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Institutional EYE

Commentary on Corporate Governance Issues

Investors can – and must define governance practices

Earlier this year IRDA asked insurance companies to roll out their Stewardship policies by 30 September. In the month that most insurance companies uploaded their stewardship codes on their websites, The Vanguard Group published its Annual Stewardship Report. This report is a clear pointer to investors in the Indian market regarding then power of a stewardship code. Investors can – and must use these to define governance practices.

A few weeks ago, F. William McNabb III Chairman and Chief Executive Officer of The Vanguard Group, an investment manager with US$4.4 trillion under management, wrote an open letter to the directors of public companies worldwide. This was accompanied with their Investment Stewardship Annual Report. Vanguard is credited with the creation of and focus on index funds - the fund will hold shares if a company is an index stock. They cannot exit shares at whim and is the ultimate long-term investor. Given this, governance matters.

In the letter to boards Vanguard has reiterated its commitment to investing for the long-term while highlighting the four governance pillars that it uses while evaluation corporate governance in companies it invests in.

The first pillar is the board, which is why the letter begins by recognizing the primacy of the board stating ‘Thank you for your role in overseeing the Vanguard funds’ sizable investment in your company. We depend on you to represent our funds’ ownership interests on behalf of our more than 20 million investors worldwide.’ As ‘good governance starts with a great board …. we believe that when a company has a great board of directors, good results are more likely to follow. What is particularly noteworthy is that Vanguard identifies gender diversity as a critical element while evaluating board composition - citing diverse boards lead to long-term shareholder value. They state that their ‘stance on this issue is therefore an economic imperative, not an ideological choice.’

The second pillar is governance structure. This refers to the provisions and structures that empower shareholders and protect their rights.

The debate on shareholder rights has gathered steam as technology firms have listed their shares, with Snap Inc. being the first no-vote listing in the US since 1940. Shareholders in Snap Inc., will not have any rights, not even to appoint the board. As markets shift to index tracking, investors are pushing back and have started a dialogue with the index providers to exclude such shares from the main indices. On this Asia and not the US, held the high ground, till recently. Hong Kong and Singapore have for long held back by not permitted listing of dual-class shares. But recently bowing down to competitive pressures, Singapore has opened the door to such listing, risking a race to the bottom by the Asian exchanges.

Appropriate compensation, the third pillar focusses on pay that incentivizes relative outperformance over the long term.

Investors - and societal angst regarding egregious compensation practices should not be under-estimated. Last autumn Theresa May, the prime minister of UK no less, initiated discussions on governance reform in UK. These reforms put compensation at the heart of the governance change. May stated that her ‘government will build an economy that works for everyone, not just the privileged few.’ Coincidentally, the week that Vanguard wrote to directors, the UK Government put out its response based on public comments it received.

A third of the report deals with compensation. Other than greater disclosure on governance, the government has invited the Financial Reporting Council (FRC) to revise the UK Corporate Governance Code by being more specific about dealing with shareholder opposition to executive pay policies and awards. The FRC has been asked to empower the remuneration committees in overseeing pay and incentives across their company requiring them to engage with the wider workforce to explain how executive remuneration aligns with wider company pay policy. There are granular recommendations regarding ESOP vesting period (‘extend from three to five years’ to encourage long-termism) to disclosures (‘The disclosure on the ratio of CEO pay to the average pay of their UK workforce needs to be strengthened with a narrative explaining changes to that ratio from year to year and setting the ratio in the context of pay and conditions across the wider workforce. The companies are expected to provide a clearer explanation in remuneration policies of a range of potential outcomes from complex, share-based incentive schemes’). Clearly compensation is a focus area on both sides of the Atlantic.

The fourth pillar is risk oversight. The ‘effective, integrated, and ongoing oversight of relevant industry- and company-specific risks.’

The pillars apart (- the assessment of which will be company-specific), Vanguard has repeated the value of engagement saying, ‘you can’t wait to build a relationship until you need it,’ and the 171,000 votes they cast during the year, represented the end process not its starting point.

LIC, the single largest investor in Indian equities, needs to play a leadership role in setting governance standards. In India, while mutual funds have been voting on shareholder resolutions since 2011, and insurance companies will operationalize their stewardship codes in October 2017, it is indeed LIC that can lead the change. The entire market, not just policy holders, are waiting for LIC to pave the way – if it does, LIC will see tremendous support from the investor community, and corporate India will be more thoughtful in its decision-making.

The one learning that LIC - but also other institutional investors - need to carry from Vanguard’s letter and stewardship report is that fund managers have the power to nudge. They need to recognize that it is they, not regulators, who have the most powerful voice in shaping governance practices.

A modified version of this column was published in Business Standard on 4Oct2017. Click here or paste the following url:

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