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Please cite this publication as:

OECD (2011),The Role of Institutional Investors in Promoting Good Corporate Governance, Corporate Governance, OECD Publishing. http://dx.doi.org/10.1787/9789264128750-en

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Corporate Governance

The Role of Institutional Investors in Promoting Good Corporate Governance Contents

Executive Summary

Assessment and Recommendations

Part I Overview Chapter 1. The Structure and Behaviour of Institutional Investors

Part II In-depth Country Reviews on the Role of Institutional Investors in Promoting Good Corporate Governance Chapter 2. Australia: The Role of Institutional Investors in Promoting Good Corporate Governance

Chapter 3. Chile: The Role of Institutional Investors in Promoting Good Corporate Governance

Chapter 4. Germany: The Role of Institutional Investors in Promoting Good Corporate Governance

Annex A. The Questionnaire of the OECD Corporate Governance Committee

Annex B. The Data Requested in the Questionnaire of the OECD Corporate Governance Committee

ISBN 978-92-64-12874-3 26 2011 11 1 P -:HSTCQE=VW]\YX:

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Corporate Governance

The Role of Institutional Investors in Promoting Good Corporate Governance

Corporate Governance

The Role of Institutional Investors in Promoting

Good Corporate Governance

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FOREWORD

Foreword

This report presents the results of the second thematic peer review based on the OECD Principles of Corporate Governance. The report is focused on the role of institutional investors in promoting

good corporate governance practices including the incentives they face to promote such outcomes. It

covers 26 different jurisdictions, including in-depth reviews of Australia, Chile and Germany.

The report is based in part on a questionnaire that was sent to all participating jurisdictions in

January 2011 (see Annex A). All countries were invited to respond to the first question so as to

provide an overall context within which the review would take place. The three jurisdictions that

were subject to the in-depth review were invited to complete all questions.

The report first reviews what is known about the institutional investor landscape including the

behavioural codes and legal framework. It then describes what is known about the incentives that

condition their actions before considering the record of engagement and voting. The second part

comprises the three country reviews. The report was prepared by Grant Kirkpatrick, Héctor Lehuedé

and Kenji Hoki with inputs from Simon Wong and Marco Morales and approved for publication

under the authority of the OECD Corporate Governance Committee in August 2011.

The OECD corporate governance peer review process is designed to facilitate effective

implementation of the Principles and to assist market participants and policy makers to respond to

emerging corporate governance risks. The reviews are also forward looking so as to help identify, at

an early stage, key market practices and policy developments that may undermine the quality of

corporate governance. The review process is open to OECD and non-OECD jurisdictions alike.

THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE © OECD 2011 3

TABLE OF CONTENTS

Table of Contents

Executive Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

Assessment and Recommendations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

Part I

Overview

Chapter 1. The Structure and Behaviour of Institutional Investors . . . . . . . . . . . . . . . . 19 1.1. Background, objectives and issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

1.2. The institutional investor landscape . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

1.3. Codes, legal frameworks and disclosure requirements . . . . . . . . . . . . . . . . . . . 32

1.4. Co-operation between investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38

1.5. Investment behaviour of institutional investors: the driving forces . . . . . . . . 40

1.6. The voting and engagement record . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63

Part II

In-depth Country Reviews on the Role of Institutional Investors

in Promoting Good Corporate Governance

Chapter 2. Australia: The Role of Institutional Investors in Promoting Good Corporate Governance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69 2.1. Institutional investor landscape . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70

2.2. Legal rules and other guidance relating to shareholder rights and responsibilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74

2.3. Exercise of shareholder rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78

2.4. Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85

Annex 2.1: Summary of legal provisions relating to the fiduciary responsibilities of institutional investors in Australia . . . . . . . . . . . . . . . . . . . . . . . . 86

Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88

Chapter 3. Chile: The Role of Institutional Investors in Promoting Good Corporate Governance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89 3.1. The corporate governance landscape . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91

3.2. Legal and regulatory framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98

THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE © OECD 2011 5

TABLE OF CONTENTS

3.3. Exercise of shareholder rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102

3.4. Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107

Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108

Chapter 4. Germany: The Role of Institutional Investors in Promoting Good Corporate Governance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111 4.1. The corporate governance landscape . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112

4.2. Institutional investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114

4.3. Exercise of shareholder rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118

4.4. Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126

Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128

Annex A. The Questionnaire of the OECD Corporate Governance Committee . . . . . . . 131

Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134

Annex B. The Data Requested in the Questionnaire of the OECD Corporate Governance Committee . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135

Tables

1.1. Financial assets by institutional investors in other jurisdictions . . . . . . . . . . . 29

1.2. Largest global investment managers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29

1.3. Ownership structure of India . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

1.4. Historical average holding period (years) by type of investors in TSE . . . . . . . 32

1.5. Summary of the status of the Principles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33

2.1. Australia’s superannuation industry (as at Dec 2010) . . . . . . . . . . . . . . . . . . . . . 71

2.2. Recent trends in the number of Australian superannuation industry by entities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72

2.3. IFSA Blue Book - Summary of guidelines for fund managers . . . . . . . . . . . . . . 75

2.4. ACSI guide for superannuation trustees on the consideration of ESG risks in listed companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76

2.5. ACSI guide for fund managers and consultants on the consideration of ESG risks in listed companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76

2.6. Substantial no votes in remuneration reports in 2009 . . . . . . . . . . . . . . . . . . . . 84

3.1. Ownership concentration (average per year) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94

3.2. Pension funds’ Investments in Chilean corporate Assets . . . . . . . . . . . . . . . . . 97 3.3. AFPs ownership in companies renewing boards per year . . . . . . . . . . . . . . . . . 103

3.4. Companies renewing their boards by year and by size of the board . . . . . . . . 103

3.5. Directors elected by AFPs by company according to % of votes . . . . . . . . . . . . 103

3.6. Percentage of companies where AFPs elected one or more directors per year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103

3.7. Independent directors’ profile . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104

4.1. Ownership concentration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113

4.2. Average shareholder turnout is reasonable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123

4.3. Shareholder dissent remain low . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124

4.4. Shareholder dissent depends on the type of resolution . . . . . . . . . . . . . . . . . . . 125

THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE © OECD 20116

TABLE OF CONTENTS

Figures

1.1. Ownership structure in selected OECD countries . . . . . . . . . . . . . . . . . . . . . . . . 20

1.2. Financial assets under management by institutional investors in OECD countries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

1.3. Type of financial assets managed by the industry (in trillion USD) . . . . . . . . . 27

1.4. Shares and other equity by class of institutional management . . . . . . . . . . . . 27

1.5. Percentage of assets held as “shares and other equity” by type of institutional asset owner . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

1.6. Share of financial assets held by institutional asset managers in 2009 . . . . . . 28

1.7. Ownership by domestic institutional investors and foreign investors in selected countries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

1.8. Average holding period on major stock exchanges (number of years) . . . . . . . 31

1.9. Voting decision making authority . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51

1.10. Voting process in Europe (simplified) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55

1.11. Estimated minority shareholder turnout in Europe . . . . . . . . . . . . . . . . . . . . . . 57

1.12. Clustering of shareholder meetings in Europe . . . . . . . . . . . . . . . . . . . . . . . . . . . 58

2.1. Equity holdings by all types of investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70

3.1. Chilean listed market capitalisation to GDP (%) . . . . . . . . . . . . . . . . . . . . . . . . . . 92

3.2. Number of Chilean listed companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92

3.3. Turnover on Chilean listed market (%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93

3.4. Market ownership concentration (three largest shareholders) . . . . . . . . . . . . . 95

3.5. Assets under administration by type of Institutional Investors . . . . . . . . . . . . 96

3.6. Evolution of pension fund portfolios (per sector) . . . . . . . . . . . . . . . . . . . . . . . . . 96

3.7. Pension fund investment in Chilean corporate assets (as % of total assets) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97

4.1. Equity holdings by all types of investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115

THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE © OECD 2011 7

The Role of Institutional Investors in Promoting

Good Corporate Governance © OECD 2011

Executive Summary

The OECD Principles of Corporate Governance embrace the underlying assumption that shareholders can best look after their own interests, provided they have sufficient rights

and access to information. The increased presence of large institutional investors in the

last decade fostered the expectation that a new breed of highly skilled and well resourced

professional shareholders would make informed use of their rights, promoting good

corporate governance in companies in which they invest. Those prospects are reflected in

Principles II.F and II.G, added in 2004 to cover disclosure of voting policies, managing

conflicts of interest and co-operation between investors. However, institutional investors

are not like other shareholders but have a unique set of costs, benefits and objectives.

Accordingly, they have not always behaved as desired. This report investigates their

behaviour by way of three peer reviews on the implementation of Principles II.F and II.G

(Australia, Chile and Germany) and a general review of academic research and country

experience.

Institutional investors are financial institutions that accept funds from third parties

for investment in their own name but on such parties’ behalf. They include pension funds,

mutual funds and insurance companies. By 2009, they manag ed an estimated

USD 53 trillion of assets in the OECD area, including USD 22 trillion in equity. Additionally,

there are large investments made by the fund management industry directly under their

client’s name. This makes institutional investors a major force in many capital markets.

With the goal of optimising returns for targeted levels of risk, as well as for prudential

regulation, institutional investors diversify investments into large portfolios, many of them

having investments in thousands of companies. Some managers pursue active investment

strategies, but increasingly, they passively manage against a benchmark, resorting to

indexing. At the same time, the investment chain has lengthened by outsourcing of

management, further distancing investee companies from the beneficial owners. As a

result, incentives do not always stimulate institutional investors to engage in monitoring

the corporate governance practices of investee companies.

Unlike in the case of private equity and hedge funds, most institutional investors are

not remunerated on the basis of the performance of portfolio companies, but on the basis

of the volume of assets under management. Moreover, fund performance against a

benchmark is reviewed often by investors on the basis of mandates not exceeding three

years. Taken together, these factors favour a focus on increasing the size of assets under

management and on investing them in indices, rather than on improving the performance

of portfolio companies. Incentives for churning of assets and strong conflicts of interest

add to those factors and create a challenging context for the notion of institutional

shareholder engagement and their promotion of better governance practices. The costs of

monitoring a large number of companies are significant, while the benefits are shared with

EXECUTIVE SUMMARY

all shareholders, creating a free rider problem. This often leads to sub-optimal monitoring

and analyst coverage of companies unless collective action is achieved.

A key problem identified in the report is that domestic investors in many jurisdictions

do not vote their foreign equity. This is important because foreign shareholders make up

around 30% of ownership in many jurisdictions. Barriers to cross-border voting that raise

the costs of exercising voting rights remain, but evidence shows that there is also a lack of

knowledge by institutional investors about foreign companies in their portfolios. This

could in principle be solved by making use of proxy advisors, but this raises other concerns.

There is the view that the proxy voting industry is already too influential leading to voting

and voting recommendations that are “tick the box” in nature and not sufficiently

differentiated by country and by company. There is also the question of conflicts of interest

prevalent in the industry.

Another relevant aspect of this review deals with whether institutional investors are

becoming increasingly short-term investors, or at least promoting short-term thinking by

investee companies. Pension funds, especially defined-benefit schemes should be able to

make long term investment to match liabilities to their beneficiaries that stretch over

many years. But a number of large institutional investors are not acting in this way.

Nevertheless, the review also points out that large institutional investors are often locked

into the shareholding of most large companies on a long-term basis, since for regulatory or

other reasons, diversification and index investing is the norm. Thus they are long-term

shareholders even if they buy and sell on a regular basis, or lend their shares for a fee. In

principle they have incentives to encourage good corporate governance but such

engagement still needs to be encouraged and facilitated.

The nature of institutional investors has evidently evolved over the years into a

complex system of financial institutions and fund management companies with their own

corporate governance issues and incentive structures. The OECD Principles make useful

recommendations in the direction of more transparency and management of conflicts of

interest by institutions, and co-operation between investors. However, the old question of

shareholder oversight of company boards needs to be re-examined in this new context.

A great deal can be done both by private agents and policy makers to improve the

corporate governance outcomes of institutional investors’ behaviour. In the private sector,

enhancing collaboration among institutional investors, as by establishing industry

associations to share the costs of monitoring and voting have shown positive results. On

the public policy side, prudential regulations sometimes excessively limit holdings by

institutional investors in individual companies and restrictions on incentive schemes may

also change their behaviour in an unintended manner. This review shows that given the

right set of conditions, institutional investors can play an important role both in

jurisdictions characterised by dispersed or concentrated ownership, their role facilitated by

private and/or public policy action. Australia is a good example of the former using a

private solution: an association of pension funds that conducts background research and

advises on proxy voting. In Chile, characterised by concentrated ownership and dominant

company groups, policy has increased the powers of institutional investors and created

incentives that they often lack in other jurisdictions, with encouraging results.

THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE © OECD 201110

The Role of Institutional Investors in Promoting

Good Corporate Governance © OECD 2011

Assessment and Recommendations

The proposition that shareholders can best look after their own interests subject to having sufficient rights and access to information is basic to the OECD Principles and

domestic law in many jurisdictions. Nevertheless, at the time of the last revision of the

OECD Principles of Corporate Governance in 2004, the need to deal with the emerging reality of

large institutional shareholders was already apparent and led to several new principles

being agreed by consensus, especially Principles II.F and II.G covering disclosure of voting

policies, managing conflicts of interest and co-operation between investors. The

Annotations to the Principles went on to note that,

“the effectiveness and credibility of the entire corporate governance system and

company oversight will… to a large extent depend on institutional investors that can

make informed use of their shareholder rights and effectively exercise their

ownership functions in companies in which they invest.”

However, the forces driving the actions of institutional investors are different from many

other shareholders being determined by a unique set of costs, benefits, and objectives. This

report therefore not only investigates the implementation of the principles covering

institutional shareholders by way of three peer reviews (Australia, Chile, Germany) and a

general review of academic research and country experience, but also examines the forces,

regulatory and economic, driving the actions of institutional investors. Not every

constellation of costs and benefits can be expected to lead to good corporate governance

outcomes. This approach is based on Principle I.A that was introduced in 2004: “the

corporate governance framework should be developed with a view to its impact on overall

economic performance, market integrity and the incentives it creates for market

participants and the promotion of transparent and efficient markets.”

Institutional investors, those financial institutions accepting funds from other parties for

investment by the institution in its own name but on their clients/beneficiaries behalf,

such as pension funds, mutual funds and insurance, are now a major feature of many

jurisdictions and are significant players in the global economy. According to the latest

available data, they managed some USD 53 trillion of assets in 2009 in the OECD area,

including some USD 22 trillion in equity. In addition, the funds management industry that

does not invest in its own name is also highly significant. In a number of jurisdictions, an

explicit policy goal is to further the development of institutional investors via, for instance,

pension funds so as to foster domestic capital markets. However, in other jurisdictions the

institutions are seen as a weak link in the company landscape related to short termism and

to the pursuit of political ends. Thus some see them as already too powerful and their

effects possibly pernicious. Others by contrast, see them as not being robust enough in

ASSESSMENT AND RECOMMENDATIONS

promoting good corporate governance and corporate accountability. Not all the arguments

in this debate relate to good corporate governance per se but to their potential for

underpinning growth and development, and addressing other issues such as

environmental and social goals. However, there is a close relationship between good

corporate governance that promotes company performance and accountability, and

addressing these broader issues.

With the goal of optimising returns for targeted levels of risk, institutional investors pursue

a range of portfolio diversification strategies, which in some cases have led to highly

diversified portfolios, many of them having investments in several thousand companies.

Though many managers pursue active investment strategies and use benchmarks for the

purpose of assessing performance, some investors seek portfolios that are passively

managed against a benchmark, in which case managers typically must purchase all the

equities in the share index (e.g. S&P 500). The level of diversification can therefore be

extreme. With the emergence of a broad universe of professional investment managers

and increasing access to information, some studies have shown that active strategies, on

average, do not significantly outperform the market on a net-of-fees basis. At the same

time, and possibly as a result of these studies, investors have increasingly channelled

funds into lower cost, passive diversification funds. This trend towards passive

diversification may not be conducive to the promotion of good corporate governance.

Diversification is, in a number of cases, also driven by prudential regulation such as

capping the percentage of a company’s equity that can be held by an institutional investor,

and not just by individual investor concerns. The review of Chile noted the benefits of

permitting pension funds to take a significant stake in companies (up to 7%). Other

jurisdictions might want to examine their restrictions to see if they are economically

efficient. At the same time, the investment chain has lengthened by outsourcing of

management to include investment managers and sub-advisors, further distancing

investee companies from the ultimate “beneficiaries”. As a result, at every stage of the

process there are possibilities that incentives will not encourage institutional investors to

take an interest in the corporate governance practices of investee companies.

Institutional investors acting as agents for ultimate beneficiaries are very often not directly

remunerated on the basis of the performance of portfolio companies, whether based on

company performance or better corporate governance practices. The exception is certain

private equity and hedge funds where performance incentives are powerful, often 20% of

fund performance. Rather, they are remunerated often on the basis of management fees

based on the volume of assets under management. In some jurisdictions such as in the US,

performance-based fees are generally not allowed for mutual funds unless the fee also

penalises the manager for poor performance (i.e. a fulcrum fee). Moreover, fund

performance (either absolute or relative) is reviewed often by investors and mandates

usually last only around three years. Taken together, the incentive structure often favours

a focus on increasing the size of assets under management, not necessarily bad but also

not necessarily an incentive to improve performance of portfolio companies, The incentive

structure might also contribute to churning of assets (i.e. buying and selling often) where it

is possible to increase the commissions from transactions. Indeed, a number of

institutional investors often exceed their own announced turnover targets. Average

holding periods have declined around the world to under one year on average although a

great deal of the decline might be due to the rising importance of high frequency traders,

another asset class. In addition, the incentive structures influencing many institutional

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ASSESSMENT AND RECOMMENDATIONS

investors and fund managers are influenced by conflicts of interest including their own

ownership by banks and insurance companies, their relationship to company sponsors of

pension plans and the fact that they may control many funds that can trade between

themselves. Such incentives might work to the disfavour of investors.

In such a system, the costs involved in monitoring the corporate governance practices over

a large number of companies are significant but the benefits will be shared with all (i.e. the

free rider problem). This implies that monitoring and analyst coverage of companies will

be sub-optimal unless arrangements can be put in place to promote collective action. This

does not mean that institutional investors can or should avoid monitoring and

engagement with their investee companies since there are private returns to them and

there can be fiduciary duties such as with private sector pension funds (ERISA) in the US

that may be fulfilled through voting. But it does mean that such activities might not be

pursued as effectively and as energetically as otherwise would be the case. In short,

Principle I.A is not likely to be fully implemented in many jurisdictions and as advocated

by the Annotations to the principle, a systematic review by jurisdictions might be

beneficial to ensure economic performance.

In view of the institutional investor landscape, Principles II.F.1 and II.F.2 appear to be

satisfactory if not very ambitious. However, implementation is not robust in many

jurisdictions. In practical terms, the restriction of the Principles to institutions acting in a

“fiduciary capacity” needs to be interpreted broadly since formal fiduciary duties are not

specified in many jurisdictions that often prefer the weaker obligation of loyalty. Formal

duties are often specified for both pension funds and collective investment schemes. Many

jurisdictions implement the principles through professional codes. Such codes are not

often on a “comply or explain” basis so that it is difficult to judge their implementation and

impact on behaviour. However, an increasing number of jurisdictions are moving to require

disclosure of actual voting records by institutional investors which represents a check on

declarations of voting policy and clarifies whether conflicts of interest are being addressed.

Where it has been implemented, important conflicts of interest have been highlighted.

Principle II.F.2 is thus important dealing as it does with management of conflicts of

interest. This is one area where the operation of voluntary codes may not be effective in the

face of strong incentives. In some jurisdictions, legal duties to investors (that might also

include fiduciary duties that cover acting in their best interests) are in place that may help

address the issue.

The importance of co-operation between institutional investors (Principle II.G) to reduce

the costs of monitoring has been clearly documented, including in the reviewed

jurisdictions. Most jurisdictions permit co-operation and in line with Principle II.G usually

include some exceptions regarding the acquisition of corporate control (acting in concert to

avoid takeover regulations) and the need for transparency to control market abuse. These

safeguards are legitimate but investors do consistently complain about what they regard as

considerable legal uncertainties. It appears that in some jurisdictions more needs to be

done by policy makers in terms of defining safe harbours, perhaps along the lines of the UK

and Australia.

A great deal can be done both by private agents as well as policy makers in many

jurisdictions to improve the corporate governance outcomes of institutional investors.

With respect to the private sector, the upturn in public interest dominated by the

remuneration debate has made institutional investors more active in voting, although the

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ASSESSMENT AND RECOMMENDATIONS

jury is still out about what they have achieved in terms of promoting remuneration policy

in the longer term interests of the company and its shareholders. In Australia, Germany,

the Netherlands, UK and US, the remuneration issue has driven a significant increase in

voting by investors and in dialogue with companies. The debate over environmental, social

and governance (ESG) reporting might also have a similar effect. However, while these

issues have made some investors more active, overall they might still be marginal. More

importantly, the private sector has also sought to deal with the free rider problem of

corporate engagement by establishing industry associations and other joint activities so as

to share the costs of monitoring and voting. This has been quite marked in the pension

sector although less so in the fund management industry more generally. In addition, there

are moves to make investors more informed about how to set an appropriate investment

mandate, such as the standard mandate being discussed by the International Corporate

Governance Network (ICGN), an organisation comprising major institutional investors.

Public policy must facilitate such private initiatives but this does not obviate the need for

policy changes in some areas where restrictions on behaviour might be limiting. This is the

case when, for prudential reasons, regulations excessively limit holdings by institutional

investors in individual companies and when restrictions on incentive schemes change the

behaviour of institutional investors in an unintended manner.

The review demonstrates that institutional investors can play an important role in

jurisdictions characterised by both dispersed and concentrated ownership. This might

involve both private and policy action. Australia is a good example of the former using a

private solution: an association of pension funds that conducts background research and

advises on proxy voting. A similar arrangement also exists in the Netherlands and in

Switzerland. However, institutional investors also play an increasingly important role in

Chile, characterised by concentrated ownership and therefore of relevance to many

jurisdictions in the world. It shows that where ownership concentration is high and

company groups dominant, policy might want to consider increased powers for institutional

investors. Although pension funds had become active some time ago, the recent law codifies

the situation: the six pension funds are able to nominate and elect (with support of other

minority investors) independent directors who in turn have enhanced powers and

responsibilities on the board. Effective participation by institutions has been made possible

by cumulative voting. At the same time, and of perhaps even more importance, is the fact

that an individual pension fund can acquire shares in a company up to 7% of voting capital.

This certainly gives it an economic interest that institutional investors often lack with more

limited shareholdings because of prudential and other rules.

A key problem is that at a time of increasingly diversified portfolios, it appears that

domestic investors in many jurisdictions do not vote their foreign equity. This is important

because foreign shareholders make up around 30% of domestic ownership in many

jurisdictions (with the notable exception of the US because of the size of its market

capitalisation relative to others). Barriers to cross border voting that raise the costs of

exercising voting rights remain even in Europe where there has been a determined push by

the European Commission to improve the situation. However, more profound factors are at

work. Market participants report a lack of knowledge by institutional investors about

foreign portfolio companies. This is certainly the case with those institutional investors

with a very large number of portfolio companies. In some cases, despite the dangers in

mandating voting, it might be worth requiring them to vote their significant investments

regardless of being foreign or domestic equity. The Spanish investment management code

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ASSESSMENT AND RECOMMENDATIONS

already goes in this direction. Of course, institutional investors can also make use of proxy

advisors but this raises other concerns.

At least amongst many boards there is a view that the proxy voting industry is already too

influential leading to voting and voting recommendations that are “tick the box” in nature

and not sufficiently differentiated by country and by company. There is also the question

of conflicts of interest, covered by Principle V.F, as when a proxy advisor also offers advice

to companies about how to obtain a good recommendation. Some form of regulation might

be required with respect to conflicts of interest. However, private contractual solutions also

have an important role in dealing with the situation. Thus in Australia (but also in the

Netherlands and Germany) some institutional shareholders require a proxy agency to

mark against their own corporate governance codes rather than against the policy of the

ratings company. In addition, there is surely a private contractual or competitive solution

to conflicts of interest. What is of utmost importance for policy making is to do nothing

that could further raise the cost of monitoring and fund management.

A key policy issue concerning institutional investors concerns whether they are only short-

term investors, or at least promoting short-term thinking by boards and managements.

The case of pension funds, especially defined benefit schemes is often cited where in

principle their liabilities to their beneficiaries stretch over many years. Despite this, they

very often issue short-term mandates to their investment managers who in turn have their

own short-term incentive systems. There is in any case already a long-term element in the

market that needs to be better recognised. Large institutional investors are often locked

into the shareholding of most large companies on a long-term basis since for regulatory or

other reasons, diversification and index investing is the norm. Thus they are long-term

shareholders even if they buy and sell the same shares on a regular basis, and even lend

them for a fee. They therefore have an incentive to encourage good corporate

governance in their large portfolio companies since it is the only way they have to earn

greater returns. A number of institutional investors already recognise this. However, a

number of large institutional investors are not acting in this way. Private initiatives to

encourage such institutions to become engaged should be supported and policy should

facilitate this development perhaps through careful definition of the obligation to

monitor large holdings.

In the public and policy debate too much time and effort is being taken up in trying to solve

the perceived problem of short termism by appealing to the notion of a long-term

shareholder who is often compared favourably with “patient family owners”. However, a

long-term share holder is clearly not necessarily a long-term engaged investor and efforts

to give incentives to hold shares may not achieve their objective. The essence of the long-

term debate might lie elsewhere. Thus the real problem of short-termism may well lie in

the executive suites of companies and financial institutions with an emphasis on short

payback periods. Nevertheless, in a world of fast moving technologies and competition,

defining short termism is still a challenge.

The Principles that cover institutional investors are focused on “bread and butter”

corporate governance issues such as voting at company meetings, the nomination and

election of board members and to making their views known on remuneration policy. They

support acting in co-operation which might take matters much further by underpinning

more engagement, while leaving open the concept of long and short-term. However, the UK

and the United Nations Principles of Responsible Investment (UNPRI) go much further by

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ASSESSMENT AND RECOMMENDATIONS

introducing the notion of stewardship which is akin to shareholder responsibility. This

topic might be worthy of more discussion by the OECD.

In sum, the nature of institutional investors has evolved over the years into a complex

system of financial institutions and fund management companies with their own

corporate governance issues and incentive structures. Investment chains have lengthened,

increasing the number of institutions between the final beneficiary and an investment in

an enterprise. At each point the incentive system might not lead to good corporate

governance outcomes. Investment strategies have also evolved with passive investing

through indices and exchange traded funds becoming more important so as to lower costs

and increase returns to beneficiaries. Against this background, the old question of investor

oversight of company boards needs to be examined. The OECD Principles II.F.1, II.F.2 and

II.G make useful recommendations in the direction of more transparency and

management of conflicts of interest by institutions, and co-operation between investors.

However, the primary implementation method of Principles II.F.1 and II.F.2 appears to be

through voluntary codes but these might be inadequate in the case of dealing with

widespread conflicts of interest. With respect to the exercise by institutions of their voting

rights, turnout at company meetings has increased in recent years and there are dedicated

corporate governance investors. However, cross border voting remains costly and

uncertain. Whether all these developments are sufficient to improve corporate

governance outcomes or whether they are just going in the right direction is an open

question, but a great deal depends on expectations. If, as in the Principles, the

expectation is the exercise of voting rights then the situation has improved over the past

decade. If the expectation is that institutional investors act as stewards of companies,

then progress might have been limited.

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PART I

Overview

THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE © OECD 2011

The Role of Institutional Investors in Promoting

Good Corporate Governance © OECD 2011

PART I

Chapter 1

The Structure and Behaviour of Institutional Investors

This chapter discusses the market environment, the legal and regulatory frameworks as well as the incentives of institutional investors in exercising their shareholders rights in a manner that is aligned with the broad market expectation that they will promote better corporate governance.

I.1. THE STRUCTURE AND BEHAVIOUR OF INSTITUTIONAL INVESTORS

1.1. Background, objectives and issues

1.1.1. The issues

Today, a high proportion of global assets under management are under the operational

control of “classic” institutional investors: pension and mutual funds that are often active

managers and insurance companies which are normally regarded as more passive.1 The

proportion they hold of equities and company debt is also high in most economies and

rising (Figure 1.1). The OECD estimates that in 2009, institutional investors managed

financial assets in excess of USD 53 trillion including some USD 22 trillion in equities. As a

result, as the Annotations to the Principles note, “the effectiveness and credibility of the

entire corporate governance system and company oversight will… to a large extent depend

on institutional investors that can make informed use of their shareholder rights and

effectively exercise their ownership functions in companies in which they invest.”

The Conclusions (OECD, 2010a) by the OECD also noted that the financial crisis served

to underpin long held concerns that the monitoring of boards by institutional investors

was generally deficient compared to what was required. Shareholders were described as

being either passive or reactionary in the exercise of their voting rights, perhaps

Figure 1.1. Ownership structure in selected OECD countries

Source: Australia (2010), Australian National Accounts: Financial Accounts, September 2010 available at www.abs.gov.au/ AUSSTATS/abs@.nsf/DetailsPage/5232.0Sep%202010?OpenDocument; Bank of Japan (2010), Flow of Funds (Fiscal Year), available at www.stat-search.boj.or.jp/ssi/cgi-bin/famecgi2?cgi=$nme_a000_en&lstSelection=11; Deutsche Bundesbank (2011), Time series database, available at www.bundesbank.de/statistik/statistik_zeitreihen.en.php; FED (2011),2 Federal Reserve Statistical Release, “Flow of Accounts of the United States”, several years, available at www.federalreserve.gov/ releases/z1/; UK (2010), The Office for National Statistics, “Share Ownership Survey 2008”, January 2010, available at www.statistics.gov.uk/pdfdir/share0110.pdf.

100

Australia 1989

Australia 2009

Germany 1991

Germany 2009

Japan 1989

Japan 2009

UK 1989

UK 2008

US 1989

US 2009

Foreign investors Insurance Pension Investment companies Mutual funds Banks Other financial institutions Private non-financial institutions Individuals Public sector%

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http://www.abs.gov.au/AUSSTATS/abs@.nsf/DetailsPage/5232.0Sep%202010?OpenDocument

http://www.stat-search.boj.or.jp/ssi/cgi-bin/famecgi2?cgi=$nme_a000_en&lstSelection=11

http://www.bundesbank.de/statistik/statistik_zeitreihen.en.php

http://www.federalreserve.gov/releases/z1

http://www.statistics.gov.uk/pdfdir/share0110.pdf

I.1. THE STRUCTURE AND BEHAVIOUR OF INSTITUTIONAL INVESTORS

mechanistically relying on proxy advisers, and failing to sufficiently challenge boards. On

the other hand, there is also a countervailing view that institutional investors are already

much too effective thereby constraining management in favour of short-term policies.

Clearly, institutional investors have an important role to play in promoting good corporate

governance, even though they represent only one small part of an effective corporate

governance system.

While the issues surrounding institutional investors are particularly important for

those markets with diffused ownership and a large institutional shareholder base, they are

also crucial in most jurisdictions within and outside the OECD area characterised by

concentrated ownership. For example, the Latin American Roundtable’s Strengthening Latin

American Corporate Governance: The Role of Institutional Investors (OECD, 2011b) argues that

Institutional Investors “can provide an informed counterbalance to controlling

shareholders to safeguard against the company’s board and management working for

interests other than those of the company and its shareholders as a whole”. The issue is

drawn out in the review of Chile (see Part II). The same can be said in both Asia and in

Middle East/North Africa (MENA). Nevertheless, a number of reports note that actual

practices have often fallen short of the potential, with institutions too often taking a

passive role and failing, or not being able, to exercise their ownership rights in an active

and informed manner.

While the public debate often treats the concept of institutional investors as a class,

they are heterogeneous in terms of their investment style, strategy, time horizon,

concentration, size and investor base. More importantly, recent research reviewed below

emphasises their own widely different corporate governance arrangements which leads to

differing principal/agent issues and to a distinctive structure of incentives and constraints

faced by each. There is also an increasing complexity in the investor chain (for instance,

with fund of fund managers adding a layer of asset management) and multiple

intermediaries in the ownership chain.3 Thus there is an increasing separation of ultimate

beneficiaries from ownership rights, and from the investee company.

The OECD Corporate Governance Committee decided to undertake a thematic review

of institutional investors based on questionnaires to participants of the Committee (see

Annexes A and B) and on research by the OECD. Three economies representing different

systems would also be examined in-depth (“peer review”): Australia, Chile and Germany.

The objectives of the report are therefore:

● to document the scale and complexity of institutional shareholders and the

determinants of their behaviour;

● to examine policy issues and the varied responses undertaken by policy makers;

● to test the relevance of the Principles against the emerging landscape and whether they

adequately address current and emerging policy challenges, or fall short of expectations;

and

● to examine several jurisdictions in detail by way of a “peer review”.

For the purpose of this report, the term “institutional investors” refers to institutions

which collect funds from investors to invest on their behalf but in the name of the

institution. They are thus an “owner” but not a final, beneficial owner. The relationship

may or may not have some form of “fiduciary duty” (the term used in the Principles) but

certainly they will have some form of responsibility or accountability for use of funds. Thus

a bank or insurance company making their own investments are excluded, but their asset

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I.1. THE STRUCTURE AND BEHAVIOUR OF INSTITUTIONAL INVESTORS

management division using client funds would be included.4 The classical institutional

investors are therefore mutual funds, investment companies, pension funds and asset

managers (although they do not invest in their own name) but there are others. Hedge

funds and private equity also receive investors’ funds to make investments rather than

issuing them equity. From the viewpoint of corporate investments only a subset of hedge

funds are of interest: those wishing to use votes and/or exert influence to change company

policy and corporate governance arrangements (so called activist and event driven hedge

funds rather than quants, arbitrage funds and high frequency traders).5 Hedge funds and

private equity have been analysed in OECD (2007) and policy implications in OECD (2008).

1.1.2. The approach of the Principles

The Principles address explicitly the issue of shareholder rights that are important for

institutional investors, especially in an international context. For example, Principle II.C.4,

shareholders should be able to vote in person or in absentia, and equal effect should be given to votes

whether cast in person of absentia); Principle III.A.2, minority shareholders should be protected

from abusive actions by, or in the interest of, controlling shareholders acting either directly or

indirectly and should have effective means of redress; Principle II.A.3, votes should be cast by

custodians or nominees in a manner agreed upon with the beneficial owner of the shares; and

Principle III.A 4, impediments to cross border voting should be eliminated.

However, three principles go to the heart of the matter. Principle II.F deals with

transparency and behaviour: The exercise of ownership rights by all shareholders, including

institutional investors should be facilitated: II.F.1. Institutional investors acting in a fiduciary

capacity should disclose their overall corporate governance and voting policies with respect to their

investments, including the procedures that they have in place for deciding on the use of their voting

rights; and Principle II.F. 2. Institutional investors acting in a fiduciary capacity should disclose

how they manage material conflicts of interest that may affect the exercise of key ownership rights

regarding their investments. Principle II.G deals with the logic of collective action that

determines the cost-benefit calculus of monitoring and engagement by voting or

otherwise: Shareholders, including institutional shareholders, should be allowed to consult with

each other on issues concerning their basic shareholder rights as defined in the Principles, subject to

exceptions to prevent abuse.

Finally, of great current interest in the post-financial crisis setting is the role of

advisors: Principle V.F: The corporate governance framework should be complemented by an

effective approach that addresses and promotes the provision of analysis or advice by analysts,

brokers, rating agencies and others that is relevant to decisions by investors free from material

conflicts of interest that might compromise the integrity of their analysis or advice. These

principles and the associated annotations reflecting the considerations of the OECD

Committee in 2004 are reproduced in Box 1.1.

1.1.3. Outline of Part I

The following section reviews what is known about the institutional investor

landscape including investor composition that varies widely across economies. The

behaviour of institutional investors is next analysed focusing on the benefits/incentives

and costs of voting and monitoring of companies by institutional investors. It assesses

what is known about their actual behaviour. It first outlines the regulatory and quasi legal

basis (e.g. codes of behaviour) for their operations and the type of disclosures they are

required to make. It then discusses what is known about their investment strategies and

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I.1. THE STRUCTURE AND BEHAVIOUR OF INSTITUTIONAL INVESTORS

Box 1.1. Relevant principles and annotations

II.F. The exercise of ownership rights by all shareholders, including institutional investors should be facilitated.

As investors may pursue different investment objectives, the Principles do not advocate any particular investment strategy and do not seek to prescribe the optimal degree of investor activism. Nevertheless, in considering the costs and benefits of exercising their voting rights, many investors are likely to conclude that positive financial returns and growth can be obtained by undertaking a reasonable amount of analysis and by using their voting rights.

1. Institutional investors acting in a fiduciary capacity should disclose their overall corporate governance and voting policies with respect to their investments, including the procedures that they have in place for deciding on the use of their voting rights.

It is increasingly common for shares to be held by institutional investors. The effectiveness and credibility of the entire corporate governance system and company oversight will, therefore, to a large extent depend on institutional investors that can make informed use of their shareholder rights and effectively exercise their ownership functions in companies in which they invest. While this principle does not require institutional investors to vote their shares, it calls for disclosure of how they exercise their ownership functions with due consideration to cost effectiveness. For institutions acting in a fiduciary capacity, such as pension funds, mutual investment schemes and some activities of insurance companies, the right to vote can be considered part of the value of the investment being undertaken on behalf of their clients. Failure to exercise the ownership rights could result in a loss to the investor who should therefore be made aware of the policy to be followed by the institutional investors.

In some countries, the demand for disclosure of corporate governance policies to the market is quite detailed and includes requirements for explicit strategies regarding the circumstances in which the institution will intervene in a company; the approach they will use for such intervention and; how they will assess the effectiveness of the strategy. In several countries institutional investors are either required to disclose their actual voting records or it is regarded as good practice and implemented on a “comply or explain” basis. Disclosure is either to their clients (only with respect to the securities of each client) or, in the case of investment advisors to registered investment companies, to the market which is a less costly procedure. A complementary approach to participation in shareholder’s meetings is to establish a continuing dialogue with portfolio companies. Such a dialogue between institutional investors and companies should be encouraged, especially by lifting unnecessary regulatory barriers, although it is incumbent on the company to treat all investors equally and not to divulge information to the investors which is not at the same time made available to the market. The additional information provided by a company would normally therefore include general background information about the markets in which the company is operating and further elaboration of information already available to the market.

When fiduciary institutional investors have developed and disclosed a corporate governance policy, effective implementation requires that they also set aside the appropriate human and financial resources to pursue this policy in a way that their beneficiaries and portfolio companies can expect.

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I.1. THE STRUCTURE AND BEHAVIOUR OF INSTITUTIONAL INVESTORS

Box 1.1. Relevant principles and annotations (cont.)

2. Institutional investors acting in a fiduciary capacity should disclose how they manage material conflicts of interest that may affect the exercise of key ownership rights regarding their investments.

The incentives for intermediary owners to vote their shares and exercise key ownership functions may under certain circumstances differ from those of direct owners. Such differences may sometimes be commercially sound but may also arise from conflicts of interest which are particularly acute when the fiduciary institution is a subsidiary or an affiliate of another financial institution, and especially an integrated financial group. When such conflicts arise from material business relationships, for example, through an agreement to manage the portfolio company’s funds, market integrity would be enhanced if they are identified and disclosed.

At the same time, institutions should disclose what actions they are taking to minimise the potentially negative impact on their ability to exercise key ownership rights. Such actions may include the separation of bonuses for fund management from those related to the acquisition of new business elsewhere in the organisation.

II.G. Shareholders, including institutional shareholders, should be allowed to consult with each other on issues concerning their basic shareholder rights as defined in the Principles above, subject to exceptions to prevent abuse.

It has long been recognised that in companies with dispersed ownership, individual shareholders might have too small a stake in the company to warrant the cost of taking action or for making an investment in monitoring performance. Moreover, if small shareholders did invest resources in such activities, others would also gain without having contributed (i.e. they are “free riders”). This effect, which serves to lower incentives for monitoring, is probably less of a problem for institutions, particularly financial institutions acting in a fiduciary capacity, in deciding whether to increase their ownership to a significant stake in individual companies, or to rather simply diversify. However, other costs with regard to holding a significant stake might still be high. In many instances institutional investors are prevented from doing this because it is beyond their capacity or would require investing more of their assets in one company than may be prudent. To overcome this asymmetry which favours diversification, they should be allowed, and even encouraged, to co-operate and co-ordinate their actions in nominating and electing board members, placing proposals on the agenda and holding discussions directly with a company in order to improve its corporate governance. More generally, shareholders should be allowed to communicate with each other without having to comply with the formalities of proxy solicitation.

It must be recognised, however, that co-operation among investors could also be used to manipulate markets and to obtain control over a company without being subject to any takeover regulations. Moreover, co-operation might also be for the purposes of circumventing competition law. For this reason, in some countries, the ability of institutional investors to co-operate on their voting strategy is either limited or prohibited. Shareholder agreements may also be closely monitored. However, if co-operation does not involve issues of corporate control, or conflict with concerns about market efficiency and fairness, the benefits of more effective ownership may still be obtained. Necessary disclosure of co-operation among investors, institutional or otherwise, may have to be accompanied by provisions which prevent trading for a period so as to avoid the possibility of market manipulation.

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I.1. THE STRUCTURE AND BEHAVIOUR OF INSTITUTIONAL INVESTORS

the economic and other forces that are involved in making these decisions. Investor

engagement and the voting behaviour of institutional investors including cross border

voting and the costs and barriers that appear to be important around the world are then

discussed. Finally, the issue of proxy advisors is considered.

A word of caution is necessary. The institutional investor scene both within and across

countries is so complex that the studies available might give a distorted view, in the same

way that the blind man describing an elephant based on touching parts of it arrives at

widely different conclusions depending on what he has last touched.

1.2. The institutional investor landscape A threshold issue for any review is to obtain a better understanding of the profile of the

institutional shareholder base across jurisdictions. Reflecting the complexity of the

industry, the existing data on investor types is quite superficial, with little data on, or

indications about, characteristics such as concentration, time horizon and strategy which

are important inputs if policy makers should wish to promote engagement. Understanding

the relative importance of different investor classes in particular markets is easier to

Box 1.1. Relevant principles and annotations (cont.)

V.F. The corporate governance framework should be complemented by an effective approach that addresses and promotes the provision of analysis or advice by analysts, brokers, rating agencies and others that is relevant to decisions by investors free from material conflicts of interest that might compromise the integrity of their analysis or advice.

In addition to demanding independent and competent auditors and to facilitate timely dissemination of information, a number of countries have taken steps to ensure the integrity of those professions and activities that serve as conduits of analysis and advice to the market. These intermediaries, if they are operating free from conflicts and with integrity, can play an important role in providing incentives for company boards to follow good corporate governance practices.

Concerns have arisen, however, in response to evidence that conflicts of interest often arise and may affect judgement. This could be the case when the provider of advice is also seeking to provide other services to the company in question or where the provider has a direct material interest in the company or its competitors. The concern identifies a highly relevant dimension of the disclosure and transparency process that targets the professional standards of stock market research analysts, rating agencies, investment banks, etc.

Experience in other areas indicates that the preferred solution is to demand full disclosure of conflicts of interest and how the entity is choosing to manage them. Particularly important will be disclosure about how the entity is structuring the incentives of its employees in order to eliminate the potential conflict of interest. Such disclosure allows investors to judge the risks involved and the likely bias in the advice and information. IOSCO has developed statements of principles relating to analysts and rating agencies (IOSCO Statement of Principles for Addressing Sell-side Securities Analyst Conflicts of Interest, IOSCO Statement of Principles Regarding the Activities of Credit Rating Agencies).

Source: OECD Principles of Corporate Governance, 2004.

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I.1. THE STRUCTURE AND BEHAVIOUR OF INSTITUTIONAL INVESTORS

establish but is still limited so that many different data sources need to be utilised, each

with problems of differing definitions and coverage,

1.2.1. The investment management industry

Historically major institutional asset managers are autonomous pension funds6

(either defined benefit or defined contribution schemes), insurance companies and mutual

funds (also termed collective investment schemes, CIS) while other forms such as

sovereign wealth funds, hedge funds and private equity represent only a smaller share of

the industry. The OECD maintains a database using a classification that is based on the

financial accounts side of national accounting (Gonnard et al., 2008). By 2009 the investment

management industry in the OECD area was responsible for some USD 53 trillion (Figure 1.2)

with investment funds the largest single class, although far from dominant. Previous work

by the OECD indicated that activist hedge funds accounted for some USD 200 billion in

2006/2007 while private equity funds managed some USD 1.5 trillion worldwide

(OECD, 2007).

Financial assets under management by institutional investors include not only

equities but also bonds, loans, and deposits (Figure 1.3). Institutional investors have

invested traditionally in mainly “shares and other equity” (includes quoted shares,

unquoted shares, other equity, and mutual fund shares), and “securities other than shares,

except financial derivatives” that are simply omitted from securities other than shares and

not included in any category as shown in Figure 1.2.

Autonomous pension funds and investment funds held about the same value of

shares (Figure 1.4) although pension funds held a higher percentage of their investments in

this form, around 57% (Figure 1.5).

The relative importance of different types of institutional investor varies widely from

country to country as shown in Figure 1.6. In some countries like Australia, Chile, Israel and

the Netherlands, pension funds are the significant domestic institutional investor but in

countries like Germany, France, Norway and Sweden, insurance institutions are key

Figure 1.2. Financial assets under management by institutional investors in OECD countries

Source: OECD Institutional Investors Database (http://stats.oecd.org/index.aspx).

