked the Secretary of State if he was willing to consider the introduction of an FTT to clamp down on poor practices (for example HFT) rather than simply making money for the exchequer, he was clear:

    Yes, I think there is a case, and I am, in some ways, quite disposed to it.[208]

He also agreed with Professor Kay that "the problem, all along, has been implementing" and drew our attention to the difficulty of identifying which transactions to tax when there were "very rapid electronic transactions" and "cross-border transactions" which were difficult to trace.[209]

113. There was some support for the concept of a Financial Transaction Tax on trading practices such as High Frequency Trading. However, concerns were raised about the practicality of implementing such a tax unilaterally. We recommend that the Government considers the viability, benefits and risks of a Financial Transaction Tax and commissions research in the following areas:

i.  An impact assessment of the introduction of a Financial Transaction Tax on equities at a level which is the average profit made on a High Frequency Trade in the UK.

ii.  A impact and feasibility study of the proposal to ban any of those banks which establish branches or subsidiaries in an offshore centre that does not adhere to the OECD's white list of financially compliant economies from trading in the UK. This should include an assessment of whether doing so would counter the arguments against a domestic FTT being ineffective in the global market.

Mergers and acquisitions

114. In his report, Professor Kay also considered the impact of mergers and acquisitions. He concluded that

    The scale and effectiveness of merger activity of and by UK companies should be kept under careful review by BIS and by companies themselves.[210]

The Secretary of State told us that he agreed with the Review's recommendation:

    There is a lot of research that tends to show that, probably on balance, it reduces shareholder value, quite apart from any social consequences. However, there is counter-evidence.[211]

He concluded that he was "sceptical about the value of takeover activity" but did not want to outlaw it altogether because "if companies are underperforming and their shareholders are being poorly awarded for bad performance, there has to be a mechanism in the market to correct that".[212]

115. Professor Kay, however, did draw a distinction:

    The openness of the UK acquisition market means that UK companies are a favoured target of global investment banks which seek to promote transactions activity. [213]

116. He concluded that "UK companies are disproportionately vulnerable to unwanted attention from predators.[214] Lord Myners agreed, arguing that the UK regime governing takeovers was very relaxed relative to other countries:

    Our rules seem to be extraordinarily permissive, and one might sit back for a moment and ask whether it is actually in the benefit of the economy and society, and why we have concluded that we want to make it so much easier to take over companies than elsewhere.[215]

117. While Lord Myners agreed with Professor Kay's analysis, he thought that the recommendation could go further. He told us "there is nothing in the Professor's report that seriously challenges the value and job destruction associated with reckless merger and acquisition activity".[216] Lord Myners urged the Government to be wary of all takeover activity, not just that involving foreign companies because "as much damage is done by M&A of British acquirers of British companies as is done by foreign acquirers of British companies".[217]

118. In his recent report, No stone unturned in pursuit of growth, Lord Heseltine recommended that the "Government should do far more to engage with potential foreign investors in our core sectors to secure commitments to developing the UK research, skills and supply base, and in exceptional cases to discourage unwanted investments".[218] The Government rejected this:

    As a Government, we have rejected the Heseltine recommendation on foreign takeovers. We should not be distinguishing between domestic and foreign ownership. It is not helpful, and some of our best companies are owned by "foreigners".[219]

119. Professor Kay recommended that the Government should take a more 'sceptical' view of the benefits of large takeovers and should be much more proactive in its monitoring of such activity. He drew particular attention to the relative vulnerability of UK companies to takeovers by foreign actors. We recommend that the Government conducts and publishes an assessment of the take-over regimes of other similar economies with a view to learning about the impact that takeovers have had on their companies and economies. Furthermore it should summarise which positive elements may be incorporated into our domestic system to strengthen our economy and ensure that takeovers benefit, rather than damage our economy.

120. The Government has accepted Professor Kay's recommendation on mergers and acquisitions but it is unclear what specific action it will take. We recommend that the Government clarifies what actions it will take over the next six months to be in a position to effectively monitor all merger activity in the UK. In its response to us, the Government should outline what action it will take to engage with companies and their investors to ensure that any investment merger activity is to the long-term benefit of the UK economy.
Box 2: A case study of The Cadbury / Kraft takeover as reported in the Financial Times.

An illustration of how short-term shareholders have influenced the UK equity market and the fate of a successful British company:

    The story

    In 2009, US food company Kraft Foods launched a hostile bid for Cadbury, the UK-listed chocolate maker. As became clear almost exactly two years later in August 2011, Cadbury was the final acquisition necessary to allow Kraft to be restructured and indeed split into two companies by the end of 2012: a grocery business worth approximately $16bn; and a $32bn global snacks business. Kraft needed Cadbury to provide scale for the snacks business, especially in emerging markets such as India. The challenge for Kraft was how to buy Cadbury when it was not for sale.

    The history

    Kraft itself was the product of acquisitions that started in 1916 with the purchase of a Canadian cheese company. By the time of the offer for Cadbury, it was the world's second-largest food conglomerate, with seven brands that each generated annual revenues of more than $1bn.

