Corporate governance and shareholder engagement

United Kingdom

With this year’s AGM season now well under way, we are likely to see leading companies raising the bar in their directors’ reports, dealings with shareholders, and meeting procedures. Best practice in corporate governance never stays still.

2005 was the first year that listed companies had to report fully on the extent of their compliance with the revised Combined Code.  Following its review of how the Code was being implemented, the Financial Reporting Council (FRC) announced earlier this year that it did not intend to make any significant further changes. Despite the protest that greeted some of Sir Derek Higgs’ proposals, the FRC found that the revised Code had bedded down well and was generally considered to be having a positive impact.  The latest amendments were announced in June 2006 and include:

  • The Chairman will be permitted to sit on (but not chair) the remuneration committee provided he was considered to be independent on appointment. The FRC estimates that nearly 30% of FTSE 350 companies, and a higher percentage outside the FTSE 350, currently choose to explain their non-compliance with, rather than comply with, the provision in the Code that requires all committee members to be independent non executives (the chairman is not considered independent).
  • To allow shareholders to communicate reservations about a proposal at any general meeting without voting against it, companies should include a Vote Withheld box on proxy voting forms, as recommended in Paul Myners’ report to the Shareholder Voting Working Group.  The proxy form and any announcement of the results of a vote should explain that withheld votes are not votes in law and are not counted for or against the resolution. According to Research Recommendation and Electronic Voting (RREV), for 92% of company meetings of the FTSE 100 in 2005 where votes were disclosed either publicly or to RREV, voting forms had an abstention or vote withheld option.  The CREST electronic proxy form already includes a Vote Withheld box.   
  • Where a vote at any general meeting is taken on a show of hands but does not go to a poll, the company should disclose (both at the meeting and on a website) the number of shares in respect of which there are valid proxy appointments, and the votes for and against, and votes withheld, shown on the proxies.  For votes taken on a poll, the Company Law Reform Bill is expected to require companies to disclose the results on their websites.

Current levels of compliance with the provisions of the Code by FTSE 100 companies are variously estimated at somewhere between a third and a half.  It is clear that rigid compliance with every provision is not required: indeed, companies are expected to explain how and why they do not comply, so that investors can cast their votes in the light of all the relevant circumstances.  The FRC reported that respondents to its consultation believe that, since the introduction of the revised Code, the quality of corporate governance in listed companies has improved, and that there has been an increase in constructive dialogue between companies and investors.

Until the Listing Rules are changed to refer to the updated Code, compliance with it will be voluntary, but the FRC is encouraging companies to adopt it for reporting years beginning on or after 1 November 2006. The updated Code is available on the FRC’s website:

Smaller listed companies and AIM companies

Although not included in the FRC’s proposed changes to the Code, there is some pressure from certain companies and investors for the FRC to create a specially tailored version of the Code for companies outside the FTSE 350. The Code already makes a few express concessions to smaller companies – for example, independent NEDs should number at least two, but need not make up at least half of the board – and when assessing corporate governance disclosures shareholders are encouraged to take account of “the size and complexity of the company and the risks and challenges it faces”. But an FRC survey last November showed that 45% of smaller companies do not believe the Code works well in practice. Most smaller companies have fewer resources to set up and maintain Code recommended practices, and to provide full explanations for any non-compliance.

In August 2004 the Quoted Companies Alliance (QCA), which represents the interests of smaller listed companies, published guidance for its members on those provisions of the Code which may create difficulties for smaller companies and which may require explanation rather than compliance. But the QCA guidance does not amount to an alternative Code.

AIM companies are not strictly required to observe the Code, but last July the QCA published a set of corporate governance guidelines for AIM companies, designed to provide a simple minimum standard of best practice. Among other things, it recommends that the roles of chairman and CEO should be split; that a company should have at least two independent NEDs, one of whom may be the chairman; and that audit, remuneration and nomination committees should be established, each comprising at least two independent NEDs. As yet, this “alternative” Code has not met with broad market approval.

