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Last chance for market-based stewardship?

The UK Stewardship Code was truly pioneering when it was introduced in 2010.

It was designed to enhance the quality of engagement between investors and companies, thus contributing to long-term corporate success and improving investment returns for the ultimate beneficiaries. The Financial Reporting Council (FRC), which developed it, can be proud that the code’s introduction has been the catalyst for the proliferation of stewardship codes globally. However, with the code’s planned revision, on which the FRC has just undertaken an initial consultation, we must recognise that it has not yet completely fulfilled its purpose and that a market for stewardship remains a hope rather than a reality.

Expectations
There is significant empirical evidence that stewardship activities can add and/or protect investment value. While investment strategies vary, we believe that stewardship is a responsibility of all authorised investment firms. We recognise, however, that genuinely understanding and engaging with companies is difficult and costly – a burden few investors have been willing to shoulder. This appears to be a case of a market failure to deliver stewardship, due to misaligned incentives.

In order to make more tangible progress, it would be rational for the regulator to impose clearer expectations regarding stewardship on the entire investment chain. If further attempts to foster a functioning market for stewardship fail, we and others have suggested the UK government should consider intervening to raise a levy on the investment industry to resource effective investor engagement.

While the idea of a levy has some merit, this approach should only be used as a last resort. There must be a strong case to warrant intervention, given the practical difficulties. After eight years’ experience with the code, we do not believe this is justified at this stage, not least because there are mechanisms that have not yet been tried. In addition, there are obvious problems with the idea of a levy, such as the difficulty of creating a framework that can measure the effectiveness of stewardship and dictate who pays what fee and the challenge of how to use the funds raised to enhance activities. We believe that now is the time to overhaul the code to create a functioning framework that avoids the need for a market intervention.

Consultation response
In our consultation response to the FRC, we have therefore suggested a programme of action.

We argue that, first and foremost, the code should aim to propel all participants in the investment chain into action so as to create and foster an active stewardship market. The revised code should apply to and be relevant for entities across the entire investment chain by articulating the varying responsibilities of each constituent group, from asset owners and managers to investment consultants. This would have the benefit of drawing out how each agent in the chain through its approach and activities is aligned with the interests of the ultimate beneficiaries. In recognition of the dispersed asset owner base in the UK, the responsibilities of investment consultants as vital intermediaries should be considered and clearly articulated. The focus should be on developing principles that apply to all participants in the investment chain. These broadly applicable principles could be supplemented by tailored provisions for specific groups within the chain.

In practice
All entities in the investment chain should be encouraged to define and articulate their individual purpose and how this leads to meeting their fiduciary duty with regard to the ultimate beneficiaries and other key stakeholders. The disclosure of purpose should in turn be accompanied by transparency on the entity’s governance and – for non-asset owners – economic model, remuneration, incentives and fee structures. These four should support the entity’s purpose and align its interests with those of its clients and beneficiaries.

The revised code should put the emphasis on how stewardship is conducted in practice instead of the creation of policies and processes. Investors should therefore report explicitly on how they fulfil their stewardship responsibilities, including the type of company interaction undertaken, the seniority of investor staff involved and the company representatives engaged, the specific issues covered, whether and how there has been collaboration with other investors and stakeholders, and, under certain circumstances, how an engagement has been escalated. Overall, we believe the code should expect investor signatories to explain how stewardship activities help their organisation and specific funds to deliver on their purpose and the resources assigned towards stewardship. This should include an explanation on how stewardship is integrated into the development of fund-level investment management.

Outcomes
The code should ensure that reporting on stewardship activities focuses on outcomes. To this end, we suggest that clear and measurable objectives are set when dialogue with a company is initiated. The objectives should be specific and time-bound so that clients and beneficiaries can assess the progress made. This should be reflected in meaningful statistics and case studies on particular company engagements.

To underpin the changes we propose, we argue that the code should switch its comply-or-explain model to an apply-and-explain one, thus imposing clearer stewardship expectations on the investment chain.

You can find our full consultation response here.

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