Chapter 6: ENGAGEMENT AND STEWARDSHIP Flashcards
Stewardship is typically used as an overarching term encompassing the approach that investors take as active and involved owners of the companies and other entities in which they invest through voting and engagement.
Voting is one aspect of stewardship activity and tends to focus on corporate governance matters raised at shareholders’ meetings.
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 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.
Stewardship ought to be a consequence of investment.
By contrast,
activism
is typically a specialist form of such engagement and stewardship, where an investment institution initiates an investment with the intent of generating investment outperformance through driving change with respect to a company’s governance, capital allocation or business practices.
This chapter considers what we mean by stewardship and engagement, and covers the emergence of different styles of engagement.
We consider the framework of guidelines and rules that direct the approach to stewardship and discuss how engagement can be delivered most effectively.
WHAT IS STEWARDSHIP? WHAT IS ENGAGEMENT?
Stewardship is an odd word that does not translate easily, yet it is being picked up and used worldwide in relation to the responsibilities of institutional investors.
It is a term that has a long history. The word ‘steward’ is derived from two Old English words (‘stig’ and ‘weard’) describing a guardian of a home –
to protect the owner’s assets.
What in the Middle Ages was the home, in the 21st century is financial markets.
The steward is the representative of the owner, charged with acting in the owner’s interests, and delivering returns and long- term value from their assets.
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.
Given this 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, including:
▶ strategy; ▶ capital structure; ▶ operational performance and delivery; ▶ risk management; ▶ pay; and ▶ corporate governance.
ESG factors are clearly integral to these.
*** Opportunities and challenges offered by ESG developments need to be reflected in the business’s strategic thinking.
Equally, a full assessment of operational performance must encompass not only financials, but vital operational areas:
▶ highlighting the long-term health of the business, such as relations with the workforce;
▶ establishing a culture that favours long-term value creation;
▶ dealing openly and fairly with suppliers and customers; and
▶ having proper and effective environmental controls in place.
In a 2018 report,1 the PRI highlighted
*** three ESG engagement dynamics
that it believes create value:
▶ communicative dynamics (the exchange of information);
▶ learning dynamics (enhancing knowledge); and
▶ political dynamics (building relationships).
Developing these dynamics requires investors to go beyond the use of data derived from box-ticking.
Just as with ESG and investment performance, there is a growing body of evidence that engagement adds value to portfolios.
One of the earliest articles to provide a detailed academic analysis of engagement impact was Returns to shareholder activism: evidence from a clinical study of the Hermes UK Focus Fund”.
This looked at the early years of the Hermes Focus Fund business (which was launched in late 1998) and considered the first 41 investments by the fund.
It studied the internal records of Focus Fund team activities and considered their impact both in terms of
delivering change at the companies in question and in delivering returns for the investors.
The majority of stated objectives were achieved, with a 65% success rate overall, with greatest success in restructuring and financial policies, and slightly less so with regard to board change.
Ironically perhaps, the lowest success rate was found in areas where shareholder engagement occurs more frequently, with only 25% of the remuneration policy changes sought achieved and only 44% of the sought improvements to investor relations.
At the time, the overall performance of the fund was 4.9% net of fees a year in excess of the FTSE All- Share Performance,
90% of this excess return being estimated as due to activist outcomes.
In Active ownership a different (anonymous) fund manager’s engagement record was studied in depth, looking at the years 1999–2009.
This study considered less activist investing and more what would now be considered standard ESG engagement and stewardship.
One benefit of studying this style of engagement is that the number of cases covered in the study are substantial: even though it considered only US activity by the fund manager, it covered more than 2,000 engagements, involving over 600 investee companies, and had an overall success rate of 18%
The core finding of this study was clear: that successful engagement activity was followed by positive abnormal financial returns.
For example, for successes in climate change engagements over the study period, the
excess return in the year following engagement was more than 10%, and nearly 9% for successful corporate governance engagements.
Typically, the time between initial engagement and success was 1.5 years, with two or three engagements being required.
On average, ESG engagement generated an abnormal return of 2.3% in the year after the initial engagement, rising to 7.1% for successful engagements and with no adverse response to unsuccessful engagement.
A more recent additional study finds that ESG engagement leads to a
***reduction in downside risk and that the effect is stronger the more successful the engagement is.
The effects are strongest in relation to governance (which also counts for the majority of engagement cases) and then for social issues (so long as these are also associated with work on governance).
