UK: Institutional Shareholder Activism: A Sea Change?

Two major statements about institutional shareholder activism were published in October; the first by the Institutional Shareholders’ Committee (ISC) and the second by Hermes Pensions Management (Hermes). For listed companies, these provide an insight into institutional thinking, an indication of the practical implications of the institutional shareholder activism debate and a forewarning of the questions that companies may be pressed by their shareholders to answer as they move into the next cycle of annual reporting and general meetings.

Cynical observers have viewed the ISC publication merely as an attempt by institutions to ward off a threatened change in the law, following the Myners report, which would place them under a duty to intervene in companies if to do so would be in the best interests of shareholders and beneficiaries. Opposition to that proposal certainly seems to have given a new lease of life to the ISC, an umbrella body for the Association of British Insurers (ABI), the Association of Investment Trust Companies, the Investment Management Association and the National Association of Pension Funds (NAPF), which had become largely moribund during the 1990s. The ISC hopes that its new Statement of Principles will enhance institutional involvement and improve company accountability and so convince the government that legislation is not needed. In addition to this political pressure, shareholder activism has of course also been given added impetus by the fall-out from high profile collapses like Enron and WorldCom – which has led to a raft of corporate governance initiatives.

Hermes on the other hand has not needed any encouragement to be vocal on institutional shareholder issues and has a long history of involvement. Its new Statement of Principles focuses instead on what it sees as the prerequisites for creating shareholder value.

The political pressure on institutions and the changed economic climate may already be having some effect on voting levels. Recent surveys carried out by PIRC and by Manifest, the proxy voting agency, indicate that voting levels at UK companies are up. Manifest’s analysis of voting trends, published in September this year, looked at meetings held during the first seven months of 2002 by companies in the FTSE All-Share index and compared them to those held in the same period in 2001. The overall level of voting had increased to 55.86%, compared with 52.72% in 2001, although across the board turnout still fell short of the DTI target of 60% of possible votes lodged. The average turnout at FTSE 100 general meetings was in fact lower than the average - at 49% - although FTSE 250 companies did hit the 60% target. Manifest suspects that the explanation for the "missing" votes at FTSE 100 companies lies in their higher levels of overseas ownership. It asks some interesting questions about why this is so, given that US institutions, who are required to exercise their votes, comprise a considerable proportion of the overseas holders. Is it the case that they are giving voting instructions, but these are not being converted into votes at the company meetings? Or is it the case that FTSE 100 levels of voting are being dragged down by Continental European and other non-US institutional investors who are displaying less interest in corporate governance and voting matters?

It will be interesting to see how the introduction of the CREST domestic proxy voting service in January 2003 will affect voting levels. Of course, whilst it will make it easier for registered shareholders to appoint and instruct their proxies, it will not be of direct assistance to beneficial owners, such as overseas shareholders, who are reliant on their nominees to implement their voting instructions.

More significantly, both Manifest and PIRC have also identified a rising trend in shareholder dissent – largely via the use of abstentions. PIRC looked at proxy voting results for AGMs between July 2001 and July 2002 in the FTSE All-Share index. Over 3% of the companies in its sample recorded votes against of more than 20% on one or more resolutions. Over 6% of companies recorded abstentions in excess of 20%. PIRC found that share schemes exceeding normal dilution guidelines were the single most contentious issue in terms of attracting the largest opposition votes, followed by directors’ pay issues.

Manifest highlights an increase in the use of abstentions and notes that the overall level of dissension, combining abstentions with votes against, has risen during the year by 18%. Manifest also notes in particular that of the companies that voluntarily put their remuneration policy to a shareholder vote, nine had high abstain votes - of greater than 10% of the votes cast. Manifest speculates that this may indicate companies are in for "a rough ride" in the next AGM cycle, when putting the remuneration policy to a vote will be compulsory.

The other key issue will be whether the increasing willingness of institutions to indicate dissent will eventually lead to them actually voting against rather than, as now, using the abstention route to indicate disagreement.

The ISC Statement of Principles is aimed at "institutional shareholders" – pension funds, insurance companies, and investment trusts and other collective investment vehicles – and at agents such as investment managers, which are appointed by institutional shareholders to invest on their behalf. The statement is available from the investment affairs section of the ABI website – www.abi.org.uk.

The ISC recommends that each individual institution should draw up a statement setting out its policy on shareholder activism, which should be a public document. The policy should include the following:

• How investee companies will be monitored; including monitoring to determine when the institution needs to enter into an "active dialogue" with the board and senior management.
• The policy for requiring investee companies’ compliance with the Combined Code.
• The policy for meeting with an investee company’s board and senior management.
• How situations where institutional shareholders and/or agents have a conflict of interest will be dealt with.
• The strategy on intervention. • An indication of the type of circumstances when further action will be taken and details of the types of action that may be taken.
• The policy on voting.

