The banking Royal Commission has shown the relationship between management and the investment community must be held to higher standards.
Aligning business and community interests
Are we fulfilling our duty to consider all stakeholders as well as shareholders?
Looking back over the past year, two concepts have dominated the lexicon regarding business performance. Namely, “trust” and “culture”. The loss of the former — and the importance of the latter — have been highlighted by the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry.
Over the past four decades, there has been a profound shift in the structure of savings and investment markets. The dominant force at play has been the institutionalisation of savings.
In 1980, Fidelity in the US became the first investment organisation managing in excess of US$1 billion. Today, the mutual fund industry and other collective investment vehicles are measured in the trillions.
In Australia, the introduction of award superannuation in the late 1980s, which morphed into compulsory superannuation in the early 1990s, has resulted in the Australian savings market becoming the fourth-largest institutionalised investment pool globally. The Association of Superannuation Funds of Australia (ASFA) reports that at the end of the September 2018 quarter, superannuation assets totalled $2.8 trillion. This includes an 8.8 per cent increase in total superannuation assets over the previous 12 months.
The main impact of this structural shift in how community savings are invested has been the proliferation of intermediaries and agents, interposed between principals and the markets in which their capital is invested.
The range of intermediaries include trustees of superannuation funds, investment managers, asset consultants, investment newsletters offering portfolio services, research houses, financial planners and dealer groups, ratings agencies, platform providers, as well as proxy advisors.
A matter of trust
I transitioned from an executive career in financial services to a portfolio of directorships some 18 years ago, and was struck by the reference by most people around the board table to investment institutions as the “shareholders”. However, given my intimate understanding of this evolving and complex investment chain, I viewed them as agents of the real owners. Moreover, industry funds and their trustees are much closer to the “mums and dads” whose money is pooled in such structures than the investment managers whose services they utilise. Accordingly, it has been industry funds that have shaped the agenda to incorporate environmental, social and governance (ESG) considerations into the investment process. Yet many investment managers have described such factors as being “non-financial”. The banking Royal Commission has exposed the fallacy of this thinking.
Perhaps one of the strongest conclusions to be drawn from the Royal Commission is the extent to which remuneration and incentive arrangements, in particular, have driven much of the misconduct within financial institutions.
It is my contention that the “elephant in the room” in terms of business regaining community trust is executive remuneration. It is not just the quantum that many in the community find it difficult to perceive as justified. More significantly, it is the apparent lack of correlation between bad performance and incentive outcomes. This lack of clear accountability for poor performance reflects poorly on boards as it is within their jurisdiction.
The intermediation of savings has had a profound impact on risk consideration in the investment chain. Principals are concerned about the return of capital as much as the return on capital. However, agents are primarily concerned about their business risk, namely winning or losing transactions or mandates. This leads to a focus on relative performance. Such behaviour, which is rational from the agents’ perspective, leads to and exacerbates so-called “short termism”.
Institutional investors and corporate management are effectively in an ‘unholy alliance’ based on mutual interest.
Investment managers are in an industry in which their relative investment returns, compared with their peers or their benchmark, usually an index, determine their business success. Their time horizon for investments is rarely much longer than 12 months and can be even shorter given the risk of not winning or losing mandates. Thus, it is rational for them to want the companies in which they invest to perform well over this relatively short time horizon. Performance fees are not uncommon in the investment industry so, naturally, incentivising company executives is accepted and even encouraged.
Institutional investors and corporate management are effectively in an “unholy alliance” based on mutual interest. This caused the focus of management to shift from “working for customers” to “working for shareholders”. Boards have aided and abetted this by narrowly interpreting directors’ duties as being owed to shareholders. Further, evidence of this is the proliferation of debt-funded share buy-backs, which will benefit both executives and shareholders, but only in the short term.
The potential moral hazard this creates is exacerbated by investment institutions imputing, or even imposing, a framework that is appropriate in their own industry on their investee companies — notably “total relative shareholder returns”. Financial analysis is their strong suit whilst real industry knowledge is often lacking.
