Ch 6 Engagement & Stewardship

Question 1

What is engagement?

Answer 1

Engagement is the way in which investors put into effect their stewardship responsibilities in line with the Principles for Responsible Investment (PRI) principle 2.
(“We will be active owners and incorporate environmental, social and governance (ESG) issues into our ownership policies and
practices”).
It is often described as purposeful dialogue with
a specific objective in mind; that purpose will vary from engagement to engagement, but often relates to improving companies’ business practices, especially in relation to the management of ESG issues.

Question 2

What is stewardship?

Answer 2

Stewardship is the process of intervention to make sure that the value of the assets is enhanced over time, or at least does not deteriorate through neglect or mismanagement.
It can encompass the buying and selling of assets to maintain value within the fund as a whole, as well as acting as a good owner of assets.
Engagement is one aspect of good stewardship; it is the individual interventions in specific assets to preserve and/or enhance value.
In modern investment terms, this is the dialogue with the management and boards of investee companies and other assets.
Voting is a particular form of engagement. It is the most visible because public company annual general meetings (AGMs) are public events and many institutions now make their voting
actions public (some even ahead of the relevant meetings). However, by its nature it is formulaic because the nature of the resolutions on which shareholders vote is restricted by law.
Engagement is much broader than just voting.

Question 3

Engagement s focus on preserving and enhancing long-term value on behalf of the asset owner.

Engagement can encompass the full range of issues that affect the long-term value of a business:

Answer 3

▶ strategy;
▶ capital structure;
▶ operational performance and delivery;
▶ risk management;
▶ pay; and
▶ corporate governance.

Question 4

the Principles for Responsible Investment (PRI) highlighted three ESG engagement dynamics that it believes create value:

Answer 4

▶ communicative dynamics (the exchange of information);
▶ learning dynamics (enhancing knowledge); and
▶ political dynamics (building relationships).

Question 5

The Financial Reporting Council, in the Code, repeatedly discusses the need for signatories to disclose the _________ of their engagement work as well as the concrete benefits from stewardship activity for clients and beneficiaries.

What word was used repeatedly in the code for
‘delivery of objectives that benefit clients’.

Answer 5

OUTCOMES

The Code also repeatedly uses the word ‘outcome’ to describe ‘delivery of objectives that benefit clients’.

Question 6

The contrast between monitoring and engagement dialogues

What are monitoring dialogues?

What are engagement dialogues?

Answer 6

Monitoring dialogues are the conversations between investors and management to more fully understand performance and opportunity, which are typified by detailed questions from the investor and which are likely to inform buy, sell or hold investment decisions.

Engagement dialogues are conversations between investors and any level of the investee entity (including non-executive directors) featuring a two-way sharing of perspectives, such that the investors express their position on key issues, and in particular, highlight any concerns that they may have.
This two-way dialogue and expression of clear positions is necessary for engagement to deliver on its intended outcomes, of changed company behaviours and so on.

Question 7

A series of other characteristics of effective engagement that are of the ‘characteristics of high-quality delivery’:

Answer 7

1. It is set in an appropriate context of long-term ownership and has a focus on long-term value preservation and creation, so that the engagement is aligned with the investment thesis;
2. It is framed by a close understanding of the nature of the company and the drivers of its business model and long-term opportunity to prosper;
3. It recognizes that change is a process and that, while haste may at times be necessary, change should not be inappropriately rushed;
4. It employs consistent, direct and honest messages and dialogue;
5. It is appropriately resourced so that it can be delivered professionally in the context of a full understanding of the individual company;
6. It uses resources efficiently so that engagement coverage is as broad as possible whilst using all the tools available, including collective engagement; and
7. It involves reflection so that lessons are learned in order to improve future engagement activity.

Question 8

AGM and EGM

Answer 8

annual general meetings (AGMs).

extraordinary general meetings (EGMs).

Question 9

Which report ushered in a new era
of shareholder engagement?

FRC

FSA

FCA

Answer 9

The Walker Report ushered in a new era of shareholder engagement.
The report formally called for the

Financial Reporting Council (FRC) to issue a stewardship code to provide a framework for shareholder engagement, and that this code was to be reinforced by a

Financial Services Authority (FSA – now the

Financial Conduct Authority (FCA)) requirement that any registered
fund manager must make a statement as to whether and how it approached its principles.

