On 23 July 2012, Professor John Kay published the final report of his independent review on activity in UK equity markets and its impact on the long-term performance and governance of UK quoted companies. The report was welcomed by Vince Cable who has stated that the recommendations made by Professor Kay will now be considered in depth and responded to in detail later this year. To see a copy of the report, click here.
The overall conclusion reached in the report is that short-termism is a problem in UK equity markets. The principal causes of this are, according to the report, the decline of trust and the misalignment of incentives throughout the equity investment chain.
The report sets out 10 principles that are designed to provide a foundation for a long-term perspective in UK equity markets and describes the directions in which regulatory policy and market practice should move. These high level statements are supported by 17 specific recommendations aimed at providing "the first steps" towards the re-establishment of equity markets that work well for their users. The recommendations can broadly be categorised into three main areas concerning corporate governance, asset managers and information, although takeovers and individual share ownership also receive a specific mention.
There is a focus in the report on stewardship. Not only by asset holders, as currently provided for by the Stewardship Code, but also by directors and asset managers. There is a recommendation that the Stewardship Code should be reviewed to incorporate a more expansive form of stewardship focussing not only on questions of corporate governance but also strategic issues. The implementation of Good Practice Statements is also suggested for adoption by directors (as well as asset managers and holders). Such statements are intended to promote stewardship as well as long-term decision making. It is also recommended that existing standards, guidance and codes of practice issued by regulators and industry groups be amended to align them with the Good Practice Statements published in the report.
Increased engagement between asset managers and holders and the companies they invest in is also advocated. The concept of investor forums is raised as a means to do this. It is also suggested that companies should consult major long-term investors over key board appointments.
Given the remit of the report and the interim report published in February, the above recommendations are not unexpected. However, the report also includes something of a surprise by including mention of reforms to executive remuneration. The report proposes that long term performance incentives should be provided only in shares which should be held until after the executive has retired from the business. Given the events of this year's so-called "shareholder spring", and the recent focus on executive pay, it is perhaps not surprising that the report touches on this hot topic, but quite how the report's suggestions might fit with the Government's current work in the Enterprise Bill on enhancing shareholder voting rights on executive pay is unclear.
The key shift as regards asset managers (and other relationships in the investment chain which involve discretion over the investments of others) is the proposal that fiduciary standards should be applied to them by regulatory authorities at EU and domestic level. It is also suggested that the Law Commission review the legal concept of fiduciary duty as applied to investment. Such a move would be significant in that it would see legal duties akin to those of pension trustees being applied to asset managers and others in the investment chain.
Other recommendations propose that there should be enhanced disclosure of costs and performance fees, and that all income from stock lending should be disclosed and rebated to investors. It is also suggested that asset managers' remuneration should be structured along similar lines to the proposal for directors' incentives, that is, a longer term incentive in the form of an interest in the fund held until the manager is no longer responsible for the fund.
In essence, the report suggests that too much information is generated for little benefit and that, in some cases, the requirement to publish certain data can encourage a focus on the short-term. In particular, it is proposed that mandatory quarterly reporting should be abolished (which is in line with currently proposed amendments to the Transparency Directive), and that there should be a review of metrics and models used in the investment chain to highlight their uses and limitations.
It is also suggested that high quality succinct narrative reporting and the exercise of informed judgement, instead of compliance with prescribed valuation and risk assessment models, should be promoted.
Interestingly, the report includes the recommendation that "the scale and effectiveness of merger activity of and by UK companies should be kept under careful review by BIS". Given Vince Cable's remarks about takeovers at the time the Kay review was launched and which led, at least in part, to the Takeover Code being revised last September, it is not surprising that the regulation of takeovers gets a mention, but the rather non-specific nature of the recommendation is perhaps unexpected.
The reasoning behind the recommendation is that the other changes recommended in the report will hopefully have "a cooling effect" on corporate transactions. However, whilst recommending that there is no immediate need to change the current regulatory framework of merger control in the UK, the report leaves the position open and puts the ball back in the Government's court.
Individual share ownership
The report also recommends that the Government should explore the most cost effective means for individual investors to hold shares directly on an electronic register. Whilst access to the internet has undoubtedly made such an option more feasible, whether it is enough to reverse the decline in individual share ownership that the report notes is debatable. Moreover, if, as the report suggests, there is an enhancement of engagement between asset managers and companies, and an imposition of fiduciary duties, the need for such a solution may decrease - indeed, the level of individual shareholdings may simply decline further as a result.
Despite the statement in the report that its search for trust and respect is not a matter of nostalgia for an earlier era, it is easy to view the report in this way. This is not so much due to the principles and values it advocates, as these are hopefully the same values and principles that have driven the current regimes of corporate governance and financial regulation. It is more the notion that change can be brought about by a cultural shift driven by the incentive of wanting and being allowed to do better, rather than by enforcement of a regulatory regime. Whilst it may be laudable to recommend not imposing yet more regulation, it is difficult to see how the ideas in the report, such as Good Practice Statements and investor forums, would operate without some framework of rules and enforcement. It will, therefore, be interesting to see how the Government responds.