European fund managers code calls for engagement, disclosure

There's a lot of talk now about how institutional investors ought to become engaged with the companies in which they invest. It might make companies more responsive to owners and owners more responsible about the long-term future of the companies. Relatively hot on the heels – nothing moves all that quickly in this part of the world – of last year's UK Stewardship Code for fund managers comes a code from the European trade association of the asset management industry. EFAMA has provided what it call "a framework of high-level principles and best practice recommendations", which it hopes will act as a catalyst for engagement. "The principles are designed to enhance the quality of the communication with investee companies and to foster creation of value to investors by dealing effectively with concerns over the companies' performance," it said. It relies, first and foremost, on disclosure:

• Principle 1: Investment management companies should have "a documented policy available to the public on whether, and if so how, they exercise their ownership responsibilities". It should include a statement on how conflicts of interest are handled, and what approach the firm takes to lending shares and to recalling them from borrowers at the time of shareholder votes.
  
• Principle 2: Investment managers "should monitor their investee companies". That means keeping tabs on the board, to make sure directors are working well and in shareholder interests. But it acknowledges that many investing firms don't want to become insiders and thus restrict their ability to trade.
  
• Principle 3: Investment companies "should establish clear guidelines on when and how they will intervene with investee companies to protect and enhance value". They should state in which circumstances they would actively intervene with a company and assess periodically the outcomes of doing so. "Intervention could be considered regardless of investment style," the code states.

And more. Voting is high on the agenda of the subsequent parts of the code, something that used to be difficult for investors outside the home country of the company but which European law has strived to facilitate in recent years.

It's a code. Nothing more. EFAMA's members are associations of asset management firms, not regulators. They won't be able to enforce much of anything on member, let alone the firms that choose not to belong. But EFAMA seems to hope that national regulators might use the code as the basis for more local sets of rules or guidelines.

Source document: The EFAMA code for external governance is a seven-page pdf file.

EFAMA wants responsible investors to be, well, responsible

The European fund management industry has a large and growing number of firms offering investment products that promise "ethical" or otherwise "responsible" investments. Yet there's no standard to which these products have to adhere, let alone a code concerning how they're marketed to the investing public. EFAMA, the European Fund and Asset Management Association, thinks that if an investment manager provides such products, it should commit to a certain degree of transparency so end-investors can evaluate and compare the product. "Increased transparency of client reporting, communication of investment approaches and selection methods would help investors distinguish between different … offerings and allow them to make more informed decisions," it said. EFAMA would welcome universal standards and hopes the European Union would back this form of self-regulatory move by the industry.

Source document: The EFAMA responsible investment report is a 27-page pdf file.

France signals need to reshape trading rules

Competition between exchanges and other platforms has brought benefits to equity markets, but coupled with high velocity trading it has also brought some unintended consequences. In a speech to the International Capital Market Association, Jean-Pierre Jouyet, chairman of the French securities regulator AMF, flagged the need for new rules and probably new regulation. The end of the quasi-monopoly of exchanges has had the effect of fragmenting liquidity with a corresponding loss in confidence among investors that they are getting the best deal. Multiple platforms require more spending on information technology and less certainty in pricing. So, more transparency is needed. More trading is taking place not only in non-exchange setting but also on an over-the-counter basis. Jouyet reckons the level is at the top end of the estimates he has heard of 15 to 40 per cent, but worse still is that he doesn't know. "This form of trading must be reserved for clearly identified types of transactions which are not supposed to contribute to price formation, such as complex transactions combining cash and derivatives," he said. More information needs to be available before trades start – too many transactions are hidden as "exceptions" to disclosure of offer size and price. And he wants the same transparecy rules for derivatives as for equity markets.

Markets for society: Perhaps more importantly, Jouyet questioned the principle that liquidity is a good thing. High frequency trading isn't helping as its advocate suggest. Offers disappear before investors can execute, a source of "permanent instability", he said. Moreover, the execution rate has fallen as orders appear and are cancelled in microseconds, creating a "feeling of artificial, fleeting or uncertain liquidity".

