Business, Innovation and Skills CommitteeWritten evidence submitted by BlackRock

BlackRock welcomes the opportunity to respond to the request for evidence made by the House of Commons and the Department for Business, Innovation & Skills on the Kay review. We set out in the attached response our view on 16 of the 17 principles recommended by Professor John Kay in his final report published in July 2012.

BlackRock is a leader in investment management, risk management and advisory services for institutional and retail clients worldwide. As at 31 December, 2012, BlackRock’s AUM was $3.792 trillion (£2.332 trillion). BlackRock offers products that span the risk spectrum to meet clients’ needs, including active, enhanced and index strategies across markets and asset classes. Products are offered in a variety of structures including separate accounts, mutual funds, iShares® (exchange-traded funds), and other pooled investment vehicles. BlackRock also offers risk management, advisory and enterprise investment system services to a broad base of institutional investors through BlackRock Solutions®.

In Europe specifically, BlackRock has a pan-European client base serviced from close to 20 offices across the continent. Public sector and multi-employer pension plans, insurance companies, third-party distributors and mutual funds, endowments, foundations, charities, corporations, official institutions, banks and individuals invest with BlackRock. BlackRock pays due regards of its clients’ interests and it is from this perspective that we engage on all matters of public policy. BlackRock supports regulatory reform globally where it increases transparency, protects investors, facilitates responsible growth of capital markets and, based on thorough cost-benefit analyses, preserves consumer choice.

BlackRock is a member of European Fund and Asset Management Association (“EFAMA”) and a number of national industry associations1 reflecting our pan-European activities and reach.

We thank you for the opportunity to address and comment on the issues raised by the Kay review. We are prepared to assist the House of Commons and the Department for Business, Innovation and Skills in any way we can, and look forward to continued dialogue on these important issues.

Joanna Cound
Managing Director
Head of EMEA Government Affairs & Public Policy

Amra Balic
Director
Head of Corporate Governance and Responsible Investment EMEA

18 January 2013

Executive Summary

1. BlackRock is supportive of most of Professor John Kay’s 17 Recommendations developed in his final report on his review of the UK equity market.

2. BlackRock strongly supports the continuing development of a robust corporate governance regime. This, in our opinion, promotes strong leadership by boards and good management practices both of which contribute to the long-term success of companies and protects and enhances long-term shareholder value. As such, we engage with companies in which we invest on behalf of our clients dedicating our time generally to one-to-one meetings where we discuss, amongst other issues, the companies’ strategic direction and the performance of management in delivering strategy.

3. BlackRock believes that there are merits in the development of the formation of an investor forum to strengthen corporate governance in companies in which we invest but has a number of reservations as to its scope of engagement and relationship with existing forums led by trade associations. In addition, while we discuss collectively with other investors when we believe this is likely to enhance our ability to engage with a company, the establishment of an investor forum poses a number of challenges which we develop in our attached response. Also, BlackRock does not think mandatory consultation by companies of their major shareholders over board appointments is appropriate for companies and/or investors. This would raise several practical questions such as inside information issues.

4. BlackRock does not consider that further changes to the application of fiduciary standards by asset managers at an EU level are required. BlackRock fully understands and endorses its duty to act at all times in the best interests of clients to protect and enhance the economic value of the companies in which we invest on their behalf.

5. With regards to transparency vis-à-vis asset managers’ clients, BlackRock is supportive of initiatives aiming at improving transparency of costs and fees. However, disclosing the full costs of certain transactions might not be technically feasible for asset managers. In addition, we support and already provide a high degree of transparency to end-investors in respect of stock lending activity. A portion of the additional income that this activity generates for end-investors is allocated to compensating the lending agent for the provision of this service. After the payment to the lending agent has been deducted, we agree that the remaining net revenue should be passed to the end-investors as incremental income.

6. With regards to transparency vis-à-vis companies’ investors, BlackRock believes that the informative quality of the narrative reports should be improved and be presented in a concise and clear way. We support guidance rather than regulation to achieve this objective. However, we believe that quarterly reports potentially create an undue focus on short-term developments that may have little material impact over the longer term. We therefore agree that quarterly reporting should no longer be mandatory.

7. BlackRock welcomes the Government initiatives to explore with market participants, the regulators, academics and relevant representative and professional bodies the metrics and models used in the investment chain.