15.0

11.2

11.2 Autonomous pension

17.0

11.9

Insurance corporations

19.6

0.9 Other forms

Investment funds

1.4

0 25 201510 5

2000 2009

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I.1. THE STRUCTURE AND BEHAVIOUR OF INSTITUTIONAL INVESTORS

THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE © OECD 2011

Figure 1.3. Type of financial assets managed by the industry (in trillion USD)

Source: OECD, Institutional Investors Database (http://stats.oecd.org/index.aspx).

Figure 1.4. Shares and other equity by class of institutional management

Note: Financial assets, shares and other equity under management in trillion USD.

Source: OECD, Institutional Investors Database (http://stats.oecd.org/index.aspx).

Figure 1.5. Percentage of assets held as “shares and other equity” by type of institutional asset owner

Source: OECD, Institutional Investors Database (http://stats.oecd.org/index.aspx).

0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Securities other than shares, except financial derivatives Shares and other equity

Currency and deposits Loans Other, not elsewhere classified

2000 2001 2002 2003 2004 2005 2009200820072006

Investment funds Insurance corporations Autonomous pension funds Other forms of institutional savings, consolidated

Shares and other equity (right axis)

Total Investment funds Autonomous pension funds

Other forms

2000 2009

Insurance corporations

http://stats.oecd.org/index.aspx

I.1. THE STRUCTURE AND BEHAVIOUR OF INSTITUTIONAL INVESTORS

institutional investors. In countries like Greece, Luxembourg and Mexico, investment

funds are major institutional investors. However, the statistics can be misleading. Thus in

the UK and the Netherlands, pension funds often outsource to fund managers subject to

investment mandates of around three years.

Official financial accounts consistent with the national accounts are not currently

available for Argentina, Brazil, China, India, Indonesia, Hong Kong (China) and Singapore. The

information that is publicly available indicates that Hong Kong (China) and Brazil have a large

mutual funds sector, and the latter also has a large pension fund sector. The pension sector is

expected to grow rapidly in China with the public pension fund (National Social Security Fund)

entitled to 20% of proceeds from IPOs of state owned companies. The insurance sector is also

expected to expand from its current level of USD 728 billion (Table 1.1).

Measured by assets under management, the funds management industry is

dominated by US registered institutions. Table 1.2 would show even more concentration if

account is taken of the fact that BlackRock has now acquired Barclays Global. It also shows

how misleading the table could be since most of the fund managers have significant locally

based operations such as Barclays Global that is now classed as a US registered fund

manager. Institutional organisation varies widely thus an investment management

Figure 1.6. Share of financial assets held by institutional asset managers in 2009

Note: The statistical data for Israel are supplied by and under the responsibility of the relevant Israeli authorities. The use of such data by the OECD is without prejudice to the status of the Golan Heights, East Jerusalem and Israeli settlements in the West Bank under the terms of international law.

Source: OECD, Institutional Investors Database (http://stats.oecd.org/index.aspx).

Belgium Austria

Australia

Finland Estonia

Denmark Chile

Canada

Iceland Hungary

Greece Germany

France

Luxembourg Korea

Italy Israel

Russian Federation Portugal Norway

Netherlands Mexico

United Kingdom Turkey

Sweden Slovenia

Slovak Republic

0 10

United States

100 %

90 20 30 40 50 60 70 80

Investment funds Insurance corporations Autonomous pension funds Other forms

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I.1. THE STRUCTURE AND BEHAVIOUR OF INSTITUTIONAL INVESTORS

company in Germany only has one board overseeing a number of funds but in the US each

fund has its own board. There are some 4000 individual equity mutual funds in the US, but

management is highly concentrated: the top 5 mutual fund families have about 37% of all

assets, the top ten have about 48% and the top 25 had 70% in 2006 (Taub, 2007).

1.2.2. Stock ownership by institutional investors

The ownership structure of companies varies widely across jurisdictions and with it

the potential role and responsibilities of institutional investors. Thus Japan and Germany

Table 1.1. Financial assets by institutional investors in other jurisdictions

Million USD Mutual funds Pension Insurance

2007 2008 2009 Source 2007 2008 2009 Source 2007 2008 2009 Source

Argentina 6 789 3 867 4 470 ICI 30 000 30 000 30 000 IFSL/TCUK

Brazil 615 365 479 321 783 970 ICI 288 000 288 000 288 000 IFSL/TCUK

China 434 063 276 303 381 207 ICI 342 158 OECD ART 728 417 OECD ART

Hong Kong 818 421 n.a. n.a. ICI 65 000 60 000 68 000 IFSL/TCUK

India 108 582 62 805 130 284 ICI2 62 000 62 000 62 000 IFSL/TCUK

Indonesia 9 788 6 764 12 019 B-LK 20 676 19 036 29 834 B-LK 9 014 7 597 11 126 B-LK

Singapore 91 000 91 000 91 000 IFSL/TCUK 100 654 89 923 106 145 MAS

Saudi Arabia 28 024 19 949 23 881 CMA 13 279 7 386 10 346 PA

South Africa 95 221 69 417 106 261 ICI 150 000 150 000 150 000 IFSL/TCUK

Source: Investment Company Institute (2011), Supplementary Tables of Worldwide Mutual Fund Assets and Flows Third Quarter 2010, available at www.ici.org/pdf/ww_09_10_sup_tables.pdf; TheCityUK (2011), TheCityUK Research Centre, “Pension Markets”, February 2011, available at www.thecityuk.com/media/214429/pension%20markets%202011.pdf; Monetary Authority of Singapore ( 2 0 1 0 ) , I n s u r a n c e D e v e l o p m e n t D a t a , a v a i l a b l e a t w w w. m a s . g o v. s g / r e s o u r c e / d a t a _ r o o m / i n s u r a n c e _ s t a t / 2 0 0 9 / Insurance_Development_09.pdf; CMA (2008), Capital Market Authority of Saudi Arabia, Annual Report 2008, available at http:// cma.gov.sa/En/Publicationsreports/Reports/CMA2008.pdf; CMA (2009), “Capital Market Authority of Saudi Arabia”, Annual Report 2009, available at http://cma.gov.sa/En/Publicationsreports/Reports/CMA_finalENGLISH.pdf; Pension Agency, Statistics of Public Pension Agency of Saudi Arabia, available in Arabic language at www.pension.gov.sa/Resources/downloads/statistics/ PPA_Statistics.pdf, www.pension.gov.sa/Resources/downloads/statistics/PPA2007.pdf; www.pension.gov.sa/Resources/downloads/ statistics/PPA2008.pdf and the questionnaire in the OECD Asian Roundtable on Corporate Governance (unpublished).

Table 1.2. Largest global investment managers

Assets under management, end- 2008 USD billion

1 Barclays Global Investors1 UK 1 516

2 Allianz Group Germany 1 462

3 State Street Global US 1 444

4 Fidelity Investments US 1 389

5 AXA Group France 1 383

6 BlackRock US 1,307

7 Deutsche Bank Germany 1 150

8 Vanguard Group US 1 145

9 J.P. Morgan Chase US 1 136

10 Capital Group US 975

11 Bank of New York Mellon US 928

12 UBS Switzerland 821

13 BNP Paribas France 810

14 Goldman Sachs Group US 798

15 ING Group Netherlands 777

1. acquired by BlackRock in 2009 Source: TheCityUK (2010), TheCityUK Research Centre, “Fund management 2010”, October 2010, available at: www.thecityuk.com/what-we-do/reports/articles/ 2010/october/fund-management-2010.aspx.

THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE © OECD 2011 29

http://www.ici.org/pdf/ww_09_10_sup_tables.pdf

http://www.thecityuk.com/media/214429/pension%20markets%202011.pdf

http://www.mas.gov.sg/resource/data_room/insurance_stat/2009/Insurance_Development_09.pdf

http://cma.gov.sa/En/Publicationsreports/Reports/CMA2008.pdf

http://cma.gov.sa/En/Publicationsreports/Reports/CMA_finalENGLISH.pdf

http://www.pension.gov.sa/Resources/downloads/statistics/PPA_Statistics.pdf

http://www.pension.gov.sa/Resources/downloads/statistics/PPA2007.pdf

http://www.pension.gov.sa/Resources/downloads/statistics/PPA2008.pdf

I.1. THE STRUCTURE AND BEHAVIOUR OF INSTITUTIONAL INVESTORS

are not characterised by a high level of institutional investor ownership (under 50%), one

having dispersed domestic ownership and the latter concentrated ownership (Figure 1.7).

Institutional ownership in China on the Shanghai Stock Exchange is around 50% with

individuals accounting for 20%.7 Institutional investors owned about 78% of the free float

of which insurance accounted for 5%, investment funds 7% and the national social security

fund (NSSF) the bulk of the remaining 64%. In India, institutional ownership is 17% overall

but 25% in the large companies. The pattern of institutional investors focusing more on

larger firms is a common phenomenon in a number of jurisdictions (Ferreira and Matos,

2008). In the US, UK and Australia, institutional investors are more important. Common in

a number of countries is a declining individual shareholder base although in India

(Table 1.3) and China they remain important.

Domestic institutional investors are important for the UK, the US and Australia.

However, statistics for foreign institutional investors are marked by a key drawback for

analytical work: the failure to distinguish between direct investment and foreign

institutional portfolio investors. Thus in Figure 1.7 ownership is high in Slovakia, Ireland

and Hungary due to a high level of foreign direct investment in these three small

economies. On the other hand, in the Netherlands, Japan and the UK, the bulk of the figure

is known to be institutional investors.

A sketch of the funds management industry would not be complete without noting

that trading volumes on the worlds exchanges have increased leading to a decline in

average holding period (Figure 1.8), albeit from a low level on some exchanges.

The market capitalisation of all stock exchanges increased during the period 1990/

1991-2008/2009 in a range of 1.1-7.8 times, while trading value increased from 1991 to 2009

by 4.8-41.7 times. On all stock exchanges, the increase in the trading value exceeded that

Figure 1.7. Ownership by domestic institutional investors and foreign investors in selected countries

Source: Australia (2010), Australian National Accounts: Financial Accounts, September 2010 available at www.abs.gov.au/ AUSSTATS/abs@.nsf/DetailsPage/5232.0Sep%202010?OpenDocument; Bank of Japan (2010), Flow of Funds (Fiscal Year), available at www.stat-search.boj.or.jp/ssi/cgi-bin/famecgi2?cgi=$nme_a000_en&lstSelection=11; Deutsche Bundesbank (2011), Time series database, available at www.bundesbank.de/statistik/statistik_zeitreihen.en.php; FED (2011), Federal Reserve Statistical Release, “Flow of Accounts of the United States”, several years, available at www.federalreserve.gov/ releases/z1/; FESE (2010), Federation of European Securities Exchanges, “Share Ownership Structure in Europe”, December 2008, available at www.fese.eu/_lib/files/Share_Ownership_Survey_2007_Final.pdf; UK (2010), The Office for National Statistics, “Share Ownership Survey 2008”, January 2010, available at www.statistics.gov.uk/pdfdir/ share0110.pdf.

50 60 70 80 90

0 10 20 30 40

Slo ve

nia 20

Ita ly

20 06

Ge rm

an y 2

00 9

De nm

ark 20

Sp ain

20 07

No rw

ay 20

Ja pa

n 2 00

Es ton

ia 20

Ice lan

d 2 00

Gr ee

ce 20

Au str

ia 20

Po rtu

ga l 2

00 7

Fra nc

e 2 00

Un ite

d S tat

es 20

Sw ed

en 20

Sw itz

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d 2 00

Po lan

d 2 00

Slo va

k R ep

. 2 00

Au str

ali a 2

00 9

Ne the

rla nd

s 2 00

Un ite

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do m

20 08

% ownership of domestic institutional investors % ownership of foreign investors%

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http://www.abs.gov.au/AUSSTATS/abs@.nsf/DetailsPage/5232.0Sep%202010?OpenDocument

http://www.stat-search.boj.or.jp/ssi/cgi-bin/famecgi2?cgi=$nme_a000_en&lstSelection=11

http://www.bundesbank.de/statistik/statistik_zeitreihen.en.php

http://www.federalreserve.gov/releases/z1

http://www.fese.eu/_lib/files/Share_Ownership_Survey_2007_Final.pdf

http://www.statistics.gov.uk/pdfdir/share0110.pdf

I.1. THE STRUCTURE AND BEHAVIOUR OF INSTITUTIONAL INVESTORS

Table 1.3. Ownership structure of India

June 01 June 09

Avg. shareholding pattern for all companies

listed in NSE

Avg. shareholding pattern for all companies

listed in NSE Nifty companies

Top 200 companies listed in NSE

based on market capitalisation

Promoters

Indian 39.65 50.93 41.22 44.23

Foreign 5.39 6.79 10.93 10.15

Person acting in concert 3.32

Total promoter holding 48.37 57.72 52.15 54.38

Public

Institutions

Banks/FIs/Insurance Cos 7.99 5.68 9.79 6.44

MFs 4.83 3.27 3.75 5.06

FIIs 4.61 8.89 15.53 13.33

Any other 0.33 0.42 0.27

Total institutions 17.43 18.17 29.49 25.1

Non-institutional holders

Individual 17.53 13.05 8.71 10.28

Corporate bodies 12.28 5.83 3.49 4.96

Any other 4.39 3.66 3.12 2.97

Total non-institutional holders 34.2 22.54 15.32 18.21

Shares held with custodians against which GDR/ADR issued

1.57 3.04 1.91

Total public holding 51.63 42.28 47.85 45.22

Total 100 100 100 100

Market capitalisation (in Rs.) USD 120 797 million USD 917 547 million

Source: Indian response to the OECD questionnaire.

Figure 1.8. Average holding period on major stock exchanges (number of years)

Note: The average holding period is computed from the annual turnover ratio, that is, the average of the total market value at the start and end of the year divided by the total value of trading during the year.

Source: World Federation of Exchanges (2010a), Time series statistics of Domestic Market Capitalisation, available at www.world-exchanges.org/statistics/time-series/market-capitalization; World Federation of Exchanges (2010b), Time series statistics of Value of Share Trading, available at www.world-exchanges.org/statistics/time-series/value-share-trading.

1991 1993 1997 1999 2001 2003 2005 200920071995

NASDAQ NYSE TSX Group Australian SE Tokyo SE Borsa Italiana Deutsche Börse London OMX Nordic Exchange Euronext Santiago SE (right axis)

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http://www.world-exchanges.org/statistics/time-series/market-capitalization

http://www.world-exchanges.org/statistics/time-series/value-share-trading

I.1. THE STRUCTURE AND BEHAVIOUR OF INSTITUTIONAL INVESTORS

of the market capitalisation by 1.7-9.9 times. As a result, the surge of trading implied a

reduction in the average holding period.

Aggregate figures are nevertheless difficult to interpret but detailed information is

scarcely available. Nevertheless, some information can be obtained from the Tokyo Stock

Exchange on both value of stock holdings by different institutions and the value of

turnover, though there are differing definitions. Table 1.4 clearly indicates the strategic

investments of banks and private non-financial institutions (NFI) that are not used for

trading. However, the period 2000-2003 would have shown a much lower average holding

period as share portfolios of banks had to be reduced to 100% of capital by 2004 (OECD, 2003).

The insurance industry, where strategic holdings are well documented, is also similar. The

overall decline for insurance was probably due to their rebalancing of assets away from

equity towards bonds. Thus the average holding period is very difficult to interpret. Foreign

investors and individuals by contrast were more likely to trade.

A reason for the global decline in the average holding period might be due to the rise

in high frequency trading by investor classes such as hedge funds that are not covered in

the report. The Bank of England (Haldane, 2010) estimates that high frequency trading

accounts for 30-40% of European trading in equities and futures. One reason for the

increase in high frequency traders, apart from improved information technology, is the

marked decline in transaction costs. Whether the global figures can be taken as evidence

of short-termism is taken up in the following sections.

1.3. Codes, legal frameworks and disclosure requirements Institutional investors are subject to widely varying levels of regulation and in a few

cases must exercise fiduciary responsibility in voting their clients’ securities. A great deal

of the regulatory framework refers to prudential issues in the insurance, pension and

mutual fund areas which is not the main subject of this report. However, they do affect

investment strategies, which are closely related to their corporate governance

responsibilities and actions as shareholders.

In recent years, a number of jurisdictions (ten in Table 1.5) have introduced

professional codes of behaviour (e.g. UK, the Netherlands and Germany) to augment the

Table 1.4. Historical average holding period (years) by type of investors in TSE

Year Banks Insurance Private non-financial institutions Foreign investors Individuals

2004 26.11 33.45 18.07 0.89 1.51

2005 26.16 36.17 13.84 0.84 0.81

2006 33.79 45.24 13.54 0.65 0.77

2007 31.63 34.40 12.08 0.44 0.70

2008 23.33 18.98 13.32 0.35 0.74

2009 29.21 19.17 16.78 0.57 0.84

Note: The holding period was calculated from two sources, one for trading value by investor type and stock figures from an ownership survey by TSE. Therefore, the classification of investor type does not match entirely. For example, trading data was provided by large securities companies while ownership information was provided by share custodians. Source: Tokyo Stock Exchange (2011a), Statistical Database on annual trading value, available at www.tse.or.jp/english/ market/data/sector/index.html; Tokyo Stock Exchange (2011b), Statistical Database on Shareownership Survey, available in Japanese at www.tse.or.jp/market/data/examination/distribute/index.html.

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I.1. THE STRUCTURE AND BEHAVIOUR OF INSTITUTIONAL INVESTORS

Table 1.5. Summary of the status of the Principles

Countries Principle II.F.1 Principle II.F.2 Principle II.G Institutional code

Disclosure of voting policies-code C or law L

Disclosure of actual voting

Duties, fiduciary F, Loyalty L, general bans G

Disclosure of conflicts of interest

Yes but subject to concert/market abuse C, subject to other restrictions R

Argentina No No F No. bans on some behaviour such as invest in owner

No special regulation Investor protection code

Australia C Code F Code and general bans on some behaviour

C Yes

Austria No No G and F No C No

Belgium Partial, new EU dir No F Not implemented but new EU dir

No information Yes, asset managers

Brazil No but in prospectus

No Implemented, protection for proxy solicitation

Yes. fund managers

Chile L Yes F Policies needed but no disclosure

Yes subject to some concerns

Czech Republic Code No L Code No special rules Yes

Germany C & L No Code and rules on conduct but no disclosure

C Restrictive. Yes, complement to law. Asset managers

Greece Code No F Code C Yes

Hungary No No Yes Disclosure but no barriers

Yes, fund managers

India Implemented Yes-mutual funds F No but bans on some behaviour

C No

Indonesia No No No but some practices banned

No special legislation No

Israel L No F Yes Yes but subject to anti trust issues

Italy UCITS. L No Regulation and code

Regulation and code C. Being clarified Yes, asset managers. Comply or explain

Japan Recommendation No No rules or code Implemented Yes, Investment trust association

Mexico No No No No rules

Netherlands Code, comply or explain

Not specific but RPT exception

C Dutch corporate governance code

New Zealand No No F No C

Poland No No No No regulations but also code

Yes, asset management

Portugal C & L No but divergence from voting policies

F and also laws against some behaviour

No but laws against behaviour

C Yes, CIS and pensions

Slovak Republic C & L No Collective investment law

Not known Yes

Spain L for relevant holdings

No L L once EU directive UCITS is in force

C but disclosure of non statutory shareholder agreements

Switzerland L only for CIS. Might change for pension funds.

F &G Disclosure for pension funds but not others

C No but a private initiative Ethos

Turkey No No No No regulation Disclosure over thresholds

United Kingdom No but disclose whether they follow code: C & L

Legal powers but relying on code

F No but code C Yes. Comply or explain. Stewardship Code

United States L Yes F Rules on behaviour but less on disclosure

Yes and disclosure rules

Source: Country Questionnaires and OECD Secretariat.

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I.1. THE STRUCTURE AND BEHAVIOUR OF INSTITUTIONAL INVESTORS

regulatory framework and the UN has also introduced its Principles of Responsible

Investment. In addition, professional organisations such as the ICGN and the European

Fund and Asset Management Association (EFAMA, 2011) have also made their own

recommendations making for an extensive patchwork of recommendations, regulation

and standards. By and large, the codes and the regulatory system cover many of the issues

of transparency and duties specified in Principles II.F.1 and II.F.2. However, the level of

compliance with codes is still not fully known.

For members of the EU, the situation will change appreciably with the implementation

into local law of the new directive covering collective investment in transferable securities

(UCITS). It requires management companies to develop adequate and effective strategies

for determining when and how voting rights attached to the instruments held in managed

portfolios are to be exercised to the exclusive benefit of the fund concerned. Article 21 calls

for a strategy including measures and procedures for monitoring relevant corporate events,

ensuring that the exercise of voting rights is in accordance with investment objectives and

preventing or managing any conflicts of interest arising from the exercise of voting rights.

In most jurisdictions there is no explicit obligation to vote. In some others there is an

obligation to vote for some types of resolution. For example, in Israel, a fund manager,

pension fund and insurance company must participate and vote if the resolution could

harm unit holders such as through approval of related party transactions and Switzerland

is considering a similar requirement. The latter two institutions must also vote in the

election of external directors. Some jurisdictions set thresholds for the need to vote. For

example, in Spain, the obligation to vote is limited to those cases in which the value of

shares is quantitatively significant and “temporarily stable”.

It appears that more jurisdictions now require disclosure of actual voting (e.g., Australia,

US, India, Chile, and Spain after UCITS amendments and possibly also Switzerland)

although investee companies are often not required to disclose the voting outcomes of

their shareholder meetings. The UK authorities have the power to require institutional

investors to disclose how they have voted but they have not been used to date. They are

instead relying on adherence to the new Stewardship Code. By contrast to many other

countries, the US relies on regulations to implement Principles II.F.1 and Principles II.F.2.

These are described in Box 1.2. Chile, Germany and Australia, the three reviewed countries

also have important elements of regulation which for the latter two jurisdictions underpins

codes.

The concept of fiduciary duty or duties of investment managers more generally varies

across jurisdictions depending on their legal traditions and is more developed with respect

to pension fund trustees. For example, Spain and Mexico have a duty of loyalty (i.e. not to

act against the interests of the investor) which covers conflicts of interest. In other

countries there is more in the nature of a fiduciary duty to act in the best interest of the

investors. In a number of jurisdictions, the duties are specified according to sector

regulation.

An important development in a number of jurisdictions is the development of codes of

behaviour, the latest one being the UK Stewardship code (Box 1.3) that was based on an

earlier industry code by the Institutional Shareholders Committee. This arose in response

to the financial crisis and the observation in the Walker Report (2009) that institutional

shareholders had failed in the run up to the crisis. This hypothesis about lack of

monitoring was also supported by Goergen et al. (2008).8

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I.1. THE STRUCTURE AND BEHAVIOUR OF INSTITUTIONAL INVESTORS

Box 1.2. Corporate governance provisions in the US covering mutual funds and pension funds

Under the US federal securities laws, registered management investment companies (including mutual funds)1 are required to disclose to investors their overall voting policies with respect to their investments, including the procedures that they have in place for deciding on the use of their voting rights. The SEC regulates mutual funds, and its rules require disclosure of a mutual fund’s overall policies for voting portfolio securities. Because a mutual fund is the beneficial owner of its portfolio securities, the fund’s board of directors, acting on the fund’s behalf, has the right and the obligation to vote proxies relating to the fund’s portfolio securities. As a practical matter, however, the board typically delegates this function to the fund’s investment adviser as part of the investment adviser’s general management of fund assets, subject to the board’s continuing oversight. The investment advisor to a mutual fund is a fiduciary that owes the fund a duty of “utmost good faith, and full and fair disclosure”.

Mutual funds are required to disclose in their registration statements the policies and procedures that they use to determine how to vote proxies relating to securities held in their portfolios. Under this disclosure requirement, the mutual fund must disclose the procedures it uses when a vote presents a conflict between the interests of fund shareholders, on the one hand, and those of the fund’s investment adviser, principal underwriter, or an affiliated person of the fund, its investment adviser, or principal underwriter, on the other. A mutual fund also must disclose any policies and procedures of the fund’s investment adviser, or any other third party, that the fund uses, or that are used on the fund’s behalf, to determine how to vote proxies relating to portfolio securities. For example, if a fund delegates proxy voting decisions to its investment adviser that uses its own policies and procedures to vote the fund’s proxies, the fund must disclose the investment adviser’s policies and procedures. If a fund’s board chooses to adopt its investment adviser’s policies and procedures, it also is required to disclose the adviser’s policies and procedures.

A mutual fund also is required to file with the SEC and to make available to its shareholders, either on its website or upon request, its record of how it voted proxies relating to portfolio securities.

With respect to pension funds, a difference is drawn between private and public funds. In the United States, most private-sector pension funds are subject to the Employee Retirement Income Security Act of 1974 (ERISA), which sets standards of conduct for plan fiduciaries who manage plans or their assets.2 Fiduciaries must discharge their duties prudently, solely in the interest of the plan’s participants and beneficiaries, and for the exclusive purpose of paying benefits and defraying reasonable expenses of administrating the plan. Fiduciaries are also prohibited from causing the plan to engage in certain transactions and from using their authority or responsibility to benefit themselves. Plan participants also have the right to sue for benefits and breaches of fiduciary duty. An entity managing the plan is subject to fiduciary standards under ERISA in voting proxies.

The Department of Labor (DOL) interpretive guidance has indicated that the fiduciary duties generally require that, in voting proxies, the responsible fiduciary must only consider those factors that affect the value of the plan’s investment and may not subordinate the interests of the plan’s participants and beneficiaries in their retirement income to unrelated objectives. Votes may only be cast in accordance with the plan’s economic interests. If the responsible fiduciary reasonably determines that the cost of voting (including the cost of research, if necessary, to determine how to vote) is likely to exceed the expected economic benefits of voting, or if the exercise of voting results in the imposition of unwarranted trading or other restrictions, the fiduciary has an obligation to refrain from voting.

THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE © OECD 2011 35

I.1. THE STRUCTURE AND BEHAVIOUR OF INSTITUTIONAL INVESTORS

Box 1.2. Corporate governance provisions in the US covering mutual funds and pension funds (cont.)

There is no requirement under ERISA that pension plan fiduciaries disclose how they manage material conflicts of interest that may affect the exercise of key ownership rights.

Neither ERISA nor the interpretive guidance issued by the DOL requires private pension funds to disclose their overall corporate governance policies with respect to their investments. There also is no requirement under ERISA to disclose the overall voting policies with respect to a pension fund’s investment. However, DOL interpretive guidance has indicated that adopting a statement of investment policy to further the purposes of the plan and its funding policy is consistent with the fiduciary obligations and that a statement of proxy voting policy would be an important part of any comprehensive investment policy.3

Public pension funds are generally operated subject to state statutory and constitutional law, and accordingly the requirements applicable to the disclosure of corporate governance and voting policies, the fiduciary responsibilities and the requirements for managing conflicts of interests will vary from state to state.

1. Registered management investment companies include mutual funds (i.e., open-end management investment companies). An open-end management investment company is an investment company, other than a unit investment trust or face-amount certificate company, that offers for sale or has outstanding any redeemable security of which it is the issuer. These disclosure rules also apply to registered closed-end management investment companies and insurance company separate accounts organized as management investment companies that offer variable annuity contracts.

2. Pension funds that are established or maintained by a governmental entity for the benefit of public employees are not subject to the fiduciary, reporting and disclosure provisions of ERISA. However, to the extent public pension funds provide their members with tax deferral on fund contributions and earnings, these funds must comply with the provisions of ERISA that are administered by the Internal Revenue Service (i.e., provisions regarding non-discrimination, coverage, participation, integration with Social Security, benefit distribution, and operating for the exclusive benefit of plan members).

3. See Interpretive Bulletin.

Source: US response to the OECD questionnaire.

Box 1.3. The UK Stewardship Code

The overall objective is to enhance the quality of the dialogue of institutional investors with companies to help improve long term returns to shareholders, reduce the risk of catastrophic outcomes due to bad strategic decisions, and help with the efficient exercise of governance responsibilities.

Principle 1. Institutional investors should publicly disclose their policy on how they will discharge their stewardship responsibilities.

Principle 2. Institutional investors should have a robust policy on managing conflicts of interest in relation to stewardship and this policy should be publicly disclosed.

Principle 3. Institutional investors should monitor their investee companies.

Principle 4. Institutional investors should establish clear guidelines on when and how they will escalate their activities as a method of protecting and enhancing shareholder value.

Principle 5. Institutional investors should be willing to act collectively with other investors where appropriate.

Principle 6. Institutional investors should have a clear policy on voting and disclosure of voting activity.

Principle 7. Institutional investors should report periodically on their stewardship and voting activities.

Source: Financial Reporting Council (2010).

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The European Commission Green Paper on Corporate Governance in Financial

Institutions (2010) also indicates an interest by the Commission in stewardship codes

noting that “shareholders lack of interest” in corporate governance raise questions in

general about the effectiveness of corporate governance rules based on the presumption of

effective control by shareholders of all listed companies. Similarly, engaging shareholders

presents a real challenge for financial institutions. As of 31 January 2011, 108 asset

managers had chosen to sign the UK Stewardship Code. The FRC (2010) estimates that they

are responsible for over 40% of all assets under management in the UK. However, at least

one author (Wong, 2010b) feels that the UK Code represents an unsatisfactory compromise

between institutions with disparate conceptions of, and commitment to, stewardship.9 In

particular, the commitment to managing conflicts of interest is weak in an industry where

they are common, so that a commitment to minimise them would be more appropriate.

There is no mention of proxy advisors and investment consultants as well as the issue of

share lending. There is no mention of investment management practices that encourage

excessive trading and the attainment of short term returns and increasing intermediation.

In this respect it is useful to compare it with the German BVI Code (German Association for

Investment and Asset Management, 2005) that cautions against excessive churning of

shares to gain commissions (see Germany review below).

The Dutch code for institutional investors (Box 1.4) is embedded in the general listed

company corporate governance code and adherence must be confirmed by institutional

investors on a “comply or explain” basis. However, it appears that this is not mandatory for

investment fund managers and foreign institutional investors don’t fall under its

jurisdiction, an important omission given that foreign shareholdings are about 60% of

Dutch equity. Follow-up research (Eumedion, 2011) on compliance found that indirect

beneficiaries of institutional investors had no, or not much, interest in how the latter make

use of their rights as shareholders Smaller institutions such as small pension funds

showed low levels of compliance (50-60%) with the comply or explain provisions of the

code of listed companies, but for large institutions this was in the range of 90-100%.

Box 1.4. The Dutch corporate governance code’s approach to institutional investors

Since 1 January 2007, Dutch institutional investors are obliged to include in their annual report or on their websites a statement about their compliance with the best practice provisions of the Dutch Corporate Governance Code. The investor that has not applied a best practice provision has to carefully explain why (comply or explain).

Principle: Institutional investors shall act primarily in the interests of the ultimate beneficiaries or investors and have a responsibility to the ultimate beneficiaries or investors and the companies in which they invest, to decide in a careful and transparent way, whether they wish to exercise their rights as shareholder of listed companies.

Best practice provisions IV.4.1, IV.4.2, IV.4.3: Institutional investors shall publish annually, in any event on their website, their policy on the exercise of the voting rights for shares they hold in listed companies. They shall report annually, on their website or in their annual report, on how they have implemented their policy on the exercise of the voting rights in the year under review. Institutional investors shall report at least once a quarter on whether and, if so how they have voted at shareholder meetings.

Source: Tabaksblatt Commission website.

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1.4. Co-operation between investors The ability for institutional investors to co-operate is fundamental to resolving the

free rider problems: one institution operating alone bears all the costs while the benefits

accrue to all and there is no benefit to them incurring any costs of action. Hence the level

of collective action might be sup-optimal. Table 1.5 indicates that laws generally allow

institutional investors to co-operate although it is often subject to disclosure rules to

prevent market abuse and to “acting in concert” provisions that underpin takeover laws. In

other cases, proxy solicitation rules might be a key barrier, such as in the US and Canada

for many years until reforms were introduced (see OECD, 2007). On the other hand, several

jurisdictions do not appear to have any regulations which might also be problematic.

It is difficult to document the extent of co-operation between shareholders.

However, one survey (McCahery, 2010)10 found that 59% of respondents stated that they

consider co-ordinating their actions. For the 41% of investors that did not co-ordinate, over

half stated that it is primarily because of legal concerns: the risk of being deemed a group for

purposes of Rule 13d-5(b) of Regulation 13D in the US or the risk of having to make a public offer

for a company in the Netherlands if the joint holding exceeds 30%, similar to the law in

Germany and in other EU countries. Interestingly, they also found that the most important

trigger for shareholder activism is not dissatisfaction with a company’s share price performance

but rather with its (long run) corporate strategy. Around 80% of investors reported that they

made positive/active investment decisions, pension fund managers being the lowest.

One report (IRRC, 2010) indicates that surveyed investors engage mostly alone, instead

of collectively. However, a distinction was possible to draw between asset managers and

asset owners (e.g. pension funds, trusts, etc.), where owners would engage more

collectively than managers.

“Part of this discrepancy between owners and managers may simply be a matter of

asset managers competing with each other in a way that pension funds or other asset

owners seldom do. Another explanation may be that asset managers, who are more

likely to show up on a company’s shareholder register than beneficial owners, are

wary of triggering restrictions on ‘acting in concert’.” (page 8).

At the most general level, co-operation by institutional investors is already quite

advanced. Thus in the Netherlands, Chile, Australia, Switzerland and the UK, private

associations (sometimes loose as in Chile) of pension funds are proving very effective at

spreading the costs of monitoring (and thereby reducing the free rider problem) by

developing guides and background research. For example, Ethos in Switzerland, Eumedion

in the Netherlands and ACSI (see Australia review in Part II) in Australia are three such

organisations and also undertake background research and plan annual themes. They will

also execute proxy votes for their members if requested. Public pension funds in the US

(e.g. IRRC, 2011) and in the UK (Institutional Shareholders Council) also have similar

arrangements. It is sometimes claimed that pension funds are more oriented to co-

operation since they do not compete. This is, however, not true in Australia and in Chile

where there is significant competition between them.

Co-operation between fund managers and mutual funds appears to be much less

although private associations such as the International Corporate Governance Network

(ICGN) are an exception. Some fund managers such as Hermes in the UK have also emerged

as leaders which suits legal restrictions better. In the Australia review it is noted that there

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is little collective engagement among fund managers due in part to fears of violating

concert party regulations.

Co-operation is facilitated by the UN PRI’s Engagement Clearinghouse (UNPRI, 2010) that

provides signatories with a forum to share information about engagement activities they

are conducting, or would like to conduct. It thus also seeks to deal with collective action

issues and the problem of free riders. There are relatively few institutional investors in the

world that have the power and legitimacy to individually influence corporate performance

on ESG issues through the size of their own institutional shareholding alone. The scheme

is based around a private online forum for signatories to pool their resources and influence,

and seek changes in company behaviour, policy or systematic conditions. To use the PRI

Engagement Clearinghouse, signatories develop a proposal for the engagement they would

like to undertake, with details for how it would be conducted, expected outcomes,

background information and any associated documents. Other signatories can see which

activities are being proposed, and then choose to participate, or simply use the

Clearinghouse as a learning platform. The UNPRI (2011) reports that from July 2009 to July

2010 a total of 223 signatories were involved in collaborative engagements promoted

through the Clearinghouse and posted 85 new proposals up from 70 in 2008-2009. In

relative terms, it is thus still quite small.

Around the world the implementation of Principle II.G appears to be difficult with

respect to the provision “subject to exceptions to prevent abuse”, especially with respect to

takeover provisions (i.e. acting in concert). Both the German and Australian reviews point

to significant legal uncertainty that sets a limit to investor co-operation. For example, in

Germany investors should avoid discussing strategy which is not regarded as legally falling

within their competence. In Australia there is a safe harbour, but it is claimed that it does

not provide sufficient protection to shareholders engaging collectively on corporate

governance matters. For example, the safe harbour applies only to voting actions, whereas

engagements between shareholders and companies often encompass non-voting matters.

The safe harbour also requires institutional investors to notify the regulator of collective

activities whereas most engagements are highly informal and undertaken in private. The

UK authorities have also sought to establish greater clarity as to when co-operation can be

regarded as “acting in concert” and thus trigger takeover rules (FSA, 2009). The key issue is

whether shareholders are attempting to obtain control such as via the appointment of

non-independent directors (i.e. those employed by the investors). Discussing business

strategy would not constitute per se acting in concert or seeking board control, unlike in

Germany. In the case of Chile, on the contrary, the authorities seem to be at ease with the

co-ordination and collective action of pension funds. Basically, the counterbalancing power

of large controlling shareholders and the 7% cap to the shareholding of any individual

pension fund in a company are deemed to mitigate the risk of abuse. In the majority of

jurisdictions characterised by concentrated ownership and little in the way of a market in

corporate control, a lot might be gained by pursuing a more relaxed approach to acting in

concert.

In the US, which does not have takeover legislation, institutional investors are

permitted to consult with each other in a meaningful manner in order to freely and

effectively exercise their rights of share ownership. As in many other countries such as

Switzerland, there are no restrictions on the ability of institutional investors to do so;

however, their exercise of ownership rights and their collaborative activities may have

implications with respect to their filing and beneficial ownership reporting obligations

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I.1. THE STRUCTURE AND BEHAVIOUR OF INSTITUTIONAL INVESTORS

(i.e. market transparency obligations). There are no provisions under the Advisers Act or

the Investment Company Act that prohibit institutional investors from consulting each

other regarding their basic shareholder rights. In addition, there are no express restrictions

under ERISA that would prevent institutional investors from consulting each other on

issues concerning their basic shareholder rights. However, the consultative activities must

be prudent and solely in the interest of the plan’s participants and beneficiaries.

The issue in the US of whether institutional or other investors have formed a group by

virtue of their actions and interactions is one of facts and circumstances. The mere fact

that institutional investors consult with one another regarding their ownership stake and

resulting plans for an issuer may not be sufficient to form a group, without an affirmative

act of coming together to behave collaboratively with respect to voting, holding or

disposition of shares. However, a group may be formed without any express written

agreement or plan. If a group is formed, filings may be required, but the consultations are

not prohibited.11

Contacts and communications among institutional or other investors may implicate

the US federal proxy rules, to the extent that a “solicitation” is present. Proxy solicitation

rules in other jurisdictions also limit co-operation between shareholders (OECD, 2007).

1.5. Investment behaviour of institutional investors: the driving forces The previous section has examined the status of the three key principles involving

institutional investors: Principles II.F.1, II.F.2 and Principle II.G. However, even if all three

principles would be fully implemented in all jurisdictions, which is clearly not the case, the

question still remains whether they would promote good corporate governance in investee

companies, or are they more in the way of a necessary but not sufficient condition. In other

words, are the incentives and costs faced by institutional investors, in combination with

disclosure and investor co-operation, sufficient to promote good corporate governance

outcomes. The need to examine these broader questions was recognised at the time of the

2004 revision of the Principles through the introduction of Principle I.A: the corporate

governance framework should be developed with a view to its impact on overall economic

performance, market integrity and the incentives it creates for market participants and the

promotion of transparent and efficient markets. This section describes some of the observed

investment behaviour of institutional investors and relates them to the business models

they have created and the costs and incentives they face.

The section first reviews what is known about investment objectives/incentive

structures and then discusses various aspects of behaviour such as churning (buying and

selling of the same stocks), index tracking and portfolio diversification. An important issue

is addressed concerning the key criticism that institutional shareholders are short-term

oriented, and therefore lead to suboptimal corporate governance outcomes. The issue of

short termism is in many ways more macroeconomic: the short-term focus leads to the

neglect of longer term projects by management which might raise growth. These

arguments go beyond corporate governance considerations per se and into the area of

growth and the operation of financial markets. It is this controversial area that raises

issues concerning banks, capital markets, private equity and activist hedge funds dealt

with previously by the OECD (OECD, 2007).

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1.5.1. Objectives and incentives vary by institution and by country

Institutional investors covered in this report are concerned with the economics of

their commitment to investors and the returns they need to meet these liabilities and to

remunerate them for the use of their own resources, both human and financial. The

business model varies across investment classes but only seldom does it depend

exclusively or in good part on increasing returns from the companies in which they have

invested via improved corporate governance and careful monitoring. Engagement is

expensive and must be matched against potential revenues which are shared with other

investors (i.e. there is a free rider problem). In the case of pension funds and insurance, a

great deal will depend on the type of financial liability issued and the regulatory

framework. For example, in a Defined Benefit scheme (DB) `the trustees can in theory, at

least, seek to look at performance over the longer term and as such can accept more risk

such as by investing in equities. Defined Contribution schemes (DC), by contrast, face a

different liability structure and therefore a different attitude to risk and equities. As the

TUC, (2006) points out, “much DC marketing makes a big point of the ability of members to

change their investment regularly, and retail fund management advertising relies heavily

on performance (page 33)”. The steady shift away from DB to DC systems in many

jurisdictions might lead to a shorter time perspective by individuals, and arguably less

interest in additional management costs such as via engagement.12 Much will of course

depend on regulatory conditions which are often quite limiting such as restrictions on

individual stock holdings which reduce incentives for engagement. Insurance companies

are also limited by insolvency arrangements, which bias investments to shorter time

horizons and to stocks which are highly liquid.

In many cases the institutional investor earns its revenues as a flat percentage of its

assets under management which creates an incentive favouring rapid fund growth.

Deviation from a targeted rate of return might end a mandate but seldom do fund

managers receive a performance fee to encourage them to active management and to

improvement in returns of investee companies. In many instances, as in the US, there are

regulatory provisions defining allowable types of performance fees for mutual funds and

public pension funds often have trouble competing for high level staff. One study (Kahan

and Rock, 2006) calculated that the implied return from improved performance in a fund

where the incentive scheme is oriented to the growth of assets is, under favourable

assumptions, only some 3% of assets. A great deal will depend on regulation that can often

determine which costs can be passed on to investors and those that have to be paid by the

fund manager. By contrast, hedge funds in the recent past would earn about 20%. Hedge

funds and private equity also have strong incentives to improve performance by the

investee company and bonuses often have to be reinvested thereby sharing risks between

the fund managers and investors (OECD, 2007). However, the review of Chile (see below)

indicates that better incentive systems can be developed and implemented even for

pension funds. Other jurisdictions might like to review their own incentives structures to

see whether incentives to improved company performance via engagement can be better

structured while maintaining prudential objectives.

In short, the business model and the incentive structures that are a part of it strongly

influence the behaviour of institutional investors that is documented in this section. The

issues are complex with competition in financial markets forcing institutional investors to

monitor their revenues and costs closely. At the same time, externalities prevail through

the free rider problem. The policy issue is what such markets imply for corporate

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governance concerns in investee companies, voting behaviour and corporate monitoring

more generally. In other words, does competition in financial markets including

institutions with restricted incentive systems lead to socially optimal outcomes from the

corporate governance or investee company perspective.

Institutional investors have heterogeneous views about investment objectives and

about corporate governance mechanisms. For instance, one survey of investors in different

jurisdictions (McCahery et al., 2010) indicates that they have diverse preferences over

governance mechanisms. The issue of most importance to the hedge funds in the sample

was equity ownership by managers (i.e. alignment issues) whereas the issue of most

importance to the insurance companies is a high free float (i.e. the possibility of liquidating

shares easily). They therefore prefer large, liquid companies. Mutual funds regarded both

equity ownership by managers and transparency about holdings of large shareholders to

be most important. However, the most important triggers for shareholder activity were not

corporate governance per se but dissatisfaction with the goals and strategy of a firm,

planned acquisitions and corporate strategy in general. Share price performance did not

appear to be the key driver. This is interesting given research indicating that acquisitions

often fail.

Interestingly in view of the current public debate, in their sample about a half did not

use proxy voting services at all and only 7% always used proxy voting firms for determining

their voting decisions. Most used their external advice to help determine their own

position. Moreover, as the sample of McCahery et al. covered fund managers with both

investments in the US and the Netherlands, it appears that the funds realised that the

optimality of certain board structures depends on country specific circumstances.13

The same survey supported other empirical work that institutional investors often

consider exit rather than voice: 80% of investors were willing to sell shares in the portfolio

company. A number of such block-holders selling shares might be very effective, especially

if firms monitor (as recommended by some associations of company professionals) the

transactions. The second preference of the sample is to vote against the company at

annual meetings, some 66% of the sample saying that they would take this approach.

Interestingly, 55% said that they would engage in discussions with the firms’ executives

and some 10% would even go public with criticisms. Thus, this wider category of

institutional investors would undertake actions similar to those documented for activist

hedge funds (see OECD, 2007). Most important, the study finds that investors who are more

likely to be conflicted (e.g. private pension funds and some mutual funds) than those that

could be considered more independent are less likely to engage in discussions with the

executive board and to disclose their voting decisions (McCahery et al., p. 25). This finding

is in line with Ferreiro and Matos, 2008, and suggests significant conflicts of interest that

actually change behaviour. Finally, the study does not show a strong relationship between

the implied time horizon (as measured by the turnover ratio) and the propensity to

shareholder activism: both “short term” and “longer term” investors are likely to engage in

activism.

A study of shareholder activism in Germany in 2009 revealed that active shareholders’

preferences strongly depend on the individual company and go further than narrowly

defined corporate governance interests.14 They included M&A activities and general

strategic questions, as well as the composition and the remuneration of the supervisory

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board (which are key corporate governance concerns), and capital policy (share buybacks

and capital increases). There are strong pre-emption rights in Germany.

