The first edition of Market reCap looked at Professor Kay's interim report on the UK equity markets, which was issued in February 2012.
The final report was published on 23 July 2012, and concludes that short-termism is a problem in UK equity markets. The principal causes are suggested to be the decline of trust and the misalignment of incentives throughout the equity investment chain.
This article examines the key recommendations in the report, and what can be expected to emerge in response to it.
The report identifies several major themes giving rise to the current situation:
- the increased fragmentation of shareholdings, driven by the diminishing share of large UK insurance companies and pension funds, and by the globalisation of financial markets. This reduces the incentives for engagement and the level of control enjoyed by each shareholder (particularly given that legal ownership, decision making on disposal and voting, beneficial ownership and economic rights in respect of a share may be held by or exercised by different people);
- the evolution of the equity markets in a way which contributes to poor managerial decisions by companies, in particular by focusing on M&A activity or restructurings at the expense of developing a company's business;
- trading and transactional cultures prevailing in the investment chain, rather than relationships based on trust and confidence; and
- undue reliance on the large quantities of information disclosed by companies, much of which is of little value but could drive damaging short-term decisions by investors.
So what is to be done to address these issues? The report proposes a number of disparate solutions which recognise that cultural changes may be more effective than new regulatory measures. Professor Kay's aim is to set incentives to adopt the right behaviour, rather than rules to stop the wrong behaviour.
Specific recommendations include the following:
- the UK Stewardship Code being developed to incorporate a more expansive form of stewardship which focuses on strategic issues in addition to questions of corporate governance;
- directors, asset managers and asset holders should adopt "Good Practice Statements" that promote stewardship and long-term decision making;
- directors’ remuneration being structured to relate incentives to sustainable long-term business performance, with long-term incentives provided only in the form of shares to be held at least until after the executive has retired from the business;
- asset managers’ remuneration should be aligned with the interests and timescales of their clients, and pay should not be related to the short-term performance of the investment fund;
- all participants in the equity investment chain ought to observe fiduciary standards in their relationships with their clients and customers, and the Law Commission should be asked to review the legal concept of fiduciary duty as applied to investment;
- all income from stock lending to be disclosed and rebated to investors;
- mandatory quarterly reporting obligations should be removed, and succinct high quality narrative reporting strongly encouraged;
- an independent review to be commissioned in relation to the metrics and models employed in the investment chain to highlight their uses and limitations;
- companies should consult their major long-term investors over significant board appointments;
- the government ought to explore means for individuals to hold shares through CREST; and
- an independent investors' forum should be established to facilitate collective engagement by investors in UK companies.
No action required
A number of further possible steps were expressly discounted. Albeit with a certain reluctance, no immediate change was advocated to the current regulatory framework of merger control in the UK, though it was suggested the scale and effectiveness of merger activity in relation to UK companies should be kept under careful review by BIS and by companies themselves.
The interim report queried whether on a takeover transaction the level of acceptances required from the target's shareholders should be raised. The final report noted that the Takeover Panel had recently consulted on this issue and found a large majority of respondents to be opposed to this change - and, perhaps more importantly, "such a move would have relevance principally for hostile transactions, which account for a very small proportion of all bids".
Professor Kay also rejected calls to amend Section 172 of the Companies Act 2006 (the duty for directors to act in good faith to promote the success of the company) to lay greater emphasis on long-term factors and engagement with shareholders. Any director who thinks his duty can be reduced to an obligation to achieve the highest possible share price in the short-term is said to have misunderstood the law.
As is apparent, the report's recommendations propose actions to be taken by the government and various authorities in relation to the equity markets, such as the Financial Reporting Council in developing the Stewardship Code.
The government is due to respond formally to the report in detail later this year, and implementation is likely to require further consultations. Nevertheless, concrete action should be possible on a reasonable timescale since Professor Kay has explicitly set out to avoid further legislation and regulation, save where absolutely necessary.
A copy of the final report can be accessed here.