Paul Lee
Director, Hermes Equity Ownership Services Ltd.

Reprinted with permission from Keeping good companies, October 2007, the Chartered Secretaries Australia Journal

All parties should look to maximise long-term shareholder value rather than looking only as far as the short term

Institutional investors should be clear about their policies and approaches to their ownership responsibilities

Companies have a great deal to gain by stable, long-term ownership

Good companies have nothing to fear from the governance debate, and from the developing approaches of long-term investment institutions to their responsibilities as owners of companies.

All too often the relationship between companies and their shareholders becomes strained and even confrontational. A disagreement over traditional corporate governance topics such as board structure or pay, or over wider issues such as strategy, capital structure, or the key risks the company is facing, can become an issue discussed not only quietly in private but also in public. This is increasingly true as hedge funds begin to take particularly strident stances on issues. Too often we see what Cool Hand Luke (in the film of that name) calls a failure to communicate - after an unnecessarily brutal encounter - being played out in the media.

It need not be this way. In particular, as all parties, both directors and investors, are agents for the same principals - the long-term underlying beneficial owners of companies - there should be more agreement than disagreement. In particular, all parties should be working to generate value over the long-term rather than benefit from volatility in the short term. It's just that sometimes something gets lost in translation by the agents who lie between the principals and their investee companies.

Increasingly, the beneficial owners - in Australia, superannuation funds - are recognising that sometimes their messages are becoming confused. As a result, they are seeking to ensure that their long-term perspective is more effectively projected to companies. This new approach is an important one for company secretaries to understand because it is likely to mean that they are having conversations with a new set of representatives of owners. It's also important because this new approach ought to make it easier for company secretaries to do their own jobs.

A key driver for this new approach by institutional investors is the United Nations Principles for Responsible Investment, the UNPRI. This sets just six deceptively simple standards for institutions, using the term ESG (environmental, social and governance) as a phrase which captures the long-term issues which are not currently approached well by investment intermediaries.

The six principles state that institutions will:

Each principle has a set of possible actions which institutions might take as a way of approaching the issues. Institutions representing some US$8 trillion in assets have so far signed up to the Principles, including Aria, AustralianSuper, CARE Super, CBUS Super, HESTA, UniSuper and VicSuper, to mention only some of the Australian funds which are signatories. You can find out more about the UNPRI at its website (http://www.unpri.org [31 August 2007]).

As I have said, the principles are deceptively simple. Implementing them is rather tougher, however. Principles 1 and 2 are causing the greatest reassessments by institutions about their approach to long-term issues and how they might address them more effectively.

One model for trying to ensure that long-term issues are taken into account more effectively by mainstream analysts - and which is therefore helping some UNPRI signatories address Principle 1 - is something called the Enhanced Analytics Initiative or EAI. Again, a number of the largest Australian super funds are now participants in EAI. To do so, they have agreed to allocate a specified portion (at least 5 per cent) of their research commission to analysts who produce research incorporating long-term issues into their analysis. This is driving more of those issues which go to long-term value into the mainstream and ought to be changing the nature of the dialogue your companies are having with analysts.

We and other EAI participants hope that this will recalibrate the focus of discussions between companies and market participants from predominantly issues which go to short-term share price volatility to those issues which will drive long-term value.

Another development, which helps institutions to address Principle 2, is the growth of specialist service providers which engage with companies on long-term issues on behalf of long-term beneficial owners. Among these is Hermes's own Equity Ownership Service, and the Regnan - Governance Research and Engagement business which seven major Australian institutions and ourselves have come together to create out of the BT Governance Advisory Service. Regnan was launched at the start of June and is headed by Erik Mather.

The founding shareholders and initial clients of Regnan are ARIA (formerly the PSS and CSS), BT Financial Group, Hermes, HESTA, NSW Local Government Super, Vanguard, VicSuper and Victorian Funds Management Corporation (VFMC). This combination means that Regnan already speaks for $50 billion, one in eight institutional dollars invested in Australian companies. Erik Mather and the team will identify risks and concerns at companies and will engage with them to encourage change that will preserve or enhance value for Regnan's clients.

As well as this engagement activity, Regnan will maintain its existing relationship with the sustainability team at Monash University and will provide company analysis developed by the Monash team to mainstream analysts. Again, the expectation is that this should ensure that more of the key long-term issues become integrated into the discussions which mainstream analysts and investors have with investee companies.

Taking a long-term perspective is a crucial part of the fiduciary duty of the pension fund trustee to their underlying beneficiaries. This responsibility is increasingly being recognised. Indeed, a study by Freshfields, an international law firm, identified that institutions can only fulfil their fiduciary duties by paying attention to longterm issues¹. Essentially, the point is that institutions can add or preserve significant value by being a good owner of investee companies and actively engaging to ensure that value is enhanced.

What makes a good owner? Institutional investors are beginning to find the answer to this question. A key document has been developed by the International Corporate Governance Network (ICGN). Its Statement of Principles on Institutional Shareholder Responsibilities (the Statement) was approved by the membership at its 2007 Annual Conference in the first week of July. This mentions both the UNPRI and EAI as models for institutional investors in developing their approach to their responsibilities, but the Statement sets more general standards.

