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Institutional Investors and Corporate Governance Reform

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By Kirsty McHugh, OUP UK

Chris Mallin is Professor of Corporate Governance and Finance & Director of the Centre for Corporate Governance Research at the University of Birmingham. She is the author of Corporate Governance and she blogs with fellow OUP author Bob Tricker at Corporate Governance. The below post, on institutional investors and corporate governance reform, is an adapted version of one found on that blog. Her previous OUPblog posts can be found here, here, here and here.


Corporate governance codes and guidelines have long recognised the important role that institutional investors have to play in corporate governance. As well as being influential in their home countries, institutional investors have increasingly become a more significant force in other countries through their cross-border holdings. Recent corporate governance reforms motivated by the global financial crisis have placed even more emphasis on the role of institutional investors.

Back in 1992, the Cadbury Report recognised the role played by institutional investors stating that ‘we look to the institutions in particular ‘ to use their influence as owners to ensure that the companies in which they have invested comply with the Code’. Various codes since then have emphasised the importance of the role. The Financial Reporting Council (FRC) publishes the UK’s Combined Code on Corporate Governance (commonly known as the Combined Code). The Combined Code (2008), in Section E, identifies three main principles. Firstly it states that ‘institutional shareholders should enter into a dialogue with companies based on the mutual understanding of objectives’; secondly ‘when evaluating companies’ governance arrangements, particularly those relating to board structure and mallincgbookcomposition, institutional shareholders should give due weight to all relevant factors drawn to their attention’; thirdly, ‘institutional shareholders have a responsibility to make considered use of their votes.’ The first and third principles relate to two of the tools of governance being dialogue and voting. All three principles essentially require institutional investors to behave in a responsible and conscientious way, taking all relevant factors into account and making considered decisions.

The UK Treasury commissioned the Walker Review of Corporate Governance of UK Banking Industry which reported in November 2009. The Walker Review recommends ‘strengthening the role of non-executives and giving them new responsibilities to monitor risk and remuneration; it also recommends a stewardship duty on institutional shareholders to play a more active role as owners of businesses.’ Kate Burgess and Brooke Masters in their article ‘Institutions urged to adopt tougher stance’ states ‘Institutional investors are being urged to be tougher on company boards by Sir David Walker, as the City grandee adds his weight to pressure for them to take their responsibilities more seriously.’

The FRC has agreed to implement those recommendations that it considers should apply to all listed companies. In addition the FRC has agreed to consult on adoption of a Stewardship Code for institutional investors as recommended by Sir David.

A recent review of the Combined Code has however recommended that Section E of the Code (addressed to institutional shareholders) be removed, ‘subject to sufficient progress being made on the Stewardship Code for institutional investors and its associated governance arrangements.’ The Stewardship Code for institutional investors as was proposed by Sir David Walker, and is an area on which the Financial Reporting Council (FRC) will be consulting separately.

The final report on the review of the Combined Code (2008) makes various recommendations which include, inter alia, annual re-election of the chairman or the whole board; new principles for the roles of the chairman and non-executive directors. Kate Burgess in her article ‘Sir Christopher misses out on succession planning’ highlights that more emphasis should have been put on succession planning in companies as this tends to be a weakness in many firms. Moreover it would be beneficial to investors in their stewardship role to have more knowledge of the process in place for succession planning.

The Institutional Shareholders’ Committee (ISC) membership comprises the Association of British Insurers, the Association of Investment Trust Companies, the National Association of Pension Funds, and the Investment Management Association. The ISC has previously published guidance on the responsibilities of institutional investors in 2002, 2005 and 2007. In November 2009, the ISC published its Code on the Responsibilities of Institutional Investors which is included as an Annex in the Walker Review and which is widely viewed as the basis for the Stewardship Code which will be monitored for the adherence of institutional investors on a ‘comply or explain’ basis. The ISC states that ‘the Code aims 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.’ The Code discusses the stewardship responsibilities of institutional investors which include effective monitoring of investee companies and voting of all shares held.

Of course in order to carry out their responsibilities as shareholders, institutional investors need to be able to exercise their rights effectively – if they cannot, then they may be tempted to exit, i.e. to sell their shares. An article in the Financial Times, ‘Shareholder rights’ points out that ‘if selling the shares is a blunt instrument, then removing board members is the sharpest. More than nine in 10 international investors say the ability to nominate, appoint and remove directors is the most valuable shareholder right. It is wrong that efforts to boost this power in the US have been delayed by the business lobby.’ Clearly it is in the interests of effective stewardship for institutional investors to be able to exercise their rights. This will enable them to take action on prominent topical issues such as having a ‘say on pay’ in relation to directors’ remuneration, and removing underperforming directors from the board.

However another dimension to consider is that of free riders. Ruth Sullivan in her article ‘Walker plan points finger at freeriders’ points out that some institutional investors will not engage more with their investee companies and be active owners, rather they will save their time and money and free ride on the efforts of other institutional investors.

The recent reforms mooted by the Walker Review and the Review of the Combined Code have made recommendations which will help to strengthen corporate governance in the UK. The role of institutional investors is seen an important one and institutional investors are being encouraged to engage more fully in their role as owners and adhere to the ISC Code of Responsibility for Investors.

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