Responsible capitalism
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By Vince Cable - Secretary of
State
22/11/2012
Introduction
Good morning. It is no exaggeration to say the pensions
industry is a lynchpin of the economy. Pension fund investments are a
critical source of capital for UK companies, and potentially for
infrastructure as well as savings vehicles.
Collectively, you hold over £150bn of UK equities. That figure
illustrates the scale of your influence, but it goes much further than
merely delivering returns to fund tomorrow’s pensions for today’s
workers.
Careful husbandry over long timescales, a core duty for any pension
fund, is an essential component in a system of responsible capitalism
that encourages the pursuit of long-term value rather than short-run,
sometimes illusory, returns.
So I would like to focus today on the work we are doing in government
to support such a system – because it is clear we have a long way to go
before we can say it exists.
Equity investment has become increasingly complex and intermediated,
with more and more links in the chain. As a result, the different
players are often working to their own agendas and timescales to the
detriment of long-term value creation.
Too often, traders go after a quick buck rather than looking for
sustainable returns based on sound stewardship of companies. Holdings
are bought and sold to turn a short-term profit with no thought given
to the underlying fundamentals.
This phantom chase was at its most frantic in the financial
markets, where banks took dross and sold it as gold. But that lack of
responsibility – the failure to take calculated investment risks based
on sound principles - is more widespread.
Capitalism
The issue of so called short-termism is part of a wider debate
about capitalism and whether it should be constrained by a wider sense
of responsibility. So, what do I mean by responsible capitalism? Let me
explain by quoting Adam Smith, who said:
"It is not from the benevolence of the butcher, the brewer, or the
baker that we expect our dinner, but from their regard to their own
interest. We address ourselves, not to their humanity, but to their
self-love, and never talk to them of our own necessities, but of their
advantages."
But Adam Smith himself was scathing about some forms of business
behaviour - particularly those that led to the suppression of
competition. He wrote “people of the same trade seldom meet together
even for merriment and diversion, but the conversation ends in a
conspiracy against the public.”
I realise that there some irony in using this particular quote in a
speech to a trade association conference. But Smith’s conception of
self-interest is distinct from the crude, material, selfishness we have
seen. Elsewhere in his writings he discusses the notion of sympathy, or
fellow feeling, and emphasises its importance. So Smith’s butcher or
baker cannot pursue their self-interest and obtain what they want
without also meeting the needs of the customer. .
The pursuit of self-interest is not inherently irresponsible: the
desire to trade and profit produced meat, beer and bread in Smith's
day, and today has given us iPads, foreign holidays and life-saving
drugs. What connects these things is their reliance on individuals
acting in their own interests to deliver goods and services that
benefit us all.
It is difficult to reconcile Smith’s butcher, brewer and baker with the
complexity of today’s capitalism. Indeed the modern public company with
dispersed shareholder ownership did not exist at that time. But they
would have recognised the key role that trust and confidence play in
effective markets. Without them, no economy can function effectively.
We have seen too many examples of irresponsible capitalism recently.
Companies not paying their taxes. Employees making up the numbers or
gambling the future of the entire company. Customers being sold complex
products they neither need nor want. Managers helping themselves to
lavish remuneration packages at the expense of customers, their
shareholders and their workforce.
Sir Roger Carr, the CBI’s President, acknowledged the problem at its
annual conference on Monday. He said:
“…standards have been variable, greed prevalent and fairness forgotten
in a number of sectors – banking and media at the forefront – but
others from all walks of life showing signs of bad behaviour.”
As someone who found myself labelled “anti-business” for criticising
the excesses of banking and media barons I empathise totally with Sir
Roger. He, like me, is of course pro-business.
But like many in this room and in business we share a sense of dismay
at some recent behaviour. I believe the majority of businesses play by
the rules, pay their taxes and contribute to the economy. Where they
don’t, Government has a duty to intervene. But as owners, institutional
investors have a major role in challenging and correcting this
behaviour.
Our task together is to reform the system in order that trust is
restored because, without it, the capitalist system cannot function
effectively.
There are fundamental questions about why parts of the capitalist
system have gone awry. At least part of the industry’s problem is one
of distorted perspective – a prevailing focus on the short term at the
expense of the long-term.
The Kay Review
This was the supposition which led me to invite John Kay to
look at this problem in the round. And he has subjected the UK’s equity
markets to rigorous independent review with support from Sir John Rose,
formerly of Rolls Royce, Chris Hitchen of Railpen and James Anderson of
Baillie Gifford
His findings amount to a compelling argument that today’s transactional
cultures and the pursuit of short-term gains in financial markets are
undermining the core responsibility of company directors and
institutional investors to act as effective stewards of the assets they
control.