1.5.2. Average holding periods

Much is made of the fact that average holding periods for shares have fallen over time

(Figure 1.8), it being taken for granted that investor time frames are shortening, which is per

se a bad thing. However, it is not clear from this aggregate data whether this is a consistent

phenomenon across asset owners or simply reflects a larger volume of turnover by a

segment of the market, especially high frequency traders (usually hedge funds and

securities firms).15 High frequency program traders now account for some 30-40% of stock

exchange trading in Europe and there are even higher estimates of 50-80% in both the US

and in Europe.16 Off-exchange trading might also have an effect since large packets of

shares are said to be traded in this manner.17 The Tokyo Stock Exchange has seen the

greatest relative decline in average holding periods, but domestic banks and insurance

companies have exhibited little change in their average holding periods (banks average

holding periods, for instance, increased between 2004 and 2009 but probably fell in the

preceding period as portfolios were rebalanced, see above) with much of the overall

reduction driven by individuals and foreign investors.

It is a reasonable hypothesis backed by a great deal of anecdotal evidence that the

average holding period is not saying that much about investor behaviour that is relevant to

corporate governance concerns. It appears that a number of large institutional investors

own relatively constant portfolios of shares measured at the beginning and end of a period

but that they take advantage of market changes and short-term incentives to trade in an

attempt to improve returns net of transactions costs. Thus index tracking discussed below

might be compatible with only slowly changing portfolios but with trading during the

course of the year. More research is required in this area.

One recent study examines the difference between planned and actual turnover rates.

Of 822 fund strategies reporting expected and actual turnover between 2006 and 2009, 65%

of them exceeded their expected turnovers by some 25% (IRRC, 2010). In some cases the

difference was very large and could have had a significant impact on transactions costs

and on whether fund strategy was being pursued. The average turnover was around 70%

with some 20% of funds being above 100% (full turnover in a year or less). However, in the

case of this study, it is difficult to overlook the sample period, which narrowly

encompasses a period of historic volatility. Value strategies, large caps and responsible

investment strategies all had lower turnover than their colleagues with other strategies.

Higher that planned turnover may be due to market volatility but in some jurisdictions

it could also reflect the incentive system. Some respondents felt that three year mandates

and periodic interim reviews of performance increased the perceived risk of losing a

mandate and also pointed to mutual funds where managers are often incentivised against

quarterly performance. “Less than 10% of managers have less than 33% turnover, the

equivalent of a three year investment horizon, even though many investors consider

three years to be a suitable time frame for showing performance over a market cycle”

(IRRC, 2010).

1.5.3. What is a long term investor?

The debate about holding periods raises the profound question about how to define

whether a “long term investor” is also a “long term engaged shareholder”; is it just about

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holding shares or more about a point of view and a corporate presence (Kemna and van de

Loo, 2009). This difference is crucial for considering policy options.

The notion that a long term engaged shareholder is about share holding is at the root

of many policy proposals. Cross holding of shares as in Japan, France or Germany might

lead to a long-term shareholder but does it make for an engaged long-term one when the

motive might be to only block hostile takeovers? Of course there might well be other

business motives with a long-term orientation such as an exchange of technology. Policy

proposals addressed to share holding propose to compensate the shareholder for the

supposed costs. Loyalty dividends and extra voting rights have been proposed and indeed

in France shareholders holding shares over a period of two years have double voting

rights.18 However, loyal shareholders are not necessarily engaged shareholders. A loyalty

dividend does not imply anything about engagement while double voting does not change

the cost-benefit calculation by investors or at least only under specific circumstances.

There are good reasons why shareholders (or fund managers) might want to trade

shares even if over the long run they might remain stable shareholders since they cannot

sell the market. Average holding period data only offers few insights here. On the other

hand, investment managers might sell shares for a number of reasons which might well be

long term such as when the company implements a change in strategy that does not

inspire trust.

The issue of high share turnover (“churning”) is, however, an important one even if the

ultimate beneficiaries remain stable in the longer run. Managements might be forced to

take a short-term perspective and beneficiaries might end up paying excessive

transactions costs. In part this is a private contractual issue and underpins work by, for

example, the ICGN and others to develop a model mandate between asset owners and their

fund managers (ICGN, 2011) and the German BVI Code described in Part II. However, it is

also a regulatory issue (e.g. soft commissions, IOSCO, 2007).

What constitutes a long-term engaged investor cannot be answered without reference

to the bigger picture and without reference to expectations. For those taking a stewardship

approach, the duty of institutional shareholders will be ranked high and cannot be simply

fulfilled by voting at company meetings. Portfolio investors will always appear short-term

even if they hold the assets over a long period as might be required by an index tracking

strategy. More important might be the perspectives of management and particularly by

CEOs whose tenure has tended to shorten in many jurisdictions – and not just Anglo Saxon

ones. This might be explained by the increased intensity of competition and by the fact

that failed strategies might be apparent more quickly than in the past. It will certainly

shorten the time perspective but is this short termism?

1.5.4. Lengthening the investment chain

An increasing number of intermediaries in the investment chain have been observed

in many jurisdictions although the underlying reasons for this development are still not

fully clear. The lengthening of the investment chain is well illustrated by the case in the

Netherlands: in the first quarter of 2009, approximately 93% of Dutch pension assets were

invested externally with one or more asset managers, while this percentage was still less

than 50% in 2001 (Eumedion, 2010). Moreover, the average duration of the mandate that a

pension fund gives to a manager is three years and the pension fund’s decision whether to

extend the mandate or not is partly based on the financial performance of the relevant

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asset manager in this period, mostly against a benchmark. This can give managers a

further incentive to pursue shorter term objectives, even if the overall portfolio might not

change significantly. Moreover, the increased scale of many fund managers in the

Netherlands means that they might be becoming distant from both the client and the

ultimate beneficiaries, and from the company whose shares are held.

The length of the investment chain may not matter that much if it results in

economies of scale by fund managers and is overseen by beneficiaries or their agents. The

review of Australia (below) notes that the pension fund administrators do keep in close

touch with fund managers but that this is only feasible given the relatively small number

of listed domestic companies. However, elsewhere it is reported that many pension funds,

with equities accounting for 70-80% of their portfolios, do not scrutinise the engagement

activities of their passive managers (Wong, 2010a). In turn, the final beneficiaries of, for

example, a pension fund may not follow closely the policy of its trustees, its fund advisors

and finally the fund management company (see for example TUC, 2006).

1.5.5. Index tracking and ETFs

Index-based investment strategies and index-based products are now a well

established segment of the investment management industry. Standard & Poor’s reports

that in 2010 there was USD 3.5 trillion benchmarked to the S&P 500 alone, including

USD 915 billion in explicit index funds. Russel estimates that USD 3.9 trillion is currently

benchmarked to its indices (Wurgler, 2010). Moreover Exchange Traded Funds now amount

to some USD 1.2 trillion (Bradley and Litan, 2010). Given concerns about tracking errors, an

active manager who is benchmarked to an index is likely to trade the stocks in that index.

One researcher notes that it is impossible to determine the exact dollar value of US equities

whose ownership and trading is somehow tied to an index, but the above figures suggest

that trillions of dollars are involved. This means that every day billions of dollars in net

flows affect index member companies but not excluded companies.

There are many financial issues related to the popularity of indexing including

herding behaviour leading to volatility. However, this review is focused on corporate

governance issues arising from this form of investing, and they are important although

indirect. It is argued that index-linked investing is distorting relative stock prices and risk-

return tradeoffs, which in turn may be distorting corporate investment and financing

decisions, investor portfolio allocation decisions, fund manager skill assessment, and

other choices and measures (Wurgler, 2010). Indeed, some companies, especially the newer

growth stocks, often opt-out of indexes as a condition to being listed!

According to one estimate (Wurgler, 2010) a company chosen on the basis simply of its

liquidity and market representation to participate in say the S&P 500 sees a price increase

due to demand of some 9% as portfolio trackers reweight portfolios – and even more if the

stock has been deleted. This is all independent of any changes in the company’s prospects.

Moreover, the stock price will track the other members of the index unrelated to its own

performance and those of comparable stocks (i.e. its covariance with other stocks will

change) (Box 1.5).

Institutional investors are believed to make heavy use of market indices such as

FTSE 100, S&P 500 and the MSCI World Index. In addition, more specialised indexes such as

those dealing with ESG or only with corporate governance are appearing all the time. In

determining the mandate for investment managers, both internal and external, indexes

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I.1. THE STRUCTURE AND BEHAVIOUR OF INSTITUTIONAL INVESTORS

are often used to set performance and indeed strategy. Passive investment managers are

those who must match the index but often active investors will also be judged on their

deviation from an index. An active fund manager whose portfolio gained 10% but the

relevant index rose by 12% will have “underperformed”. The advantage of passive

investing, through for example, a mutual fund is that transactions costs are lower than

with active investing.

The potential significance of passive investors can be gauged from a Towers Watson

study that predicts that over the next ten years, the proportion of institutional investor

Box 1.5. Effects of company inclusion in S&P 500 index

The S&P 500 Index is a capitalization-weighted index. Each stock that is newly added to the Index must be bought by explicit index fund managers and others – and rather quickly so, because their mandate is to replicate broadly or exactly the Index.

Wurgler (2010) notes that “On average, stocks that have been added to the S&P between 1990 and 2005 have increased almost 9% around the event, with the effect generally growing over time with Index fund assets. Stocks deleted from the Index have tumbled by even more. Given that mechanical indexers must trade 8.7% of shares outstanding in short order, and an even higher percentage in terms of the free float, not to mention the significant buying associated with benchmarked active management – this price jump is easy to understand and, perhaps, impressively modest.

The obvious explanation for this jump is simple supply and demand. One might be able to argue that one component of the price jump is due to expected increases in liquidity (an impact distinct from fundamentals of the firm). However, changes in volume, quoted spreads, and quoted depth are much smaller than would justify a price increase of several percentage points. After all, these stocks were already selected by the S&P in part because of their high liquidity. (…)

If a one-time inclusion effect of a few percentage points were the end of the story, then the overall impact of indexing on prices would be modest. But the inclusion effect is just the beginning. The return pattern of the newly-included S&P 500 member changes magically and quickly. It begins to move more closely with its 499 new neighbours and less closely with the rest of the market. It is as if it has joined a new school of fish. It is worth repeating that this pattern is occurring in some of the largest and most liquid stocks in the world. (…)

These co-movement patterns are where the real economic impact starts. Just as the initial price jump is a result of sudden index fund demand for the new stock, the increased co-movement with other members of the S&P 500 is related to the highly correlated index fund inflows and outflows that they experience.

The net flows into index-linked products are both large and not perfectly correlated with other investors’ trades. Indexers and index-product users are by definition pursuing different strategies from those of the more active investor. They are less interested in keeping close track of the relative valuations of index and non-index shares. Some are index arbitrageurs or basis traders who care only about price parity between index derivatives and the underlying stock portfolio. The upshot is that over time, the index members can slowly drift away from the rest of the market, a phenomenon I (Wurgler) will call ‘detachment’.”

Source: Wurgler (2010), pages 5-7.

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asset allocation to passive investing will increase from 25-33% to 50% (as quoted in Wong,

2010a). In 2009, passive assets rose by 62% to USD 7.3 trillion. Towers Watson noted that

“passive investment management remains a growth business as more institutional

investors have concluded that their governance arrangements are stretched thin in

overseeing the successful active management of their assets and have added to their core”

(Towers Watson News, 2010).19 Establishing a tracking mutual fund could of course include

the commitment to engage with companies in the prospectus. This is regarded as a

potential policy option in some jurisdictions.

There can be several negative features of indexing from the viewpoint of good

corporate governance. First, there is a danger of “invest and forget” even for corporate

governance or ESG indices. In theory a passive investor could always generate excess

returns from the market average (indeed it is the only way) by engaging, subject of course

to costs. This is, for example, the position of the UNPRI (2011). However, the empirical

question is, do they actually monitor their portfolio companies? One large investor told the

OECD that it is an index tracker. However, this fund was also an important activist investor

and saw the two strategies as not in conflict. Similarly, it is reported that the two largest

index trackers in the UK market, Legal and General and BlackRock, argue that their inability

to sell compel them to be more interested in company engagement. This is underpinned by

them taking a 4% to 5% stake in listed companies. Chilean pension funds showed a similar

approach on the domestic equity market (see review below).

Back in 1991, Lowenstein already pointed out that indexing had obvious advantages as

a way to reduce heavy brokerage commissions and advisory fees charged by active

investment strategies that seldom proved to beat the indexes anyway. Industry wide, he

stressed, it is impossible to escape a return to the mean as the gain made by one investor

is the loss of another. Easy access to a diversified portfolio was another upside of indexing.

But Lowenstein also pointed to several doubts as to the functioning of indexation,

concluding that “in a capitalist system there is no substitute for capitalists”, and that

indexed funds presented a high risk of passive shareholding that would deteriorate

corporate governance at companies.

Second, the MSCI World Index consists of more than 1 500 companies which will need

to be bought by an index tracker. Such a portfolio runs the danger of making engagement

impractical and reduces the ownership of companies to being merely commodities.

Third, if a narrow time interval (e.g. quarterly) is used to measure success of

investment managers there is a danger of short-term focus and heard behaviour (Wong,

2010 c). Rather it is suggested to lengthen the performance review period and reduce

emphasis on market indices to gauge asset management performance. For example, the

Marathon Club (2007) recommends annual reviews and reviews of portfolio holdings

against the investment philosophy. They also suggest examining internal rates of return

for exited investments.

Exchange traded funds are growing rapidly. The question that cannot be answered

definitively at this stage is to what extent they will be used by institutional investors and

what it might mean for engagement. As with indexes, much depends on the detail about

how they are structured. For example, it is understood that one large sponsor, BlackRock,

has maintained monitoring of the companies in its portfolio comprising a number of its

ETFs. This might be due to the tradition of company engagement from the old Barclays

Global team that it bought. Another large sponsor does no engagement at all. One market

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participant (Wong, 2010) noted the case of one ETF provider that had decided not to charge

any management fees but instead to rely on securities lending to generate income. From

the corporate governance viewpoint this could be a negative development although the

issue of borrowing shares to vote remains controversial as an empirical phenomenon20

(Box 1.6).

1.5.6. A high level of diversification

A marked feature of the institutional investor landscape is the common strategy of

holding a very large number of companies in portfolios. For example, Wong (2010a) notes

that one UK pension fund held shares in most of the 700 plus companies in the UK All

Share Index and another US fund held 5 000 equity holdings in the US alone. One sovereign

wealth fund holds shares in 8 000 plus companies globally. One reason for such large

holdings is due to index tracking but another is also in some cases prudential regulations

Box 1.6. Exchange traded funds: What are they?

One critique of the widening use of ETFs is that they circumscribe the traditional price discovery role of the exchanges where individual stocks are traded. This is similar to the criticism of indexation.

ETFs were first developed to accurately track the performance of a portfolio. This enables asset managers to remain largely passive since as in a mutual fund they do not own any of the stock. The advantages of an ETF over an indexed mutual are lower commissions and, especially in the US, tax advantages.

The sponsor of an ETF such as BlackRock first determines the basis for an ETF and acquires or borrows these securities. The ETF might be based on a market capitalisation index such as the S&P 500 which avoids rebalancing risk. However, ETF sponsors have now moved into highly specific indexes and industries and these companies might not trade on liquid markets and so could prove difficult to liquidate.

The sponsor engages an Authorised Participant which is responsible for creating new ETF units. It also organises the secondary market and often provides the trading platform. A major participant is Susquehanna Financial Group which notes that at all times an AP can create more ETF units. Thus they can eliminate short exposures (Bradley and Litan, 2010 – page 3).

ETFs can be created to meet increasing demand or even redeemed. Creating ETF units consists of inputting (like warehousing) baskets of stocks comprising the index in large quantities – usually enough to make 50 000 ETF shares (so called creation units) that match the underlying index composition. The redemption process consists of accepting a basket of shares of the underlying units in exchange for creation units. No cash changes hands. Authorised participants (i.e. Brokers) are permitted to execute such trades at the end of the trading day. The creation and redemption process often eliminates any differences between the price of the ETF and the Net Asset Value.

Unlike a mutual fund, an ETF unit is not a claim to a fixed proportion of the underlying shares but is a derivative based on such shares. Turned around the other way, the value of a company share can be determined not by trading in that share but in trading the whole ETF. Arbitrage will force the price to follow that implied by the ETF valuation. The prevailing price of an ETF is not necessarily the cumulative net asset value of the underlying securities as in a mutual.

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that limit exposures to individual companies. In some cases regulations quite purposely

deny institutions such as pension funds and insurance from exceeding a low percentage of

shares in individual companies. Some institutional investors have also pursued

diversification to reduce volatility risk even though some studies show that the objective to

reduce portfolio volatility diminishes rapidly after 20-50 stocks (as quoted by Wong, 2010a).

Either way, it makes engagement difficult and weakens the link to good corporate

governance through company monitoring.

Some investors are undertaking changes although they may not represent a large

proportion of the industry. Thus Wong (2010a) notes that two large investment funds

are contemplating shrinking their equity portfolios from 4 000-5 000 holdings to

300-400 holdings, and in the UK a large investment house abandoned the practice of

replicating or “hugging” market indices several years ago and today takes sizeable holdings

in a small group of companies. It is reported that other investors are turning to such an

approach. In Chile (see Part II) the pension funds can hold up to 7% of the equity of a

company which, combined with co-operation between them, gives a significant voice. This

is suitable in a market where exit is not a viable option.

1.5.7. The responsible investment movement: ESG issues

A major feature of the institutional investors’ landscape in recent years is the advent

of ESG investing as an asset class, primarily as a result of the UNPRI Principles (Box 1.7).

The UNPRI process involves asset owners and asset managers, in total around 500

institutions. Most of these signatories classify themselves as active managers although

over 85% of asset owners have at least some funds that are passively managed. In their

recent report, the UNPRI reports progress in implementing their Principles. However, being

a mixture of governance, environment and social factors it is difficult to determine the

economic drivers. However, some observations are useful. Thus they note that “in the

global market as a whole, ESG integration is being implemented across 8% and 6% of

listed equities in developed and emerging markets respectively” (UNPRI, 2011). Over

4 000 extensive engagements run by internal staff were reported by signatories.

Approximately 90% of signatories were involved in formal or informal collaboration with

other investors on ESG issues and more than 35% collaborated to a large extent.

Box 1.7. UN Principles for Responsible Investment

Principle 1. We will incorporate ESG issues into investment analysis and decision making processes. The integration of ESG issues can be defined as using ESG research and analysis and/or screening potential investments based on ESG criteria in order to improve the portfolio’s financial performance.

Principle 2. We will be active owners and incorporate ESG issues into our ownership policies and practices. This principle encourages signatories to take a stewardship approach, vote in an informed way at company meetings or on boards, and engage with investee companies and other entities in order to improve ESG performance.

Principle 3. We will seek appropriate disclosure on ESG issues by the entities in which we invest. For signatories to be able to implement Principles 1 and 2, they need companies and other entities to provide date on ESG performance, impacts, risks and opportunities. Until the disclosure of such data becomes standard practice in global markets, investors need to use their influence to drive transparency and disclosure from theirs investees, either directly or via third parties.

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1.6. The voting and engagement record Actual voting and engagement practices are described in this section. A key

overarching point to bear in mind is that such activities do not come cheaply. For example,

the California Public Employees Retirement System spends USD 1 billion on external asset

management fees which include tens of millions on governance funds. They are

apparently under pressure to scrutinize such outlays as is the New York City public

employee pension funds schemes that oversee USD 113 billion in funds (Global Proxy

Watch, 2011). They have recently dismissed three external asset managers that have lost

money after fees over six years.

1.6.1. Engagement with investee companies

The Principles call for institutional investors (and others) to “make informed use of

their shareholder rights and effectively exercise their ownership functions”. Codes and

public discussion often go further and call for “engagement” or “stewardship”. What do

these actually mean in practice? Do they imply the same behaviour and responsibilities for

different types of investors?

The recent UK Stewardship Code defines engagement to include pursuing purposeful

dialogue on strategy, performance and the management of risk, as well as on issues that are

the immediate subject of votes at general meetings (See Box 1.3). It clearly states that

institutional shareholders “are free to choose whether or not to engage but their choice

should be a considered one based on their investment approach”, since institutional

investors as agents have a mandate to fulfil. The annotations for Principle 3 of the UK

Stewardship Code recommend that “investee companies should be monitored to determine

when it is necessary to enter into an active dialogue with their boards. This monitoring

should be regular, and the process clearly communicable and checked periodically for its

effectiveness.” What happens in practice at the moment in the UK is not known.

Box 1.7. UN Principles for Responsible Investment (cont.)

Principle 4. We will promote acceptance and implementation of the Principles within the investment industry. The Principles were designed to be a framework for the whole investment industry, and Principle 4 signatories to help spread responsible investment throughout the investment chain.

Principle 5. We will work together to enhance our effectiveness in implementing the Principles. Many ESG issues are too large and too complex for any one signatory to solve on their own. Therefore collaboration – through forums like the PRI Clearing house, PRI work streams and other industry initiatives – has become a key part of responsible investment implementation. Working together can increase the influence that investors bring to bear on investee entities, and being able to raise issues with other investors in a company is vital to sending unified signals on the importance of managing ESG issues appropriately.

Principles 6. We will each report on our activities and progress towards implementing the Principles. The issue of transparency and reporting is of increasing importance to investors and applies to both an investor’s policies and how they are implemented. It is core to Principle 6 that investors report on how they put the Principles into practice. From 2012, greater transparency requirements will be introduced by the PRI initiative.

Source: UNPRI (2010).

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However, a recent study conducted by the IRRC Institute (2011) has documented the

engagement practices of US corporations and shareholders. The study shows that

“engagement between issuers and investors is common and increasing both in terms of

frequency and subject areas”, with a majority of the respondents saying they are engaging

more than before 2007.

The IRRC report describes that increased engagement has been fuelled by: i) a greater

awareness by institutional investors regarding risk at their portfolio companies following

the recent financial crisis, as well as growing unease about the performance of boards

overseeing management; ii) key regulatory changes that as a result of improved disclosure

have prompted shareholder interest for comparable information and provided them with

“greater visibility into company financials, potential conflicts of interest involving officers

and directors, and compensation practices”; and iii) a favourable approach from issuers to

the benefits of engaging with shareholders, as it may help them to address early potential

issues or deal with existing ones “before they reach a boiling point”.

Among the key findings of the report, it describes that a majority of respondents have

internal research and monitoring teams, with between two and five people involved in

engagement. However, they may not have the final say. Thus a German survey (DSW, 2008)

points out that it is often the case that decisions on voting are not made by these people

but rather by a managing director or a compliance officer (Figure 1.9). Institutional

investors can also have conflicts of interest that can interfere with any research: Cohen

et al. (2007) analysed a dataset of private pension plans in the US (401[k] retirement plans)

and found that they were overweight in the shares of their client (the sponsoring company)

even when the shares underperformed.

The IRRC report also shows that most investors engage alone, instead of collectively

with other institutions. The report also shows that most engagements involve executive

Figure 1.9. Voting decision making authority Who is responsible for the decision how to vote the fund’s shares?

Source: Deutsche Schutzvereinigung für Wertpapierbesitz e.V. (DSW) Newsletter, April 2008, available at www.dsw- info.de/uploads/media/Newsletter11.pdf.

29%

36%

26%

Corporate governance manager

Managing director

Compliance officer/fund manager

Other

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I.1. THE STRUCTURE AND BEHAVIOUR OF INSTITUTIONAL INVESTORS

compensation issues and almost exclusively with domestic issuers.21 But responses also

reveal “that engagement also means different things to different people: While some use

the term to refer to a campaign to persuade a company to change its behaviour, others

(particularly issuers themselves) classify routine conversations with investors about

financial results as engagement as well”. However, the study also concludes that most

engagements remain private and only few cases reach high-profile cases (see Australia

review below).

1.6.2. Voting practices

The Principles approach voting from the perspective of shareholders’ rights, rather

than as one of their obligations. Nevertheless, they do call for institutional investors to

disclose their “overall corporate governance and voting policies with respect to their

investments, including the procedures that they have in place for deciding on the use of

their voting rights” (Principle II.F.1).

Voting is an obvious form of engagement and the natural means for shareholder to

manifest their preferences and exercise their voice. Most jurisdictions either mandate some

institutional investors to vote (e.g. US, Box 1.8) or encourage them to do so as part of their

fiduciary duties. A recent study estimates, by measuring the difference in the prices of the

stock and the corresponding synthetic stock, that the mean annualized value of a voting

right would be 1.58% of the underlying stock price (Kalay et al., 2011). It also shows vote value

increases around meetings with a high-profile agenda as well as for M&A events.

ICGN22 has recently highlighted that in their view:

“for long-term investors to exercise their voting rights effectively, particularly on

contentious or material issues, engaging with companies before the general meeting

is invaluable. Voting at general meetings is not an end in itself: it should actually be

viewed as a form of stewardship which prompts engagement rather than a form of

engagement itself. Voting against management without prior engagement essentially

blunts voting as a stewardship tool and is likely to be counterproductive and less likely

to result in companies making changes particularly where investors have concerns.”

Principle III.A.4 states “impediments to cross border voting should be eliminated” and

Principle III.A.5 notes that “processes and procedures for general shareholder meetings

should allow for equitable treatment of all shareholders. Company procedures should not

make it unduly difficult or expensive to cast votes.”

In practical terms, the exercise of voting rights in some jurisdictions operates as an

impediment to effective engagement, and jurisdictions are making efforts to streamline

the processes involved in exercising these rights. A study (MPRA, 2008) examined several

legal and economic obstacles to institutional investor activism in the EU and in the US,

concluding that there is a lower voting presence of investors in the EU that may be due to

the difficulty of accessing proxy voting and a degree of apathy derived from the small

stakes they own in the foreign companies.

Impediments are particularly visible with respect to cross-border voting, especially

with the increasing prevalence of foreign institutional investors in most markets. In

Europe, the Shareholder Rights Directive (2007) seeks to facilitate cross border voting but

difficulties still remain, as it did not address some of the technical barriers and is still not

fully implemented by national jurisdictions. One study of cross-border voting in Europe

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(Manifest Information Services, 2007) concluded that the obstacles can be attributed to

market issues, problems at the issuer level, and inefficiencies caused by the chain

approach to voting (Box 1.9).

Among the reasons explaining the difficulties of cross border voting, Manifest (2007)

points to the sheer inefficiency of the chain of intermediaries through which voting

instructions must pass, with additional time required by each member in the chain, adding

to a total that means that the end investor has no real time to decide how to vote. The

report explains that “the logistical challenges faced by cross-border institutional

engagement on a large scale, combined with the continued significance of passive

investment strategies, means that voting has far from lost its place as a prime means of

engagement in general”. The results of the study point also to the fact that very few

investors are able to know with certainty that their cross-border voting instructions are

actually carried out at the meetings. The aggregate meeting poll data is the best

information they can currently obtain as to how the resolutions were voted, having to

satisfy themselves with an assumption that their voting instructions were received and

carried out. Only some jurisdictions in the OECD area require companies to publish voting

results (Manifest, 2011 and ISS, 2010).

Box 1.8. Main proxy voting obligations under US laws and regulations

Investment Companies (including mutual funds, closed-end funds, and exchange- traded funds) and their advisers have obligations with respect to proxy voting, many of which stem from specific requirements under the Investment Company Act of 1940 and the Investment Advisers Act of 1940. The major proxy voting obligations include:

● A fund’s board of trustees, acting on the fund’s behalf, is responsible for the voting of proxies related to the fund’s portfolio securities. The fund’s board normally delegates voting responsibility to the fund’s adviser, subject to board oversight, in recognition that proxy voting is part of the investment advisory process.

● Federal law imposes a fiduciary duty on a fund’s adviser, and this duty extends to proxy voting. An adviser that votes a fund’s proxies therefore must do so in the best interests of the fund and its shareholders and without regard to the adviser’s own business interests. Thus, when voting proxies on a fund’s behalf, the adviser must not be influenced by its other business interests, such as whether it manages or administers a 401(k) plan for the company whose proxies are being voted.

● Funds and their advisers must establish and disclose written proxy voting policies and procedures. Among other things, these policies and procedures must specify how the interests of fund investors will be protected when a vote presents a conflict between the interests of fund investors and those of a fund’s adviser. A fund’s board must review these policies at least annually.

● Funds must “recall” loaned securities to vote proxies. Funds frequently enter into securities lending programs to generate extra income, thus increasing their total return. Because the right to vote proxies passes to the borrower of the securities, funds must terminate these loans and recall the securities on loan in time to vote proxies if funds have knowledge that a material event affecting those securities will occur.

● Unlike other shareholders, funds must disclose all the proxy votes they cast. They do this by filing Form N-PX with the SEC, which must be filed each August.

Source: Investment Company Institute (2010).

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Manifest has made a diagram illustrating the complexity of the voting chain

(Figure 1.10). It shows what is called a “very simplistic representation of the voting process,

involving only one beneficial owner/fund manager, one global custodian, one sub-

custodian and one voting service provider”. The “more realistic” chart involves dozens of

agents and intermediaries with all kinds of cross-links between them, that makes the

entire picture look like the chemical representation of a very complex molecule.

A study examining general overall patterns of voting behaviour among shareholders

across OECD member countries was commissioned from Manifest for this report

(Paul Hewitt, Manifest Information Services, 2011). It tabulated the results of votes cast at

shareholder meetings to assess the degree to which investors use their voting rights

(an engagement tool) to register their concerns with companies on key corporate issues.

The results show that the analysis of voting patterns is much more complex than it

would at first appear.

“Analysis of the role of major shareholders is made very difficult without specific

additional disclosure as to how each major or regulated shareholder has voted at a

meeting. This is information which could be reported in the meeting minutes, as is the

case in Chile.23 In this way, it would be possible to ascertain the role of major

Box 1.9. Main obstacles to cross border voting in Europe

Market issues that impede effective voting in Europe include: i) share blocking; ii) re- registration requirement; iii) requirement for a power of attorney; iv) existence of bearer shares; v) inadequate meeting notification periods and methods of distributing meeting information; vi) lack of provisions for distance and, specifically, electronic voting; vii) lack of recognition of electronic signatures; viii) voting restrictions; cumbersome registration process; etc. Some market issues can only be resolved by legislation. In view of this, the European Commission’s Shareholders’ Rights Directive was welcomed by all the participants in the study, as it aims to remove some of the above impediments to voting and encourage the introduction of more effective systems (e.g. the record date system) by obliging EU member states to change their company law.

Practices of issuers that are considered by institutional investors to be precluding foreign shareholders from participating and voting in company meetings include: i) Non- compliance, or compliance with only minimum legal requirements for meeting notification periods (where such periods are obviously short); ii) Publication of meeting notices in media easily accessible only to domestic shareholders; iii) Setting voting deadlines and other pre-meeting deadlines as early as allowed by law, or long in advance of the meeting, if there is no legal provision to this respect; iv) Introducing complicated meeting attendance requirements (e.g. share blocking or cumbersome registration procedures, etc.), where there is no statutory obligation to do so; v) Limitations on the appointment and powers of proxies, where these issues are left to the company’s discretion; and vi) Non-permission of distance voting, where it is not prohibited by law.

The inefficiencies in the voting process caused by the chain approach are indentified as: i) lack of sufficient and meaningful information long in advance of the meeting; and ii) stock lending activities around the annual general meeting (separate annual general meeting and dividend dates are recommended).

Source: Manifest Information Services (2007).

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shareholders in deciding meeting business. It would also serve to encourage in a more

efficient way, collaborative engagement as it would enable shareholders to identify

other potentially influential shareholders who might be sympathetic to their cause in

order to work together to better leverage change.”

Improving disclosure of voting records may be an area of future policy consideration

(Box 1.10).

In terms of turnout, the Manifest study shows that the average meeting turnout per

country, is about 63%, with only a minimal difference between general and special

Figure 1.10. Voting process in Europe (simplified)

Source: Manifest Information Services (2007), Cross-Border Voting in Europe: A Manifest Investigation into the Practical Problems of Informed Voting Across EU Borders, May 2010.

Alternative route for meeting information

Alternative route for voting

instructions

Voting Service

Provider

Subcustodian

Tabulator

Issuer

In fo

rm at

io n/

An al

ys is

Vo tin

g in

st ru

ct io

Vo tin

g in

st ru

ct io

Vo tin

g in

st ru

ct io

Holdings data

In fo

rm at

io n/

An al

ys is

H ol

di ng

s da

H ol

di ng

s da

Vo te

r es

ul ts

Holdings data

Custodian

Holdings and blocking data may also be received from CSD or Custodian, as applicable

Beneficial Owner/

Fund Manager

Meeting information and material

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I.1. THE STRUCTURE AND BEHAVIOUR OF INSTITUTIONAL INVESTORS

shareholders meetings. The US is an outlier in the sample with a high 81% average turnout

despite a large foreign shareholding and dispersed ownership, characteristics associated

with lower averages. Two systemic explanations are offered: i) the practice of allowing

brokers, which are a significant player in the US, to vote “non-instructed” shares under

their street name; and ii) ERISA laws, pursuant to which institutional investors, especially

mutual funds and pension funds, view it as mandatory to vote their shares.

A recent ISS report on voting in Europe (ISS, 2010) arrives at similar conclusions,

showing an average turnout of 61.5% for 2010. Interestingly, it also tries to assess whether

the minority shareholders exercise their voting right by estimating the turnout among

minority shareholders on the assumption that all relevant large shareholders voted. The

results show that considering only the shares of investors owning less than 5% of the stock

of companies, the average turnout would be around 37%. They conclude that there is a

general disinterest that is exacerbated by the presence of block holders that cast more

votes than all voting minorities put together (Figure 1.11.).

Manifest suggests that turnout levels can be just as good an indicator of institutional

engagement as the degree of “dissent” expressed on resolutions. Both show the proportion

of investors for whom it is deemed important enough to bear the cost of voting their

Box 1.10. Disclosure of voting records

There is little public information about the actual outcome of voting procedures and the information provided not always allows for statistical analysis. Turnout figures are often not revealed (only percentages or approval or rejection), voting data is incomplete (only describing the votes of some investors, like institutional investors) or described in general “passed or failed” terms (not showing number of votes in favour or against), or not disclosed on a resolution by resolution basis.

To the extent that this information is significant to regulators and governments, especially with the high degree of inter-connectedness and interdependency which characterises today’s financial markets, such lack of transparency might be viewed as surprising. Only comparatively recently that European regulators have attempted to take a co-ordinated approach to ensuring such information is made available as a matter of course. In general terms, countries in the Anglo-Saxon tradition have a better history of disclosing meeting results information, whereas developing and emerging markets tend to be characterised by lack of disclosure.

The importance of disclosure of meeting results is already enshrined in supra-national initiatives such as the European Shareholder’s Rights Directive in 2007 (Article 14) and features in some other jurisdictions around the world:

“The company shall establish for each resolution at least the number of shares for which votes have been validly cast, the proportion of the share capital represented by those votes, the total number of votes validly cast as well as the number of votes cast in favour of and against each resolution and, where applicable, the number of abstentions. […]

Within a period of time to be determined by the applicable law, which shall not exceed 15 days after the general meeting, the company shall publish on its Internet site the voting results established in accordance with Paragraph 1 [above].”

Source: Paul Hewitt, Manifest Information Services (2011).

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I.1. THE STRUCTURE AND BEHAVIOUR OF INSTITUTIONAL INVESTORS

shares, if that is not mandatory. Voting is after all one of the main engagement tools

available to shareholders. But the report suggests that there are several reasons why it

should not be viewed as the main measure of the quality of the dialogue between

companies and shareholders:

● As institutional share ownership has grown, direct engagement between large

shareholders and boards has also increased. These private forms of engagement shape

the types of proposals presented at meetings and turn voting results into a rather limited

sample to examine the degree of investor activity. As one Chilean pension fund manager

mentioned in an interview conducted for this report, “most meetings are a waste of time,

I never attend them but send a very junior staff member that knows exactly was has

already been agreed, and makes sure things go just like that”.

● Blind voting is also a practice that hinders the quality of engagement. There is no real

communication between shareholders and companies when votes are automatically or

mandatorily cast as a response to a “real or perceived” regulatory requirement to vote.

Investors may be more interested in showing that they voted than on the content of the

decision, with the result that they may well opt to issue “standing instructions” to

always vote with management. This is a practice that Manifest claims is especially

difficult to prove, precisely because professional investors cannot afford to be seen to be

doing the “bare minimum”.

● High levels of cross border investment may also be a factor leading to low turnouts or low

levels of dissent in meetings, as explained above.

The Manifest report also shows remarkably low levels of dissent, both at general and

special shareholder meetings. For general meetings, the average dissent level was only

3.5% across over 16 000 resolutions, with a maximum of 6.2% for Israel, and only 2.6%

across 911 resolutions proposed at special shareholders meetings. The ISS Report on

Europe shows a similar 3.7% average dissent for 2010 (ISS, 2010).

Most of the dissent votes had to do with remuneration. Research conducted by ICI

examining 10 million votes placed by institutional investors in the US between 2007 and

2009, arrived at similar findings (ICI, 2010). It showed that dissent was lower than 10% and

mostly related to shareholder rights and executive compensation issues (mostly say-on-

pay proposals). At the same time, it shows that approval of proposals made by other

shareholders (as opposed to management) had risen among these investors from 25% in

Figure 1.11. Estimated minority shareholder turnout in Europe

Source: Institutional Shareholder Services (ISS) (2010), ISS 2010 Voting Results Report: Europe, September 2010, available at www.issgovernance.com/policy.

55.3 60

25.2 23.3

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THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE © OECD 2011 57

http://www.issgovernance.com/policy

I.1. THE STRUCTURE AND BEHAVIOUR OF INSTITUTIONAL INVESTORS

2007 to 50% in 2009, and that one of the most approved resolutions was to call for special

meetings.

The Manifest study also noted that voting shares has a cost for the investor, so that a

cost/benefit analysis will always take place. Key issues will likely be the perceived or actual

regulatory obligation to vote; the perceived strategic importance of a given meeting, either

in the long or short term, the degree to which investors demand voting as a part of the

investment processes; the administrative costs of voting at meetings (especially when they

are part of global custody services); and the reputational costs of being seen as passive.

Adding an extra layer of complexity to voting, many markets have a tradition of

clustering all general meeting in just a few weeks of the year, and sometimes there is a

significant overlapping among jurisdictions as well, resulting in weeks when more than

80 meetings would take place only in Europe. Manifest reports that in those periods

“investors’ governance and proxy teams are usually stretched to the limit, and have less

time to deal with each company meeting than they would have outside of the peak season”

(Figure 1.12). In Japan the concentration of meetings on only around two days makes the

situation extremely difficult for shareholders and their agents.

There is also an issue with voting by custodians and the related issues of share-

lending. Principle III.A.3 notes that “Votes should be cast by custodians or nominees in a

manner agreed upon with the beneficial owner of the shares”. The annotations to the

Principles note that the trend in OECD countries is to remove provisions that automatically

enable custodian institutions to cast the votes of shareholders. This has happened in

Germany (see German review). The German law also requires custodian institutions to

provide shareholders with information concerning their options in the use of their voting

rights. In the United States, the Dodd-Frank Act amended the Exchange Act to require the

rules of each national securities exchange to be amended to prohibit brokers from voting

Figure 1.12. Clustering of shareholder meetings in Europe European meetings 5 March-6 August period (excl. GB)

Source: Manifest Information Services (2007). Cross-Border Voting in Europe: A Manifest Investigation into the Practical Problems of Informed Voting Across EU Borders, May 2010.

11 June

30 July

0 150 200 250 300 35010050

5 Mar.

23 Apr.

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I.1. THE STRUCTURE AND BEHAVIOUR OF INSTITUTIONAL INVESTORS

uninstructed shares on the election of directors, executive compensation, or any other

significant matter, as determined by the Commission. What is not clear yet, but often an

issue, is disclosure by institutional investors of their policies on lending securities and

recalling lent shares.

1.6.3. The role of proxy advisors

The use of proxy advisors and voting services has been pointed out as one practical

approach to complexities in cross border voting as well as in relation to large and

diversified portfolios. These agents provide mainly two services: i) they analyse the

proposals and documents to be considered at the shareholders meeting and advise

investors on how to vote, and ii) they provide the logistics to actually cast the votes.

“Depending on the service provider, the actual exercise of the voting rights can take

place in accordance with the institutional investor’s prior instructions to vote in

conformity with a voting policy drafted by the investor himself (unless there are

specific instructions to deviate from that policy) or to always vote in conformity with

the service provider’s own guidelines” (Verdam, 2006).

By recommending investors about whether to approve or reject proposals at shareholders

meetings, proxy advisors may significantly facilitate the investors’ decision making, while

exercising strong influence on the market. Verdam (2006) points out that most investors tend

to follow their advice, first of all, because it is easier from an administrative perspective “for 15

to 20% of ISS’ clients the votes are cast automatically – so without any further action being

required– in conformity with ISS’ recommendations” (page 4). In addition, it would require the

investor conducting its own research to conclude differently, and would have to “justify and

render account both to themselves and to their beneficiaries why they are going against the

advice of the expert called in by them” (page 5). Verdam cites research that has shown that 40%

of the votes cast by institutional shareholders for shares in US-listed companies are in

conformity with ISS’ recommendations.

But proxy advisors’ recommendations are not exempt from debate. The question

many studies ask is how do they reach their recommendations? Among the issues debated

is whether they analyse company proposals on a company by company basis or rely upon

their policy position for the corresponding type of proposals and whether they consider

national conditions or vote from a foreign perspective.

“It looks as if proxy advisors let themselves be chiefly guided in their recommendations by

policy lines which are highly thematic in nature and which have first been abstracted

from the individual companies that they concern” (Verdam, page 7).

Some proxy advisors are willing to adopt the voting policy of their clients and issue

recommendations based on those parameters. Verdam also notes that ISS declared to the

SEC that in 2003 it had 320 “distinct voting policies” for its voting services, but also that

informal inquiries from ISS showed that about two thirds of clients would be satisfied with

ISS standard voting policy. Clients are given a chance to respond to questions and ISS takes

their answers into consideration when deciding on their proxy advice. By 2005, it is

reported that only 13% of ISS clients would respond, and that about 70% of the responses

would come from the US alone. In Australia, as shown in the review below, institutional

investors demand that their own policies are used by their proxy advisors.

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I.1. THE STRUCTURE AND BEHAVIOUR OF INSTITUTIONAL INVESTORS

Some proxy advisors explain that they base their recommendations on their own

corporate governance ratings of companies. Studies of those ratings show that some

metrics are correlated with company performance, but that in general they are far from

being able to predict firm performance (Robert Daines, et al., 2010 and Sanjai Bhagat et al.,

2008). Ratings firms “offer a profusion of proprietary rating systems, each constantly

tweaked and recalibrated-a process that could be described as ‘methodology churn’. No

two are alike”. Rose (2011) argues that poor-quality ratings are damaging corporate

governance and, citing Bebchuk, 2009, concludes that they are more useful “to spot ‘bad

governance’ structures than it is to effectively prescribe ‘good governance’ structures.”

Conflicts of interest are another concern with institutional investors delegating their

voting decisions to proxy advisors. Principle V.F. recommends that “Analysts, brokers,

rating agencies and others who provide analysis or advice which is relevant for decisions

by investors should disclose any material conflicts of interest that might compromise the

integrity of their analysis or advice”.

In the US, a debate is in progress with respect to the adoption of new regulations for the

Proxy advisory industry (Box 1.11). The Society of Corporate Secretaries and Governance

Professionals (2010) wrote to the SEC in a consultation process asking that all proxy

advisors should be required to register as investment advisors and that all investor

advisors relying on proxy advisory firms should be required to oversee their

recommendations and analysis. In the past, the US SEC (ISS, 2004) has argued that in

accordance with their fiduciary duties, investment advisers should ensure that they “can

make recommendations for voting proxies in an impartial manner and in the best interests

of the adviser’s clients. Those steps may include a case by case evaluation of the proxy

voting firm’s relationships with issuers, a thorough review of the proxy voting firm’s

conflict procedures and the effectiveness of their implementation, and/or other means

reasonably designed to ensure the integrity of the proxy voting process.”

Box 1.11. Proxy advisors’ conflicts of interest – a recent debate

The US Department of Labor has proposed regulations broadening the definition of “fiduciary” under ERISA in order to expand the parties who can be sued for plan advice. That proposal has resulted in serious questions being raised about the fiduciary responsibilities of proxy advisory firms in providing advice to shareholders. Glass Lewis, the second largest proxy advisory firm, urged DOL to prohibit the ISS business model of providing consulting services to corporate issuers while serving as an independent advisor to institutional investors. Glass Lewis also recommended that ISS be required to provide more specific disclosure of its relationships with issuers in its proxy reports. However, Glass Lewis sought to exclude itself from the new rule, stating it is not “appropriate to include un-conflicted proxy research advisors like Glass Lewis in the revised definition of fiduciary”. Yet, Glass Lewis is owned by the Ontario Teachers’ Pension Plan, which has an ownership interest in many public companies, thus creating its own conflicts of interest. In addition, it provides no transparency as to its methodologies, while ISS provides at least some information.

Without directly responding to Glass Lewis, ISS filed its comments with the DOL. In an effort to justify the conflicts of interest problem in the proxy advisory industry, ISS stated “[t]he complexity of relationships among parties in the proxy voting chain means that the potential for conflict of interest is always present for all proxy advisory firms”.

Source: Center on Executive Compensation (2011).