    Cadbury, founded by John Cadbury in 1824 in Birmingham, England, had also grown through mergers and demergers. It too had recently embarked on a strategy that was just beginning to show results. Ownership of the company was 49 per cent from the US, despite its UK listing and headquarters. Only 5 per cent of its shares were owned by short-term traders at the time of the Kraft bid.

    The challenge

    Not only was Cadbury not for sale, but it actively resisted the Kraft takeover.

    Sir Roger Carr, the chairman of Cadbury, was experienced in takeover defences and immediately put together a strong defensive advisory team. Its first act was to brand the 745 pence-per-share offer "unattractive", saying that it "fundamentally undervalued the company". The team made clear that even if the company had to succumb to an unwanted takeover, almost any other confectionery company (Nestlé, Ferrero and Hershey were all mentioned) would be preferred as the buyer. In addition, Lord Mandelson, then the UK's business secretary, publicly declared that the government would oppose any buyer who failed to "respect" the historic confectioner.

    The response

    Cadbury's own defence documents stated that shareholders should reject Kraft's offer because the chocolate company would be "absorbed into Kraft's low growth conglomerate business model—an unappealing prospect that sharply contrasts with the Cadbury strategy of a pure play confectionery company".

    Little did Cadbury's management know that Kraft's plan was to split in two to eliminate its conglomerate nature and become two more focused businesses, thereby creating more value for its shareholders.

    The result

    The Cadbury team determined that a majority of shareholders would sell at a price of roughly 830 pence a share. A deal was struck between the two chairmen on January 18 2010 at 840 pence per share plus a special 10 pence per share dividend. This was approved by 72 per cent of Cadbury shareholders two weeks later.

    The key lessons

    As this deal demonstrates, these shareholders may not (and often will not) be the long-term traditional owners of the target company stock, but rather very rational hedge funds and other arbitrageurs (in Cadbury's case, owning 31 per cent of the shares at the end), who are swayed only by the offer price and how quickly the deal can be completed. Other stakeholders may have legitimate concerns that need to be addressed but this can usually be done after the deal is completed, as Kraft did.[220]

121. We followed closely the Cadbury / Kraft takeover and published two Reports on the matter.[221] At the beginning of that takeover, only five percent of owners were considered 'short-term'. By the time the takeover went through this figure was more than 31 per cent.[222]

122. Professor Kay analysed the problem of short-term investors essentially forcing takeovers of companies against the wishes of longer-term shareholders. He considered solving this problem through 'differential voting rights' on shares:

    One suggestion was that voting rights should accrue only after being on the share register for a specified period. This might be a general rule or one specifically applicable during takeover.[223]

However, he concluded that this was not practicable because "the introduction of such provisions by legislation or regulation would involve practical difficulties and would be unlikely to achieve the intended effect".[224] He also believed that regulation would be unnecessary should his recommendations on good stewardship bear fruit.[225]

123. Many expert witnesses agreed with this perspective. Anita Skipper, Corporate Governance Advisor for Aviva Investors, told us that the "one share, one vote principle is the fairest principle".[226] She argued that introducing differential voting rights would introduce new problems:

    There are too many problems once you start giving out differential voting rights, and things that are not actually supportive of what we are trying to do here. You could entrench management whom you are trying to persuade to change what they are doing.[227]

Neil Woodford agreed, and argued that in this case the market had worked efficiently:

    The long-term shareholders who owned Cadbury decided that the price that was being offered was attractive enough for them to sell their shares, because there is always, of course, an opportunity cost associated with investment. You can take your capital from your particular investment and deploy it more productively elsewhere.[228]

124. We asked the Secretary of State if he had considered whether to give preference to long-term investors over short-term investors. He told us that his "instincts are to go back to it".[229] However, he identified three specific obstacles to differentiating voting rights during the takeover of a company:

    ·  If you stop the short-term investors, you reduce the demand for shares, you drive down the share price and you then make the takeover more attractive.

    ·  If you stop long-term investors from acquiring shares in order to build up their stake in the company during the takeover period.

    ·  We do not have an effective system, at the moment, for distinguishing between nominees and original owners. In the UK, we do not have that, so it is not possible to divide the share register in the way that one would ideally like.[230]

He closed his evidence asking us to "help me by finding a way past them".[231]

125. We have heard evidence that the 'one-share one-vote' is fairest. Some witnesses pointed out to us that the long-term shareholders must choose to sell to short-term traders and argued that the 'market' ruled. However we cannot help but think back to the evidence that we have heard that, overall, takeovers detract value from companies. The Secretary of State told us that his instinct was to go back and consider introducing differential votes (i.e. encouraging the principle that short-term traders should have no influence over the takeover vote).

126. We recommend that the Department produces a feasibility study which clearly outlines the risks and benefits of introducing a policy that differentiates between shareholders and voting rights based on the length of time a share has been held.

127. We further recommend that the Government commissions a study to set out the impact on the UK of foreign takeovers of British companies over the past 25 years.

