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Corporate Governance - The Duties of Trustees
Mark Da Silva outlines the duties of trustees as regards corporate governance
1. Introduction
There has been much debate in recent years about how best to ensure good corporate governance, especially about the role played by institutional investors, and pension funds in particular. We have had to digest a number of guidelines such as Cadbury, Greenbury and Hampel, not to mention the Stock Exchange Rules, all of which were consolidated in 1998 into the Combined Code.
The Government has taken a keen interest in these issues and is looking to shareholders to play a more active part. In particular, it is now urging institutional shareholders to make greater use of their rights to vote.
2. Trustees' general duties
What are the responsibilities of pension scheme trustees and fund managers towards better corporate governance?
The first preliminary is to consider what are trustees' current investment duties. Trustees' general duties are set out in three sorts of law: the pension scheme trust deed, trust law and pensions legislation. The general requirements of trustees are:
- to act in good faith (to be honest and without ulterior motive; to give effect to the trust deed; to act as a prudent and reasonable man);
- to exercise their own discretion (receiving advice in a formal manner); and
- to act in the best financial interests of the beneficiaries.
Until recently, the level of expertise required of a trustee was simply to carry out his or her duties with the same care that an ordinary man of business would extend towards his own affairs. However, Myners has proposed that trustees should be required to make investment decisions with the skill and care of someone familiar with the issues concerned.
The Government is expected to legislate along the lines of the "prudent man" principle followed in the US. This would require trustees to have a higher standard of care when dealing with investments than on other matters.
3. Trustees' investment duties
So far as investment is concerned, a trustee's basic duty is to ensure that the investment performance generates sufficient funds to meet the payments to current and future pensioners. In current market conditions that is unlikely to be the case for many schemes, without further funding from the employer.
The key principles are set out in the Pensions Act 1995, which states that trustees have the power to make investments as if they owned the assets themselves. In making those investments, trustees are required to:
- invest prudently;
- invest in a diversified manner;
- prepare a Statement of Investment Principles (SIP); and
- take advice on the SIP and on whether the investments are satisfactory.
The SIP has to include a number of matters including, in particular, the trustees' policy on socially responsible investment and corporate governance. This leaves much scope for interpretation. Some SIPs are only two sides of A4, whereas others run to over 40 pages of detailed guidelines. Myners recommended that the SIP should be strengthened in a number of areas.
On voting rights, many SIPs simply say that the trustees have delegated these to the fund manager, who exercises those rights in accordance with their own corporate governance policy.
4. Corporate governance
The second preliminary is to clarify what we mean by corporate governance. Put simply, this means that shareholders should take more than just a simple financial interest in their shares. An unethical management could pay itself excessive bonuses, drink champagne with abandon and lose sight of the fact that its job is to manage the company for the benefit of the shareholders.
Corporate governance perhaps dates back to the South Sea Bubble of 1720, when nearly £220m was lost in schemes promoting trade with South America. From the Bubble Act of 1720, trading companies were effectively outlawed, except by Royal Charter. The Industrial Revolution in the 1800s forced the Government to relax its hold, but it is only over the last 50 years or so, with the growth of international trade, that companies have been forced to be more accountable.
There have been many examples of directors abusing their position of trust. Cadbury (1992), Greenbury (1995), Hampel (1998) and Turnbull (1999) developed a legal framework of governance to protect shareholders from the worst excesses. Two obvious examples are the establishment of formal audit committees (to ensure that accounts give a "true and fair" view) and independent remuneration committees (to monitor the benefit packages of senior executives).
There is a range of definitions of corporate governance, but perhaps the most widely accepted is in the 1992 report of the Cadbury committee, which states that: The shareholders' role in governance is to appoint the directors and the auditors and to satisfy themselves that an appropriate governance structure is in place.
The subsequent Hampel committee wisely noted that good corporate governance is not so much a set of firm rules but rather general principles that reflect the responsibilities of directors and shareholders. Corporate governance in the UK is therefore self-regulatory and principles-based and requires a pragmatic approach to be effective.
5. Why is corporate governance important?
There are three main reasons that have been identified by PIRC:
A shareholder's first interest is to preserve their rights as owners. Institutional shareholders do not like practices that diminish their rights as owners, such as issuing shares with restricted voting rights.
Other examples are where directors are protected from the need to seek re-election, or companies providing professional indemnity insurance for their auditors.
The second concern is to minimise risk to their assets. Many corporate collapses have been linked to poor corporate governance through a lack of checks and proper balances on the board, inadequate reporting by auditors or ineffective non-executive directors.
The third interest shareholders have is enhancing value through their corporate governance activity. Shareholder activism aims to improve corporate performance and thereby enhance returns.
Many investors take the view that companies will benefit from a closer relationship between shareholders and the board, especially on questions of long-term strategy. So called "activist funds" have been established to exploit this "governance effect".
There are three main drivers for institutional investors establishing a governance programme:
It stands to reason that good corporate governance should result in better long-term performance. A study by McKenzie showed that investors are willing to pay a 20% premium for well-governed companies.
