top stories

by Peter Atrill 28 Mar 2006 Diploma in Financial Management Relevant to Module B

Much attention has been directed towards corporate governance issues in recent years. This has been prompted by a variety of factors including poor corporate performance, accounting scandals, and allegations of excessive compensation for directors.

The main focus of this attention has been towards developing a framework of rules for the management of companies listed on the London Stock Exchange. While such rules are important, there are many who take the view that it is also important for those who own the companies to play their part by actively monitoring and controlling the behaviour of directors. In this article, I identify the main shareholders of listed companies and discuss their role in establishing good corporate governance. I also consider why there has been greater shareholder activism in recent years.

Who are the main shareholders?

Figure 1 on page 15 provides an analysis of the ownership of shares, by market value, in UK listed companies at the end of 2004. It shows that large financial institutions such as insurance companies, banks, pension funds, unit trusts and investment trusts, are now the most important investors in shares listed on the London Stock Exchange. These institutions have increased their hold on the ownership of Stock Exchange listed shares over time, while the proportion of listed shares held directly by individuals has decreased. The proportion of shares (by market value) owned by various financial institutions is now around 52% of the total market value of the Stock Exchange.

This concentration of ownership of listed shares means that financial institutions have enormous voting power and, as a result, the potential to exercise significant influence over the way in which Stock Exchange companies are directed and controlled. In the past, however, they have been reluctant to exercise this power and have been criticised for being too passive and for allowing the directors of companies too much independence. Most financial institutions have chosen to take a non-interventionist approach and have preferred to confine their investment activities to determining whether to buy, hold or sell shares in particular companies. They appear to have taken the view that the costs of actively monitoring directors and trying to influence their decisions are too high in relation to the likely benefits. It is also worth pointing out that these costs are borne by the particular financial institution undertaking the monitoring whereas the benefits are spread across all of the company's shareholders. (This phenomenon is often referred to as the 'free-rider' problem.)

Waking the sleeping giants

In recent years, however, financial institutions have begun to play a more active role in corporate governance. More time is being invested in monitoring the actions of directors and in engaging with the directors over key decisions. This change of heart has occurred for a variety of reasons. One important reason is that the increasing concentration of share ownership has made it more difficult for financial institutions to simply walk away from an investment in a poorly-performing company by selling its shares. A substantial number of shares are often held and so a decision to sell can have a significant impact on the market price, leading to heavy losses.

A further reason why it may be difficult to disinvest is that a company's shares may be included in a stock market index (such as the FTSE100 or FTSE250). Certain types of financial institutions, such as investment trusts or unit trusts, may offer investments that are designed to 'track' the particular index and so they become locked into a company's shares in order to reflect the index. In both situations outlined, therefore, a financial institution may have little choice but to stick with the shares held and try to improve performance by seeking to influence the actions and decisions of the directors.

It is also worth mentioning that financial institutions have experienced much greater competitive pressures in recent years. There have been increasing demands from clients for them to demonstrate their investment skills, and thereby justify their fees, by either outperforming benchmarks or beating the performance of similar financial institutions. These increased competitive pressures may be due, at least in part, to the fact that economic conditions have not favoured investors in recent years; they have experienced a period of relatively low stock market returns. Whatever the reason, the increased pressure to enhance the wealth of their clients has led financial institutions, in turn, to become less tolerant towards underperforming boards of directors.

The regulatory environment has also favoured greater activism on the part of financial institutions. The effect of new rules concerning the way in which companies should be governed has provided financial institutions with greater opportunity to exert pressure on companies. A key element of these new rules is the Combined Code, which sets out best practice for listed companies. While the recommendations are not binding, it is difficult for companies to resist calls for adherence to the Code.

Financial institutions are likely to take an interest in a wide range of issues affecting a company. Some of the more important issues that are likely to attract their attention include:

• objectives and strategies adopted
• trading performance
• internal controls
• policies regarding mergers and acquisition
• major investments and disinvestments
• adherence to the recommendations of the Combined Code
• corporate social responsibilities
• directors' incentives schemes and remuneration.

This is not an exhaustive list. As shareholders, and therefore owners, of a company, anything that might have an impact on their wealth should be a matter of concern.

