shareholder activism by Konstantinos Sergakis
Introduction
Current investment strategies and the very nature of institutional ownership have become extremely complicated and interrelated to a series of other investment priorities. The empirical studies conducted in the past are not conclusive as to whether shareholder activism is crucial to improving companies’ performance or simply irrelevant. Regardless of the negative or positive effect of this kind of activism, we argue that – in theory – it is always preferable to have a certain amount of indirect pressure from asset managers or asset owners, which will possibly alert the company’s management in order to avert certain deficiencies in conducting business.
This assumption holds true if of course such engagement and pressure aim to improve corporate governance assistance and are not simply seen as an excuse for exercising more pressure with distorted incentives that go against the company’s and shareholders’ interests.
This presentation will attempt to draw the line between these two scenarios by supporting the idea that, despite regulatory reforms (Stewardship Codes and the revised Shareholder Rights Directive) aimed at changing the market’s investment mentality, there is a range of issues that will continue to be a preoccupation in the corporate landscape. We will also argue in favour of an ongoing dialogue that will enable a cultural shift amongst various market actors.
The variety of investor profiles
Broadly speaking, investors can be classified as retail (individual) or institutional investors. Retail investors have frequently been seen as a priority for EU policy-making since capital markets have a clear interest in becoming more accessible to household investment and not to rely exclusively on institutional investors. The accentuation of disclosure obligations upon issuers and the excessive regulatory focus on the importance of well-informed and independent investors may seem single-minded and potentially incomplete. This is particularly true if we take into consideration that disclosure – on its own – is not sufficient to ensure optimal decision-making. Investors may be influenced by myriad reasons in making their decisions. Moreover, bounded rationality[1] in the markets, as well as the lack of financial literacy are inevitable and need to be addressed by a multi-layered regulatory response that goes beyond the informational transparency concept. EU law has gradually broadened the concept of investor, by including that of the consumer, thus making the regulatory framework more interventionist with regard to the provision of financial services, the product regulation and relevant regulatory safeguards that aim to protect investors/consumers from various deficiencies.
Institutional investors present different characteristics from their retail counterparts, since they are grouped and entrust their assets to a series of intermediaries, such as asset owners and managers. These intermediaries make investment decisions as to which investee company represents a good investment opportunity for the large number of portfolios they manage, representing the interests of the ultimate beneficiaries of the group who are their clients. In theory, this multi-layered investment chain is justified thanks to the presence of experienced intermediaries that are supposed to act in the best interests of their clients and, with the assistance of financial analysts and proxy advisors, are able to evaluate issuers, fulfil their duties towards their clients and contribute to the success of capital markets worldwide. Intermediation represents the advantage of allowing the ultimate beneficiaries to participate in investment groups, by delegating the decision-making function to experts.
Nevertheless, agency problems that are well known in company law can be reproduced in this framework since asset owners and asset managers may have distorted incentives in executing their roles and may not act in the best interests of their clients. A notable example relates to their remuneration schemes of asset managers: these schemes are based on a purely short-term evaluation (a quarterly benchmark), which focuses on their capacity to generate short-term returns by exercising adequate pressure on investee companies towards that objective. In this case, it is highly unlikely that asset managers will be willing to engage with companies to build up a better understanding of the long-term priorities and objectives that will eventually lead to better financial performance for the benefit of all actors engaged in this procedure. The quarterly benchmark triggers a collateral effect on the short-termism with which asset managers and companies interact in order for both of them to capture profits to satisfy their mandates according to the predominant trading rules and methods of evaluation.
To ensure a more efficient investment chain and constructive shareholder engagement with investee companies, there are other broader and equally important factors that must be taken into consideration in any kind of debate aimed at improving such engagement. As stated in the Kay Report, the distance between companies and investors continues to become lengthier and more complicated due to a series of factors that characterize modern investment and trading techniques.[2] The number of financial intermediaries continues to increase, which does not facilitate the establishment of a true dialogue between a company and shareholders. Moreover, the tendency to diversify investment portfolios does not encourage shareholders to commit themselves to a long-term relationship with investee companies.
The debatable ‘usefulness’ of institutional shareholders
More generally, academic literature has developed the debate surrounding the usefulness of institutional investors, reaching controversial conclusions. Some views support the idea that investor groups are beneficial to capital markets since they prefer long-term investment, loyalty to the investee company, and serious engagement with the latter in order to improve corporate governance strategies.[3] This is especially the case with ethically or environmentally-driven institutional investor groups, but not necessarily with all such groups. Others consider institutional investors to be potentially harmful to the stability of companies and markets in general, since they are deemed to act with an excessive focus on short-term returns and the achievement of a specific set of goals that are not compatible with the true progression of the company and its overall perspectives and objectives.[4]
The debate continues on the existence of empirical proof of the benefits of shareholder engagement and on the overall benefits of engagement, especially considering that engagement may nurture more pressure for short-term profits – when shareholders have short-term agendas – or for the adoption of potentially counter-productive decisions in the long term. The empirical studies conducted in the past are not conclusive as to whether shareholder activism is crucial to improving companies’ performance or simply irrelevant. Regardless of the negative or positive effect of this kind of activism, it could be said that in theory it is always better to have a certain amount indirect pressure from asset managers or asset owners of the shares, which will possibly alert the company’s management in order to avert certain deficiencies in conducting business, if of course such engagement and pressure aim to improve corporate governance systems and are not simply seen as an excuse for exercising more pressure with distorted incentives that go against the company’s and shareholders’ interests.
The new engagement shareholder duties
The stewardship and shareholder engagement concepts continued to gain momentum across the EU and, influenced by this trend while trying to address market deficiencies arising from short-termism, the Commission proposed an amendment to the Shareholder Rights Directive with the aim of encouraging long-term shareholder engagement and certain elements of the corporate governance statement.