8. BlackRock agrees that “companies should structure directors” remuneration to link incentives to sustainable long-term business performance”. However, we are not supportive of directors having to hold the shares of the company in which they work until after they have retired from the business as this could incentivise a higher turnover of directors in the company who leave simply in order to cash in their shares contrary to the long term interest of the company. BlackRock is also of the view that asset management firms should structure remuneration to align their interests with those of their clients. We show evidence in our detailed response that BlackRock’s compensation structure encourages a focus on the medium to long-term.

9. Finally, BlackRock fully agrees with Professor John Kay that it is key for individual investors to have all their rights preserved when holding shares through electronic means at a cost-efficient basis. We would welcome any initiatives which may reduce the cost of electronic trading intermediation for individual investors and encourage their ability to vote.

Introduction

In this response, BlackRock expresses its views on 16 of the 17 Recommendations given by Professor John Kay in his final report published in July 2012. We provide as much as possible factual information and recommendations for actions that we hope will be insightful for the House of Commons and the BIS.

BlackRock’s response to the House of Commons and BIS request for evidence on the Kay review

(1.) The Stewardship Code should be developed to incorporate a more expansive form of stewardship, focussing on strategic issues as well as questions of corporate governance.

10. BlackRock agrees with Professor John Kay’s first recommendation. In our experience, the most important factors in determining success of a company are the strong leadership and execution of a company’s strategy. As part of our engagement with companies, the BlackRock Corporate Governance team discusses with companies in which we invest strategy and execution issues and also aims to reach a better understanding on broader corporate governance policies and procedures and how executive pay is linked to achievement of the strategic goals.

11. It is worth noting that BlackRock approaches each engagement individually and does not have a prescribed escalation strategy, as suggested by the UK Stewardship Code, as we do not see engagement as mechanistic. Triggers for engagement can include our assessment that there is potential for material economic ramifications for shareholders resulting from a governance concern. Indeed, where we are concerned about the strategic direction the company is taking or the performance of management in delivering strategy, we will engage more heavily and through regular and frank meetings with management, we try as much as possible to raise queries before they become significant concerns that require greater attention.

12. BlackRock is very unlikely to make public statements about our engagements or to call an extraordinary general meeting or propose shareholder resolutions. Our preference is to engage privately as we believe it better serves the long-term interests of our clients to establish relationships, and a reputation, with companies that enhances rather than hinders dialogue.

13. Last, it is important to clarify that BlackRock defines 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. Yet we perceive a widespread belief that stewardship implies that shareholders have a responsibility to engage with companies and “make them better”. This confuses the two responsibilities. 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.

(2.) 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 take steps to align existing standards, guidance and codes of practice with the Kay review’s Good Practice Statements.

14. BlackRock supports this second recommendation made in the final Kay report. We are a member of the Institute of Chartered Secretaries and Administrators (ICSA) steering group created in the summer of 2012 to improve the Quality of Investor Stewardship. This was at the request of the 2020 Investor Stewardship Working Group, of which BlackRock is a founding member. The steering group is developing a good practice guide to improve the quality of engagement activity and aims to identify more effective means for companies and institutional investors to provide feedback on the quality of meetings.

15. BlackRock believes that corporate governance and engagement are an integral part of an asset manager’s fiduciary duty to enhance the value of its clients’ assets and to ensure management are running the company in the best long-term interest of shareholders. In observance of our fiduciary duties to our clients, we: (i) as already mentioned above, engage with companies we invest in on a number of corporate governance and performance related issues; (ii) vote at shareholder meetings (for those clients who have given us a legal right through the Investment Management Agreement to vote on their behalf) and (iii) engage on wider policy issues that are in our view fundamental to protection of investors and their rights as shareholders.

(3.) An investors’ forum should be established to facilitate collective engagement by investors in UK companies.

16. In principle, we are in favour of creating an investor forum that would (further) facilitate collective engagement. However, we also acknowledge that there are some challenges, such as:

Minimise/limit overlaps and duplication of efforts: the new forum needs to cover topics/issues that go beyond the typical discussions currently conducted through the existing industry bodies (ie Association of British Insurers (ABI), National Association of Pension Funds (NAPF) and Investment Management Association (IMA)).

The forum’s governance policies need to ensure confidentiality of the meetings and views expressed as this aspect will be the key determining factor of the forum’s effectiveness and ultimate success.

The governance policies and terms of reference also need to be designed to allow effective actions in a way which does not conflict with rules on market abuse and acting as concert party in view of a takeover bid.

17. As UK Plc. (companies registered in the UK) is decreasingly owned by UK savers, bringing some large foreign investors (such as sovereign wealth funds) to the table would broaden the discussion and enable exchange of views.