Many institutional investors will, of course, already have a written statement of their policy, although it may not cover all these aspects and may not have been made public. Also, they may not necessarily pursue the same policy in relation to every investment. There has been speculation that the public nature of the document, and the implied requirement that it should cover all the companies in which the shareholder invests, will mean that the statements of policy will tend to be quite bland.

Listed company boards will be interested in, although hardly surprised by, the instances listed by the ISC of when institutions may want to intervene. These are where they have concerns about:

• The company’s strategy.
• The company’s operational performance.
• The company’s acquisition/disposal strategy.
• Independent directors failing to hold executive management properly to account.
• Internal controls failing.
• Inadequate succession planning.
• An unjustifiable failure to comply with the Combined Code.
• Inappropriate remuneration levels/incentive packages/severance packages; and
• The company’s approach to corporate social responsibility.

The Statement also describes the hierarchy of actions that could be taken by institutions and agents if boards fail to respond constructively to their initial approaches, ranging from holding additional meetings with management through to putting resolutions at shareholder meetings and seeking to requisition an extraordinary general meeting.

This is probably not a radical departure from what shareholders with a policy of engaging with their investee companies have been doing already. The key question is whether it will persuade the silent majority to do the same. It is therefore difficult to predict at this stage what the extent of the impact on listed companies will be. Companies which are not seen as under-performing and which already have a fair amount of ongoing communication with their largest investors may not notice much difference. Even if a company is underperforming, or proposing resolutions to which shareholders object, it is likely that, as now, many shareholders will choose to express their views through the ABI or the NAPF, which will lobby on their behalf, rather than approach the company direct. But some shareholders who have hitherto been content to let others take the lead may start to have more active dialogue with the companies in which they invest. It may be a gradual process, with institutional shareholders increasing the amount of their involvement as they gain confidence in their more active role. Listed companies should certainly be preparing themselves for:

• more demands by institutional shareholders for an active dialogue, including meetings with them (and directors will of course need to be on their guard here to ensure that there is no breach of the company's obligation not to selectively disclose price sensitive information);
• more vocal opposition from institutions on controversial issues, particularly in relation to corporate governance; and
• an increasing use of abstentions, and possibly votes against, by institutions.

The ISC Statement of Principles is a document which focuses very much on the basics of how shareholder engagement should take place: setting out policy, monitoring performance, intervening when there are concerns over shareholder value, voting and reporting. It does not say what the policy should be, or attempt to describe good corporate governance or what the ultimate aims of shareholder engagement might be. This is very much in contrast with the Hermes Principles, discussed below, which in a sense steal the ISC’s thunder by attempting to move the debate on to the question of what institutions are actually looking for from the companies in which they invest.

The ISC says that it will review the principles and their operation within two years. The Government has announced that it welcomes the ISC’s "best practice" approach, and that it will decide after that two-year period whether this approach has been successful in delivering change.

Hermes has had its own statement of corporate governance principles for several years. The new Hermes Principles are completely different. They are a detailed statement of "What shareholders expect of public companies – and what companies should expect of their investors". Hermes says its aim is to foster better understanding between companies and their owners – that is, those who invest in them: "A company is a joint enterprise between those that run it – its directors and managers – and those that own it – its shareholders. Investments in public companies are more likely to succeed if investors communicate reasonable expectations properly and corporations better understand what is being asked of them." The Principles can be read in full on the Hermes website – www.hermes.co.uk.

The prevailing theme of Hermes’ approach is "We’re in it for the long-term," and specifically for long-term shareholder value, and all ten of the Principles underpin this. Other keywords are "communication", "stewardship", "competitive" and "ethical".

Before setting out the Principles themselves, Hermes gives its explanation of why companies and investors can and do lose sight of the ultimate goal of long-term shareholder value creation. Hermes draws a distinction between the objectives of a fund manager, such as itself, which has as its sole long-term aim the accumulation of a financial surplus sufficient to fund the pensions and insurance policies of millions of people, and the activity of trading in shares, which seeks to exploit relatively short-term movements in share prices to gain a competitive advantage over others who also trade. One problem is that so much of the information flow in the investing world is based around share trading. This can lead companies to focus their investor relations activities on brokers and analysts, and neglect to have a proper dialogue with their investors. Another problem is that the attention given to short-term performance may distract company managers from the goal of creating long-term shareholder value. They should understand that much of the questioning they receive from brokers and fund managers is to help them make decisions about short-term buying and selling of the company’s shares; they should not let it influence the basis on which the company is run.