Any answers? Jouyet doesn't have the answers, but he does have the questions: "To ensure permanent liquidity in order books, should we impose a minimum period of time before orders can be cancelled, or a pricing system for cancelled orders? Should we place curbs on latency? Should pricing increments be limited? Should we simply confine ourselves to establishing circuit-breakers that put an end to domino effects on markets when algorithms get out of hand?"

Source document: The Jouyet speech is an 11-page pdf file.

Dark pools illuminated?

The Technical Committee of the International Organization of Securities Commissions has published its "Principles on Dark Liquidity", outlining ways to assist securities markets authorities in dealing with issues concerning dark liquidity, the growing phenomenon when trading occurs outside the view of other market participants. The principles are designed to:

• Minimise risk: minimise the adverse impact of the increased use of dark pools and dark orders in transparent markets on the price discovery process by generally promoting pre-trade and post-trade transparency and encouraging the priority of transparent orders;
  
• Offset fragmentation: mitigate the effect of any potential fragmentation of information and liquidity by generally promoting pre-trade and post-trade transparency and consolidation of such information;
  
• Provide information: help to ensure that regulators have access to adequate information to monitor the use of dark pools and dark orders for market monitoring/surveillance purposes and to enable an appropriate regulatory response to market developments; and
  
• Provide more information: help to ensure that market participants have sufficient information so that they are able to understand the manner in which orders will be handled and executed.

The IOSCO technical committee has handed the report over to the member regulators for consideration and implementation. ISOCO wants market liquidity and efficiency, but also integrity for markets.

Source document: The IOSCO report is a 32-page pdf file with attachments.

Board thoughtfulness, not just behaviour, in demand

What makes a board effective? There are dozens of books about it, hundreds of academic studies. There are laws, too: In America, Dodd-Frank has followed Sarbanes-Oxley down the route of specifying actions. In the European Union, the commission is gathering information through a green paper consultation aimed at deciding whether to create law. Much attention is being paid around the world to the issue of gender quotas, an idea made tantalisingly real through legislation in Norway, now being copied in other countries. There are codes of practice, too: In the UK the various iterations of the code of corporate governance have sought, among other things, to define what makes a good board. In 2003, the Higgs Review set out to give guidance on the effectiveness of non-executive directors. Its findings were incorporated, at least in part, into the Combined Code and then revised in 2006. With the drafting of a new UK Corporate Governance Code last year came a desire to revisit the Higgs guidance, updating it for changed perceptions. Where its emphasis seems to lie – as with the emphasis in the new code, is on thoughtfulness – an elusive commodity, one that will defy attempts of the governance industry from setting standards and calculating performance.

The new guidance was published with relatively little fanfare in mid-March. The Financial Reporting Council, the accountancy watchdog that oversees the governance code, published the report following research conducted by the Institute of Chartered Secretaries and Administrators. Baroness Hogg, the FRC chairman and a long-standing corporate director, introduced the guidance with these words:

Boards need to think deeply about the way in which they carry out their role and the behaviours that they display, not just about the structures and processes that they put in place. This change of emphasis is reflected in the most recent edition of the UK Corporate Governance Code, published in 2010, and also in this guidance. For example, boards are encouraged to consider how the way in which decisions are taken might affect the quality of those decisions, and the factors to be taken into account when constructing the board and reviewing its performance. The FRC hopes that this guidance will assist in those considerations.
But what does thoughtfulness entail? The guidance document suggests: "An effective board should not necessarily be a comfortable place. Challenge, as well as teamwork, is an essential feature. Diversity in board composition is an important driver of a board's effectiveness, creating a breadth of perspective among directors, and breaking down a tendency towards 'group think'," which is, of course, an example of not thinking. The actions and purposes of an effective board involve:

• Direction: Providing direction for management, that is.
  
• Leadership: Demonstrating ethical leadership, displaying – and promoting throughout the company – "behaviours consistent with the culture and values it has defined for the organisation". So behaviour matters.
  
• Performance: Creating a performance culture that "drives value creation without exposing the company to excessive risk of value destruction".
  