18. In general terms, as a large investor in UK companies, BlackRock will work with other investors, often on an ad hoc basis, when we believe it is likely to enhance our ability to engage with a company or to achieve the desired outcome. This facilitates communication between shareholders and companies on corporate governance and social, ethical and environmental matters. We will also engage collectively on matters of public policy, when appropriate.

(4.) The scale and effectiveness of merger activity of and by UK companies should be kept under careful review by BIS and by companies themselves.

19. We do not have comments on this principle.

(5.) Companies should consult their major long-term investors over major board appointments.

20. BlackRock agrees in principle that companies should consult their major investors over the key board appointments. However, we do not see the need to make this consultation mandatory for companies and/or investors. Both parties should be allowed to determine if or when the consultation is necessary. We also acknowledge that there are some practical issues surrounding this type of engagement and consultation that need to be discussed further. Specifically, there are issues in relation to inside information and wall crossing, timing of consultation and subsequent communication with investors.

21. It is also worth pointing out that today companies and investors are already engaging over the major appointments but those conversations vary for the reasons cited above. At a minimum, investors will have a view on the background and skill set required. At the same time, investors will unlikely want to be made insiders for an extended period of time depending on a number of factors such as investment strategy, size of holding, company performance etc. In this case, we would urge the House of Common and BIS to take into account current developments in the market abuse regime such as the European Union Market Abuse Regulation and to ensure that appropriate balance is reached between investors’ engagements and preventing market abuse.

(6.) Companies should seek to disengage from the process of managing short term earnings expectations and announcements.

22. Based on our experience in recent years, the demand for greater disclosure on short term earnings, such as quarterly reporting and the operating review, has helped boards to communicate better their long-term strategic objectives. However, quarterly reporting does potentially places undue focus on short-term developments that may have little material impact over the longer term. Too frequent disclosure can make the market lose sight of the longer term objectives and judge the company on its short-term achievements. This, in turn, might make it more difficult for boards to focus on the long-term development of their business. Therefore, BlackRock supports moves to drop the requirement for mandatory quarterly reporting. This will allow companies to be freer to disengage from the process of managing short term earnings expectations and announcements and focus more on their long-term objectives. We develop this point further in our comments to Recommendation 11.

(7.) Regulatory authorities at EU and domestic level should apply fiduciary standards to all relationships in the investment chain which involve discretion over the investments of others, or advice on investment decisions. These obligations should be independent of the classification of the client, and should not be capable of being contractually overridden.

23. BlackRock does not consider that implementing a new fiduciary standard at an EU level is required for asset managers. We believe that UK asset managers understand their obligations, which include contractual (setting the scope of who a manager’s customer is, the guidelines to be applied, etc.) and regulatory (both at an EU or UK level) duties. These are high standards already.

24. In the UK we understand that fiduciary responsibility has been developed (and continues to develop) by case law and introducing an EU wide standard which cannot be contractually overridden may cause confusion and perhaps affect the competitiveness of the UK asset management industry.

(8.) Asset managers should make full disclosure of all costs, including actual or estimated transaction costs and performance fees charged to the fund.

25. BlackRock fully supports initiatives aiming at improving transparency of costs and fees. We do note that there are a number of ways of addressing this issue and in particular, for retail investors, this needs to be coordinated at a European Union level as part of the packaged retail investment products (PRIPS) initiative.

26. However, providing full transparency of costs for non-equity product presents a number of challenges such as the effects of spreads on fixed income instruments. It is important that a common methodology is agreed which can apply across all product ranges.

27. Also, given unbundling of advisory fees from product specific fees in the UK retail distribution review (RDR), it is important that investors have a clear way of assessing total product cost and total investment cost (ie product and advice costs together). Asset managers will only be able to disclose the product cost to the end-investors but not the full cost of investing given they will not have information post-RDR on the fees end-investors will have to pay to the advisers. BlackRock is supportive of clear disclosure delivered by advisers to clients regarding the new fee arrangements.

28. As a member of the IMA and the NAPF, BlackRock endorses the efforts of both organisations to establish industry wide best practice on fee transparency and is currently working towards compliance across all client communication channels.

(9.) The Law Commission should be asked to review the legal concept of fiduciary duty as applied to investment to address uncertainties and misunderstandings on the part of trustees and their advisers.

29. BlackRock cannot comment on uncertainties and misunderstandings on the part of trustees. As referred to in Recommendation 7 above, we do not believe that additional clarity is needed for UK asset managers regarding the rules around being a fiduciary as these rules are sufficiently well understood under English law.

