06 June 2017

Blog: CAG Corporate Governance Dinner – Changing Basis

by Scott Fulton | 06 June 2017

It seems that UK corporate behaviour has been under one microscope or another for decades. However, from the days of reacting to Polly Peck (Cadbury Report 1992) and Enron (The Smith Report 2003), more recent developments have been proactive, reflecting a growing realisation that corporate governance is a driver of corporate performance.

The nature of the dialogue between companies and their shareholders is changing and increasingly driven by regulation which understands that both constituencies have a responsibility to ensure that best practice is achieved.

This was certainly the view expressed by Gervais Williams of Miton Group and Jennifer Walmsley of CMi2i at Capital Access Group’s (“CAG”) recent dinner on corporate governance, on 24th May 2017, which was attended by companies and advisers.

As an active investor specialising in small to mid-cap companies, Gervais highlighted that he was looking increasingly at a range of factors in addition to the more traditional measures of performance. He commented that clear lines of internal reporting, truly independent non-executives and an understanding of the operational importance of corporate reputations should all be factored into the investment decision. It is insufficient to simply generate growth. Companies must seek to manage it on a sustainable basis which should encompass the structure of the company and how it behaves within the communities in which it works.

However, Gervais was at pains to stress that good corporate governance can only go so far. The primary function of fund managers is to generate positive returns for their clients. While risk is reduced by adherence to best practice, it must be accompanied by sensible economic models. It was important for investors to combine financial assessments with an understanding of corporate behaviour.

Echoing these comments, Jennifer Walmsley highlighted that corporate governance should be policed by a range of stakeholders who should seek agreement on which areas are important. In her roles at Hermes Fund Managers and The Financial Reporting Council, she came across a number of instances where investors and companies did not understand each other’s corporate governance agenda. This lack of communication remains a feature and, according to her recent research, could worsen. As pension funds across Europe are required to consider the “social” implications of their investments, fund managers now have to address issues such as board structures, succession planning, risk management and cybersecurity. Companies have yet to fully catch up on these issues and, anecdotally, are often insufficiently prepared to discuss them with investors.

The role of non-executive directors (NEDs) here is critical. As the 2010 Combined Code makes clear, “the board as a whole has responsibility for ensuring that a satisfactory dialogue with shareholders takes place”. As the independent voice on the board, NEDs are well placed to take soundings on a range of governance issues. On this point, Jennifer warned that investors are not solely concerned about remuneration, although this remains important.

From a CAG perspective, we believe that current and emerging regulation is likely to increase the requirement for companies to engage on a broader basis with investors. MiFID II’s implementation in January 2018 is likely to change the manner in which companies communicate with shareholders and investors. Prior to this regulation, companies have used analyst research reports as a means of “carrying the message” to the market. As MiFID II requires research to be economically independent, CAG believes that the “communication” role it served previously will be substantially reduced. Research output may be entirely determined by fund managers’ requirements and portfolio composition. This could result in fewer research reports which are focused on investment theories and ideas rather than commentary on corporate performance. A particular casualty of this change in basis may be the level and quality of market feedback on which companies rely to test shareholders’ views of their performance.

We have witnessed an increase in the number of non-broking, independent advisers as companies seek to “fill the gaps” created by changes to the traditional broking model. CAG believes that this trend will accelerate as we near MiFID II implementation. Indeed, given that investors may need to meet members of the whole board more frequently, we believe that independent corporate access is the only means of guaranteeing compliance with the regulation and ensuring a sustainable route to market. Clearly, we believe that CAG is well positioned to advise companies on these issues.