Trustees have a fiduciary duty to manage the investments in the long-term interests of the members. It could be argued that this duty extends to exercising their voting rights.
In the UK, there has been a move towards an index-tracking investment approach. One could argue that indexation means that managers need only match the returns of the index and therefore intervention is unnecessary. However, more fund managers are now taking the view that being a passive investor doesn't mean being a passive owner.
Index-trackers cannot sell their holdings in underperforming companies, but even active managers are constrained from taking excessive positions against the index. By pursuing better corporate governance, index-trackers (and indeed active managers) aim to improve the performance of the index as a whole, to everyone's benefit.
But despite these drivers for change, Myners concluded that there is a culture of wanting to avoid public confrontation with companies and in practice votes against a board are rare. Perhaps fund managers are concerned that, having spent valuable resources pursuing a more activist strategy, other investors could then "piggy-back" on their efforts.
Myners suggested that there is little incentive for fund managers to adopt activist strategies, which don't deliver the quick results that quarterly returns demand.
6. Ownership of UK equities
The rise of the institutional shareholder, especially the major pension funds, has shifted the balance of power away from shareholders and towards management.
The graph below shows that the UK equity market has become steadily more "institutionalised" since the early 1960s, with individual share ownership dropping from 50% of the market in 1963 to 20% today.
In contrast, pension fund investments have grown from 6% to 20% over the period, peaking at just over 30% in 1989. The decline since 1989 has occurred mainly because pension funds have been net sellers of equities in recent years, for maturity reasons.
The decline in individual share ownership has moderated in recent years, whilst overseas ownership has increased sharply.
7. Proposed legislation
Following Myners, the Government intends to legislate to require trustees and fund managers to use shareholder powers to intervene in companies, where this is in the interests of shareholders and beneficiaries. This principle will therefore differ from the other Myners principles in that compliance will be mandatory.
However, a fundamental point is that it is the trustees who will retain the overall responsibility for corporate governance, as this is required by their fiduciary duties. Trustees will not be able to delegate their responsibility for ensuring that the duty of active shareholding is carried out.
8. The Government's objectives
The Government is trying to encourage what it calls "appropriate and informed intervention". Given the important roles of both trustees and fund managers in this area, it wishes to include both in the scope of its proposals.
In most cases one would expect the fund manager or custodian to take on the practical role of discussions with companies and decisions to vote shares. But the trustees will still need to ensure that the fund manager is carrying out their strategy as instructed. The Government does not wish to make voting or intervention compulsory, regardless of circumstances, especially where the costs would exceed the benefits. Clearly, this would not be right.
The Government argues that the duty to intervene already exists in UK law, but that this is not well accepted by trustees and fund managers. This is why the Government has said that legislation may be necessary. Myners identified a number of reasons why fund managers are reluctant to intervene and the Government believes that legislation would provide a counterweight to these factors.
9. The proposals
The statutory duty on trustees and fund managers to intervene will apply to all pension arrangements (defined benefit, defined contribution and personal pensions), and irrespective of the size of a scheme (although SSASs are excluded).
However, the Government has conceded that the costs of actively engaging with companies and exercising shareholder votes for small schemes may well mean that, in practice, taking no action is in the members' best financial interests for such schemes.
The proposed duty is framed so that any person who is responsible for investing a pension scheme's assets must (in respect of any investee company), use such rights attaching to that investment in the best interests of the beneficiaries of the scheme. This duty will override the scheme's trust deed and rules, but the requirement may be varied in the investment management agreement (IMA) if the trustees want the fund manager to comply with a specific trustee voting policy.
In order to enforce the new legislation, the Government is proposing to make a breach of the new statutory duty the subject of civil proceedings. Funds will also have to disclose their approach to activism in the SIP or trustees' report and accounts.
10. Implications
Financial services legislation
Most trustees (and some fund managers) are not qualified to advise on the exercise of voting rights and so this may have to be outsourced. Under the financial services legislation, advice given by third parties on whether, for example, to support a rights issue is classed as advising on investments.
Conflicts of interest
The Government recognises that conflicts are likely to arise. For example, between the voting policies of different schemes for whom a fund manager acts.
Insider dealing
Some concerns have been expressed that requiring fund managers to intervene may leave them exposed under the "insider dealing" legislation. This might in theory restrict them from dealing on the shares of those companies. However, the Government believes that fund managers (like the banks) should be able to isolate this sort of information from their buy/sell decision-making process.
Compliance costs
I have a concern that compliance with the new statutory duty will impose additional costs on fund managers, which in turn may be passed on to trustees. The Government claims that, because fund managers already carry out a lot of work in understanding investee companies, the new duty merely requires them to act when it is appropriate to do so, and hence the additional cost should not be significant.
The Government does recognise that, if the costs were to exceed the benefits of intervention, then clearly intervention should not take place. Few fund managers have the skills or resources necessary to "micro-manage" companies.