(10.) All income from stock lending should be disclosed and rebated to investors.

30. Stock lending is a well-established and low risk activity that is comprehensively regulated in Europe. Investment vehicles such as UCITS funds, ETFs, pension funds and insurance companies make short-term loans of their securities to banks and broker dealers, who, in return, provide collateral that is in excess of the value of the underlying loans. The funds receive the full economic value of the security lent including any dividends paid, and further receive a fee for lending their securities, which generates incremental returns for their portfolios contributing to the overall investment performance.

31. In addition, stock lending has wider benefits for financial markets as it provides liquidity that helps to improve settlement efficiency and contributes to tighter trading spreads for investors.

32. Stock lending is considered to be a low risk activity. The risk mitigation tools utilised include using high quality counterparties, over-collateralisation, and in some cases contractual indemnifications against losses as a result of borrower default.

33. We support efforts to increase transparency on stock lending activities for end investors to ensure that are fully informed of the nature of risks and returns involved from this activity. We further support disclosure of the fees paid in connection with securities lending, in the same manner as other fees paid to fund service providers are disclosed. However, we do not agree that all income should be passed to investors given that running these activities represents a cost for the lending agents appointed by the funds.

Stock lending is a resource-intensive activity. A high proportion of stock lending trades are executed automatically, which requires significant investment in systems and technology. A smaller number of trades are negotiated manually, where pricing can be influenced by many variables, and the outcome for end investors can be significantly improved through the application of quantitative and fundamental research and analytics. In addition, investment in risk management capabilities is required to continuously review counterparties and collateral parameters. Significant resources are also required to monitor settlement, collateralisation and corporate actions activity. These investments permit the lending agent to provide their trading expertise, scalability and risk controls across all lending clients. It is difficult to assign these costs to specific lending clients. 

34. As a result, beneficial owners and the stock lending industry have established a model whereby the lending agent receives a percentage of gross revenues for their service of providing stock lending services. This model ensures that the lending agent is compensated only if the lending client generates revenue for the fund. In our view, paying the lending agent a percentage of the gross revenue generated is the most appropriate way of ensuring alignment between the interests of the investors and the lending agent.

35. There are at least three active compensation models being used for stock lending in the European markets today:

(1.) Affiliated Model: In-house lending programmes, where the asset manager or an affiliate performs stock lending services as the lending agent. The agent receives a portion of the gross stock lending revenue generated.

(2.) Outsourced Model: All stock lending services are outsourced to a lending agent, which could be a custodian, another asset manager or a specialised third-party lending provider. As before, the agent receives a proportion of the gross stock lending revenue generated.

(3.) Three-Way Split Model: Stock lending is outsourced as in the second model, but the investment manager also receives part of the stock lending revenues. Fees are split between lending agent, fund and asset manager.

36. As explained above, we are not supportive of having all of the gross income generated from stock lending passed to end-investors. However, we do agree that transparency should be provided to clients so that they fully understand revenue sharing arrangements. We also believe that the cost of operating a lending programme should be paid by lending agent from their portion of the income. After the payment to the lending agent has been deducted, we agree that the remaining net revenue should be passed to the end-investors as incremental income.

(11.) Mandatory IMS (quarterly reporting) obligations should be removed.

37. As already mentioned on our comments to Recommendation 6, BlackRock supports moves to drop the requirement for mandatory quarterly reporting. While further investigation into the impact of quarterly reporting might be worthwhile, we believe that quarterly reporting potentially places undue focus on short-term developments that may not have a significant impact over the longer term.

38. Also, we think that consideration might be given to whether there should be more flexibility in reporting requirements, which can be disproportionately costly for smaller companies. Investor pragmatism and engagement would ensure that the right balance is achieved between meeting shareholder expectations and not unduly burdening smaller companies.

12) High quality, succinct narrative reporting should be strongly encouraged.

39. BlackRock agrees with this principle. We believe that the informative quality of the narrative reports should be improved whilst giving companies an appropriate level of flexibility in respect of the nature and scope of disclosure. We support guidance rather than regulation that would focus on balancing the need for reports to be complete and comparable with the need to be concise and accessible to all users.

40. Also, when preparing the annual report companies should focus on the matters material to the long-term success of the company and those that explain performance during the period under review. All focus should be on providing information to investors that is useful for making their investment decisions. We think that narrative highlights should give both what is most material in the long/medium term outlook and what the companies believe are material changes to previous narratives about that outlook. The areas that a business decides are most applicable can itself contain useful information. However, while we see value in providing additional information (as mentioned above), we also urge companies to present them in a concise and clear way.

