Banking Standards

13. Similarly, Ferdinand Mount has argued that the shareholders we rely upon to oversee company managers are in fact part of the same managerial elite, sharing the same culture and the same incentives (i.e. the short-term maximisation of the share price). [5] If true, this is even more so in the case of banks, where the two groups are part of the same industry – and even in some cases, since the Big Bang, part of the same parent company. Moreover, the loss of public trust caused by incidents like the LIBOR scandal has not been confined to banks but has affected the entire finance industry. In the most recent survey by the National Association of Pension Funds, mistrust of industry was the number one reason given by people planning to opt out of enrolling into a pension scheme under the government’s workplace pension reforms. [6] The Commission should therefore ask itself what can be done to ensure that investment institutions (a) regain public trust and (b) effectively fulfil their role in the governance of the banks they own.

Impact of the UK Stewardship Code

14. The UK Stewardship Code has been effective in promoting the concept of stewardship (virtually the entire UK asset management industry, by assets under management, has signed up to the Code). What is less clear is its impact on the quality of stewardship in practice.

15. Examples such as the blocking of Prudential's planned takeover of the Asian arm of AIG in 2010, or the recent wave of rebellions over executive pay, might suggest a step up in shareholder oversight. However, the general picture is much more mixed. In the recent FT/ICSA Business Bellwether survey, 79% of responding FTSE 350 companies reported no increase in engagement since the introduction of the Code, with the remaining 21% reporting only a slight increase. [7] Similarly, the FRC's first review of the Code found that most companies "[had] noticed relatively little change in approach to engagement". [8]

16. Our own research [9] suggests that the decision to keep the Code high-level and principles-based has not prevented a 'tick-box' approach to disclosures, with many asset managers simply repeating the wording of the Code's Principles. This was particularly the case regarding management of conflicts of interest. Disclosures on investors’ approach to company 'explanations' for non-compliance with the Corporate Governance Code were also an area of weakness. For instance, one firm simply stated "We evaluate each deviation on its own merits" without giving any insight into the criteria on which explanations were judged. Such detail was a feature of the better statements we examined, but unfortunately these were the exception rather than the rule. [10] The recent attention given to the quality of explanations by the FRC and industry participants is welcome. This issue should continue to be monitored closely.

17. Disclosure of voting records under Principle 6 of the Code also remains poor. One study by PIRC found that just 21% of signatories disclose full records, and over half do not disclose any information at all. [11] The government has reserve powers to introduce mandatory voting disclosure if voluntary initiatives do not generate sufficient improvements (under section 1288 of the Companies Act 2006).

18. The FRC’s success in gathering signatories to the Code must now be built on with efforts to raise standards of behaviour and disclosure. The FRC’s present review of the Code offers an important opportunity to do this. However, there is also a need to examine the structural barriers to greater uptake of stewardship behaviour. The remainder of this submission explores what we believe are some key problems, along with possible solutions.

Structural problems - the investment chain

19. It is well established in economic theory that the relationship between shareholders and company managers creates ‘principal/agent’ problems. There is now general consensus that managing these problems requires active shareholder oversight. However, to achieve this there is a need to disaggregate what we mean by the term 'shareholder'. Institutional investment is itself a chain of principal/agent relationships: the asset managers who generally exercise shareholder rights are agents acting on behalf of asset owners (such as pension funds), who in turn are agents acting on behalf of individuals (such as pension savers). This 'triple agency problem' is the source of many key barriers to better shareholder oversight of banks and other listed companies.

20. For example, as the evidence discussed above shows, there is clearly a misalignment between the inherently long-term financial interests of pension savers and the short-term metrics used both by pension funds to assess fund manager performance, and by fund managers to assess company performance. It is unclear that the post-crisis focus on stewardship has done anything to alleviate this problem – and equally unclear that current norms of shareholder oversight would be effective in preventing a repeat of the 2008 crisis.

21. Fiduciary duties are the main legal mechanism used to deal with principal/agent problems in UK law. Those who act on behalf of others have a fiduciary duty to act in their best interests, and not to use their position to further their own interests or those of third parties. FairPensions has conducted extensive research on interpretations of fiduciary duty. This has helped to inform the Kay Review, whose final report included an extended discussion of fiduciary duty. [12] In our view, there are two key problems with the current situation: firstly, confusion over what fiduciary duties require, and secondly, inconsistencies in who is deemed to have fiduciary duties.

Problem 1: Narrow interpretations of fiduciary duty

22. Pension fund trustees’ fiduciary obligations are widely interpreted as a duty to maximise short-term returns and ignore other considerations, even if they might have a material impact on long-term outcomes for beneficiaries. This is a real barrier to stewardship: legal advice given to one large UK pension scheme even suggested that their policy of exercising voting rights could breach their fiduciary duties if they could not demonstrate that the costs incurred were justified by monetisable benefits to that individual scheme. Since the benefits of stewardship almost inevitably accrue to the market as a whole, this contributes to a 'free-rider' problem.

23. Institutional investors' fiduciary duty to invest prudently has also been interpreted by UK and US courts as being relative to the behaviour of other investors. [13] This encourages herding behaviour, sometimes characterised as 'reckless caution', and potentially exacerbates systemic risk. For instance, we have been told privately that, before the dot-com bubble burst, some managers who recognised the bubble and avoided tech stocks were sacked by pension fund clients for underperforming their peers in the short-term.

24. In combination, these widely held perceptions of the law contribute to a focus on chasing short-term outperformance (alpha) rather than improving the performance of the market itself (beta) through stewardship activities. This is one driver of the short-term, benchmark-relative remuneration structures which incentivise fund managers to demand that their investee companies prioritise short-term returns. It also has no place for the wider interest of pension fund beneficiaries in the management of systemic risk: market volatility and systemic crises have a far greater impact on pension savers than the degree to which their individual fund outperforms the market, yet current interpretations of the law require their agents to relentlessly prioritise the latter.

Proposed solution

25. FairPensions has proposed statutory clarification to remove these perceived legal barriers to better shareholder oversight. The aim would be to create a more flexible and enabling environment by clarifying that fiduciary investors may consider factors beyond quarterly results, and to encourage a focus on sustainable wealth creation. We have published draft legislation which suggests, among other things, that investors should be explicitly permitted to have regard to "the impact of [their] investment activities on the financial system and the economy". [14] This is intended to help resolve the problems outlined above, and should create space for better shareholder oversight of systemically important financial institutions. The Kay Report essentially endorsed this recommendation, concluding that "there is a need to clarify how these duties should be applied in the context of investment, given the widespread concerns about how these standards are interpreted." [15]

Problem 2: Inconsistent application of fiduciary duties

26. One less frequently invoked aspect of fiduciary duty is the duty to avoid conflicts of interest. There is considerable anecdotal evidence that conflicts of interest among fund managers are one barrier to more robust shareholder engagement. For example, one recent paper cites an instance where "the company secretary of a UK manufacturer reminded a fund manager who was intending to vote against the company’s remuneration report that his firm was bidding for an investment mandate from the corporation’s pension plan". [16] In financial conglomerates, conflicts may arise between asset management arms and investment banking arms. When we surveyed asset managers' disclosures under the Stewardship Code, we found that many gave little or no insight into how these conflicts were managed. The FRC has also identified this as an area for improvement.