Question 10

The 2010 Stewardship Code had seven principles:

Answer 10

Institutional investors should:
1. publicly disclose their policy on how they will discharge their stewardship responsibilities;

2. have a robust policy on managing conflicts of interest in relation to stewardship and this policy should be publicly disclosed;
3. monitor their investee companies;
4. establish clear guidelines on when and how they will escalate their activities as a method of protecting and enhancing shareholder value;
5. be willing to act collectively with other investors where appropriate;
6. have a clear policy on voting and disclosure of voting activity; and
7. report periodically on their stewardship and voting activities.

Question 11

The principles of all the codes around the world

Answer 11

The principles of all the codes around the world are remarkably similar.
Typically there are six or seven principles, with the first often requiring investors to have a public policy regarding stewardship,
and the last noting the need for honest and open reporting of stewardship activities.
The main body of the principles between these two usually call for:

1. regular monitoring of investee companies;
2. active engagement where relevant (sometimes termed “escalation”, or sometimes escalation is deemed worthy of a separate principle of its own); and
3. thoughtfully intelligent voting.

Question 12

The two principles that are sometimes but not always present are

Answer 12

The two principles that are sometimes but not always present (though they appear in the UK Code in both its former and current iterations) require:

I. investors to manage their conflicts of interest regarding stewardship matters; and

II. the escalation of stewardship activity to include a willingness to act collectively with other institutional
investors.

Question 13

ENGAGEMENT STYLES

Answer 13

top-down and bottom-up

Most investment houses mix the two, though company-focused, bottom-up engagement fits most naturally with active investment approaches, particularly those with concentrated portfolios, whereas issues-based, top-down engagement tends to align more closely with passive or otherwise broadly diversified investment portfolios.

issue-based and company-focused
Passive investors, and others with broadly diversified portfolios, typically start with an issue, whether identified by the team from news or broader analysis, or through a screening or other research provider, and seek to engage with all the companies impacted by that issue (which may be a sector as a whole, or broader than
this). Usually the starting point is a letter written to all those impacted, which is then followed up by dialogue.

Active investors, particularly those with focused portfolios, start with the company itself and its business issues and develop a tailored engagement approach cutting across a range of issues, often with the investment teams taking a leading role. Companies selected for this approach are often identified from investment underperformers or ones that trigger other financial or ESG metrics. The starting point is typically to seek a direct discussion with senior management and then the board.

Question 14

Five of these are types of individual engagement
(engagement by a single investment institution):

Answer 14

1. generic letter: these are broad communications across a swathe of investment holdings;
2. tailored letter: these are more targeted and can cover a range of topics at varied levels of detail;
3. ‘housekeeping’ engagement: this is annual dialogue to help maintain and enhance a relationship with a company, but with only limited objectives;
4. active private engagement: targeted and specific engagement; and
5. active public engagement: engagement deliberately made public by the institution.

Question 15

The others are forms of collaborative engagement (where an institution works with one or more others):

Answer 15

1. informal discussions: institutions discuss views of particular corporate situations;
2. collaborative campaigns: collaborative letter-writing or market/sector-wide campaigns;
3. follow-on dialogue: company engagement dialogue led by one or some investors in follow-up to a broader group letter or expression of views;
4. soliciting support: solicitation of broader support for formal publicly stated targets (e.g. ‘vote no’ campaigns, or support for a shareholder resolution);
5. group meeting(s): one-off group meeting (or a series of meetings) with a company, followed up either with individual investor reflections on the discussion or with a co-signed letter;
6. collective engagement: a formal coalition of investors with a clear objective, typically working over time and with a coordinating body; and
7. concert party: formal agreement, in any form, with concrete objectives and agreed steps (e.g. collectively proposing a shareholder resolution or agreeing how to vote on a particular matter).

Question 16

Two different forms of necessary prioritization:

Answer 16

1. identifying which company in a portfolio is most in need of engagement; and
2. determining which engagement issues should be prioritized in the dialogue between the investor and company (if change is to be delivered effectively, it is impossible for an investor to raise every possible concern with the company – not least as they risk creating confusion as to what issues the investor believes are most in need of
   attention).