The long-term pursuit of value creation has been crowded out by a focus
on short-term gains.
Company directors have a clear legal responsibility to make decisions
with regard to the long-term. This is part of their duty to promote the
success of the company. Engagement by investors needs to change to
support directors to meet this responsibility. The focus should be
aligned with the timescales of the company's business model - which may
be very long term.
And the stewardship relationship must be based on an understanding of
company fundamentals. That’s the best way to create an environment of
trust and challenge, which enables those managing the company to take
sound long-term decisions on investment and strategy.
John Kay found there is a particular problem in how the performance of
active asset managers is currently measured. Faced with the need to
deliver short-term performance, active asset managers will have an
incentive to focus on what the market is doing - seeking to outperform
other asset managers - rather than to engage with companies to
understand and foster the creation of value.
So pension schemes and other asset holders need to issue clear mandates
for active asset managers. They must set targets to achieve absolute
returns that meet the needs of savers rather than just chasing the
market.
That approach will send a strong signal that it’s time the
short-termism ended and was replaced by a clear-sighted focus on
long-term value creation.
I am grateful to John for his cogent analysis of the problems in the
corporate sector. Today I am publishing the Government’s response to
his review. It focuses on restoring relationships based on trust and
confidence to the investment chain. The report has provoked
constructive debate on many of the issues raised, and progress is being
made on a number of the recommendations.
The Financial Reporting Council has revised the Stewardship Code to
give a sharper emphasis on long-term company strategy, reinforcing the
message that engagement has to be more than a box-ticking exercise.
Instead, it requires genuine dialogue with companies about the
long-term prospects for growth.
Investors are also recognising they need to engage collectively with
companies. The review recommended an investor forum to maximise their
influence, and there are encouraging signs that this will happen soon.
I am happy to be a catalyst but it is not for government to create a
new quango – a forum will only succeed if it is created and run by the
investors it represents.
High on the to-do list for any forum is to tackle overly complex
incentive schemes which encourage short-termism and tend to pay out
asymmetrically. Some executives see spectacular rewards for good
performance but there is no corresponding fall in pay when performance
is poor.
John Kay called on companies and asset managers to change their own
practices. Our reforms to executive pay – including giving shareholders
a binding vote on pay policy for the first time - will support this by
empowering investors to engage more effectively with companies.
We have come a long way in the last year. The shareholder spring has
shown there is real appetite among shareholders to be much more
challenging of unjustified pay awards.
The crucial factor is ensuring investors have the information they need
to make long-term decisions, on pay and a range of other issues. John
Kay was scathing about the effect of quarterly reporting on long-term
investment. I agree with his analysis, and the government will work
with our European counterparts to change the law so it is no longer
required.
But there is a challenge here too for asset owners, including pension
funds, who need to look beyond quarterly performance to judge their
managers.
Our narrative reporting reforms, to encourage better quality annual
reports that put the numbers into context, will help. The new rules,
which come into force next year, will make reports simpler, more
relevant and more focussed on forward looking strategy.
Trust is also the product of behaviour – a commitment to act with
integrity and expect integrity from each other.
The term 'Fiduciary duty' is used a lot in the debate on these issues,
but it means different things to different people. We need clarity,
with consistent standards of behaviour required throughout the
investment chain.
So today we are making it clear that all intermediaries should act in
good faith in the long-term interests of clients or beneficiaries.
These standards should be universal and immutable. We need to achieve
them by making sure that our regulatory framework supports them - but
also by promoting them as behavioural norms in the investment industry.
So we will ask the Financial Conduct Authority to consider whether
their regulatory rules and approach support these standards and, where
necessary, we will argue for changes to regulatory requirements at EU
level.
In addition, we are asking the Law Commission to conduct a review of
the legal obligations on investment intermediaries seeking to act in
their clients’ best interests – and to report back as soon as is
practicable
Takeovers bring the discussion of duty and long-termism into
particularly sharp focus. Company directors have a legal duty to
promote the success of the company. A duty that requires that decisions
be made with regard to the long-term consequences.
Company directors must recommend that shareholders reject a bid if they
believe that the transaction will destroy long-term value, or that the
premium being offered does not reflect the fundamental value of the
company. Directors must give their best advice to shareholders.
Shareholders must then decide what to do.