However, this approach does not transpose well to the real world, particularly in Australia where many industries are effective oligopolies. Moreover, senior executives do not place much value on long-term incentives tied explicitly to something they cannot control. Consequently, they place more weight on their fixed remuneration and short-term incentives. Given this reality, it is critical that boards do not allow the setting of short-term incentives (STIs) to be gamed and also exercise their discretion to ensure that there is a stronger link between performance and the vesting of STIs.
Some intermediaries are designated as fiduciaries. Although many are not, even though their services may be utilised by fiduciaries, this has a significant impact on the outcomes for investors. In recognition of this — and to better reflect the importance of ESG considerations — the International Corporate Governance Network (ICGN) approved the ICGN Guidance of Investor Fiduciary Duties in June 2018, consistent with its objective of promoting better stewardship by investors.
Another consequence of the changed structure of the investment chain is the challenge it creates for the regulatory framework. Historically, regulators have focussed on systems and processes as symbols of good governance. Too often, this leads to a tick-the-box approach. Such a compliance culture does not axiomatically equate to effective risk management. It is people and culture, reflected in their behaviour, which provides the strongest foundation for protecting investors.
Exposures and disclosures
The current review of the ASX Corporate Governance Principles and Recommendations is occurring against a background of disclosures of corporate misconduct. This had led to a focus on the notional social licence to operate and for calls of an explicit recognition of this in the guidelines. This is not necessary and, worse, would be a retrograde step. The Corporations Act 2001 (Cth) sets out directors’ duties clearly, namely that they: “must exercise their powers and discharge their duties in good faith in the best interests of the corporation”. This identifies the corporation as more than just its shareholders.
The apparent tension between this “shareholder primacy” and a “social obligation” perspective can be readily resolved, as they should not be in conflict. What is required is for boards to adopt an objective to create value for shareholders over the long term. Moreover, they need to distinguish between those shareholders who act as “owners” and those who behave as “renters”. Industry funds and many self-managed super funds (SMSFs) fall into the former category, whereas day traders, algorithmic traders, most hedge funds and traditional active investment managers fall into the latter. Long-term value cannot be delivered without appropriate consideration of employees, customers, suppliers, the community and environmental impact.
Aligning incentive arrangements to a longer time horizon will be critical in aligning the interests of executes with owners. Three years for the vesting of long-term investments (LTIs) should not be regarded by boards as long-term, even though this is usually acceptable to institutional investors.
Until business regains the trust of the community it risks increasingly prescriptive regulation. This would be a bad outcome for Australia. Such a compliance focus would inevitably lead to a more cautious approach by boards reinforcing an already conservative culture. Risk taking and innovation, which are the source of growth, would likely be stifled. Moreover, business would have little influence over public policy creating the risk of harmful populism. Making the case for innovation, research and development and LTI projects will be made easier if there is a stronger alignment between management and investors.
Getting with the program
Boards need to improve their engagement with asset owners, such as the Australian Council of Superannuation Investors Limited and industry funds in Australia. Participating in ICGN conferences can play a useful role in developing a deeper understanding of the perspectives of investors with a longer time horizon. The members of ICGN represent the largest asset owners and investment managers globally with more than US$34 trillion of investible funds. In Australia, the two strikes rule is likely to move rapidly beyond using the vote on remuneration reports on occasions to express dissatisfaction about a company’s performance. Increasingly the asset owners will actively, and proactively, determine who will be the directors of their investee companies.
Regaining trust will require greater oversight of culture by boards. Good behaviour needs to be reinforced and bad behaviour held accountable. In this respect, there must be a focus on the overall health of the organisation. Loss of corporate reputation and the resultant diminution of brand equity can even be terminal. Corporate culture needs to be approached with the same board focus that has led to a strong safety culture improving workplace health and safety outcomes.
In this regard ensuring diversity on boards is critical. A board largely comprising eminent former CEOs and partners of professional firms, despite differences in skills and industry background, is unlikely to produce a sufficient diversity of perspectives. Moreover, the focus on improving gender diversity should not overshadow this important issue of diversity of perspective.
So, who on your board takes the customer viewpoint?
Charles Macek is chair of Australian-based energy efficiency and data monitoring company Vivid Technology, a member of the AICD Corporate Governance Committee and a member of the Unisuper Investment Committee. He will be speaking at the upcoming Australian Governance Summit, 4–5 March.
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