Clearly, this is easier said than done and there is obviously scope for: "Well they would say that, wouldn’t they?" It will be interesting to see how far institutional activism can alter the focus of "investor relations" away from "the City" – that is analysts and brokers – and back to the investors themselves – particularly given the current debate, both in the US and the UK, about the role that analysts played in hyping bad stocks and the need for analysts to be independent.

The ten Principles described in the Hermes document are summarised below:

Companies should use the annual report to say what the company believes its cost of capital is, what its competitive advantage is in the businesses that it owns, and what surplus it is generating over that cost of capital. It should not just have a description of the company’s activities and aspirations withoutexplaining how or if they are creating shareholder value.

Hermes considers that the best way for companies to focus on their primary goal of long-term shareholder value is to measure it in terms of cash flow returns. It emphasises the importance of the Weighted Average Cost of Capital (WACC) to corporate decision-making, but notes that very few companies state clearly in their annual report and accounts their WACC assumptions. One of the few to do so is Geest plc, and Hermes quotes approvingly from its 2001 annual report.

Hermes says it will not support the pursuit by companies of growth for growth’s sake. It refers to the UK Treasury trend growth projections of 2%-3% and says that while some companies will be capable of achieving growth substantially higher than this, "it has long been apparent that the sheer number of companies aspiring to growth substantially in excess of this does not stand up in overall economic terms."

Hermes says it wants companies to be realistic, and to acknowledge that future customer requirements and competitive pressures may mean that price reductions and service improvements may be needed simply to stand still.

In one of its most controversial stances, Hermes has clearly nailed its colours to the anti-diversification mast. It recommends that listed companies should assess the areas in which they have the best competitive advantage – and then concentrate on them. It acknowledges that this strategy may involve considerable risks, and that risk assessment should be done – but what companies should not do is to attempt to balance risk by diversification within their own portfolio of businesses. In particular they should be aware of the very real risks involved in growth by acquisition which, Hermes says, tends to be a triumph of hope over experience – (from an interview with Tony Watson, Hermes Chief Executive on www.cantos.com, 25 October 2002) – and quotes evidence from firms such as KPMG and PA Consulting which shows that as many as 80% of acquisitions fail to deliver shareholder value.

Hermes makes it clear that it is not opposed to the amounts that managers can earn under remuneration schemes per se and that it believes in motivation. However it says that most remuneration schemes do not link performance criteria with a long-term strategy for shareholder value.

What the appropriate balance of debt and equity is will depend on the particular circumstances of the company concerned. However, Hermes notes that there are companies with substantial cash balances or undergeared balance sheets, which may not be compatible with seeking to maximise shareholder value. Similarly, there are companies which have been overgeared, but which have not felt able to ask shareholders for further capital. Hermes sees the solution to this as a two-way process – proper dialogue by a company with the shareholders and the need for support from shareholders for equity issues where it would create a more efficient capital structure. It says that it is willing to provide this support.

Investors must be able to understand the company’s business strategy, as well as look at its balance sheet, in order to judge whether it will be able to deliver long-term shareholder value. Management must therefore be able to describe a coherent strategy for each of the businesses they are in.

If the company cannot justify its continuing ownership of a particular business unit in terms of its contribution to long-term shareholder value, it should be making plans to divest it.

Hermes has neatly squared the circle of the ‘stakeholder’ versus shareholder debate by expanding on why, in its view, the two are in fact interdependent rather than mutually exclusive. It says that ethical behaviour is not some kind of optional add-on for companies doing well; but is instead an intrinsic part of business success: "eventually behaving badly catches up with you and you can’t treat employees badly in the long-term, you can’t treat suppliers badly in the long-term and you can’t treat the environment badly in the long-term because eventually something will give and you’ll end up with a less good business than would otherwise be the case" (from the interview on www.cantos.com).

"Companies should support voluntary and statutory measures which minimise the externalisation of costs to the detriment of society at large."

In its final Principle Hermes then makes a further leap in this debate by suggesting that the interests of the wider society are the same as those of investors. Hermes says that, given that the ultimate beneficiaries of most investment activity include the greater part of the adult population who depend on private pensions and life assurance, it makes little sense for pension funds to support commercial activity which creates an equal or greater cost to society by robbing Peter to pay Paul.

To what extent are the Hermes Principles representative of the beliefs of institutional investors as a whole? Paul Lee of Hermes describes them as being somewhat "ahead of the curve", but believes that other institutional shareholders are beginning to think along similar lines and hopes that the publication of the Hermes Principles will assist them in articulating their thoughts. Clearly they have the potential to be very influential within the investing community, and listed company boards will (even if they do not agree with them) at least be expected to have an understanding of them. The document is an interesting and detailed analysis of the issues and will create much food for thought for commentators and for listed company boards.

© Herbert Smith 2002

For more information on this or other Herbert Smith publications, please email us.