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A 2007 US Government Accountability Office Report (GAO, 2007) concluded that the

main source of potential conflict of interest for proxy advisors was the simultaneous

provision of services to institutional investors and corporate clients. Proxy advisors “could

help a corporate client design an executive compensation proposal to be voted on by

shareholders and subsequently make a recommendation to investor clients to vote for this

proposal”. Also, companies could feel compelled to contract services from proxy advisors

“in order to obtain favorable proxy vote recommendations on their proposals and favorable

corporate governance ratings”. A number of other areas of concern were also indentified.24

The Society of Corporate Secretaries and Governance Professionals letter to the SEC

argues that in the current framework, proxy advisors not only have significant influence on

voting, “but for many matters they have become the de-facto arbiters of good governance”.

It also adds that such influence is not always used to benefit shareholders and that proxy

advisors act “without having any economic interest in the shares of the companies they

vote and without being subject to any fiduciary duties to the beneficial owners of the

shares for whom they are voting”. By asking for more regulation, the Society seeks to

promote transparency, reduce conflicts of interest, and “provide greater discipline in the

way vote recommendations are determined, thereby ensuring that votes are cast in the

financial best interests of the beneficial owners” (Society of Corporate Secretaries and

Governance Professionals, 2010).

Notes

1. Activist hedge funds and private equity are also important although much reduced from when the Committee last investigated them in depth in 2006/2007.

2. Note that the US data includes shares issued by all US Companies, not just listed companies, hence the relatively high share of individual share ownership.

3. As an example of the latter, an institutional investor in one country buying a stock in another country may use a home country custodian, which in turn uses an account at a global custodian, which could then use a host bank to hold the shares, whose name may be that on the register.

4. This approach does not consider the role of banks and insurance companies which, it has been argued, have been key players in not only the development of Japan and Germany but also in their post war reconstruction. The “insider” model has received considerable attention in developmental economies and elsewhere.

5. Such hedge funds may of course affect corporate governance indirectly by influencing relative equity prices. These possible indirect effects are discussed in the report in the context of indexing.

6. The pool of assets forming an independent legal entity that are bought with the contributions to a pension plan for the exclusive purpose of financing pension plan benefits. The plan/fund members have a legal or beneficial right or some other contractual claim against the assets of the pension fund. Pension funds take the form of either a special purpose entity with legal personality (such as a trust, foundation, or corporate entity) or a legally separated fund without legal personality managed by a dedicated provider (pension fund management company) or other financial institution on behalf of the plan/fund members.

7. Derived from a speech by Shang Fulin at http://data.cnfol.com/110114/104,1298,9164208,00.shtml.

8. Georgen et al. examine directors’ sales or purchases in their own companies to see whether new information was being conveyed to the market. As new information appeared to enter the market they conclude that institutional shareholder monitoring was inadequate.

9. The term Stewardship is also used by the UNPRI. Stewardship involves managing another person’s property, financing and other affairs. In its newest use it refers to institutions looking after property for beneficiaries. It is controversial when referring to institutional investors. Thus Frentrop (2011) states that engagement as promoted in the UK Code would require investors “to give up liquidity, reduce portfolio turnover, endure long periods of relative underperformance, significantly concentrate portfolios and take much larger stakes in single companies”. Accordingly,

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I.1. THE STRUCTURE AND BEHAVIOUR OF INSTITUTIONAL INVESTORS

Frentrop suggests that “he who promotes stewardship isn’t merely asking for improvements in corporate governance. Stewardship implies and demands a whole new system of institutional investors and pension fund governance”. Can an investor really engage with and have loyalty to hundreds of companies in its portfolio?

10. Based on 118 survey responses to funds active in both the US and in the Netherlands. The sample comprised 6% hedge funds, 8% insurance, 62% mutual funds 6% pension funds and 18% others.

11. Contacts and communications among institutional investors could also have implications under the Hart-Scott-Rodino Antitrust Improvements Act (HSR Act). Under the HSR Act, certain purchases of voting securities or assets may not be consummated unless certain information has been furnished to the Antitrust Division of the Department of Justice and the Federal Trade Commission, although the acquisition of up to 10% of the stock of a public company is exempt from HSR filing and clearance requirements if it is made solely for the purpose of investment. While the group concept for purposes of Section 13(d) of the Exchange Act does not apply in the HSR context, institutional investors may consider whether any actions, such as communications with other investors, could be considered to invalidate their investment intent.

12. The impact on asset allocation and risk appetite will depend on a number of country specific factors. For a review see Broadbent et al. 2006.

13. In particular, the data does not suggest that investors accustomed to a one tier board system in their home country will always prefer the same system when they invest. It is argued that with concentrated ownership, a two tier board structure has some advantages. In the Netherlands, firms can select either board structure, but the majority have remained with a two tier system apart from some large international companies.

14. Private study conducted by McKinsey for the Deutsches Aktien Institut as quoted in the German questionnaire reply.

15. Across exchanges several factors have reduced impediments and increased access to active trading, suggesting that the observed reduction in average holding times, may reflect more frequent trading of a small portion of the float. The factors that have contributed to more active trading include: tax reductions; switching to computer-based matching from open outcry systems, internet and computer based trading, and shrinking bid/ask spreads by using smaller ticks.

16. Haldane 2010 estimates the figure as 30-40%. Other industry sources are more in the range of 70% for both the US and Europe. For example, see http://eschatonic.worldpress.com/2011/01/28/casino- world-high-frequency-trading/.

17. In addition a great deal of trading is now taking place off exchange through so called dark pools. See Christiansen and Koldertsova, 2009.

18. “Common French practice is for shares to acquire double voting rights after they have been fully paid and registered continuously in the name of the same shareowner for specified periods of time, usually two years. When the share is either converted into a bearer share or transferred (except through an inheritance, division of property between spouses, or a donation by the shareowner to the benefit of a spouse or another eligible relative), the double voting right is automatically cancelled.” (CFA Institute 2009, page 24) It should be recalled that this policy is a way of underpinning the idea of a “noyer dure”, a strong group of loyal shareholders who will prevent takeovers.

19. It should be noted also that the 62% increase is overstated by the incorporation of BlackRock’s passive assets of USD 1.7 trillion for the first time. The actual growth rate was thus some 30%, still impressive.

20. Some dispute that the actual use of borrowed shares to engage in empty voting is important and deserving the policy and academic attention that it has received.

21. Of those institutions that responded to the relevant question of the IRRC questionnaire, “11 of 42 asset managers and six of 25 asset owners stated that they engage with domestic issuers only”. According to the report, this was attributed mainly to the fact that their portfolios tend to be dominated by domestic companies, but also to the lack of responsiveness to requests for engagement by foreign counterparts, and lack of familiarity with companies “particularly on the part of Indexed investors”.

22. ICGN response to the UK Department for Business Innovation & Skills’ consultation “A Long Term Focus for Corporate Britain”, 14 January 2011, page 4. It also adds that for institutional investors and fund managers, the disclosure of their voting activities publicly “creates the perception that by being transparent they are fulfilling their fiduciary responsibilities”. But ICGN also notes that this

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I.1. THE STRUCTURE AND BEHAVIOUR OF INSTITUTIONAL INVESTORS

can prompt blind voting, if only as a way to escape ‘name and shame’ lists of “passive” investors which “fail to capture the extent to which investors have engaged with companies prior to the vote and have encouraged changes.”

23. In the case of Chile, all listed companies have to submit to the SVS the minutes of their shareholder meetings, including detailed voting data in respect of specified shareholders (regulated pension funds and those who are representing others at the meeting – the sub-custodian banks). However, those minutes are normally filed in physical form, and are not available on the company or the SVS websites, making the information very hard to research.

24. The GAO Report points out that several other situations in the proxy advisory industry could give rise to potential conflicts. Specifically it lists: i) Owners or executives of proxy advisory firms may have a significant ownership interest in or serve on the board of directors of corporations that have proposals on which the firms are offering vote recommendations; ii) Institutional investors may submit shareholder proposals to be voted on at corporate shareholder meetings. This raises concern that proxy advisory firms will make favourable recommendations to other institutional investor clients on such proposals in order to maintain the business of the investor clients that submitted these proposals. iii) Several proxy advisory firms are owned by companies that offer other financial services to various types of clients, as is common in the financial services industry, where companies often provide multiple services to various types of clients.

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IRRC Institute and ISS, The State of Engagement between U.S. Corporations and Shareholders, 22 Feb. 2011, available at www.irrcinstitute.org/pdf/IRRC-ISS_EngagementStudy.pdf.

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http://www.bundesbank.de/statistik/statistik_zeitreihen.en.php

http://www.dsw-info.de/uploads/media/Newsletter11.pdf

http://www.efama.org

http://www.federalreserve.gov/releases/z1

http://www.fese.eu/_lib/files/Share_Ownership_Survey_2007_Final.pdf

http://www.frc.org.uk/images/uploaded/documents/UK%20Stewardship%20Code%20July%2020103.pdf

http://www.gao.gov/new.items/d07765.pdf

http://www.bvi.de

http://www.bankofengland.co.uk/publications/speeches/2010/speech445.pdf

http://www.oecd.org/daf/corporateaffairs/wp

http://www.thecityuk.com/media/2432/Pension_markets_2010.pdf

http://www.ici.org/pdf/ww_09_10_sup_tables.pdf

http://www.irrcinstitute.org/pdf/IRRCMercerInvestmentHorizonsReport_Feb2010.pdf

I.1. THE STRUCTURE AND BEHAVIOUR OF INSTITUTIONAL INVESTORS

Institutional Shareholder Services (ISS) (2010), ISS 2010 Voting Results Report: Europe, September 2010, available at www.issgovernance.com/policy.

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Kalay, A. et al. (2011), The Market Value of Corporate Votes: Theory and Evidence from Option Prices, SSRN- id1747952, January 2011.

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Lowenstein, L. (1991), Index investment strategies and corporate governance, The University of Toledo, College of Law.

Manifest Information Services (2007), Cross-Border Voting in Europe: A Manifest Investigation into the Practical Problems of Informed Voting Across EU Borders, May 2010.

Marathon Club (2007), Guidance note for Long term investing, UK.

McCahery, J. et al. (2010), “Behind the scenes: The corporate governance preferences of institutional investors”, Tilburg University Legal Studies Working Paper Series, 010/2010.

Monetary Authority of Singapore (2010), Insurance Development Data, available at www.mas.gov.sg/ resource/data_room/insurance_stat/2009/Insurance_Development_09.pdf.

MPRA, “A Comparative Analysis of the Legal Obstacles to Institutional Investor Activism in Europe and in the US”, MPRA Paper No. 8929, June 2008.

Odenius, J. (2008), “Germany’s Corporate governance reforms: Has the system become flexible enough”, IMF Working Paper, 08/179.

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OECD (2007), The Implications of Alternative Investment Vehicles for corporate Governance: A Synthesis of Research about Private Equity Firms and Activist Hedge Funds, available at www.oecd.org/dataoecd/60/11/ 39007051.pdf.

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http://www.issgovernance.com/policy

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I.1. THE STRUCTURE AND BEHAVIOUR OF INSTITUTIONAL INVESTORS

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http://www.world-exchanges.org/statistics/time-series/value-share-trading

PART II

In-depth Country Reviews on the Role of Institutional

Investors in Promoting Good Corporate Governance

The following chapters provide detailed analysis of each of the three focus countries of the peer review: Australia, Chile, and Germany. The reviews are based on detailed questionnaire responses provided by the reviewed countries, together with independent research by the OECD including several missions.

For each country review the document describes the institutional investor landscape and then outlines the legal framework within which they operate and how they exercise their shareholder responsibilities. The transparency requirements are assessed along the lines of Principles II.F.1 and II.F.2 and the possibilities for co-operation in accordance with Principle II.G. The use of proxy advisors covered in Principle V.F is also described. Finally, policy conclusions are drawn for each country.

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The Role of Institutional Investors in Promoting

Good Corporate Governance © OECD 2011

PART II

Chapter 2

Australia: The Role of Institutional Investors

in Promoting Good Corporate Governance

This review provides an objective description and analysis of existing institutional investor practices in Australia and their influence on the corporate governance practices of companies in which they invest. It examines different dimensions of institutional investor activism in Australia, including features of the institutional investor landscape, legal rules and other guidance relating to institutional investor responsibilities, and voting and engagement practices.

II.2. AUSTRALIA: THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE

In recent years, Australian institutional investors have assumed a more prominent role in promoting good corporate governance in the domestic market. The catalysts for greater

institutional investor involvement on corporate governance in Australia include the rapid

growth of pension (“superannuation”) assets, corporate collapses that brought about

greater pressure on institutional investors to be active owners, and stronger shareholder

rights. While institutional investors – particularly superannuation funds – have done more

to instil good corporate governance practices, passivity and a lack of interest in this topic

persist amongst many members of the institutional shareholder community. Moreover,

there are impediments to the effective exercise of shareholder rights, although the

problems in Australia appear less acute than in other markets.

This review provides an objective description and analysis of existing institutional

investor practices in Australia. It examines different dimensions of institutional investor

activism in Australia, including features of the institutional investor landscape, legal rules

and other guidance relating to institutional investor responsibilities, and voting and

engagement practices.

2.1. Institutional investor landscape Mirroring the trend in many OECD member countries, the presence of institutional

investors in Australia has grown in recent decades (Figure 2.1). In the 1990s, institutional

investors’ holdings in Australian companies amounted to 45-50% of the total stock market

capitalisation. By 2009, this figure had increased to 64%.1

Figure 2.1. Equity holdings by all types of investors

Source: Australia Bureau of Statistics (2010), Australian National Accounts: Financial Accounts, September 2010 available at: www.abs.gov.au/AUSSTATS/abs@.nsf/DetailsPage/5232.0Sep%202010?OpenDocument.

Public sector

Individuals

Non-financial enterprises

Banks

Other institutional asset owners

Mutual funds

Pension funds

Insurance companies

Foreign investors

0 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009

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In Australia, the two major categories of institutional investors are investment

managers (including insurance companies) and superannuation funds. Investment

managers, many of which serve the retail and institutional market segments, include

domestic firms such as AMP Capital and Colonial First State as well as foreign houses such

as BlackRock and Fidelity International. In terms of size, the Investment and Financial

Services Association2 (IFSA), an investment manager industry body, estimated that its

members managed assets totalling AUD 1.1 trillion in 2009 (compared to Australia’s GDP of

AUD 1.3 trillion).

Superannuation assets have surg ed since the introduction in 1992 of the

“superannuation guarantee charge” (SGC), which requires employers to contribute 9% of

each employee’s “ordinary time earnings” (e.g., wages, bonuses, and commissions) into

individual retirement accounts.3 From a base of AUD 32.6 billion in 1981, superannuation

assets grew to AUD 183 billion in 1993 and reached nearly AUD 1.3 trillion at the end of 2010

(Cooper Review 2010 and The Association of Superannuation Funds of Australia 2010).

The growth in superannuation assets will likely accelerate if, as expected, the

Australian Government adopts a proposal to raise the superannuation guarantee charge

to 12%.4

Superannuation funds are divided into five principal segments – corporate, industry,

public sector, retail, and small funds (see Table 2.1).5 According to the Australian Prudential

Regulation Authority, these categories are differentiated as follows:

● Corporate – superannuation fund sponsored by a single or group of related employers for the benefit of company employees

● Industry – superannuation fund that draw members from a range of employers in a single industry. Industry funds currently exist in such sectors as construction and

building, hospitality, and healthcare

● Public sector – superannuation fund where the sponsoring employer is a government agency or business enterprise that is majority-owned by the government

● Retail – for-profit superannuation fund that offers retirement products to the general public

● Small – superannuation fund with less than five members, including self-managed superannuation funds (SMSFs)

Corporate, industry, and public sector superannuation funds usually restrict

membership, although some are open to the public. Retail funds are usually operated by

large financial institutions, such as AMP, AXA, and Colonial First State.

Table 2.1. Australia’s superannuation industry (as at Dec. 2010)

Sector No. of funds Assets (AUD billion) Market share (%)

Corporate 162 58.0 4.80

Industry 65 237.7 18

Public sector 39 181.9 14.10

Retail 156 352.9 27.90

Small funds 438 194 409.6 32.00

Balance of life office statutory funds n.a. 40.0 3.10

Total 438 616 1 280.1 100

Source: The Association of Superannuation Funds of Australia (2010), Superannuation Statistics – December 2010, www.superannuation.asn.au/statistics/default.aspx.

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As Table 2.2 shows, corporate pension funds have shrunk dramatically over the

past decade as companies have increasingly chosen to close their retirement schemes

and transfer existing employee superannuation accounts to third parties such as retail

and industry superannuation funds. In-house superannuation funds still exist at some

large companies, such as Commonwealth Bank and BHP Billiton. Meanwhile, self-

managed superannuation funds (SMSFs) have continued to grow, reaching 414 707

accounts in 2009.

In addition, corporate, industry, and public superannuation funds have experienced

varying levels of consolidation, fuelled principally by a desire to realise economies of scale.

However, some mergers, particularly in the public sector, unwound subsequently due to

differences in membership characteristics.

Since 2005, Australian workers generally have had the right to choose the

superannuation fund into which their employer’s contributions are deposited (although

employers have continued to designate a default fund for their employees). As a result,

superannuation funds compete with each other to attract members. For example,

healthcare industry superannuation fund HESTA competes with other industry funds

serving this sector as well as with retail funds.

According to a superannuation fund representative, the bases for competition among

superannuation funds include breadth of investment offerings, fee levels, portfolio

performance, and technology (e.g., quality of website). In addition, each superannuation

fund seeks to gain a competitive advantage by being designated as the default fund by

companies.6

Most superannuation funds outsource all investment management to third-party

investment managers. For some funds, such as State Super, internal management of

retirement assets is prohibited by law. In recent years, a number of the largest

superannuation funds – for example, Australian Super and UniSuper – have formed in-

house teams to manage investments in such areas as fixed income, active Australian

equities, and alternatives (e.g. infrastructure).

To help reduce costs and realise economies of scale, more than 30 superannuation

funds – including HESTA, Cbus, Australian Super, and Vision Super – outsource some

investment management to Industry Funds Management. IFM, which is collectively

owned by its superannuation fund clients and managed AUD 23.4 billion as of

Table 2.2. Recent trends in the number of Australian superannuation industry by entities

Sector 2003 2004 2005 2006 2007 2008 2009

Corporate 1 862 1 405 962 555 287 226 190

Industry 124 106 90 80 72 70 67

Public sector 58 42 43 45 40 40 40

Retail 235 232 228 192 176 169 166

SMSFs 262 175 286 313 303 004 323 200 361 860 389 308 414 707

Pooled Super Trusts 160 143 130 123 101 90 82

Total number of entities 264 614 288 241 304 457 324 195 362 536 389 903 415 252

Source: Super System Review Final Report (2010), “Cooper Review”, www.supersystemreview.gov.au/content/ content.aspx?doc=html/final_report.htm).

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II.2. AUSTRALIA: THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE

June 2010, offers listed equities, fixed income, private equity, and infrastructure funds.

IFM is unique because it does not strive to maximise profits. Rather, according to an IFM

shareholder, “IFM seeks sufficient excess earnings only to hire staff and develop new

products”.

In Australia, the institutional shareholder landscape also includes two influential

industry bodies, IFSA and the Australian Council of Superannuation Investors (ACSI).

IFSA is the principal industry association for investment managers. Its members

manage an aggregate AUD 1.1 trillion and own 25% of the shares of companies listed on the

Australian Stock Exchange (IFSA, 2009). The organisation was founded in 1990 following

the collapse of several Australian firms. Known initially as the Australian Investment

Managers’ Group, IFSA’s principal objectives included (Hill, 1994):

● Advance the integrity of the Australian capital markets.

● Protect the rights of investors.

● Promote the interests of investors.

● Facilitate investors taking action when warranted by circumstances.

● Provide assistance to the Australian Securities Commission, stock exchange, and other

government agencies in matters relating to investors’ interests.

● Assist companies in understanding the requirement of investors.

Greater recognition by superannuation funds of their institutional responsibility led to

the formation of ACSI in 2000. According to ACSI, the overriding objective of the

organisation is to ensure that its members are “equipped to deal with governance risks in

their investments in a practical way... consistent with their general duty to protect and

advance the investments of superannuation fund members”.

ACSI’s membership comprises 39 superannuation funds with AUD 250 billion in funds

under management. ACSI provides a suite of services to its members, including:

● Advise members on the governance practices of companies.

● Provide proxy voting services to assist members to exercise their voting rights efficiently

and effectively.

● Engage with companies to improve governance practices.

● Commission and produce research to support its policy positions.

● Publicly advocate for improved governance practices and standards including promotion

of effective legislative and regulatory regimes.

● Develop good governance standards and practices that apply to public companies.

As discussed further below, IFSA and ACSI have both sought to promote good

corporate governance by developing best practice guidance for institutional investors and

listed companies. IFSA, for example, issued its influential Blue Book on Corporate

G ove r n a n c e i n 1 9 9 5 , wh i ch e nu m e ra t e d t h e e x p e c t a t i o n s ab o u t s h a re h o l d e r

responsibilities for IFSA members and corporate governance practices for listed

companies. Since its inception, the Blue Book has been amended six times, most recently

in June 2009.

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II.2. AUSTRALIA: THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE

2.2. Legal rules and other guidance relating to shareholder rights and responsibilities

2.2.1. Shareholder rights

The analytical basis for this discussion is Principle II.C.3, which declares that “effective

shareholder participation in key corporate governance decisions, such as the nomination

and election of board members, should be facilitated. Shareholders should be able to make

their views known on the remuneration policy for board members and key executives. The

equity component of compensation schemes for board members and employees should be

subject to shareholder approval.”

Shareholders in Australia possess strong rights. The Corporations Act grants

shareholders the right to amend a company’s articles of association, appoint and remove a

director, convene a shareholder meeting, and inspect the company’s books. With respect to

board appointments, director candidates are elected on individual ballots7 and each

director candidate must garner a simple majority of votes cast to be elected to the board.

Correspondingly, shareholders are able to remove a director at any time8 through a

resolution at a shareholder meeting, which must be convened if requested by

100 shareholders or investors holding voting rights of 5% or more. Moreover, Section 203E

of the Corporations Act explicitly prohibits the board from removing an incumbent

director.9

Shareholder rights also extend to significant areas of executive and board

remuneration. Australian Stock Exchange Listing Rules require companies to obtain prior

approval from shareholders in order to issue any equity securities under an employee

incentive scheme or raise the pre-existing maximum aggregate fees payable to directors.

Since 2004, shareholders have had the right to express their views on executive

compensation through a non-binding vote on the remuneration report. Similar to other

jurisdictions, the Australian government introduced a non-binding “say on pay” in

response to widely-held perceptions that the remuneration of top corporate executives

was too high.10

In addition to “say on pay,” several new shareholders rights have been promulgated in

recent years. In 2000, shareholders were granted a statutory right to file “derivative”

lawsuits, subject to court approval. Two years ago, companies were required to obtain

shareholder approval for any termination payments to executives in excess of one year’s

salary.

The Australian government has now adopted a “two strikes” proposal whereby “no”

votes on the remuneration report exceeding 25% for two consecutive years would trigger a

resolution to require all directors to stand for re-election. If a majority of shareholders support

such a resolution,11 the entire board must be put up for re-election within 90 days of the vote.

While many shareholders in Australia support having a greater influence on executive

remuneration, companies worry that the focus on compensation has become excessive.

According to one company representative, “the board’s contributions on strategy,

investments, and divestments are much more consequential to company performance

than its role in setting executive pay, yet the whole board may be removed under the ‘two

strikes’ proposal simply because shareholders think they have paid the executives too

much. This remedy is a bridge too far and clearly disproportionate”.

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2.2.2. Fiduciary duties and shareholder responsibilities

Similar to markets such as the UK and US, the fiduciary duty of investment managers

in Australia is to act in the best interests of their clients. In particular, fund managers have

a responsibility to their clients to manage their investments in accordance with the stated

investment objectives. According to an ACSI representative, the fiduciary duty of

superannuation fund trustees and ag ents under the Superannuation Industry

(Supervision) Act 1993 is to act in the “best financial interests of all members by

maximising returns and mitigating risks”. With respect to the voting of shares held on

behalf of clients, one investment firm executive declared that the firm’s duty was “to vote

if clients wanted them to do so and to vote in the best interest of clients”.

In Australia, the concept of fiduciary duty has been established by a large body of case

law and legal regulations. However, there is no overarching regime that sets out the duties

and responsibilities of institutions. Instead, their duties and responsibilities are defined by

the type of entity,12 the services it is performing, and for whom those services are being

performed. Similar to many OECD member countries, guidance on institutional

shareholder responsibilities in Australia has emerged principally from industry best

practice recommendations.

The IFSA Blue Book on Corporate Governance acknowledges that “as major

shareholders, IFSA members are in a position to promote improved company performance

that provides positive benefits to all shareholders and the economy as a whole” and further

states that “effective corporate governance depends heavily on the willingness of the

owners of a company to exercise their rights of ownership, to express their views to boards

of directors and to exercise their voting rights”. Similarly, ACSI recognises “the leading role

that active institutional shareholders perform in each jurisdiction in lifting the standards

of corporate governance”.

Specifically, both organisations call on superannuation funds and investment managers

to put in place policies relating to environmental, social, and governance (ESG) matters, vote

their Australian equity holdings,13 engage with investee companies, and consider material

ESG issues in investment, voting, and engagement activities (see Tables 2.3. – 2.5.).

Table 2.3. IFSA Blue Book – Summary of guidelines for fund managers

Guideline 1 – Corporate Governance Policy and Procedures

Fund Managers should have a written Corporate Governance policy which is made available on their website. The policy should be approved by the board of the Fund Manager and should note the general principles underpinning formal internal procedures to ensure that the policy is applied consistently.

Guideline 2 – Communication with Companies

Fund Managers should establish direct contact with companies in accordance with their Corporate Governance Policy. Engagement with companies should include constructive communication with both senior management and board members about performance, Corporate Governance and other matters affecting shareholders’ interests.

Guideline 3 – Voting on Company Resolutions

Fund Managers should vote on all Australian company resolutions where they have the voting authority and responsibility to do so. An aggregate summary of a Fund Manager’s Australian proxy voting record must be published at least annually and within 2 months of the end of the financial year.

Guideline 4 – Reporting to Clients Wherever a client delegates responsibility for exercising proxy votes, the Fund Manager should report in a manner required by the client. Reporting on voting and, where required, other corporate governance activities, should be a part of the regular reporting process to each client. The report should include a positive statement that the Fund Manager has complied with its obligation to exercise voting rights in the client’s interest only. If a Fund Manager is unable to make the statement without qualification, the report should include an explanation.

Guideline 5 – Environmental and Social Issues and Corporate Governance

Fund Managers should engage companies on significant environmental and social issues that have the potential to impact on current or future company reputation and performance.

Source: Investment and Financial Services Association (2009), Blue Book on Corporate Governance, www.ifsa.com.au.

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Given that most pension funds in Australia outsource some or all investment

manag ement to external asset manag ers, the IFSA standard-form investment

management agreement also includes a default provision whereby the asset owner

delegates voting to the investment manager.14

Whereas the IFSA Blue Book focuses on domestic activities, ACSI has developed

guidance on institutional responsibilities with respect to both domestic and overseas

equity holdings. The emphasis on international activities comes at a time when

superannuation funds’ overseas equity investments are expected to surpass their domestic

holdings over the next few years.

As the 2008-2009 global financial crisis did not impact Australia significantly, there has

been limited demand by policymakers or the public to strengthen the obligations of

institutional investors by, for example, adopting an equivalent of the UK Stewardship Code.

However, some companies favour strengthening institutional investor responsibilities in

order to create a better balance between the extensive governance obligations of listed

companies and the much less demanding responsibilities of institutional investors.

Table 2.4. ACSI guide for superannuation trustees on the consideration of ESG risks in listed companies

ACSI believes that there are six principal steps that superannuation investors can take to integrate ESG issues into the management of investment portfolios:

Put in place the right policies and frameworks on ESG issues.

Ensure that their service providers (particularly asset consultants and investment managers) deal with ESG issues in a satisfactory way.

Manage direct investments and investment portfolios with ESG issues in mind.

Be “active owners”.

Where appropriate and relevant, seek to influence public policy.

Ensure the fund’s own ESG issues are in order.

Source: Australian Council of Superannuation Investors (2009), A guide for superannuation trustees on the consideration of environmental, social & corporate governance risks in listed companies, www.acsi.org.au/acsi- guidelines.html.

Table 2.5. ACSI guide for fund managers and consultants on the consideration of ESG risks in listed companies

ACSI members believe that fund managers (including those using passive investment styles) should:

Provide details of their ESG policies to trustees.

Report to their clients about: ● their expertise and resources to analyse ESG issues ● their ESG activities, including research, voting and engagement with companies, and ● how they integrate consideration of ESG issues into their investment analysis and decision-making

processes

Make considered use of their votes at company meetings, including voting in accordance with the ACSI member’s instructions, where appropriate.

Have a process to engage (either directly, indirectly or through outsourcing) with investee companies about their performance, ESG issues and other matters affecting shareholders’ interests. However, we note that superannuation funds reserve the right also to engage with companies (either directly or through an intermediary) if they deem this to be appropriate in a particular case.

Source: Australian Council of Superannuation Investors (2009), A guide for fund managers and consultants on the consideration of environmental, social & corporate governance risks in listed companies, www.acsi.org.au/acsi- guidelines.html.

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2.2.3. Disclosure obligations

There are no legal requirements in Australia relating to the disclosure by institutional

investors of their corporate governance activities. However, through industry best practice

guidelines, Australian institutional investors partially conform to the requirements of

Principle II.F.1, which states that:

“institutional investors acting in a fiduciary capacity should disclose their overall

corporate governance and voting policies with respect to their investments, including

the procedures that they have in place for deciding on the use of their voting rights.”

The IFSA Blue Book recommends that a fund manager publish its voting record

annually and within two months of the end of its financial year. In terms of content, IFSA

Blue Book Guideline 4 calls on fund managers to report voting “in a manner required by the

client” and provide “a positive statement that the Fund Manager has complied with its

obligation to exercise voting rights in the client’s interest only”. Furthermore, the IFSA

standard form investment management agreement obligates fund managers to furnish a

copy of their proxy voting policies to their clients and inform them of any changes thereto.

Meanwhile, ACSI has adopted a softer tone, suggesting that a superannuation fund

“may wish to consider publicly reporting on its ESG policies and its ESG activities (including

voting and company engagement)”. In practice, some superannuation funds voluntarily

disclose their corporate governance policies and voting records on their websites.

In addition, there is no legal obligation to disclose conflicts of interest as

recommended by Principle II.F.2, which states that:

“institutional investors acting in a fiduciary capacity should disclose how they manage

material conflicts of interest that may affect the exercise of key ownership rights

regarding their investments.”

An indirect reference to conflicts of interest is made in IFSA Blue Book Guideline 8.1.5,

which states that if a fund manager is unable to make an unqualified statement that it “has

complied with its obligation to exercise voting rights in the client’s interest only”, it should

explain why.

More broadly, Paragraph 2.3 of IFSA Code of Ethics and Conduct15 requires IFSA members

to be fair and not allow conflicts of interest or bias to influence their actions.

Paragraph 3.5 further states that where a conflict of interest arises, an IFSA member

should conduct itself with the highest degree of integrity and fair dealing to ensure that

customer interests are paramount in all decisions and transactions and to ensure that

the conduct of the IFSA member contributes to an effective, efficient, and informed

market. Similarly, institutional investors holding an Australian Financial Services Licence

or regulated by the Australian Prudential Regulation Authority have obligations to

properly manage conflicts of interest.

According to an Australian investment executive, conflicts of interest with respect to

corporate clients is less acute in Australia than in other markets (such as the UK and US)

due to the dwindling number of corporate superannuation funds in the country. At a large

Australian investment firm, for example, only 5 out of 30-plus superannuation clients are

corporate pension funds.

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2.3. Exercise of shareholder rights

2.3.1. Overview

There is some evidence that institutional investors in Australia are striving to meet the

expectations of Principle II.F.1, the annotation of which stresses that:

“the effectiveness and credibility of the entire corporate governance system and

company oversight will ... to a large extent depend on institutional investors that can

make informed use of their shareholder rights and effectively exercise their

ownership functions in companies in which they invest.”

As summed up by a prominent Australian commentator, “there is more push back

from institutional investors when things go wrong at companies today”.

In Australia, superannuation funds and investment managers have become more

diligent in exercising ownership rights over the past decade, prompted by a perception of

passivity during the corporate collapses of the 1980s and 1990s, a rise in the holdings of

institutional investors, and strengthened shareholder rights. Greater institutional investor

involvement on corporate governance has been spearheaded by superannuation funds,

particularly industry funds with their labour union heritage. A small number of fund

managers – including large institutions such as AMP and Colonial First State and smaller

outfits such as Perpetual Investments – have also gained a reputation as interested share

owners. In addition, listed unit trust AFIC, a top 20 shareholder in many Australian

companies, and the Future Fund, established by federal legislation in 2006 to help meet

unfunded superannuation liabilities of government employees, are known to take

corporate governance seriously.16

Although foreign investors own 42% of the equity in Australian listed companies

(Stapledon, 2011), they have not been actively involved – in terms of voting and engaging

on corporate governance matters – in the Australian market. Many foreign investors do not

vote their Australian shares and those that do typically follow the recommendations of

proxy voting agencies.

A decade ago, there were no expectations on investment managers to focus on

corporate governance. Since then, however, superannuation funds have increasingly

pressed their asset managers to vote and engage investee companies more actively.

Importantly, some superannuation funds, such as HESTA and Cbus, take a fund manager’s

corporate governance record into account when awarding investment mandates. One

superannuation fund stated that it was willing to pay a higher management fee to enable

fund managers to devote greater resources to corporate governance activities.

At the same time, however, many superannuation funds appear to incentivize their

asset managers to deliver short-term performance. According to a veteran investor

relations executive, fund managers in Australia rarely ask questions on long-term

sustainability and corporate governance matters because their superannuation clients

focus mostly on their near-term performance.

More recently, the United Nations Principles for Responsible Investment (UNPRI) –

which strive to encourage institutional investors to incorporate ESG considerations into

investment decision-making and behave as active owners – have also helped to increase

the ESG activities of Australian institutional investors. As of January 2011, Australian

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institutions accounted for 14% of UNPRI signatories worldwide (121 out of 872). According

to one asset manager, superannuation funds that have signed up to the UNPRI have

“harassed their asset managers” to do more on corporate governance so that they can

declare that they are complying with UNPRI requirements.

To a certain extent, the relatively small size of the Australian market has facilitated

monitoring of investment managers by their superannuation clients. For example, some

pension funds – particularly the larger ones – would occasionally telephone their asset

managers to inquire about corporate governance matters. At one public superannuation

fund, the investment team monitors external asset managers by selecting a handful of

controversial shareholder meetings to audit each quarter. Yet, some commentators have

observed that most superannuation funds do not pay much attention to the voting records

disclosed by their asset managers.

2.3.2. Role of proxy advisors

As further discussed below, the exercise of voting rights by institutional investors in

Australia is facilitated to a great extent by proxy research providers. In fact, IFSA helped to

establish Corporate Governance International (known today as CGI Glass Lewis) in the mid-

1990s specifically to advise fund managers on voting matters.

CGI Glass Lewis and Institutional Shareholder Services (ISS) are the two main proxy

research providers in Australia and both wield substantial influence. While Glass Lewis

and ISS are headquartered in the US, their presence in Australia was established through

acquisitions of local outfits.17 Consequently, in contrast to many countries, CGI Glass Lewis

and ISS are generally regarded as domestic institutions.

According to a superannuation fund executive, conflicts of interest among proxy

research providers are not a problem in Australia. For example, ISS Australia differs from

its counterparts in the United States and Europe in that it does not offer any consulting

services to corporate issuers. While CGI Glass Lewis charges companies a fee to receive its

proxy research, this arrangement is widely known and not perceived to constitute a serious

conflict of interest. It is worth noting that because proxy research providers furnish facts

and opinions that their clients are free to follow or ignore and are not granted decision-

making authority with respect to voting the holdings of their clients, they do not owe their

clients fiduciary obligations to which investment managers are subject.

With a competitive market for proxy research, coverage of a substantial proportion of

listed Australian companies, and limited conflicts of interest amongst proxy voting firms,

Australia largely conforms – with respect to voting-related analyses – to Principle V.F, which

states that:

“the corporate governance framework should be complemented by an effective

approach that addresses and promotes the provision of analysis or advice by analysts,

brokers, rating agencies and others, that is relevant to decisions by investors, free from

material conflicts of interest that might compromise the integrity of their analysis or

advice.”

2.3.3. Voting and engagement practices

Voting turnout at shareholder meetings in Australia has risen steadily over the past

decade, from around 35% at the end of the 1990s to approximately 60% today. A key

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development that magnified the attention paid to voting was a 2000 study showing that

only 35% of outstanding shares were voted at Australian companies in 1999, compared to

50% in the UK, 73% in Germany, and 80% in the US over the same period. Prompted in part

by the collapse of a major insurance company (HIH), ACSI has played a prominent role in

raising voting turnout by encouraging its superannuation fund members to vote, which in

turn have exerted pressure on their asset managers to follow suit.

However, voting by retail shareholders continues to be at a low level. At an Australian

bank whose investor base consists of approximately 55% domestic retail, 30% domestic

institutional, and 15% foreign shareholders, only 40% of shares are typically voted, the bulk

of which is believed to represent institutional holdings.

Most superannuation funds delegate voting to their investment managers. At a large

investment firm, only 15% of its superannuation clients have decided to vote their own

holdings. Super funds that choose not to delegate voting to their asset managers are

typically the larger schemes, such as Australian Super, UniSuper, HEST and Cbus. Amongst

these funds, only a few have dedicated internal resources to carry out voting, with the rest

generally following the proxy voting advice of ACSI18 or another provider.

At investment management firms, most rely on individual fund managers or analysts

to carryout voting. Exceptionally, AMP, BlackRock, and a few others – mirroring the

standard practice at large institutional investment firms in the UK and US – have dedicated

corporate governance teams to undertake this activity. According to commentators,

Australian fund managers have not adopted the proxy voting model of their UK-US

counterparts because most Australian equity portfolios are of manageable size (up to

80 holdings). To some, voting by fund managers and analysts is ideal because these

individuals are highly familiar with the companies they vote on.19 Moreover, this approach

helps to integrate voting and investment decision-making.

Some superannuation funds in Australia engage in share lending, usually through

their custodians. However, it is uncertain the extent to which shares are recalled when

contentious items appear on a shareholder meeting agenda.

Most investment firms subscribe to external proxy research to help them reach voting

decisions. Despite greater expectations on institutional investors to vote their shares

actively, many fund managers in Australia – particularly smaller outfits – continue to

slavishly follow the recommendations of their proxy providers and some are loathe to

express dissenting views. According to one observer, a large Australian asset manager

“would bend over backward to avoid voting against any resolution”.

The annotation of Principle II.F.1 notes that “a complementary approach to

participation in shareholders’ meetings is to establish a continuing dialogue with portfolio

companies”. In Australia, the IFSA Blue Book provides that, where a fund manager intends

to vote against a resolution, he should engage with the company sufficiently in advance of

the shareholder meeting with “a view to achieving a satisfactory solution”.20 In practice,

this recommendation does not appear to be embraced fully. At the Australian subsidiary of

a global investment firm, pre-shareholder meeting communication is undertaken only for

holdings in excess of 5%. For all other holdings, a letter explaining the firm’s voting

decision is sent after the shareholder meeting.

Nonetheless, engagements between institutional investors and companies on

corporate governance matters – in relation to voting resolutions at shareholder meetings

and other contexts – have become more prevalent in recent years. On their part, companies

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generally appear to be adopting a more proactive approach to engaging with their

shareholders on corporate governance. Whereas meetings between the CEO/CFO and

investors to discuss company performance are an established practice, discussions

between chairmen and institutional investors on governance matters are a relatively

recent phenomenon.

The advisory vote on the remuneration report has served as the impetus for increased

shareholder-company engagement. According to ACSI, “the introduction of a non-binding

shareholder vote has been the single biggest catalyst for improved levels of engagement”.

Proxy advisor CGI Glass Lewis similarly observed recently that there has been “a significant

increase in dialogue instigated by (non-executive directors) on remuneration issues since

the non-binding vote was introduced … Ten years ago engagement by listed entities with

their key institutional shareholders was minimal.”

At a large mining company, for instance, the chairman – accompanied by the

company secretary or head of investor relations – arranges meetings once a year with the

firm’s largest institutional investors in Australia and abroad. In Australia, the chairman

sees mostly investment firms, although he will also meet with superannuation funds

that have “clawed back” voting from their investment managers. Topics addressed in

recent years include executive compensation, environmental and social issues, board

governance, and acquisitions. Correspondingly, the remuneration committee chair will

meet with the firm’s most significant investors to discuss compensation matters,

particularly when changes are proposed. Over the past few years, the company has

become more proactive in engaging its shareholders on corporate governance-related

matters, particularly relating to executive pay.

Similarly, led by the chairman and remuneration committee chair, the board of a

domestically-focused Australian bank has stepped up engagement with the institution’s

top investors. Given that the bank’s shareholder base is primarily Australian, the board

focuses on meeting domestic investors. In terms of timing, the chairman would initiate a

dialogue with its largest half-dozen shareholders when the annual shareholder meeting

notice is published – the principal purpose of these meetings is to give investors an

opportunity to ask questions. Even though the bank has outperformed its peers and

support for its remuneration report has exceeded 90% the past couple of years, the board is

nonetheless paying close attention to investor perceptions of its remuneration

arrangements due to the continuing public scrutiny on compensation in the financial

sector.

In terms of overall market trends, executive remuneration appears to be receiving

the most attention in engagements between investors and companies. However, other

ESG-related issues – such as board independence, succession planning, and sustainability –

are also routinely addressed.

One company representative observed that engagement approaches and quality differ

markedly amongst institutional investors – some are extremely well-prepared while others

are much less diligent. Broadly speaking, fund managers tend to focus on operational and

financial issues while superannuation funds place a greater emphasis on corporate

governance and sustainability matters.

The reliance of domestic and foreign institutional investors on proxy research

providers in reaching voting decisions means that companies must also engage with these

advisers on voting-related topics. The mining company mentioned above, for example,

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typically meets with proxy research firms several times a year to discuss matters to be

voted on at the shareholder meeting.

Due to a dearth of internal resources as well as a belief that collective engagements are

more effective than one-on-one meetings, many superannuation funds rely on ACSI to

engage on their behalf. Each year, ACSI agrees with its members the key engagement

themes. In 2010, the priority issues were executive remuneration, board representation

(particularly diversity), sustainability report, commitment to tackling climate change, and

company performance. Thereafter, ACSI identifies approximately 60 Australian companies

with which to engage on one or more of the priority themes. In terms of participation, ACSI

members are normally invited to the company meetings that it organises. Several

members, such as HESTA, attend regularly.

Some superannuation funds also delegate engagement to Regnan, a for-profit advisory

firm owned by eight institutional investors. In 2009-2010, Regnan’s engagements focused

on board quality (board performance, board diversity, and mix of skills), executive

remuneration, and ESG disclosure.

By contrast, there is no industry body to facilitate collective engagement amongst

investment managers. Individual asset managers also do not engage as a group, although

they may discuss corporate governance matters informally with each other. One

investment manager mentioned that collective engagements do not take place amongst

managers due in part to fears of violating “concert party” regulations.

The conflicting positions of superannuation funds and investment managers

regarding collective engagement suggest that Australia may not be fully compliant with

Principle II.G., which stipulates that:

“shareholders, including institutional shareholders, should be allowed to consult with

each other on issues concerning their basic shareholder rights as defined in the

Principles, subject to exceptions to prevent abuse”

and II.F.1, which states that institutional investors:

“should be allowed, and even encouraged, to co-operate and co-ordinate their actions

in nominating and electing board members, placing proposals on the agenda and

holding discussions directly with a company in order to improve its corporate

governance.”

Some commentators – including ACSI and several legal academics – have argued that

Class Order 00/455, the “safe harbour” promulgated by the Australian Securities and

Investments Commission (ASIC), does not provide sufficient protection to shareholders

engaging collectively on corporate governance matters.21 Under this safe harbour, two or

more institutions planning to act collectively will not breach Corporations Act

shareholding notification and takeover provisions provided they comply with its

requirements.

The criticism of Class Order 00/455 centres on two areas. First, the Class Order applies

only to voting actions, whereas engagements between shareholders and companies often

encompass non-voting matters. Second, the current safe harbour requires institutional

investors to formally notify ASIC of their collective activities. Most engagements between

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companies and their shareholders, however, are highly informal and undertaken in

private.

On a separate but related matter, there are safeguards to ensure that shareholder-

company engagements comport with Principle II.F.1 annotation that:

“it is incumbent on the company to treat all investors equally and not to divulge

information to the institutional investors which is not at the same time made

available to the market.”

The IFSA Blue Book, for instance, admonishes that “companies and fund managers

should manage communications so that no investor or potential investor obtains material

or price-sensitive information that has not been disclosed to the market in accordance

with the Corporations Act and the ASX Listing Rules”. The Blue Book also states that:

“if a fund manager considers that material information has been provided during

discussions with a company, it must warn the company that it may have breached the

continuous disclosure provisions of the Corporations Act. The fund manager must

implement appropriate mechanisms to ensure that the information is strictly

safeguarded and insulated from any other activity. This may include a temporary ban

on trading in the company’s shares or implementing ‘Chinese Walls’ until the

appropriate disclosures have been made to the full market.”

From the perspective of companies, a key challenge is reconciling the diverse views of

institutional investors on a broad array of topics, particularly executive remuneration. In

addition, some company directors are concerned about the ideological stances of certain

investor representatives. Lastly, there appears to be some confusion amongst company

directors as to who – between superannuation funds and their asset managers – has

responsibility for voting and engagement on corporate governance and sustainability

matters.

