On 9 April 2014, the Commission published proposals to amend the existing Shareholder Rights Directive (2007/36/EC). The proposals follow last month's publication of its 'Communication on the long-term financing of the European Economy', in which the Commission announced proposals to revise the Shareholder Rights Directive as part of its action plan to meet certain key objectives which include improving the governance and financial performance of EU listed companies; enhancing the long-term financing of companies through the equity markets; and improving conditions for cross-border equity investments.
EU action required to address key issues
The current Shareholders' Directive, which was adopted in 2007, sought to improve corporate governance in EU companies whose securities are traded on regulated markets by enabling shareholders to exercise their voting and information rights across borders. Since its adoption, the Commission has consulted on various proposals to enhance the corporate governance of EU listed companies, with a particular focus on encouraging a 'long-termist' view amongst shareholders, the lack of which the Commission believes to be a fundamental contributing factor to the financial crisis.
Whilst a limited number of Member States, including the UK, have taken action to address certain problems in the area of corporate governance, the Commission considers that this is not sufficient - different rules across certain Member States will create an uneven playing field for issuers and investors, undermining the efficient functioning of the internal market. Rather, the Commission considers that EU intervention is necessary to harmonise regulation across Member States, which should promote cross-border investment and maintain Europe's currently strong position amongst competitive global markets.
Click here to read the Commission's proposals, otherwise read on for a summary of the main points.
Five key proposals
Having identified five systemic issues relating to corporate governance in EU listed companies, the Commission proposes a package of proposals to be set out in an amending directive to address each issue. We summarise the proposals below.
- Improving engagement of institutional investors and asset managers
The 'short-termist' approach to investments is held as partially responsible for the global financial crisis. The Commission notes that institutional investors and asset managers were not effectively monitoring their investments or engaging with investee companies to ascertain their long term performance. Instead, there was disproportionate focus on short-term share price movements, which has led to sub-optimal returns for end-beneficiaries and put short term and damaging pressure on companies.
Consequently, the Commission seeks to improve the engagement of institutional investors and asset managers in investee companies and has proposed the following measures:
Engagement policy – Member States must ensure that institutional investors and asset managers develop, on a comply-or-explain basis, a policy on shareholder engagement. The policy should provide, among other things, a method for monitoring investee companies, how to exercise voting rights and how to integrate shareholder engagement in their investment strategy. Additionally, the policy should outline how to manage actual or potential conflicts of interest regarding shareholder engagement (for example, where a director of an institutional investor is a director of an investee company). Institutional investors and asset managers should be required to disclose publicly the engagement policy on an annual basis and must provide details of how it has been implemented, together with the results of the policy. For example, such firms would need to disclose if and how they cast their votes at general meetings of investee companies and provide reasons for the way in which they cast those votes.
Investment strategy of institutional investors and arrangements with asset managers – It is proposed that institutional investors should disclose how their investment strategy is aligned with the profile and duration of their liabilities and how it contributes to the medium to long term performance of their assets. The strategy should be published on the website for so long as it is applicable. Additionally, where an asset manager invests on behalf of an institutional investor, the latter is required to disclose annually six specified elements of the arrangement, including whether and to what extent it incentivises the asset manager to align its investment strategy with the profile and duration of its liabilities. Where the arrangement does not contain one of the specified elements, the institutional investor must give a clear and reasoned explanation.
Transparency of asset managers – Asset managers will be required to disclose certain specified information on a half-yearly basis to the institutional investor which details how their investment strategy complies with its arrangement with that investor, and additionally, how the implementation of the investment strategy contributes to the medium to long-term performance of the assets of the institutional investor.