Forms of activism

It is important to be clear as to what is meant by the term 'shareholder activism' as it can take various forms. In its simplest form it involves taking a more active role in voting for or against the resolutions put before the annual general meeting or any extraordinary general meeting of the company. This form of activism is seen by the UK government as being vital to good corporate governance. Shareholders have been urged to exercise their rights to vote and the government is keen to see much higher levels of participation than currently exists. In the past, financial institutions have often indicated their dissent by abstaining from a vote rather than outright opposition to a resolution. There is some evidence, however, that they are now more prepared to use their vote to oppose resolutions of the board of directors.

Much of the evidence available remains anecdotal rather than based on systematic research. One such example concerns the recent merger of two large media companies - Carlton and Granada. The chairman of Carlton, Michael Green, was nominated as independent chairman of the combined company but some financial institutions felt he was unsuitable and succeeded in opposing his appointment by voting against the resolution. A particularly rich source of contention between shareholders and directors concerns directors' remuneration and there have been several shareholder revolts over this issue. One fairly recent example involved the shareholders of the pharmaceutical giant GlaxoSmithKline plc voting down the proposed £23m pay package of the chief executive, Jean-Pierre Garnier.

Although the examples mentioned above are widely reported and catch the newspaper headlines, they do not happen very often. Nevertheless, the benefits for shareholders of flexing their muscles and voting against resolutions put forward by the directors may go beyond their immediate, intended objective: other boards of directors may take note of shareholder dissatisfaction and adjust their behaviour in order to avoid a similar fate. The cost of voting need not be high as there are specialist agencies which offer research and advice to financial institutions on how their votes should be cast.

Another form of activism involves meetings and discussions between representatives of a particular financial institution and the board of directors of a company. This requires a fairly high degree of involvement with the company and some of the larger financial institutions have dedicated teams for this purpose. This can, therefore, be a costly exercise. Below is an extract from the website of one major financial institution that is committed to this form of activism and which gives an insight to the approach taken.

Jupiter International Group plc, a major provider of unit trusts and investment trusts, believes that, when monitoring investments:

'An important part of the process is the dialogue (usually private) between institutional shareholders and the companies in which it invests. As such, its fund managers and analysts host and attend regular meetings with the management of the investee companies, with a high percentage of companies being seen twice a year where corporate strategy, performance and other management issues are discussed.' (Source: www.jupiteronline.co.uk)

Such meetings can be a useful mechanism for exchanging views and for gaining a greater understanding of the needs and motivations of each party. This may help to pre-empt public spats between the board of directors and financial institutions, which is rarely the best way to resolve issues.

The final form of activism involves intervention in the affairs of the company. This, however, can be very costly, depending on the nature of the problem. Where strategic and operational issues raise concerns, intervention can be very costly indeed. Identifying the weaknesses and problems relating to these issues requires a detailed understanding of the nature of its business. This implies close monitoring by relevant experts who are able to analyse the issues and then propose feasible solutions. The costs associated with such an exercise would normally be prohibitive, although the costs may be mitigated through some kind of collective action by financial institutions. Not all forms of intervention in the affairs of a company, however, need be costly. Where, for example, there are corporate governance issues to be addressed, such as a failure to adhere to the recommendations of the Combined Code, a financial institution may nominate individuals for appointment as non-executive directors who can be relied upon to ensure that necessary changes are made. This should involve relatively little cost for the financial institution.

The future of shareholder activism

The rise of shareholder activism raises two important questions that have yet to be answered. First, is it simply a passing phenomenon? It is no coincidence that shareholder activism has taken root during a period when stock market returns have been fairly low. There is a risk that financial institutions will become less active and less vigilant in monitoring companies when stock market returns improve. Second, does shareholder activism really make a difference to corporate performance? The research on this topic so far has been fairly sparse but early research in the US is not encouraging for those who urge financial institutions to take a more active approach. We may have to wait some while, however, for clear answers to these questions.

Conclusion

In this article we have seen that financial institutions are the major investors in the London Stock Exchange. In the past, they have adopted a non-interventionist approach to company issues but a number of factors have combined to stir these financial giants from their slumber. There is a growing body of evidence to suggest that they are now becoming more active in voting and in engaging with the boards of directors of investee companies. However, the costs of engaging with companies should not be underestimated and must be weighed against the potential benefits. At this point, it is too early to say whether these financial institutions will become increasingly active over time or whether activism is of real benefit to them.

Peter Atrill is examiner for Module B of the Diploma in Financial Management

Back to top