Owners and asset managers have a vital role here. In order to protect
their long-term financial interests they must challenge management to
explain the strategy and logic of large deals and provide robust,
consistent push-back where they have concerns. Events continue to show
it is as true for the shareholders in the bidding company as it is in
the target.
I understand that the Takeover Panel are carrying out a review of the
impacts of last year's changes to the Takeover Code. I look forward to
seeing their findings, and their assessment of the progress that has
been made.
In the light of the debate around takeovers in the wake of the Kraft
acquisition of Cadbury, I was anxious to ensure that takeover activity
should be subject to greater transparency over fee incomes, and that
rules should not play into the hands of short-term speculative
investors. I therefore welcomed the reforms by the Takeover Panel.
But Government also has a wider role to play here - particularly in
strategically important sectors. This is recognised by the current
legal framework, and we are not proposing to change it. It is important
that companies focus on creating sustainable competitive advantage, not
on complex merger and acquisition strategies that destroy shareholder
value.
Takeovers are part of a wider context: the need to ensure that the
bedrock of the capitalist system – the competitive market – functions
as effectively as possible. The government is consequently
strengthening the regulatory framework to create a single, powerful
competition authority – the Competition and Markets Authority.
It will have a duty to promote competition for the benefit of consumers
and will observe the principle of supporting long-term growth. This
objective will be formally embedded in its performance framework.
We will also ensure that the Competition and Markets Authority works
closely with sector regulators to more vigorously tackle competition
issues in regulated sectors.
All of the areas I’ve discussed depend on effective engagement between
companies and their owners for progress to be made. So to fuel to the
cultural change that’s required, we are endorsing John Kay's
‘Principles for Equity Markets’ - and the directions for market
practice which flow from these.
In particular we have challenged leading industry bodies - including
the NAPF - to review the report's Good Practice Statements. I am
delighted the NAPF has accepted this challenge.
And to measure the headway we are making on John Kay’s recommendations
we will publish a progress check in eighteen months’ time, setting out
how Government has taken forward the recommendations and how well
companies and investors have stepped up to the plate.
Industrial Strategy and Financial Services
There are other major policies afoot which have at their heart
an attempt to inject a more long term approach to business decision
making. One is the industrial strategy in which we sit down with
sectors like aerospace, life sciences, automobiles, energy supply
chains, and others to plan the long term implications for skill
development, technological change and innovation and procurement.
Another is financial services. Tim Breedon’s recent review for me found
the UK has one of the most sophisticated financial centres in the
world. But UK businesses outside the financial sector aren't getting
the benefit from this. There is a kind of enclave development
unconnected with the real economy.
One specific example is that while the City can provide a range of
sophisticated services to international business, British medium and
small companies cannot get long-term, patient capital for love nor
money.
So, we need to fundamentally change the system so the financial
services industry serves businesses, and not the contrary.
We are taking a number of steps to reform the banking industry, but we
need to go further and reshape the business finance market. That is why
I have announced the creation of a business bank that will have as its
core mission to stimulate competition in the business finance markets
and make them work for businesses.
With a clean balance sheet, and £1bn worth of funding, this bank will
be tasked with expanding lending and investment to the manufacturers,
exporters and high growth companies that power our economy, in
particular addressing the need for long-term, patient capital.
We will shortly announce the appointment of an advisory group for the
bank. Its task will be to help shape the design and its future
activities.
Wider work
There are many other areas that will help promote long
termism, and truly responsible capitalism, such as greater diversity in
workforces - especially in the boardroom, the growth of social
enterprise and alternative models such as employee ownership and
mutuals. I cannot hope to go into detail on all of these areas in this
speech, but we are making good progress.
Conclusion
This then, is the government’s clear priority – ensuring we
have a market economy rooted in a system of responsible capitalism.
Expectations of the market system have changed since the financial
crisis – after paying for its reconstruction, UK citizens must see and
share in the benefits of recovery and growth.
The far-reaching reforms I have discussed today will help, but they are
the start of a much longer process. One that requires a change in
attitude and behaviour among key players in the system.
Many companies are beginning to recognise this, and are investing in
jobs, skills, supply chain development, and other areas that will help
create long-term value.
It is only by responding to these concerns that we can restore trust in
markets - and as major shareholders you are in a uniquely strong
position to help achieve that.
About the Author
© Crown Copyright. Material taken from the BIS Department for Business, Innovation and Skills. Reproduced under the terms and conditions of the Click-Use Licence.
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