THOSE ACTIVIST FUND managers that have taken a lead in campaigning for improved corporate governance have now begun to broaden their influence by taking on mandates to advise other investors specifically on the corporate governance issues of companies in which they invest.
In June, Hermes, a pioneer in corporate governance and shareholder engagement, was appointed as adviser for all governance matters by the British Coal Staff Superannuation Scheme in relation to its £6 billion equity portfolio.
This new equity ownership service (EOS) involves Hermes providing ownership and corporate governance oversight, though the financial management of the fund’s assets will continue to be the task of other fund managers.
Insight Investment, the asset management arm of UK bank group HBOS, which has over £71.8 billion in assets under management, was appointed in July to provide a shareholder activism service on governance and corporate responsibility issues for UK medical research charity Wellcome Trust’s £3 billion UK FTSE 350 quoted equity portfolio.
Under the terms of the mandate, Insight will help develop and maintain the trust’s governance policy, pursue engagement with companies, and manage the voting of the trust’s shareholdings.
Such services could transform the way the UK pension fund industry approaches corporate governance, by bringing a new solidarity in the messages investors send to companies. Both Hermes and Insight Investment believe this trend of outsourcing will increasingly gain momentum.
Craig Mackenzie, head of investor responsibility at Insight Investment, argues that there still aren’t enough asset managers actively doing anything. “If you haven’t got the resources to install an activism unit, the easiest thing to do is buy an international guidance service such as the ISS service that delivers votes according to standard governance templates,” he says. “It isn’t valueless but we believe that if you really want to change an aspect of how a company is run, dialogue with directors is key. Template-driven voting isn’t often effective and irritates directors.”
Aside from institutional shareholders, other can pressure companies to improve corporate governance.
Peer pressure Corporations considering mergers, acquisitions, joint ventures and other large investments are paying more attention than ever to the corporate governance of companies which they are considering investing in.
“While much of the attention has focused on whether institutional investors are directly engaging with companies in emerging markets, I am not convinced that investor interest is the strongest driver for improving corporate governance,” says Rory Sullivan, director of investor responsibility at Insight Investment. “I suspect that the strongest pressures are actually coming from other companies – in particular down through the supply chain and through expectations that partners will meet certain standards of probity and governance.”
Mining, oil and gas companies from the developed markets for example, all have a big impact on developing countries and will consequently endeavour to transfer their corporate governance standards to all their overseas operations.
BP’s acquisition of a 2.2% stake in PetroChina in April 2000 caused a stir relating to PetroChina’s parent CNPC’s shareholding in an oil project in Sudan and involvement in pipeline construction in Tibet. Pressure groups urged BP to use its influence with PetroChina to stop the construction of the Sebei-Lanzhou gas pipeline through ethnic Tibetan areas and divest its 2.2% shareholding.
In a press release issued in response to a letter sent to BP by NGOs, the company defended its investment. “Although BP’s 2.2% stake allows us to influence joint ventures constructively we do not control or direct PetroChina,” it said. “We have been working to ensure that PetroChina is fully aware of the concerns expressed by your coalition with the aim of building a new consensus through dialogue.”
Insight Investment’s Mackenzie says: “BP has had conversations with other business partners in China about what international investors will be expecting. Part of the case that BP made to Sinopec for example, was that if Sinopec improves the quality of its governance, it will be a more attractive investment proposition for international investors. It is a clear-cut business case.”
Philip Armstrong, managing director of ENF Corporate Governance Advisory Services Limited, a division of South African corporate law advisers Edward Nathan & Friedland, says that cross-border alliances have been a big driving force raising and changing corporate governance standards in South Africa.
“Any South African company is perceived to carry greater risk as it is based in an emerging market but some of these companies are operating in markets that have more advanced corporate governance standards and these standards are cascading back into their South African operations,” he says.
Although this may be another triumph for corporate governance activists, it also provokes problems for developing countries that are struggling to keep up with advanced corporate governance attitudes.
“Transition economies are struggling due to the huge international demands being imposed on them by measures such as Basle II,” says Armstrong. “Combined with the fact that such markets are seen as high-risk areas of investment, even if they did adhere to all the demands, foreign investment would still be limited.”
Armstrong believes that it will be more a case of increasing marginalization than assimilation between corporate governance standards in emerging and developed markets in the future. “The willingness to increase corporate governance quality is there in a number of cases but I think the level of measures required in these markets is underestimated and other social issues tend to have obvious priority,” he says.
Forcing countries to adopt requirements from US and western Europe might not be compatible with the different ownership structures, social issues and business cultures.
Yet Korea has made notable advances in addressing board responsibilities, in particular increasing the role of outside directors and improving shareholder rights.
Korea Telecom, which ranks second in this year’s Euromoney corporate governance survey of emerging market companies, has been active in both these areas. It believes that its high ranking results from its plan to increase the ratio of outside directors from the current 60% to 67%. The chairman of the board is now an outside director and the audit committee consists of outside directors too. It has also adopted a cumulative voting system designed to give minority shareholders a bigger say in the election of directors.
“In Asia, most of the region’s investors – domestic and foreign – have traditionally been reluctant to express strong views on corporate governance issues, preferring instead to sell if the risks have become too great,” says Insight Investment’s Sullivan. “This is changing, driven by the desire to attract more foreign investors and, consequently, the need to ensure integrity of listed companies.”
Although corporate governance has become a global issue, there are still differences over various policies. The UK and the US concur on many aspects but on separating the role of chairman and chief executive they cannot agree. In the UK, 95% of the FTSE 350 adhere to the principle of separating the roles whereas 80% of the S&P500 combine them. Such divergences can only weaken the drive to install a global system of corporate governance standards.
