In June 2011, the Secretary of State for Business, Innovation and Skills asked Professor Kay to review whether equity markets in the UK gave sufficient support to the key objectives of developing British companies’ capacity for innovation, brands and reputation and the skills of their workforce. Professor Kay published his final report in July 2012 and the government published its response in November of that year (see our December 2012 newsletter article for more information). The Business, Innovation and Skills Committee of the House of Commons (Committee) then sought the views of interested parties on both the Kay review recommendations and the government’s response. The Committee published its findings (Third report of session 2013-14) on 25 July.
In the main, the Committee's report endorses the findings of the Kay review and the government's stated intentions in respect of them. The main issue that the Committee identifies with the government's response is that it lacks clear objectives and deadlines. For the most part, therefore, the Committee's response urges the government to clarify its proposals and set clearer objectives and earlier deadlines.
However, in some instances, the Committee's recommendations have the effect of slightly modifying or extending what Professor Kay originally proposed and/or the government's approach as set out in its response. For example, the government response took a fairly low key approach in respect of M&A, but the Committee appears to be attempting to re-introduce a call for analysis of the UK takeover regime, if not actual change. Perhaps, the most surprising point, however, relates to a possible Financial Transaction Tax (FTT), which the Kay review had not previously considered in any detail. The key points of the Committee's recommendations are set out below.
The Committee agrees with Professor Kay and the government that collective engagement benefits the equity markets and UK businesses. It notes that the government has said it will publish an update in the summer of 2014 but thinks this is not soon enough and that progress will stall. It recommends that the government outlines a clear timetable, together with milestones and assigned responsibilities, before that time.
The Law Commission is currently consulting on the legal definition of fiduciary duty and will not report back until June 2014. The Committee believes this is too slow and recommends that the government liaises with the Law Commission to bring forward the timing.
Appointment of executives
The Committee notes that the government has agreed to implement Professor Kay's recommendation that companies consult with major investors on board appointments. The Committee suggests that the government publishes a timetable for the implementation of this policy, clarifies which investors companies are to consult with and outlines how it intends to combat the issues surrounding insider trading and confidentiality which may accompany such appointments. Alongside this, the Committee suggests that the government should undertake an impact assessment, particularly looking at the possible increase of bureaucratic burdens on small businesses and the possibility of an opt-out clause for them.
Remuneration of executives
The Committee supports the recommendation that company directors should be tied into the long-term performance of their companies through the holding of shares for an appropriate period. It recommends that the government outlines how it intends to combat the issue of directors using options and derivatives to avoid these rules. Alongside this, it suggests that the government should outline how it will ensure that departing directors will not be perversely incentivised to artificially inflate the share price immediately before their retirement or to retire early in order to realise the locked-in value of their shares.
Incentivising fund managers
The Committee recommends that the government takes a harder line when framing the culture in which fund managers work by highlighting best practice where it sees it. It further recommends that the government should work towards the goal that fund manager performance be reviewed over longer time horizons than the typical quarterly cycle.
In particular, the Committee suggests that the government can help effect a culture change in the incentives driving fund-manager behaviour by developing and publishing a set of long-term measures of success alongside options for sanctions for demonstrable failure. It goes on to suggest that a list of those firms that have fully adopted such measures should be published annually.
The Committee supports Professor Kay’s recommendation that the requirement for quarterly reporting should be removed and recommends that the government outlines a clear timetable to implement this recommendation including what alternative strategies would be followed should the anticipated change in EU law to remove the requirement does not happen.
It also recommends that the government sets out details of progress in negotiations with other international accounting standard bodies (such as the US Securities and Exchange Commission) on the requirement for quarterly reporting to ensure that any changes made to domestic or EU-wide accounting practices are accepted on a global level.
The Committee recommends that the government sets out how it will ensure that enhanced narrative reporting will remain consistent with, and accepted by, overseas regulators, for example, the US Securities and Exchange Commission. It goes on to say that, when changes are made to the structure and format of reporting, the government (through the Financial Reporting Council) should ensure that any accompanying guidance on the new provisions includes clear minimum standards to ensure comparability, and should not shy away from strict enforcement of these standards. The Committee therefore recommends that the government outlines how it proposes to implement auditing and monitoring of narrative reports.
