Speech by Baroness Hogg at the 2012 NAPF Conference
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Published: 20 November 2012
Find below the plain text version of Baroness Hogg's speech at the 2012 NAPF Conference.
It is a great pleasure to be here today, and to act as the starter course for the Secretary of State, who I understand will be talking about the government’s response to the Kay review. This is the right gathering for that subject, because the issue of long termism clearly matters to the NAPF and your members, as you have demonstrated by your involvement with the Stewardship Code. So I would like to start, on behalf of the Financial Reporting Council, by thanking you for your support, which came at such a critical point in the Code’s development.
Capital markets and long-termism
But perhaps before turning to Codes – and one or two issues there that I know concern you - I might offer one or two broader thoughts. Since the banking crisis began, we have spent a lot of time and effort discussing with others the regulation and supervision of financial institutions. But the debate has not been as well-focused on the sort of capital market we need, and what can be done to encourage its development. I hope that Kay report will help to stimulate this, and I would therefore like to add our perspective.
Our mission at the FRC is to “promote high quality corporate governance and reporting to foster investment”. Those last three words are there to emphasise the ultimate economic long-term purpose of what we try to do. And this means we are in tune with much of the fine analysis in the Kay review, to which I will return in a minute. But we are perhaps more anxious than he appears to be about the future of the equity market.
The Kay report noted that the equity market has for some time ceased to be a source of net new capital for companies, and therefore argues that its role is nowadays mainly to be the focus for corporate governance control. This is an important role, but we believe in something wider than that.
The market for risk capital, when it is working well, enables savers to share in the growth of the most successful companies, and those companies to attract risk-sharing capital at the lowest possible cost. It can thus be a powerful driver of growth. The provision of risk capital to companies depends on the confidence providers can have that their interests are protected. Protected, that is, by a good board, and buttressed by clear and honest reports on the company’s performance. Hence our work on reporting, auditing and governance is, we believe, related to this supply.
We need, perhaps more than ever in the wake of the banking crisis, a diverse, well-functioning capital market. And indeed, one of our reasons for supporting John Kay’s work is that we hope it will contribute to a strengthening of the equity market so that it can play its essential part. Moreover, the debate over new forms of risk capital, such as bail-in debt, for banks, shows that the need for it has not disappeared – indeed that the boundaries between risk capital and debt are permeable.
The Kay report highlights three objectives that we at the FRC fully support:
- Companies, savers and intermediaries should be encouraged to adopt investment approaches and make corporate decisions which achieve long-term returns;
- The information companies provide should be directly relevant to this end, and reporting should be clear, relevant, timely and related closely to the needs of users;
- And all links in the investment chain should act according to the principles of stewardship, which for investors includes greater involvement with the companies in which they invest.
Much of our work is directed towards these aims. Take, for example, the inquiry we asked Lord Sharman to lead, into going concern assessments – a point of serious concern following the financial crisis. Lord Sharman’s panel, which reported a few months ago, believed that the primary purpose of the going concern assessment should be to reinforce responsible management of risk. He also argued that the going concern considerations made by directors - and reviewed by auditors - should cover both solvency and liquidity; and that these should cover a longer period than they currently do. Our new guidance to directors on going concern, on which we will be consulting before the end of the year, will reflect these recommendations.
The panel also recommended that the going concern assessment should be integrated with business planning and risk management. Its report stipulated that investors should be given a fuller picture of the principal risks the entity faces, rather than highlighting going concern risks only when there are significant doubts about the entity’s immediate survival. For that reason, we will issue for consultation at the same time an updated draft of our guidance to directors on risk and internal control.
Both these consultations reflect our belief that if reporting requirements are designed intelligently, they can be used to create more focus in the business on its longer term sustainability. This applies to financial reporting just as much as to the front half of the report. Financial statements need to do more than help forecasts of earnings and cash flows: they need to portray the progress of the business. Only if investors have this information can they engage in real discussions as to how value can be created and sustained in the long-term.
This is precisely the target of one of our current projects. Accounting standard setters tend to focus on prescriptions for specific kinds of transactions: by contrast, we are looking at the totality of the information in the financial statements, and examining ways of making it more useful to the long-term investor.
This is a project we are undertaking jointly with EFRAG – the European Financial Reporting Advisory Group - and the French accounting standard-setter. International consistency should not be an end in itself. But there are benefits if it can be achieved while also delivering the best outcome.
Our perennial concern is the complexity in financial reports, and the search for ways in which “clutter” can be reduced. Recently, we have published a paper on “disclosure overload”, urging the development of a clear disclosure framework that could be used by all regulators. We believe this would be preferable to the current, often piecemeal, approach whereby regulators place ever more add-ons on to an overloaded reporting structure.
We also welcome the International Accounting Standards Board’s commitment to complete its work on the Conceptual Framework. This provides an opportunity to focus on ensuring financial statements are fit for purpose. We will be looking at the role that a concept of reporting for stewardship, rather than reporting for transactional valuation, should play.
Perhaps most significantly of all, we have established the Financial Reporting Lab. This does not exist to push an FRC approach, but provides a facility for companies and investors to develop pragmatic solutions – either within current reporting requirements, or as evidence that those requirements need to be changed.
The Lab has, for example, worked – on behalf of BIS – on the compilation of a single figure for executive remuneration. I’m grateful to the NAPF members who took part in that project, whose conclusions have informed the Department’s draft legislation.