2.3.4. Areas of contention between shareholders and companies

In recent years, shareholders and companies have clashed on a number of topics,

including executive remuneration, board accountability, and buyout terms.

Since its introduction in 2004, the non-binding vote on executive remuneration has

served as a key tool for institutional shareholders to voice their dissatisfaction. Amongst

countries that have introduced “say on pay”, investors in Australia have utilised it most

aggressively, as indicated by the level of “no” votes on the remuneration report.

In 2009, 27 companies in Australia suffered votes against of greater than 25% on the

remuneration report, including seven firms that garnered opposition of greater than 50%

(Table 2.6). In 2010, “say on pay” resolutions at 8 Australian companies failed to win the

support of a majority of investors. By way of comparison, less than ten companies in the

UK have seen their remuneration reports defeated since the introduction of “say on pay”

in 2003.

In addition, institutional investors have removed directors at several poorly

performing companies in the past couple of years. In November 2010, institutional

investors played an instrumental role in ousting two directors at Transpacific Industries. At

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several companies, one or more board directors ultimately decided to not stand for re-

election when they realised they did not have sufficient backing from shareholders.

Activism on voting has also extended to investment matters. One commentator noted

that, a decade ago, most fund managers “wouldn’t think of opposing mergers” but an

increasing number of them are now willing to spurn offers that they perceive as

undervaluing the target company. In 2007, a private equity consortium made an offer to

buy Qantas airlines. Even though Qantas’s board had recommended acceptance of the offer

and the Australian government had approved the transaction, a majority of shareholders –

led by institutional investors – declined to tender their shares because they felt the offer

price was too low. The consortium’s bid ultimately failed.

The News Corporation litigation is perhaps the most emblematic example of increased

institutional investor activism in Australia. In 2004, media conglomerate News Corporation

announced its intention, subject to shareholder approval, to change domicile from

Australia to the US state of Delaware. To protect against a weakening of shareholder rights

arising from this move,22 a group of Australian and international institutional investors

(led by ACSI) reached agreement with the company to preserve certain shareholder rights

– including a requirement to obtain shareholder consent if the company decides to extend

its poison pill in excess of one year – in return for their support.

Table 2.6. Substantial no votes in remuneration reports in 2009

Company “No” vote percentage (%) Index

Abacus Property Group 31 ASX200

Aspen Group 48 ASX300

Avoca Resources 26 ASX200

Babcock and Brown Infrastructure 32 ASX200

Bendigo and Adelaide Bank 32 ASX100

Cabcharge 45 ASX200

Challenger Financial 29 ASX200

Clough 36 ASX300

Crane Group 43 ASX200

Dominion Mining 37 ASX200

Downer EDI 59 ASX100

Energy Developments 60 ASX300

Kingsgate 52 ASX200

Lend Lease 42 ASX100

Macmahon Holding 28 ASX200

Nexus Energy 27 ASX200

Novogen 81 ASX300

NRW Holdings 53 ASX300

Qantas 43 ASX50

Ramsay Health Care 32 ASX200

Riversdale Mining 25 ASX200

Sims Metal Management 29 ASX100

St Barbara 58 ASX200

Straits Resources 48 ASX200

Transurban 47 ASX50

United Group 49 ASX100

Western Areas 56 ASX200

Source: Australian Government Productivity Commission (2009), Executive Remuneration in Australia, www.pc.gov.au/projects/inquiry/executive-remuneration).

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In August 2005, News Corporation announced a two-year extension of its poison pill

without first obtaining shareholder approval. After attempts to convince News Corporation

to honour their previous commitment proved futile, twelve Australian and international

pension funds sued the company in Delaware to enforce the 2004 agreement. In April 2006,

two weeks prior to the scheduled start of trial, News Corporation acceded to the demands

of the institutional shareholders.

2.3.5. Impediments

Although shareholders in Australia possess strong rights, there are some

impediments to the effective exercise of those rights. First, as discussed above, the ASIC

safe harbour on collective activities appears to provide inadequate protection to

institutional investors. Second, similar to other jurisdictions where the processing of votes

remains largely manual, uncounted votes are an issue. For instance, a 2006 study by

investment manager AMP revealed that 4% of its voting instructions had been “lost”.

Third, the ability of Australian companies under the ASX Listing Rules to issue up to

15% of shares annually without pre-emptive rights 2 3 has been mentioned by

commentators as constraining investor activism because institutional shareholders fear

they would not be allocated their proportionate shares in future capital-raising

transactions. In other words, institutional investors are concerned about being diluted if

they speak out aggressively against companies.

In addition, some commentators assert that investment managers have not exhibited

a strong interest in corporate governance because they are incentivized by their clients

(including superannuation funds) to deliver short-term performance.

2.4. Conclusions Overall, institutional investors in Australia appear to be taking their ownership

responsibilities more seriously, including greater diligence and activism in exercising

shareholder rights. However, commentators have noted that a number of institutional

investors continue to be rather passive, as evidenced by their heavy reliance on proxy

research providers for voting and industry bodies for engagement and, with respect to

superannuation funds, the dearth of internal resources to undertake monitoring of the

corporate governance activities of their investment managers. Consequently, current

institutional investor practices in Australia on voting and engagement may not fully meet

Principle II.F.1 expectation that institutional investors “set aside the appropriate human

and financial resources to pursue this [corporate governance] policy in a way that their

beneficiaries and portfolio companies can expect”.

Looking forward, there is an expectation that the focus of engagement between

companies and shareholders will expand to a broader array of ESG issues. Due in part to

the extreme weather patterns that Australia has experienced recently and its proximity to

Southeast Asia, where environmental topics such as rain forest preservation have come to

the fore, there is growing recognition by shareholders and companies that they must

jointly address environmental risks.

In addition, one commentator predicts that as superannuation funds continue to grow

and their holdings in individual firms rise, they may become more active in director

appointments, including by directly nominating candidates to sit on the boards of investee

companies.

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II.2. NOTES

Annex 2.1. Summary of legal provisions relating to the fiduciary responsibilities of institutional investors in Australia

Responsible entity

Under paragraph 601FC(1) of the Corporations Act, the fiduciary duties of a responsible

entity are:

a) the duty to act honestly;

b) the duty to act in the best interests of members and, if there is a conflict between

the members’ interests and its own interests, give priority to the members’ interests;

c) the duty to treat members who hold interests in the same class equally and

members who hold interests in different classes fairly;

d) the duty to not make use of information acquired through being the responsible

entity in order to gain an improper advantage for itself or another person or cause

detriment to members of the scheme; and

e) the duty to ensure that scheme property is i) clearly identified as scheme property

and ii) held separately from the property of the responsible entity and the property of any

other scheme.

Superannuation trustees

Under section 52(2) of the Superannuation Industry (Supervision) Act 1993, the duties

of a superannuation scheme trustee include:

a) the duty of efficient management (that is, to preserve the trust property);

b) the duty of loyalty;

c) the duty to keep and render to the beneficiaries full and candid accounts;

d) the duty to act personally;

e) the duty to consider from time to time whether to exercise powers; and

f) the duty to exercise powers for proper purposes and upon relevant considerations.24

Australian Financial Services Licence holders

Under section 912A of the Corporations Act, the responsible entity or trustee, as an

AFSL holder, is required to comply with (amongst other things) the obligation to:

a) do all things necessary to ensure that the financial services covered by the licence

are provided efficiently, honestly and fairly;

b) have in place adequate arrangements for the management of conflicts of

interest;

c) for a responsible entity, have available adequate resources (including financial,

technological, and human resources) to provide the financial services covered by the

licence; and

d) have adequate risk management systems.

Notes

1. In 2009, domestic institutional investors owned approximately 36% of the shares in quoted Australian companies while foreign shareholders held approximately 42%. As two-thirds of foreign shareholders are estimated to be institutional investors, the holdings of domestic and international institutional investors in listed Australian equities totalled approximately 64% (Stapledon, 2011).

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II.2. NOTES

2. Although IFSA was recently renamed the Financial Services Council, the latter name is not yet widely used.

3. The superannuation guarantee charge was originally set at 3% and increased gradually until it reached 9% in 2002. In 2010-2011, the annual earnings limit on which the SGC is calculated is AUD 168 880.

4. Under the government’s proposal, the SGC is to be increased in two stages – rising in annual increment of 0.25% during 2013-2014 and 0.50% thereafter until 12% is reached.

5. According to the Australian Prudential Regulatory Authority, “balance of life office statutory funds” are assets held for superannuation or retirement purposes in statutory funds of life insurance companies.

6. According to commentators, the majority of Australian workers pick the default fund designated by their employers because they are not familiar with the alternative choices available to them.

7. By contrast, directors standing for re-election are often bundled as a group as in such countries as Canada and Germany.

8. Section 201D(1) of the Corporations Act provides that “a public company may by resolution remove a director from office despite anything in: a) the company’s constitution (if any); or b) an agreement between the company and the director; or c) an agreement between any or all members of the company and the director”.

9. Of course, the board can choose not to re-nominate a director upon the expiration of his/her current term.

10. For example, a 2001 survey by investment consultants Towers Perrin showed that Australian CEOs were the third highest paid among the surveyed markets, after the US and UK.

11. This resolution is to be voted on at the shareholder meeting where the company’s remuneration report received “no” votes in excess of 25% for the second consecutive year. However, detailed voting mechanics have not been developed (i.e. would shareholders vote on this resolution at the same time as they vote on the other resolutions appearing on the shareholder meeting agenda or would they be asked to vote on this resolution only after the voting results on the remuneration report are known?).

12. The responsibilities of the “responsible entity” (manager) of a unit trust are defined under Chapter 5C of the Corporations Act, general law, and the specific scheme constitution. Correspondingly, the responsibilities of superannuation trustees are set out in Section 52 of the Superannuation Industry (Supervision) Act 1993. Responsible entities and superannuation trustees that hold Australian Financial Services Licences must also adhere to obligations under Section 912A of the Corporations Act. See Appendix A for a summary of these provisions.

13. In contrast to the United States, where corporate pension funds are required to vote their shares, neither superannuation funds nor investment managers in Australia are obligated to exercise their voting rights. However, some Australian legal scholars have argued fiduciaries must ensure that “active and genuine consideration has been given to the issue of whether to vote” (Ali, Gold, and Stapledon, 2003).

14. Section 12.1 provides that “the Trustee authorises the Manager to exercise any right to vote attached to a share or unit forming part of the Portfolio or to so direct the Custodian. In the event that the Manager receives a direction from the Trustee in relation to the appointment of a proxy and the way in which the proxy should vote, the Manager must use its best endeavours to implement the direction, but in the absence of any direction, the Manager may exercise or not exercise the right to vote as it sees fit, having regard to any general direction.”

15. IFSA Standard No. 1: Code of Ethics and Conduct (available at www.ifsa.com.au).

16. The Future Fund was funded by the Australian government through infusions of AUD 51.3 billion in cash and AUD 9.2 billion in Telstra shares. The fund held assets of AUD 67 billion as of June 2010.

17. ISS purchased Proxy Australia in 2005 while Glass Lewis bought Corporate Governance International in 2006.

18. In terms of mechanics, ACSI has contracted with proxy research giant Institutional Shareholder Services to generate voting recommendations for Australian shareholder meetings based on ACSI’s corporate governance policies. In terms of policy, ACSI and ISS follow similar approaches, although ACSI is stricter on director independence and executive remuneration – consequently, ACSI’s voting recommendations tend to contain a higher proportion of “votes against” on these two issues. ACSI has entered into a similar arrangement with CGI Glass Lewis with respect to

THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE © OECD 2011 87

http://www.ifsa.com.au

II.2. REFERENCES

voting recommendations for overseas shares but only a few ACSI members currently subscribe to this service.

19. By contrast, in many countries, corporate governance specialists have been criticised for failing to consider (and understand) a company’s individual circumstances when rendering their voting decisions.

20. This is similar to the practice in the UK.

21. For further details, see McKay R. (2007) Collective Action by Institutional Investors is More Than a Passing Fad, Australian Council of Superannuation Investors (available at www.acsi.org.au/general/ collective-action-by-institutional-investors-is-more-than-a-passing-fad.html).

22. In general, Delaware provides less extensive shareholder rights than Australia and News Corporation admitted that the company law framework in Delaware was less “shareholder friendly.”

23. By way of comparison, the UK Pre-emption Guidelines permits disallowing pre-emption rights up to a limit of 5% a year and 7% over a rolling 3-year period.

24. Extracted from Ali, P., M. Gold and G. Stapledon (2003).

References

Ali, P., M. Gold and G. Stapledon (2003), Corporate Governance and Investment Fiduciaries.

Australia Bureau of Statistics (2010), Australian National Accounts: Financial Accounts, September 2010 available at: www.abs.gov.au/AUSSTATS/abs@.nsf/DetailsPage/5232.0Sep%202010?OpenDocument.

Australian Council of Superannuation Investors (2009), “A guide for fund managers and consultants on the consideration of environmental, social & corporate governance risks in listed companies” (available at www.acsi.org.au/acsi-guidelines.html).

Australian Council of Superannuation Investors (2009), “A guide for superannuation trustees on the consideration of environmental, social & corporate governance risks in listed companies” (available at www.acsi.org.au/acsi-guidelines.html).

Australian Government Productivity Commission (2009), Executive Remuneration in Australia (available at www.pc.gov.au/projects/inquiry/executive-remuneration).

The Association of Superannuation Funds of Australia (2010), Superannuation Statistics – Dec. 2010 (available at www.superannuation.asn.au/statistics/default.aspx).

Hill, J. (1994), Institutional Investors and Corporate Governance in Australia, in Baums, Buxbaum and Hopt (eds.), Institutional Investors and Corporate Governance (Walter de Gruyter and Co, Berlin/New York) (available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1120587).

Hill, J. (2010), “The Architecture of Corporate Governance in Australia”, Sydney Law School Legal Studies Research Paper No. 10/75 (available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1657810).

Investment and Financial Services Association (2009), “Blue Book on Corporate Governance” (available at www.ifsa.com.au).

McKay, R. (2007), “Collective Action by Institutional Investors is More Than a Passing Fad”, Australian Council of Superannuation Investors (available at www.acsi.org.au/general/collective-action-by- institutional-investors-is-more-than-a-passing-fad.html).

Stapledon, G. (2011), “The development of corporate governance in Australia”, in C. Mallin (ed.), Handbook on International Corporate Governance (2nd edition).

Super System Review Final Report (2010), “Cooper Review”, available at www.supersystemreview.gov.au/ content/content.aspx?doc=html/final_report.htm).

THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE © OECD 201188

http://www.acsi.org.au/general/collective-action-by-institutional-investors-is-more-than-a-passing-fad.html

http://www.abs.gov.au/AUSSTATS/abs@.nsf/DetailsPage/5232.0Sep%202010?OpenDocument

http://www.acsi.org.au/acsi-guidelines.html

http://www.pc.gov.au/projects/inquiry/executive-remuneration

http://www.superannuation.asn.au/statistics/default.aspx

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1120587

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1657810

http://www.ifsa.com.au

http://www.acsi.org.au/general/collective-action-by-institutional-investors-is-more-than-a-passing-fad.html

The Role of Institutional Investors in Promoting

Good Corporate Governance © OECD 2011

PART II

Chapter 3

Chile: The Role of Institutional Investors

in Promoting Good Corporate Governance

This chapter explores the experience of Chilean institutional investors in promoting good corporate governance practices in the companies in which they invest. It documents the influence of institutional investors, particularly the Pension Fund Administrators (AFPs under their Spanish acronym), which is one of the key factors explaining the current corporate governance landscape and the development of its capital market. This report describes the rules, practices and prominent cases that have contributed to shape Chile’s institutional investors behaviour.

II.3. CHILE: THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE

The influence of institutional investors, particularly the Pension Fund Administrators (AFPs under their Spanish acronym), is perhaps one of the key factors explaining the

current corporate governance landscape and the development of the capital market in

Chile. The large pool of assets under their administration as well as their active engagement in

improving and promoting good corporate governance practices in the companies where they

invest, have turned institutional investors into influential actors. They have become strong

enough to stand up to powerful controlling shareholders in the concentrated Chilean stock

market. As Strengthening Latin American Corporate Governance: The Role of Institutional Investors

(OECD, 2011b) pointed out, in Chile as in many other Latin American countries, the

institutional investors are playing a primary role in the stock market growth, as the largest and

most influential minority shareholder for many listed companies.

Compared to AFPs, other Chilean institutional investors such as mutual funds,

insurance companies, and investment funds have not assumed a similar role in relation to

corporate governance practices. As stated by the OECD Report on Corporate Governance in

Chile (OECD, 2011a),

“government requirements for investment and insurance funds have been a lower

public policy priority so far in Chile due to their smaller size and impact on the equity

markets, and the perspective that pension funds have a higher regulatory threshold to

meet not only because of their greater impact on the market, but also due to their

mandatory nature and role in providing for all Chileans’ retirement.”

The Chilean stock market where these investors interact is characterized by a

relatively small number of firms with a significant degree of ownership concentration, and

where financial conglomerates control the boards of most listed companies. As Lefort and

Walker (2000) showed, pyramid schemes are the most common way of achieving control in

Chilean conglomerates, since cross-holdings are forbidden by law and dual (or multiple)

class shares are unusual. Pension funds are the main minority shareholders of Chilean

companies, investing a significant proportion of their resources in the domestic corporate

sector. In fact, according to Agosín and Pastén (2003):

“a specific feature of Chilean capital markets is the existence of well-developed

institutional investors, specifically the private pension funds that arose from the

pension reform of 1981 where in spite of the limitations imposed upon the AFPs in the

kinds of investments they can make, they have been responsible for a significant

deepening of the stock market”.

The influence of institutional investors in the Chilean corporate governance

framework has been well documented. Iglesias (2000) argues that pension fund

participation in the stock market has had positive effects on: i) the number of independent

board members; ii) a decrease of monitoring costs as a result of improved quality of public

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II.3. CHILE: THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE

information; iii) an enhancement of the supervision of companies where pension funds

have invested; and iv) an improvement of bondholder’s protection.

More recently, Lefort (2007), analyzing the direct and indirect channels through which the

AFPs may influence Chilean companies, concludes that such influence is particularly positive

in three areas: i) the emergence of legal reforms and the improvement of oversight under

which the companies operate, affecting the quality of the regulatory external mechanisms of

corporate governance; ii) the development of greater liquidity in capital markets by the growth

of funding and the volume of their trading; and iii) the professionalization of the financial

intermediaries and the adoption of more advanced and cost-efficient transaction processes.

He also concludes that the direct monitoring and intervention of AFPs in exercising their rights

as minority shareholders, or as bondholders, has contributed to improving the internal

mechanisms of corporate governance of Chilean companies.

Furthermore, Lefort and Walker (2007) point out that after controlling for ownership

and control structure, companies with institutional investors as shareholders show a

statistically significant increase in market value. By the same token, Lefort and Urzúa

(2007) show that having institutional investors as shareholders is correlated with a greater

number of independent directors in boards, and that there is a premium for companies

with such directors.

Considering these features, Chile was an obvious candidate for a review of the role of

institutional investors as shareholders. Prima facie, it seemed clear that the case for lack of

engagement and passivity of institutional shareholders should not be applicable to Chile.

This report describes the extent to which that is true, as well as the rules, practices and

prominent cases that contributed to and explain this phenomenon.

This report is organized in four sections. Section 1 describes the main aspects of the

Chilean corporate governance landscape, describing its stock market and addressing

ownership and control, as well as the relative importance of institutional investors in the

market, particularly pension funds. Section 2 deals with the legal and regulatory

framework affecting institutional investors and their supervision. Section 3 reviews

evidence of the role of AFPs in improving corporate governance practices in Chile. The last

section offers some conclusions.

3.1. The corporate governance landscape

3.1.1. The Chilean stock market1

The Santiago Stock Exchange (SSE) constitutes the third largest equity market in Latin

America, behind the stock exchanges of Brazil and Mexico, with a relatively high market

capitalisation of USD 230 billion for 230 listed firms at the end of 2009 – equivalent to 127%

of GDP (Figure 3.1).

The SSE is the largest of the three stock exchanges, responsible for approximately 86%

of transactions, while the Electronic Stock Exchange accounts for 13%, and the Valparaíso

Stock Exchange has less than 1% (Larrain, G. et al., 2008). As of September 2007, the free

float (defined as shares not owned by controlling parties) was estimated at 36% of equity in

the IPSA and IGPA indexes. The IPSA index is made up of the 40 most traded firms with

greater than USD 200 million in market capitalisation, reflecting 74% of overall market

capitalisation, while the IGPA index tracks the 138 most significant and actively traded

stocks among the 230 companies listed on the market (Figure 3.2).

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II.3. CHILE: THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE

With an average volume of USD 196 million in 2007, Chile’s daily trading is relatively

low, at less than 10% of total market capitalisation, and new listings are rare. However, the

number of listed companies can be considered as relatively high in relation to population,

constituting about 15 firms per million inhabitants, according to the Chilean Ministry of

Finance. Most of Chile’s largest firms are listed in the local markets, with the proportion of

equity of Chilean firms cross-listed on US exchanges falling in the range of 8-10% of Chile’s

market capitalization since 2003. Chile’s listed firms are also relatively diversified. Chile’s

IGPA index, which tracks the most significant and actively traded listed firms, comprises

28% of firms from the utilities sector, 20% from commodities, 20% industrial, 9% financial,

9% retail, 7% in consumer goods, and 6% in communications and technology.

The lack of liquidity of the Chilean stock market is further exacerbated by the fact that

domestic pension funds hold about one-fourth of the free float, and tend to hold onto their

shares. By comparison, 12 Chilean corporations listed abroad through ADRs account for

another USD 50 million in daily trading, approximately 25% of the Santiago Stock

Exchange’s daily turnover (Lefort and Walker, 2007).

While overall liquidity is low, it has been improving, with annual trading volume rising

from about 10% of GDP in 2002 to about 30% by 2007. Turnover – defined as total annual

Figure 3.1. Chilean listed market capitalisation to GDP (%)

Source: World Bank Data (n.d.), “Market capitalization of listed companies (% of GDP)”, http://data.worldbank.org/ indicator/CM.MKT.LCAP.GD.ZS/countries/CL?display=graph, accessed February 2011.

Figure 3.2. Number of Chilean listed companies

Source: World Bank Data (n.d.), “Listed domestic companies”, http://data.worldbank.org/indicator/CM.MKT.LDOM.NO/ countries/CL?display=graph, accessed February 2011.

100

120

140

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http://data.worldbank.org/indicator/CM.MKT.LDOM.NO/countries/CL?display=graph

II.3. CHILE: THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE

trading volume divided by market capitalisation – has increased from 7% to 22% during the

2002-09 period (Figure 3.3).

3.1.2. The corporate governance framework

Chile’s current corporate governance landscape reflects historical influences over the

last four decades. Chile’s economy featured heavy state control and nationalisation of the

copper sector and other important industries under the Allende government, which

culminated with a severe economic crisis before the military coup in 1973. A period of

market-oriented reforms and massive privatisations followed. By 1990, about

550 enterprises under public-sector control, including most of Chile’s largest corporations,

had been privatised. By the end of 1991, fewer than 50 firms remained in the public sector.

The overall privatisation programme undertaken in the late 1980s has been criticised by

some Chilean and international economists who have suggested that banks and

manufacturing firms were sold too rapidly and at “very low prices” (Lüders, 1991),

contributing to the current landscape of concentrated ownership and conglomerate

dominance. Reform of the banking sector, following a banking crisis in the early 80s, and

privatisation of the Chilean pension system also took place during this period.

The Corporations Law and the Securities Market Law, both enacted in 1981 and

amended several times since, are the principal pieces of legislation bearing on corporate

governance in Chile. Key amendments have included laws enacted in 2000 on Public

Tender Offers and on Corporate Governance, which moved to strengthen minority

shareholder rights by, among other things, enhancing disclosure and establishing

directors’ committees which serve a role similar to audit committees.

Chile has recently taken major steps to improve its corporate governance legal

framework. The 2009 Corporate Governance law strengthens protection for minority

shareholders through enhanced transparency standards and mechanisms for addressing

use of privileged information, related party transactions and the management of conflicts

of interest. Other provisions improve the definition of independent directors and

strengthen their role in reviewing sensitive issues relevant to minority shareholder

protection through the directors’ committees.

Chile’s Superintendence of Securities and Insurance (SVS) is responsible for

overseeing the securities and insurance markets, while separate regulators oversee

pension funds (Superintendence of Pension – SP) and banks.

Figure 3.3. Turnover on Chilean listed market (%)

Source: World Bank Data (n.d.), “Stocks traded, turnover ration %”, http://data.worldbank.org/indicator/CM.MKT.TRNR/ countries/CL?display=graph, accessed February 2011.

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II.3. CHILE: THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE

3.1.3. Ownership and control

One of the main features of Chile’s corporate sector is the very high concentration of

ownership of individual firms, usually in the hands of conglomerates or business groups

that are also few in number. These business groups function as holdings, having majority

stakes in a large number of firms, and minority stakes in others. They seek control

basically through pyramidal structures with several layers of investment companies above

the level of operating firms (Table 3.1).

As of 2002, some 50 major conglomerates had ownership control of more than 70% of

non-financial listed companies, and companies controlled by them accounted for more

than 90% of total equity in the SSE (Lefort and Walker, 2007).

Of the 40 most traded firms, only four had a free float larger than 2/3 of equity in 2007,

which implies that the remaining 36 were subject to significant control, since Chile’s

company law requires a super-majority of two thirds of voting capital for certain major

decisions, giving a controlling shareholder at least blocking power in such cases. Similarly,

only 16 of the 138 firms in the IGPA index as of September 2007 needed to obtain the votes

of minority shareholders for such decisions. Despite the existence of such pyramid

structures, controlling owners in Chile typically own far more equity than is necessary for

effective control.

To measure ownership concentration, the international literature usually considers

the sum of the three largest shareholders, given that companies in countries like the US or

the UK are widely held. In the Chilean case the main shareholder -on average- owns 44% of

the company (Morales, 2009), followed by shareholders owning 13% and 6% of the shares,

respectively (Figure 3.4).

Conglomerates in Chile are not structured around banks, although a few have a bank

within their company group, because banks were forbidden from owning equity in non-

financial companies since 1986. The 1986 banking law also imposed strict controls on

related lending due to its role in the 1982-83 banking sector collapse (credit to related

parties amounted to 19% of total loans in 1982).

Indications of how much these control groups may be used to exert disproportionate

control and minority expropriation can be discerned from the size of the control premium

found in changes of corporate control. One study (Lefort and Walker, 2000) analysing

12 major acquisitions involving changes of control between 1996 and 1999 found an

average control premium of 70%. However, the abnormal return was 5% for the stock after

control was transferred, suggesting that the transfer also added value in the eyes of minority

Table 3.1. Ownership concentration (average per year) Percentage

Year Rights of the controlling shareholder

Control Cash flow

1990 63 56

1995 65 57

2000 70 61

2005 70 61

2009 68 59

Source: Larrain, B., M. Donelli, and F. Urzúa (2010), “Ownership dynamics with large shareholders: An empirical Analysis”, available at www.faceapuc.cl/personal/blarrain/papers/ownerdynamics.pdf.

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II.3. CHILE: THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE

shareholders. The study used these results to estimate the total private benefits of control

at approximately 25% of the value of common shares.

The predominance of company groups, high ownership concentration, indications of

private benefits of control and low liquidity in Chilean markets are characteristics that may

weaken the effectiveness of market mechanisms, leading the Chilean authorities’ to

conclude in 2008 that “the central corporate governance challenge in Chile is the risk of

minority shareholder expropriation at the hands of controlling shareholders”. The

expectations for institutional investor engagement should be seen in this context.

3.1.4. Pension funds and other institutional investors

The Chilean capital market is characterised by the prominence of pension funds as the

largest institutional investors in the market, followed by foreign investors and mutual

funds. By far the most relevant are pension funds, whose transactions accounted for 52%

of trading volume in the Chilean stock exchange in 2007. These funds, representing the

pension savings of more than 8 million workers are precisely the minority shareholders

that face the risks that preoccupy the Chilean authorities.

The early development of Chilean capital markets was partly propelled by the reform

to Chile’s privately-owned pension system designed in 1980, with a mandatory

contribution scheme. The assets of institutional investors, as a percentage of GDP, have

gradually increased during the last three decades. Among them, pension funds (currently

divided in 6 privately-owned AFPs) represented about 65% of GDP by the end of 2009

(Figure 3.5). In addition, almost half of the investment funds are owned by pension funds,2

so their share on total institutional investment is sizeable.

The pension fund managers have been allowed to invest in equities since 1985. Their

investments have represented a significant contribution to financing the corporate sector

in the country (Figure 3.6). According to testimony of the local experts, as much as half of

all corporate bonds ever issued by the market have been bought by the AFPs (Table 3.2).

By the end of 2009, the AFPs had USD 15 billion in local equity, representing 6.9% of the

total SSE capitalisation (Figure 3.7). While this percentage may appear relatively small,

pension funds’ influence is enhanced by the existence of cumulative voting provisions and

Figure 3.4. Market ownership concentration (three largest shareholders)

Source: Morales, M., “Determinants of Ownership Concentration and Tender Offer Law in the Chilean Stock Market” Superintendencia de Valores y Seguros, Serie de Documentos de Trabajo, No. 1, 2009, available at www.svs.cl/sitio/ publicaciones/doc/Serie%20de%20documentos/morales.pdf.

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Shareholder 1 Shareholder 2 Shareholder 3%

THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE © OECD 2011 95

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II.3. CHILE: THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE

the co-ordination among pension funds and other institutional investors to elect

independent directors.3 These directors play an important role within Chile’s Directors’

C o m m i t t e e s , w i t h re s p o n s i b i l i t i e s s i m i l a r t o a n a u d i t c o m m i t t e e i n m a k i n g

recommendations to the board on related party transactions, appointment of auditors and

others.

However, as indicated above, pension funds face limited liquidity in the Chilean domestic

market, constraining the choice of actively traded stocks in which they can invest. This has

been mitigated by relatively recent pension law reform that relaxed limits on how much

pension funds can invest overseas. A cap on investments by AFPs outside Chile has been

gradually lifted, from 6-12% in 1999 to a current global maximum of 80%.

Recent reforms have also created a wider spectrum of choices for workers’ savings,

with each AFP having to offer five risk-differentiated funds, with proportions devoted to

equity ranging from 5% in the lowest risk fund to as high as 80% in the most risky. This has

had implications for corporate governance, as higher concentrations of equity investments

Figure 3.5. Assets under administration by type of Institutional Investors

Source: SVS Superintendencia de Valores y Seguros, Estadísticas del Mercado Asegurador, available at www.svs.cl/sitio/ estadisticas/seg_mercado.php, and Estadísticas del Mercado de Valores, available at www.svs.cl/sitio/estadisticas/ valores_vision_archivos.php.

Figure 3.6. Evolution of pension fund portfolios (per sector)

Source: SP Superintendencia de Pensiones, Centro de Estadisticas, available at www.spensiones.cl/safpstats/stats/ .sc.php?_cid=46.

120250 000

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Pension funds Life insurance companies Mutual funds

Investment funds Foreign funds Total as % of GDP$ %

2005

2007

2009

1995

2001

2003

2005

1985

1995

0 100 20 40 60

State Financial Corporate Foreign

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http://www.spensiones.cl/safpstats/stats/.sc.php?_cid=46

II.3. CHILE: THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE

allow for greater voting power. AFPs have a ceiling of 7% of any individual issuer’s equity.

While such limits significantly constrain individual pension funds’ potential impact on

governance, by eliminating the possibility of becoming controlling shareholders, collective

pension fund actions may be powerful. The law expressly permits them to co-ordinate

their votes and use cumulative voting in order to attain the 12.5% of votes necessary to

secure the election of a director in a 7-member board.4

Mutual funds and insurance companies had about USD 35 billion each in assets under

management by the end of 2009, but almost entirely invested in fixed income instruments.

This is why among the key institutional investor groups involved in the market, pension

funds are clearly the dominant players.

Table 3.2. Pension funds’ investments in Chilean corporate assets

Contribution of Pension Funds to finance the corporate sector

Equity Bonds Investment funds

Total Pension funds Total Pension funds Total Pension funds

(MMUSD) (MMUSD) (%) (MMUSD) (MMUSD) (%) (MMUSD) (MMUSD) (%)

1985 2 012 0 0.0 222 17 7.6

1990 13 619 754 5.5 1 256 744 59.2

1995 71 177 7 471 10.5 2 410 1 334 55.4

2000 60 514 3 984 6.6 3 643 1 448 39.7

2002 48 110 3 210 6.7 6 541 2 535 38.8 1 256 795 63.3

2003 85 534 6 735 7.9 9 681 3 806 39.3 1 852 1 358 73.3

2004 116 212 8 173 7.0 11 463 3 803 33.2 2 422 1 479 61.1

2005 135 873 10 402 7.7 13 756 4 952 36.0 2 513 1 923 76.5

2006 173 873 14 306 8.2 15 066 6 948 46.1 4 019 2 952 73.5

2007 213 364 16 110 7.6 18 645 8 822 47.3 5 841 4 106 70.3

2008 132 595 9 932 7.5 18 216 7 896 43.3 3 230 1 890 58.5

2009 230 837 15 860 6.9 27 522 13 127 47.7 4 845 2 811 58.0

Source: SP Superintendencia de Pensiones, Centro de Estadisticas, available at www.spensiones.cl/safpstats/stats/ .sc.php?_cid=46 and SVS Superintendencia de Valores y Seguros, Estadísticas del Mercado de Valores, available at www.svs.cl/sitio/estadisticas/valores_vision_archivos.php.

Figure 3.7. Pension fund investment in Chilean corporate assets (as % of total assets)

Source: SP Superintendencia de Pensiones (2011b), Centro de Estadisticas, available at www.spensiones.cl/safpstats/stats/ .sc.php?_cid=46.

19 81

19 82

19 83

19 84

19 85

19 86

19 87

19 88

19 89

19 90

19 91

19 92

19 93

19 94

19 95

19 96

19 97

19 98

19 99

20 00

20 01

20 02

20 03

20 04

20 05

20 06

20 07

20 08

20 09

Shares Bonds

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http://www.spensiones.cl/safpstats/stats/.sc.php?_cid=46

http://www.svs.cl/sitio/estadisticas/valores_vision_archivos.php

http://www.spensiones.cl/safpstats/stats/.sc.php?_cid=46

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A final important investor group in Chile is represented by foreign investors. Exact

information on how much foreign investors hold in Chilean equity is not available, but in

2007 the Chilean authorities estimated that USD 3.8 billion was a “lower floor”, while the

Central Bank estimated foreign investors’ net portfolio of investment in Chile, with equity

not separated at USD 9.3 billion.5 Moreover, foreign multinationals control several

prominent local companies, including one of the largest banks, Banco Santander, as well as

Endesa and Enersis (the largest electricity generator and its holding company,

respectively), Telefónica-CTC, D&S (retail), and IANSA (sugar).

3.2. Legal and regulatory framework

3.2.1. Disclosure obligations

Principle II.F states that:

“The exercise of ownership rights by all shareholders, including institutional

investors, should be facilitated: 1) Institutional investors acting in a fiduciary capacity

should disclose their overall corporate governance and voting policies with respect to

their investments, including the procedures that they have in place for deciding on the

use of their voting rights. 2) Institutional investors acting in a fiduciary capacity should

disclose how they manage material conflicts of interest that may affect the exercise of

key ownership rights regarding their investments.”

As mentioned, Chile’s corporate governance framework for institutional investors has

focused heavily on pension funds (Box 3.1), and only slightly on other classes of

institutional investors such as mutual funds or insurance companies. This is attributed to

the fact that the size of pension fund investments in the equity markets is much larger

proportionally and therefore more influential.

Existing regulations require pension funds to disclose their overall corporate

governance voting policies. They are moreover obliged to attend shareholder meetings and

exercise their voting rights in cases where they hold more than 1% of a corporation’s

equity. Pension fund administrators are also prohibited from voting for a board candidate

related to the controlling shareholder, and must publicly disclose their voting intentions

and proposed candidates. With the Pension Fund Reform of 2007, AFPs can now only vote

for independent directors and must propose suitable candidates previously included in a

voce” for their candidates to the board, leave record of their votes on any relevant issue for

the company, as well as report their votes to the SP.

The 2007 reforms also instituted a number of governance reforms for the pension

funds themselves, an important step in view of the potential for conflicts of interest

involving banks (e.g. BBVA and Citigroup) and other economic groups that are listed among

Chile’s main shareholders of pension funds. Thus, Chile’s pension funds are now required

to adopt investment policies and mechanisms to deal with conflicts of interest, to be

approved by the pension fund board, and to be disclosed on the fund’s web site, to the SP

and to a Commission of Users of the System. Further reforms require the appointment of a

minimum of two independent (referred as autonomous6) directors to pension fund

administrator’s boards, and the establishment of a directors’ committee to review

investments and conflicts of interest that must include independent directors among its

members.

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By contrast, the regulatory framework for oversight of investment funds and insurance

companies is not as comprehensive about governance-related requirements, including no

current requirements to report on voting policies. Investment funds and insurance

companies are not obligated to make public disclosure of their engagement with investee

companies, but have to inform only the SVS about general policies. In terms of conflicts of

interest, the Securities Market Law (Article 230) requires managers of open and closed

funds to determine how they will manage potential conflicts involving different funds

administered by them. In addition, given the risk-based approach followed by the SVS,

mutual funds’ managers are required7 to develop policies specifying procedures to identify

and manage conflicts of interest. Mutual fund managers and insurance company’s

managers are also subject to regulation about conflicts of interest contained in the

Corporations Law, in terms of related party transactions. Similarly, the board of insurance

companies is required by the Insurance Law to inform the regulator about general policies

adopted in terms of investments, financial risk management (use of derivative assets), and

internal control.

In accordance with a recent amendment to the Law on Corporations, listed companies

have the obligation to disclose the votes of each of the shareholders in the shareholders

meeting, which indirectly allows the public to know how mutual fund administrators and

insurance companies are exercising their voting rights. Unfortunately, this information is

not accessible electronically but hardcopies are available at the offices of the regulator,

which makes it almost impossible to research.

On the other hand, AFPs have to inform about their investment policies and the way

they would solve potential conflicts of interest as investors. Each AFP has taken specific

positions in terms of corporate governance issues, mainly on the eligibility requirements for

independent director candidates that would be supported by them, as well as regarding

compensation to members of the board. For example, one AFP has stated that a director

elected with its votes cannot stay more than six years on the same board and cannot be elected

as independent director in more than two boards simultaneously. Actually, starting as of year

2011 the SP requires AFPs to report in their investment policy about principles and corporate

governance practices they will consider on the companies where the funds are invested.

Finally, beyond the regulatory framework, some pension funds have issued their own

codes and regulations. Since 2007 one AFP has a corporate governance code promoting best

practices for Chilean companies. In this document, the AFP defines its position on the

main issues of corporate governance for the companies, making explicit what policies

would or not be supported by the AFP.

3.2.2. Shareholder rights

Principle II.G states that:

“Shareholders, including institutional shareholders, should be allowed to consult with

each other on issues concerning their basic shareholder rights as defined in the

Principles, subject to exceptions to prevent abuse.”

The Chilean Corporation Law does not promote or prevent co-ordination among

shareholders, but such co-ordination does take place. In practice, the pension funds as the

dominant institutional investor class actively work with other institutional investors and

minority shareholders, particularly in relation to voting for independent directors. For a

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board candidate to be eligible to obtain the support of AFPs, he or she must be included in

the Register of Directors at the SP. Those candidates have to satisfy the minimum

standards in terms of academic qualifications, and to inform of any conflict of interest to

be director of a specific company where the AFPs have their investments. In addition, AFPs

are forbidden to vote for a candidate related to the main shareholders of the company

(including family members or members of management in a company controlled by the

main shareholders). Starting in 2008 the AFPs have delegated the selection of suitable

candidates to executive search consultants, making the whole process more transparent

and helping to expand the pool of professional directors at Chilean companies.

Considering that – by regulation – the investment of a single AFP cannot be more than

7% of a company’s equity, they are allowed by law to vote as a group in order to maximize

the number of independent directors on the board. As most companies have a large

controller shareholder already, there is little risk of abuse in relation to their collaboration

with others. Rather, as in the case of takeovers, they are more likely to co-ordinate in the

negotiation of what may constitute a better treatment for their minority shares. Cases have

also been documented of minority shareholders co-ordinating their position in relation to

appointment of external auditors, and in relation to the level of pay for board members or

executives.

Mutual funds are also forbidden to participate in the management of the company

where they invest their resources, but the Securities Market Law allows them to actively

search agreement among themselves and with other minority shareholders for board

nomination and elections. For the rest of institutional investors, there is no specific

regulation on shareholder co-operation.

3.2.3. Shareholder responsibilities and fiduciary duties

In their role as shareholders of publicly traded companies, institutional investors in

Chile are in general not affected by specific regulations beyond those that affect general

shareholders.

However, the 2010 reform to the Mutual Funds Law introduced the obligation for open

funds – owning more than 1% of a company – to vote in the election of the board. There is

no mandatory rule for insurance companies, closed mutual funds, investment funds or

foreign funds. As mentioned, this could be due to the lower amount of their investments

that are allocated to equities, or to the costs associated with monitoring, given the

investment strategies of these institutions (short-term horizon, diversification, etc.). This

doesn’t mean there are no fiduciary obligations for mutual funds. The Securities Market

Law requires fund managers to look after the best interest of their clients. They are

required to manage the funds with the same diligence as if they were attending their own

business, looking for an adequate trade-off between risk and return for the corresponding

portfolios.

In contrast with the institutional investors mentioned above, the shareholder

obligations of AFPs are tightly defined by the law and supervised by the pensions regulator.

This differentiated degree of control on AFPs is often explained by the fact that the Chilean

pension system is mandatory, fully funded (defined contribution) and operated by the

private sector (only 6 firms by 2011). This makes the fiduciary role of AFPs an objective to

be carefully supervised by the authorities in order to ensure a responsible investment of

workers’ retirement funds.

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Box 3.1. Pension funds main regulation regarding Principles II F and G

Under Decree Law (D.L.) No. 3.500 of 1980, the Pension Funds’ Investment Regime, private pension fund administrators are required to adopt investment and conflict of interest policies. They must publish them on the AFP’s website. The minimum content of the investment and resolution of conflict of interest policies must include the existence of procedures, manuals and codes of conduct guiding the exercise of their role as investor. They must also refer to matters that include the requirements and procedures for selecting candidates to the boards of the listed companies in which they invests. The directors for whom the AFPs vote must be included in a Registry of the Pensions Superintendence. A new requirement that came into force on March 2011 demands that these investment policies must also refer to the criteria and measures adopted in relation to the corporate governance and practices of the companies in which they invest. In addition, guidelines on good corporate governance have been drawn up voluntarily and made public.

AFPs have an obligation to attend shareholders’ meetings, to vote publicly and to explain the grounds for their votes. They must attend all the shareholders’ meetings of those companies in which the pension fund has invested, providing they hold more than 1% of the subscribed capital. Under that level it is however necessary for them to participate in shareholders’ meetings when the votes of the entire AFP system are relevant to make an important decision for the company, such as the election of an independent director. They must be represented by individuals appointed for this purpose by the board of directors. These representatives cannot act with powers other than those conferred on them and must always express an opinion, viva voce, on the agreements adopted by the shareholders meeting and ensure that their vote is recorded in the corresponding minutes.

The AFPs must file a monthly report with the Pensions Superintendence, setting out their attendance and participation in shareholders’ meetings. In this report, they must also set out the grounds for their vote on the following matters: i) election or removal of directors and alternate directors, the directors’ committee and the adjusters and inspectors of the administration; ii) the company’s investment and financing policy; iii) distribution of the period’s profits and payment of dividends; iv) observations about its financial statements; vi) all those matters that correspond to an extraordinary shareholders’ meeting in accordance with the Corporations Law. The Pensions Superintendence carries out an annual evaluation of AFPs’ compliance with the obligations and then publishes a report of compliance.

In the election of directors in the companies in which the AFPs invest the candidates for which the AFP’s representatives will vote must be decided by the AFPs board. The board must also establish the criteria to be followed by its representatives if the pension fund’s interests require them to vote for a candidate other than the one selected by the board. These decisions must be recorded in the minutes of the board meeting along with the grounds on which they were taken. An AFP representative who votes for a candidate other than the one chosen by the board must present a written report to the subsequent board meeting, setting out the reasons for this action and the circumstances. This must be noted in the meeting’s minutes along with the board’s opinion about this action.

Pursuant to the D.L. No. 3.500, pension funds may not invest directly or indirectly in instruments issued or guaranteed by persons related to the AFP. As a result, conflicts of interest related to investments do not, in general, arise. However, as indicated above, investment and resolution of conflict of interest policies are public.

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In addition, given the low liquidity observed in the Chilean stock market, AFPs are not

able to “vote with their feet”. Just selling shares whenever they don’t agree with corporate

governance practices of a company is not an attractive option, essentially because of the

size of pension funds in the market, as well as the herding behaviour among AFPs. The

liquidity premium paid in such a transaction would cause an important loss for workers’

retirement savings.

The AFPs are therefore forced to participate in shareholder meetings to represent

workers’ retirement savings in all companies where they hold more than 1% of equity.

These obligations also extend to bondholder meetings, where the AFPs have gained a

reputation as tough negotiators with companies that fail to meet a bond covenant. The

objective behind these regulations fostering engagement and collective action is to ensure

that AFPs will monitor their investment carefully. But at the same time the rules prevent

their engagement to go further, prohibiting their involvement in the management of the

companies where they invest.

