For the past two decades, at least since Cadbury, the corporate governance agenda has been dominated by shareholder responsibility. The current corporate governance code, though administered by the Financial Reporting Council, relies on shareholder activism to pursue its ambitions. A continuing chorus exhorts shareholders to do more, and the mission has expanded from corporate governance to environmental and social concerns.
In January 2015, the FRC published “Developments in Corporate Governance and Stewardship 2014” which reports that more than 300 investment institutions have signed up to the Stewardship Code. The Investors Forum, recommended by John Kay, has been formed with its twin declared objectives to make the case for long-term investment approaches, and to create an effective model for collective engagement with UK companies, but due to its confidential method of operation, no judgement of its success is feasible. Notwithstanding the copious statistics in the FRC report, it acknowledges that not all signatories are following through on their commitment to the Code. It is strange that the FRC’s proposed workflow should only now include “developing the evidence base for the benefits of stewardship”.
If attendance at public and private conferences is a reliable metric, environmental, social and governance activities are now primary concerns for financial asset owners and managers across Europe. The greater unknown is the motivation for the apparently substantially increased level of engagement by corporate management and boards.
Shareholders’ rights are stronger in the UK than the US or most other jurisdictions. It should follow then that shareholders here would be better placed to rein in the behaviour of companies than elsewhere, but there is scant evidence to support this hypothesis. The alignment of management incentives with shareholders’ interests, of course, places all other stakeholders in positions of relative weakness, though these are crucial to the long-term sustainability and success of the business. It is unfortunate that much of the empirical analysis of the effects of shareholder engagement concentrates on portmanteau statistics, such as profitability or return on equity, or irrelevances such as the share price; these can all be inflated at the expense of other stakeholders – customers, suppliers, creditors or employees. There is though little doubt that shareholder engagement when effective does result in higher immediate returns and lower costs of equity capital for the firm, and that is problematic in that it is not; prima facie, consistent with a sustainable long term.
There are three characteristics of interest with public listed companies: permanence, commitment (also known as asset lock-in) and free transferability of shares. Asset lock-in arises because shareholders have rights only to dividends declared by the board. Contrary to widely held belief, shareholders are not the residual claimants to the assets of a company other than in liquidation. Limited liability serves to facilitate share transferability by lowering investment risks and allowing free exchange. The elementary, and true, explanation is that these arrangements permit a scale of investment not available from individuals. However, there is a second and more important reason; that these companies are capable of investment over terms that exceed the lives of the current human generations - permanence. Here, they are complements to the state.
Asset lock-in has some significant advantages for the stakeholders of a company. It protects stakeholders against exploitation by other stakeholder groups, notably creditors and suppliers from management and shareholders; it even protects shareholders against the actions of other shareholders – think of the liquidator of an insolvent shareholder pursuing assets within the company rather than selling the shares. Asset lock-in also encourages firm specific investment by employees and other stakeholders.
Of course, the fact that a company may invest for the inter-generational long-term does not mean that it will. Few shareholders would be comfortable with investments producing returns only after their demise, and there are limits to altruism. In general, there is a concern that shareholders today may not value returns occurring in the distant future. The introduction of an exchange listing removes this concern to the extent that the marketplace values all future returns and impounds them in current prices. Shareholders can now benefit today from the discounted present values of these returns even though these occur long after today’s shareholder has ceased to exist.
There are, of course, further concerns as to the degree to which today’s share price fully reflects the fundamental value of these returns flows, and both under and over valuation are possible. A bird in the hand really is preferred to two in the bush. The excess returns to longer-term equity ownership, known as the equity risk premium, may be explained as arising from historic excessive discounting of realised subsequent fundamental flows. These departures bring with them other concerns – for example, over-valuation, market bubbles, will tend to result in poor projects being undertaken, with overinvestment that results in capital scrappage.
Shareholders are not a homogenous group; their motivations and strategies can vary significantly. Some have even developed strategies, such as the “washing machine”, where engagement and activism seek to achieve short-term gains before the manager then moves on to the next. Heterogeneity among shareholders will tend to reinforce collective preferences for the short-term. In times of corporate action, such as hostile take-overs, groups of activist short-term shareholders, often hedge funds, do have a tendency to arise naturally, through self-interest, without any formal co-ordination or collusion. By contrast, when engagement is concerned with the long-term, formal co-ordination through bodies such as the Investors Forum is deemed advisable or even necessary.
For the purpose of engagement, differences among shareholders may be caricatured as the benign and the malign with respect to the long-term. Their motivations may vary from wealth appropriation, transfer from others, to wealth creation and accumulation through long-term productive activity. In just the same way that optimists dominate market activity in good times and pessimists in bad, we can expect the malign to dominate in the short-term. The problem for shareholder empowerment is that law or codes cannot distinguish, ex ante, between these two types of shareholder. Increasing shareholder rights and powers will act disproportionately to empower the malign short-term activist. Proposals for differential voting rights with length of tenure of ownership, such as the Loi Florange, can be seen as attempts to make this distinction, but of course are ex post remedies.
If the optimal long-term could be achieved as a sequence of short-term optimal allocations, there might be no problem with the distinction between the short and the long, but that is neither feasible nor even theoretically true. The problem with such short-term activity is that it interferes with the asset allocation and investment activities within the firm and that in turn affects the path of long-term business prospects and outcomes, and the real economy.
By contrast, an independent board can distinguish through engagement and experience between these two types of shareholder. With weak shareholder rights, for the board, engagement is simply an additional source of advice. Having all or many stakeholder groups represented within the board is neither feasible nor advisable, as the presence of multiple interest groups would be likely to reduce the board to paralysis, rendering it impotent.
It is worth recalling that the original reason for the appointment of external auditors was for the board to demonstrate compliance with banking and debt covenants. The role has changed with the passage of time. While many talk of a company’s social license to operate, few have explicitly considered the state granted concession of legal personhood and limited liability. Though the implicit considerations for this were discussed earlier, there is also the explicit question of taxation. A board that has greater independence must also have greater accountability and that argues for the appointment of external auditors by an external government body – the FRC, HMRC and the Department of Business Innovation and Skills are all potential candidates.
Quite apart from the immediate issue of taxation, the state is the trustee of future generations, those as yet unborn and without voice or market impact. In this context, if problems were to persist with the power of appointment of auditors proving insufficient by way of influence, then it may become necessary to consider more by way of sanction such as restrictions and limitations on the rights and powers of the legal person including limited liability. Such solutions are firmly in the spirit of solutions to the tragedy of the commons where that party with the usage rights most remote in time has control rights over current usage.