On 23 July 2012, the Final Report on The Kay Review of UK Equity Markets and Long-Term Decision Making (the “Report”) was published. The Report presents Professor Kay’s assessment of the main problems in the UK equity markets which he concludes are derived in the main from (a) a culture of short-termism, (b) a loss of trust and (c) a system of incentivisation for directors and asset managers through the equity investment chain which is poorly designed to achieve the goals of savers. It recommends that there should be a change in the culture of the stock market, a restoration of relationships on the basis of trust and confidence, and a readjustment of incentives across the investment chain.
In November 2012, the UK Government Department of Business, Innovation and Skills (“BIS”) published a response to the Report (the “UK Government’s Response”) broadly endorsing and supporting it and announcing a call for evidence in relation to the Report’s recommendations.
The Report is divided into 13 chapters each of which is briefly summarised in this article together with details of the UK Government’s Response (where relevant). In addition, chapters 6 to 12 of the Report identify various principles and recommendations which are set out in this article under the relevant chapter summaries.
Chapter 1: Short and Long-Term Decisions
Professor Kay defines short termism as under-investment and hyperactivity. He points to statistical evidence that investment by large quoted UK companies in their assets has declined over the last 10 years as a percentage of GDP more dramatically than in Germany, France or the US despite such companies being cash rich. Hyperactivity, he suggests, is evidenced in frequent internal re-organisation, corporate strategies designed around extensive mergers and acquisitions and financial re-engineering which may preoccupy senior management but have little relevance to the capabilities of the underlying business.
The Report states that such activity is potentially at variance with the statutory duty of directors of a UK company to promote the success of the company for the benefit of its members as a whole, taking into account various factors including the likely consequences of any decision in the long-term. The chapter concludes by examining a number of cases in which poor decision making has damaged the long-term success of companies such as BP (which, in Professor Kay’s opinion, underinvested in environmental and health and safety issues leading to the blow-out in the Gulf of Mexico) and ICI and GEC (both of which, he states, unsuccessfully pursued aggressive acquisition and disposal programmes leading to their eventual takeover).
Chapter 2: Equity Markets and Listed Companies
The Report states that the equity markets have not been an important source of capital for new investment in large UK companies for many years as such companies are self-financing through their own profits. It also maintains that finance raised through placings and rights issues by established companies and initial public offerings by new companies, has generally been more than offset by the acquisition of the shares of other companies for cash in takeovers and the buy-back of their own shares by such companies. Therefore, new equity issuance by UK companies in the UK capital markets (as opposed to non-UK companies in the UK capital markets) has been negative over the last decade.
In any event, the Report argues, the need for investment in physical capital is much less important than it was, especially for information technology companies. The chapter concludes that the equity markets today should primarily be seen as a means for investors who support fledgling companies to realise the value of their investment i.e. as a means of getting money out of companies rather than putting money in.
Chapter 3: The Structure of Shareholding
The Report draws attention to the changing nature of the structure of the shareholder base in UK companies over the last 50 years. The Report notes the change from primarily individuals fifty years ago, to UK insurance companies and pension funds in the 1990s and to non-UK holders such as sovereign wealth funds now. Further fragmentation has been caused by registrars, nominees, custodians, asset managers, managers who “sit” in between the Company and the saver and who allocate funds to specialist asset managers, trustees, investment consultants, agents who ‘wrap’ products, retail platforms, distributors and independent financial advisers.
The Report points out that each of these agents must employ its own compliance staff to monitor consistency with regulation, use the services of its own auditors and lawyers and earn sufficient amounts to remunerate the employees and reward its own investors. The Report links the growth of this intermediation both to rising costs for investors and the decline of trust in the investment chain: “the question of who guards the guards is inevitably followed by the question of who guards the guards who guard the guards”.
Chapter 4: Market Efficiency: Economic Issues
This chapter challenges the hypothesis which holds that the market price is an unbiased estimate of the fundamental value of a security (expressed by the maxim “the market knows best”) on the basis that the central assumption for this proposition (namely that all relevant information is known to all market participants) is flawed on the basis that information about future company performance is speculative and imperfectly transmitted.
Professor Kay maintains that this problem is exacerbated by the bias towards action in relation to information and advice which is found at almost every point in the equity investment chain. For example, traders and market makers earn returns which are closely related to the volume of activity in the securities in which they deal; analysts are rewarded for the narratives they provide that generate buy or sell recommendations; investment bankers and advisers derive earnings from transactions. The chapter concludes by stating that many people in the financial services industry who claim to be in the business of providing advice are in fact in the business of making sales.
Chapter 5: The Role of Asset Managers
The Report states that the concern of asset managers (and the basis on which they are monitored by many asset holders, and by advisers to asset holders and retail investors) is the short term relative performance of a company whereas the interests of beneficiaries are, largely, in long-term absolute performance of a company. This misalignment of incentives creates many problems, one of which is that analysis of and engagement with a company (which Professor Kay considers will increase its long-term value for beneficiaries) is regarded by asset managers as a cost (because of the investment of time and resource involved) which may impede their ability to secure mandates awarded on the basis of fees.