3.3. Exercise of shareholder rights There are two main sources of evidence on the role of AFPs in promoting good

corporate governance practices by Chilean companies. First, a summary of the mandatory

reports of AFPs participation in shareholder (and bondholder) meetings can be obtained

from the Pension Superintendence. These summary reports present statistical information

on the election of directors supported by the AFPs, as well as the role of AFPs in important

decisions adopted in some of the meetings. On the other hand, there are several prominent

cases where the role played by some AFP was crucial in setting corporate governance

standards in the country (addressed in Table 3.3).

Between 2007 and 2010 AFPs have elected one or two directors in 60% to 70% of the

companies renewing their boards. These figures are interesting when considering that the

sum of the share of AFPs ownership is less than 20% in 90% of these companies. This

means that AFPs should not have been able to elect such a number of independent

directors with their own votes alone. They must vote together with other minority

shareholders in order to reach the minimum vote required to elect them. These

agreements or correlated votes are evident in 2010, for example, where 11 independent

Box 3.1. Pension funds main regulation regarding Principles II F and G (cont.)

AFPs may act in consultation with each other or other shareholders, except the majority shareholder or those related to the majority shareholder, in electing the directors of the companies in which the pension funds invest. They may not, however, take steps that imply participating or being involved in companies in which they have elected one or more directors. In practice, AFPs have jointly commissioned studies and reports and hired consultancy services to help them take better decisions in shareholders’ meetings (for example, when strategic assets have been sold or for approving the price of a tender offer). However, in these cases, the decision on how to vote is taken individually by each AFP. In several cases the AFPs have taken joint legal action.

Source: Chilean responses to the OECD questionnaire.

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directors were elected in companies where AFPs controlled less than 50% (and

27 independent directors were elected in companies where they held between 50% and

100%) of the minimum votes required to elect a member of the board (Tables 3.3-3.6).

Table 3.3. AFPs ownership in companies renewing boards per year Percentage

Participation 2007 2008 2009 2010

Greater than 20% 8 6 6 9

Between 10 and 20% 22 16 29 30

Source: SP Superintendencia de Pensiones, “Informe de asistencia y participación de las administradoras de fondos de pensiones en juntas de accionistas, juntas de tenedores de bonos y asambleas de aportantes de fondos de inversión, nacionales”, several years, available at www.safp.cl/573/propertyvalue-1848.html.

Table 3.4. Companies renewing their boards by year and by size of the board Percentage

Size of board % to elect a director Proportion of companies renewing board members

2007 2008 2009 2010

5 16.67 3.1 3.9 8.20 0

6 14.30 1.6 2.0 4.10 2

7 12.50 56.3 68.6 55.10 72

8 11.11 12.5 0.0 2 0

9 10 21.9 19.6 22.40 26

10 9.09 0.0 2.0 4.10 0

11 8.33 4.7 3.9 4.10 0

Table 3.5. Directors elected by AFPs by company according to % of votes

Directors elected

2007 2008 2009 2010

Greater than 100% of required % to elect a director 12 4 13 6

Between 50% and 100% of required % to elect a director 16 14 15 27

Less than 50% of required % to elect a director 14 8 4 11

Table 3.6. Percentage of companies where AFPs elected one or more directors per year

Percentage

Number of directors elected by pension funds

2007 2008 2009 2010

None 0 38 33 28

1 66 44 50 46

2 24 18 11 21

3 10 0 6 5

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Furthermore, in order to select their candidates to the board, the pension funds have

for a few years already collectively retained the services of executive search consultants.

They are given precise instructions by pension funds managers as to the professional

profile and qualifications of candidates that would fit the needs of the respective company

board. Managers report that by doing so they have managed to broaden the scope of

candidates, professionalize the process and distance themselves personally from the

screening of candidates.

This has affected the profile of independent directors elected with the support of the

pension funds’ votes. Candidates are increasingly characterized by a professional and

technical profile. This is reflected in a significant proportion of master and Ph.D-holding

board members (Table 3.7). This is in line with the goal of improving the competences of

boards by introducing analytical and strategically oriented directors. Overall, the role of

AFPs and other institutional investors in increasing the number and qualification of

independent members of the Boards has been recognised in surveys of Chilean

companies (McKinsey, 2007) as significantly enhancing corporate governance practices.

3.3.1. Explanatory factors

Interviews with managers of pension funds confirm their strong engagement with

domestic companies, which they attribute to basically three factors: i) above all, the small

size and reduced liquidity of the market; ii) the admitted heard behaviour of pension funds,

and iii) historical and regulatory reasons.

With controlling shareholders owning about half of the shares of domestic listed

companies, the average holding by all institutional investors leaves little room for liquidity

in the market. In 2010 AFPs alone held equity in 101 listed companies out of the 230 shares

making up the IPSA index. They owned on average 6.4% of the shares of each issuer,

fluctuating from 26.3% to 0.0001%. Those few relevant listed companies are precisely those

that would give the AFPs the exposure to the Chilean equity market they seek, so there is

not much option for investors to further diversify their domestic equity holdings beyond

those 100 firms.

Low liquidity and a small market act as constrains on pension funds’ portfolio and,

according to their own testimony, force a buy-and-hold strategies. “Since there is no way

out, the reasoning is that we better make sure we use our influence to get the best returns

we can” stated a pension fund manager interviewed for this report. Most pension funds

claim to monitor closely about 70 domestic companies with their own small internal

Table 3.7. Independent directors’ profile Percentage

Academic profile of independent directors elected

Academic degree 2007 2008 2009 2010

Professional 72 25 36 39

Master 23 52 42 47

PhD 5 13 22 14

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research departments (two to ten researchers), although many accused a degree of free

riding from other funds and institutional investors.

Chilean pension funds compete for the workers’ savings, which are obliged to

contribute but can choose the administrator of their choice. Every quarter, the SP publishes

a ranking of returns by pensions funds. This is said to have a big influence on choices by

individuals, especially newcomers. Managers explain that 10 basis points of advantage on

the portfolio return in a given quarter may not make a big difference for future pensions,

but may put their management company on top of the ranking, which could make a big

difference for their evaluation as managers. This competition takes place mostly within

fixed income and on foreign investments, where managers make small, calculated bets

that would provide for enough returns so as to beat the competition while not risking much

in case the investment fails.

Heard behaviour in domestic equity portfolios has been well documented and is

openly acknowledged by pension fund managers. According to the testimony of managers

interviewed for this review, they do not compete on the domestic equity market. The

Chilean authorities say that AFPs’ equity investments have remained stable in time and

they cannot be considered as excessively focused on the short-term. In fact, their

behaviour has involved effectively monitoring and prompting change in the policies of the

companies in which they invest (mainly related to investments, leverage, board

remuneration and the definition of essential assets).

One explanatory factor for this heard behaviour is that pursuant to the Chilean

pension system design, AFPs have to guarantee workers a return of at least 50% of the

industry return of the prior 36 months, so there are very few incentives for them to assume

high individual risks that could make them depart from the mean. Beyond that, managers

also mention that the unwritten consensus is that the domestic equity market is “a neutral

territory”. “We do not compete with local shares and when one buys in, we all do. We

cannot afford to take differentiated risks here.” The unintended effect of this is that since

they all have the same portfolios, co-ordination is somehow a rather natural consequence.

When the Chilean privately-run pension fund system was launched in the 1980s, the

ruling military government warned the economist and engineers’ behind the proposal

that they had better made sure that the system would not lose the workers’ savings, as

that could lead to additional political unrest which the de-facto regime could not afford.

This conservative approach permeated the entire system, from the types of investment

allowed to the early adoption of required voting and encouraged co-ordination rules.

Managers at pension funds acted from the early stages under the assumption that they

had a strong fiduciary duty, and engaged with firms even beyond the minimum legal

requirements.

Moreover, the system also has economic incentives for aligning the interest of the

fund managers. AFPs have a legal requirement to set aside capital for the equivalent to

1% of their assets under administration, which must be invested in the five pension funds

administered by them, pro rata to their relative size. This represents a considerable

investment of the AFPs own resources, adding up to more than USD 1.4 billion by December

2010 (SP, 2011b), aligning the incentives in the direction of increasing the return of the

portfolio of the workers’ savings, as it is common in the private equity or venture capital

industry.

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All these factors have shaped a general institutional investor attitude towards

engagement with investee companies, affecting the way in which they exercise their

shareholders rights, at least in the domestic market. Even though the legislation is not as

explicit as in other countries establishing a clear distinction between local engagement

and the duties of pension funds with respect to their foreign holdings, both the

interpretation of the authorities and the practice of funds mark a sharp difference between

domestic and foreign companies. “Abroad we do not engage but with our asset managers,

every trimester, and mostly to measure them against the agreed benchmark” was the

position of one pension fund manager. Others confirmed their passivity with regards to

individual companies, but claimed more monitoring of the asset managers, including

regular inspection visits and due diligence. None admitted considering the degree of

engagement of the asset manager with the individual investment as bearing any real

relevance. Voting policies, voting records and the like, were not really considered. They

would not ask to be given the chance to decide their proxies, nor to know the general stand

of the asset manager with respect to voting, if it used or followed a proxy advisor or not.

The real concerns, managers explained, are often only the reputation of the manager and

past performance.

When required to explain this different engagement approach between domestic and

foreign equities, the responses referred to the size of companies, the relative weight of

their ownership on the fund’s portfolio, the small size of their research teams and the high

cost of research on foreign equities. But above all, their attitude was marked by their

understanding that they were investing in a market (be it the Russian or the Chinese

markets), and not in the individual companies that composed the portfolio. They were

clear that they wanted exposure to the market risks and return, and that their investment

horizon was very short. If a manager failed to deliver in comparison to the benchmark, a

new manager would be quickly selected.

Box 3.2. Case studies of institutional investors engagement

In terms of emblematic cases, following Lefort (2007) they can be divided based on what corporate governance issue was affected by the actions taken by AFPs. These cases involve: i) minority shareholder rights, ii) composition and functioning of the board; and iii) remuneration of the board. In all these cases the AFPs have satisfied their fiduciary duties by exercising their minority shareholder rights, as well as enhancing the functioning, composition and incentives for the board in the best interest of shareholders.

i) Minority shareholder rights

● The “Chispas” case (1997): The AFPs challenged the agreement between ENERSIS and ENDESA Spain to obtain the control of ENDESA Chile. The AFPs called for an extraordinary shareholders meeting where they obtained a better deal for minority shareholders out of the new acquisition plan proposed by ENDESA Spain. This case was an important element in the later development of the tender offer reform adopted by Congress a few years later.

● Acquisition of Telefonica Net by Terra (1999): The AFPs considered that the price offered for Telefonica Net was under market value. Independent directors, elected with the support of AFPs, were also in disagreement with the transaction. AFPs representatives rejected it during the shareholders meeting, but the controller managed to obtain the necessary votes. The transaction was completed, and the pension funds filed a law suit asking for compensation for Telefonica Net. It did not prosper.

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3.4. Conclusions The Chilean securities market presented challenges to the institutional investors,

mainly with high ownership concentration, a relatively small listed sector and low

liquidity. The policymakers and the institutional investors, particularly the pension funds,

faced those challenges with co-ordination and engagement, promoting investors’ interest

but at the same time shaping the Chilean corporate governance framework.

Unlike in other markets, the Chilean authorities were not concerned about institutional

investors acting in concert, as most Chilean listed companies had and still have controlling

Box 3.2. Case studies of institutional investors engagement (cont.)

● Asset sale between Telefonica CTC and Telefonica Moviles (2004): The AFPs called for an extraordinary shareholders meeting to challenge the conditions under which the mobile business of Telefonica CTC would be bought by its related company, Telefonica Moviles. The original price was subsequently increased by USD 50 million, and Telefonica CTC agreed to pay an extraordinary dividend of USD 800 million.

● Merger MASISA-Terranova (2004): The AFPs obtained a better exchange ratio between shares of the two companies, as well as an extraordinary dividend of USD 54 million.

● Amendment to Soquimich’s charter (2005): The AFPs gave support to Potash Corporation to change the statutory charter of SQM in order to unify the rights of the two series of shares, as well as to impose a cap of 37.5% on the voting rights for any given group of shareholders under a shareholders agreement.

ii) Composition and functioning of the board

● FASA (2009): The AFPs asked for the dismissal of top managers of the company and the renewal of the board, after it was made public that the managers and the Chairman failed to inform the board (in order to by-pass the independent directors) about a leniency agreement the company had reached with the Chilean competition authority. T h e c o m p a ny h a d b e e n a c c u s e d o f p r i ce c o l lu s i o n w i t h t h e t wo o t h e r b i g pharmaceutical companies in the country. The reason given by the Chairman (also the controlling shareholder of the company) for not informing independent directors about the agreement, was the lack of confidence he had in them. He argued that because of their relationship with some other companies from the pharmaceutical industry related to the collusion case, independent directors should not be trusted. The Securities Regulator imposed a fine on the Chairman, as well as to all the individual members of the board due to their passivity on satisfying their obligation to be informed. The board was partially replaced, with all the members elected by the Chairman, including him, stepping down. Top managers were also replaced. Subsequently the Chairman sold the company.

iii) Remuneration of the board

● La Polar (2006): One AFP proposed a new compensation scheme for the board, where earnings would be shared with the board only if profits had reached a minimum threshold that would provide for adequate return for shareholders. It also contemplated that additional compensation should be paid to directors closely related to the management of the company, with a performance evaluation process for the board. It also included stocks options with the restriction of not selling them for a two year period. The proposal was approved with almost 90% of votes and the support of the rest of the AFPs.

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II.3. CHILE: THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE

shareholders owning almost half of the issued shares. This has allowed co-ordination and

collective engagement to go even beyond the few areas where the law encouraged it, in

many cases with positive consequences for the whole market. Many factors have wrought

this outcome, from policy design to controversial cases, but all demonstrating that

institutional investors may have a role to play even in concentrated and small markets.

The influence of institutional investors in the behaviour of domestic companies is well

documented by papers and reflected in real cases, perhaps showing that the criticism about

investor passivity that rose after the recent financial crisis is not applicable worldwide.

However, many of those same criticisms are entirely applicable with respect to the foreign

investments of Chilean pension funds. There, the short-term focus, the lack of interest on

voting and the focus on benchmarks rather than on company performances, are all true.

In terms of compliance with Principles II.F and II.G, Chilean laws and regulations

broadly meet the standards considered for institutional investors. This is particularly clear

in the case of pension funds, both in the text of the rules and in the practices. In the case

of insurance companies, mutual funds and investment funds, perhaps due to lack of closer

attention in the past, the rules and regulations are still insufficient, but many are going

through upgrading exercises or have been targeted for future amendments.

In sum, Chile has been successful in crafting rules and special powers for institutional

investors that meet their unique market and corporate structure.

Notes

1. Sections 3.1.1 to 3.1.3 of the report are mostly extracted from OECD (2010), Corporate Governance in Chile, OECD Publishing, available at http://dx.doi.org/10.1787/9789264095953-en, which was prepared as part of the process of Chile’s accession to OECD membership.

2. Pension funds buy investment funds as a way to increase their exposure to high yield assets (mostly shares) when they reach the limit for direct investment, as defined for the portfolios types in the regulation of pension fund investments.

3. Under the 2009 Corporate Governance Law, independent directors who previously could be elected only by minority shareholder votes are now defined in relation to economic and relational criteria, and may be elected by the votes of all shareholders. It is important to note that independent directors elected with the support of institutional investors have the same rights and obligations as any other member of the board, and by no mean should they give any information to them which is not simultaneously available for the rest of the shareholders or even for the market.

4. The 12.5% share necessary to elect a board member applies to boards with seven directors, the minimum number required by law. Some corporations voluntarily have larger boards, in which case a smaller percentage of votes is required.

5. OECD (2010).

6. Autonomous pension fund directors are defined in relation to economic criteria. Their independence is also reinforced by requirements that board members cannot serve in the legislature or as Ministers or deputy chiefs of public services during the 12 months following departure from their board position.

7. Circular 1869.

References

Agosín, M. and E. Pastén (2003), “Corporate Governance in Chile”, Working Papers No. 209, Central Bank of Chile.

Braun, Matías and Ignacio Briones (2007), Chapter 6: “Development of the Chilean Corporate Bond Market”, Bond Markets in Latin America On the Verge of a Big Bang?, MIT Press, Cambridge, Massachusetts.

THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE © OECD 2011108

http://dx.doi.org/10.1787/9789264095953-en

II.3. CHILE: THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE

Cuprum AFP (2007), “Políticas de Gobierno Corporativo: Aumentando el Valor de los Fondos de Pensiones”.

Dyke, A. and Luigi Zingales (2004), “Private Benefits of Control: An International Comparison”, Journal of Finance, Vol. LIX.

Hormazabal, S. (2010), “Gobierno Corporativo y Administradoras de Fondos de Pensiones (AFP). El Caso Chileno”, Working Paper No. 10/05, Research Department, BBVA.

Iglesias, A. (2000), “Pension Reform and Corporate Governance: Impact in Chile”, ABANTE 3(1): 109-141.

Larrain, B., M. Donelli, and F. Urzúa (2010), “Ownership dynamics with large shareholders: An empirical Analysis”, available at www.faceapuc.cl/personal/blarrain/papers/ownerdynamics.pdf.

Larrain, G. and Vicente Lazen (2008), “Financial Markets in Latin America: Convergence and Integration – The Case of Chile”, Center for Financial Stability Working Paper No. 25, July 2008.

Lefort, F. and Eduardo Walker (2000), “Ownership and Capital Structure of Chilean Conglomerates: Facts and Hypotheses for Governance”, Abante, Vol. 3, No. 1, pp. 3-27.

Lefort, F. and Eduardo Walker (2000b), “Gobierno corporativo, protección a accionistas minoritarios y tomas de control”, Documentos de discusión, Superintendencia de Valores y Seguros de Chile, Santiago, Mayo de 2001.

Lefort, F. and Eduardo Walker (2002), “Pension Reform and Capital Markets: Are There Any Hard Links?”, Social Protection Discussion Paper Number 0201, World Bank.

Lefort, F. and Eduardo Walker (2003), “Chilean Financial markets and Corporate Structure”, www.bcra.gov.ar/pdfs/eventos/Walker1.pdf, accessed in September 2007.

Lefort, F. and Eduardo Walker (2007), “Do Markets Penalize Agency Conflicts Between Controlling and Minority Shareholders? Evidence from Chile”, The Developing Economies, Vol. 45, pp. 283-314.

Lefort, F. and Francisco Urzúa (2008), “Board independence, Firm Performance and Ownership Concentration: Evidence from Chile”, Journal of Business Research, Vol. 61, Issue 6, pp. 615-622.

Lefort, Fernando (2003), “Gobierno Corporativo: ¿qué es? y ¿cómo andamos por casa?”, Latin American Journal of Economics No. 120.

Lefort, Fernando (2007), “La Contribución de las Administradoras de Fondos de Pensiones al Gobierno Societario de las Empresas Chilenas”, www.afp-ag.cl/estudios/EstudioFL.pdf.

Lüders, Rolf J. (1991), “Massive Divestiture and Privatisation: Lessons from Chile”, Contemporary Policy Issues, Vol. 9.

McKinsey & Company (2007), “Potenciando el Gobierno Corporativo de las Empresas en Chile”.

Morales, Marco (2009), “Determinants of Ownership Concentration and Tender Offer Law in the Chilean Stock Market” Superintendencia de Valores y Seguros, Serie de Documentos de Trabajo, No. 1, 2009, available at www.svs.cl/sitio/publicaciones/doc/Serie%20de%20documentos/morales.pdf.

Nenova, Tatiana (2003), “The Value of Corporate Voting Rights and Control: A Cross Country Analysis”, Journal of Finance Economics, No. 68, pp. 325-351.

OECD (2004), OECD Principles of Corporate Governance, Paris.

OECD (2011a), Corporate Governance in Chile, Paris.

OECD (2011b), Strengthening Latin American Corporate Governance: The Role of Institutional Investors, OECD Latin America Corporate Governance Roundtable, Paris.

SP Superintendencia de Pensiones (2011a), “Informe de asistencia y participación de las administradoras de fondos de pensiones en juntas de accionistas, juntas de tenedores de bonos y asambleas de aportantes de fondos de inversión, nacionales”, several years, available at www.safp.cl/573/propertyvalue-1848.html.

SP Superintendencia de Pensiones (2011b), Centro de Estadisticas, available at www.spensiones.cl/ safpstats/stats/.sc.php?_cid=46.

SVS Superintendencia de Valores y Seguros (2011a), Estadísticas del Mercado Asegurador, available at www.svs.cl/sitio/estadisticas/seg_mercado.php.

SVS Superintendencia de Valores y Seguros (2011b), Estadísticas del Mercado de Valores, available at www.svs.cl/sitio/estadisticas/valores_vision_archivos.php.

World Bank Data (n.d.):

THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE © OECD 2011 109

http://www.faceapuc.cl/personal/blarrain/papers/ownerdynamics.pdf

http://www.bcra.gov.ar/pdfs/eventos/Walker1.pdf

http://www.afp-ag.cl/estudios/EstudioFL.pdf

http://www.svs.cl/sitio/publicaciones/doc/Serie%20de%20documentos/morales.pdf

http://www.safp.cl/573/propertyvalue-1848.html

http://www.spensiones.cl/safpstats/stats/.sc.php?_cid=46

http://www.svs.cl/sitio/estadisticas/seg_mercado.php

http://www.svs.cl/sitio/estadisticas/valores_vision_archivos.php

II.3. CHILE: THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE

“Market capitalization of listed companies (% of GDP)”, http://data.worldbank.org/indicator/ CM.MKT.LCAP.GD.ZS/countries/CL?display=graph, accessed February 2011.

“Listed domestic companies”, http://data.worldbank.org/indicator/CM.MKT.LDOM.NO/countries/ CL?display=graph, accessed February 2011.

“Stocks traded, turnover ration %”, http://data.worldbank.org/indicator/CM.MKT.TRNR/countries/ CL?display=graph, accessed February 2011.

THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE © OECD 2011110

http://data.worldbank.org/indicator/CM.MKT.LCAP.GD.ZS/countries/CL?display=graph

http://data.worldbank.org/indicator/CM.MKT.LDOM.NO/countries/CL?display=graph

http://data.worldbank.org/indicator/CM.MKT.TRNR/countries/CL?display=graph

The Role of Institutional Investors in Promoting

Good Corporate Governance © OECD 2011

PART II

Chapter 4

Germany: The Role of Institutional Investors

in Promoting Good Corporate Governance

This chapter on Germany describes the structure of institutional investors both domestic and foreign. It then outlines shareholder rights and how institutional investors make use of such rights, including via voting, and to monitor their investee countries. The regulatory framework under which they operate is outlined and a study reported on shareholder turnout at annual meetings of German companies.

111

II.4. GERMANY: THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE

Institutional investors, their role, powers, and organisation have been a controversial issue in Germany. Indeed, at some times there has been outright hostility to some such

as following the Deutsche Börse affair and another private equity transaction when they

were famously characterised as “locusts”. At the same time, it is important to note that

financial institutions such as insurance companies and banks have always had an

important role in Germany. Despite this rhetoric, the role of institutional investors,

especially in the larger German companies has increased markedly in recent years

raising a number of policy issues.

This review first outlines the corporate governance framework and landscape before

documenting the situation of institutional investors. The following section discusses

shareholder rights and how institutional are acting within this framework and the OECD

Principles. A final section sets out conclusions.

4.1. The corporate governance landscape

4.1.1. Market concentration and control

Control of corporate Germany has evolved rapidly in the last ten years with an

unwinding of cross shareholdings and the phasing out of voting caps and multiple voting

rights that often underpinned corporate control. Germany for many years was

characterised by extensive cross holdings especially by Deutsche Bank and Allianz

insurance leading to the characterisation of Germany as a corporativist system (labelled by

some as Deutschland AG). Bank borrowing was a significant source of corporate finance

during the 1950s and the 1960s. In addition to their direct shareholdings, banks were also

able to vote shares that they held on behalf of clients since they acted as depositories. Their

own management also served on the supervisory boards of numerous companies.

However, changes in capital gains taxation in 2002, higher capital requirements for banks

and the implementation of new insider trading laws have led to a substantial unwinding of

cross holdings in the last ten years. The presence of bankers as board members has also

declined and they now emphasise that they are acting in a personal capacity. Since 1998

depositaries also need explicit approval to vote shares held as a custodian. Deutschland AG

in its traditional form with numerous cross holdings and shared non-executive

directorships and retiring CEOs routinely becoming chair of the Supervisory Board is very

much becoming a thing of the past.

The ownership structure of German listed companies has now become quite dualistic

with a number of enterprises still under tight control but others now have a broad

ownership base. Table 4.1 indicates that many enterprises are characterised by large block

holders: the median largest voting block is over 50% for the 20 largest companies and on

par with Italy. Family wealth is also important with 20% of total stock market capitalisation

controlled by the ten richest families. Families have traditionally established foundations

through which to exercise their ownership rights. Pyramid ownership remains prevalent

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II.4. GERMANY: THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE

among such companies allowing a dominant shareholder to exercise control of one

company through the ownership of another. However, the largest listed companies are

quite different and are characterised by a very high free float1. Indeed, the free float of the

largest 30 companies comprising the DAX increased from 64.5% in 2001 to over 80% in 2010

(DAI, 2010). The top ten companies dominate the equity market accounting for a third of

the market capitalisation. Of these, half have a very high free float: Allianz SE and Munich

Re had free floats of 100% and 90% respectively and Siemens, 95%.

4.1.2. Corporate law and company practices

Germany has a two tier board system with the management board (MB) appointed by

a supervisory board (SB) which does not include any representatives of management. The

MB is appointed for a fixed term (usually five years although the German code

recommends an initial appointment of only three years) and they can only be removed

for cause by the supervisory board. German takeover law grants the MB the right to

interfere with takeover attempts allowing four different types of defensive measures.

While some of these measures require shareholder approval, the MB with the approval of

the SB may also use specified defensive measures without ad-hoc shareholder approval

(if shareholders have approved previously actions for the eventuality of a future

takeover), including the purchase or sale of important assets.2 In any case, uninvited

takeover attempts have been rare until recently due in part to the difficulty of being able

to change the two boards.

An issue that has been taken up by institutional investors concerns “creeping control”

(Porsche/VW, Schaeffler/Continenetal) that involved purchases in excess of the 3% and 5%

threshold. Investors and companies called for enhanced reporting requirements to cover,

for example, cash settled options. A change was enacted in April 2011. Another weakness

recently applied in takeover cases is applying the law to raise control status cheaply after

the initial hurdle of 30%, through avoiding to make a “mandatory offer” by making a

“voluntary offer” when the stake is still below 30%. Companies can increase their stake

further by buying additional shares on the open market without regard to the price of the

“voluntary offer” and a control premium until the next disclosure threshold of 50%

ownership.

The law mandates that Supervisory Boards in large companies (more than

2 0 0 0 e m p l oye e s ) comprise a half labour representation (including three union

representatives) but only one third in companies with between 500 to 2 000 employees.

They are elected directly and not by shareholders. As a result, the SB are usually large

Table 4.1. Ownership concentration Percentage

Widely held Family control Pyramid control Median largest voting block Family wealth

France 60 20 15 20 29

Germany 50 10 20 57 21

Italy 20 15 20 55 20

United Kingdom 100 0 0 10 6

United States 80 20 0 5 (NYSE) n.a.

9 (NASDAQ)

Source: Jurgen Odenius (2008), “Germany’s Corporate Governance Reforms: Has the System Become Flexible Enough?” IMF Working Paper WP/08/179, International Monetary Fund.

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II.4. GERMANY: THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE

ranging from 12 to 21 depending on company capital. How the SB functions has been the

object of long debate. Some observe that half the board representing the shareholders

(including the chair who has a casting vote) usually meets in the morning to discuss

company affairs separately. In the afternoon, the full board meets with more an

emphasis on labour issues. Executive compensation used to be dealt with by the

shareholder part of the board but since last year the whole board bears responsibility,

shifting the balance of influence significantly. Finally, the need to ensure labour

representation has prevented law makers from establishing requirements for

professional skills for board members.

The role of the work force in the operation of a company is more significant than is

indicated by representation on the SB. Works Councils have an important role including in

the extensive training system. As a result, one observer argues that management of

German companies is in continuous negotiation with employee representatives but that

the system suits the innovation system and the emphasis on high quality manufactured

products (Goyer, 2006). The normative model of the all powerful CEO does not hold. It is

thus hardly surprising that German managers emphasise that companies belong to

stakeholders and place a great emphasis on job security.3

There is a new option for companies to register as Societas Europeae (SE) which gives

them the option to choose between a two tier or one tier board system. The larger German

companies that have chosen to take the SE form have retained the two tier system. The SE

allows, regardless of the number of employees, a reduction in the number of SB members

to 12 thus making the board more efficient. Since the representative of the employees must

reflect the company’s international operations, it also increases the international

representation of the workforce. With these features, it is no surprise that Germany has the

most SE incorporations in the EU.

In addition to company law, there is also a German corporate governance code (Kodex).

Companies have to declare annually the “shall recommendations” with which they comply

and explain any deviations. The Kodex makes important recommendations concerning

shareholder rights (see below).

4.2. Institutional investors As noted above, Germany has a long history of significant direct shareholdings in non-

financial companies by the banking and insurance sectors as well as established corporate

groups and pyramids. This is illustrated in Figure 4.1 by the high level of holdings by non-

financial institutions, banks and insurance with a total share of around 55% of domestic

equity. Of the institutional investors, investment companies are the most important with

about a 10% equity share. Retail ownership both directly and indirectly has declined from

in any case a low base and accounted for only 13% of the population in 2010, and around

10% of equity (Rúdiger von Rosen, 2010). At the same time, there has been significant

inflows of equity investments from foreign institutional investors, apparently

predominantly pension funds rather than mutuals although alternative investments such

as hedge funds have also been active at times (Maurer, 2003). Foreign ownership increased

from around 14% in 1999 to nearly 30% in 2007. It was still the second lowest in Europe after

Italy (FESE, 2008). However, Figure 4.1 is misleading since it refers to the entire listed sector.

For the thirty companies comprising the DAX, institutional investors (foreign and

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II.4. GERMANY: THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE

domestic) own 70% of the outstanding shares and foreign ownership now exceeds 50% in a

number of them. The policy interest in the question of institutional investors and their

engagement is thus easy to appreciate.

Banks and insurance companies also act as depositories and have in the past often

been able to vote a large proportion of privately held shares. There are special rules

pertaining to the exercise of voting rights by credit institutions and professional agents

when acting as a proxy agent. According to the law (Article 135 Aktiengesetz), a credit

institution may only exercise voting rights attached to shares it does not hold (i.e. they

are not in the share registry of a company) only if it has been authorised to do so by

proxy. A credit institution which intends to exercise the voting rights of a proxy shall

make available in a timely manner to the shareholder its own proposals for the exercise

of the voting right with respect to individual agenda items. The voting power of

depositaries was evident during the HP and Compaq takeover battle where the voting

power of Deutsche Bank was said to have been crucial. The new German Shareholders

Rights Act (Gesetz zur Umsetzung der Aktionärsrichtlinie, 2009) adapts the proxy voting

powers of banks (Depotstimmrecht) and makes it more attractive for shareholders to

grant proxy voting powers to them as well as to Shareholder Protection Associations

(see below).4

The mutual fund is the most common type of investment fund in Germany. They are

run by an investment management fund company (KAG) that is typically owned by a

commercial bank or insurance company. The companies rather than the individual funds

are subject to a comprehensive legal framework to protect investors’ rights under the

Investment Act (Investmentgesetz). The incorporated KAGs are required to have a

supervisory board that has to represent the interests of the fund clients. It is, however,

debateable whether Article 9 of the law that requires the company to act in the sole interest

of the customer and the integrity of the market, includes the duty to exercise ownership

rights as there are only a few legal cases concerning liability for mismanagement of

investments. Article 32 of the Investmentgesetz states that institutional investors “should”

Figure 4.1. Equity holdings by all types of investors

Source: Deutsche Bundesbank (2011), Time series database, available at www.bundesbank.de/statistik/ statistik_zeitreihen.en.php.

Individuals

Public sector

Banks

Investment companies

Insurance

Foreign investors

Non-finance

1991 1993 1995 1997 1999 2001 2003 2005 2007 2009

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http://www.bundesbank.de/statistik/statistik_zeitreihen.en.php

II.4. GERMANY: THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE

(i.e. it is not mandatory) exercise their shareholder rights “themselves” which some

observers believe implies a duty to vote, except in certain circumstances. Some observers

feel that it is this clause that has led to most investment funds voting their domestic

shares. By January 2011 investors could choose between 6 668 mutual funds which were

managed by 51 investment management companies (KAG and their Luxembourg

subsidiaries). The largest KAG’s are DWS Investment (a subsidiary of Deutsche Bank with

assets under management of EUR 135 billion), Deka Investment (asset manager of

the German savings banks, AUM EUR 103 billion) and Union Investment (subsidiary of the

co-operative DZ Bank, AUM EUR 86 billion). A fund is managed on the basis of a

management contract by the investment management company and the unit holders.

Although such funds have expanded, their world market share has tended to decline, one

reason advanced being that in Germany there are no tax benefits for long term savings

with mutual funds.

With predominant ownership of investment management companies by financial

institutions, there are clear potential conflicts of interest between the KAG’s and investors.

This issue is dealt with in part by regulation with respect to fund management companies

but also until recently in great measure by the investment managers’ BVI code of conduct

(i.e. quasi self-regulation) (Box 4.1). German fund management companies have not been

generally required to disclose their overall corporate governance policies and voting policy

with respect to their investment (Principle II.F.1). Moreover, they have not been required to

disclose how they handle conflicts of interest (Principles II.F.2). These requirements were

handled by self-regulation of the industry (Box 4.1) that also encourages the exercise of

ownership rights as a duty of investors. However, since January 2010, the German financial

markets regulator (BaFin) uses Part 1 of the BVI code (When performing its functions, the

investment company (KAG) acts exclusively in the interest of the investors and the integrity of the

market … The investment company endeavours to avoid conflicts of interest…) for interpretation

purposes of the legally defined rules of conduct of the Investmentgesetz. Compliance with

Part I of the BVI rules is verified by the auditor of the management company/ investment

company who has to outline in its report to the regulator whether companies have

considered the BVI rules. If an infringement is reported, the BaFin can order a special audit.

From July 2011 investors will have access to a great deal of the audit report. Germany is also

in the process of implementing the EU UCITS Directive in 2011 (see Section 1.3 above)

which requires significant disclosures to the public concerning the use of voting rights and

the management of conflicts of interest.

Part I of the BVI code also sets out to limit churning with the object to increase fees

(a strong criticism of funds in other jurisdictions) and also specifies some governance

arrangements in the voluntary Part II. In particular, the investment company supervisory

board should have at least one member independent of the owners of the investment

company. While there are other laws specifying fiduciary type duties of the supervisory

board members, the requirement of only one independent board member is fairly minimal,

especially compared with the SEC (Rule ICA 26520) that effectively requires a 75% majority

of independent directors as well as an independent chairman of the board. Moreover, in

contrast to German law, audit and nominating committees have to consist entirely of

independent directors.

The level of compliance with the voluntary code in the past is not known with any

certainty but as noted above Part I is now mandatory. A number of market participants

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II.4. GERMANY: THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE

believe that compliance has been minimal with very few publishing their proxy voting

policy and only one having a significant number of independent board members on their

supervisory board and thus going beyond Part II of the BVI Code. The code is also less

ambitious than another proposed in 2005 (German Working Group, 2005).5 In sum,

Principles II.F.1 and II.F.2 are probably only partially implemented as at mid 2011 but this

will change with the implementation of UCITS.

The OECD is aware of only one study about practices of institutional investors: a DSW

survey of 2008. However, only 25 fund managers are said to have responded. However, 80%

replied that they had fund guidelines which included important corporate governance

aspects. Some 40% exercised votes on German shares of 80 to a 100% and a further 40% of

between 60-80%. When asked what were the main reasons for the non-execution of votes

for German and foreign shares, 50-60% of respondents replied that they did not have

enough time, and that costs and administrative efforts were too high. Over half the

respondents exercised less than 20% of their foreign voting rights in 2007.

Domestic pension funds are much less developed in Germany than in many other

countries since pensions have been met traditionally by the budget on a pay-as-you go

basis and by companies setting aside book reserves. However, since 2001 a new funded

system of supplementary pensions has been in force. The new pensions accounts are

offered by regulated financial institutions such as investment management companies,

banks and insurance companies. Insurance company assets are much greater than those

for investment funds with classical pension funds quite small.

Although mutual funds predominate there are many different investment strategies

ranging from indexed funds to actively managed funds. There are also funds focused on

special issues such as the environment and some funds also follow the UN’s Principles for

Responsible Investment. Cutting across these various investment strategies is the question

of investment horizon: being mutual funds, are they more short term than it is alleged is

the case with pension funds.6 The OECD is not in a position to make a judgement on this

complex issue since it lacks turnover data which, as discussed in Part 1, is only at best a

poor proxy for investment horizon.

Box 4.1. Voluntary code of conduct of the German Association for Investment and Asset Management

The voluntary code seeks to establish a governance framework for the industry. As such it deals with issues such as valuation of funds and performance reporting. From the governance perspective, the most important provisions are:

● Part I. When performing its functions, the investment company (KAG) acts exclusively in the interest of the investors and the integrity of the market. This aims at controlling price manipulation and the use of insider information. The principle states that the investment company exercises the shareholder and creditor rights of assets of the individual funds independently of the interests of third parties, including a depositary bank and affiliated enterprises. The independent exercise of voting rights also applies in respect of recommendations made by the investor of a special fund.

II.4. GERMANY: THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE

4.3. Exercise of shareholder rights This section reviews what is known about the actions by institutional investors, both

domestic and foreign. The most observable action is voting but this says in itself little about

the quality of company monitoring and about direct consultations with companies.

4.1.3. Shareholder rights

The potential role of shareholders and of institutional investors is constrained by

corporate law. Indeed, even a controlling shareholder who wants to alter the business

model has great difficulty, because they have first to change the SB which then changes the

management board. This also makes takeovers very difficult and in some cases several

years may be required to exercise control over a target company. There are, however,

significant powers for shareholders as a class and a number of key areas where they can

make their influence felt in rejecting company actions.

Shareholders have always had strong pre-emption rights but rights in general have

been reinforced more recently. A 1998 law implemented the one-share-one vote doctrine

and phased out voting caps and shares with multiple voting rights that were previously

held by insiders to buttress their control. This was welcomed by institutional investors. The

authorities implemented a Ten Step Program during 2003-2005, the core of which were

measures to improve the protection of minority shareholders by enhancing transparency

and disclosure, limiting the scope for market manipulation and increasing the liability of

the management and supervisory boards. Transparency was also aided by the disclosure of

substantial voting rights in a more detailed way.

Box 4.1. Voluntary code of conduct of the German Association for Investment and Asset Management (cont.)

● Part I. The investment company endeavours to avoid any conflicts of interest. By implementing appropriate organisational measures, the investment company ensures that risk of conflicts of interest between the company and third parties is kept to a minimum. Potential conflicts of interest include incentive systems for employees, reallocation of investments between funds, transactions between the company and individual funds and frequent trading. The investment company must establish procedures which are suitable to; identify circumstances giving rise to conflicts of interest; and to resolve such conflicts paying due regard to the protection of the interests of the investors and/or investment undertakings. Of particular importance, for the funds managed by a company, there will be suitable procedures to avoid excessive transactions costs as a result of inter alia, excessive turnover. Transactions which merely serve to generate additional fees are not permissible.

● Part II. The supervisory board and management of the investment company will work towards good corporate governance on the investment company. The two boards may not pursue their own interests and the supervisory board will ensure that the management have appropriate risk management and control. The supervisory board shall have at least one member who is independent of the owners, their affiliated companies and the business partners of the investment company.

Source: German Association for Investment and Asset Management (BVI), www.bvi.de, draft translation

http://www.bvi.de

II.4. GERMANY: THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE

Class actions regarding management liability (i.e. claims brought in the name of an

unknown group of claimants) are not permitted although there has been some recent

easing of the law. Thus the only redress available to shareholders until recently involved

derivative law suits, requests for a special audit and requests to the regulator for an

investigation. These are all collective rights. A single shareholder cannot file suit in the

name of the company, however minorities representing more than 10% of share capital can

launch a suit. Special meetings of shareholders can be called by shareowners owning an

aggregate of at least 5%. Shareowners with a minimum of 20% or 500 000 euro of nominal

share capital can require that items be included in the published meeting agenda. All

significant company transactions such as mergers and acquisitions must be approved by at

least 75% of those present: 25% represents a blocking minority. Around 80% of German

companies have at least one shareholder controlling more than 25%. The German system

of shareholder protection puts less emphasis on management liability claims by

shareholders and more on contesting decisions of the Annual General meeting. A single

shareholder with a single share is able to appeal against an AGM decision in court and can

have it stopped. This powerful right has led to some misuse by such shareholders.

A key area of concern for minority shareholders including institutional shareholders

is conflict with large shareholders due to self-dealing. According to company law, the

control of such transactions is the responsibility of the supervisory board. In the case of

companies controlled by another, German company law (Konzernrecht) regulates conflicts

between minority and large shareholders and requires SB approval for specified self-

dealing transactions. However, Baums and Scott (2003) and others question whether SBs

have the requisite independence to effectively control self-dealing, especially in the case of

dominant owners. Independent SB members comprise only 22% of boards compared with

the European average of 43% (Heidrick & Struggles, 2011) Shareholder approval of self-

dealing transactions is absent under German law. An annual report detailing such

transactions is shared with the SB but is not shared with shareholders.

Institutional shareholders have also expressed concern about the lack of shareholder

consent for significant measures such as takeovers, disposals and reorganisations. This

has arisen after the co called Gelatine decisions of the high court (Bundegerichthof) that

requires a very substantial (say 80%) change in company assets to necessitate shareholder

approval. A significant example that was taken up by institutional investors was the 2006

takeover of a large pharma company Schering by Bayer for EUR 17 billion, two thirds of its

own market capitalisation. This major strategic change did not require the consent of

shareholders.

According to German law, shareholders are to be treated equally under equal

circumstances. The courts and jurisprudence have recognised a fiduciary duty of

shareholders both vis-à-vis the company and between each other to complement the

principle of equality. In general terms, under the concept of fiduciary duty, shareholders

have to use their ownership rights in such a way that they contribute to the corporate

purpose. Indeed, they should refrain from all acts that run contrary to the corporate

purpose: they may not use their rights in a way to severely damage the company or

jeopardise measures to rescue the company in a severe crisis. Whenever they exercise their

individual rights, they may not do so in an arbitrary or disproportionate way and have to

take into consideration the rights of other shareholders. The breach of these duties may

lead to liability or to the loss of voting rights. This is a potential barrier to more activist

investors such as some hedge funds.

II.4. GERMANY: THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE

The German Corporate Governance code first published in 2002 and last amended in

2010 stresses the need for transparency and clarifies shareholder rights. Moreover, the

code’s “comply or explain” concept helps to foster transparency by requiring an

explanation from those companies not complying with provisions of the code. An

important power available to shareholders is the need for the SB and MB to seek a

discharge from shareholders for the annual accounts. Dissatisfied shareholders have often

sought to raise pressure on the boards by seeking to reject the discharge (see below).

Since 2010 German companies are required to make detailed remuneration

disclosures and may propose an advisory vote on remuneration policy at the AGM which

ensures full accountability of the supervisory board. Almost all major companies (DAX 30)

introduced such votes in 2010 and even went so far as to hold discussions with major

institutional shareholders. Some institutional shareholders have said that they would also

seek the appropriate quorum to put the item on the agenda as shareholders (Manifest

Information Services, 2010).

In sum, shareholder rights that may be of concern to institutional investors differ from

those in other countries especially with the small role of the market in corporate control.

Whether institutional investors can make use of the existing opportunities will depend in

part on limits to co-operation to reach threshold voting levels, discussed below.

4.3.2. Shareholder co-operation

In view of extensive block shareholdings in smaller German companies and the very

large size of others, and the need to obtain critical thresholds for certain shareholder rights

(see above), it is important for institutional shareholders to be able to co-operate. This has

to be done very carefully so as to avoid being judged to be acting in concert that requires a

mandatory bid for the company. To indicate what is involved, the recent case of Infineon

might be typical. The “initiator” was a foreign fund (Hermes) which wished to initiate

action in a company in long term decline by voting against its Chairman. After consulting

legal counsel, it avoided contact with other institutional investors but published what it

was intending to do in the hope others would join.

Acting in concert has been defined under German law as “co-ordinating conduct on

the basis of an agreement or in a similar manner”.7 Sections 30 and 35 of the German

Takeover Act (Wertpapiererwerbs- und Übernahmegesetz, WpÜG) describe the consequence

that a mandatory offer has to be made if the votes of parties acting in concert exceed 30%.

Agreements on the exercise of voting rights in individual instances (“Einzelfälle”) are

excluded from the definition.8 In addition, case law has emerged laying down additional

criteria to clarify this legal definition of acting in concert. In a landmark case (Pixelpark

Aktiengesellschaft), the Higher Regional Court of Frankfurt held that the serious legal

consequences of acting in concert demanded further clarification and developed the

following criteria:9 parties are acting in concert if they co-ordinate their behaviour with the

objective to exercise voting rights in a co-ordinated and continuous manner and to exert

enduring (“nachhaltig”) influence. In 2006, the Federal Court of Justice provided for further

clarification (Münchener Rückversicherungs-Gesellschaft AG) construing the legal

definition of acting in concert narrowly.10 It held that only co-ordinated behaviour relating

to the exercise of voting rights during the AGM can amount to acting in concert. Many

activist investors expressed concern about whether co-operation that is allowed in other

jurisdictions might nevertheless be interpreted as acting in concert in Germany, and

II.4. GERMANY: THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE

therefore either be illegal and /or require a mandatory bid for the company, depending on

the voting power of the “group”.

