Globalised governance

Does it matter who determines local governance norms?

There has been a lot of discussion over the past couple of years of the decline of the UK stockmarket. A number of interlocking concerns have been articulated including low valuations of UK stocks, the lack of IPOs and delisting of existing constituents, a governance regime which may put the UK at a competitive disadvantage and a lack of investment in UK equities by UK institutions.

As I’ve written before, it is worth bearing in mind that some of the voices in this debate have a very strong interest in transactions, which may not always align well with policy designed to support good companies. Nonetheless it seems foolish to not take the overall health of the UK market seriously.

There is one part of the story that I don’t think gets enough scrutiny: the governance implications of the low allocation to UK equities by UK investors. As an aside, having followed asset allocation at a distance for years it always struck me that UK pension funds had a stronger domestic allocation than you might expect. So I’m not surprised that this has reduced, but it has now fallen a lot.

Most of the debate around this is focused on the lack of domestic investment, whereas, obviously, the corollary is high overseas investment. The discussion usually stops there but if you’re at all interested in governance and stewardship there are obvious knock-on effects.

If overseas investors hold the large majority of UK equities, do their expectations of companies in relation to governance (or social or environmental issues for that matter) differ from their UK counterparts? Does this in turn influence the decisions of UK companies, and by extension impact UK citizens? My own anecdotal feedback suggests these things may indeed be happening, and I think there is an important research job to be done here.

My first example is executive pay. I have had many meetings with remco members and the PLC staff who support them over the years. A frequent comment is that they receive very different views from shareholders that are hard to balance both against each other and against what they perceive to be the needs of the business. An additional point that is often made is that US investors are a) far more focused on performance - and performance linkage in pay - and b) less concerned about quantum or ESG metrics.

There are lots of caveats: companies sometimes use self-serving arguments to justify questionable pay practices; many investors say they take account of local market norms when assessing governance; European ex-UK investors are also in the ‘overseas’ category and might be a counterweight etc. But I have heard the point enough times now to think there may be something in it worth exploring.

My second example is board level employee representation. This is reasonably common in some European markets and virtually non-existent in the US. The UK took a look five or so years ago and fudged a compromise that, in my opinion, has delivered very limited benefits to either companies or their workforces. Nonetheless there are now half a dozen PLCs with versions of employee directors.

One of these is Capita, which initially had two employee directors. However, in 2022 one of the two employee directors received a 20%+ vote against their re-election. As this was over the significant opposition threshold set in the UK Corporate Governance Code this required a response from the company.

In its immediate statement on the vote at the AGM last May, Capita stated: "[T]he Board notes the concerns of certain shareholders that Lyndsay as a non-independent director is a member of the Remuneration Committee. The Board will consult with shareholders on this matter to further understand and address their concerns."

In a subsequent update it stated: "Recognising... shareholders’ views with regards to independence, Janine Goodchild who was appointed as an Employee Director on 1 July 2022 was not appointed as a member of the Remuneration Committee." 

Digging into this, I found that a number of investors have adopted or follow a policy where they will oppose the re-election of employee directors if they are members of remuneration or audit committees but are not required to be so.

This is the specific policy position which you can find in some US investors’ voting policies: “Vote AGAINST employee and/or labor representatives if they sit on either the audit or compensation committee, if they are not required to be on those committees.”

Since the UK Corporate Governance Code does not require the appointment of employee directors, or therefore their membership of remcos or audit committees, this policy triggered a vote against the Capita employee director.

When Capita subsequently appointed a new employee director the company made clear that they had not been made a member of the remuneration committee. The company also now has one employee director, rather than two. Remember that remcos are encouraged to think about workforce terms and conditions, and even engage with the workforce, when setting executive pay. As such, voting against an employee director because they are a member of a remco seems odd. It must also create a disincentive for boards to consider employee involvement in remco decisions and at board level more widely.

I have seen other less significant examples, including US investors voting against - and defeating - resolutions seeking authority to hold meetings on short notice.

Given that domestic allocations to UK equities have continued to fall it seem likely that governance outcomes at UK PLCs will be increasingly influenced by overseas investors. And if overseas investors do not share the same views as their UK counterparts the nature of those outcomes might be different.

At the same time, the workforces of our PLCs clearly also have a large UK component. So we have globalised corporate governance with an often localised workforce. (If companies that derive more of their revenue from, or have more employees overseas delist from the UK this could be exacerbated.) It doesn’t take much effort to see problems where, for example, overseas investors are untroubled by high intra-firm pay inequality at investee companies but the workforces of those same companies are. Or disagreement over distributions by buybacks etc.

I think we are at a very early stage of seeing these impacts but we should be alert to them. It also perhaps help contextualise the comments from the head of the LSE that a problem for UK-listed companies is that domestic investors are putting too much downward pressure on pay, making them unable to attract the talent necessary to be competitive. These have been seen, probably correctly, as lobbying for domestic investors to back off. But perhaps they were also made in the knowledge that the situation on the ground is already changing.