At the NAPF Corporate Governance Seminar,
Cheapside, London EC2, Tuesday 09 February 2010
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Thank you for the invitation to speak today.
I am encouraged to see the generating momentum in debate surrounding governance and engagement.
Pension funds are significant owners of many our country's most important companies. Many funds take their ownership responsibilities very seriously, with well-established systems in place to effectively engage with boards and management. But all of us who work or have worked in fund management know that improvements are possible and needed.
The NAPF's leadership will be important in delivering the changes to which the industry is committed, and today's publication is an important step in that process.
Importance of Governance
My views on governance and engagement are quite clear: there have been significant shortcomings in the past and these have cost investors and savers dearly.
Irrespective of culpability, we all have a duty to respond to these shortcomings because we all stand to gain from overcoming them.
While there has been progress, the challenge is still there and the question remains; how do we put successful governance and engagement at the heart of the investor and corporate agenda?
I take on board the obstacles to investment managers adopting a governance centric approach.
I realise that there will always be an incentive to "free ride" on the governance efforts of others and that the relative invisibility of governance-driven returns can make it hard to justify the necessary expense.
But, in light of the recent financial turmoil and the sheer quantum of value destroyed by some governance shortcomings, I think it is fair to ask all participants in the investment chain to act in every way possible to prevent history repeating itself.
Academics may have struggled to prove whether good governance adds value. But we have indisputedly seen poor governance and ineffective stewardship play a major part in causing significant loss of value.
Over the past decade people who owned shares in UK banks have enjoyed a return of little more than zero.
Over the same period bank executives and traders have taken home many billions of pounds in remuneration.
If you owned a bank outright, that is to say you were the sole shareholder, you would never stand for such a situation - but collectively we have. Somewhere in the fragmentation of ownership of quoted companies, coupled with ever shortening performance horizons and ever-more complex decision chains linking shareholders with their agents, we appear to have lost the ability to hold the Boards of some public companies to account.
And this is nothing new - back in 1990 Rupert Pennant Rea said "What is wrong with the British and American system is that far too many shareholders, both institutional and individual, do not behave like owners". Put simply, there is an 'agency gap' and a cost in terms of lower returns.
As a shareholder you are an owner, irrespective of the size of your holding.
Ownership brings both rights and duties.
Rights to share in the returns generated by the business and duties to ensure the business acts in the interests of all stakeholders.
If you own shares on your own account you can possibly justify shirking these ownership duties - but in doing so, take the consequences of bad governance.
However, if you own or manage shares on behalf of others, as Trustees do, you cannot justify a failure to ensure effective stewardship.
As a voter, you can stay at home on election day. That is your choice - although the consquences for democracy might be bad. But MPs have a duty to turn up to vote in Parliament.
You have a legal duty to your beneficiaries to protect the value of assets held in trust on their behalf and a duty to the businesses in which you invest.
Shareholders need to meet their responsibilities as owners; they should live up to their fiduciary obligations.
No-one wants corporations, run by senior executives in their own interest rather than in the interests of shareholders. But seemingly, few want to 'do governance'; they are content to "free-ride" on the efforts of others to hold Boards to account.
The picture I paint is one that has led us to what I have characterised as "the ownerless corporation", reflected in fragmented share registers and non-existent or inconsistent investor engagement. The true owners, pension fund trustees and others, have been intermediated out of the story by agents who do not think and act as economic theory would tell us to expect of owners.
To me, one of the iconic failures of governance has been executive remuneration.
There is a large body of data that shows a continual upwards spiral of senior executive pay.
The PwC compensation review of 2009 highlights how, over the last decade, executive pay in the UK has increased exponentionally.
The latest Income Data Services statistics show that CEOs of the companies in the FTSE 100 earn 81 times the average pay of full-time workers.
A decade ago, the multiple was less than 50. And Paul Drucker, the godfather of many aspects of modern management theory, used to reckon the appropriate level was around 20 times. In my own experience of sitting on remuneration committtees I have always asked challenging questions when compensation for individuals or tiers of management exceeds 150% of that of their direct reports. We have clearly moved beyond these parameters when setting compensation levels for our most senior executives.
Elsewhere, various sets of data have estimated that the average CEO in the United States earned between 250-500 times the pay of the average worker in 2007, compared to around 20 times in the 1960s.
Why has this happened? An economist might ask the following questions to find an explanation:
Is the rise in salaries a reflection of contraction in the supply of talent or an increase in the demand for talent?
Or have the demands, pressures and stresses of work risen over the past five decades, requiring this to be reflected in compensation?
