By Professor Simon Deakin, Director, Corporate Governance Research Programme, Centre for Business Research, University of Cambridge
John Kay’s interim report finds that equity markets are failing in their primary tasks, which he identifies as enhancing the long-term growth of listed companies and providing savers with an appropriately high, risk-adjusted return on their investments. The failure lies, he suggests, in the way that market actors are currently incentivised. If asset managers are assessed on a quarterly or biannual basis, it is not surprising that they apply benchmarks based on the short-run performance of the firms they invest in.
Corporate managers, on the other hand, believe that they have a legal duty to maximise short-term shareholder value, and act accordingly. Kay rightly suggests that this view is mistaken as a matter of law but, again, it is no surprise that directors and managers think in these terms, given the way that shareholders are routinely described as the ‘owners’ of the firms they invest in. Disclosure rules add to the problem, in particular those requiring quarterly reporting of corporate results. Lawyers will recognise that shareholders are the owners of their shares, not the company, and that they have no right to manage the firm, having delegated this power to the board, but these subtleties are clearly being lost in translation.
What can be done?
It is not just a question of getting across a more accurate understanding of the legal structure of the company limited by share capital. The idea that managers should run listed companies in such a way as to maximise share prices is deeply embedded in UK corporate governance practice. It is reflected in the way top managers are remunerated, through bonuses and options linked to share price movements, and in the way that company performance is benchmarked, through metrics such as earnings per share and return on equity. Kay takes aim at some of these practices which, he points out, do not just privilege the short-term, but also tend to discourage large-scale capital investment by companies.
Kay also reports suggestions that there are elements in the regulatory framework beyond company law which favour corporate restructuring and deal-making over long-term growth, notably the City Code on Takeovers and Mergers. While the Takeover Panel’s view that the principal aim of the Code is to protect minority shareholders is undoubtedly correct, it is no less clearly the case that its main effect is to facilitate hostile takeovers of UK-listed companies by denying boards the room for manoeuvre that they would have in virtually every other developed economy.
How should these concerns be addressed?
The final report will have to set out a plausible agenda for regulatory reform if it is to be more than a well intentioned review of existing practices. There are some practical changes Kay could suggest such as making clarifying the legal duty of the board to have regard to the long-term interests of the company under section 172 of the Companies Act 2006 and making clear that this duty takes priority over the terms of the Takeover Code. But going forward, Kay also needs to give a clearer account of the philosophy that would guide reform.
Kay argues that shareholders should act as ‘stewards’ of the companies they invest in. This is fine as far as it goes, and may chime with the ambitions of some pension fund trustees and asset managers to support investment in innovative manufacturing and infrastructure. However, the final report needs to recognise that there are numerous instances in which the interests of shareholders simply do not coincide with the wider public interest in maintaining a sustainable and competitive corporate sector in the UK.
The restructuring of British enterprise through hostile takeover bids, hedge fund activism and private equity over the past three decades was not just the consequence of decisions taken by capital market intermediaries acting without regard to the interests of their shareholder ‘principals’. Institutional investors were highly critical of listed companies which did not prioritise shareholder value, and pressed for a greater role for independent directors on boards as a way of getting their views across. There is more than anecdotal evidence that some of the deals involving the restructuring of companies with a core role in the British economy, from the takeover of BAA by Ferrovial through to RBS’s bid for ABN Amro, were driven by a combination of pressure from boards and shareholders for quick returns, with considerations of corporate strategy pushed to the margins.
It is naive to see hostile takeovers, private equity and hedge fund activism as addressing problems of ‘failed’ companies. Much more often, these forms of investment simply extract value from companies for the benefit of investors and intermediaries, at a direct cost to workers (who lose jobs and protected terms and conditions of employment), customers (who experience a deterioration in the quality of products and services) and the taxpayer (who foot the bill through tax reliefs on corporate leverage).
What has brought us to this point?
Since the early 1980s, company law and corporate governance regulation have given shareholders many more rights to ‘hold management to account’. Kay recognises that trading in the secondary market for shares does not bring in new capital for firms, but he justifies shareholder influence on the grounds that investors can exercise effective oversight over firms’ capital allocation decisions and over their governance. This is implausible.
In today’s liquid capital markets, shareholders are for the most part transitory owners who have no lasting connection to the firms whose traded securities they hold. The question we should be asking is why law and regulation have ceded such large influence to this group. It is partly intellectual fashion, a misguided belief in the informational efficiency of liquid capital markets. It is also down to intense lobbying by the market intermediaries (the asset management firms, legal advisers and investment banks) who benefit most from current arrangements.
John Kay is on the right path in arguing for a long-term approach to investment decisions, but too optimistic in believing that shareholders will always act as enlightened owners.
We need to replace shareholder value with corporate value as the objective of management and take a detailed look at corporate governance regulation and practice with this guiding principle in mind. If this means sidelining the Takeover Code and subordinating it to the wider goal of a reformed company law in promoting sustainable enterprise, so be it. This is the kind of hard choice we will have to make if we want capital markets to make a real contribution to prosperity and growth.