142   Financial Reporting Council website, UK Stewardship Code [accessed 21 June 2013] Back

143   Financial Reporting Council, UK Stewardship Code, September 2012, page 5 Back

144   Professor Kay, The Kay Review of UK equity markets and long-term decision making, July 2012, page 45, rec 1 Back

145   Department for Business, Innovation and Skills, Ensuring equity markets support long-term growth: The government response to the Kay Review, November 2012, para 3.5 Back

146   Department for Business, Innovation and Skills, Ensuring equity markets support long-term growth: The government response to the Kay Review, November 2012, para 3.5 Back

147   Ev 138 Back

148   Q 250 Back

149   Ev 111-112 Back

150   Ev 129 Back

151   Ev 129 Back

152   A full list of sign-up to the Stewardship Code may be found on: Financial Reporting Council website, UK Stewardship Code statements [accessed 21 June 2013] Back

153   Ev 170 Back

154   Ev 170 Back

155   Q 307 Back

156   Ev 123 Back

157   Q 252 Back

158   Q 354 Back

159   Q 280 Back

160   Professor Kay, The Kay Review of UK equity markets and long-term decision making, July 2012, page 48, rec 2 Back

161   Department for Business, Innovation and Skills, Ensuring equity markets support long-term growth: The government response to the Kay Review, November 2012, para 3.6 Back

162   Professor Kay, The Kay Review of UK equity markets and long-term decision making, July 2012, para 6.22 Back

163   Professor Kay, The Kay Review of UK equity markets and long-term decision making, July 2012, para 6.22 Back

164   Q 23 Back

165   Ev 92 Back

166   Group of 30, Long-term finance and Economic Growth, February 2013 Back

167   Q 150 Back

168   Ev 102 Back

169   This is an updated version of the diagram found in Ev 102. Solid connections represent those which Aviva plc argue are covered by Professor Kay's Good Practice Statements, dotted connections are those which it argues are not. Back

170   Q 349 Back

171   Q 349 Back

172   Q 349 Back

173   Q 117 Back

174   Q 117 Back

175   Q 179 Back

176   Q 179 Back

177   Ev 167 Back

178   Ev 167 Back

179   Ev 96 Back

180   Ev 97 Back

181   Q 153 Back

182   Ev 107 Back

183   Ev 107 Back

184   Ev 107 Back

185   Ev 107 Back

186   Q 355 Back

187   Q 356 Back

188   Bank of England, Working paper 469: High-frequency trading behaviour and its impact on market quality: evidence from the UK equity market, December 2012, page 22 Back

189   Government Office for Science, Crashes and high frequency trading, August 2011, page 4 Back

190   Government Office for Science, Crashes and high frequency trading, August 2011, page 4 Back

191   Government Office for Science, The future of computer trading in Financial markets, October 2012, page 5 Back

192   Government Office for Science, The future of computer trading in Financial markets, October 2012, page 5 Back

193   Government Office for Science, The future of computer trading in Financial markets, October 2012, page 14 Back

194   Government Office for Science, The future of computer trading in Financial markets, October 2012, page 14 Back

195   Q 74 Back

196   Q 74 Back

197   Q 269 Back

198   Q 271 Back

199   Q 272 Back

200   Q 103 Back

201   Q 103 Back

202   Q 273 Back

203   Q 273 Back

204   Q 204 Back

205   Q 207 Back

206   Q 207 Back

207   Q 358 Back

208   Q 358 Back

209   Q 358 Back

210   Professor Kay, The Kay Review of UK equity markets and long-term decision making, July 2012, page 62, rec 4 Back

211   Q 363 Back

212   Q 363 Back

213   Professor Kay, The Kay Review of UK equity markets and long-term decision making, July 2012, para 8.13 Back

214   Professor Kay, The Kay Review of UK equity markets and long-term decision making, July 2012, para 8.13 Back

215   Q 109 Back

216   Q 83 Back

217   Q 109 Back

218   Lord Heseltine, No stone unturned in pursuit of growth, October 2012, page 154, rec 73 Back

219   Q 369 Back

220   Financial Times, Case study: Kraft's takeover of Cadbury, 9 January 2012 [extracts] Back

221   Business, Innovation and Skills Committee, Ninth Report of Session 2009-10, Mergers, acquisitions and takeovers: the takeover of Cadbury by Kraft and Business, Innovation and Skills Committee, Sixth Report of Session 2010-12, Is Kraft working for Cadbury? Back

222   Financial Times, Case study: Kraft's takeover of Cadbury, 9 January 2012 Back

223   Professor Kay, The Kay Review of UK equity markets and long-term decision making, July 2012, para 8.32 Back

224   Professor Kay, The Kay Review of UK equity markets and long-term decision making, July 2012, para 8.32 Back

225   Professor Kay, The Kay Review of UK equity markets and long-term decision making, July 2012, para 8.32 Back

226   Q 256 Back

227   Q 256 Back

228   Q 260 Back

229   Q 330 Back

230   Q 330 Back

231   Q 330 Back

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Prepared 25 July 2013