Chapter 6: Establishing Trust
The Report proposes that the trust which has been eroded in financial intermediaries and the financial system as a whole over the last 5 years be re-established by shortening the chain of investment with fewer and deeper relationships supported by clear and specific “principles based” guidance for each of the groups in the chain. The historical concept of stewardship should also be embraced in order to try and re-establish trust.
- All participants in the equity investment chain should act according to the principles of stewardship, based on respect for those whose funds are invested or managed, and trust in those by whom the funds are invested or managed.
- Relationships based on trust and respect are everywhere more effective than trading transactions between anonymous agents in promoting high performance of companies and securing good returns to savers taken as a whole.
- The Stewardship Code should be developed to incorporate a more expansive form of stewardship, focussing on strategic issues as well as questions of corporate governance.
- Company directors, asset managers and asset holders should adopt good practice statements (which are set out in the Report) that promote stewardship and long-term decision making. Regulators and industry groups should takes steps to align existing standards, guidance and codes of practice with these Good Practice Statements.
Chapter 7: Strengthening the Investment Chain
Professor Kay proposes the establishment of an investors’ forum to expand the opportunities for both supportive and critical action by investors on issues of importance to investors.
- Asset managers can contribute more to the performance of British business (and in consequence to overall returns to their savers) through greater involvement with the companies in which they invest.
- An investors’ forum should be established to facilitate collective engagement by investors in UK companies.
Professor Kay regards it as highly unlikely that persons would be deemed to be “acting in concert” simply by membership of such a forum (and therefore potentially required to make mandatory bids under the UK Takeover Code) as the UK Panel on Takeovers and Mergers has confirmed that it does not intend to constrain normal collective shareholder action.
Chapter 8: The Business Environment
The Report argues that, while the limitation of public regulation of merger activity to those transactions which raise concerns of competition policy has not necessarily been beneficial, to change this by the substitution of a general public interest test would put either UK Government ministers or the UK Competition Commission in the undesirable position of being expected to overrule bad business judgment when that judgment has been affirmed by boards and shareholders. Professor Kay concludes that the UK Government should use its informal and formal authority as effectively as possible in relation to merger activity but should take a negative view of a transaction only in cases where at least one of the following conditions was fulfilled: (i) the acquirer appears to have significantly less capacity to manage the business than the existing management team; (ii) the combined concern appears likely to be substantially weaker financially than the existing UK business; (iii) a probable consequence of the transaction is a material loss of high level functions or of employment from the UK. Assurances given to allay these concerns should be regarded as legally binding on the company.
- Directors are stewards of the assets and operations of the business of the Company. The duties of directors are owed to the company, not its share price, and companies should aim to develop relationships with investors, rather than with ‘the market’.
- The scale and effectiveness of merger activity of and by UK companies should be kept under careful review by BIS and by companies themselves.
- Companies should consult their major long-term investors over major board appointments.
- Companies should seek to disengage from the process of managing short term earnings expectations and announcements.
Chapter 9: Fiduciary Duty
The Report identifies the core fiduciary duties of loyalty and prudence and states that, whatever the current legal position governing particular relationships in the equity chain (and in this regard the Report notes that some contracts between intermediaries and their clients seek to exclude fiduciary duties), there can be no sound basis for placing trust in an intermediary who does not recognise these duties.
Short selling and the associated practice of stock lending (by which stock is lent by an asset manager to a short seller and then sold on to a buyer and replaced by the short seller at a lower price) are at first sight incompatible with the concept of stewardship as the practice implies a lack of trust and confidence in, and respect for, the management of the company whose shares are sold. Whilst the Report does not propose that the practice of stock lending be discouraged, it is concerned that the income from stock lending may not be separately disclosed, and may be retained in whole or part by the asset manager.
- All participants in the equity investment chain should observe fiduciary standards in their relationships with their clients and customers. Fiduciary standards require that the client’s interests are put first, that conflict of interest should be avoided, and that the direct and indirect costs of services provided should be reasonable and disclosed. These standards should not require, nor even permit, the agent to depart from generally prevailing standards of decent behaviour. Contractual terms should not claim to override these standards.
- Regulatory authorities at EU and domestic level should apply fiduciary standards to all relationships in the investment chain which involve discretion over the investments of others, or advice on investment decisions. These obligations should be independent of the classification of the client, and should not be capable of being contractually overridden.
- Asset managers should make full disclosure of all costs, including actual or estimated transaction costs, and performance fees charged to the fund.
- The Law Commission should be asked to review the legal concept of fiduciary duty as applied to investment to address uncertainties and misunderstandings on the part of trustees and their advisers.