• Decision: Making "well-informed and high-quality decisions based on a clear line of sight into the business". Here it looks as though management-speak got the better of the authors. Whatever does that mean?
  
• Complying: Creating the right framework for "helping directors meet their statutory duties".
  
• Accountability: Particularly "to those that provide the company's capital"; and reading between the lines not exclusively to them.
  
• Thoughtfulness: Thinking "carefully about its governance arrangements and embraces evaluation of their effectiveness".

Independence of mind is an elusive quality that arises from thoughtfulness. It's what the framers of the code in its various iterations have sought, in different terms, over the past 20 years. This guidance illustrates the point in describing the role of the "senior independent director": In "normal times" the incumbent in this defined role becomes a "sounding board for the chairman", providing support and taking on roles the chairman couldn't without a conflict of interest, such as recruiting the chairman's successor. But when times are stressful, SIDs, as they are colloquially known, need to change their spots. The guidance puts it this way: "When the board is undergoing a period of stress, however, the senior independent director’s role becomes critically important. He or she is expected to work with the chairman and other directors, and/or shareholders, to resolve significant issues. Boards should ensure they have a clear understanding of when the senior independent director might intervene in order to maintain board and company stability." It then goes on to list a variety of such circumstances, including when the path followed by the chairman and CEO ignores the concerns of shareholders or other non-executives.

Thoughtfulness shows up, therefore, in the ability to change direction and even change roles. It shows up in not slavishly following the group direction, but not needlessly falling out with the group, either. Thoughtfulness in the boardroom should be easy to detect. From the outside, you will know it when you see it, by which point it may be too late. If board effectiveness is characterised by thoughtfulness, then investors will need to trust directors, though not blindly. Investment is, after all, a statement of trust.

Source document: The FRC report "Guidance for Board Effectiveness" is an 18-page pdf file.

Consob outlines minority protection in new takeover rules

The Italian equities market shares with many of its European counterparts a collection of companies with strong, dominant shareholders. There are real benefits to such arrangements, but some drawbacks as well. Now the Italian securities regulator Consob has stepped up its regulation to counter one of those risks – the abuse of the interests of minority shareholders in takeover bids. The move has four aims:

• Stronger minority rights: The measures seek in increase minority voice during a change of ownership or control, as well as in response to regulation and financial innovation.
  
• Transparency and efficiency: To facilitate a market for corporate control, it has cleared up some regulatory ambiguities that got in the way of shareholder activism.
  
• Equal treatment: Italian investors won't get preferential treatment in the new regulations.
  
• Reduced compliance costs: Here the focus is on standardising documentation and making Consob's own control processes more efficient.

Among the specific measures is the demand that bids supported by "insiders", that is management or directors closely tied to a major shareholder, the view of the independent directors should be published separately, so small shareholders have better information to judge whether to support a takeover.

Source documents: The executive summary in English is a five-page pdf file. The full regulations, in the unofficial translation, runs to 31 pages.
http://www.consob.it/mainen/legal_framework/consultations/takeover_bid_regulation_2011_executive_summary.pdf

GRI launches 'report-or-explain' initiative

The Global Reporting Initiative, a movement that emerges from the United National Environmental Programme, thinks it's time that a lot more companies followed the approach of reporting on non-financial matters focused on the use of resources and other aspects of social responsibility and sustainability. While the GRI standards for reporting are used by a wide variety of large listed companies, they are far from universal. So far it has been a voluntary programme, but GRI now wants to put regulatory weight behind it. "Governments, regulators, stock exchanges, investors and associations can help information reach a critical mass in the market by asking: 'Why don’t you report?'" it said. "There are many ways to do this, for example through regulation. Sustainability reporting does not necessarily need to be mandatory: If regulators were to adopt a report or explain policy, companies could still be free to choose what information to disclose." This "report-or-explain" approach echoes the "comply-or-explain" principle widely used in corporate governance codes around the world.

Source documents: The initiative website has links to background information. Its report "Carrots and Sticks" is a 96-page pdf file.

