In its recent green paper, the European Commission expressed concern about the effects of conflicts of interest on institutional investors’ willingness and ability to engage investee companies actively on corporate governance matters. Given the pervasiveness of asset manager conflicts and their adverse impact on shareholder engagement and voting behaviour, the remedies pursued must venture beyond the EC’s proposal of requiring ‘independence of the asset manager’s governing body’.
Three Layers of Conflicts
Conflicts of interest at investment firms arise at three levels – institution, individual, and group – all of which pose risks to effective stewardship by institutional investors.
Institutionally, the core conflict of interest pertains to asset managers’ unwillingness to actively engage and hold the boards and management of investee companies accountable because they fear losing corporate business. In reality, the risk of commercial harm varies by market. In the UK, for example, companies do not usually retaliate by withholding business when investment managers vote against management’s proposals. Nonetheless, the occasional veiled threat – such as when the company secretary of a UK manufacturer reminded a fund manager who was intending to vote against the company’s remuneration report that his firm was bidding for an investment mandate from the corporation’s pension plan – may be enough to make investment houses hesitate about embracing stewardship.
The way investments are managed can also misalign interest between portfolio managers and their clients. Take the practice of ‘underweighting’ – that is, holding a stock in an amount that is less than its market index weight. This has the potential to harm client interests because an asset manager who is underweight in a company will actually benefit – in relative terms – if the price of that stock declines. In other words, even though an investor is a shareholder in a company, his underweight position means that it would be contrary to his financial interest to intervene – through voting and engagement – to improve that firm’s performance.
Equally, fee arrangements can create a similar divergence of interest. For example, when fund managers are compensated solely from securities lending revenues, they may choose to maximise lending income rather than portfolio value.
Within an investment firm, conflicting interests among personnel are not uncommon. Take the tension between portfolio managers who make investment decisions and corporate governance staff who vote the firm’s holdings and engage with investee companies on governance and related issues. In brief, fund managers worry they will lose access to management at current and prospective investee companies if their institutions – due to the corporate governance team’s activities – are perceived as ‘agitators’. For this reason, portfolio managers at a large European investment firm have often thwarted efforts by the responsible investment staff to raise environmental, social, and governance concerns.
Conflicts can also arise when fund managers maintain opposing investment positions. For instance, one investment manager may be bearish on a company’s prospects and, believing its shares will underperform, go ‘underweight’ or ‘short’ (selling borrowed shares and hoping to repurchase them later at a lower price). However, the investment house may also have passive funds owning this stock and other portfolio managers who – employing differing investment strategies – are ‘overweight’ in the company.
This situation complicates how their firm should act as a shareholder. Should it suggest to the company ways to rectify weaknesses – for instance, poor board or disclosure practices – so that the shares will rise in value, thereby benefiting its passive funds and ‘overweight’ managers? Or should it draw attention to these deficiencies publicly and use its voting rights to, say, re-elect a dysfunctional board so that the share price will fall, thus helping the bearish managers?
This problem is not theoretical. At a European investment institution, a portfolio manager who had shorted a basket of stocks recently inquired whether the corporate governance team could help further his fund’s investment objective – which was a drop in the shorted companies’ share values – through voting the holdings of the firm’s other funds.
Where an investment firm is owned by a financial conglomerate, a third layer of conflicts often surfaces. Here, conflicts of interest situations typically involve corporate or investment banking staff overtly or subtly pressuring their asset management colleagues to avoid antagonising their clients by, for example, voting against the CEO’s pay arrangements.
Concern over improper interference is heightened when the different arms of a financial conglomerate operate under a single umbrella brand. This is because commercial and investment banking clients may not distinguish between the different businesses or be sympathetic to explanations that the asset management division must operate autonomously.
The problem is particularly acute with respect to investment banking clients because the advice provided is pricey and highly personal, often involving helping the CEO to realise his vision for the company. Consequently, investment bankers are usually not averse to utilising the available means to ensure their customers are satisfied.