I am not persuaded that I can find a satisfactory answer to any of these questions.
Supply of talent has surely increased with higher educational achievement, the increasing number of business school graduates and in response, of course, to powerful price signalling through remuneration trends relative to other occupations.
Demand for leadership and talent seems to me to be no greater now than when I first came to work in the City 35 years ago - even then we had large and complex companies that needed good management.
Nor am I persuaded that somehow the act of management has become intrinsically more difficult over the last decade.
In short, a simple economic framework does not provide convincing answers.
One is therefore obliged to consider whether there are other factors at work.
It seems to me that one explanation that sits comfortably with observed behaviour is the absence of an effective voice of ownership, as a consequence of multiple changes that have weakened the relationship between shareholders and companies, including internationalisation of ownership and increased investment portfolio diversification, leading to a diminishing interest in company specific governance.
It is also possible that the professionalisation of the non-executive component of Boards, through the increasing appointment of candidates who are either currently, or recently have been, executives of other public companies, has reduced challenge around compensation; and increased the tendency to look at matters from a limited perspective, rather than from the broader lens that would come from directors from more diverse (and less well rewarded) backgrounds.
Widely diverging trends in remuneration between those at main Board level and those immediately below the main Board and in middle management would also tend to offer prima facie evidence of a failure to develop adequate depth in management- itself a critical role for executive directors who should deliver organisational resilience and avoid dependence on a small number of highly paid people by, for instance, giving priority to developing bench strength and institutionalisation of knowledge and relationships.
Relevant to issues connecting bank remuneration and the interests of shareholders is an observation made by Andy Haldane of the Bank of England, who recently noted:
"If UK banks had reduced dividend payout ratios by a third between 2000 to 2007, £20bn of extra capital would have been generated. Had payouts to staff been trimmed by 10%, a further £50bn in capital would have been saved. And if banks had been restricted from paying dividends in the event of an annual loss, £15bn would have been added to the pot.
In other words, three modest changes in payout behaviour would have generated more capital than was supplied by the UK government during the crisis."
We all know that remuneration requires delicate judgement - this is after all an art, rather than a science. We also know that it is in no-ones' interests, and certainly not shareholders', for companies to seek false economies by not securing and maintaining the talent needed to provide leadership and create long-term value. Shareholders have a duty, however, to ensure that judgements are well made and that outcomes are fair and reasonable and in the best long-term interests of the corporation.
Shareholders can, and need to be, engaged - after all, it is in your interest to maximise the value of the firms in which you have invested.
I understand Patrick Hosking who, when writing in the Times, said "Collective action by shareholders has been timid. One wonders how sincere the institutional investors are about reforming banker pay... Shareholders should be the solution to the bonus problem. In fact they are self-serving agents who have become part of the problem."
I believe that Institutional investors, on behalf of their clients, need to be more challenging in the future than they have been in the past. And you, as Trustees, have a duty to satisfy yourselves that your agents, the fund managers, are taking necessary action to protect and enhance the value of the investments they make on your behalf and on behalf of those for whom you act in trust.
Equity underwriting is another area where I believe institutional investors and their clients might benefit from greater engagement.
Primary underwriting fees for equity issues have increased steadily over the last few years, while at the same time the discount at which new shares are issued to the market price has tended to widen. Investment bankers have also made increasing use of pre-marketing to prepare investors and the market for issues - two factors that, all things being equal, should lead to lower risk for the underwriter. Put simply, fees have been rising while the outcome has been simultaneously, significantly de-risked.
Underwriting fees used to be 2%, with 1.25% going to sub-underwriters, and the issue pitched at a discount to market price in the mid to upper teens. We now regularly see discounts close to 40% with fees between 3% and 4%.
Shareholders have largely gone along with this although it has not necessarily always been in their best interests - particularly when sub-underwriting and parallel equity placings have been targeted at hedge funds and new investors.
This is an area where investors and their advisers could perhaps take a lead in reviewing the trend, acting in the best interests of pension funds and other end-investors. An industry led review, with a published report would represent compelling evidence of fund managers and their clients taking the initiative to represent the voice of the investor. Perhaps this is something for the NAPF to raise with other members of the Institutional Shareholders Committtee.
Taking an active and visible role on such issues would enhance the legitimacy of institutional investors in protecting their clients' interests and head off the charge that some investment managers are unwilling to challenge existing practices or pricing.
Let me be clear, this is not lecturing for the sake of it. I am simply observing that Government should not have to step in to protect the interests of others when they should be perfectly able to act themselves.