Areas of controversy

Two particular areas in which companies continue to clash with investors are executive remuneration and the independence of NEDs. In December, the ABI reissued its annual guidelines on executive remuneration and share incentive schemes. The revised guidelines emphasise that:

  • Remuneration committees are responsible for ensuring that all reward arrangements remain appropriate and challenging. Where necessary, employee share schemes should be reviewed to check that grant levels, performance criteria and vesting conditions previously approved by shareholders remain appropriate.
  • The vesting of awards under share incentive schemes should be conditional on satisfaction of performance criteria that are stretching in comparison to an appropriate defined peer group of sufficient size or another relevant benchmark. For example, where the lowest level of performance to achieve an award is reached, the initial level of award should be modest and there should be no large initial award or “cliff” vesting. Higher levels of award should vest as performance increases, with full vesting only arising on achievement of significantly greater levels of performance.
  • Shareholders should be given enough information in the remuneration report to judge the appropriate size of the award for any given performance level. The maximum level of grant should also be disclosed.
  • Where an employee terminates his employment or is dismissed for cause, any unvested options or conditional share-based award should normally lapse. Where an employee is otherwise unable to complete the vesting period, vesting should occur on a pro-rata basis only, and performance conditions should still apply.
  • Where, in the event of death or cessation of employment of an option holder or where a company is taken over (except where arrangements are made to roll over options into options over shares in the bidder), outstanding options vest or have already vested, they must be exercised (or lapse) within 12 months.

While executive remuneration is likely to remain controversial, the fact remains that to date only six advisory votes on remuneration reports have been lost.

Independent NEDs are regarded by many investors as a bastion of good corporate governance. Assessing whether or not a particular director is in practice able to exercise his judgement independently of any personal interests or outside pressures is, of course, not something that can be done purely by reference to objective criteria, such as material business relationships with the company or remaining on the board for more than nine years. Institutional investors have made it clear that, where companies – as they often do – consider a NED to be independent notwithstanding the existence of such indicators, it is not enough simply to assert the individual’s independence of character. Shareholders will look closely at the justification given and, in borderline cases, at other circumstantial evidence indicating independence – such as whether the company’s remuneration policies comply with best practice.

In its report on “Board effectiveness and shareholder engagement”, RREV devoted six pages to the factors that NAPF members take into account when assessing independence. They also give various examples of circumstances where investors have accepted company explanations of why a particular NED should be considered independent. A company concerned about this issue would do well to read this section of the report (which is available on RREV’s website:

Shareholder engagement

It is fundamental to the success of the comply or explain model that shareholders engage actively and intelligently with their investee companies – and that they have weapons at their disposal to make their views properly felt. In November Paul Myners reported that voting levels in FTSE 100 companies have increased from around 50% in 2003 to 61% in 2005. Roughly the same level of engagement applies across the rest of the FTSE 350. Electronic voting is increasingly being used: in the six months to 30 June 2005, 42% of the FTSE 100’s share capital was voted electronically, compared to 22% in the previous year, and every company in the FTSE 100 now allows electronic voting.

Both Myners and the Government are looking at ways to increase shareholder engagement further by removing barriers to voting where investors hold interests in shares through ISAs, nominee accounts and intermediaries. Technical difficulties have forced withdrawal of clauses in the Company Law Reform Bill designed to enable registered shareholders in listed companies to nominate someone else (such as a beneficial owner) to exercise voting rights and receive documents in their place, but the Government has promised to explore other ways of achieving this.

Disclosure of institutional voting records

It seems likely that the Company Law Reform Bill will include a power for the Secretary of State to make regulations compelling institutional investors to disclose their voting records. The Government has threatened to use this power if enough institutions fail to disclose on a voluntary basis. It will be for the Secretary of State to decide whether disclosure should be just to beneficiaries, to a wider class of interested parties, or to the public at large. More than a dozen institutions, including Fidelity International, F & C Asset Management, Hermes and CIS, have agreed over the last few months to publish their votes on each resolution proposed by their UK and overseas investee companies.