It states boldly:

There is a strong emphasis in the ICGN document on the responsible exercise of ownership rights; the point is clearly emphasised that these rights extend well beyond the usual voting activity to the much richer area of engagement between institutions and investee companies - and extend to engagement beyond that purely on governance matters, narrowly understood. The argument is that by using these rights responsibly, institutions will be more likely to gain traction and encourage positive change, and ensure therefore that they add value for their beneficiaries. Readers can find the Statement at http://www.icgn.org [31 August 2007].

The Statement says:

This is not an end in itself, the ICGN states. Rather:

One aspect of the Statement is that institutions should be very clear about their policies and approaches to their ownership responsibilities. One step we at Hermes have taken is to publish what we called the Hermes Principles, a statement of what shareholders expect of public companies. These lay out what good companies already do. The Hermes Principles - first published in 2002 - fall into four categories as follows.

Communications

Principle 1 - Companies should seek an honest, open and ongoing dialogue with shareholders. They should clearly communicate the plans they are pursuing and the likely financial and wider consequences of those plans. Ideally goals, plans and progress should be discussed in the annual report and accounts.

Financial

Principle 2 - Companies should have appropriate measures and systems in place to ensure that they know which activities and competencies contribute most to maximising shareholder value.

Principle 3 - Companies should ensure all investment plans have been honestly and critically tested in terms of their ability to deliver long-term shareholder value.

Principle 4 - Companies should allocate capital for investment by seeking fully and creatively to exploit opportunities for growth within their core businesses rather than seeking unrelated diversification. This is particularly true when considering acquisitive growth.

Principle 5 - Companies should have performance evaluation and incentive systems designed cost-effectively to give managers incentives to deliver long-term shareholder value.

Principle 6 - Companies should have an efficient capital structure which will minimise the long-term cost of capital.

Strategic

Principle 7 - Companies should have and continue to develop coherent strategies for each business unit. These should ideally be expressed in terms of market prospects and of the competitive advantage the business has in exploiting these prospects. The company should understand the factors which drive market growth, and the particular strengths which underpin its competitive position.

Principle 8 - Companies should be able to explain why they are the 'best parent' of the businesses they run. Where they are not best parent they should be developing plans to resolve the issue.

Social, ethical and environmental

Principle 9 - Companies should manage effectively relationships with their employees, suppliers and customers and with others who have a legitimate interest in the company's activities. Companies should behave ethically and have regard for the environment and society as a whole.

Principle 10 - Companies should support voluntary and statutory measures which minimise the externalisation of costs to the detriment of society at large.

In many ways, these are statements of motherhood and apple pie; as I say; good companies already do these things. But we believe that the Hermes Principles do provide a significant addition to the debate on the role of companies and the relationship between owners and their investee companies. In particular, we believe that they act as a counterbalance to the shorter-term voices in the market. A company which is genuinely and actively addressing all the issues raised by the Hermes Principles deserves the support of its shareholders and should expect to be able to see off the shorter-term pressures which it might occasionally face.

Good companies have nothing to fear from the governance debate, and from the developing approaches of long-term investment institutions to their responsibilities as owners of companies. Instead, they have everything to gain from having stable long-term owners. Companies which address genuine concerns of these longterm owners and build trust through effective and transparent communications will earn the ongoing support of their investors. Those that fail to do so may face the increasing cacophony seeking short-term fixes to their problems.

As institutions increasingly focus their finite investment resources on those companies where engagement and good ownership can add value, companies which are operating effectively and performing sustainably well for their investors are likely to be supported and left to continue to plough their successful furrows. If they need the outside perspective of an interested long-term owner, they should expect to have individuals whom they can contact. There may be the occasional clarification sought about structures or explanations of non-compliance from institutions, but otherwise, they can expect to be left to perform.

However, companies which are not performing well, and which fail to communicate effectively the reasons for that underperformance and to articulate a practical strategy for bringing it to an end, should expect to have involved institutional investors paying close attention and seeking meetings with board members on a more frequent basis than usual. Whether that is done directly by investment institutions themselves or by an organisation which they have hired to represent them in such engagement meetings, companies and directors need to be ready to meet to discuss these genuine concerns.

After all, there is a clear alignment of interests here: all parties are working for the same principals. If it is in those principal's interests for a company to change, it is part of the fiduciary duties of every member of the chain of accountability from the underlying beneficiaries to the company - including the pension trustees, their agents, and the company directors - to seek to carry forward that change. There need not be public dissent and argument. There need be no failures to communicate, but if necessary all parties may need to pull together to make change occur.

However, companies which are not performing well, and which fail to communicate effectively the reasons for that underperformance and to articulate a practical strategy for bringing it to an end, should expect to have involved institutional investors paying close attention and seeking meetings with board members on a more frequent basis than usual. Whether that is done directly by investment institutions themselves or by an organisation which they have hired to represent them in such engagement meetings, companies and directors need to be ready to meet to discuss these genuine concerns.

After all, there is a clear alignment of interests here: all parties are working for the same principals. If it is in those principal's interests for a company to change, it is part of the fiduciary duties of every member of the chain of accountability from the underlying beneficiaries to the company - including the pension trustees, their agents, and the company directors - to seek to carry forward that change. There need not be public dissent and argument. There need be no failures to communicate, but if necessary all parties may need to pull together to make change occur.