Engagement – if carried out well, so that it is focused on material and relevant issues and pursued with persistence – works.
Engaged companies change their behaviours against ESG factors, and this leads to increased value.
Engagement also works, often, to further inform investment analysis and fill out an investor’s understanding of the potential for a business model to adapt to a changing business environment and evolving expectations,
and of the willingness of a particular management team and board to strategically address these challenges.
Thus engagement for many is a crucial part of active investment decision-making.
WHY ENGAGEMENT?
Explain why engagement is considered beneficial and its relationship with fiduciary duty.
Engagement helps investee companies to understand their investors’ (and potential investors’) expectations, allowing them to provide relevant information.
It also enables companies to explain how their approach to sustainability relates to their broader business strategy and can provide an opportunity for companies to comment on ratings or scores driven by templates that they feel do not reflect the complexity of an issue.
And clearly, engagement allows investors to work closely with an investee over time on specific governance, social or environmental issues that the investor regards as posing a downside risk to the business.
By working with companies’ management – either individually or collectively – investment firms are able to influence companies to adopt better ESG practices, or at least to relinquish poor practices.
The Investor Forum –
a UK group set up to facilitate collective dialogue between investors and investees –
describes engagement as
“active dialogue with a specific and targeted objective…the underlying aim…should always be to preserve and enhance the value of assets”.
In their 2019 white paper, Defining stewardship and engagement”, the Investor Forum provides a framework for understanding the nature and key elements of stewardship.
Not least by defining stewardship in terms of assets with which an organisation has been entrusted, this deliberately
***frames stewardship within the context of fiduciary duty – the duty held by any party holding assets for another.
***Trustees (of pension funds or other assets) and directors fully understand that they are fiduciaries because they are charged with caring for assets on behalf of others.
Because they are also entrusted with assets, similar fiduciary duties apply to investment institutions as well.
Stewardship is one aspect of delivering on those duties.
Particularly, key in this analysis is the contrast that it draws between monitoring and engagement dialogues.
As the paper articulates it, 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.
In contrast, 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.
If engagement is to be effective in generating change outcomes, it requires that a clear objective has been set from the start.
As well as this need for clear objectives, focused on affecting change, the paper also identifies a series of other characteristics of ***effective engagement.
These are a gathering of the ‘characteristics of high-quality delivery’ set out in Table 6.1 above, and require that 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;
▶ 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;
▶ recognises that change is a process and that, while haste may at times be necessary, ***change should not be inappropriately rushed;
▶ employs consistent, direct and honest messages and dialogue;
▶ is appropriately resourced so that it can be delivered professionally in the context of a full understanding of the individual company;
▶ uses resources efficiently so that engagement coverage is as broad as possible whilst using all the tools available, including collective engagement; and
▶ involves reflection so that lessons are learned in order to improve future engagement activity.
These characteristics are explored through the case studies and wider discussion below.
Engagement in practice
Some examples of how this form of process can influence companies to adopt improved ESG practices are described in this section.
Examples of engagement in practice
A PRI case study describes Boston Common Asset Management’s long-term engagement with VF Corporation (VF Corp) around the water risks in its cotton and leather supply chains.
This multi- year engagement – during which Boston Common submitted and then withdrew a shareholder resolution (in response to the company’s commitment to address the issue) –
saw VF Corp improve relevant reporting, undertake material risk assessment and sign up to good practice standards in the Better Cotton Initiative.
Hermes EOS (Equity Ownership Services)’s engagement with Siam Cement
has seen that company improve from a level one company (the lowest score) to level three as rated by the Transition Pathway Initiative (an asset-owner led initiative that assesses companies’ preparation for the transition to a low carbon economy).
In early 2018, the investment firm met senior management to discuss its 2020 emissions targets.
It then held a TCFD (Task Force on Climate-related Financial Disclosures) workshop with senior executives at Siam Cement to share industry best practice and to encourage the company to improve assessment of physical risks of its assets, take part in industry collaboration and establish a group-wide climate governance mechanism.
The company has now committed to the Paris Agreement’s global temperature limitation goal, extended its scenario planning and improved its governance and business management around climate.
In 2018, the Investor Forum worked with its members to address concerns around Imperial Brands’ strategic direction, operational execution and disclosures.
The chair engaged:
“rapidly and constructively …announcing a disposal programme, enhancing its communications on its approach to Next Generation Products and implementing changes to segmental reporting at the full year results”.