Recently, a senior investment banker asked his asset management colleague to accompany him to meet the chief executive of an industrial conglomerate in which the asset management unit held significant stakes. At the meeting, the banker told the CEO that ‘we want to do more business with you’ and emphasised that ‘our fund management colleagues are supporters of the company.’
Impact of Conflicts on Stewardship Behaviour
Conflicts of interest at investment firms impair their stewardship behaviour in multiple ways. Most obviously, corporate governance personnel may succumb to overt client or colleague pressure to, for instance, refrain from opposing a director’s re-election, the executive compensation plan, or other matters that the client’s management supports.
A more subtle but more pernicious effect is self-censorship, which – due to its hidden nature – is extremely difficult to detect and remedy. To illustrate, corporate governance staff who sense that a robust approach to voting and engagement will invite a backlash from the firm’s or parent company’s clients or grumblings from senior colleagues who would ‘have to take time away from the business to iron things out’ may choose the path of least resistance and avoid raising any controversy.
Another form of self-censorship is to curtail the scope of activity. At one bank-owned investment institution, the corporate governance team proposed that the firm start voting its rising holdings in a large emerging market. In their deliberations, top management considered the modest costs entailed, the fact that clients were not actively demanding voting in that country, and the high probability that companies there would retaliate against dissenting votes by withholding business from other units of the financial group. Although they ultimately decided to vote in this market, a subtle but clear message was conveyed that further expansion of voting activity would not necessarily be welcome.
What, then, are the potential solutions?
Some conflicts of interest are so harmful to institutional investor stewardship that client and public policy interests demand their elimination rather than ‘management’ through disclosure and other less drastic measures. This would include the situation of fund managers earning fees from securities lending rather than growth in portfolio value.
An argument can also be made to restrict voting rights for investors who are underweight or ‘net short’ – that is, where their short positions are greater than long holdings – because their votes could be abused to harm both clients and investee companies.
More broadly, certain combinations of businesses in the financial sector may prove so detrimental to client interests that policymakers could deem it necessary to impose a stricter regulatory regime or, in the extreme, proscribe them.
Less severe conflicts of interest could be managed through greater independence of decision-making within or outside an investment firm. A few asset managers, for instance, outsource to an independent third party the voting of their parent companies’ shares. Where an investment firm belongs to a financial conglomerate, this approach could be extended to its holdings in all clients of the group.
To prevent inappropriate meddling from colleagues servicing corporate clients, some investment houses prohibit client relations staff from speaking to the corporate governance team about voting matters pertaining to their customers.
Moreover, certain conflicts can be resolved by re-allocating decision rights within an institution. At firms where different funds might pursue conflicting investment strategies, voting authority could be given to individual fund managers – rather than a centralised corporate governance unit – so that voting decisions are aligned with investment objectives.
Equally, performance metrics for fund managers should be suitably long term so that corporate governance issues – which are more likely to impact company performance over an extended timeframe – would be of greater inherent interest to them.
Although robust structural and procedural remedies are needed, behavioural measures also matter. Top management can make a real difference by demonstrating a willingness to do the right thing and confront individuals – whether clients or colleagues – who exert inappropriate pressure on the corporate governance team. According to the corporate governance head of a large asset manager, ‘There is nothing more disheartening to my team than to see the senior leadership give in to client pressure or pre-emptively seek to avoid upsetting investment banking customers.’
At one investment house, the head of the institutional business made it clear to his staff – in words and deeds – that no interference in voting would be tolerated. By contrast, a senior executive at another firm was more equivocal, displaying a willingness to entertain preventive steps to minimise potential backlash from corporate clients.
To ensure the right ‘tone at the top’ has been established, supervisory authorities should periodically probe the organisational ‘culture’ of regulated investment firms. Pension fund and other clients can play an important monitoring role by taking the time to discuss the details of engagement activities and voting decisions with their fund managers.
If conflicts of interest at investment firms are left unchecked, current efforts to promote active, long-term oriented stewardship behaviour among institutional investors will falter. Moreover, as institutionally managed assets are expected to continue growing, the ‘absentee landlords’ share-ownership model will likely prevail.