Egon Zehnder sees more global, diverse boards

The board of the future will be different. Berthold Leube and George Davis at the headhunting firm Egon Zehnder sense that big changes are in the wind. "Good governance has gone global," they write. They're not the first to say so, and the evidence they present is more indicative than definitive. But as far as large, listed companies are concerned it sounds right. Seven drivers, they say, lie behind the change:

• Transparency: Disclosure requirements are rising around the world.
  
• Diversity: And not just gender and ethnic make-up. Diverse work experience, expertise, nationalities, even ways of thinking will characterise the board of the future.
  
• Global directors: Which is not quite the same thing as diversity – directors will be similar in the diversity of their backgrounds.
  
• Risk: Risk awareness will be more important as risk management grows as a component of the board's agenda.
  
• Duality: A split between chairman and CEO is happening, like it or not. Where it isn't, a lead independent director is achieving much of the same result.
  
• Independence: These non-executive now chair the main committees at most companies and will have an increasing voice in decisions.
  
• Professionalism: Being a director used to be a job for the talented and experience amateur. "Within committees, members may work on specialized topics like sustainability, risk management, and succession planning," they write. "All of this work requires an unprecedented degree of professionalism, dedication, and fine-grained knowledge on the part of today's board member."

With those changes come – perforce – as change in how boards recruit new directors. That, too, will be more professional. If that sounds like the pitch at the end of the presentation, you're right. What it doesn't discuss is what might be lost in the move towards professionalisation.

Source document: The Egon Zehnder briefing has a link to a pdf version with a couple of photos that speak volumes about the images and symbols of boards.

Gender diversity comes under scrutiny in UK

There's been a flurry of activity around the world in the past couple of months looking afresh and an old chestnut in corporate governance: women on boards. We're not sure where it came from or why, now, it has resurfaced with such intensity when previous ripples have come and gone without making waves. What we're seeing isn't perhaps a tsunami, but there's a swelling evident, not least in the decision of the UK accounting watchdog launching a formal consultation that could be a harbinger for a code if perhaps not a law about gender diversity on boards.

The Financial Reporting Council, which also provides a home for the UK Corporate Governance Code and the Stewardship Code for institutional investors, launched the consultation to determine whether the governance code, revised only last May, should be revised again to identify key issues to be considered when boards review their effectiveness, including gender. FRC chairman Baroness Hogg said: "Board diversity and effectiveness are closely linked. Diversity widens the perspectives brought to bear on decision-making, avoids too great a similarity of attitude and helps companies understand their customers and workforces. A board with too few women on it risks a weakness in at least one of these respects."

The code already makes a general reference to board diversity and to women. But a government-sponsored report, published in February, noted what everyone else knew already: "the rate of change in recent years has been glacial", in Baroness Hogg's words. Consultation closes on July 29, and a decision on whether to amend the code will follow later in the year.

Source document: The FRC consultation paper is a 14-page pdf file.

How do financial firms deal with carbon disclosure?

Financial institutions – in particular the investment side of the business – have a greater indirect than direct impact on carbon emissions. The policies they adopt with respect to environmental disclosure can easily affect the business decisions of their client companies. The UK Carbon Disclosure Standards Board has published an academic study of how financial companies in the US, Europe, Japan and Australia deal with the information that is being increasingly available from the corporations in which they invest. The researchers were surprised with what they found:
We identify an absence of a general market momentum towards environmental investing while at the same time strong demand for company reports on environmental matters. Although most questionnaire respondents and interviewees had collected company-issued reports on greenhouse gases emissions levels and environmental management programmes, all were dissatisfied with that information, and none had used it to guide portfolio allocation levels.

It will come as little surprise from corporations that deal with the analysts on Wall Street and in the City of London, however, that investment banks and asset managers demands tons of information and then do relatively little with it. The same might be said of academic researchers. But we know there's a lag-time with knowledge. Information accumulates and then emerges as insight, well before reaching a tipping point. A bit like climate change itself.

Source document: The Carbon Disclosure report, "Financial institutions: Taking greenhouse gases into account," by Matthew Haigh and Matthew Shapiro, is a 74-page pdf file.