What effect will this have on corporate governance? The main aim is to encourage institutions actually to vote their shares and in doing so, it is hoped, to assess whether management’s proposals accord with the investors’ own views about what is best for the company. In most cases, public disclosure is likely to reveal that the institution supported management’s proposals: for example, in the 12 months to 30 June 2005 Fidelity voted against one or more resolutions at only 392 meetings, compared to 2,474 meetings at which it voted in favour of all the resolutions proposed by management. Where support was withheld, brief reasons were usually given. Some institutions are concerned that pressure groups may try to “name and shame” them for supporting proposals that the group disapproves of, but the risks may be more apparent than real. Hit rates on the pages of institutions’ websites where voting records have been published were reported in the House of Lords debate on the Bill to be very low, and one manager who disclosed had had no questions raised as a result.

General meetings and shareholder rights

Essential to the effectiveness of the comply or explain model is that shareholders have the means to voice their disapproval of any explanations they do not like, to put pressure on management to amend or drop proposals, to put their own resolutions, remove existing directors and, ultimately, to sell out or take control of the company themselves. In the UK such opportunities and rights are usually readily available, at least in principle, but the same is not always true elsewhere in Europe or in the United States. For example, in some EU member states, to be eligible to vote at a general meeting, shareholders must deposit their shares with a credit institution or other entity a few days before the meeting and cannot then trade them until the end of the meeting. This “share blocking” is a huge obstacle to voting, as institutional shareholders often prefer not to vote rather than lose the opportunity to sell their shares during the blocking period. A survey commissioned last year by the ABI also found that about a third of companies in the FTSE Eurofirst 300 index (particularly French, Dutch and Swedish companies) have voting structures that “distort voting rights and make management less accountable to shareholders”. Similarly, in many US listed companies it is difficult for shareholders to remove directors or to put resolutions, and boards often have power effectively to block takeovers by putting in place poison pills.

Additional rights under the Company Law Reform Bill

In the UK, the Bill is likely to add to the weapons available to shareholders. In particular:

  • Shareholders in listed companies who hold at least 5% of the voting rights, or who number at least 100 (with an average of at least £100 of share capital each) will have the right to publish on the company’s website free of charge a statement of any concerns about the audit, or the circumstances in which the auditors have resigned, that they intend to raise at the AGM.
  • Shareholders in public companies will be able to require the company to circulate resolutions and any accompanying statement at the company’s expense if the materials are provided to the company before the end of the financial year.
  • Listed companies will have to disclose the results of any poll on their website. Some listed companies already do this. Shareholders who hold at least 5% of the voting rights, or who number at least 100 (with an average of at least £100 of share capital each), will be able to require the directors to obtain an independent report on any polled vote.
  • Members of both private and public companies will be able to appoint more than one proxy. Proxies will be given the same rights as registered holders to ask questions, demand a poll and vote on a show of hands at general meetings (as well as on a poll).

Consistency across Europe

At a European level, the Commission is concerned to ensure that member states all provide shareholders in listed companies with certain minimum rights. In January it proposed a Directive on Shareholder Rights, which, if adopted, would have to be implemented by 31 December 2007 (although the deadline may slip). Among other things, the Commission proposes that:

  • At least 30 calendar days’ notice should be given for all general meetings, and the meeting documents (including proxy forms) should be published on the issuer’s website not less than 30 calendar days before the meeting.
  • Shareholders from all countries must have the right to add items to the agenda for a general meeting and to table resolutions. Where the right is subject to a minimum stake condition, the minimum stake must not exceed the lower of 5% of the share capital of the issuer or a nominal value of €10 million.
  • Share blocking should be replaced by a record date system. The actual record date will be left for determination by member states, but must not be earlier than 30 calendar days before the meeting.
  • Shareholders must not be prevented from participating in general meetings by electronic means. However, the technology is not yet advanced enough for the Commission to make electronic voting compulsory.
  • Shareholders must be permitted to ask questions orally at general meetings and/or in written or electronic form ahead of the meeting. Issuers must respond to those questions, and post the responses on their websites, subject to any legitimate concerns
    over confidentiality.
  • Member states must not require proxies to meet any eligibility criteria (for example, that the proxy be a family member or another shareholder, or that the appointment be notarised), except where strictly necessary to identify the shareholder and the proxy holder. Proxies should be capable of being appointed electronically.
  • Companies must not require intermediaries or nominees who hold shares for investors in omnibus accounts to separate out the holdings of each investor temporarily before any votes are cast.

This article first appeared in our Clearly corporate bulletin July 2006.  To view this publication, please click here to open a new window.