05 March 2019 by Peter Swabey
The UK Stewardship Code is receiving cross-regulatory attention
On 30th January, the Financial Reporting Council (FRC) published a consultation on Proposed Revision to the UK Stewardship Code. On the same date, the Financial Conduct Authority (FCA) published a Consultation on proposals to improve shareholder engagement and both regulators published a joint discussion paper on Building a regulatory framework for effective stewardship.
Notwithstanding the question of whether we need three separate papers on the topic, it is encouraging to see stewardship receiving joined-up, cross-regulatory attention and it is to be hoped that this will presage greater cooperation in the future.
The UK Stewardship Code was launched by the FRC in 2010 in an effort to support the UK Corporate Governance Code by setting standards for investors for monitoring and engaging with the companies in which they own shares. Since December 2010, it has been a requirement under the FCA’s Conduct of Business Rules that all UK authorised Asset Managers produce a statement of commitment to the UK Stewardship Code or explain why it is not appropriate to their business model, and in 2016 the FRC categorised signatories to the UK Stewardship Code into tiers based on the quality of their Code statements. This identified more than 120 of the 300 signatories as being ‘tier 1’, indicating that ‘Signatories provide a good quality and transparent description of their approach to stewardship and explanations of an alternative approach where necessary’.
The FRC explained that ‘Asset managers who have not achieved at least Tier 2 status after six months will be removed from the list of signatories as their reporting does not demonstrate commitment to the objectives of the Code’.
The intention was to improve the quality of dialogue between investors and companies. It was undoubtedly a very good idea at the time and one which has subsequently been adopted in a number of other countries. However, times – and expectations – change as we are seeing in the audit market and although the UK Stewardship Code, and the structures underpinning it, have developed over the last eight years, it has been criticised as weak and lacking in sanctions, not least by Sir John Kingman in his review of the effectiveness of the FRC, who said ‘The Stewardship Code, whilst a major and well-intentioned intervention, is not effective in practice’ and ‘A fundamental shift in approach is needed to ensure that the revised Stewardship Code more clearly differentiates excellence in stewardship. It should focus on outcomes and effectiveness, not on policy statements. If this cannot be achieved, and the Code remains simply a driver of boilerplate reporting, serious consideration should be given to its abolition’.
Abolition would be short-sighted. If a code is widely copied throughout the world, but needs updating to reflect the changed needs of the market, then surely change rather than abolition is what is needed. If one of the criticisms is that the code is insufficiently effective – i.e. that not enough asset managers and owners comply with it – it makes no sense to get rid of it; make it tougher so that they do have to comply.
So what are the FRC and FCA proposing? The FRC says that ‘The new Code aims to increase demand for more effective stewardship and investment decision-making which is aligned to the needs of institutional investors and clients’. They are doing this by raising the standard required of investors and by ‘devoting more resource to evaluating the quality of disclosure of both policies and activities’.
“In practice, this will require a number of behavioural changes from investors, including an organisational purpose... ”
They have changed the definition of stewardship to focus more on the primary purpose of looking after the assets of beneficiaries that have been entrusted to the care of others. At the same time, they have broadened the scope of the Code to include investment decision-making and investment in assets other than listed equity, for example fixed-income bonds and infrastructure equity.
In practice, this will require a number of behavioural changes from investors, including an organisational purpose, strategy, values and culture that must enable them to fulfil their stewardship obligations to their clients or beneficiaries and will require them to integrate their stewardship responsibilities into their investment processes, including investment decision-making, mandate design and other activities. There is also an increased recognition of the importance of environmental, social and governance (ESG) factors in investment decision-making with the rise of sustainable finance and responsible investment initiatives since 2012. Signatories are now ‘expected to take into account material ESG factors, including climate change, when fulfilling their stewardship responsibilities’. Perhaps most importantly, ‘all signatories will be required to make public disclosures about their stewardship activities and their assessment of how effectively they have achieved their stated objectives. Reporting will now be in two parts: a Policy and Practice Statement upon signing the Code and an annual Activities and Outcomes Report’.
The FCA Consultation on proposals to improve shareholder engagement is a more focussed document, looking at the UK implementation of the Revised Shareholder Rights Directive (SRD2) which the government has undertaken to implement even though the effective date does not fall until after the UK is expected to have left the EU. Generally, UK market practices already go beyond most SRD2 requirements but, in order to be fully compliant, the FCA will require asset managers to make disclosures relating to their shareholder engagement policies, their arrangements with asset owners and how their investment strategies are consistent with the medium and long-term performance of the assets of the asset owner or fund. It will also improve life insurer disclosures and require UK listed companies to disclose and seek board approval for related party transactions.
Finally, the FRC and FCA joint discussion paper looks at Building a regulatory framework for effective stewardship. This ‘paper aims to advance the discussion about what effective stewardship should look like, expectations for financial services firms, and how this can be best supported by the UK’s regulatory framework’.
As the document explains, ‘Poor corporate governance and a lack of shareholder engagement have been cited as contributing to a culture of short-termism and to high-profile corporate failures’. Recital 2 of SRD II, for instance, states ‘there is clear evidence that the current level of “monitoring” of investee companies and engagement by institutional investors and asset managers is often inadequate and focuses too much on short-term returns, which may lead to suboptimal corporate governance and performance’. Consequently, the FCA and FRC are seeking the views of the market on ‘what constitutes effective stewardship; the challenges in delivering an effective regulatory framework for stewardship in the UK; and how to strike the right balance between regulatory rules and voluntary codes of best practice’.
This will be a challenge, as there are plenty of market participants who will have their own well-formed views, many in the form ‘it’s not our fault, it’s them’, who will seek to protect their own working practices and cost structure.
In many cases, the answer needs to be a balance. For example, should investors have sufficient staff to effectively oversee the governance at all their investee firms? Some might say yes, but this would mean either significantly increasing costs, which would, in turn, be passed on to clients, or limiting investments to those for whom they do have oversight resources which would reduce client portfolio diversity. The questions asked are wide-ranging and create an opportunity for a holistic review of stewardship and engagement – let us hope that the two regulators take it.
As the FRC state in their consultation document, ‘engagement which is constructive, and where there is a clear intention or objective, is one of the most effective ways that investors fulfil their stewardship responsibilities. However, there is frequent criticism from companies that investors often engage with them on a limited range of issues, only when they have concerns, or not at all’. Certainly, this is something that I hear quite regularly from our corporate members.
In Chris Hodge’s paper for ICSA on the future of governance in January 2017, he wrote of the need to recognise that the market has changed since the UK Corporate Governance Code was first established in 1992 and it may be time to question whether investors remain best placed to exercise oversight of the governance of investee companies, particularly given the increased and increasing focus on corporate responsibilities to stakeholders.
One thing is clear and receives emphasis in the FCA document. ‘Stewardship will be an area of focus for the FCA’s supervisory engagement, which reflects its importance to the FCA’s objectives. This work will consider the extent to which a firm that claims to engage in stewardship is doing it appropriately, and will also review how stewardship contributes to the fulfilment of a firm’s stated purpose’.
Perhaps the UK Stewardship Code will now be given some real teeth and we can all look forward to closer collaboration.