- Strengthening the link between pay and performance of directors
The Commission acknowledges that directors' remuneration plays a key role in aligning the interests of directors and shareholders and should incentivise directors always to act in the best interests of the company. Regulation of directors' remuneration differs across Member States. In the UK, we are familiar with the reform in this area, with the new regime on directors' remuneration reporting recently coming into force so that it applies for companies with financial years ending after 30 September 2013. The Commission is seeking to harmonise regulation in this area, particularly with regard to allowing shareholders to exert sufficient control over directors' remuneration and to ensuring that information disclosed by companies is comprehensive, clear and comparable. The proposal does not regulate the level of remuneration, which is left to the discretion of companies and their shareholders. The Commission has proposed the following amendments to be adopted by Member States in due course:
Right to vote on the remuneration policy – Member States must ensure that shareholders have the right to vote on the directors' remuneration policy at least every three years, which is the position in the UK. The policy must be 'clear, understandable and in line with business strategy, objectives, values and long-term interests of the company'. The policy should further explain how the pay and employment conditions of employees were taken into account when setting the policy on directors' remuneration, by explaining the ratio between the average remuneration of directors and the average remuneration of full time employees of the company (other than directors), and further explain why that ratio is appropriate. In the latest edition of its UK Shareholder Voting Guidelines, published in March 2014, the Pensions Investment Research Consultants (PIRC) introduced recommendations concerning directors' remuneration to reflect the new reporting regime from 1 October 2013. In particular, PIRC calls for the disclosure of the ratio of fixed CEO pay to average employee pay as a whole, and notes that it will give credit to companies who apply a ratio of 20:1 in assessing whether executive and employee pay are adequately aligned. Consequently, there appears to be some appetite in the UK for disclosing a ratio to explain how remuneration levels are set.
Other notable points in relation to the policy are that it must explain how it contributes to the long-term interests and sustainability of the company. The policy must further explain the remuneration decision making process and, where such a policy is revised, it must explain any significant changes and how the revised policy takes into account shareholder views received in the previous years (as is also required under the new UK regime).
Information to be disclosed in remuneration report and the rights to vote - It is proposed that Member States require companies to draw up clear and understandable remuneration reports which provide a comprehensible overview and include all benefits granted to directors (both new and former) in the last financial year. The reports must include specified items, a number of which are required in the UK, but there is particular emphasis on explaining how the total remuneration is linked to the company's long-term performance.
It is proposed that shareholders will have the right to vote on the remuneration report of the past financial year during the annual general meeting, In the UK, the remuneration report is subject to an annual advisory vote. Where the shareholders vote against the remuneration report, the company must explain in the next report whether or not, and, if so, how the shareholder votes have been taken into account. The Commission is empowered to provide for a standardised presentation of the required information in an implementing act.
- Improving shareholder oversight on related party transactions
The Commission has identified related party transactions as another area which could give rise to abusive transactions that operate to the detriment of shareholders, in particular, to those who hold minority shareholdings. Consequently, the Commission proposes to confer more oversight on shareholders where there are related party transactions. Whilst the Transparency Directive (implemented in the UK by the Disclosure and Transparency Rules) contains certain provisions regarding the disclosure of certain transactions with shareholders, there are no EU rules that provide for public disclosure at the time when the related party transactions are concluded, or for shareholder approval of such transactions. Member States have differing approaches to related party transactions - for example, the UK has an established regime in Chapter 11 of the Listing Rules, which provides for the regulation of related party transactions of premium listed companies, some of which must be approved by shareholder vote.