Aiming to increase transparency in financial intermediation, Article 3(g) of the amended Shareholder Rights Directive requires Member States to ensure that institutional investors and asset managers will develop an ‘engagement policy’ that will define the general way they will exercise their activities with regard to the integration of shareholder engagement into their strategy, the monitoring of and dialogue with investee companies, the exercise of voting rights, the use of proxy advisory services, and cooperation with other shareholders. Most importantly, this engagement policy shall describe how they manage actual or potential conflicts of interest that may arise in this framework. They are also expected to describe in this policy how they monitor investee companies with regard to non-financial performance and social and environmental impact, as well as how they communicate with relevant stakeholders of these companies.
The enlargement of the engagement spectrum is – in theory – welcome, but it may prove to be problematic in practice since non-financial elements and stakeholders may be difficult to evaluate, disclose and describe in a meaningful way. EU law has undoubtedly taken this into account, which is why such disclosure obligations will function in accordance with the ‘comply or explain’ principle; institutional investors and asset managers will either declare compliance with these requirements or publicly disclose an explanation as to why they have chosen not to comply with one or more requirements. The flexibility given to investors in this framework is considerable since they can disregard certain or all requirements, being nevertheless expected to explain in a clear and reasoned way their stance. The experience from the function of the same principle in corporate governance statements issued by companies in various jurisdictions has shown that the explanatory part is not meaningful most of the time; such reservations with regard to the efficiency of the same principle in this new emerging area thus still hold true.
From the above-mentioned the disclosure obligations, we can observe a shift of attention from a purely private company law agenda (enabling and flexible nature amongst shareholders and companies) towards a top-down capital markets law agenda (stricter and based on increased the disclosure obligations for all market actors in the investment chain). Institutional investors and asset managers are now expected to make public various facets of their engagement with companies, shareholders and stakeholders. Such widely applicable disclosure obligations reflect EU law’s vision about the future role that such investors are expected to play with regard to a wider range of actors in capital markets. Chiu and Katelouzou have opined that we are witnessing a legalization of stewardship via the introduction of a duty to demonstrate engagement which is based upon public interests that aim to re-regulate this area.[5]
But is disclosure enough on its own to ensure engagement and long-termism in capital markets? Indeed, these new obligations may be seen under a more critical light; Birkmose has noted that disclosure in this area will not necessarily increase the low levels of engagement since it does not create any financial incentives for investors towards the accomplishment of such role. At a parallel level, it may increase the costs of engagement if the ultimate beneficiaries start exerting pressure upon institutional investors for more engagement.[6]
Conclusion
Stewardship has moved and will remain at the centre of debate in order to introduce and strengthen a better coexistence in the same investment chain of different and various participants. Even if we cannot expect an ongoing communication amongst all these constituencies of capital markets, the inculcation of a sound capital raising (for issuers) and investment (for other market actors) mentality needs to be promoted by the legal order in the most efficient way.
More recently, the Shareholder Rights Directive has envisaged an educational role for all actors, by encouraging disclosure of information with regard to the ultimate objectives in the agendas of groups or other asset managers, as well as the conception of their role. As we have seen, disclosure has been called on to play a critical role in this emerging framework, by offering the public a series of information and expecting demonstration of engagement for some market actors.
Even if the entire investment chain needs to be fully transparent – and open to criticism when decision-making methods are subject to different interpretations and generate excessive risk levels – how disclosure will be used by other constituencies cannot be predicted. At the current stage, disclosure seems to be the only preferred way by EU law to foster engagement in capital markets. We firmly believe that disclosure can only be one of the main pillars for such strategy to succeed. The concomitant provision of financial incentives and the avoidance of inconsistencies, as well as of unduly burdensome and inconsistent rules, may prove to be a reasonable auxiliary component for the success of this ambitious EU agenda.
Improvement in the investment philosophy will not be accomplished immediately since educating investors and their asset managers will be a long and arduous process. Nevertheless, enabling investors to be properly informed about other market actors’ activities is currently a reasonable regulatory tool, given that if investors start changing their demands towards companies, institutional investors and asset managers, the cycle currently driven by short-term objectives will start functioning around a whole new series of priorities that have thus far been dissociated from long-term targets.
[1] E. Avgouleas, ‘Cognitive Biases and Investor Protection Regulation an Evolutionary Approach’ (2006), at https://ssrn.com/abstract=1133214.
[2] J. Kay, ‘The Kay Review of UK Equity Markets and Long-Term Decision Making’ (2012), at http://www.bis.gov.uk/ assets/biscore/business-law/docs/k/12-917-kay-review-of-equity-markets-final- report.pdf.
[3] S.L. Gillan and L.T. Starks, ‘The Evolution of Shareholder Activism in the United States’ (2007) 19 Journal of Applied Corporate Finance 55.
[4] J. Winter, ‘Shareholder Engagement and Stewardship: The Realities and Illusions of Institutional Share Ownership’ (2011), at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1867564; B.W. Heineman Jr., “A ‘Stewardship Code’ for institutional investors”, Harvard Business Review blog, 18 January 2010, 24, at http://blogs.hbr.org/cs/2010/01/a_ stewardship_code_for_institu.html.
[5] I. H-Y. Chiu and D. Katelouzou, ‘From Shareholder Stewardship to Shareholder Duties: Is the Time Ripe?’ in Birkmose, above, 143.
[6] H. Søndergaard Birkmose, ‘European Challenges for Institutional Investor Engagement – Is Mandatory Disclosure the Way Forward’ (2014) 2 European Company and Financial Law Review 214, 236.
El Blog del IDEIR 