In the News
AUGUST 2006
FT.com ReportsDebate sharpens over shareholders' duties
Published: August 7 2006 03:00 | Last updated: August 7 2006 03:00
Shareholders are entering a new era of navel gazing. As shareholders step up the pressure on executives to exercise good corporate governance, the focus is turning to how institutional investors govern themselves.
A recurring theme underlying many of the sessions at the International Corporate Governance Network conference in Washington last month was how do investment groups, with their myriad clients and investments, manage the inherent conflicts of interest.
Ira Millstein, US doyen of corporate governance, lawyer and senior associate dean for corporate governance at Yale School of Management, was blunt. He told delegates, most of them from the world's biggest fund management groups managing pensions and savings on behalf of millions of individuals, that "there is a need to clean things up".
"Institutional investors have to, at the least, balance customer and self-interest with their duty to beneficiaries. That's our future task," he said.
Mr Millstein urged the 400 or so delegates to look at how they handle the conflicts of interest within their organisations.
"The attitude on the part of investors does not place the interests of their beneficiaries above their own self-interest," he said urging shareholders to exert their rights as owners of business.
In part, the problem lies with the way that capital markets work - a system "that places pleasing the visible corporate customer over pleasing the unseen beneficiary."
"Too many shareholders take the easy road of favouring management in proxy voting because that suits their business interests."
But this results in shareholder passivity, notably in selection of directors, which is not in the interests of the ultimate beneficiary of funds and leaves "the scales tipped in favour of management".
"I urge everyone to remember that you are not investing your own money, you are investing other people's money," he said.
"To restore the balance means dealing with all the vested interests at both ends of the scales, and it may well mean serious changes in the governance of some of our institutional investors."
Mr Millstein's comments are likely to be applauded by many company executives, who have been pushing back on the governance of shareholders for some time. Last year in April, Cadbury's chairman John Sunderland called on the investment industry to put its own house in order before applying yet more stringent demands on companies.
He accused banks and investors of lacking the openness they demanded from listed companies, both in terms of remuneration and on how they vote. He also singled out short-term trading of hedge funds..
"It may be old fashioned but I view a shareholder as a shareowner - someone whose interest in the success and prospects of the company lasts more than three weeks," he said.
The theme has been picked up and repeated many times since. Earlier this year company directors, in a survey by KPMG, again accused investors of short-termism, linking it to bonuses based on performance assessed over short periods of as little as three months.
Other governance experts and regulators are increasingly asking whether short-term trading, linked to heady levels of fund managers' pay and performance fees, might create unforeseen and possibly systemic risks, skewing the behaviour of fund managers as well as the banks that provide services to them.
This year the ICGN proposed a new code of practice to encourage a universal standard of good governance among institutional shareholders, amending 2003 principles, and detailing the re-sponsibilities of institutional investors and their accountability to their clients.
Shareholders must recognise that they cannot have shareholder rights without responsibility, the ICGN said.
And if shareholders are to exercise their responsibilities, "they must be equipped to manage conflicts of interest, set high standards of transparency, command the right levels of expertise and resources and have a balanced organisational structure, which permits them to carry out their obligations to beneficiaries."
Only then can "investee companies make sound decisions and manage risks to deliver sustainable and growing earnings over time."
Greater self-scrutiny among investors has been prompted by new regulations on "unbundling commissions" paid by investors to their brokers.
In the UK, investment groups must now make clear what and why they pay their advisers. US authorities are also looking hard at introducing similar rules on "unbundling" commission payments.
The pressure to disclose voting practices publicly is also mounting. The UK's company law reform bill proposes to make it mandatory. It is already mandatory in the US.
Mr Sunderland's comments found an echo again at the ICGN conference. Mark Anson, incoming chief executive of Hermes, laid the blame for some of the worst breakdowns in good corporate governance - which have had such a marked downward impact on market values - at the door of short-term investors where investors "rent" rather than own shares.
"How can shareholders practice good governance if they are flipping their portfolios every year?" asked Mr Anson.
