Corporate stewardship: making the leap from theory to practice

THE chairman of a well-known property company was reminiscing, in private, on the boom years before 2008. He admitted that, to his great regret, he had failed to resist the pressure from institutional shareholders to increase the company's debt and pay out more to those shareholders. This decision left the company dangerously exposed when the cost of credit increased. He hadn't thought it was the right thing to do at the time. He just didn't know how to resist.

Short-termism is costly, to companies as well as economies. As Dominic Barton and Mark Wiseman pointed out recently in an April 1 article for the London Financial Times, the pressure to meet quarterly earnings targets has been estimated to have reduced research and development spending and cut US growth by 0.1 percentage point a year. In contrast, stewardship is about building enduring companies which are the cornerstone of a civilised economy. They sustain human existence through the needs they meet; they train and educate; they create working communities in which people can be their true selves; they pay salaries and dividends; they build infrastructure.

If companies are to live up to this potential, they need stewarding. That requires the joint effort of the management, board and owners. Together, they have the responsibility to keep the company on course. In our first article ("Boards and owners need to be stewards", BT, March 17), we defined stewardship as the management of assets with which we have been entrusted so that we hand them on in better condition. And we talked about the "golden thread of stewardship" connecting the management to the board, the board to the asset manager, the asset manager to the asset owner and all the way back to the individual saver. In this second article, we deal with the effective practical steps that make stewardship work.

A starting point for practical improvement in the investor chain lies in the application of two very simple words. The first of these two words is value. The second is mandate.

DEFINING VALUE

Asset owners (pension funds and insurance companies) ought to define carefully and clearly what they want from their investments. What do they mean by value? Or, more importantly, what do they understand their clients (individual savers) mean by value?

There are quick and superficial answers to this question that are obviously wrong.

It is easy to say that their clients want the largest possible financial return. But, of course, the highest returns are usually associated with the highest risks.

So how much risk are the clients prepared to tolerate? What is the timescale over which they want their return?

Do those clients want their asset managers to encourage companies to invest for the future, to train their people and have a strong corporate culture? Or do they want the asset managers acting in their name to sweat the assets of the company?

People saving for a pension want to be confident that the money will be there one or two or more decades hence. Few of us should feel comfortable having shares in companies that explode into profitability like fireworks in the sky, only to fall feebly back to earth five years later, having destroyed their shareholders capital.

Trustees of pension funds (the proxy owners) often feel inhibited from challenging short-termism. Their fear is that they may be accused of putting subjective preferences about intangible matters in front of straight financial benefit. Or as professor John Kay put it in his report on short-termism in the UK, "some pension fund trustees equated their financial responsibilities with a narrow interpretation of the interests of their beneficiaries which focused on maximising financial returns over a short timescale and prevented the consideration of longer-term factors which might impact on company performance, including questions of sustainability or environmental and social impact".

In the UK, at least, that concern has been clarified with a legal position. In July 2014, the Law Commission, after a review following Prof Kay's report, stated that investment is about balancing the risk/reward ratio. While the pursuit of financial return is predominant, the law does not prohibit trustees from making value judgements about the desirability of investments. By taking such factors into consideration, they could ultimately be protecting the trustees' interests. Our understanding of value is deepening, and its definition broadening. Over time, this will make it easier and comfortable for the ultimate savers and the asset owners to send clearer messages to the asset managers and so to the companies.

This brings us to the mandate which defines how stewardship should be exercised by asset managers on behalf of their clients, and then by boards on behalf of the investors.

MANDATE

If stewardship is working well, clients will send a clear message, based on their own definition of value, down the line to the asset managers to whom they entrust their savings. Such investment mandates issued by asset owners to asset managers will be a statement of investment principles.

Each asset manager is usually responsible for holding a portfolio of shares. We would reasonably expect the asset manager to be able to identify shortcomings in a portfolio company and to challenge that company to deal with them. But the reality is that the same asset manager may own hundreds or thousands of shares. And there are limits to the amount of time and attention that can be dedicated to the stewardship of each company in which the asset manager owns shares.

This is where the idea of a mandate for the board comes in useful and effective.

The board of directors has been elected by the shareholders, and has been entrusted with the direction of the company. But what is the mandate on which those directors would be expected to operate?

In a private business with a single owner, the owner is expected to define that mandate. In a listed company where there is no dominant shareholder, it would be impractical to expect the initiative to reside with the multitude of shareholders. We suggest that such a mandate could originate with the board. It is for the directors to set out their understanding of their mandate, and to communicate that to the shareholders for alignment of thoughts and action.

Clear mandates are important to boards; they need a backbone to be able to function confidently, and with focus. They need to be able to say to shareholders: "You have elected us. You can always call an EGM and sack us. But unless and until you wish to do that, we have a clear purpose and a clear strategy, and we intend to stick to it."

If our now-regretful property company chairman had gone through this discipline, he would have found it easier to protect the longer-term interests of the company against opportunistic short-term investors.

For boards, the starting point of good stewardship is a clear mandate. The board sets out what it intends to do - its purpose - and how it intends to uphold the company's integrity - its values. It defines its ambitions and its risk appetite.

The board knows where it stands. With the articulated mandate, investors will also know where they stand. By adopting the principles of stewardship, we could change for the long term the view of companies. No longer do we see companies as narrow dividend-generating machines. Instead, we acknowledge them as human organisations, whose survival depends on their ability to sell goods and services and generate sufficient cash and profit. And whose enduring success depends upon their ability to create value in all of their relationships over time.

If boards of directors, and institutional investors could focus on defining value, and if they could articulate a clear mandate which properly reflects this understanding of value, then the foundations are laid for meaningful and responsible wealth creation, overcoming the snare of short-termism.

In our next article, we will share about how stewardship and corporate governance go hand in hand for the betterment of growing and enduring companies, while challenging the conventional thinking associated with some aspects of corporate governance. Good stewardship is largely common sense, and a reflection of the right values and principles. It is time to clear the ground of some of the abstract and theoretical assumptions about certain corporate governance practices, and get back to the basics of entrepreneurial wealth creation pursued in a responsible and accountable spirit.