Mergers and acquisitions
The Committee recommends that the government conducts and publishes an assessment of the takeover regimes of other similar economies with a view to learning about the impact that takeovers have had on their companies and economies. Furthermore, it should summarise which positive elements may be incorporated into our domestic system to strengthen our economy and ensure that takeovers benefit our economy.
The Committee notes that, whilst the government has accepted Professor Kay’s recommendation on mergers and acquisitions, it is unclear what specific action it will take. It therefore recommends that the government:
clarify the actions it will take over the next six months to be in a position to monitor all merger activity in the UK effectively
outline what action it will take to engage with companies and their investors to ensure that any investment merger activity is to the long-term benefit of the UK economy.
produce a feasibility study which clearly outlines the risks and benefits of introducing a policy that differentiates between shareholders and voting rights based on the length of time a share has been held
commission a study to set out the impact on the UK of foreign takeovers of British companies over the past 25 years.
Financial Transaction Tax
The Committee notes that in the submission made to it, there was some support for the concept of an FTT on trading practices such as High Frequency Trading. However, it notes that concerns were raised about the practicality of implementing such a tax unilaterally. It recommends that the government considers the viability, benefits and risks of an FTT and commissions research in the following areas:
an impact assessment of the introduction of an FTT on equities at a level which is the average profit made on a High Frequency Trade in the UK
an impact and feasibility study of the proposal to ban any of those banks which establish branches or subsidiaries in an offshore centre that does not adhere to the OECD’s white list of financially compliant economies from trading in the UK - this should include an assessment of whether doing so would counter the arguments against a domestic FTT being ineffective in the global market.
The Committee notes that Professor Kay recommended that the Stewardship Code should be developed to take account of strategic issues as well as those around corporate governance. The Committee recommends that this should be implemented through a formal consultation by the Financial Reporting Council, and specifically recommends that the Code be enhanced:
to allow investment managers to focus, within their policies on how they discharge their stewardship responsibilities, on strategic issues facing companies (rather than the current focus on profit, which is inherently short-term)
to include the principle that engagement and corporate governance should extend beyond financial affairs and encompass more long-term value adding activities such as environmental, social and governance factors
to provide that institutional investors and significant owners should be members of at least one investor’s forum
to clarify that the role of institutional investors should be to attend to potential systemic risks rather than only engaging with risks to individual companies in their portfolio
to redefine a clearer explanation of conflicts of interest and, in particular, for asset management firms to publish how key conflicts of interest are managed in practice
to provide one clear and authoritative definition of the term ‘stewardship’.
The Committee observes that whilst progress has been made in the number of asset managers signing up to the Stewardship Code, adoption by owners remains low. It recommends that the government:
outlines what it considers a minimum acceptable level of adoption (making provision for the distinction between manager and owner)
makes clear that it is government policy to encourage adoption of the Code and publishes a clear target (and timescale of no more than two years) for success
clearly outlines what action it will take if this target is not met.
Good practice statements
In the Committee's view, Professor Kay’s Good Practice Statements should be the standard level of behaviour. It expects the government to outline its timetable for all companies to sign up to these Good Practice Statements. If this target is not met, it suggests that the government should be prepared to incorporate the statements into the Stewardship Code.
The Committee notes that asset managers are currently allowed to use commissions to pay for long-term research, including in respect of stewardship, but that it appears that few are aware of this. It therefore recommends that the Financial Conduct Authority contacts all major institutional investors highlighting that long-term investment research that is orientated towards good stewardship could (and should) be paid for using a proportion of equity commissions reserved for research. Furthermore, it recommends that the FCA sets and publishes:
an appropriate minimum proportion of a firm’s commission allocated to research that should be used towards such activities
an annual list of those firms which do not achieve that level.
Started over two years ago, the Kay review process has not been a quick one and it is still far from reaching any definitive conclusion. Whilst much of its content is laudable, its wide ranging scope makes its recommendations hard to implement given the number of regulatory and advisory bodies which are affected, not to mention the range of legislation and rules that may be impacted. Professor Kay's preference for change to be brought about by a voluntary buy-in in order to change cultural values and behaviour also made it difficult to see how its proposals would come to fruition. The government's response went some way to identifying more practical action to achieve the proposals, but, as the Committee has found, this was still dependent on a number of further reviews and consultations. In addition, where deadlines were set, these were, generally, some way off. It is, therefore, not surprising that the Committee is trying to invigorate the process by suggesting the government sets clearer goals and timescales against which performance can more easily be measured. However, the degree to which this approach succeeds remains to be seen.