The relationship between companies and financial markets has been a key element of Tomorrow’s Company’s work over the years (a summary of key findings follows).  The work has concentrated on the investment system – pension funds, institutional investors and the other agents involved in generating returns for savers and financing industry.   The insights generated, however, have relevance for the wider financial system.

 

Firstly, financial services are just that, a service, not a string of products for generating fees.  Wealth creation and productivity improvement are vital parts of meeting the future demands of the global population.  The financial services industry can facilitate or hinder this.  Providers need to get themselves aligned with the needs and wants of users. 

 

The industry needs to regulate itself, so that companies can trust who they are dealing with and customers, savers and clients can have confidence that the industry is acting in their interests.  It should be guided by statement of principles, such as the Hippocratic Oath in the medical profession, and maintain a thorough dialogue that ensures the agent knows what the principal wants. 

 

The statement of principles is a soft framework that can guide the market.  Effective self-regulation builds reputation and trust.  But it is not enough on its own.  The interconnected nature of recent events has shown the need for global frameworks.  Formal regulation can have unintended consequences, so companies that are serious about operating in the global economy need to take the time and commitment to work with others, including governments and NGOs, to create effective frameworks.  Both global frameworks and effective self-regulation are needed.

 

Part of the alignment with the users of the financial system comes through performance- related incentives.  The industry also needs to disclose much more – the economic interests held in companies, details of charges; the rationale behind pay and bonus arrangements and the assumptions of the risks being taken are among the areas for improvement.  Smart transparency is needed that delivers accountability, so that people can better see the contribution made to the global economy and can value the service the service they get.  This accountability needs to be broadly-based, not just financial or monetary; e.g. what is the wealth created from the deals generated or underwritten by investment banks?

 

All parts of the investment system need to exercise the rights and responsibilities of ownership and be stewards of the resources they are given, undertaking a broad analysis of financial and extra-financial performance and engaging in a critical and wide-ranging dialogue about the use of resources.  Shareholders, directors and advisers each need to focus on how they act in the best interests of the company.  Actions are needed to counter short-term pressures in the system, such as having the same disclosure requirements for economic interests in a company, whether long or short, direct or indirect.

 

There is a significant shortage of understanding about the industry, how it operates, the wider benefits it brings and the risks it runs.  A wider debate is needed on the purpose and methods of the financial services industry and how it fits into the wider economic, social and environmental systems:
• Shorting can more quickly expose overvalued companies, yet can destabilise confidence in companies;
• Securitisation can improve the pricing of some risks, yet fundamentally is repackaging risks, not reducing them;
• Investment banks can identify and underwrite value-creating deals, but can generate fees from products with poorly understood risks;
• Derivatives can permit the exercise of hedging strategies that increase cash-flow certainty, but can concentrate risks in unexpected ways;
• Liquidity enables accurate valuation, but can reduce the rigour needed in analysis.
The individual investor, whether direct or beneficiary, needs to be brought into the dialogue.

 

What Tomorrow’s Company has said …

 

 

The report set out five key areas for change:

 

1. Standards and principles

At the heart of the proposals is self-regulation.  A forum was mooted, where leaders from all parts of the investment system might meet on a regular basis to address those issues key to the building of public trust and the development of a positive reputation for the industry.  There should be an overarching ‘statement of principles’ to cover all aspects of the industry and to which all parties can commit, supported by an industry-wide ‘seal of approval’ to provide both a visible and marketable endorsement.  The positive identification of potential malpractice by an attentive industry would not only help to offset the debilitating impact of regular assaults on the industry’s reputation; it would go some way to enhancing it. Boards of directors or senior partners would need to set the example.

 

Recommendations included:

• Develop an overarching code, which is clear, simple, sets out high level principles and standards and is easily understood.  This can be a reference point for industry bodies and financial services providers. 
• Implement through a forum for self-regulation, with specific benefits and sanctions through a “seal of approval”.
• Keep the code under constant review.

2. Alignment and transparency

The Team expressed concern that there is a lack of alignment of the incentives and remuneration of the industry with those of the long term interests of their customers; a lack of transparency in respect of industry charges and costs; and a failure to disclose and manage conflicts of interest.  Unless the various players in the system improve the transparency and alignment of their operations and resolve the many conflicts of interest, they will lack credibility when exercising the rights and responsibilities of ownership.

For better alignment recommendations included:

• pension funds should:
 • Encourage trustees to set out investment objectives more clearly; e.g. though tougher and broader statements of investment principles;
 • Construct mandates on the assumption that they are for the long-term, ideally seven to ten years;
 • Address short-term pressures from accounting requirements, solvency requirements, trust law and actuarial valuation standards; and
 • Improve dialogue between principals (pension fund trustees) and their agents (fund managers);
• remuneration and incentives should be based on:
 • Performance related fees linked to value creation, rather than volume-driven measures such as assets under management;
 • A published rationale for pay / bonus arrangements;
 • Rewarding management with shares rather than options; and
 • Associations and professional bodies collaborating on best practice in this area.

 

For better transparency there should be:

 

• The full disclosure of charges;
• The declaration of  potential conflicts; e.g. investment bank broker / research conflicts, and addressing through
 • Independent advice where possible; and
 • Governance procedures, with separation of functions in extreme cases
• benchmarking investment banks through the performance of deals they are associated with.

3. Exercising ownership rights and responsibilities

There is a considerable body of evidence revealing a link between the way in which a company is governed and its performance; in particular a link between active ownership and enhanced performance in those companies with the potential to improve. 

