Shaping governance practices

Indian institutional investors have important lessons to learn from the policies of an investment management company

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, issued an open letter to the directors of public companies worldwide (https://about.vanguard.com/-investment-stewardship/governance-letter-to-companies.pdf). This was accompanied by the Investment Stewardship Annual Report (https://about.vanguard.com/investment-stewardship/annual-report.pdf). Vanguard is credited with the creation of and focus on index funds and is the ultimate long-term investor — the fund will hold shares if a company is an index stock. Given this, governance matters hugely.
 
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 evaluating corporate governance in companies it invests in.
 
The first pillar is the board, which is why the letter begins by recognising the primacy of the board, stating “Thank you for your role in overseeing the Vanguard funds’ sizeable 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 noteworthy is that Vanguard identifies gender diversity as a critical element while evaluating board composition — citing that 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 being the first no-vote listing in the US since 1940. Shareholders in Snap 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 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 permitting listing of dual class shares. Recently, bowing to competitive pressures, Singapore opened the door to such listing, risking a race to the bottom by the Asian exchanges.     
 
Appropriate compensation, the third pillar, focuses on pay that incentivises relative outperformance over the long term.
 

Illustration: Binay Sinha

Investors and societal angst regarding egregious compensation practices should not be underestimated. Last autumn, Theresa May, the prime minister of the UK, initiated discussions on governance reform in that country. These reforms put compensation at the heart of 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 (https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/640631/corporate-governance-reform-government-response.pdf).
 
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 operationalise 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 LIC does, it 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 — needs to carry from Vanguard’s letter and stewardship report is that fund managers have the power to nudge. They need to recognise that it is they, not regulators, who have the most powerful voice in shaping governance practices.

The author is with Institutional Investor Advisory Services. Twitter: amittandon_in