(13.) The Government and relevant regulators should commission an independent review of metrics and models employed in the investment chain to highlight their uses and limitations.

41. BlackRock welcomes the Government initiatives to explore with market participants, the regulators, academics and relevant representative and professional bodies the metrics and models used in the investment chain.

(14.) Regulators should avoid the implicit or explicit prescription of a specific model in valuation or risk assessment and instead encourage the exercise of informed judgment.

42. BlackRock fully agrees with this principle.

(15.) Companies should structure directors’ remuneration to relate incentives to sustainable long-term business performance. Long-term 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.

43. BlackRock agrees that “companies should structure directors” remuneration to relate incentives to sustainable long-term business performance”. However, we do not believe that company shares are the only asset that can incentivise directors’ long term performance. In some cases and in certain industries, shares coupled with subordinated debt/bonds can also be efficient. We do not agree either that the directors should hold the shares until after they have retired from the business as this may lead executives to leave the company when they think it is the best timing to cash in with adverse effects on the long term interest of the company.

(16.) Asset management firms should similarly structure managers’ remuneration so as to align the interests of asset managers with the interests and timescales of their clients. Pay should therefore not be related to short-term performance of the investment fund or asset management firm. Rather a long-term performance incentive should be provided in the form of an interest in the fund (either directly or via the firm) to be held at least until the manager is no longer responsible for that fund.

44. BlackRock agrees that asset management firms should structure remuneration to align the interests of asset managers with the expectations of their clients.

45. BlackRock’s approach to compensation reflects the value senior management places on its clients, employees and shareholders. Consequently, the compensation structure is designed to align with client and shareholder interests, to reflect performance and to attract and retain the best talent and to reinforce stability through the organisation.

46. The predominant compensation model includes a salary and a discretionary bonus reflecting firm, business area, and individual performance. For most investment professionals, compensation reflects investment performance over the short, medium and long term and the success of the business or product area and the firm Variable compensation deferred from annual bonus awards is paid out in BlackRock’s stock which vests over a number of years In addition, a limited number of investment professionals have a portion of their annual discretionary awarded as deferred cash that notionally tracks investment in selected products managed by the employee. The intention of these awards is to align further investment professionals with the investment returns of the products they manage through the deferral of compensation into those products. Clients and external evaluators have increasingly viewed more favourably those products where key investors have “skin in the game” through significant personal investments. However, such co-investment is not always possible. For example, as a result of the significant compliance burden with respect to the US Foreign Account Tax Compliance Act (FATCA), a US national is generally precluded from investing in a UK fund. The combined effect of this approach means that the variable compensation an investment manager receives in any one year reflects the investment performance achieved over a considerable time period. BlackRock believes that this correctly aligns compensation with the client experience and that it is not appropriate for the incentive to be held until the investment manager is no longer responsible for a particular fund. The compensation structure outlined above is designed to retain best talent and reinforce stability of personnel (because clients select managers on long term performance and stability of investment processes and personnel). Withholding the deferred compensation until the investment manager no longer is responsible for the fund could instead encourage greater personnel turnover.

(17.) The Government should explore the most cost effective means for individual investors to hold shares directly on an electronic register.

47. BlackRock would welcome initiatives which may reduce the cost of electronic trading intermediation for individual investors and safeguard and encourage their ability to vote. As such, we are of the view that it is important to find the most cost effective means for individual investors to hold shares electronically in their own name. We note that investors already have the ability to hold their shares electronically through nominees which represents a less significant cost for them than holding the shares in their own name. However, we are of the view that individual investors should have all their rights preserved when holding shares through electronic means.

48. BlackRock also believes that any such initiative needs to be viewed in the context of central securities depositaries and the proposed securities law directives.

1 Association of British Insurers (ABI), Association Française de Gestion (AFG), Assogestioni, Association française des Sociétés financières (ASF), Association suisse des institutions de prévoyance (ASIP), Bundesverband Investment and Asset Management (BVI), Dutch Fund and Asset Management Association (DUFAS), Eumedion, Financial Reporting Council (FRC), Irish Association of Pension Funds (IAPF), Irish Funds Industry Association (IFIA), Investment Management Association (IMA), Inverco, Alternative Investment Management Association (AIMA) and National Association of Pension Funds (NAPF).

Prepared 24th July 2013