The high turnover, he said, was the result of the owners of assets pressurising their asset managers to out-perform their benchmarks on a quarterly or annual basis.
"Asset managers, in turn, demand short-term out-performance of the companies in which they invest. This puts pressure on public companies to focus on short-term earnings rather than long-term growth. A vicious circle results," he said.
"We have to look in the mirror," Mr Anson told delegates.
FROM DIRECTORS & BOARDS
We’re All Owned by Hedge Funds
Line up an institutional investor and a hedgie side by side and what do you see: A distinction without a difference?
By Jim Kristie, Editor
While attending the conference on June 13 that launched the new Yale Center for Corporate Governance and Performance , where much of the discussion centered on the power and accountability of institutional investors, I came to a provocative conclusion: Corporate America is owned by hedge funds..
We all read the statistics of institutional investors’ growing clout. The Conference Board reported in an October 2005 study that institutional investors controlled 69 percent of the equity of the 1,000 largest U.S. corporations in 2004, up from 61 percent in 2000. For many corporations, that control position is much higher.
Now match that figure up with the various findings that the average institutional holding period is bout 12 months – i.e., the average portfolio turnover in a year approaches 100 percent, as columnist Gary Sutton expands on below. For many funds, that turnover rate is much higher.
The third angle of this pyramid is the rise in number and activism of hedge funds. Our lead article in this e-Briefing addresses issues related to coping with that trend.
Now consider this. Line up one of your traditional institutional owners and a hedge fund side by side and what do you have: a distinction without a difference? Hedge funds, while notoriously able to sell short, are by some analyses net long in their holdings. So how do you tell them apart when their time frames are quite similar – short or shorter -- as is the range of their activism, from soft to louder to bullying? And institutional investors of course hedge their positions in various ways with various instruments, arbitrage strategies, and balancing of their holdings – which include, yes, placing a portion of their investments with hedge funds.
I may be off base on this, and if I am please tell me, but it sure seems to me that if a majority chunk of your equity is institutionally owned, you may as well consider yourself owned by hedge funds.
Question of the Month
Last month we asked, “How worried are you about the probe into the backdating of stock option grants?” Your response:
The practice is widespread and likely to erupt into a major scandal |
18.8% |
Not widespread, but still a damaging example of board oversight |
62.5% |
Limited cases, and not likely to broaden into a general indictment |
18.7% |
So isolated that it’s a ‘tempest in a teapot’ and the issue will quickly subside |
0% |
The backdating of stock option grants is still much in the news, spreading a bit wider than when we teed up the question four weeks ago. The majority response seems about right, as do these individual replies:
“Executives with the gall to ‘gold plate’ their already lucrative options packages via a backdating scheme which essentially guaranteed them unusually attractive gains should be ashamed! Every executive involved in such a scheme should be forced to resign and/or relinquish all the options so tainted -- and their boards should accept nothing less to make up for their own lapses in effective oversight.”
“I trust the backdating issue is very limited. Most directors are informed and ethical. Any who have played or allowed these games should be loudly exited for cause along with their CEOs.”
“Equity granting practices have been loosely monitored for some time. Adding to the complexity is that executive compensation surveys have only recently (and on a limited basis) broken out restricted stock and options into separate LTI components. Using only ‘peer’ (and that is also an elastic definition) data as comparison creates a domino-effect of bad practices.”
“Maybe I'm naive, but I believe the overwhelming majority of boards take their oversight and fiduciary responsibilities seriously. However, even a relatively small number of cases will probably be blown out of proportion by the press.”
“Regardless of whether or not the practice is revealed as widespread, the underwriters of directors and officers liability insurance will undoubtedly use the possibility as an excuse to try to increase premiums.”
“It has been a practice for many, many years. The next question is when will they discover the other end: manipulating the exercise and sell dates?”
Now here is something that I invite your reaction to. At the aforementioned Yale conference, former SEC Chairman William Donaldson stated that, thanks to Sarbanes-Oxley, “It used to be said that it’s the CEO’s board; now it’s the board’s CEO.” Agree or disagree?