The Commission has proposed a new article which covers the following measures:
- companies will be required to seek shareholder approval for transactions with related parties representing more than 5% of the company's assets, or transactions which could have a significant impact on profits or turnover. If the related party transaction involves a shareholder, that shareholder will be excluded from the vote. Transactions must not be concluded without shareholder approval, although an agreement for a transaction can be entered into provided that it is conditional on shareholder approval being obtained
- transactions with the same related party that have been concluded within the previous 12 months and have not been approved by shareholders must be aggregated. If the value of the aggregated transactions exceeds 5% of assets, the transaction which breaches the threshold, and subsequent transactions with that related party, must be submitted to a shareholder vote and may only be concluded after shareholder approval has been obtained
- where related party transactions represent 1% of assets, companies must publicly announce the transactions at the time of their conclusion. The announcement must be accompanied by a report from an independent third party assessing whether or not it is on market terms and confirming that the transaction is 'fair and reasonable' from the perspective of the shareholders, including the minority shareholders. A similar measure has been proposed by the UK's Financial Conduct Authority (FCA). In its consultation paper 13/15, the FCA proposes that 'smaller related party transactions' which have a value of more than 0.25% but less than 5% on the relevant class tests should be disclosed via an RIS at their conclusion, rather than reported on in the premium listed company's next published annual report and accounts. In addition, it is worth noting that in the UK, it is the sponsor who must confirm that related party transactions are 'fair and reasonable' to the FCA (note that consultation paper 13/15 proposes that this confirmation should be made to the listed company), although there is no additional requirement to publish a report on the analysis of the 'fair and reasonable' statement, as is currently proposed by the amending directive. It is also worth noting that a company whose securities are traded on AIM is required to state that its directors consider that the terms of a related party transaction are 'fair and reasonable,' having consulted with its nominated advisers
- member States may exclude transactions entered into between a company and its wholly owned subsidiaries. Additionally, Member States may provide that companies may seek shareholder approval for an exemption from the requirement to provide an independent third party report for certain clearly defined types of recurrent transactions with an identified related party for a period of no longer than 12 months after granting the exemption is granted. In the UK, we have a prescribed list of transactions which are exempt from the related party transaction regime. Arguably, the UK approach to exempting transactions might be viewed as a more practical way to deal with such transactions, rather than the company having to seek shareholder approval for each transaction, as is proposed under the amending directive.
- Enhancing transparency of proxy advisers
The fast-moving pace of the European financial markets and the prevalence of more complex cross-border issues has meant that certain investors have become more dependent on the services of proxy advisers, an industry which is thought to have become increasingly influential on the voting behaviour of investors. The Commission has identified two issues with the proxy adviser industry. First, there is concern that proxy adviser recommendations do not always take into account local market and regulatory conditions. Secondly, where proxy advisers provide various other services to issuers, such services may affect their independence and ability to provide objective and reliable advice to investors. Furthermore, the Commission notes that proxy advisers are not subject to any regulation at EU level and non-binding rules exist only in a few Member States. For example, in the UK, the Financial Reporting Council's Stewardship Code also applies to proxy advisers. The Commission notes that proxy advisers are influential in the voting behaviour of certain institutional investors and consequently, in some jurisdictions, they are a 'standard-setter in corporate governance'. Consequently, the Commission has inserted a new article relating to a proxy adviser's conflict of interest procedures and its methodologies behind its voting recommendations. In particular, the article provides the following measures:
- member States must ensure that proxy advisers adopt and implement adequate measures to guarantee that their voting recommendations are accurate and reliable based on a thorough analysis of all the information that is available to them
- proxy advisers must, on an annual basis, publicly disclose certain information relating to the preparation of their voting recommendations. Such information includes the extent and nature of any dialogues they have with the companies who are the object of their voting recommendations and whether they have taken national market, legal and regulatory conditions into account. The information must be published on their website for at least three years from the publication date
- member States must also ensure that proxy advisers identify and disclose without delay to their clients and the company concerned any actual or potential conflict of interests or business relationships that may influence the preparation of the voting recommendations and the actions taken to mitigate or eliminate these interests.
- Facilitating the exercise of rights flowing from securities for investors
The Commission notes that one of the obstacles to encouraging long-term shareholder engagement is the existence of chains of intermediaries which stand between an issuer and what the amending directive notes as 'its shareholders'. The original directive defines a 'shareholder' as 'the natural or legal person that is recognised as a shareholder under the applicable law', so in the UK, a shareholder for these purposes, will be the registered holder of the shares.