In response to uncertainties, the German federal government modified the concept of

acting in concert with the Risk Limitation Act (Risikobegrenzungsgesetz), the voting rights

sections of which came into force on 1 March 2009.11 The law envisages the following

definition of acting in concert: concerted actions in a manner suitable to influence the

corporate strategy (i.e. business model) permanently or substantially. Contrary to what was

contemplated in the original draft, shareholders co-ordinating their conduct in individual

cases continue to fall outside the scope of acting in concert. Jointly exercising influence on

issuers does not per se constitute acting in concert, as long as it is limited to specific

individual cases (Einzelfälle). Where the parties acting in concert are deemed to hold more

than 30% of the voting rights, a mandatory bid offer must be launched. Any party holding

over 10% of the voting rights must declare the source of their financing and their intentions

with the investment such as whether they intend to influence the appointment of directors

and members of the supervisory board.12 This is similar to the SEC’s schedule 13d.

Disclosure is also mandatory on voting rights emanating from financial instruments

(threshold of 5%). However, scandals relating to Porsche and Schaffler where cash options

were used to build up undeclared positions indicate significant loopholes. A suspension of

voting rights for six months is required for intentional violations; a lengthy period is

foreseen as an enforcement mechanism. The draft bill met with considerable opposition

and it remains to be seen whether legal uncertainties will serve to reduce shareholder co-

operation. A number certainly remain cautious. In sum, Germany has broadly

implemented Principle II.G even though it might be limiting.

4.3.3. Use of proxy advisors

The larger fund management companies and specialised ones that run individual

funds have their own resources for monitoring companies. However, they are increasingly

using a number of external proxy agents, the largest being ISS with domestic competitors

such as IVOX. It is believed that in some cases investors have provided the proxy agents

with their own corporate governance guidelines against which to judge recommendations.

In response to the OECD questionnaire, the German authorities stated that there are

estimates that 80% of foreign institutional investors follow the advice of shareholder

service companies. It is not known the extent to which Principle V.F is implemented: the

provision of advice is free from material conflicts of interest that might compromise the integrity of

their analysis or advice.

4.3.4. Dialogue with companies

According to market participants, a number of larger domestic institutional

shareholders and some foreign institutions (particularly British, Dutch, and US) are active

in meeting company representatives and in explaining their positions. In some cases it is

reported that companies have altered their proposed actions. On the other hand, the small

study by DSW does indicate that monitoring is costly.

Several German companies have also been active in seeking institutional investors to

take a significant shareholding (e.g. Daimler). In several cases these are reported to have

been from sovereign wealth funds. Little more is known about relations with these

investors and indeed whether and how they are active.

II.4. GERMANY: THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE

4.3.5. Voting behaviour

Foreign institutions

Information about voting by foreign institutional investors is not readily available

apart that is from controversial cases such as at Deutsche Börse. One study based on a

small sample of 14 large shareholder meetings between 2003 and 2005 concluded that,

relative to their holdings, their voting propensity was only a very small fraction of voting by

domestic entities (as quoted in Zetzsche, 2008). Market participants in Germany believe

that turnout by foreigners is quite low relative to their shareholdings and indeed this

pattern is repeated in other countries. The DSW study (see above) indicates that German

investors are not active in voting their foreign shares.

Domestic voting

Manifest (2011) has undertaken on behalf of the OECD a study of voting at company

shareholder meetings. Almost 50% of German companies now disclose details of

abstentions, a significant improvement on the prior year. The absence of abstention data

in respect of voting at meetings impedes an informed analysis of the true level of dissent,

particularly given that the stated policies of some German investor organisations include

an escalation strategy which explicitly provides for abstention votes as one of a series of

steps that should be used by investors to highlight concerns. Based on Manifest’s

experience, meeting minutes containing the voting results are often published in German

only with no English translation.

4.3.6. Turnout

Participation levels at shareholder meetings steadily declined in the early part of this

decade, but the introduction of the record date in 2005, as well as other measures to

facilitate the exercise of voting rights, has helped contribute to a resurgence in turnout.

This increase is believed to be attributable in part to some foreign institutional investors

who started voting at German general meetings after the introduction of the record date in

Germany in 2005. Foreign ownership in DAX30 companies has breached 50% in recent

years and was one reason for the introduction of the record date by the authorities.

Research by Manifest has shown that the number of German fund managers

exercising their voting rights on domestic shares has increased dramatically, with the

reasons given for the non-execution of votes being high costs/administrative expenses and

time pressure.

A significant proportion of German blue-chip companies include large blockholders

which boosts average turnout levels. The turnout figures show a reasonably healthy level

of participation by shareholders – Germany is a solid “mid table” in terms of global turnout

figures, and is towards the stronger turnout levels within Europe.

It is impossible to judge from meeting poll data the degree to which domestic

shareholders vote their shares more than foreign shareholders, if at all. It may also be quite

impossible for issuers to be able to tell either, due to the lack of transparency of ownership

which prevails within and between the various levels of intermediation that exist between

owners and issuers especially in the cross-border context. The names that appear on their

share register are very different from the actual underlying shareholders.

II.4. GERMANY: THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE

Improvement to turnout figures may be partly challenged by the legacy of previous

practice. Whereas there used to be a perception of Germany being a “blocking market”,

whereby shares (especially bearer shares) might have been immobilised from trading for a

period of time as a part of the process of registering the shares in order to vote them, this

is by and large no longer the case. However, misconceptions on this may persist, especially

amongst retail investors.

Germany is characterised to an extent by a multitude of small, regionally-based banks

many of whom act as intermediaries in the voting process. In the transition towards voting

by correspondence or proxy, and away from physical participation in meetings, the

demands placed on the role of intermediaries has changed from a relatively passive

registration facilitation role towards one of proxy representation in meetings. Some

smaller, provincial intermediaries have been slow to respond (or slow to receive sufficient

demand to change), meaning some shareholders rightly or wrongly perceive it is not

possible to vote.

Comparing the average turnout for AGMs and EGMs, one must be cautious in making

too many generalisations due to the relatively small number of EGMs in the sample.

German companies tend to hold back on extra-ordinary meeting business until the next

scheduled General Meeting of shareholders. However, the figures do seem to suggest that,

in general, EGMs receive a higher turnout. This is not to suggest that it is easier to vote at

them, but, due to the extra-ordinary nature of the meeting business decided at the

meetings, the cost and difficulty of voting is deemed less problematic by shareholders in

the face of the extra-ordinarily important decisions (such as exceptional capital raisings or

take-overs). This is borne out by the higher dissent levels for such questions in the section

below on management resolutions.

4.3.7. Dissent

Dissent by meeting type

Almost 50% of German companies now disclose details of abstentions, a significant

improvement on the prior year. The absence of abstention data in respect of voting at

meetings impedes an informed analysis of the true level of dissent, particularly given that

the stated policies of German investor organisations include an escalation strategy which

explicitly provides for abstention votes as one of a series of steps that should be used by

investors to highlight concerns.

Table 4.2. Average shareholder turnout is reasonable (April 2009-November 2010)

Event type Number Turnout

AGM 134 64.84

Class 2 26.26

EGM 5 71.50

Total 143 64.52

Source: Paul Hewitt (2011) (representing Manifest Information Services), “The Exercise of Shareholder Rights: Country Comparison of Turnout and Dissent”, OECD Corporate Governance Working Papers, No.3, www.oecd.org/daf/ corporateaffairs/wp.

II.4. GERMANY: THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE

Dissent on EGM resolutions is slightly higher than for AGM resolutions, if still at a very

low average level. This may be explained by the fact that, although such meeting business

is by definition unusual (hence not being treated in quite the same “routine” manner as

may be the case for AGM resolutions), the expense of holding an EGM in the first place

means that business is nevertheless very carefully prepared and choreographed; it stands

to reason that management would not call an EGM (as was the case in all 5 in this sample)

without being confident that shareholders would approve the business they wish to

conduct.

Dissent by resolution type

Manifest analysed average dissent by type of resolution at all of the German meetings

for which they obtained poll data. A number of patterns and observations emerge from the

data. First, with regard to the number of resolutions of each type there is a clear variety.

Perhaps most unusual is the relative lack of Annual Report resolutions. This can be

explained by the fact that only KGaA companies (partnerships limited by shares) are

required to have a vote on the Report and Accounts. Normal listed companies may present

the Report and Accounts without then having a vote.

From an investor perspective, more significant is the “Director’s discharge” resolution,

whereby the directors are collectively (or, more commonly, individually) discharged from

liability in respect of the financial year under review. This helps to explain the fact that the

most common type of resolution in Germany concerns “Director’s Discharge”. The

resolution is an indicator of whether the shareholders agree with the work of the directors

in general. It does not mean a discharge from any liability claims. It is thus a good means

of registering discontent rather than mounting a proxy contest against a sitting member.

Table 4.3 indicates that it is used with sometimes very high levels of dissent

(i.e. considering both the average and a standard deviation of 21%, Table 4.4).

Manifest also analysed the average dissent per resolution type, as well as the standard

deviation for each set of dissent figures. The first gives an indication of the relative

likelihood that shareholders vote against management on particular types of issue. The

standard deviation figure gives an indication of the relative consistency of the level of

dissent (the lower the standard deviation, the more consistent shareholders are in showing

the indicated average level of dissent. With regard to the average dissent levels for each

resolution type, the most conspicuous is shareholder proposals. These are discussed in

more detail below.

Unsurprisingly, remuneration related resolutions are the most contentious in German

meetings. Amongst these resolutions, the most contentious are consistently resolutions

proposing a new remuneration system for the board and frequently for executives. Only

Table 4.3. Shareholder dissent remain low

Event type Dissent (%) Resolutions

AGM 2.95 1 978

Class 17.75 3

EGM 4.45 11

Total 2.98 1 992

II.4. GERMANY: THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE

one resolution in this category was defeated, that of Heidelberg Cement AG whose proposal

to approve the remuneration system for the management board members at their AGM in

May 2010 was defeated with an “Against” vote of 54%.

Remuneration resolutions are also those on which there is most variety in the level of

approval (highest standard deviation). This would suggest that shareholders have reason to

be and are more vocal on remuneration issues.

Whilst less contentious than remuneration resolutions in terms of average dissent,

capital resolutions also had a comparatively high level of dissent and standard deviation

compared to most resolutions. By definition these issues are highly company and investor

specific, touching as they do on the strategic considerations as to how the company’s

finance and ownership is structured, which explains the standard deviation levels.

Director’s discharge resolutions are the most numerous in the sample, and show an

interesting trend in that when shareholders are asked to review and approve the past acts

of board members at an individual level (effectively the consideration for individual

discharge resolutions), they are more critical than when evaluating the future prospects of

board members as represented by their voting on director (re-) elections.

The high standard deviation levels for director discharge levels also seems to suggest

that, alongside remuneration, this type of resolution is the one on which shareholders are

most vocal and consider most on a case by case basis, because of the variety with which

they respond to such resolutions. This might be summarised by saying that shareholders

in German companies are at their most critical when approving the acts of specific

directors in the past and when evaluating the reward structures under which they will

operate in future.

Shareholder resolutions are quite prevalent in Germany because of the practice of

counter-proposals. Any shareholder may submit counter proposals within one week of the

publication of the meeting notice in the Bundesanzeiger. However, the actual counter

proposals are not published in the Bundesanzeiger but are published on the website of the

Company. It is typical for voting on the board proposal to be taken first, with the counter

proposal only presented to the meeting if the board proposal is defeated.

Table 4.4. Shareholder dissent depends on the type of resolution

Resolution type Average dissent (%) Standard deviation (%) Number of resolutions

Shareholder 15.92 20.84 23

Remuneration 6.68 11.22 62

Capital 5.40 7.92 326

Director’s discharge 3.05 8.63 750

Election 2.38 5.09 254

Other 1.36 1.31 4

Articles 0.82 2.89 250

Dividend 0.77 2.43 119

Agreement 0.56 0.73 53

Auditors 0.50 1.54 143

Annual Report 0.19 0.30 7

Grand total 2.98 1 992

II.4. GERMANY: THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE

The majority of the counter proposals are published in German language only and are

not accompanied by an English translation, which can hinder the decision making process

of foreign investors. Those counterproposals which merely reject proposals by the

management and supervisory boards do not appear on the proxy form. If shareholders

wish to vote for these counterproposals they must vote against the respective item on the

agenda.

Some companies identify those counter proposals which not only reject the Board

proposal but put forward a concrete alternative proposal. These counterproposals may

appear on the proxy form, however they are not always actually voted upon at the meeting.

Although many counter proposals relate to trivial matters or personal grievances, the

counter-proposal mechanism does offer some benefits and has been used by institutional

investors in the past to express concern. Most recently it has been used at Infineon in a

dispute over the election of the chair of the Supervisory Board. Counter-motions when

used by institutional investors are seen as an expression of discontent that ranks higher

than votes against management proposals. Given their varied nature, it is not surprising

that shareholder resolutions also display a high level of standard deviation.

4.3.8. Major shareholder voting

The importance of understanding who are the major shareholders in a company is

underlined by the fact that they must be reported to the market. This is done at the time

the major shareholding is established or changes.

However, in the context of meeting results analysis where the holding on a specific

date is key, the publicly available information may not be sufficiently accurate. Companies

disclose in their annual report the major shareholders, either as at the financial year end,

or as at some other date subsequent to the year-end but (obviously) prior to the publication

of the annual report and accounts. This lack of consistency of reported data hinders

meaningful analysis.

Additionally, given that the annual report is subject to approval at an AGM, major

shareholders disclosure becomes a part of the meeting materials and, by definition, is

therefore around two months out of date by the time of the meeting to which it is

purported to relate.

In the absence of the ability to obtain detailed meeting-date share register analysis

from publicly available information, the typical role of major shareholders at corporate

meetings is technically impossible to quantify, though the poll results of some meetings

may offer convincing circumstantial evidence, especially where a major shareholder is a

majority shareholder.

Analysis of German companies and the role of major shareholders is therefore made

very difficult without specific additional disclosure as to how major shareholders have

voted. Disclosure of this kind is, in turn, made very difficult by the lack of transparency

with regard to ownership through a chain of financial intermediaries to the ultimate or

beneficial owner.

4.4. Conclusions In sum, Germany has an important domestic institutional shareholder base as well as

a significant presence of foreign institutions, especially in large companies. Domestic fund

managers appear to have become much more active over the past decade at least in terms

II.4. GERMANY: THE ROLE OF INSTITUTIONAL INVESTORS IN PROMOTING GOOD CORPORATE GOVERNANCE

of voting at shareholder meetings. Moving to a record date for eligibility in 2005 has

certainly underpinned this development and has also stimulated foreign investors. There

have also been a number of occasions when domestic institutional investors have shown

their displeasure with actions being carried out by companies. In the past, such investors

would have been more passive but now it has extended to the first proxy fight over the

supervisory board, rejected agenda items and counter-motions that have been carried at

certain companies (e.g. Heidelberg Cement, Infineon and Siemens). Activist hedge funds

are also active under certain circumstances such as at Porsche and VW.

Nevertheless, it is difficult to form conclusions about the effectiveness and extent of

such engagement since little information is available from fund management companies

about compliance with the BVI voluntary code of behaviour. The code is minimal with

respect to corporate governance arrangements of investment companies but it is now

mandatory in other areas such as engagement, transparency and avoiding excessive

churning of shares. The Code covers the basic elements of Principles II.F.1 and II.F.2 and

with the implementation of the UCITS Directive in 2011 Germany should have fully

implemented these principles. This is important since the potential for conflicts of interest

is present given the ownership of investment companies by banks and insurance

companies.

The governance of fund management companies also needs further attention. The

recommendation of the BVI Code that there be only one member of the supervisory board

independent of controlling shareholders is not sufficient in Germany given the extensive

ownership of institutional investors by banks and insurance companies. Strengthening the

supervisory board should also require an independent audit committee.

The most concerning gap in the institutional structure concerns the engagement with

foreign investments. There are two sides of this. German funds now have significant

investments abroad but their voting behaviour is minimal and other engagement activities

possibly even less. There are of course difficult issues concerning cross border voting and

costs that still need to be resolved including record dates too far in advance of a

shareholders meeting. Nevertheless, other measures might still be needed such as a

revised code of conduct requiring them to vote on their significant foreign investments. On

the other hand, foreign investors are now a significant force in Germany but all the

evidence points to reduced voting behaviour and engagement in comparison with

domestic investors, apart from one or two exceptions. Although this is a more general issue

in the global economy, the German authorities should examine what potential domestic

policy options are available. Among these it would be important to move to simplify further

the voting chain, even though a lot has already been achieved (e.g. electronic voting,

proxies).

In view of the institutional structure of Germany, proxy advisors are thought to play a

significant role. It is believed that some investors request the proxy advisors to use the

investor’s corporate governance standards rather than their own. Whether conflicts of

interest have been resolved (Principle V.F) remains unclear.

The rules governing co-operation between investors have been clarified since 2009 but

still remain potentially restrictive. This is because they seek to prevent investors from

seeking to “influence a company’s strategic orientation in a permanent and strategic

manner”. This is understandable in Germany since company law assigns responsibility for

strategy to the management with significant input by Works Councils in a consensual

II.4. NOTES

process. However, it does mean that investors must present their views in a highly

personalised manner to avoid discussing strategy which is really their concern. This serves

to reduce market transparency.

Notes

1. Defined as total shareholding minus holdings of over 5%, government holdings and those known shareholder agreements extending beyond six months.

2. Poison pills involving the issue of stock at a deep discount are illegal since they contravene strong pre-emption rights in company law.

3. Managers in most continental countries and Japan also favour a stakeholder perception and place a strong emphasis on job security. Dividends are nevertheless important with the notable exception of Japan where job security dominates corporate objectives (Odenius, 2008).

4. In particular, if banks want to exercise the proxies, they have to publish proposals for voting before the meeting, and vote this way, if the respective shareholder has not issued other instructions and; shareholders may issue general instructions to the bank to vote as proposed by the managing board and the supervisory board (D. Bohn et al., 2009).

5. Under the proposed code, management companies were recommended to publish their own guidelines on corporate governance policy (including conduct for the exercise of voting rights), rules for share voting and any deviations from the code. In addition, a shareholder protection association (Deutsche Schutzvereinigung für Wertpapierbesitz, DSW) developed ten principles in 2002 covering investment funds.

6. In countries such as the Netherlands and Australia, pension funds outsource fund management to investment managers, so that the general term pensions does not convey much information about strategies.

7. Section 30, Para. 2 of the German Takeover Act and Section 22, Para. 2 of the German Securities Trading Law (Wertpapierhandelsgesetz, WpHG).

8. Section 30, Para. 2 of the German Takeover Act.

9. OLG Frankfurt, 20th Zivilsenat, 25 June 2004, ref. No. WpUeG 5/03, WpUeG 6/03, WpUeG 8/03.

10. BGH, 2nd Zivilsenat, 18 September 2006, ref. No. Az. II ZR 137/05.

11. For an English language discussion of the law see J. Perlitt et al., 2008, “German risk Limitation Act Provide for investor Transparency and Protection of borrowers”, Euro Watch, 15 September.

12. This is also the case in Korea and is similar to declarations under Schedule 13D in the US. In Korea, changes were introduced following the activities in the Korean market of an activist investor (Sovereign). See OECD Economic Survey of Korea, 2007. In Japan, there has also been concern to declare the “beneficial investors” if an investment fund is involved. The proposed German law also covers beneficial ownership which would be disclosed to the management board but not to shareholders.

References

Baums, T. and K. Scott (2003), “Taking shareholder protection seriously: corporate governance in the United States and Germany”, ECGI Law Working Paper, 17/2003.

Bohn, Daniella et al. (2009), Improvements of shareholders rights: The German shareholders rights Act, Corporate Alert, K&L Gates.

Deutsche Aktien Institute (DAI) (2010), Factbook 2010, Frankfurt.

Deutsche Bundesbank (2011), Time series database, available at www.bundesbank.de/statistik/ statistik_zeitreihen.en.php.

DSW (2008), “DSW’s most recent fund Survey”, DSW Newsletter. April 2008.

German Working Group on Corporate Governance for Asset Managers (2005), Corporate Governance Code for Asset Management Companies.

http://www.bundesbank.de/statistik/statistik_zeitreihen.en.php

II.4. REFERENCES

Gonnard, Eric et al. (2008), “Recent trends in Institutional Investors Statistics”, Financial Market Trends, OECD 2008.

Goyer, Michael (2006), “Varieties of institutional investors and national models of capitalism: the transformation of corporate governance in France and Germany”, Politics and Society, 2006 34.

Goyer, Michael (2007), “Institutional investors in French and German Corporate governance: the transformation of corporate governance and the stability of co-ordination”, Center for European studies, program for the study of Germany and Europe, Working Paper, 07.2(2007).

Heidrick & Struggles (2011), Challenging Board Performance: European Corporate Governance Report, London.

Maurer, Raimond (2003), “Institutional investors in Germany: Insurance companies and investment funds”, Center for Financial Studies, 2003/14.

Odenius, Jürgens “Germany’s Corporate Governance Reforms: Has the system become flexible enough”, IMF Working Paper, WP/08/179.

von Rosan, Rúdiger (2010), “zu Hause ist es immer noch am sichersten”, FTD, 24/09/2010, s 26.

Zetzsche, Dirk (2008), “Shareholder passivity, cross border voting and the shareholder Rights directive”, Arbeitspapiere des Instiuts für Unternehmensrecht, Düsseldorf, Research Paper, 07/2008.

http://www.oecd.org/daf/corporateaffairs/wp

The Role of Institutional Investors in Promoting

ANNEX A

The Questionnaire of the OECD Corporate Governance Committee

INSTITUTIONAL INVESTORS AND KEY OWNERSHIP FUNCTIONS

Objective

At its meeting on 16-17 November 2010, the OECD Corporate Governance Committee

agreed to carry out a thematic peer review on the exercise of ownership rights by

institutional investors. The scope of the exercise is presented in the scoping paper DAF/CA/

CG(2010)12, which is annexed in this questionnaire. The review will focus on the

implementation of Principle II.F, which addresses the need for institutional investors

acting in a fiduciary capacity to disclose their overall corporate governance policies; their

procedures for using their voting rights, and; how they manage of conflicts of interest, and

Principle II.G, which addresses the right for shareholders to consult with each other.

Beyond a review of the implementation of Principles II.F and II.G, the review shall aim at a

better understanding of factors that determine to what extent institutional investors make

use of their ownership rights and what differences may exist between different categories

of institutional investors in this respect. Finally, the exercise shall review the existence and

experiences with any statutory regulation or voluntary codes that address the exercise of

ownership rights by institutional investors.

131

ANNEX A

How to complete the Questionnaire?

The questionnaire has two parts. Part one shall be completed by all countries, while

part two shall be completed only by those three countries that are subject to an in-depth

review. For other countries, part two is voluntary.

Those members only replying to the first section should point the Secretariat to the

main features of the relevant corporate governance framework and existing studies, if

available. It is not expected that replies should be long and detailed. For example, we do not

expect full translations of legal documents as required for FSAP and FATF reviews. We are

only interested in relevant parts.

For those 3 countries that participate in the in-depth review, (and others which wish to

also participate on a more detailed level), it is suggested that a response to Questions II and

III might be around 3-5 pages each. In preparing the responses, delegates may want to

emphasize differences within classes of institutional investors, their governance

structures, incentives and performance. For that, it is suggested that the securities and

sectoral regulators may be consulted, as well as any code oversight or professional bodies

(directors’ institutes and investor bodies) that have responsibility over institutional

investor behaviour. Academic, research and corporate governance organisations might

also be appropriate sources of information.

PART 1

To be completed by all countries

For the purpose of this review, we are going to consider that institutional investors

includes pension funds, insurance companies, mutual funds, and trusts, together with any

agents appointed to act on behalf of investors such as asset managers. They are collectively

termed “institutional investors” in this questionnaire. This definition thus goes further

than the institutional investor definition used in the Principles which is confined to those

institutions acting in a “fiduciary capacity” regardless of investment strategy. This is in line

with the Conclusions paper that argued for a widening of the definition and at the same

time recognising the need to look at the behaviour of other institutions active in the capital

markets. If in your respective jurisdiction there is another important category, please also

include it. Please also provide, if available, information on sub-categories (like privately-

owned or state-controlled, local or foreign, life insurance versus non-life, etc.).

1.1. In your jurisdiction, are institutional investors required to disclose their overall corporate governance policies with respect to their investments? If yes, please describe the

legal status of this requirement, how the requirement is formulated and where it can be

retrieved.

1.2. In your jurisdiction, are institutional investors required to disclose their overall voting policies with respect to their investments, including the procedures that they have

in place for deciding on the use of their voting rights? If yes, please describe the legal status

of this requirement, how the requirement is formulated and where it can be retrieved.

1.3. What percentage of the shares of listed companies in your country is typically voted at their annual meeting? If available, please provide statistics in terms of averages or

verified estimates. To what extent do institutional investors in your country use their

voting rights? If available, please provide any statistics or verified estimates. If the statistics

are not self-explanatory, please indicate if there are major differences in voting

participation between different categories of institutional investors?

ANNEX A

1.4. In your jurisdiction, are institutional investors required to disclose how they manage material conflicts of interest that may affect the exercise of key ownership rights

regarding their investments? If yes, please describe the legal status of this requirement,

how the requirement is formulated and where it can be retrieved. What is known about the

major conflicts of interest such as ownership by other corporate entities?

1.5. In your jurisdiction, are institutional investors allowed to consult each other on issues concerning their basic shareholder rights as defined in the Principles, subject to

exceptions to prevent abuse? What is the nature of these exceptions? What restrictions are

imposed, what is the legal status of these restrictions?1

1.6. Please explain how in your jurisdiction the duties and responsibilities of different institutions are defined. Is there a general concept of fiduciary duty? Please provide

reference to the relevant rules.

1.7. In your jurisdiction, is there statutory regulation, voluntary codes or other instruments that mandate or encourage the exercise of ownership rights as a duty by

institutional investors (e.g. a code of behaviour covering investors)? If there are, please

describe them and provide references. What are the experiences with such rules, codes or

guidelines? Please provide references to any studies concerning the exercise of shareholder

rights in your jurisdiction.2

1.8. Please complete as far as possible the attached table concerning assets under administration and the distribution of equity holdings (both foreign and domestic) among

different categories of shareholders.3

PART 2

To be completed by Australia, Germany and Chile (by others on a voluntary basis)

Where other jurisdictions have information to hand through, for example, specific

studies, it would be very useful to provide them to the Secretariat and also if they wish to

respond to the following questions. The Secretariat will follow up on the responses from

each economy being reviewed by short visits or conference calls, if necessary.

2. What is your evaluation of the role that institutional investors play in your jurisdiction in terms of their engagement as shareholders? Does their engagement go

beyond voting? Does their voting behaviour focus on certain specific issues only? Is there a

national concept of what is regarded as a responsible investor? Are their differences in the

behaviour of foreign and domestic institutional investors? In case your evaluation is that

they are engaged enough, please provide examples. In case your evaluation is that they do

not engaged enough, could you please elaborate on the possible causes (like the existence

of practical barriers, legal restrictions or simply issues related to their business model and

corporate governance arrangements, for instance). In such a case, have you done or are you

planning to do something to address those factors or influence their incentives to become

more engaged? If yes, please describe the policy measures, their rationale and their

expected (or already obtained) results.

3. What is your view about the time horizon of institutional investors such as whether they are “excessively short term”? What issues are thought to arise from index tracking

business models? What potential issues arise with Exchange Traded Funds? Could they

lead to a decline in company monitoring?

ANNEX A

The completed questionnaire should be returned to the Secretariat (Hector.Lehuede

@oecd.org and Kenji.Hoki@oecd.org with Ruth.Fishwick@oecd.org on copy) by the 14 February

2011.

Any questions of procedure or content should be addressed to Grant.Kirkpatrick@oecd.org

and Hector.Lehuede@oecd.org with Ruth.Fishwick@oecd.org on copy.

Notes

1. This question is aiming to review the extent to which jurisdictions have been able to clarify the scope of “concert party” rules in order to facilitate investor co-operation on corporate governance matters.

2. The purpose of this question is to review how and to what extent industry codes of best practice on “stewardship” are being used to promote more active engagement, and the experiences that regulator, industry bodies and investors have with such measures.

3. The purpose of this question is to obtain a proper understanding of the institutional shareholder base, including characteristics such as concentration and time horizon. Understanding the relative importance of different investor classes in particular markets will help determine the extent to which policy responses are likely to be effective.

mailto:@oecd.org

mailto:Hoki@oecd.org

mailto:Fishwick@oecd.org

mailto:Kirkpatrick@oecd.org

mailto:Lehuede@oecd.org

mailto:Fishwick@oecd.org

The Role of Institutional Investors in Promoting

ANNEX B

The Data Requested in the Questionnaire of the OECD Corporate Governance Committee

Year 2009 1999 1989

AU M

( lo

ca l c

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AU M

( U

S D

)

% a

llo ca

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qu ity

% o

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AU M

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AU M

( U

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to e

qu ity

% o

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AU M

( lo

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AU M

( U

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% a

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to e

qu ity

% o

w ne

rs hi

p st

ru ct

ur e

In st

itu tio

na l a

ss et

o w

ne rs

Domestic

Pension funds

Insurance companies

Mutual funds

Other institutional asset owners

Foreign

Pension funds

Insurance companies

Mutual funds

Other institutional asset owners

Fi na

nc ia

l se

ct or

Banks

Other financial institutions

N on

-f in

an ci

se ct

Non-financial enterprises

Individuals

Public sector

Others

Total 100% 100% 100%

Controlling shareholders

Block shareholders

Minority shareholders

Total 100% 100% 100%

135

ORGANISATION FOR ECONOMIC CO-OPERATION AND DEVELOPMENT

The OECD is a unique forum where governments work together to address the economic, social and

environmental challenges of globalisation. The OECD is also at the forefront of efforts to understand and

to help governments respond to new developments and concerns, such as corporate governance, the

information economy and the challenges of an ageing population. The Organisation provides a setting

where governments can compare policy experiences, seek answers to common problems, identify good

practice and work to co-ordinate domestic and international policies.

The OECD member countries are: Australia, Austria, Belgium, Canada, Chile, the Czech Republic,

Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Israel, Italy, Japan, Korea,

Luxembourg, Mexico, the Netherlands, New Zealand, Norway, Poland, Portugal, the Slovak Republic, Slovenia,

Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States. The European Commission

takes part in the work of the OECD.

OECD Publishing disseminates widely the results of the Organisation’s statistics gathering and

research on economic, social and environmental issues, as well as the conventions, guidelines and

standards agreed by its members.

OECD PUBLISHING, 2, rue André-Pascal, 75775 PARIS CEDEX 16

(26 2011 11 1 P) ISBN 978-92-64-12874-3 – No. 59667 2011

Please cite this publication as:

OECD (2011),The Role of Institutional Investors in Promoting Good Corporate Governance, Corporate Governance, OECD Publishing. http://dx.doi.org/10.1787/9789264128750-en

This work is published on the OECD iLibrary, which gathers all OECD books, periodicals and statistical databases. Visit www.oecd-ilibrary.org, and do not hesitate to contact us for more information.

Corporate Governance

The Role of Institutional Investors in Promoting Good Corporate Governance Contents

Executive Summary

Assessment and Recommendations

Part I Overview Chapter 1. The Structure and Behaviour of Institutional Investors

Chapter 3. Chile: The Role of Institutional Investors in Promoting Good Corporate Governance

Chapter 4. Germany: The Role of Institutional Investors in Promoting Good Corporate Governance

Annex A. The Questionnaire of the OECD Corporate Governance Committee

Annex B. The Data Requested in the Questionnaire of the OECD Corporate Governance Committee

ISBN 978-92-64-12874-3 26 2011 11 1 P -:HSTCQE=VW]\YX:

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Corporate Governance

The Role of Institutional Investors in Promoting Good Corporate Governance

Foreword
Table of Contents
Executive Summary
Assessment and Recommendations
Part I. Overview

Chapter 1. The Structure and Behaviour of Institutional Investors

1.1. Background, objectives and issues

1.1.1. The issues

Figure 1.1. Ownership structure in selected OECD countries

1.1.2. The approach of the Principles

Box 1.1. Relevant principles and annotations

1.1.3. Outline of Part I

1.2. The institutional investor landscape

1.2.1. The investment management industry

Figure 1.2. Financial assets under management by institutional investors in OECD countries
Figure 1.3. Type of financial assets managed by the industry (in trillion USD)
Figure 1.4. Shares and other equity by class of institutional management
Figure 1.5. Percentage of assets held as “shares and other equity” by type of institutional asset owner
Figure 1.6. Share of financial assets held by institutional asset managers in 2009
Table 1.1. Financial assets by institutional investors in other jurisdictions
Table 1.2. Largest global investment managers

1.2.2. Stock ownership by institutional investors

Figure 1.7. Ownership by domestic institutional investors and foreign investors in selected countries
Table 1.3. Ownership structure of India
Figure 1.8. Average holding period on major stock exchanges (number of years)
Table 1.4. Historical average holding period (years) by type of investors in TSE

1.3. Codes, legal frameworks and disclosure requirements

Table 1.5. Summary of the status of the Principles
Box 1.2. Corporate governance provisions in the US covering mutual funds and pension funds
Box 1.3. The UK Stewardship Code
Box 1.4. The Dutch corporate governance code’s approach to institutional investors

1.4. Co-operation between investors
1.5. Investment behaviour of institutional investors: the driving forces

1.5.1. Objectives and incentives vary by institution and by country
1.5.2. Average holding periods
1.5.3. What is a long term investor?
1.5.4. Lengthening the investment chain
1.5.5. Index tracking and ETFs

Box 1.5. Effects of company inclusion in S&P 500 index
Box 1.6. Exchange traded funds: What are they?

1.5.6. A high level of diversification
1.5.7. The responsible investment movement: ESG issues

Box 1.7. UN Principles for Responsible Investment

1.6. The voting and engagement record

1.6.1. Engagement with investee companies

Figure 1.9. Voting decision making authority

1.6.2. Voting practices

Box 1.8. Main proxy voting obligations under US laws and regulations
Box 1.9. Main obstacles to cross border voting in Europe
Figure 1.10. Voting process in Europe (simplified)
Box 1.10. Disclosure of voting records
Figure 1.11. Estimated minority shareholder turnout in Europe
Figure 1.12. Clustering of shareholder meetings in Europe

1.6.3. The role of proxy advisors

Box 1.11. Proxy advisors’ conflicts of interest – a recent debate

Notes
References

Part II. In-depth Country Reviews on the Role of Institutional Investors in Promoting Good Corporate Governance

Chapter 2. Australia: The Role of Institutional Investors in Promoting Good Corporate Governance

2.1. Institutional investor landscape

Figure 2.1. Equity holdings by all types of investors
Table 2.1. Australia’s superannuation industry (as at Dec. 2010)
Table 2.2. Recent trends in the number of Australian superannuation industry by entities

2.2. Legal rules and other guidance relating to shareholder rights and responsibilities

2.2.1. Shareholder rights
2.2.2. Fiduciary duties and shareholder responsibilities

Table 2.3. IFSA Blue Book – Summary of guidelines for fund managers
Table 2.4. ACSI guide for superannuation trustees on the consideration of ESG risks in listed companies
Table 2.5. ACSI guide for fund managers and consultants on the consideration of ESG risks in listed companies

2.2.3. Disclosure obligations

2.3. Exercise of shareholder rights

2.3.1. Overview
2.3.2. Role of proxy advisors
2.3.3. Voting and engagement practices
2.3.4. Areas of contention between shareholders and companies

Table 2.6. Substantial no votes in remuneration reports in 2009

2.3.5. Impediments

2.4. Conclusions
Annex 2.1. Summary of legal provisions relating to the fiduciary responsibilities of institutional investors in Australia
Notes
References

Chapter 3. Chile: The Role of Institutional Investors in Promoting Good Corporate Governance

3.1. The corporate governance landscape

3.1.1. The Chilean stock market1

Figure 3.1. Chilean listed market capitalisation to GDP (%)
Figure 3.2. Number of Chilean listed companies
Figure 3.3. Turnover on Chilean listed market (%)

3.1.2. The corporate governance framework
3.1.3. Ownership and control

Table 3.1. Ownership concentration (average per year)
Figure 3.4. Market ownership concentration (three largest shareholders)

3.1.4. Pension funds and other institutional investors

Figure 3.5. Assets under administration by type of Institutional Investors
Figure 3.6. Evolution of pension fund portfolios (per sector)
Table 3.2. Pension funds’ investments in Chilean corporate assets
Figure 3.7. Pension fund investment in Chilean corporate assets (as % of total assets)

3.2. Legal and regulatory framework

3.2.1. Disclosure obligations
3.2.2. Shareholder rights

Box 3.1. Pension funds main regulation regarding Principles II F and G

3.2.3. Shareholder responsibilities and fiduciary duties

3.3. Exercise of shareholder rights

Table 3.3. AFPs ownership in companies renewing boards per year
Table 3.4. Companies renewing their boards by year and by size of the board
Table 3.5. Directors elected by AFPs by company according to % of votes
Table 3.6. Percentage of companies where AFPs elected one or more directors per year
Table 3.7. Independent directors’ profile
3.3.1. Explanatory factors

Box 3.2. Case studies of institutional investors engagement

3.4. Conclusions
Notes
References

Chapter 4. Germany: The Role of Institutional Investors in Promoting Good Corporate Governance

4.1. The corporate governance landscape

4.1.1. Market concentration and control

Table 4.1. Ownership concentration

4.1.2. Corporate law and company practices

4.2. Institutional investors

Figure 4.1. Equity holdings by all types of investors
Box 4.1. Voluntary code of conduct of the German Association for Investment and Asset Management

4.3. Exercise of shareholder rights

4.1.3. Shareholder rights
4.3.2. Shareholder co-operation
4.3.3. Use of proxy advisors
4.3.4. Dialogue with companies
4.3.5. Voting behaviour
4.3.6. Turnout

Table 4.2. Average shareholder turnout is reasonable

4.3.7. Dissent

Table 4.3. Shareholder dissent remain low
Table 4.4. Shareholder dissent depends on the type of resolution

4.3.8. Major shareholder voting

4.4. Conclusions
Notes
References

Annex A. The Questionnaire of the OECD Corporate Governance Committee

Notes

Annex B. The Data Requested in the Questionnaire of the OECD Corporate Governance Committee

__MACOSX/._OECD - The Role of Institutional Investors in Promoting Good Corporate Governance.pdf

Institutional-investors-ownership-engagement.pdf

OECD Journal: Financial Market Trends

Volume 2013/2

Institutional investors and ownership engagement

Serdar Çelik and Mats Isaksson*

This article provides a framework for analysing the character and degree of ownership engagement by institutional investors. It argues that the general term “institutional investor” in itself doesn’t say very much about the quality or degree of ownership engagement. It is therefore an evasive “shorthand” for policy discussions about ownership engagement. The reason is that there are large differences in ownership engagement between different categories of institutional investors. There are also differences in ownership engagement within the same category of institutional investors such as hedge funds, investment funds, etc. These differences arise from the fact that the degree of ownership engagement is determined by a number of different features and choices that together make up the institutional investor’s “business model”. When ownership engagement is not a central part of the business model, public policies and voluntary standards aiming to improve the quality of ownership engagement among institutional investors are likely to have limited effect. Based on an empirical overview of the relative size of different categories of institutional investors, the article identifies a set of 7 features and 19 choices that in different combinations define the institutional investor’s business model. These features and choices are then used to establish a taxonomy for identifying different degrees of ownership engagement ranging from “no engagement” to “inside engagement”.

JEL Classification: G30, G32, G34, G38.

Keywords: Corporate governance, institutional investors, incentives, shareholder engagement, shareholder activism.

* This article was produced by Serdar Çelik and Mats Isaksson, Corporate Affairs Division, OECD Directorate for Financial and Enterprise Affairs. It is based on their research and documentation in OECD Corporate Governance Working Paper, No. 11 (2013), “Institutional Investors as Owners: Who Are They and What Do They Do?”, http://dx.doi.org/10.1787/5k3v1dvmfk42-en. The paper has benefitted from discussions on an earlier draft by the OECD Corporate Governance Committee and the participants in the project on Corporate Governance, Value Creation and Growth. The authors thank their colleagues in the OECD for their comments. They would also like to thank the Capital Markets Board of Turkey whose financial support has contributed to making this work possible. This article is published on the responsibility of the Secretary-General of the OECD.The opinions expressed and arguments employed herein are the authors’ and do not necessarily reflect the official views of the Organisation or the governments of its member countries.

Information on data for Israel: http://dx.doi.org/10.1787/888932315602.

http://dx.doi.org/10.1787/5k3v1dvmfk42-en.The

http://dx.doi.org/10.1787/888932315602

INSTITUTIONAL INVESTORS AND OWNERSHIP ENGAGEMENT

I. Summary, conclusions and policy implications During the last decade, most OECD countries have experienced a dramatic increase in

institutional ownership of publicly listed companies. In the UK, for example, only 10% of all

public equity is today held by physical persons. Moreover, a number of new institutions

have entered the scene and have become important owners alongside the more traditional

institutional investors, such as pension funds and investment funds.

These developments have given new impetus to the discussion about the role of

institutional investors as owners of publicly listed companies. Of particular interest is how

they carry out the corporate governance functions that are associated with share

ownership. The increase in institutional ownership has also provoked regulatory and

voluntary initiatives aiming at increasing their level of ownership engagement. The

1994 interpretation of the US Employee Retirement Income Security Act is one example.

A more recent one is the UK Stewardship Code.

While such initiatives have typically increased voting among institutional investors,

there is also concern that they have had little effect on the quality of ownership engagement.

To minimise the costs that are associated with a voting requirement, many large institutions

primarily rely on consultants that, for a fee, provide arguably standardised advice on how to

vote and help with the actual process of exercising voting rights.

In this article, we argue that such voting based on a pre-defined formula (passive

outsourcing of voting) as well as the total abstention from voting, may be perfectly rational

from the perspective of institutional investors. The reason is that the degree of ownership

engagement is not determined by share ownership as such. Instead, it is determined by a

number of different factors that together make up the institutional investors’ “business

model”. In some business models, active ownership engagement is a vital component. In

other business models, ownership engagement has no function whatsoever and a

requirement to vote represents nothing but a cost. In the first case mandatory rules on

ownership engagement are unnecessary and in the latter case they are likely to have little

effect beyond simple box ticking. As a matter of fact, the most active and engaged owners

are typically under no regulatory obligations at all to vote or otherwise engage with the

companies that they own.

Considering the importance of institutional investors, this study takes a closer look at

the different factors that determine ownership engagement, such as the purpose of the

institution, its liability structure and its portfolio strategy. We find that these determinants

vary not only between different categories of institutional investors, but also within a given

category of institutional investors, for example, hedge funds. Depending on the “business

model” ownership engagement among institutional investors will vary from totally

passive, to very hands on engagement. As a consequence, we conclude that the general

term “institutional investor” in itself doesn’t say very much about the quality or degree of

ownership engagement. It is therefore an ambiguous “shorthand” in any policy discussions

about ownership engagement.

INSTITUTIONAL INVESTORS AND OWNERSHIP ENGAGEMENT

It is important to note that this article is written from a public policy perspective. So,

we need to be clear why the quality of ownership engagement is of wider societal interest.

Why should policy makers care? The degree of ownership engagement is hardly a moral

issue or a general fiduciary duty that must override other objectives, such as maximising

returns to the institutions’ ultimate beneficiaries. Instead, what matters for society as a

whole is the role that ownership engagement is expected to play for effective capital

allocation and monitoring of corporate performance.

The market economy relies on shareholders to price and allocate capital among

different business opportunities. Since the shareholders are assumed to have a self-

interest in the return on the capital that they provide, we trust that the shareholders also

seek as much information as possible to identify those companies with the best future

prospects. Since it is in their own interest, we also expect shareholders to continuously

monitor corporate performance to see how well corporations actually use the capital they

have been given.

If shareholders fulfil these functions, they carry out a socially beneficial role, since they

bring new and unique information to the economy. This new information will improve the

allocation of productive resources and make better use of those resources that are already

employed. It is therefore the very basis for genuine value creation and economic growth.

Since shareholders are expected to serve these functions, they have also been given

the legal rights to carry them out. These rights include the transferability of shares, access

to information, participation in key decisions concerning fundamental corporate changes

and the election of the board of directors. Exercising these rights is always associated with

certain costs, which some shareholders are motivated to pay and some are not.

Shareholders that for some reason do not find it worthwhile to inform themselves or to

exercise any monitoring of corporate performance are obviously ill equipped to serve the

wider economic role of improving allocation and corporate performance. Instead, their role

in the economy will be limited to providing capital. This distinction is not theoretical, since

in reality we have shareholders that exhibit different degrees of ownership engagement. This

has given rise to a debate about the possibility to differentiate dividends and/or shareholder

rights between on the one hand those shareholders that contribute capital, information and

monitoring and, on the other hand, those shareholders that only contribute capital.

This article represents a partly new approach to understanding the ownership

engagement by institutional investors. We are aware that both the suggested determinants

for ownership engagement and the definition of engagement levels that we present can

– and should – be debated and refined. Some of them may be taken out and others should

perhaps be added.