There are also situations where engagement (or at least some form of stewardship) is required – when an investor must take a view.
These could be corporate actions, such as share issuances in which the investor can choose to participate or not, or proposed takeovers where the investor must decide whether to sell up or, if it is permitted, to hold on to their shares.
For most investors, some dialogue with the company will be needed before reaching the relevant conclusion.
Most investors now regard the vote as a client asset like any other, and thus as something to be considered carefully and exercised with due thought.
Voting comes around annually, at the annual general meeting (AGM), and occasionally in between at special meetings, in most countries called extraordinary general meetings (EGMs).
In addition to voting to receive the report and accounts, the issues considered at each meeting depend on local law, but are often fundamental issues about the structure of the board, audit and oversight, executive pay and the capital structure of the company.
Not considering such issues with due care can clearly be seen to be a failure of fiduciary duty,
and due care will often require active dialogue with the company in order to understand the issues and express any concerns and perspectives.
Another driver for investors to act as good stewards is the growing expectations enshrined in codes, standards and regulations.
CODES AND STANDARDS
6.1.3
Explain the main principles and requirements of stewardship codes as they apply to institutional asset management firms:
UK Walker Review (2009) and Stewardship Code (2020);
US Employee Retirement Income Security Act (ERISA) guidelines;
EU European Fund and Asset Management Association (EFAMA) Stewardship Code.
Regulators are convinced that engagement adds value, not just within investment portfolios but for markets as a whole.
In his powerful 2009 report on the financial crisis, Sir David Walker stated:
“Before the recent crisis phase there appears to have been a widespread acquiescence by institutional investors and the market in the gearing up of the balance sheets of banks … as a means of boosting returns on equity”.
“The limited institutional efforts at engagement with several UK banks appear to have had little impact in restraining management before the recent crisis phase”.
cool
Regulatory interest in stewardship has grown from the disappointment of the financial crisis.
As an adjunct to the institutional investor soul-searching that followed the financial crisis, 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.
Following consultation, in 2010 the FRC issued the UK’s first stewardship code – largely unchanged from the existing
Statement of Principles on the Responsibilities of Institutional Shareholders and Agents
issued by the Institutional Shareholders Committee
(dated 2005, but itself built upon a 1991 document,
The Responsibilities of Institutional Shareholders in the UK).
Industry best practice had not delivered in the run-up to the financial crisis, but a code with regulatory backing was thought to likely have greater force.
Industry acceptance of the code was relatively rapid, particularly among fund managers.
The UK Code went through a further iteration in 2012,
clarifying the distinction between the roles of asset owners (pension funds and the like) and their fund managers and other agents.
While some of the largest pension funds may seek to carry out stewardship activities themselves, most delegate this role, either by a specific contract or
as part of their fund management services.
Thus, the role of most asset owners is overseeing, challenging and assessing the stewardship activities of their service providers.
The UK model has been followed around the world, and at the time of writing, there are now stewardship codes in 20 markets, either developed by stock exchanges or regulators, or by investor bodies themselves keen to advance best practice.
Among these are:
▶ Global – ICGN Global Stewardship Principles.
▶ Europe – European Fund and Asset Management Association Stewardship Code 2018.
▶ Hong Kong – Securities and Futures Commission Principles of Responsible Ownership 2016.
▶ Japan – Financial Services Agency Principles for Responsible Institutional Investors 2017.
▶ USA – Investor Stewardship Group Stewardship Principles.
Code revisions 2020
The UK Stewardship Code went through a more fundamental redrafting to produce the 2020 version of the code, published in late 2019.
The new code, which came into effect from 1 January 2020, includes **twelve principles (plus an **alternate six for service providers), where formerly there were seven, and a tripling of the number of pages as compared with the 2012 code.
But the biggest change is not the growth of the document, but the increased ambition for practical delivery by signatories.
The former focus on statements of intent no longer exists.
Instead, investors are now expected to report annually on activity, and most importantly, on outcomes from that activity.
Each of the new principles has an associated outcome that must be reported as well as concrete examples of what has been delivered.
Signatories will no longer fulfil the demands of the Code by publishing policy statements filled with ambitious assertions, instead they must deliver practical effects from their actions.
The twelve new principles fall into four categories but cover two distinct functions:
▶ principles 1 to 8 address the **foundations for stewardship; while
▶ principles 9 to 12 focus on the **practical discharge of **engagement responsibilities.
The need to report on concrete examples applies even to the foundational principles 1 to 3 and 5 to 6 of the new code.
