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Corporate governance - The Duties of Trustees
What are the duties of pension scheme trustees as far as corporate governance is concerned?
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 (1992), Greenbury (1995) and Hampel (1998) and the Stock Exchange Rules, all of which were consolidated in 1998 into the Combined Code, followed by Turnbull (1999). Most recently, the Myners' review covering pension scheme investment has focused trustees' minds into thinking about good pension scheme management and placing more emphasis on the job of a trustee than ever before.
Recently this has hit the headlines in the national press on the subject of "fat cat" pay and, post-Enron, everyone is demanding more accountability.
The Government has taken a keen interest in these issues and is looking to shareholders to play a more active part. In particular, trustees need to be seen to be doing corporate governance and it is now urging institutional shareholders to make greater use of their rights to vote.
What is corporate governance?
Corporate governance refers to the relationship between a company's management and its shareholders and other stakeholders.
Perhaps the most widely accepted principle 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 Hampel committee subsequently 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, which requires a pragmatic approach to be effective.
The next part of this note covers how this might actually affect trustees. The final section covers some of the more technical background as to how we got to where we are today.
Practical implications for trustees
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 retain control of their corporate governance strategy.
It is unlikely that trustees themselves will be qualified to determine whether voting in a particular way at a company's Annual General Meeting (AGM) will be in the best financial interests of shareholders. Trustees will therefore need to take advice. This advice could come from the investment manager or an external consultant.
Sources of information
A typical UK equity portfolio may contain shares in a 100 different companies. This means an average of two AGMs per week. For the trustees to obtain advice on every voting issue and instruct the fund manager to vote accordingly would be very time consuming and expensive. A practical solution is to subscribe to a voting service offered by independent organisations such as Manifest, the National Association of Pension Funds (NAPF) or the Pensions Investment Research Consultants (PIRC). These organisations review company reports and make recommendations on how to vote. Trustees could require their fund manager to vote in accordance with these recommendations. If the trustees consider taking advice or subscribing to a voting service to be too costly, the alternative is to delegate their voting rights to the investment manager.
Ask your fund manager
The first step for many trustees will be to find out what actions their fund manager(s) is taking. Trustees could discuss with their fund managers their policy on the exercise of voting rights and ensure this is consistent with the new proposals and their own views. Most investment managers will review company reports and have a policy on voting, and trustees should understand and be comfortable with the voting policy of their fund manger.
A fund manager's viewpoint could become one of the criteria to consider when appointing a new manager.
Furthermore, on the reporting side, trustees could ask their fund manager to review its voting behaviour at regular intervals and assess its effectiveness. Fund managers could 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.
The ability a trustee has to influence a manager is likely to depend on the size of investment with that manager and the type of fund. For example, where a scheme has a segregated fund, then it should be possible to ask the manager to vote in a certain way on the shares held within that fund. This isn't quite so straightforward for pooled fund investments, although the fund manager may be willing to vote the relevant proportion of the total number of shares held in the pooled fund, if asked.
The trustees may also need to amend investment manager agreements and their Statement of Investment Principles in order to incorporate any new guidelines. By asking the trustees to require their investment manager to pay more attention to corporate governance, the government is hoping that investment managers will become more active in voting than they have been in the past.
Whether the trustees take an active approach to corporate governance or whether this is left to the fund managers, some suitable approaches are discussed below.
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;
- The extent to which auditors are truly independent (is it right that auditors often also carry out consultancy work for the same company?).
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;
- Concerns about the company's approach to corporate social responsibility.
The new Institutional Shareholders Committee 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.
Two common concerns have been raised about intervention. First, it is important that enterprise should not be stifled by additional red tape. 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.
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;
- Letter writing or dialogue with non-executive directors or other shareholders;
- Voting shares and (in exceptional cases) attendance at annual general meetings
- Proposing a shareholder resolution.
The background
Trustees' general duties
What are the responsibilities of pension scheme trustees and fund managers towards better corporate governance?
Currently, the level of expertise required of a trustee is 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.
Trustees' investment duties
So far as investment is concerned, a trustee's basic duty is to set a strategy for which he/she anticipates that the investment performance will generate sufficient funds to meet the payments to current and future pensioners as far as possible. 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, and the investment policy must be set out in a Statement of Investment Principles (SIP) - however, Myners has recommended that the SIP should be strengthened in a number of areas.
Why is corporate governance important?
There are three main reasons:
- Preserving rights - shareholders' first interest is to preserve their rights as owners.
- Minimising risk - a related concern is to minimise risk to their assets.
- Enhancing value - shareholders also want to enhance long-term value through their corporate governance activity.
Many investors take the view that companies will benefit from a closer relationship between shareholders and the board of directors, 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:
- Value - good corporate governance should result in better long-term performance.
- Fiduciary - 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.
- Investment style - in the UK, many investors have moved towards an index-tracking investment approach. However, more fund managers are now taking the view that being a passive investor doesn't mean being a passive owner.
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.
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 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 share ownership has grown from 6% to 20% over the period, peaking at just over 30% in 1989, although this figure has declined since then mainly because pension funds have been net sellers of equities in recent years to buy bonds to match maturing liabilities.
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 consistent with their fiduciary duties.
The Government's objectives
The Government is trying to encourage what it calls "appropriate and informed intervention".
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.
The proposals
The statutory duty on trustees and fund managers to intervene should apply to all pension arrangements (defined benefit, defined contribution and personal pensions), irrespective of the size of a scheme (although SSASs may be 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. Funds will also have to disclose their approach to activism in the SIP or trustees' report and accounts.
Implications
- 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 - such as between the voting policies of different pension 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.
- Compliance costs - may rise with a new statutory duty.
- Pooled funds - fund managers should try and vote the shares in the appropriate proportions (if they are unable to reconcile differences).
For specific advice on pension investment issues please speak to your usual Barnett Waddingham contact.
To download a PDF version of this document, please click on the link in the image bar on the above right.
Barnett Waddingham, August 2003.