The Commission recognises that an issuer can face difficulties identifying its shareholder base which impacts on its ability to directly communicate with its shareholders. In its view, direct communication facilitates the exercise of shareholder rights and strengthens corporate governance. However, the Commission has found that, in intermediated holding chains, there is a danger that information is not passed to shareholders from companies, or shareholder votes get lost or even misused by intermediaries. The Commission recognises that the identification of shareholders in a domestic context can be difficult and cites the procedure set out in the UK's section 793 Companies Act 2006 which allows a public company to identify its shareholders, although notes that the process can be 'highly intensive and time-consuming'.
The Commission notes that the cross-border position to identify shareholders can be even more cumbersome. Consequently, it proposes the following measures:
Identification of shareholders - Member States must ensure that intermediaries offer companies the right to have their shareholders identified (although, given the definition of 'shareholder', as described above, this is not a problem for UK companies). If requested by the company, the intermediary must communicate without undue delay the name and contact details of the shareholders, and where the shareholders are legal persons, their unique identifier, where available. Shareholders will be informed by the intermediaries that their details have been transmitted for the purposes of identification pursuant to the article. The company and the intermediary are not to preserve the information relating to the shareholder for longer than two years after receiving it. Furthermore, Member States must ensure that the intermediary is not in breach of any application or regulation if it reports the name and contact details of the shareholder pursuant to the new provisions. The provisions clarify that the information may only be used for the purpose of facilitation of the exercise of the rights of the shareholder.
Transmission of information - If a company chooses not to communicate directly with its shareholders, information necessary to exercise a shareholder right, or information directed to all shareholders of a class, must be transmitted to the relevant shareholder or, if directed by the shareholder, to a third party, by the intermediary without delay.
Facilitation of the exercise of shareholder rights - Member States must ensure that intermediaries facilitate the exercise of the rights by shareholders, including the right to participate and vote in general meetings. Furthermore, companies must confirm the votes cast in general meetings (although it is not clear whether companies are required to confirm votes or whether they should do so at their discretion). Where an intermediary casts the vote, it must transfer the voting confirmation to the shareholder.
Transparency on costs and third country intermediaries - Intermediaries should be permitted to charge fees for services under these new requirements, provided that they are 'non-discriminatory and proportionate'. Any difference levied between domestic and cross-border exercise of rights must be justified. Furthermore, a third country intermediary which has established a branch in the EU must be subject to the same provisions.
The proposal will be forwarded to the Parliament and the Council under the ordinary legislative procedure. Member States will have 18 months to implement the directive following its entry into force.
Overarching framework of 'long-termist' values
The Commission's proposals follow various consultations with European market participants to identify and address gaps in the current European corporate governance regime. Since the Shareholder Rights Directive came into force in 2007, various Member States have sought to address these areas on a national level. However, the Commission has recognised that it must pull together an overarching framework of consistent shareholder rights over the European financial markets in order to harmonise regulation, improve transparency and boost cross-border investment. The UK will be familiar with some of these proposals, having already implemented certain measures to deal with the issues identified, such as the new remuneration reporting regime which came into force last autumn, and the well-established Chapter 11 of the Listing Rules which governs the related party transactions of premium listed companies. Furthermore, the 'Kay Review of the UK Equity Markets and Long-Term Decision Making' was launched in response to the Government recognising that short-termism was a significant factor contributing to the financial crisis. Consequently, there is continuing regulatory focus in the UK on preventing a recurrence of the same corporate governance failures and overall, it appears that the UK and the European authorities are broadly in agreement with regard to finding appropriate solutions to identified issues. With regard to the proposals on the identification of a company's shareholders, we do not expect that the measures will have any significant impact for UK companies, given that the provisions relate to the identification of 'legal' rather than 'beneficial' shareholders.
Overall, market participants, and particularly investors, are likely to welcome the changes. Whilst there may be administrative costs in implementing the new measures, the resulting transparency and consistency of standards throughout the EU should reduce the overall costs of investment in the long-term for investors, and the authorities hope that this will have a positive impact on the European economy.