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Is Shareholder Engagement a good thing?

When it reported in 2012, the Kay Review[1] took the view that shareholder engagement is neither good nor bad in itself but that it is the character and quality of that engagement that matters.

Brad Pomfret argues that shareholder engagement is a good thing and should be encouraged generally amongst institutional investors. The exercise of shareholder rights and use of engagement for selfish purposes ulterior to the long term success of the investee company is inevitable given the company structure, but may be reduced by more widespread and transparent engagement.

In considering the view expressed at the top of the page, the logically first question is what is meant by the term “engagement”. It appears that the Kay review used it to mean all forms of involvement with the governance and strategy of the company by shareholders, from activism to stewardship[2].

Next, to consider the hypothesis in context, we must ask what are the particularly important features of the current legal and market environment in the UK. So far as the market is concerned, the first thing to note is the prevalence of institutional investors and, more recently, particularly hedge-fund activists. These type of investors are distinct from others, and particularly the previously more commonplace retail investor, in a number of ways; most notably in that they owe duties to their ultimate beneficiaries and will invariably have better infrastructure and expertise to monitor the investments that they make. Building on these factors, it must be noted that in the fallout from the financial crisis in the UK, institutional investors were criticised for failing to monitor the risk-taking bankers ultimately held responsible[3]; see further the Walker Review (2009).

As to the legal landscape, we must note first that the common law has rejected the notion of shareholders owing fiduciary duties to the company or the general body of shareholders[4]. Nor is there any hard law regulation of shareholders (although they do have rights under the Companies Act 2006). There is, however, soft law applicable to institutional investors, asset managers and their service providers, in the shape of the Stewardship Code. This sets out seven principles of good stewardship with which signatories to the Code must comply, else explain why they do not comply in any case.

Why shareholder engagement is a good thing

Building on the Hirschman (1970) analysis of the voice or exit approach to exercising shareholder power, engagement is essential to controlling management agency costs. It may also be used to improve corporate governance, which seems likely to improve the performance of the company[5]. Moreover, as noted above, it is thought that better engagement might have helped avoid the financial crisis.

Perceived disadvantages of shareholder engagement

A risk in shareholders engaging too far is that they will generally lack the knowledge of the company’s managers. Winter notes[6] “the knowledge and expertise institutional investors need… is mainly related to the market and only to a limited extent to individual companies and their long term prospects… There is usually no in-depth insight into the prospects and risks of individual companies, nor a real interest in the governance of those companies”. However, it is perhaps no bad thing that managers and directors should have to meet any challenge to their conduct and persuade shareholders to vote with them.

The major dark side of engagement is seen to be agency capitalism, typically by hedge fund activists who are often said to be focussed on value extraction for short term gain, although there does not seem to be empirical evidence to prove such concerns[7]. Nonetheless, there is no doubt that in the absence of fiduciary duties, engagement is open to abuse by those with selfish interests, from short-termists to corporate raiders; but this is an inevitable consequence of shareholder rights.

The role of wider and more transparent engagement to mitigate malevolent activism

A significant advantage of the change in company ownership over the last thirty years or so is that institutional investors make up a far more fertile environment for stewardship. There are of course difficulties (at least in the absence of fiduciary duties) in placing engagement obligations upon individuals, who are not subject to any regulator and less prone to be sensitive to how others view them. Individuals are also likely to lack the expertise and infrastructure to monitor the directors of public companies and the cost of doing so would be out of all proportion to their interest. Institutional investors, on the other hand, are often particularly well placed to scrutinise their investee companies, with wide experience and access to the company’s management and information about its business. Moreover, given their duties to those persons for whom they invest the funds, it can readily be said that they owe an obligation to oversee their investees, especially in the aftermath of the financial crisis.

It is against this background that there is every good reason for institutional investors to comply with the Stewardship Code. Although it might be said that the Code is toothless (it is voluntary, subject to COBS 2.2, and operates on a comply or explain basis), its widescale take-up by institutional investors[8] means that it is nevertheless difficult to justify not complying with it without good cause. Institutional investors are likely to comply with the Code for two main reasons: (1) commercial pressure to do so given industry acceptance, and (2) the threat of hard law, with attendant sanctions, being imposed in the absence of voluntary compliance.

Widespread engagement of the main institutional investors can help to mitigate the negative engagement of others such as hedge fund activists, since stewardship will require that they analyse and respond[9] to the proposals put by such shareholders. The more who engage in this way and who declare their policies on voting and their voting activities, the less scope there must be for malevolent activists to succeed.


 

[1] https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/253454/bis-12-917-kay-review-of-equity-markets-final-report.pdf

[2] See for example paragraph vii of the executive summary

[3] “From shareholder stewardship to shareholder duties: is the time ripe?” Chiu & Katelouzou (2016) p4

[4] Pender v Lushington 6 ChD 70 (MR 1877)

[5] C.A. Mallin, Corporate Governance (2010), p122-123

[6] “The realities and illusions of institutional share ownership”; Jaap Winter (2012) p5

[7] “Myths and realities of hedge fund activism”; Katelouzou (2013)

[8] Chiu & Katelouzou ibid p5

[9] “Agency Capitalism: further implications of equity intermediation”; Gilson & Gordon (2015), identifies rational reticence as a solution to the agency capitalism problem represented by activists.

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