And it’s not as if the US and the UK any longer have a particularly proud record of corporate governance.
Creditors’ concerns Corporate governance is not solely a concern of equity investors. Credit rating agencies, acting almost as a proxy for credit investors, can play an important part.
While Fitch Ratings, for example, has always taken aspects of corporate governance into account, in April this year it formalized a more systematic framework for reviewing governance practices that affect credit quality.
“After consulting market participants, we concluded that investors would rather see corporate governance formally incorporated into our credit rating methodology,” says Trevor Pitman, group managing director at Fitch corporate department.
In a report Fitch says that “in reflecting corporate governance within Fitch’s ratings process, the focus primarily will be on how weak practices can impair a company’s financial position with somewhat less focus on how strong practices might help to enhance credit quality”.
So those companies with exceptionally weak corporate governance might face a negative rating action but those with very strong corporate governance might merit a special mention but not necessarily an upgrade.
This asymmetry is derived, in part, from the low upside return but potentially high downside risk inherent in bonds. Fitch argues that while strong governance will help to promote timely repayment on an obligation generally, fundamental weaknesses in a company’s governance framework can potentially dissipate corporate assets or cashflows and leave bondholders vulnerable to significant losses.
Fitch is also sensitive to how its methods of corporate governance assessment might affect companies based in emerging markets. “As Fitch is a global ratings company, our methodology for assessing corporate governance is the same for companies in developed and emerging markets,” says Pitman. “However, it can be seen that certain elements of our criteria are more relevant for companies in emerging markets. For example, private ownership and complex group structures are common features in Russian and Turkish companies.”
National stock exchanges and indices have been instrumental in urging companies to demonstrate their commitment to global corporate governance standards. “In developing markets there is a division between companies that want domestic investment and companies that are pushing for foreign investment,” says Bob Monks, who founded Institutional Shareholder Services (ISS) and publishes his own website dedicated to information and opinion about global corporate governance. “In Brazil, for example, the Bovespa Novo Mercado listing has enabled companies to demonstrate to international investors that they are willing to conform to Anglo/US corporate governance codes.”
Linked to this, in July Bovespa became the first stock exchange worldwide to join the Global Compact entity linked to the UN, which aims to promote sustainability and social inclusion practices.
Corporate honesty, sustainability and social responsibility have become a great obsession of financial markets in recent years, especially since the spectacular failures of such companies as Enron and WorldCom. Many companies have now installed robust strategies to meet greater regulatory scrutiny, demonstrate high standards of corporate governance and promote the positive aspects of their agendas.
But has it all been worth the effort?
Companies are becoming increasingly concerned at the growing burden placed on them by investors’ demands for information on corporate responsibility and governance issues.
“One of the changes we have seen this year is that the attention has switched from what companies are doing about corporate governance to what investors can do about it,” says Colin Melvin, director of corporate governance at Hermes, the activist UK fund manager with about £45 billion ($82 billion) in assets under management.
Increasing access to information on corporate activity has armed investors with more power to influence companies’ behaviour. The Carbon Disclosure Project (CDP) for example, asks the largest FT500 Global Index companies for disclosure of investment-relevant information concerning their greenhouse gas emissions. Back in May 2002, the first cycle of the project was supported by just 35 institutional investors. By November 2003, the second cycle had received signatures from 95.
Additionally, responses from the FT500 Global Index companies rose sharply from 47% to 59%, indicating that respondents are aware of the increasing sense of urgency about climate risk and carbon finance. The second cycle responses also revealed that corporate climate strategies are becoming more coherent and comprehensive, with the number of banks reporting involvement in renewable energy initiatives more than doubling in the past year, for example.
“Investors are saying that climate change can impact shareholder value both positively and negatively, and the market needs information to assess and value the issue,” says James Cameron, chairman of CDP. “Companies are now acknowledging that they should communicate what they know to their investors or, at the very least, find out what they don’t know.”
Other environmental initiatives are attracting big names, such as Brazilian bank Banco Itaú, which ranked first in the 2003 Euromoney survey of corporate governance standards and was ranked eighth this year. It and Banco Itaú BBA both subscribed to the Equator Principles in August. This latest move by the bank will mean that it will have to observe the social and environmental policy of the International Finance Corporation in loan operations amounting to more than US$50 million.
“Over the last few years, it has become increasingly clear that environmental performance has significant implications for financial institutions,” says Silvio de Carvalho, executive director at Banco Itaú. “The key issues now for banks, investment funds and other financial institutions include financial, reputation and political risks associated with the environmental status and impact of their portfolios.”
Although some investors have become activists for good corporate governance, most still prefer to sell share holdings if they have corporate governance concerns rather than agitate for improvements. Few fund managers have the resources or inclination to investigate corporate governance issues in companies where they may have significant financial exposure but are holding only a small percentage of a company’s total market capitalization.
Winning ways South African gold explorer and developer Durban Roodepoort Deep Limited, which tops this year’s survey, believes its success lies equally in the better corporate governance systems in place as the personalities of the people running the company.
“Our success in the survey this year stems from the people that run the company as they all now have a logical understanding of why corporate governance is important,” says Ilja Graulich, head of investor relations at Durban Roodepoort. “With more transparent communication with shareholders and an annual evaluation of our policies and board members, if something should happen, there are enough drivers in place to deal with it quickly. If a person wants to abuse a system they will, so the personalities you attract are just as important as any policies or regulations that are in place.”
Despite the progress made in the quality of corporate governance in both primary and emerging markets, the biggest hurdle will be installing a universal standard. “Corporate governance is like psychotherapy. You can’t make someone go through with it unless they want to. The challenge now is persuading people, as it is as much an expression of culture as a regulatory issue,” says Bob Monks.
