Economist John Kay has published the Final Report of his independent review of investment in UK equity markets and its impact on the long-term performance and governance of UK quoted companies.

Professor Kay concludes that short-termism is a problem, driven principally by the decline of trust and the misalignment of incentives in the investment chain. He wants to shift regulatory philosophy and practice towards supporting market structures that create appropriate incentives, rather than using detailed rules of conduct to counter inappropriate incentives. He has put forward 10 high-level principles and 17 recommendations to encourage long-term investment and mark out the directions in which regulatory policy and market practice should move. Most of these focus on the role of asset managers but a number are of interest to listed companies.

We have identified the following key recommendations for asset managers and corporates:

• Fiduciary duties – Professor Kay’s recommendations here could be significant. He wants fiduciary standards to apply to all relationships in the investment chain that involve discretion over the investments of others or advice. While this seems uncontroversial at first sight, he notes that some agreements try to create a purely contractual relationship. He therefore recommends that it should not be possible to contract out of fiduciary standards. In this connection he specifically recommends that all income arising from stock lending should be disclosed and rebated to the client. He also believes the FSA principles on treating customers fairly and handling conflicts of interest fall short of these standards and should be strengthened.
• Asset manager remuneration – Asset management firms should structure managers’ remuneration so as to align their interests with those of clients. A long-term performance incentive should take the form of a (direct or indirect) interest in the relevant fund, to be held at least until the manager is no longer responsible for it.
• Engagement by asset managers – Professor Kay wants asset managers to act as stewards of their client’s property and engage with investee companies. Specifically he recommends that the Stewardship Code should be developed to reflect the fact that asset managers should focus on strategic issues as well as corporate governance. It is unclear how effective he expects this to be, as he recognises that the lack of incentive for engagement is an inescapable feature of the investment landscape.
• Cost disclosure by asset managers – This has long been a controversial issue. The Investment Management Association is due to issue new guidance to members on disclosure shortly. Professor Kay recommends that if this produces inadequate results, full and meaningful disclosure should be achieved by regulation.
• Investment performance metrics – Commonly used performance metrics are criticised for their focus on short-term relative performance when what asset owners are interested in is long-term absolute performance. Professor Kay recommends that there should be an independent review of metrics and models used in the investment chain to highlight their uses and limitations.
• Investors’ forum – Professor Kay proposes an investors’ forum to facilitate collective engagement by institutional investors in UK companies, with asset managers as critical participants. The forum would discuss issues of company strategy and corporate governance generally, as well as issues arising at particular companies. He recommends that the government should ‘explicitly encourage’ the establishment of the forum – in particular, he thinks this would encourage sovereign wealth funds to participate – but some have queried whether investors would be willing to take part, especially those based outside the UK.
• Good practice statements – Company directors, asset managers and asset holders should adopt the ‘good practice statements’ set out in the report to promote stewardship and long-term decision making. Professor Kay says that he favours guidance over regulation because it allows flexibility to individual circumstances and for change over time. He encourages regulators and industry groups to align existing standards, guidance and codes with the good practice statements.
• Directors’ remuneration – Companies should structure directors’ remuneration to relate incentives to sustainable long-term business performance – in particular, long-term performance incentives should be provided only in the form of shares which should be held at least until after the executive has retired from the business. This would involve a fundamental change in remuneration design. The review does not elaborate – for example, how LTIPs with performance targets would fit in – but Professor Kay clearly has in mind longer vesting periods for share awards than the customary three years. His ideas chime with some existing developments in the market, including the concept of ‘career shares’ – awards with very lengthy vesting periods that are not subject to conventional performance targets. The thinking here is that a lengthy vesting period (for example, five or seven years) may be a substitute for conventional performance targets measured over a shorter period. All this raises complex issues, including (i) whether it is really sensible for directors to have most of their wealth tied up in the company’s shares; and (ii) how the concept of a ‘vesting’ (basically, leavers losing their share awards) should be applied. Taken at face value, Professor Kay’s suggestion would itself involve a perverse incentive – encouraging a ‘rush for the door’ by resigning from the company in order to be able to realise shareholdings. Of course, directors’ remuneration is very much in the news at the moment, and Professor Kay’s ideas are a useful contribution to the mix.
• Directors’ appointments – Companies should consult their major long-term investors over key board appointments.
• Merger activity – The scale and effectiveness of merger activity of and by UK companies should be kept under careful review by the government and by companies themselves.
• Managing short-term expectations – Companies should seek to disengage from the process of managing short-term earnings expectations and announcements.
• Quarterly reporting – Mandatory interim management statement (quarterly) reporting obligations should be removed. The European Commission has already proposed removing this requirement from the Transparency Directive.
• Narrative reporting – The report says that high quality, succinct narrative reporting should be strongly encouraged. The government has already consulted on changes to the narrative reporting regime and plans to publish draft regulations later this year.
• Individual holdings on electronic register – The government should explore the most cost-effective means for individual investors to hold shares directly on an electronic register.

While Professor Kay’s emphasis on incentives and structures seems well-founded, there is one structural problem which he does not address, and which may not have a solution. He does not make any recommendation about the short-term nature of asset management appointments by institutional investors, which many think is at the heart of the problem of short-termism. If your client (and its advisers) are monitoring your performance by reference to quarterly performance, it is very hard for a fund manager to hold to a long-term approach (especially a contrarian one). And although he recognises that mark to market accounting encourages short-term thinking, he does not comment on the fact that the mark to market approach has now been enshrined in Solvency II and other regulatory capital requirements which makes it much more costly (in capital terms) for affected institutions to invest for the long term in securities which may be price volatile in the short term.

It is also not yet clear how the report’s objectives will be achieved – it makes few concrete proposals for action. Professor Kay says that he has tried to avoid prescriptive regulation wherever possible in framing his recommendations and that ‘the cultural changes we seek can be achieved only by changing the structure of the industry and the incentives of those who work in it, not by ever more prescriptive rule books of behaviour’.

The government has said that it will consider the report in depth and respond in detail later this year. Other responses to the report have been mixed. The Institute of Directors has broadly welcomed it, while reserving judgement on whether some of Professor Kay’s conclusions are ‘workable and appropriate’. According to the FT, ‘the investment industry response… runs the full gamut, from optimistic expectation of change in investment culture to a cautious wait-and-see attitude and outright disagreement’.