07 June 2016
The company secretary is critical in maintaining integrity in the financial system
If Adam Smith were to be transported to the present day, he would be surprised at the way we conduct business. That is because at the heart of every Western economy sit listed companies, yet these companies’ shareowners are different from the managers of the enterprise.
Smith thought that doing business through such companies was a recipe for disaster. ‘Negligence and profusion’, he thought, is bound to occur when managers are in control of other people’s money.
But he was wrong – and every company secretary knows he was wrong. Although we are far from free of scandal, and excessive executive rewards, the fact is the system works fairly well. Boards do take shareholder interest into account; they consider the effect of their decisions on ‘the members as a whole’ and give regard to other stakeholder interests.
As a result, share ownership (or at least beneficial share ownership) is not just the preserve of the wealthy. As companies can be trusted, they have attracted investments from pension funds and other savings institutions representing millions of people. If a big British company was to ask itself who its ultimate owners are, it would discover they are millions of people, often of modest means, saving diligently for their retirement.
The development of limited liability and the quoted company are two of the great social inventions of the last 200 years. When we study history we all too often focus just on political developments, such as wars, battles, or the introduction of universal education, health and pensions.
Sometimes we think about technological developments, such as those that helped the industrial revolution. Equally important however is the development of our economic institutions; and quoted limited liability is one of the most important of those.
It is because we are able to use and not abuse those institutions that we are able to channel the savings of hundreds of millions of people to support productive activity. That is perhaps the most important function of the finance industry – in technical jargon, known as ‘intermediation’. Or in the plainer language of the third Lord Rothschild, ‘taking money from point A where it is, to point B where it is needed’.
It is a process of enormous value. At its most simple it can be combining savings deposits and helping individuals buy homes or businesses to buy assets. It allows economies to grow and enables social mobility.
Before modern banks, assets were simply passed from generation to generation. What social mobility there was, amounted to a process of everyone raising themselves by their bootstraps. So intermediation is of profound importance to our global economy.
Indeed this service is so important that many finance pioneers were known as philanthropists, seeking to address the problems people faced when they could not get access to financial services.
The first funded pension fund, for example, was set up by two Scottish clergymen to look after the widows and orphans of other ministers. Indeed, the difference between doing finance well and doing it badly is extraordinary.
One financier, an economics professor in Bangladesh called Mohammed Yunus, won the Nobel Peace prize for his pioneering work in providing microfinance to poor people, mainly women, which transformed their lives. What Yunus was doing was, in theory, little different from a loan shark or from Wonga. Yet in practice totally different. Doing intermediation well, and preserving its integrity, is central to solving almost all the great problems that the world faces.
Here is the big question: does the finance industry do its job well? Does it, cost effectively, get our savings from where they are to where they are needed? The answer to that question is challenging if you work in, or are interested in, the financial services industry.
Here is an uncomfortable truth. Over the last 130 years, on the best evidence available, it looks like the finance industry has not passed on any productivity gain to the real economy. In other words ‘the industry which sustained the expansion of railroads steel and chemical industries… seems to have been more efficient than the current finance industry’, according to economist Thomas Philippon.
That is despite the fact that we have invented computers, the internet and even telephones during that period. Yet the advantage of all those enabling technologies has not been to pass on benefit to consumers. They have been consumed by the finance industry itself.
That is exactly the sort negligence and profusion that Adam Smith would have warned us about. It occurs not so much in the way that the companies are managed, but in the way our savings are handled before they ever purchase company securities. It is dangerous because if the finance industry is not doing its job well it is a huge drag on economic growth.
But how can this have happened? The finance industry is not uncompetitive and, with proper enabling technologies (of which finance has seen many), competitive markets should pass on benefits to consumers. So, why has the finance industry failed to do so?
One reason is that in finance, no one has started by asking about purpose, and then thought about how best to build a system that will deliver that purpose. As a result, we have not built institutions designed to be ‘fit for purpose’ and have instead assumed that the market will do that for us. We have overlooked many of the features that contribute to a successful financial system.
For example, although we have given a lot of attention to corporate governance, we have all but overlooked the governance of the institutions that manage our money, that buy company shares on our behalf, and are charged with holding those companies accountable.
Company secretaries might like to take note. At the end of the chain of capital, directors understand their duties to shareholders and to society. Their boards include a majority of independent members. Nomination, remuneration and audit are overseen by those independent directors. The role of the chair is split from the chief executive. All board members stand for election, their remuneration is made public and is ratified by shareholders.
In large measure, these reforms have been brought about thanks to the lobbying from institutional investors and have generally been accepted as good practice by companies.
But what about intermediary institutions themselves? Take, for example, a typical ‘contract-based defined contribution’ pensions manager, who represents the majority of new pensions being sold today. Do they have a board elected by the pension holders whose money they manage? Do they report on performance? Do we know how they are paid and how they vote on it? Not a bit.
Yet surely some equivalent form of good governance should apply to the fund manager, just as it applies to the companies in which they invest. Even worse, developments in modern investment theory mean that fund managers are ever less able to perform their role as stewards of the companies they invest in.
Our system of company law rests on the assumption that the shareholders of the company will always want to ensure its success and so will behave as good owners. That is fine until you remember that many portfolio managers, upon discovering that a company is ill-managed, will simply sell the stock.
It is even worse if you know that many pension funds, which for good reason have followed the diversification strategies of modern portfolio theory, now find themselves with holdings in literally thousands of companies. I remember a conversation with one chief investment officer who told me that, as he made the annual sign-off of the fund’s holdings, he did not even know the name of half the companies listed.
It gets worse – the increased use of ‘derivatives’ means that you can own the economic interest in a company, separately from your influence upon it as a shareholder. So one agent can be entitled to the capital and dividend but not have a vote or a say in the company’s future. That makes them entirely absent owners.
If misused, derivatives can create the situation where an unscrupulous agent can have an interest in the company doing badly while having the power to vote its shares. That is exactly what happened at Mylan Laboratories in 2004.
Mylan made an overpriced bid for King Pharmaceuticals; but it needed the approval of Mylan shareholders, and they were unlikely to give their consent. So a hedge fund that had a large stake in King – and wanted the deal to go through – bought Mylan shares and then sold the economic interest in them while keeping the votes. In other words, he was a shareholder who aimed to hurt the company.
Company law simply is not designed to work if there are many such people around. We do not know how many incidents like this have taken place – they tend to be extreme and are conducted in the shadows. Yet 80 cases have been documented where so-called investors have found ways to insulate their economic exposure while affecting other people’s interests.
Here is the bottom line: what they do with your money is very important for the future of the world. Right now, however, the financial system is not designed to be ‘fit for purpose’. If it was, the benefits would be huge.
Take just one example: a British and a Dutch person both save the same amount for their pension; that is a predictable income that will last them from the day they retire until the day they die. They work for the same number of years, have the same life expectancy, and retire on the same day. Yet because the British system is not designed to be fit for purpose, the Dutch person will receive an income in retirement that is a full 50% higher.
The opportunity, bit by bit, to understand, reform and improve the finance system is great. The benefit of doing so would be huge. That subject, why the finance industry fails us, and what we can do about it, is the subject of the book What They Do With Your Money.
I hope these observations on governance give some sense of what goes wrong between the citizen saving for a pension and the companies they ultimately own. It gives an even greater sense of why, within a system that has so many dysfunctions, the company secretary is so critical in maintaining integrity. Adam Smith would be proud of you.