- All income from stock lending should be disclosed and rebated to investors.
Chapter 10: The Information Users Need
The Report notes that the demand for more information in the interests of disclosure and transparency has led to a cascade of data of limited value in which useful information may be buried and maintains that this is particularly the case with respect to the requirement to publish quarterly earnings which will be dominated by random fluctuations.
- At each stage of the equity investment chain, reporting of performance should be clear, relevant, timely, related closely to the needs of users and directed to the creation of long-term value in the companies in which savers’ funds are invested.
- Metrics and models used in the equity investment chain should give information directly relevant to the creation of long-term value in companies and good risk adjusted long-term returns to savers.
- Risk in the equity investment chain is the failure of companies to meet the reasonable expectations of their stakeholders or the failure of investments to meet the reasonable expectations of savers.
- Mandatory IMS (quarterly reporting) obligations should be removed.
- High quality, succinct narrative reporting should be strongly encouraged.
- The UK Government and relevant regulators should commission an independent review of metrics and models employed in the investment chain to highlight their uses and limitations.
- Regulators should avoid the implicit or explicit prescription of a specific model in valuation or risk assessment and instead encourage the exercise of informed judgment.
Chapter 11: Establishing the Right Incentives
The Report states that executive remuneration has attracted more controversy and public attention than any other issue related to equity markets and has been the subject of extensive review and consultation by BIS.
Whilst not intending to cover the same ground, Professor Kay notes that the normal tenure of a corporate chief executive is in the range of 3–5 years and that many important decisions about the performance and activities of a large, complex business will have consequences extending well beyond that period. He therefore concludes that an incentive scheme which pays out during the term of office of the executive is biased against long-term decision making because, faced with particular strategic choices, there is an incentive for an executive to make decisions whose immediate effects are positive even if the long run impact is not. The Report also notes that the bonuses of an asset manager should be linked to the long-term absolute return on the fund, so as to try and align the interests of the asset managers with that of the client.
However, Professor Kay does not believe that the UK Government or regulatory authorities should mandate the structure of remuneration packages for company directors or asset managers but would like to see a shift in practice driven by the application of fiduciary standards throughout the equity investment chain and by the statements of good practice set out for company directors and asset managers.
- Market incentives should enable and encourage companies, savers and intermediaries to adopt investment approaches which achieve long-term returns by supporting and challenging corporate decisions in pursuit of long-term value.
- Companies should structure directors’ remuneration to relate incentives to sustainable long-term business performance. Long-term performance incentives should be provided only in the form of company shares to be held at least until after the executive has retired from the business.
- Asset management firms should similarly structure managers’ remuneration so as to align the interests of asset managers with the interests and timescales of their clients. Pay should therefore not be related to short-term performance of the investment fund or asset management firm. Rather a long-term performance incentive should be provided in the form of an interest in the fund (either directly or via the firm) to be held at least until the manager is no longer responsible for that fund.
Chapter 12: Regulating Equity Markets
The Report notes that since the establishment of CREST in the 1990s, it has become increasingly common for retail investors to hold shares through omnibus nominee accounts and that although some private client brokers offer the alternative of CREST personal membership to their clients, most execution only stockbrokers require their clients to use these nominee accounts.
Professor Kay has expressed regret that equity markets have evolved in a way which diminishes the sense of involvement which savers enjoy with the companies in which their funds are invested and has also expressed concern about the security of nominee holdings. He notes that other jurisdictions which have also dematerialised securities holding, such as Australia, Hong Kong and Sweden, have nonetheless made arrangements to facilitate direct access by individuals. With the advent of widespread internet access, he is of the view that investors holding shares electronically should be able to enjoy the same opportunities for engagement with companies as in the past, whether they hold those shares either directly or through an intermediary.
- The regulatory framework should enable and encourage companies, savers and intermediaries to adopt investment approaches which achieve long-term value by supporting and challenging corporate decisions in pursuit of long-term value.
- The UK Government should explore the most cost effective means for individual investors to hold shares directly on an electronic register.
Chapter 13: Markets for Users
In summary, Professor Kay visualises a shorter equity investment chain, in which the central figure is the asset manager, who develops trust relationships with a narrower range of companies in which he or she chooses to invest and persuades savers and asset holders of the long-term merits of a distinctive investment approach. He also seeks a profound change in regulatory approach, with regulation directed towards the interests of market users (companies and savers) rather than the concerns of market intermediaries and seeks to aid the rebuilding of trust by re-emphasising the fiduciary obligations of participants in the investment chain.
The Report concludes by reiterating that the effectiveness of British equity markets is best measured by the impact on the long-term performance of the companies which list on these markets and that such long-term performance is, in the long run, the only source of the returns that long-term savers require.
BIS has committed to publishing an update in the summer of 2014, setting out the further progress which has been achieved by the UK Government (and/or others) to deliver the specific recommendations of the Report.