These cover ***structural issues within the investment institution such as governance, culture and conflicts and so, the outcomes that need to be disclosed are evidence that those structures work in practice.
Principles 7 and 8 integrate ESG factors into the investment process and include an effective
*** oversight of service providers.
The disclosures need to be explanations of how these processes have delivered effectively on behalf of clients and beneficiaries.
Principles 9 to 12 regard engagement (and voting) activities.
**The intended outcome of these principles is to show substantive change at companies as a result of the engagement activity.
Perhaps the most challenging is principle 4…
… which charges signatories with identifying and responding to market-wide and systemic risks.
Some investment institutions already recognise their obligation on behalf of beneficiaries and clients to maintain and promote well-functioning markets and social and environmental systems,
…but for many this may feel like a significant additional burden.
To be required to “disclose an assessment of their effectiveness in identifying and responding to” such risks imposes a burden even for those who already recognise this as being a stewardship responsibility.
Only the Australian Asset Owner Stewardship Code, developed by the industry body Australian Council of Superannuation Investors (ACSI), had a similar expectation in place, in its principle 5:
“Asset owners should encourage better alignment of the operation of the financial system and regulatory policy with the interests of long-term investors”.
While this new UK Code may prove as much of a model for global stewardship codes as its predecessors, the latest country to propose changes is Japan, which has not followed the UK’s example closely.
There is a move to require reporting on the outcomes of engagement activity….
…but this is downplayed and given little prominence so may only have a limited impact (the contrast to how central this is to the new UK Code is very marked).
Beyond this, the proposed changes to the Japanese Code are:
▶ to extend coverage to all asset classes, not only equity;
▶ to incorporate sustainability and ESG;
▶ to add encouragement for asset owners to become involved in stewardship, and provide a little more clarity on their role in the stewardship hierarchy; and
▶ to clarify the position of service providers in the hierarchy, and add higher expectations of proxy advisers.
Code provisions
Other than the new UK Stewardship Code, 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:
- regular monitoring of ***investee companies;
- active ***engagement where relevant (sometimes termed “escalation”, or sometimes escalation is deemed worthy
of a separate principle of its own); and - thoughtfully intelligent voting.
The two principles that are not always present (though both appear in the UK Code in both its former and current iterations) require investors to manage their conflicts of interest regarding stewardship matters.
The escalation should include a willingness to act ***collectively with other institutional investors.
Codes developed by regulators usually focus on addressing ***potential conflicts of interest, whereas those produced by investor bodies usually place less emphasis on this issue, perhaps because some investors are not keen to draw attention to concerns in that regard.
Stewardship codes are expressed to apply to all asset classes but their language tends to reveal an initial focus in practice on ***public equity investment.
In 2016, the FRC went through a process of assessing the quality of the UK Code signatories.
This was not based on the substance of the stewardship activity delivered, but simply on the basis of the stewardship statements published by each signatory in response to principle.
The regulator gave signatories an indication of which tier (1, 2 or 3) the quality of these disclosures placed them in, which led to a rapid improvement in the quality of disclosures.
Out of the 300 signatories in total,
120 were deemed to be tier 1 and best practice
(“Signatories provide a good quality and transparent description of their approach to stewardship and explanations of an alternative approach where necessary”),
compared to the 40 in that category at the start of the process.
It is not yet clear whether or how the FRC will conduct a tiering process in relation to the new Code.
If it does do so, the tougher expectations in the new 2020 Code are likely to lead to a greater differentiation being drawn between signatories.
The number of stewardship codes in Europe is likely to increase significantly following the Shareholder Rights Directive II coming into force from June 2019.
Among other things, SRD II, as it is known, will raise expectations in each country about the level of stewardship carried out by local investors.
This is likely to supersede initiatives such as the voluntary EFAMA Code (updated in 2018 from the original 2011 version) and will move European markets towards expanding expectations that have regulatory backing.
While by name it is about shareholder rights, in reality the directive is more about shareholder ***responsibilities.
Expectations with regard to stewardship are set by legislation as well as codes.
Foremost among these is the US ERISA legislation, the Employee Retirement Income Security Act of 1974.
Among the Act’s requirements are a number that are relevant to stewardship, in particular that advisers should act as fiduciaries in relation to the beneficiaries.
Among the obligations expected under fiduciary duty (as narrowly defined in the Act)
is that the fund will
**vote at investee company general meetings and engage with companies.