I have been clear that I do, however, have a duty to facilitate necessary action and dialogue where I can. For example, the Government and FSA have been working with key market participants, including AFME and ABI, to develop guidance for issuers considering a rights issue. This will be published shortly.
And I have recently written to the chief investment officers at leading fund management firms, asking them to share with me the actions that they have taken to promote the interests of their clients, the providers and owners of risk capital, in the matter of pay and incentives principles in banking. My intention is to encourage investors to start talking openly the approach they are taking on remuneration and for them to showcase the efforts they are making on behalf of their clients.
Government should not seek to intervene when there are perfectly practical ways in which investors can act in their own interests - using their voice and influence to deliver satisfactory outcomes.
When, however, poor governance requires the taxpayer to pick up the tab, there is a role for Government and regulators.
I am sure you are aware of the work that is underway in this repect, but for the sake of clarity let me explain our agenda.
Sir David Walker issued his recommendations for improvements to the governance framework in the UK banking sector back in November last year.
We will work to implement these reforms throughout the coming year, including requiring much greater disclosure on remuneration (in order to facilitate informed review by shareholders).
Chief amongst Walker's recommendations was the suggestion that investors sign up to a best practice code of ownership principles - the Stewardship Code.
The ISC's Principles offer a very good starting point for this Code. The FRC is currently in consultation on how best to take ownership of this Code and what, if any, amendments are needed.
Walker concludes that compliance with the code should be disclosed, and that this should be inside an FSA framework which will assure the clarity of those disclosures.
Disclosure by funds managers of compliance with the Stewardship Code should encourage trustees to consider engagement track records in their fund manager selection criteria, and be more probing of governance approaches,competencies and record and, in so doing addressing aspects of the free-rider effect.
I am also keen to further the debate on establishing an independent industry body with a mandate to represent the institutional investor community and raise the profile of governance and engagement as an investment strategy.
There would be very real benefit in establishing an industry-wide institute that speaks with one voice on behalf of all institutional investors.
It should be independent and its membership should probably comprise mainly the long-only long-term institutional investors whose clients have the most to gain from good governance.
It would need to be chaired by a respected industry leader and would need a compentent and expereienced secretariat.
The organisation's role should be to coordinate investors on governance and to speak with one voice for investors as a whole (and not on behalf of any one industry group, type or type of product provider).
It should maintain close links with government and regulators work to promote the cause of good governance more widely. It should also maintain strong relations with academia to promote governance as a research and applied discipline.
Governerment welcomes the ongoing discussions within the investment industry to meet this requirement and stands ready to provide support if necessary and appropriate.
I am encouraged to hear of the ISC's commitment to look at restructuring options, including placing clearer water between the ISC and the various industry trade association bodies it currently comprises. I also note the debate within and around the ISC to develop a permanent establishment and budget.
In the bigger sphere, investors must continue the trend of being more active in driving change through good engagement; governance will not change on it's own. It is happening; the quality of corporate and pension fund governance has improved markedly over the past two decades and fund managers have played a vital role in promoting this trend. But more is required if the system is to work optimally.
I have not been able to comprehend why so much institutional investor time and money is devoted to stock-picking, which is at best a zero-sum game, while only a fraction of the same resource and commitment goes into governance and stewardship, which has the opportunity to add real value.
Nor is it clear why the clients of fund managers, the people paying the piper, are willing to pay high fees for an aggregate zero outcome in stock-picking (the industry-wide negative alpha effect), while requiring little or no resources to be devoted to enhancing the value of owned assets.
The Government can and will help in enabling good corporate governance, but, if the market and trustees are to meet their fiduciary duties, you need to develop and promote solutions to the problems that still impede effective engagement and governance. This should include a thorough evaluation by pension fund trustees of the appropriateness of goals they set for their fund managers and the development of effective economic incentives to good value-adding governance - those who are willing to put the effort and resource into successful stewardship deserve to be handsomely rewarded.
We have seen from some an ardour of opposition to the need for continuous improvement that clouds logic during this crisis.
But the continual appealing to tradition that some still insist upon will only be of detriment in the long run.
I understand that there has been a lot of scrutiny, but this has only been invited as a result of previous failings.
And I hope that recent events have signified a watershed.
So, to remedy the deficiencies of scrutiny and drive progress, we must not just show a willingness for change, but push forward with vigour to improve the functioning of the investment chain.
I commend those in the industry who have seized the opportunity to embed a new culture that values governance and stewardship.
And I want us to continue to herald in the change where good governance is not on the periphery, but at the heart of what we do.
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