Pooled funds
Where a fund manager holds the funds of more than one set of trustees, who have conflicting wishes as to how their proxy votes are cast, fund managers should try and vote the shares in the appropriate proportions (if they are unable to reconcile these differences). Clearly though, it would be better if the pensions industry had standard views on these important issues.
11. ISC statement on activism
In November, the Institutional Shareholders Committee (ISC) drew up a new statement of shareholder activism principles for institutional investors. The statement expands on the Combined Code and sets out best practice for institutional shareholders in relation to their responsibilities towards investee companies.
It stresses that the principles do not impose any obligation on institutional investors to "micro-manage" companies. Instead, it requires shareholders to deal effectively with concerns about underperformance. This is consistent with Myners' recommendations that trustees should:
- publish their corporate governance policy;
- monitor the performance of, and establish a regular dialogue with, the companies in which they invest;
- intervene when necessary including voting against boards who fail to act upon investors' concerns; and
- monitor the effectiveness of their actions and report to clients on how they have discharged their responsibilities.
Although the statement did not refer to Myners, it seems to be an attempt by the fund managers to pre-empt legislation.
12. The Higgs Report
In January, Derek Higgs published his review of the role of non-executive directors (NEDs). He made a large number of recommendations, building on the "comply or explain" philosophy upon which the Combined Code is based.
Higgs believes that a formula for corporate governance that works for one company may not work for another. For example, in a company such as WM Morrison Supermarkets, which is roughly 40% family-owned, the absence of NEDs from the board may be of less concern to investors than with other listed companies. There has already been opposition to some of the review's recommendations, in particular the significant strengthening of the role of the senior NED.
If the Financial Reporting Council (FRC) takes forward the review's recommended changes to the Combined Code, these would apply to reporting years starting on or after 1 July 2003.
13. What should be monitored?
Here are some of the areas in which trustees and fund managers can influence the management of companies:
- the independence and expertise of candidates for the board of directors;
- the appropriateness of executive remuneration and dividend policy;
- the extent of debt financing, capitalisation and long-term business plans;
- the company's investment in training to develop its workforce; and
- by considering the extent to which auditors are truly independent (is it right that auditors often also carry out consultancy work for the same company?).
This sort of monitoring can be carried out through fund manager correspondence, meetings with management and by exercising voting rights.
14. When to intervene
Trustees should ask fund managers to identify the circumstances in which they would intervene in the company. Here are some examples of situations that might prompt intervention:
- if fund managers think that the company lacks strategic direction;
- independent directors failing to hold executive management properly to account;
- internal controls failing;
- inadequate succession planning;
- failure to comply with the Combined Code;
- inappropriate remuneration levels/incentive packages/severance packages; or
- concerns about the company's approach to corporate social responsibility.
The new ISC principles state that fund managers should vote all shares held directly or on behalf of clients wherever practicable. Fund managers should not automatically support the board, but if they cannot reach a satisfactory outcome through active dialogue, they should abstain from the resolution, informing the company in advance of why they are doing so.
I have two concerns about intervention. First, it is important that enterprise should not be stifled by additional red-tape. This was a concern raised by companies at the time of the Hampel report.
Secondly, if markets are to remain efficient then some companies should be allowed to fail. An investor's ability to sell should not be constrained by a legal requirement to intervene first. The Government says that it wants to improve market efficiency, but this would not be achieved by artificially sustaining those companies that should rightly fail.
15. How to intervene
The ways in which fund managers may intervene should be communicated to trustees and come within the scope of an "engagement" strategy. Methods might include:
- meetings between the fund manager and the company at which questions of corporate strategy can be hammered out;
- letter writing or dialogue with non-executive directors or other shareholders;
- voting shares and (in exceptional cases) attendance at annual general meetings; or
- proposing a shareholder resolution.
16. Actions for trustees
What do trustees need to do? Above all, one must be mindful that trustees retain overall responsibility for corporate governance as part of their fiduciary duties. Trustees will therefore want to be in control of their corporate governance strategy, even if it is the fund manager who is executing it.
Trustees need to discuss with their fund managers their policy on the exercise of voting rights and ensure this is consistent with the new proposals. Most fund managers will already have such a policy but more detail may be needed on, for example, how the effectiveness of the strategy is to be measured and the circumstances under which the manager will intervene.
Furthermore, on the reporting side, trustees should ask their fund manger to review its voting behaviour at regular intervals and assess its effectiveness. Fund managers should be asked to produce quarterly reporting on their voting strategy and the extent to which they enter into dialogue with investee companies on these issues. Legal & General, for example, not only report on how it has used its votes, but also why it has voted against decisions.
Finally, trustees will need to amend IMAs and their SIP in order to incorporate these principles.
At present, most trustees are reluctant to incorporate the US Bulletin into their mandates unless they have to. Many leave intervention to the judgement of their fund managers and simply request regular reports on how they have voted. In most cases trustees are relying on their fund managers' own corporate governance policies and it remains to be seen if this is considered adequate for the purposes of the code.
What the pensions industry most needs, however, is a consistent and workable approach to corporate governance if the new measures are to be effective.
Mark Da Silva, March 2003