Through that very discussion, we hope to contribute to a better understanding of how

public policy may strengthen the economic contribution from ownership engagement and

perhaps avoid policies that have no effect and even unintended consequences. While it is

written from a policy perspective, we hope that the discussion in this article can stimulate

thinking also in the private sector and in individual institutions, where the ability to

identify and actually influence the determinants for ownership engagement often resides.

II. The institutional investor landscape There is no simple definition of an “institutional investor”. The closest we get to a

common characteristic is that institutional investors are not physical persons. Instead they

INSTITUTIONAL INVESTORS AND OWNERSHIP ENGAGEMENT

are organised as legal entities. The exact legal form, however, varies widely among

institutional investors and covers everything from straightforward profit maximising joint

stock companies (for example, closed-end investment companies) to limited liability

partnerships (like private equity firms) and incorporation by special statute (for example,

in the case of some sovereign wealth funds). Institutional investors may act independently

or be part of a larger company group or conglomerate. This is, for example, the case for

mutual funds who are often subsidiaries of banks and insurance companies.

Very often, institutional investors are synonymous with “intermediary investors”.

That is to say, an institution that manages and invests other people’s money. But again,

there are exceptions. Sovereign wealth funds, for example, can be seen as ultimate owners

when they serve as financial stabilisation funds or de facto state ownership agencies. We

also have hybrid forms, such as private equity funds, where the managing partner co-

invests, to varying degrees, with the limited partners.

While the picture will become even more complex in Sections III and IV, just the

simple fact that institutions are legal rather than physical persons is an important

observation with implications for corporate governance. Primarily because it creates at

least one additional step in the link between the income of the ultimate provider of money

(typically a household) and the performance of the corporation. The fact that institutional

investors come in a great variety of forms also suggests that they will differ in terms of the

character and degree of ownership engagement. As the importance of institutional

investors as owners of public equity has increased, so has the need to understand who they

are and what role they play as shareholders. In this part, we will therefore provide an

overview of who the large institutions are, their relative importance in terms of assets

under management and what they own.

As late as in the mid-1960s, physical persons held 84% of all publicly listed stocks in the

United States. Today they hold around 40%.1 In Japan, the portion of direct shareholdings is

even smaller and in 2011 only 18% of all public equity was held by physical persons.2 In

the UK, the decrease in direct ownership is even more pronounced. In the last 50 years, the

portion of public equity held by physical persons has decreased from 54% to only 11%.3

We have also seen an increase in the number and diversity of institutional investors,

with new categories and sub-categories of institutions being added. In this article we refer

to three broad “categories” of institutional investors, which to some extent reflect this

development. The first category of institutional investors is reffered to as “traditional”

institutional investors and comprises pension funds, investments funds and insurance

companies. Second, we use the term “alternative” institutional investors for hedge funds,

private equity firms, exchange-traded funds and sovereign wealth funds. As a third

category we have added asset managers that invest in their clients’ name. The main

reasons for adding this third category is the rapid growth of outsourcing to asset managers

and the fact that the UK Stewardship Code recently included asset managers in their

definition of institutional investors.4

We are fully aware that this list of institutional investors is incomplete. Other

categories, like closed-end investment companies, proprietary trading desks of investment

banks, foundations and endowments could obviously be added. Partly because of a lack of

reliable data5 and partly because we want to keep the presentation as simple as possible,

we have not sought to include all possible types of institutional investors in this study. This

does not affect the analysis and conclusions.

INSTITUTIONAL INVESTORS AND OWNERSHIP ENGAGEMENT

However, even for the institutions that we do include, aggregate data on total assets

under management and the allocation between different asset classes is limited. We must

also raise concerns about the accuracy of estimations in the data that are actually

available. An important reason behind this concern is an increasingly complex investment

chain where institutional investors often invest in instruments offered by other

institutional investors. Pensions funds may, for instance, invest in private equity funds and

insurance companies may buy into mutual funds. At the aggregate level, the result may be

a certain degree of double counting. Considering the growing importance of institutional

investors and their role as owners of our corporations, improvements in data gathering and

processing should be an important priority.

Being aware of existing shortcomings, Figure 1 illustrates the total assets under

management of different types of institutional investors and the portion of these assets that

they have allocated to public equities. The figure shows that in 2011, the combined holdings

of all institutions represented was USD 84.8 trillion. Out of this, 38% (USD 32 trillion) was

held in the form of public equity. The largest institutions by far were investment funds,6

insurance companies and pension funds. Together they managed assets with a total value of

USD 73.4 trillion, of which USD 28 trillion was held in public equity. Alternative institutional

investors as a group, represented by sovereign wealth funds, private equity funds, hedge

funds and exchange traded funds were estimated to hold total assets of USD 11.4 trillion, of

which 40% (USD 4.6 trillion) was invested in public equity.

II.1. “Traditional” institutional investors

In OECD countries, pension funds, investment funds and insurance companies have in

the last decade more than doubled their total assets under management from

USD 36 trillion in 2000 to USD 73.4 trillion in 2011. The largest increase among the three

categories of traditional institutions has been for investment funds that have increased

Figure 1. Total assets under management and allocation to public equity by different types of institutional investors

In trillion USD, 2011

Note: Investment funds, insurance companies and pension funds data do not cover non-OECD economies. Since institutional investors also invest in other institutional investors, for instance pension funds’ investments in mutual funds and private equity, the comparability of different data cannot be verified. Source: OECD Institutional Investors Database, SWF Institute, IMF, Preqin, BlackRock, McKinsey Global Institute.

Public equity Assets other than public equity

Investment funds

Insurance companies

Pension funds

Sovereign wealth funds

Private equity funds

Hedge funds Exchange traded funds

INSTITUTIONAL INVESTORS AND OWNERSHIP ENGAGEMENT

their assets under management by 121%. As a consequence, their relative share of total

assets under management by traditional institutional investors increased from 37% in 2000

to 40% in 2011, while the share held by pension funds decreased from 31% to 27%. The

share held by insurance companies remained fairly stable during the period at around 32%

of all assets managed by traditional institutional investors.

It is again important to note that both pension funds and insurance companies invest

in mutual funds which are part of the investment funds category. In particular, almost 40%

of mutual funds’ assets in the US are assets of individual retirement accounts (IRAs) and

defined contribution pension plans that are invested in mutual funds (ICI, 2012).

Considering the fact that institutions based in the US account for almost 40% of total assets

under management of OECD traditional institutional investors, a significant part of

pension funds’ assets may also be counted under investment funds.

As shown in Figure 2, the amount of assets managed by institutional investors and the

relative importance of different types of institutions vary widely across OECD countries. In

the Netherlands, Switzerland, Denmark and the UK, for example, assets under management

by traditional institutional investors account for more than twice their GDP. On the other

hand, total assets under management by traditional institutions in Hungary, Czech Republic,

Mexico, Slovak Republic, Estonia, Greece and Turkey is less than a quarter of their GDP.

In some OECD countries like Australia, Chile, Iceland and the Netherlands, pension

funds are the dominant form of institutional savings, whereas in Belgium, Finland, Italy,

Korea, Norway, Slovenia and Sweden insurance companies are the significant domestic

institutional investors. The countries where investment funds is the largest category of

institutional investors are Austria, Hungary, Turkey and the US.

Figure 3 provides a detailed picture of how the traditional institutional investors

allocated their holdings between different asset classes in 2000 and 2011, respectively. For

Figure 2. Assets under management by traditional institutional investors in OECD countries % of GDP, 2011

Note: Since insurance companies and pension funds invest in mutual funds, investments funds data also include pension funds’ and insurance companies’ assets. Source: OECD Institutional Investors Database, GDP data from OECD National Accounts.

300

250

200

150

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Investment funds Insurance companies Pension funds

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INSTITUTIONAL INVESTORS AND OWNERSHIP ENGAGEMENT

both investment funds and pension funds, public equity was the single largest asset class

in 2000 and 2011. In 2011, public equity represented almost half of the portfolio of pension

funds and 41% of the total portfolio of investment funds. Insurance companies held 26% of

their assets in the form of public equity.

While public equity was the single largest asset class both years, all three categories of

traditional institutional investors decreased their portion of public equity between 2000

and 2011. The largest decrease was for insurance companies which reduced their holdings

of public equity by about 22%, while pension funds during the same period reduced their

holdings by 14.4% and investment funds by about 7%. For pension funds, public equity was

primarily replaced by the category “other”, which includes investments in private equity

funds, venture capital, hedge funds, real estate, commercial loans and financial

derivatives, which increased from 9 to 15% of total assets.

Despite the decrease in their relative allocation to public equity, traditional

institutional investors increased their share of all outstanding public equity owned by

institutional investors by about 5% between 1995 and 2011. The primary explanation for

this is that the 121% increase in their total assets management mentioned above

outstripped the growth in global stock market capitalisation. The total stock market

capitalisation in the US, for example, was almost at the same level at the end of 2011 as it

was at the end of 2000.7 This is partly explained by the fact that the US stock market lost

almost half of its listed companies between 1997 when it had 8 823 listed companies

and 2012 when it had only 4 916 listed companies (Weild et al., 2013). The dramatic

decrease was partly the effect of de-listings and partly by an 80% decrease in the annual

Figure 3. Asset allocation by traditional institutional investors in the OECD Percentage

Note: Other category includes investments in private equity, venture capital, hedge funds, real estate, commodities, commercial loans, financial derivatives, etc. Source: OECD, Institutional Investors Database.

Equity Securities other than equity Loans Currency and deposits Other

Investment funds, 2000 Insurance companies, 2000Pension funds, 2000

Investment funds, 2011 Insurance companies, 2011Pension funds, 2011

125 3

33 42

125 8

239

51 30

2 4

INSTITUTIONAL INVESTORS AND OWNERSHIP ENGAGEMENT

average of new listings, from 525 in the period 1993-2000 to 116 for the period 2001-12

(Isaksson and Celik, 2013).

Looking at country level data, in 2011 the asset allocation of institutional investors

varied considerably between OECD countries. In many countries, public equity was not the

single largest asset class. The allocation to public equity varied from 5.7% in Turkey to 56.9%

in Finland. In the US, traditional institutional investors allocated 47% of their portfolio to

equities, which is almost 51% of the total equity investment by institutional investors from

OECD countries. The category “other investments”, which includes investments in real

estate, private equity, venture capital and hedge funds, constituted an important part of the

institutional investors’ portfolios in the United Kingdom (35.3%) and Japan (23.2%).

II.2. “Alternative” institutional investors

As we mentioned above, there is no clear distinction between what we call

“traditional” and “alternative” institutional investors. Nor do we claim that “alternative

investors” have a distinct set of common features. The main rationale for the label

“alternative” is that they are relatively new and have emerged as an alternative or

complement to more “traditional” types of institutional investors. Another reason for

treating them separately from traditional institutional investors is that reliable data for

hedge funds, private equity firms and sovereign wealth funds is quite limited compared to

what is available for traditional institutional investors.

It is estimated that in 2011, the four main categories of alternative investors – hedge

funds, private equity funds, sovereign wealth funds and exchange traded funds – together

held about USD 11.3 trillion in assets under management globally.8 This represents around

15% of the amount of assets managed by traditional investors. The portion of total assets

that they hold in the form of listed equity varies widely between the four categories of

investors. While sovereign wealth funds are estimated to allocate around half of their

assets to listed equity (McKinsey, 2011), private equity and hedge funds as a group have a

considerably smaller portion of assets invested in public equity. Almost 80% of ETF assets

are allocated to public equities. Taken together alternative institutional investors hold a

relatively small portion of the world’s public equity equivalent to about USD 4 trillion.

The largest category among alternative institutional investors, measured by total

assets under management, is the sovereign wealth funds (SWFs). As mentioned above,

SWFs is itself a highly diverse concept in terms of organisational model, governance,

purpose and investment strategies. They include stabilisation funds, savings funds,

pension reserve funds, or reserve investment corporations, with a majority of either

savings funds for future generations or fiscal stabilisation funds (Kunzel et al., 2011). Some

of them serve as central state ownership agencies with controlling stakes in publicly listed

state-owned companies complemented with portfolio investments in individual local and

foreign listed companies. Some others are themselves state-owned enterprises.

The diverse and evasive nature of SWFs is actually well illustrated by the definition of

SWFs used in the Santiago Principles (IWG), which were agreed in 2008 and provide a

framework for governance, accountability and investment practices of SWFs. The

definition includes three main elements, which leave considerable room for variations in

terms of organisational forms, governance structure, investment purposes, investment

strategies, regulatory constraints, etc.: i) they are owned by general government; ii) they

INSTITUTIONAL INVESTORS AND OWNERSHIP ENGAGEMENT

manage or administer assets to achieve financial objectives; and iii) they employ a set of

investment strategies that include investing in foreign financial assets.

According to SWF Institute data, Norway, with about USD 560 billion of assets under

management is the only OECD country that has a significant sovereign wealth fund. Other

countries with large SWF assets are China, United Arab Emirates, Saudi Arabia and

Singapore. This points to a regional concentration of SWF assets with 40% of total assets

estimated to be in East and South East Asian countries and 35% in the Middle East.

Again, reliable, complete and consistent information about the asset allocation of SWFs

is hard to come by and more could certainly be done to improve information about the

holdings of central government owned investment vehicles. However, IMF data from 2010

indicate that public equity constitutes a significant portion of their total assets, except for

stabilisation funds and the asset allocation of different types of SWFs vary depending on

their mandates and objectives. For instance, stabilisation funds which are established to

insulate economies and government budgets from commodity price volatility and external

shocks mainly invest in sovereign fixed income instruments (IMF, 2011). The other three sub-

categories of SWFs, saving funds, pension reserve funds and reserve investment funds, have

relatively longer investment horizons and allocate significant parts of their portfolios to

equities. In particular, reserve investment funds that are created to invest foreign reserves to

higher return investments allocated 66% of their funds to equities in 2010.

The shortage of comprehensive data is an obstacle also when it comes to identifying

and estimating the holdings of what are commonly referred to as private equity firms and

hedge funds. Again, there is no simple unifying principle in terms of investment strategy

or services that defines either category. Traditionally however, private equity firms have

been seen as managing a leveraged private pool of capital through active engagement with

individual companies, whereas hedge funds use an active investment strategy to benefit

from arbitrage opportunities combined with leverage and derivatives (Blundell-Wignall,

2007). It is also common to differentiate between private equity firms and hedge funds with

respect to the character, size and the time horizon of their equity holdings in individual

companies. Private equity funds are generally seen as having large, long-term holdings in

individual non-listed companies. Hedge funds on the other hand are usually associated

with small non-controlling stakes in publicly listed companies (Achleitner et al., 2010).

In the years up to the 2007 financial crisis, private equity firms experienced a dramatic

surge in assets under management. After the crisis, they continued on a moderate growth path

and reached USD 3.4 trillion in 2011 (Preqin, 2012). Out of this USD 3.4 trillion, almost

USD 1 trillion is estimated to be in the form of committed capital (Bain and Co., 2012). Only a

small part of the remaining USD 2 trillion is invested in listed equities, the rest is invested in

different asset classes, including real estate and credit instruments. A simplified way to

describe the business model of private equity firms is that they first obtain capital

commitments from their investors. These commitments are put in a discrete fund for which

the managers of the private equity firm seek investment opportunities. They normally do not

receive the committed capital until they find an investment opportunity, but still charge a flat

management fee on the committed capital. In addition to the flat fee, the private equity firms

also charge a performance related fee that is related to the performance of the investments.

Hedge funds are estimated to hold only about 2% of total assets under management of

institutional investors. And compared to the total amount held by institutional investors,

their holdings in public equity are quite limited and estimated at about USD 500 million,

INSTITUTIONAL INVESTORS AND OWNERSHIP ENGAGEMENT

which is roughly 1% of the total global market capitalisation. Still, hedge funds often play

an important role in financial markets and governance by using derivatives and other

financial techniques such as share lending, to increase their voting power and their ability

to convince other shareholders to influence corporate boards and managers (OECD, 2007).

As a consequence, their relatively modest holdings of equity do not necessarily reflect their

role in equity markets and corporate governance (Gilson and Gordon, 2013).

The most recent addition to the family of alternative institutional investors is

exchange traded funds (ETFs). ETFs have grown dramatically during the last decade. What

in 2000 was a USD 74 billion industry, had in 2011 reached USD 1.35 trillion of assets under

management. That is an increase of almost 1.750%. At the end of 2011, there were

3.011 ETFs trading on 40 different stock exchanges around the world.9 The market for ETFs

is relatively concentrated with the top three ETF providers, iShares, State Street Global

Advisors and Vanguard, having an almost 70% market share in terms of assets under

management (BlackRock, 2012).

Like mutual funds, ETFs are structured like collective investment vehicles that offer

diversified exposure to the different financial assets that are included in the fund. Unlike

mutual funds, however, ETFs are continuously traded and quoted on a stock exchange

(Ramaswamy, 2011). It can be argued that with these characteristics, and the fact that they

are sold by large financial institutions, ETFs should be defined as a financial product rather

than institutional investors in themselves. They are used by both passive investors to

diversify the portfolio and decrease costs, and by active investors such as hedge funds for

active investment strategies.

II.3. Asset managers

Finally, and for the reasons explained above, we are also including asset managers

under the general heading of institutional investors. In the UK Stewardship Code, asset

managers (as opposed to asset owners) are defined as having the day-to-day responsibility

of managing investments. The capital that they manage can be provided not only by

physical persons, but also by most categories of institutional investors, including pension

funds, SWFs and insurance companies. Since institutional investors also trust private

equity and hedge funds with the day-to-day responsibility of managing their assets, the

distinction between an asset manager and an asset owner is not always clear cut. Asset

managers (as we use the term in this article), however, are not expected to invest in their

own name (like a private equity firm would do) but directly in their clients’ name and based

on their clients’ investment policy.

While a few large institutional investors manage their assets internally, the last couple

of decades have seen an increase in outsourcing of asset management to external asset

managers. Globally, asset management firms are estimated to have had about

USD 63 trillion under management at the end of 2011 (Towers Watson, 2012). However,

some of the asset managers are themselves traditional or alternative institutional

investors, that manage their assets through a special asset management arm. This is often

the case for insurance companies whose asset management arms are one of the largest

categories of asset managers. In addition to managing the assets of the insurance company

of which the insurance owned asset manager is an arm, the asset management arm also

manages assets on behalf of other institutional investors, including pension funds.

INSTITUTIONAL INVESTORS AND OWNERSHIP ENGAGEMENT

It is estimated that half of the USD 63 trillion in assets under management by asset

managers is split between asset managers that are owned by insurance companies and

asset managers that are owned by banks. The remainder is managed by independent asset

managers (TheCityUK, 2012).

When we look at the aggregate numbers of assets under management by institutional

investors, it is important to note that asset managers are by far the largest sponsors of both

mutual funds and exchange traded funds, which they offer to their clients as investment

products. This means, for example, that the numbers for the “mutual fund” category are

almost totally included in the USD 63 trillion registered as assets under management by

asset managers. Also exchange traded funds, which is another product commonly sold by

asset managers, such as BlackRock, are statistically included in the amount of assets

managed by asset managers. Hence, just like there is a case for double counting when a

pension fund invests in a hedge fund, the USD 63 trillion in assets under management by

asset managers should not be added to the USD 85 trillion in total assets under management

by traditional and alternative investors, since there is a considerable degree of overlap.

The asset management industry is fairly concentrated. At the end of 2011, the top 20

asset managers’ assets under management accounted for USD 24.4 trillion, which was

almost 40% of the total assets under management in this industry. According to Towers

Watson (2012) data, 11 out of the top 20 managers are based in the US and account for 64%

of the total assets of the top 20. The remaining managers were European (33%) and

Japanese (3%). Amongst the top 500 asset managers across the world, there are only

36 firms from emerging markets, namely Brazil, China, India and South Africa (Towers

Watson, 2012). Again, it is important to note that some of the largest asset managers are

special asset management arms of traditional or alternative institutional investors,

particularly in the form of strategic affiliates of insurance companies.

III. Ownership engagement by institutional investors In Section II, we illustrated how institutional investors have become the dominant

owners of public equity in most OECD countries. We showed the relative importance of

different categories of institutional investors and increased complexity in the investment

chain.

We also illustrated that the general concept of “institutional investor” is not very

useful when it comes to predicting the character and degree of ownership engagement.

Even the more detailed definitions of institutional investors, such as “hedge fund” and

“sovereign wealth fund”, are quite evasive. This is an important insight for any policy

maker that wants to understand, or perhaps even influence, ownership engagement

among institutional investors. And it is food for thought for policy initiatives that often

address the institutional investment community as a homogenous group (Millstein, 2008).

In this section, we will look beneath the surface of labels and discuss the different

factors that influence the degree of ownership engagement by institutional investors. We

will conclude that if we want to predict, or perhaps influence, the degree of ownership

engagement among institutional investors we must focus on specific features of the

institution’s business model that determine the incentives for ownership engagement.

These features include characteristics such as the purpose of the institution, their liability

structure, the regulatory framework, etc. We will illustrate how these features vary, not

INSTITUTIONAL INVESTORS AND OWNERSHIP ENGAGEMENT

only between different categories of institutional investors, but also within each category

of institutional investors.

For this purpose, we have identified seven main features, or components, of an

institution’s business model. And for each of these features, we have identified a number

of choices and regulatory conditions that in turn determine the character and degree of

their ownership engagement.

Before we discuss these different determinants of shareholder engagement, it is

important to remind ourselves why the degree of ownership engagement is a public

policy concern. Why should policy makers care? From a public policy perspective,

ownership engagement is not a moral issue. Nor can it be seen as a general obligation or

fiduciary duty that would override other objectives, such as maximising the return to the

institution’s ultimate beneficiary. What is primarily matters for public policy is the role

that ownership engagement plays for effective capital allocation and the informed

monitoring of corporate performance.

A well-functioning market economy requires the presence of shareholders that have a

self-interest to allocate their money to the most prosperous ventures and then monitors

these companies to make sure that they make the best possible use of the money. To carry

out this job well, it is in the self-interest of shareholders to gather as much information as

possible about the corporation’s prospects and, whenever necessary, use this information

to engage with the company and influence key issues, such as the company’s strategic

orientation, its dividend policy and board composition. When shareholders gather and use

information in this manner they carry out a function that is essential to value creation and

and economic growth. In short they are providing society with new knowledge on how it

can improve the allocation and use of scarce resources.

Since shareholders are assumed to play this role, they are also given the legal rights to

carry it out. These rights include the transferability of shares, access to information,

participation in key decisions concerning fundamental corporate changes and election of

the board of directors. Exercising these rights is always associated with certain costs,

which some shareholders are motivated to shoulder and some are not.

Shareholders that for some reason do not find it worthwhile to gather information

about the companies they own and do not contribute to monitoring through any form of

ownership engagement are obviously ill equipped to serve the wider economic role of

improving allocation and corporate performance. Their role as shareholders is limited to

providing risk capital. This distinction is not theoretical, since in reality we have

shareholders that exhibit different degrees of ownership engagement. This has given rise

to a debate about the possibility to differentiate returns or shareholder rights between

those shareholders that contribute risk capital, information and monitoring on the one

hand and those who only contribute risk capital on the other hand.

III.1. Determinants of ownership engagement

Equity ownership in its own right is not a determinant of ownership engagement.

Moreover, the name of an institutional investor provides limited guidance about the

character and degree of their ownership engagement. Instead, we need to look at a range

of different factors that constitute the institution’s business model and the regulatory

constraint under which this business is carried out. These determining factors vary not

only between different categories of institutions, but also within a given category of

INSTITUTIONAL INVESTORS AND OWNERSHIP ENGAGEMENT

institutional investors, for example, between two different hedge funds or two different

pension funds. It is an understanding of these determining factors, rather than the

categorisation of institutional investors as such, that will help us predict the character and

the degree of their ownership engagement.

To illustrate this, we have identified seven different features that influence how an

institution will behave as an owner. For each of these features, different options are

available depending on the institution’s choice of business model and the regulatory

framework in which it operates. We refer to these options as the determinants of

ownership engagement. While we have identified some of the more important features

and determinants of ownership engagement, we do not claim that the list is in any way

exhaustive. At this stage, the features and determinants are mainly selected to illustrate

the approach and to stimulate further discussion about which features and determinants

to include. The features and determinants are briefly discussed in the following

Sections III.1.1 to III.1.7, and summarised in Table 1.

III.1.1. The purpose of the institution

An important distinction among institutional investors is between those that have a

profit maximising obligation to the institution’s owners and those that do not. A public

pension fund, for example, typically does not have any shareholders that expect a return

on an investment in the pension fund. Rather, they are often run as public agencies or

some other, not incorporated, legal form. The sole focus is on the returns to the

beneficiaries. The incentives to work towards this objective can obviously be affected by

the fact that a public institution is under limited pressure to attract capital (customers) in

competition with other institutions. This distinction between institutional investors with

captive assets and institutional investors that have to compete for assets in the market

may itself be a determinant of ownership engagement. Many other institutional investors

however, are organised as joint stock, profit maximising companies. In some instances

these entities, or their parent companies, may themselves be publicly listed companies.

This is true for many investment funds that are owned and marketed by banks. To be

attractive, these funds must obviously deliver at least satisfactory results to those who

invest in the funds. But they are also under pressure to generate profits to their own

shareholders. Profits that typically come from management fees paid by those that invest

in the fund. For such funds, there is always a trade off in terms of the resources they spend

on attracting savers by improving the portfolio value (for example, through ownership

engagement) and the resources they spend on other classical means of attracting

customers, such as marketing and product differentiation.

Table 1. Determinants of ownership engagement

Purpose Not for profit For profit

Liability structure Long-term Short-term

Investment strategy Passive index Passive fundamental Active fundamental Active quantitative

Portfolio structure Concentrated Diversified

Fee structure n.a.1 Performance fee Flat fee Zero fee

Political/social objectives Political/social incentives No political/social incentives

Regulatory framework Engagement requirements Engagement limitations No legal requirements/limitations

1. Not applicable for not-for-profit institutional investors.

INSTITUTIONAL INVESTORS AND OWNERSHIP ENGAGEMENT

III.1.2. The liability structure

An important part of an institution’s business model is the choice of liabilities. Basically,

what kind of products they are offering the investors. Some institutions, like life-insurance

companies, specialise in long-term obligations, while the commitments of other institutions,

for example, mutual funds, are undefined or short term. When long-term obligations, for

example, the maturity of a pension plan, can be calculated with accuracy, the institution is able

to match its portfolio liquidity accordingly. The liability structure of, for example, mutual funds

on the other hand, where investors can exit without prior notice, typically requires a fully

liquid portfolio. The liquidity requirement may in some instances be an obstacle to ownership

engagement, for example, if board participation in a portfolio company triggers legal

restrictions on the shareholders ability to trade the shares in the company.

III.1.3. The investment strategy

There is no given number of investment strategies. And in principle we may find as

many investment strategies as there are investors. In Table 1, we have nevertheless

identified four main strategies that are associated with different business models and are

at the same time relevant for the degree of ownership engagement. The strategy “passive

index” is basically a (sometimes binding) commitment to hold a portfolio that mimics a

predefined index of shares. Indexes may be constructed in different ways, but the

important point here is that the composition is pre-defined. The companies are not

typically chosen on the basis of fundamentals and adjustments in the portfolio are not by

active choice, but rather the automatic result of changes in the index weighting. Many

mutual funds and pension funds use this strategy. Per definition, the holding period for

individual stocks is very long, or at least as long as another strategy is applied.

By “passive fundamental”, we refer to investors that initially make an active choice in

selecting the individual companies in which to invest and then keep them for an extended

period of time. Examples could be “strategic” national investments by a sovereign wealth

fund or core investments of a closed-end investment company.

The “active fundamental” strategy is supposed to illustrate a business model where an

investor relies on continuously buying and selling companies that are chosen on the basis

of fundamental analysis, for example, cash richness or fairly short-term growth potential.

This strategy is often associated with a high degree of, at least temporary, ownership

engagement to bring about certain changes in the company, such as an increase in

dividends. The strategy is often associated with so called “activist hedge funds”. Finally,

rather than being active and fundamental, institutions might apply an active strategy that

relies on the quantity rather than the quality of information about individual companies.

Such an “active quantitative” strategy is typically based on the large inflow of information

processed by sophisticated software and used in the form of high frequency trading that

has extremely short time frames for transactions and that benefits from stock exchanges’

co-location services. This choice of investment strategy provides minimal incentives for

ownership engagement.

III.1.4. The portfolio structure

A main determinant for the degree of ownership engagement arising from portfolio

structure is the degree of concentration. Or in other words, how many companies does the

institution have to look after. The degree of portfolio concentration obviously covers a large

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spectrum, from institutions with very few holdings, to institutions like CalPERS that hold

stocks in as much as 10 000 different companies. The implications for ownership

engagement are simply arithmetic. The costs of exercising the same quality of informed

and engaged ownership in 10 000 companies is obviously much higher than if you monitor

only a handful. This is why institutions with highly diversified equity portfolios abstain

from ownership engagement. Or minimise the costs of monitoring by buying services from

consultancy firms that carry out the function following a pre-defined formula. As one fund

manager put it “since we invest by formula we vote by formula”.10 While a highly

diversified portfolio is a pretty good determinant of an institution’s ownership engagement,

the same is not necessarily true for concentrated portfolios. An institution with a fairly

concentrated portfolio may still exhibit limited ownership engagement. Some foundations

and certain sovereign wealth funds could be examples.

III.1.5. The fee structure

As mentioned above, many institutional investors are themselves profit maximising

institutions that make money from the fees that they charge from their clients. There are

two main types of fees: i) flat fees, which are associated with, for example, mutual funds;

and ii) performance fees, which are typically associated with more sophisticated

institutions such as hedge funds and private equity firms. Some institutions also charge a

combination of the two. The way in which the choice of fee structure determines the

degree of ownership engagement is not straightforward. Ultimately, it will depend on how

the institution sees the costs and benefits of using a high degree of ownership engagement

to improve performance. Neither for mutual funds that charge flat fees, nor for

quantitative hedge funds that charge performance fees, is ownership engagement

typically an option. From the perspective of ownership engagement it is also of interest to

note that there are examples where the institution’s business model is to charge very low

or no fees at all, but rather rely on income from share lending. Some exchange traded

funds are examples of this.

III.1.6. The presence of political and social objectives

For profit making institutions, there is no a priori reason that political and social

objectives should enter as a determinant of ownership engagement. The extent to which

they do align their ownership engagement with such objectives is likely to depend on their

business model, marketing and product differentiation strategy. An example could be

mutual funds that want to attract investors who want to avoid holdings in certain

companies regardless of the returns. Not-for-profit institutions, such as public pension

funds, sovereign wealth funds and endowments may very well have political and social

objectives that translate into a certain kind of ownership engagement or positions on

specific governance issues.

A special case in point is the various types of public pension funds where the boards

are appointed by governments; sometimes following a formula of stakeholder

representation. In certain instances the most relevant framework for understanding the

incentives for ownership engagement in such institutions may be the public choice theory,

which applies economic tools to political science. Boards and managements in such

organisations may focus their ownership engagement on other aspects than the efficient

allocation and monitoring of corporate performance.

INSTITUTIONAL INVESTORS AND OWNERSHIP ENGAGEMENT

III.1.7. The regulatory framework for ownership engagement

While company law does not require any specific degree of ownership engagement

from individual investors, in some jurisdictions there is a complementary regulation that

does. Within the OECD, such regulations range all the way from quasi mandatory

obligations for certain institutions to vote their shares, to regulations that explicitly

prohibit certain institutions to vote any shares. In the United States, for example,

institutions that are subject to the ERISA Act are, according to an interpretive bulletin

in 2008, generally assumed to have a de facto obligation to vote all shares under

management. In the UK the Stewardship Code is an alternative way to encourage

shareholder voting. Conversely, in Sweden the Swedish pension fund AP7, which manages

pension savings for 3 million people, is explicitly prohibited by law from voting their shares

in any Swedish companies. The same is true for mutual funds in Turkey which are

prohibited participating in the governance of the investee companies. This has been

interpreted by the industry as a voting ban.

Between these extremes, countries can also have limitations on the portion of shares

in an individual company that an institution may hold and vote. In some instances, the

companies themselves may introduce voting caps that limit the number of votes a

shareholder cast in their articles of association. Voting caps are allowed in, for example,

Belgium, Denmark, France, Norway, Spain, the UK and the US. It is also fairly common that

the disclosure of voting policies and practices be addressed in their rules and codes. This is

the case in, for example, Australia, Chile, Denmark, Germany, Israel, Italy, Japan, the

Netherlands, Spain, Switzerland, the UK and the US, where regulations and/or national

codes include requirements to disclose voting policies (OECD, 2013).

While they would not be specific to any particular institution, there are sometimes

references to regulatory or administrative obstacles to cross-border voting (European

Commission, 2011; OECD 2011). However, considering the high turnout levels in the

countries with high foreign ownership, such as the UK with over 40% foreign ownership

and an average turnout of almost 70% in shareholder meetings, the obstacles to cross-

border voting may not have a significant impact on voting.

The institutional features and determinants for ownership engagement that are

discussed above are summarised in Table 1.

III.2. Levels of ownership engagement

In Section III.1, we discussed a set of factors and choices that influence an institution’s

ownership engagement. In the absence of strict regulatory requirements to engage or not

engage, the degree of ownership engagement is the result of these factors and choices that

together make up the institutions “business model”. The fact that the business model

includes the ownership of shares doesn’t in itself say anything about the institution’s

degree of ownership engagement. Both mutual funds and sovereign wealth funds own

equity. But their engagement as owner may vary greatly as a result of other factors, such as

purpose, investment strategy and portfolio diversification.

As a result of the factors and choices discussed in Section III.1, different institutions

will end up with different types and levels of ownership engagement. In a survey

from 2010, more than half of the asset owners and asset managers reported some form of

dialogue with the board or the management of investee companies. However, the character

of those contacts varied widely, from campaigns to persuade a company to change their

INSTITUTIONAL INVESTORS AND OWNERSHIP ENGAGEMENT

behaviour, to a routine conversation via an email exchange or a telephone call. It is worth

noting that 76% of the asset owners and 56% of the asset managers stated that they had

five or less staff members devoted to ownership engagement with investee companies

(IRRC and ISS, 2011). This number should be compared to the hundreds or perhaps

thousands of companies that these institutions may hold in their portfolios and are

expected to monitor. Against this background, it is not surprising that limited staff was

identified to be the main impediment to ownership engagement.

To illustrate different degrees of ownership engagement, we have identified four

different levels (or degrees) of ownership engagement ranging from zero engagement to

inside engagement. These are indeed fairly broad categories and a large number of

variations exist in reality. What is important here however is to illustrate the link between

the degree of ownership engagement and the different determinants that were discussed

in Section III.1 and summarised in Table 1. The conclusion is that any degree of ownership

engagement can be perfectly rational and a logical consequence of the choice of

determinants that make up the institutions “business model”. Below, we briefly discuss the

four broad categories of ownership engagement. It is important to remember that, in

principle, an endless number of variations between the two extremes could exist.

1. No engagement: This category comprises institutions that do not monitor individual

investee companies actively, do not vote their shares and do not engage in any dialogue

with the management of investee companies. Examples include those exchange-traded

funds that do not charge any fees to their investors, but instead generate income from

share lending (Wong, 2010). Another example would be institutional investors that are

subject to engagement limitations or an outright prohibition to vote their shares, like

Turkish mutual funds.

2. Reactive engagement: Reactive engagement represents voting practices that are primarily

based on a set of generic, pre-defined criteria that guide voting with respect to the

different proposals put before the shareholders’ meeting. Reactive engagement often

relies on buying advice and voting services from external providers such as proxy advisors.

It may also consist of reactions to engagement by other shareholders. For example, when

an otherwise passive shareholder supports initiatives by another institution such as an

activist hedge fund who is attempting to influence the dividend policy in a specific

company or to make changes to the board. It may also include reacting to public tender

offers from a private equity firm. Reactive behaviour is represented by many US pension

funds and mutual funds that – subject to legal requirements11 – vote their shares with the

help of proxy advisors and also respond to shareholder campaigns led by hedge funds or

private equity funds (Gilson and Gordon, 2013).

3. Alpha engagement: This engagement level is associated with ownership engagement that

seeks to support short or long-term returns above market benchmarks. Using quite

different strategies, both activist hedge funds and private equity funds can be examples

of alpha engagement. Hedge funds that practise alpha engagement usually influence

companies through small holdings, sometimes complemented by derivatives, actively

seeking the support of other investors to support their intentions (OECD, 2007). Private

equity firms on the other hand acquire large or controlling shares of companies in order

to be able to restructure the company, improve its performance and, within a pre-

defined period, sell with a profit.

INSTITUTIONAL INVESTORS AND OWNERSHIP ENGAGEMENT

4. Inside engagement: Inside engagement is an engagement level characterised by

fundamental corporate analysis, direct voting of shares and often assuming board

responsibilities. Owners at this engagement level typically hold controlling or large

stakes in the company. A good example might include a closed-end investment

company such as Berkshire Hathaway, Inc. This company is the largest shareholder in

Coca Cola, Inc. and is represented on the board of Coca Cola, Inc. by one of its directors.

Inside engagement may also be practiced by some sovereign wealth funds.

IV. Corporate governance taxonomy of institutional investors So far, we have discussed how informed and engaged ownership serves an important

economic function in society for the efficient allocation of capital and the monitoring of

corporate performance. But we have also concluded that many of today’s institutional

shareholders on rational grounds may not be willing to bear the costs for carrying out this job.

The degree of ownership engagement is not tied to ownership of shares itself or to the category

of institutional investor as such. Instead, the ability and willingness to serve as informed and

engaged owners is determined by a set of different features and choices that together make up

the institutions’ business model. In the previous section we examined seven features and the

choices that can be made. We are well aware that the list is not exhaustive. Other determinants

could be added and some of the existing ones dropped. At this stage however the main

objective is to illustrate a systematic approach to help us understand the factors that cause

large differences in ownership engagement between the large group of shareholders,

commonly referred to as “institutional investors” in the policy debate.

In this section, we illustrate how the features, choices and levels of engagement that we

discussed in Section III can be used as a taxonomy for describing an institution investor’s

business model and its impact on the character and degree of ownership engagement.

In Table 2, we have characterised institutional investors with respect to each of the

seven different determinants and choices and all four levels of shareholder engagement.

In addition to a hedge fund that practises high frequency trading, examples of “no

engagement” include an exchange traded fund that lends the shares in their portfolio and a

mutual fund that is subject to regulatory voting restrictions. They are all for-profit

institutions, with short-term liabilities, diversified portfolio structures and without any

specific political or social objectives. An important difference among them is the fee

structure. The hedge fund typically has a performance fee structure, the mutual fund a flat

fee structure based on assets under management of the fund and the exchange traded fund

doesn’t charge any fees to its investors, but generates income from share lending. While the

hedge fund pursues an active quantitative investment strategy based on sophisticated

software and co-location services offered by stock exchanges, both the mutual fund and the

ETF pursue a passive indexed strategy. For mutual funds subject to legal limitation on

engagement, this is a decisive regulatory condition for their ownership engagement.

For the reactive engagement level, the two examples in Table 2 are a public pension

fund and a sovereign wealth fund with a local investment arm. Both are not-for-profit

institutions with a long-term liability structure. However, while the sovereign wealth fund

has an active fundamental investment strategy for its diversified portfolio, the pension

fund pursues a passive index strategy with the same portfolio structure. This means that

the SWF buys and sells shares based on company specific information. The pension fund,

however, composes its portfolio based on a pre-defined index. The pension fund is

INSTITUTIONAL INVESTORS AND OWNERSHIP ENGAGEMENT

typically expected to hold a larger number of companies than the SWF. In both cases, there

is some political influence as governments directly appoint or can influence the

appointment of managers of the institutions. Additionally, the pension fund has a

requirement to vote their shares. With both differences and similarities in their business

models, they can both be classified as “reactive engagement”.

The fact that a voting requirement in itself does not lead to a higher level of ownership

engagement is rational in light of the pension funds other choice in terms of business model.

Particularly the choice of indexing as a means to pick its portfolio. If the policy rationale for

introducing a voting requirement is that the institution in the very first place is totally

passive, it is highly unlikely that the voting requirement in itself will change the level of

ownership engagement unless other features of the business model are changed at the same

time. With strong economic incentives working against engagement, a mandatory voting

requirement can only lead the horse to the water, but it can’t make it drink.

Alpha engagement is illustrated by a private equity firm and a hedge fund. The private

equity firm is a closed end investment pool with a long term (or at least defined) liability

structure. The hedge fund on the other hand, is structured as an open-ended pool with

withdrawal options for investors and a short-term (or undefined) liability structure. The

rest of the determinants are the same for the two of them; they both have an active

fundamental investment strategy, concentrated portfolios and a performance related fee

structure. Neither of them is under any political or social pressure for shareholder

engagement, nor do they have any engagement requirements or limitations. Without any

Table 2. Corporate governance taxonomy of institutional investors

Not for profit For profit

Long-term Short-term

Passive index Passive fundamental Active fundamental Active quantitative

Concentrated Diversified

NA Performance fee Flat fee Zero fee

Political/social incentives No political/social incentives

Engagement requirements Engagement limitations No legal requirements/limitations

Purpose

Liability structure

Investment strategy

Portfolio structure

Fee structure

Political/social objectives

Regulatory conditions

Taxonomy

Inside engagementAlpha engagementReactive engagementNo engagement • Hedge fund (HFT) • ETF (share lending) • Mutual fund (subject to voting ban)

• Public pension • SWF (foreign investment)

• Hedge fund • Private equity

• SWF (local investments)

• Investment company

H ed

ge fu

nd H

M ut

ua l f

un d

ET F

P ub

lic p

en si

S W

F- F o

re ig

H ed

ge fu

Priv ate

equ ity

S W

F- Lo

ca l

Inve stm

ent com

pan y

INSTITUTIONAL INVESTORS AND OWNERSHIP ENGAGEMENT

legal or regulatory requirements to seek returns above market benchmarks they both – but

through different means – exercise a high degree of ownership engagement.

The last level of ownership engagement, inside engagement, is illustrated by a SWF

and a closed-end investment company. Both with controlling or significant stakes in listed

companies. The SWF, as a government investment arm, is a not-for-profit institution with

political incentives. The bank is a for-profit institution without any political or social

requirements in terms of ownership engagement. Neither of them have any short-term

liquidity constraints and both pursue a passive fundamental investment strategy with a

portfolio that consists of a limited number of companies. Their engagement is typically

characterised by direct involvement in the decision-making process of a company, often

through participation on company boards.

There have been other attempts to classify institutional investors. The taxonomy

presented above differs from most of them, since it does not aim at grouping different

categories of institutional investors based on a specific and systematic criteria. Rather, the

purpose is to show that in terms of ownership engagement, different institutions from two

different categories may have more in common than two institutions from the same

category. While the taxonomy is highly simplified, it is obvious that the informed reader, by

using examples from real life, can come up with an almost endless number of combinations

of features and choices that in different ways influence the character and degree of

ownership engagement. And at this stage, there are at least three important messages:

1. In order to understand the level of ownership engagement we need to identify a whole

range of different determinants.

2. Legal or regulatory requirements for voting may have little effect on ownership

engagement if other and more dominant determinants for ownership engagement

remain unchanged.

3. Institutions with the highest degree of engagement typically have no regulatory

obligation with respect to the degree of their ownership engagement.

Notes

1. Data for 1963 and 2011. The US Federal Reserve (www.federalreserve.gov).

2. Data for 2011. The Bank of Japan (www.boj.or.jp).

3. Data for 1963 and 2012. The UK Office for National Statistics (www.ons.gov.uk). The share of foreign portfolio investors has also increased dramatically in the United Kingdom from 7% to 53% between 1963 and 2012. However, national data do not identify foreign owners with respect to their category (e.g. individuals, pension funds). As a consequence, the increase in foreign ownership makes it increasingly difficult to track the relative importance of different categories of owner at a national level. In addition, it is argued that the foreign ownership data for UK is exaggerated since it includes holdings by asset managers whose parent company is US based but management is conducted from the UK and the manager may be acting on behalf of UK clients (Kay Review, 2012).

4. The 2012 revision of the UK Stewardship Code includes a classification of institutional investors as asset owners and as asset managers. According to the Code asset owners are the providers of capital including pension funds, insurance companies, investment trusts and other collective investment vehicles whereas asset managers are institutions responsible for day-to-day management of investments.

5. In addition to traditional institutional investors, OECD Institutional Investor Database provides data on other forms of institutional savings under “Other” category, including foundations and endowment funds, non-pension fund money managed by banks, private investment partnership and other forms of institutional investors. Institutions in Other category had USD 1.8 trillion in assets under management as end of 2011.

http://www.federalreserve.gov

http://www.boj.or.jp

http://www.ons.gov.uk

INSTITUTIONAL INVESTORS AND OWNERSHIP ENGAGEMENT

6. Investment funds include mutual funds and other investment funds. In some countries, “collective investment schemes” is used to refer investment funds.

7. Market capitalisation data from World Bank World Development Indicators.

8. Of which, sovereign wealth funds, USD 4.8 trillion; private equity firms, USD 3.4 trillion; hedge funds, USD 1.8 trillion and exchange traded funds, USD 1.4. trillion (Sources: SWF Institute, IMF, Preqin, BlackRock).

9. There are also 1 210 other exchange traded products (ETPs) that are similar to ETFs in the way they trade and settle. These products, that do not use a mutual fund structure, had USD 174 billion under management at the end of 2011 (BlackRock, 2012).

10. The director of proxy voting services at Wells Fargo (Lowenstein, 1991).

11. The ERISA Act of 1974 and interpretive guidance 1994 and 2008.

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