Author: | Published: 9 Oct 2003
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It has been a year for taking stock. Last year saw frenzied responses around the world to the apparent governance disasters in the US, most notably the eclectic and some would say rushed and confused Sarbanes Oxley Act. This year has seen rather more measured responses and the first signs that a culture change may be beginning to seep into the attitudes of investment institutions. This is partly driven by the bear market, but partly also by an awareness among institutions - occasionally with the encouragement of regulatory change - that they can do more to avert corporate failures.


The first signs of this culture change can be seen in the area of remuneration. Historically, pay has often been the driver for developments in corporate governance and it seems to be so again. This is not surprising: in a bear market, large payouts are more obvious and the apparent lack of any link to performance draws the attention of investors. On a longer-term basis, pay drives behaviour. Constructed well, pay can encourage executives to focus on the creation of shareholder value. Constructed poorly, it can have value destructive effects. Many in the US now accept that poor pay structures helped cause the wasteful period of the tech bubble and fuelled many of the activities now exposed as accounting scandals.

The most dramatic demonstration of cultural change occurred in the UK where GlaxoSmithKline's shareholders voted against the resolution to accept the directors' remuneration report. GlaxoSmithKline (GSK) reported the result as 51% against, 49% in favour. When positive abstentions - or withheld votes - were included, it was clear that only around 37% of voting shareholders felt able to support the board's stance. GSK's board has set the precedent that defeat on such a resolution means not that the whole board must resign - as some directors of other companies have threatened - but that the board should embark on a consultation process to establish schemes which investors can feel more comfortable with. This is a positive sign and other companies facing close votes on this resolution have also begun consultation processes.

Pay has begun to have greater prominence in other countries too. The US, for long the scene of extraordinarily generous payouts, particularly in the form of ludicrous option grants, has seen some curbing of its worst excesses. The scandalized reaction to the divorce-led disclosure of Jack Welch's post-retirement benefits from GE set the tone for a more general reassessment. CalPERS and other US institutions are now taking a much stronger line on pay votes, and under new NYSE listing rules (inspired by pressure from the SEC) they will have more pay resolutions to vote on. Many of the former exceptions to shareholder voting rights have been swept away. Importantly, the extraordinary rule allowing brokers to vote when beneficial owners had not is being swept away. Whether as a result of the new institutional attitude or because they recognize the need for restraint in a bear market, boards have been significantly less generous this year than in previous years.

Europe is also preparing for some change in this area. The Tabaksblat Committee has produced a new draft corporate governance code, which includes a requirement that option awards be subject to performance conditions, accompanied by a rule that shares obtained through the exercise of options are retained while the director remains on the management board. The draft code, now open for consultation, also sets limits on the length of executive contracts and severance pay. Germany also seems set to encourage further disclosure, as would the current form of the European Commission's Action Plan on Corporate Governance.

France, too, seems set for some reassessment. The country, Europe's most generous to its executives according to a study this year by the European Corporate Governance Institute, has been shocked by the golden parachute package agreed with Jean-Marie Messier by Vivendi Universal, the company which he brought close to ruin. His successor Jean-Rene Fourtou has stated his intention to contest the payment, agreed shortly before Messier was ousted last year, and so far the French courts have backed his position, freezing the payment. French politicians seem to have been roused to action by what they see as embarrassing generosity.


Pay gets the headlines. Journalists like big numbers and the issues are revealed in their starkest form. But disagreements over remuneration are just a symbol of wider change. First, the corporate governance community is growing. The GSK vote was only possible because institutions now taking a stance on governance issues joined older hands like Hermes. That can only be a positive development.

Secondly, governance attitudes are changing. Hermes has long argued that governance is not a box-ticking, compliance issue, but a matter of good ownership, and of value protection and value enhancement. This is a viewpoint which happily is gaining ground. The International Corporate Governance Network (ICGN) recently approved a document on the responsibilities of institutional investors, which highlights the obligations which come with ownership. A vote is an asset like any other, and institutions have a fiduciary duty to their clients to make best use of that asset, the ICGN suggests. This reflects the thinking which underlies the voting obligations of institutions under ERISA in the US and under Myners in the UK.

The ICGN goes further, and discusses not just institutional duties around the use of the vote, but also duties to be good owners of investee companies in other ways. In particular, it highlights the duty to intervene at underperforming companies where doing so may help preserve or enhance value for clients. This again reflects thinking in the UK's Myners report on pension funds and reflects studies which show that companies with good owners tend to perform better. These studies are highlighted in Hermes' own brief review of the evidence, The Value of Corporate Governance (available at

There is an international trend to recognize these greater obligations of institutional investors. In the US, the SEC has obliged mutual funds to disclose their voting records. The hope is that transparency will mitigate the conflicts which some fund managers face and so ensure that governance decisions can be taken with only clients' interests in mind. These issues are also captured to some extent in the EU's Action Plan.

And from a purely UK perspective, a strident debate marked the publication of the Higgs Review of the Role and Effectiveness of Non-executive Directors. This debate was an articulation of the lack of confidence felt by many company directors in the ability and willingness of institutions to move away from the tick-the-box mentality that many have been prey to. The debate became focused on the phrase 'comply or explain', with many suggesting that this will become a 'comply or else' (or some other play on words) model, principally because institutions do not wish to invest in the resources to listen to and understand explanations and so enter into debate with companies on why it is that they are not compliant with specific terms of the Combined Code.

This fear on the part of corporate directors has been reflected in the redrafted Combined Code which a hastily-assembled Financial Reporting Council committee produced. This explicitly emphasises the need for institutions to spend time and effort seeking to understand the unique qualities of individual companies: "it is important that those concerned with the evaluation of governance should do so with common sense in order to promote partnership and trust, based on mutual understanding. They should pay due regard to companies' individual circumstances and bear in mind in particular the size and complexity of the company and the nature of the risks and challenges it faces."

Those directors who have called so strongly for greater thought by institutional investors can be expected to ensure that their own pension funds fulfil and perhaps exceed these strictures, and that their own boards are available for discussion of the value of the explanations they have provided.


There is a new mood spreading through the investment world. Initially this has affected specific debates on pay structures at individual firms. But as it spreads wider it is beginning to affect the duty that institutions have to understand and involve themselves fully in the governance of the companies in which they invest on their clients' behalfs. Among other things, the new mood will require more institutions to hire further staff and to involve themselves more deeply with investee companies facing problems. Other institutions must now rise to this challenge.

Hermes Investments Management
Paul Lee
Lloyds Chambers
1 Portsoken St
London, E1 8HZ
Tel: +44 20 7680 2371
Fax: +44 20 7680 2563