The Stewardship Code
Many of the changes to the latest Codes for which we have responsibility – for Stewardship and Corporate Governance – have also been made with the intention of improving communication and engagement between companies and investors.
When the FRC took responsibility for the Stewardship Code in 2010, we took the view that the Statement of Principles by the Institutional Shareholders’ Committee – in whose development the NAPF was closely involved – should be adopted almost unchanged. In the 2012 edition we have resisted the temptation to add new principles, and have instead sought to clarify and sharpen up what was already there.
So, first: we have toughened the language on conflicts of interest. It is not always clear from the statements made by asset managers how such conflicts are managed, for example, in situations where the interests of different clients converge.
Second: we have asked asset managers to give a clearer picture of how they use proxy voting agencies. Outsourcing activities to third parties does not absolve managers of their responsibilities for stewardship. Proxy agencies must not be seen to stand between you and the companies in which you invest. And there is much unease in boardrooms, at present, about the extent to which they do.
Third: we have asked signatories to explain their policy on stock lending, and in particular whether they recall lent stock for voting purposes. We have not however addressed the issue of voting in pooled funds. This was raised by some of your members, but it is one where we felt there was as yet insufficient consensus to write provisions into the Code. We will be hosting discussions on this in the New Year and hope we can identify a way to take it forward to everybody’s satisfaction.
Fourth: we have strengthened the principle of the Code dealing with assurance. There is now a presumption that asset managers should obtain independent assurance that their reports on stewardship accurately reflect what they do - although they can of course choose to explain rather than comply with this. The Code also states that the assurance reports should be made available to clients on request. This provides another mechanism by which owners can hold managers to account, and assess how well their interests are being looked after.
Fifth – and perhaps most importantly – the new version of the Code distinguishes much more clearly the roles of asset owners and asset managers. While individual asset owners – including, most importantly, some NAPF members – have committed to the Code, the way it was first written perhaps made it too easy for others to argue that it was nothing to do with them.
We have never believed that to be the case - quite the opposite, in fact. But we needed to recognise that while some asset owners are in a position to engage directly with companies, the majority will do so indirectly through the mandates given to asset managers. So the Code now states that they should clearly communicate their policies on stewardship to their managers, and seek to hold their managers to account. This message also came through very strongly in the Kay report, and I’m delighted to see it has been reinforced in the new stewardship policy that the NAPF has published today.
The Corporate Governance Code
There are also changes in the 2012 Corporate Governance Code, although here we have tried to keep these to a minimum. First – and I trust uncontroversially - Boards are asked to confirm that the report and accounts, taken as a whole, are fair, balanced and understandable. These simple requirements are a polite reminder that a narrative report is not merely a marketing document, but should complement the figures in the financial accounts, to provide a clear and coherent portrayal of the progress of the business.
Second: we have sought to encourage more informative audit committee reports. Audit Committees play a vital role, but few of them manage to convey this fully to shareholders. Here – with some pioneering exceptions - boilerplate still rules, doing a disservice both to the committees themselves and to shareholders.
Third: we have asked boards to set out their policies on boardroom diversity. We are very glad to see that the European Commission has decided against mandatory quotas for women, since we believe that a combination of disclosure and promoting best practice is a better approach. And the emphasis on diversity, first added to the Code in 2010, together with Lord Davies’s report, have helped trigger an acceleration in the appointment of women to boards that helps demonstrate the value of a voluntary approach. Your interest, as the givers of investment mandates, is important to ensuring this momentum is sustained.
Fourth: in the 2012 Code, we have turned the spotlight on the “explain” side of the “company or explain” choice. Here too, boilerplate serves neither companies nor shareholders, nor our efforts to defend the British Code-based approach on the international stage. This is an important issue and is expected to feature in the European Commission’s forthcoming company law action plan.
We hope these changes will help broaden the dialogue between companies and their shareholders. But that depends on investors, too. Engaging on remuneration is important; engaging only on remuneration risks a backlash from companies who have tried to raise their reporting game.
Fifth: the new version of the Code also includes the proposition that FTSE 350 companies should put their audit out to tender at least every 10 years. You, I know, have advocated mandatory rotation. I could simply note that, so far as we can tell from the responses we received to our consultation, your approach represents a minority view, even among investors. It is not supported by other investor bodies. However, because I know the NAPF consider these things seriously, I would like to give you a fuller explanation of our view.
We believe that mandatory rotation would, in fact, be less of a discipline, especially in sectors, like banking, where there may be only a couple of firms capable of doing the audit. In those sectors, rotation would be simply a matter of revolving doors, with no real competition or incentive to offer superior quality. Even where three or four major firms are in play, we think it would be inimical to competition and quality to restrict choice by excluding the incumbent.
Of course I understand the theoretical fear of box-ticking exercises designed to leave the incumbent in place! But we believe that today’s audit committees take their role seriously and so are very unlikely to want to take part in such a farce. And the enhanced disclosures we are now expecting from audit committees help give you a hook on which to engage and ensure that they don’t.
I hope that helps to reassure you as to our approach. We agree on so many things, and over the years have welcomed your steadfast contribution and that of your members to the governance process. An important part of this contribution is a willingness to debate, which I share, and I look forward to many more discussions with you in the future.