 

Shareholder engagement can be a positive force, but it needs to be carried out with intelligence and integrity.  The exercise of the responsibilities of ownership calls for constructive dialogue between investors and companies.  Despite the encouragement of government and others, the Team believed that many of the fiduciaries representing companies’ largest shareholders have largely abdicated their responsibilities as owners.  Effective dialogue, focused on future value creation, demands that institutional shareholders develop a deep understanding of what drives a particular company’s business success.  Companies need to supply the right information, but investors and their agents also need to ask the right questions.

 

Recommendations included:

• Noting the responsibilities of institutional shareholders to:
 • Set out policy on discharging their responsibilities;
 • Monitor performance of and establish regular dialogue with companies;
 • Intervene when necessary;
 • Evaluate impact of their activism; and
 • Report back to clients/beneficial owners.

 

• Concluding that best practice by institutions includes:
 • Telling companies what is expected of them;
 • Attending company general meetings more frequently;
 • Providing prompt and full responses to company info requests / consultations;
 • Publishing  statement of how will exercise responsibilities;
 • Adopting the Myners Working Group recommendations on voting practices; and
 • Publishing voting records, including details of which companies are client companies.

 

• Institutions should consider collaborative working and pool resources on companies in which they jointly invest.  In any case, institutions need to have competence and authority; i.e.
 • Sufficient practical experience of boards;
 • Sufficient number of experts;
 • Canvas beneficial owners on expectations about governance and remuneration policies; and
 • Robust systems of reporting and accountability.

 

• Consultants should develop ratings for the function of exercising ownership.

 

• OIECS and unit trusts should have independent boards focused on investors’ requirements.

4. Evaluating long-term business success

Efficient markets require objective, accurate and relevant information.  To meet these criteria, analysis of a company’s performance needs to be as complete as possible and take into account tangible and intangible factors and financial and non-financial information.
 

Research findings show that the majority of mergers and takeovers made by large quoted companies had failed to produce any benefits and over half had actually destroyed value.  Growth for growth’s sake via takeovers has been a prime cause of shareholder value destruction.  Companies need to initiate a deeper and more strategic dialogue with their investors; they should also be bolder in setting out their long term strategy.

 

Recommendations included:
 

• Improving knowledge and understanding of range of performance indicators available, collaborate on evaluation frameworks and review professional education;

• The need for deeper research:
 • Using independently verifiable sources of information;
 • Reviewing processes to ensure the use of up to date thinking;
 • Evaluating a wider range of companies;

• Enhancing accounting and reporting to include:
 • The presentation of forward looking information;
 • Greater attention to non-financial indicators of performance;
 • Greater transparency on future cash flows; and
 • Reviewing the potential to simplify accounting and reporting standards;

• Developing the dialogue between companies and shareholders to include long-term strategy issues; e.g. through statements and events; and

• Companies disclosing decisions to exclude or disadvantage analysts providing unfavourable comment.

 

5. Empowering the individual investor
 

The ultimate investor is the private individual.  Just as a better dialogue needs to be in place in order to improve the relationship between the institutional investor and the company in which it invests, a similar improvement needs to be set in train between the individual investor and the financial service provider or adviser.

 

The retail financial services sector has been plagued by a series of scandals, yet attempts to protect the individual investor and to tighten regulation have sometimes been counter-productive; adding layers of extra cost and creating complicated compliance documentation that individuals find difficult to understand.  A healthy retail investment climate is dependent on investor confidence in the market’s products and providers, an industry with a reputation for fair dealing and a growing investor understanding of risk.

 

Recommendations included:
 

• Improving awareness and education through
 • Teaching of basic finance at school;
 • Building on success of initiatives such as Yong Enterprise;
 • Including more complex topics; e.g. retirement provision in higher education
 • Improving understanding of risk;

• Improving motivations and incentives through
 • Politicians setting out a long-term approach to means-testing;
 • Fiscal incentives to encourage move from state provision and an incentive for companies to contribute to stakeholder plans;

• Advisers need to build stronger relationships and have a deeper dialogue, ensure the alignment of incentives and move beyond the minimum required for compliance;

• Developing guidelines about the use of "guarantee" and a risk classification to help understanding;

• Allowing greater flexibility in taking retirement benefits;

• Greater disclosure of costs in managing the product; and

• Protection for customers through adopting the statement of principles.

 

 

This publication was produced as part of the debate into long-term pension provision in the UK.  It challenged a number of assumptions about future pension provision.  Key points included:

 

• It is dangerous to try to predict now what the world will look like in 40 years time; instead take a quinquennial approach
• The dependency ratio is not being calculated appropriately.
• There is no automatic link between savings, investment in productive resources and economic growth.
• There are strong barriers to overcome if people are to save more:
 • Lost of trust in the financial services industry
 • The scale of initial charges and management fees
 • The existence of means testing
• House ownership can provide retirement income, but only for some.
• Encourage the move away from an all or nothing approach to work and retirement.
• The main factor affecting our ability to afford an ageing population without erosion of living standards is the impact of rising productivity.  Companies will continue to be the underlying source of pensioners’ incomes in real terms.  A highly competitive economy is the best means of ensuring the predicted crisis does not materialise.
• There is support for a universal taxation-funded state pension.

 

Tomorrow’s Global Company (2007)

 

This report was the conclusion of an 18 month inquiry into the challenges and choices faced by tomorrow’s global company.  The key points made by the Inquiry Team were:

• We believe in a strong market economy.  This has driven human progress and growth, lifting the living standards of many people.
• The world is now undergoing a period of unprecedented change and it is becoming clear that the current frameworks in which the market operates are leading to unsustainable outcomes.
• Global companies can be a force for good and are uniquely placed to deliver the practical solutions that are urgently required.
• Tomorrow’s global companies need to work together, accepting their share of responsibility for addressing the world’s challenges.
• Redefining success, embedding values and creating frameworks are three specific ways in which global companies can fulfil this role.