Question 17

The behavioral challenges in working as part of investor coalitions are significant. These include:

Answer 17

▶ the challenge of reaching consensus;
▶ conflicts of interest; and
▶ competition.
Investors will often agree that there is a problem at a company, or at least that they share concerns about
a company. But discussions about collective action often fail because the investors are unable to reach any
consensus about what might need to change at the company to address the problem. Having said that,
agreement is not always possible between investors even on the nature of the problem. Companies sometimes
rightly feel that they receive such a range of views from investors that responding to them all is impossible
(though some investors often feel this is an excuse rather than a reason for inaction).

Question 18

a helpful list of escalation measures that can be considered to advance engagements. While

Answer 18

the first three might be seen by many engagement professionals as part of a standard set of tools in normal dialogue with companies,
the subsequent four will certainly be recognised as forms of escalation:

1. holding additional meetings with management specifically to discuss concerns;
2. expressing concerns through the company’s advisers;
3. meeting with the chair or other board members;
4. intervening jointly with other institutions on particular issues;
5. making a public statement in advance of general meetings;
6. submitting resolutions and speaking at general meetings; and
7. requesting a general meeting, in some cases proposing to change board membership.

Question 19

Additional methods used by some as part of their escalation models might include:

Answer 19

▶ writing a formal letter setting out concerns, usually following one of the above meetings, and typically to the chair; such letters are usually private, but may occasionally be leaked publicly if frustrations worsen (sometimes those leaks come from within the company, if there are internal individuals who are frustrated by a
lack of progress);
▶ seeking dialogue with other stakeholders, including regulators, banks, creditors, customers, suppliers, the workforce and non-governmental organisations (NGOs) (stakeholder dialogue is most typically a tool in European markets and is specifically referenced as important in the Shareholder Rights Directive II, but is
increasingly being used elsewhere as well);
▶ formally requesting a special audit of the company (a right for shareholders in certain countries, most notably Germany, to consider particular areas of concern);
▶ taking concerns public in the media or in some other form, not only as the code said in relation to AGMs or other general meetings;
▶ seeking governance improvements and/or damages through litigation, other legal remedies or arbitration; and
▶ formally adding the company to an exclusion list, or otherwise exiting or threatening to exit from the investment.

Question 20

The challenges around collective engagement are

Answer 20

the obvious ones of coordinating a potentially disparate group of separate investors, and trying to maintain a consistent perspective, or at least enough consistency of perspective, that the company receives a clear message from its investors in the key areas.

A number of investors are also concerned by the rules in particular markets around anti-competitive behavior or activities that abuse or exploit the market (such as those dealing with
acting in concert – where a number of separate investors work together to use their holdings as a single bloc).

Question 21

The vote is a key tool for the active investor, and any voting decision should be aligned with the investment thesis for the holding and any stewardship agenda that the institution has in relation to the company. Thus, for example:

If there are concerns about the capital structure and financial viability of the business
If there are concerns about the effectiveness or diversity of the board,

Worries about the independence or effectiveness of the audit process

Answer 21

▶investors need to pay close attention to votes in relation to dividends, share buybacks, share issuance or scope for further debt
burden.
▶ that needs to be reflected in voting decisions on director re-elections (and particularly in relation to the members of the nominations committee).
▶ should be taken into account when
voting on the reappointment of the auditor, its pay and the reappointment of members of the audit committee.

Question 22

One form of public engagement is putting forward a shareholder resolution

Answer 22

One form of public engagement is putting forward a shareholder resolution – a shareholder right in most jurisdictions, though the local law often restricts the nature of the resolution that can be proposed, as well as the size and period of shareholding that the proponents of the resolution must represent in order to hold the right. In many jurisdictions, the proposal of a resolution must be made public by the company;

but in the USA, where they are most common, they do not typically enter the public domain until the papers for the relevant AGM are published. Typically, this will be after the company has tried to exclude the resolution from the AGM agenda and sought a ruling from the Securities and Exchange Commission (SEC) as to whether this exclusion is permitted.

Proposing a shareholder resolution in the USA can therefore be the trigger for private engagement,
which may reach enough of a satisfactory conclusion for the investor to withdraw the resolution, and thus never coming to public attention.